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Why You Should Avoid Tax Deferred Exchanges Whenever Possible

Why You Should Avoid Tax Deferred Exchanges Whenever Possible

5 min read
Jeff Brown

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My first few dozen tax deferred exchanges were in the days before what’s now called the delayed exchange — or back in the dinosaur days, a Starker exchange. You think they’re fun now? Try closing all properties involved in the same moment in time, at least virtually. The pretty phrase used back then was simultaneous close. I owe countless sleepless nights to that innocuous phrase. Today? Tax deferred exchanges are far less stressful, at least in most cases. The rule requiring the closing of all properties simultaneously no longer applies. We can thank the Starker family for that, another story, but incredibly interesting.

It’s Still About Deferring Taxation — and More

This isn’t about the many, many rules governing tax deferred exchanging. This is about why you should or shouldn’t opt to execute one. The oversimplified guideline is the policy taught to me eons ago.

Don’t execute a 1031 exchange unless there’s no other choice, AND it so vastly improves your status quo the decision is a Captain Obvious no-brainer.

The result of a 1031 should be a significant increase in cash flow, or capital growth, or both. Sometimes it can be part of a sideways move of sorts. That is, a simple improvement in the quality of your buildings and/or their location(s). In sports that’s known as addition by subtraction. You rid yourself of previous unfortunate investment decisions and the taxes that may’ve attached themselves to your escape. This happens more than you might imagine. An example came over a decade ago in my last active SoCal years.

The PorTfolio Rehab Exchange

Investors called me wondering if I could help them rethink their investment plan for retirement. They’d just began regrouping from being kneecapped by the Nasdaq crash. They’d watched what was to be a pivotal part of their retirement income lose over a third of its value almost faster than they could watch it happen. Ouch. That was the bad news.

The kinda sorta good news was that they had four small income properties. But what a truly motley crew.

A single family home older than Grandma, and in far worse shape, and in a neighborhood I’d never put her. A truly depressing piece of property. A well located condo, but with a poor tenant. A triplex in a blue collar neighborhood that’d seen better days. Saving the best for last, a home located on an almost impossible lot location that was the former host of a massage parlor. I think. It was sure set up that way, no doubt about it. Like I said, a motley crew. What to do?

The #1 priority was to improve all facets of this portfolio through several exchanges. We first established that there simply was no alternative to exchanging, tax deferred, as the taxes were gonna be prohibitive. We did so, and they ended up with an equal number of properties which all sported vastly superior locations and were all in much better physical condition. The management drama disappeared. Their cash flow zoomed. The most important improvement though was the almost instant increase in the velocity of their capital growth rate. Though the process took several months and was a gigantic logistical hassle to say the least, they were all smiles when the last exchange closed.

Related: BP Podcast 017 – Finding Mentors, Facing Retirement, and Note Investing with Jeff Brown

What’s the Downside of Tax Deferred Exchanging?

First, allow me to warn you of a mistake more common than people think.

Let’s say you have a free ‘n clear property you wish to refi. The lender appraises it for $500,000 and agrees to lend you $300,000. So far, so good. It’s not a taxable event, and you’re good to go. You invest the cash into more property. Next year about the same time you decide you’d like to do a tax deferred exchange with the refinanced units. You do so, exchanging your net equity for property you’re convinced puts you in a superior position then and for the foreseeable future. You followed all the rules. Man, you’re in for a rude awakening. Here’s why.

Your buddies at the IRS will, very possibly, tell you that your previous refi just a year earlier, was executed in your anticipation of this exchange. They will then say you owe taxes on that $300,000 as if you took it out of the exchange itself, directly. Oops. They’ll label it as ‘boot’, which will then trigger a capital gains tax bill for which you may or may not have the cash to pay. Remember, you bought more property with that money, and it’s long gone. Every time I’ve seen this happen first hand it’s been without bad intent by the investor. They just didn’t know and nobody around them knew either. ‘Course, the IRS cares not whether you knew the rules at the time.

It’s a great example of the one of my favorite axioms.

It’s not the answers to the questions we know to ask that get us. It’s the answers to the questions we wouldn’t ever know to ask that nail us. This is why it’s so foolish to ‘research’ 1031s then try one. You might be lucky and come out smellin’ like a rose. Or not.

The 2 Main Negative Consequences to a Tax Deferred Exchange

1. More likely than not your annual depreciation amount in terms of dollars will be less than if you’d simply sold the old property then bought the new one(s). This is due to the rules requiring the old baggage from your relinquished property being brought with you in the exchange. The short version is that you bring the old depreciation amount with you. Then you get additional depreciation from your newly acquired property, but at a reduced amount. Instead of subtracting the value of the land then dividing by 27.5 (residential), you’re only allowed to depreciate the difference in the debt you left and the debt you acquired. But not the whole debt, so stop grinning. Ya still hafta subtract the land value from that figure.

2. If you ever wanna consider taking a straight sale in the future, a tax deferred exchange will cause your potential capital gains tax to be higher. This is a direct result of the IRS formula for computing that gain. If you’d just bought the property in a tradition purchase, your original cost basis would’ve been the price you paid, give or take. But since you exchanged into it, you brought with you the previous property’s adjusted cost basis. By IRS definition this will result in the formula beginning with a lower original ‘cost’. So, instead of maybe paying $400,000 in a straight purchase, the formula might say your actual bottom line ‘origninal’ cost was much lower. Obviously that fact alone will increase your gain which will in turn increase your potential tax bite.

If you can stomach the taxes and avoid a tax deferred exchange (IRC code section 1031) it’s more likely than not in your best interests to do so. 10-20 years from now you won’t be able to find, nor will you care about the taxes you paid ‘back in the day’ on good ol’ Maple Street. But you will definitely smile as you tally up the taxes you didn’t hafta pay due to higher depreciation numbers and lower capital gains.

Don’t mistake this for a policy. The decision whether or not to sell/buy or exchange should never be taken lightly or given short shrift. It’s often one of the most pivotal decisions a real estate investor makes in their lives. Make that decision a solid and informed choice.  In fact, sometimes the choice is neither. Either stand pat, or refi and buy more. I’m not a fan of the ‘policy’ of  keepin’ everything you acquire ’til death do you part. That ‘school’ of thought simply does’t compute with me, as they’re constant refinancing to buy other properties results in far too many unintended consequences. Sometimes refinancing a property is exactly the thing to do. But that’s another topic altogether.

Photo: Alex Dram