The Tax Cuts and Jobs Act of 2017 changed the realm of acceptable application of IRC Section 1031. The remaining acceptable uses benefits Real Estate Investors as all but uses in real estate were removed. Here’s how real estate investors can benefit from a 1031 Exchange.
Whenever a long term real estate investment in the US is sold for a “gain”, several forms of tax liability may be triggered – federal capital gains tax, state related taxes (depending on the state), accumulated depreciation recapture tax and potentially others.
With IRC Section 1031, a properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property with the potential to defer all of these taxes. IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
An EXAMPLE Of A Typical 1031
- A family bought a home in 1989 in a prominent Southern California coastal community with great schools for $425,000. The kids attended local schools, went away for college and returned for a short time until they moved out permanently when they got jobs. In 2012 the parents downsized, but kept the home as a rental. The property rented well at $5,600 per month, but after all of their costs and making the payment on the loan, they were still coming out of pocket to cover an annual loss of $17,000.
- Clearly not a sustainable situation, they decided to sell in 2017. After $100,000 in improvements over the time of their ownership and paying off a $1,000,000 loan at sale, their $1,600,000 sale turned in to $480,000 in proceeds with approximately $1,450,000 in gain. Without a 1031 exchange they may owe as much as $450,000 in gain related taxes. The remaining $30,000 in cash after paying taxes might be a great deposit to place in the bank, but it isn’t going to provide much support to retirement income. (Lets hope they did something smart with the cash out refi proceeds!)
- Now consider how this hypothetical family may benefit from a properly structured 1031 exchange. By keeping all of the cash proceeds from the sale with a qualified intermediary and utilizing them for the purchase of 10 homes at a 5% cap rate in San Antonio for $1,430,000 and a 70% LTV $1,000,000 loan they are able to defer all of their gain related taxes. Further, their net income before making loan payments doubled and the previous $17,000 annual loss is transformed to $6,800 in the positive after making their loan payments.
It’s clear from this example that a 1031 can be a key tool for investors to realize great benefit.
An even more well informed investor may have elected to sell 2 or 3 years earlier to also achieve the benefits of section 121 Home Sale Gain Exclusion. Conatus Real Estate is here to help you understand what may be the best decisions to make related to your investment property.
1031 exchanges can provide for great benefits, but are complex and take a lot of coordination to execute. Conatus Real Estate takes care of all of the headaches so all you need to stay on top of are the benefits. Give us a call at 949-267-3990 for insight as to what a 1031 sizing may look like for your situation.
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