Tax Deferred Exchanges — 1031s — THE Crucial Question
I literally haven’t a clue how many exchanges I’ve executed in my career. When asked, I usually just say ‘over 200′ cuz that’s when I stopped the silly practice of keepin’ score. Wanna know how to prove I’ve never had an exchange disallowed or fail? That one’s easy — cuz I’m above ground writin’ this. 🙂 Seriously, what would you do if somebody cost you five or six figures in taxes you never should of owed? After doing a few dozen I realized most folks seemed to think the tax deferred exchange was evidence they’d made it as an investor. Nothing could be further from the truth. Fact is, if by planning or just plain luck you can manage to avoid a 1031 exchange, and still come out smilin’, you’ll most often be better off. That statement surprises many investors, always has. So, the crucial question is: Do I really need to execute a tax deferred exchange, or is there a superior alternative?
The ability to defer capital gains taxes (and other taxes) is simply a tool found in Section 1031 of the Internal Revenue Code — NOT the be all, end all magic wand of real estate investing. In fact, using it needlessly will actually penalize the investor as time passes.
There are many consequences not necessarily beneficial resulting from 1031 exchanges. Possibly the biggest pain in the patute is the baggage you, as the exchanger must carry with you — adjusted basis. (Oversimplified stoopidly to the max, it’s price paid, minus depreciation, plus capital improvements, plus costs of sale.) Adjusted basis is like the freakin’ Scarlet Letter for some. It decreases what might’ve, or more accurately put, would’ve been your annual post transaction depreciation. It also — and this is understated as merely critical to understand — increases your capital gain if you ever sell what the IRS lovingly refers to as ‘the acquired’ property(s). Over the years I’ve had the pleasure to have saved dozens of taxpayers literally millions of dollars in completely unintended capital gains taxes. Most of the time it was a direct result of either the investor or their agent calling me to âmake sure' they were doin' things according to the IRS version of Hoyle. Um, no, you aren’t. Though I have myriad war stories on that point alone, a guy in my own town of Paradise, I mean, San Diego, probably has 20 for every one of mine. His name is Bill Exeter, and if you’re a serious long term investor, you either need to know him, or somebody like him. He, or more accurately his firm, specializes as a Qualified Intermediary — what guys like me call an Accommodator. I’ll let him explain what that is next week.
For every rule found in Sec. 1031 most real estate investors think they know, there are a few related rules of which they’ve never heard. Here’s a pretty common example for a rule I’ll paraphrase.
You’ve sold the property from which you’re exchanging. The IRS sometimes refers to it as the ‘relinquished’ property. Since you know the rule that says you can identify more than one property, you promptly ID five of ’em. Oops. Though so far you haven’t made a mistake yet, you’re now swimming in different waters, deeper than you may realize. If you’d identified two or three properties, you had the option of closing on three, two, or just one, as long as all other code requirements were met. However, since you chose to ID (more on that later) more than three, you’ve made yourself subject to what’s known as the 95% rule, or ‘exception’. Simply stated, you’re now obligated to close no less than 95% of the value identified. If not, you’ll have some ‘splainin’ to do, Lucy.
Or how ’bout this one?
The net equity proceeds from the ‘relinquished’ property you just closed, is $300,000, from a sales price of $325,000. Since you’re happily exchanging to a different market/region sporting far superior rent/price ratios, you’ll easily be able to acquire roughly $1 million in value. Another oops. Although you may ID as many properties as you want (See 95% rule), you can only exchange into a maximum of 200% of the value of the property relinquished. In this example you were limited to $650,000. Is it a nonsense rule? Yes, in my view. But it’s there, and trust me, the IRS doesn’t appreciate taxpayers makin’ up new rules as they go, based upon common sense. 🙂
What’s this ‘ID’ you keep talkin’ about?
For roughly the first 15 years after I transitioned from a house broker to a real estate investment broker, tax deferred exchanges had almost none of the above rules. When you closed the ‘relinquished’ property, you closed all the properties you acquired, also! It was commonly referred to a simultaneous closing, and was akin to herding cats most of the time. The emergence of the so-called delayed exchange eliminated the need to close all properties, sold and purchased, simultaneously. Though there was a ‘wild west’ kinda time period ’til things were codified by the IRS in the summer of 1990, it created two crucial, yet easy follow time periods.
1. From the close of escrow on the relinquished property, the taxpayer has 45 days to ‘identify’ the property or properties to be ‘acquired’ in the exchange. There are many rules tryin’ to explain what 45 days actually amounts to, but that’s the gist.
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2. ALSO from the close of escrow of the relinquished property, the taxpayer has 180 days to close the exchange completely. There are a few rules that are WAY critical to know and understand about this one, and they ARE NOT mere technicalities. I will tell ya though, that they’re very easily dealt with without much sweat — that is as long as you or your advisor actually, you know, understands the rules.
It was one family, God bless the Starkers forever, who changed the mechanical landscape of tax deferred exchanging.
Long Story short
They owned gazillions of timberland acreage, and Crown Zellerback wanted to buy ’em. Tax advisors told the Starkers they’d require a tax deferred exchange. The transaction was begun. However, finding all the ‘like kind’ property to be acquired proved daunting, and after several years, Crown Zellerback said fish or cut bait. The Starkers didn’t wanna abandon the exchange so they told their tax attorneys to figure it out, a loose paraphrase if ever there was one. Bottom line? The IRS disallowed the exchange cuz the family had closed the sale of the relinquished property without all the necessary acquired properties. They appealed to ‘tax court’. They lost. They appealed again and won — which is why real estate investors everywhere should toast the Starker family immediately after the successful closing of any ‘delayed exchange’. 🙂
Next week it’s my intention to publish a killer interview with Bill Exeter on the subject of tax deferred exchanges per Section 1031 of the Internal Revenue Code. Ya won’t wanna miss it.
Photo: Est Nyboer