The Section 1031 Exchange

Purchasing Investment Property to Defer Capital Gains Taxes

The “Section 1031 Exchange” is a process by which a property owner can “defer” a capital gains tax bill from sold property by using the proceeds to purchase new property. The median sales price for single-family residential homes in San Luis Obispo County has jumped 22% in the past two years, and 14% alone between 2012 and 2013. As the housing market improves, buyers, sellers, and investors have more options for real estate transactions.

 

The prospect of a large capital gains tax bill, however, can dissuade some sellers, move-up buyers, and investors. The Section 1031 Exchange offers a perfect way around this dilemma.

Here to guide us through the Section 1031 Exchange overview is Guy Torelli from Torelli Investment Realty. Guy is an investment property specialist and he is a returning guest on our radio show Mortgage Matters. Please listen to our episode on Saturday, January 25th (Live on KVEC 920 from 10 a.m. to 12 noon) or download from our Soundcloud page (posted by January 29th).

 

You can contact Guy Torelli by email (guy@guytorelli.com) or phone (949.862.1000) for more information.

What is a Section 1031 Exchange

A Section 1031 Exchange allows somebody to take the equity of one property – or several properties – and input it into the purchase of a new property or properties. The exchange allows the owner to “defer” his or her capital gains tax bill on the profits made from the original sale.

Who should consider a Section 1031 Exchange?

The best candidates for 1031 Exchanges have equity in a property and want to “move up” to invest in something bigger or with more long-term potential. It can be a house, retail building, 3 unit building, industrial building, etc.

Torelli gave us an example:

“I had a client who owned two rental houses in Bakersfield. He bought them at a good price and fixed them up, but they were ‘maxed out’ – they were at market value and there wasn’t much more opportunity for appreciation.

Using the 1031 Exchange, this client is able to sell the homes and use the proceeds as equity to purchase a small apartment building in San Luis Obispo. The client deferred paying capital gains tax from his previous rental properties because he ‘exchanged’ his profits into a new investment.

Now he can take this undervalued apartment building, manage it, increase cash flow, and build more value.”

What are the Benefits of a 1031 Exchange?

You are able to defer all of the capital gains taxes on a property to a later date. Say you bought a property for $100,000 and sold it for $200,000. You would have to pay capital gains tax on the $100,000 of profit. Say the capital gains rate is 25%: you would have to pay $25,000 in taxes to the government.

With the 1031 method, you are able to take the entire $100,000 of profit and use it to buy another property. The capital gains taxes are rolled over or “deferred.”

Ok, so you can defer paying taxes. When do you ultimately pay the tax bill?

There are a few possible exit strategies. Sometimes Congress lowers the capital gains tax rate, and when that happens an asset-selling window opens. The rate was 15 percent for awhile.  If you have been using the 1031 Exchange program and have millions in equity, you can sell and pay just 15 percent.

Another option is more long-term. For example, let’s say a couple has been exchanging their whole life and own $1.5 million of current market-value property with $500,000 in property appreciation over the years. When one person dies, the surviving spouse is able to evaluate the property at the time of death, and “step up” the tax basis to the current $1.5 million valuation – capital gains free.

There are other options: trusts and other tax tools that can balance out the taxes. Make sure you have a good, educated accountant to learn more.

What are the Requirements for the Section 1031 Exchanges?

There are a few simple rules. For one, you must close escrow on a new property within six months of selling the old property for the Exchange to be valid.

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