Entrust Learning Center > Investments > July IRA Insights: Interesting Trend in 1031 Exchanges

July IRA Insights: Interesting Trend in 1031 Exchanges

While the numbers of 1031 Exchanges are down, they are not out. A 1031 Exchange is a tax code section that allows a taxpayer to sell investment real estate and defer some or all of the taxes if they follow the guidelines when purchasing replacement prope

By: Dave Owens

IRA Insights

By: Dave Owens

While the numbers of 1031 Exchanges are down, they are not out. A 1031 Exchange is a tax code section that allows a taxpayer to sell investment real estate and defer some or all of the taxes if they follow the guidelines when purchasing replacement property. 1031 is suffering what I call a "triple whammy" from the real estate boom: decrease in number of transactions, tightening credit, and decrease in real estate values that have eroded gains. All three have caused a big hangover for the 1031 industry. It is estimated the volume of exchanges is down approximately 70%, according to recent studies by the national 1031 groups.

But 1031 exchanges are still occurring every day. The investors performing exchanges today are the same clients who were performing exchanges before and during the boom. They are smart, savvy, long term investors. The question is, "Where are they putting their money?"

We do business all over the United States. I have not talked to one person who has not been affected by rising oil prices, and real estate investors are no different. One interesting trend we have seen in the 1031 business is going "green". When I say green, I mean clients are selling older, energy deficient properties and moving to new, more energy efficient properties. A current 1031 client commented that tenants don't want to be in old buildings that are costing them money with leaky windows, un-insulated walls and inefficient air conditioning systems. Green buildings are easier to rent and can be profitable.

In April 2008, we performed an exchange for a client who sold two old, wood frame houses that were as far from "green" as possible and purchased a brand new, four unit strip mall with many modern energy efficient features. The houses were over 30 years old and fully depreciated. The seller had a gain of over $300,000 with a possible capital gains tax of $70,000. With a 1031 exchange, the investor paid zero tax. All capital gains tax, depreciation recapture tax and state tax were deferred.

To be able to execute a 1031 exchange, there are several rules you must follow. The first rule is also the most commonly asked question: "How much do I need to reinvest to defer all tax?" To deferral all tax with a 1031 exchange, the taxpayer must purchase a replacement property equal or greater in value to the property they sold. If they purchase a property for less value than the relinquished property, they only pay tax on the money not reinvested.

Typically in a 1031 exchange, the property to be exchanged must be business or investment real estate. Most exchanges performed are rental properties, vacant land or real estate used in a business. Many times you will hear 1031s called "like-kind' exchanges; it is only like-kind from the stand point that you're selling deeded real estate and buying deeded real estate. So that means you can sell a rental house and buy a rental condo or sell a commercial property and buy vacant land. As long as it is deed to deed, it should qualify.

Also in a 1031 exchange, you must use a Qualified Intermediary (QI) to facilitate the exchange. The QI will perform many functions-primarily prepare the exchange agreement, escrow the equity funds in a segregated account, and finally, they will coordinate the exchange with all buyers, sellers and title closers. Please note you must call the QI before you sell the relinquished property to qualify for 1031 treatment.

Finally, there are two timing rules for a 1031 exchange. If you do not have your replacement property picked out when you sell your relinquished property, the tax code gives you 45 days from date of sale to identify three properties to purchase. Identification usually means notifying the QI exactly which three properties you are looking to get a contract on. The other timing rule is that from the date of sale of the relinquished property you have 180 days to close on the replacement property. The rules for 1031 can be complex; please consult tax advisor before starting an exchange.

Another example of doing a "green" 1031 was performed by one of our clients recently. The investor had three rental homes all on septic. The city in Florida was getting ready to mandate removal of the septic and replace it with a new sewer system costing over $15,000 per house. The investor did a 1031 exchange selling the homes and purchasing two newer, efficient homes on sewer. Even though he only has two properties, they have equal value, they are in a desirable neighborhood, and the tax saved by doing the exchanges was over $50,000.

1031 Exchanges can also be structured as a "Construction Exchanges" so that the investor can purchase property and use 1031 monies to make the property green. Typically, this will be a reverse exchange where the QI holds title to the property while improvements are made. While this may sound complex, it is actually very easy and common practice in the industry.

The thing I have learned about this real estate market is that clients are very resourceful. They look for opportunity and they gravitate towards it. Green investing with 1031 is just one example of investors seizing an opportunity. In southwest Florida, another trend for 1031 investors is foreclosures. Many foreclosures caused by the flipper of boom days, are now an opportunity for right investors. In the words of Dale Carnegie, "Opportunity does not knock, it presents itself when you beat down the door."

Dave Owens, CPA, Certified Exchange Specialist, is the managing member of the Tax Strategies Group, a company specializing in 1031 Exchanges, Entrust Self-Directed IRAs and Cost Segregation, with offices in Fort Myers, Gainesville and Chicago.

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