Is There A 1031 In Your Future?
A lot has been written about the virtues of Section 1031 exchanges, the so-called like-kind exchanges. The attraction is very simple, it defers taxes to a later date, and there seems to be universal appeal to that. But there are some drawbacks which I will highlight below.
But first, the basics. At its core, a like-kind exchange permits an investor to acquire more expensive property than the property being sold. Generally this means trading up in terms of equity and debt, because the taxpayer cannot take cash out (it is "boot"), and cannot decrease the debt. Many investors look to decrease their leverage and increase their cash flow by essentially rolling their equity into a new property, but this is not generally permitted. So an $800,000 property with $600,000 of debt cannot be traded for a $200,000 debt free property.
Once the first property is sold, an investor generally has 45 days to designate a new property, and then 180 days to close. As a word of caution, there are pitfalls that exist such as filing a tax return prior to the running of the 180 day period that may trip up the transaction or identifying too many properties, so an investor will need to have competent advisors to guide through the process.
Primary Reasons For Engaging In A Like-Kind Exchange
- Time the market. An investor may believe that she has maximized the potential return in a given asset class or market and decide to sell.
- Increase the leverage. Ever optimistic real estate investors know for certainty that in a rising market the more leverage the better. Assuming that the first leg (the property being sold) has increased in value and some amortization of principal, an investor may find herself with 40% equity in a property. By purchasing a more expensive property, the investor can take the equity and borrow more money and get 80% leverage.
- Engage a professional manager. One of the big pushes in the early part of this century (I always wanted to use that phrase) was to sell a more management intensive property such as a small apartment building and invest in TIC program promising 8 plus percent annual returns with a diversified portfolio and upside. Others promoted single tenant/net lease deals providing 6-10% cash on cash deals. Needless to say each strategy has veered dramatically off-course, but there still is a good case to be made for exchanging into a less management intensive property type, so long as the underlying real estate is good.
- Defer taxes. Always and still a good reason.
Reasons To Consider Not Engaging In A Like-Kind Exchange
- Tax rates may increase in the future. We currently have historically low capital gain rates of 15% (but with recapture and state taxes, the amounts are often higher). Most prognosticators predict higher tax rates in the future as the state and federal governments try to reign in spiraling deficits. Many investors will look back and wonder why they didn"t take advantage of those rates and pay their taxes.
- Property values may not increase when compared to other investments. People tend to forget that real estate is a market, and markets move in both directions. Many a trade investor has learned that paying taxes today is better than having a property consistently running a negative cash flow and decreasing in value.
- Take losses today to fully or partially offset gains. Some investors have become so accustomed to trading properties that they forget that recognizing gain does not necessarily mean paying taxes. I had a client recently all set to do a like-kind exchange when I advised him to talk to his accountant because I believed that he had significant losses from other real estate holdings that would result in no taxes being paid, essentially washing the gain. Today, with the melt-downs in the real estate and equity markets, there may be an opportunity to sell appreciated real estate assets and take the opportunity to re-balance one"s portfolio in a tax advantaged manner.
Conclusion
While like-kind exchanges are still a powerful arrow in any investor's quiver, one must still understand the motivations, expectations and pitfalls inherent in this strategy.
David G. Estes
Attorney
San Francisco, CA
