By Roger W. Bowlin
Investors should explore the possibility of exchanging before closing on the sale of investment property.
The “Section 1031 Tax Deferred Exchange” is an important option to consider when selling your appreciated investment real estate. A wide range of investment objectives can be met through exchanging.
I. PRESERVATION OF EQUITY (see illustration below)
A properly structured exchange provides real estate investors with the opportunity to defer 100% of both Federal Capital Gain taxes. This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash. Often the capital gain taxes are deferred indefinitely because many investors continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with each exchange and holding until eligible for the “step-up in basis” allowed in the tax code.
Many investors exchange from a property where they have a high equity position, or one that is “free and clear”, into a much more valuable property. A larger property may potentially produces more cash flow and provides greater depreciation benefits, which therefore increase the investors’ return on their investment.
Those who exchange have a number of opportunities for diversification. This can be by owning more properties, located in different markets and of different property types. An example would be to diversify geographically into regions of high growth a mature market. For example exchanging out of one apartment building in Queen Ann for two additional properties – a retail strip center in Vancouver, Washington, and an apartment building in Austin, Texas (neither with a State Income Tax). One could also consider a vacation rental in Jackson Hole, Wyoming, eventually converting it to one’s primary.
IV. MANAGEMENT RELIEF
Some investors accumulate several single-family rentals over the years. The ongoing maintenance and management of what can be a far-reaching group of properties can be lessened by exchanging these properties for one property better suited to on-site maintenance and management. Exchanging into a single apartment complex with a resident manager is a good example of this strategy.
V. ESTATE PLANNING
Sometimes a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property, which they can either hold or sell.
Keeping ALL your equity working for you is the greatest benefit of the exchange.
The example below illustrates this. Assume a real estate investor has held an investment property for many years and will have $500,000 in net proceeds after closing. Also assume this property has $500,000 of capital gain and $200,000 of this gain is due to depreciation recapture. As you can see in the comparison below, the investor who exchanges can obtain considerably higher investment returns from deferring the payment of capital gain taxes. The current low rates for financing provide a unique opportunity for investors to lock-in excellent loan terms.