By: William L. Exeter President/CEO of Exeter 1031 Exchange Services, LLC.
Each month we review some of the common questions we receive about 1031 Exchanges. Your questions are always welcome. Submit them to us at [email protected] or by posting them to the Discussion Board at exeterboard.com.
Q: I’m preparing to put my rental property in Brooklyn, NY, on the market this year. When I realized just how much we’d have to pay in taxes (23% federal capital gains tax + 9% New York State capital gains tax + 2% transfer tax = 34%!!!) I nearly had a heart attack. So I started exploring the possibility of doing a 1031 exchange.
There is so much misinformation out there about 1031 exchanges! The more I speak with attorneys, accountants and so-called 1031 exchange experts, the more confused I become. Everyone gives me different and often conflicting information. I was excited and grateful to find your website offering straight answers on 1031 exchanges. I would greatly appreciate any answers you could provide on my situation, please.
Here are the particulars of my case in a nutshell:
- I purchased this 3-family investment property in Bedford-Stuyvesant, NY for $779,000 in 2007. It was brand new construction at the time, in a neighborhood that’s going through gentrification.
- I co-own the house with my mother, 50%-50%.
- The balance on my mortgage (in my name only) is approx. $600,000.
- We’re looking to price the house in the vicinity of $1.5 million, which is in line with recent comps in the area.
Our plan is to sell the house, pay off the mortgage and closing costs, and reinvest the remaining proceeds in a rental property in Austin TX, where I currently live. I do not wish to take out another mortgage for the replacement property–just reinvest, in cash, whatever money we’re left with after paying off the mortgage and sale expenses.
CAN WE DO THIS, AND TAKE ADVANTAGE OF THE 1031 EXCHANGE TAX DEFERRAL???
A: Yes, it is referred to as a partial 1031 Exchange. Essentially, you are trading down in value, so the amount that you trade down by, which is likely the value to be paid off, will be taxable. If you trade too far down in value, the 1031 Exchange will not provide you with any benefit. The key is your “adjusted cost basis.” You bought for $779,000 and then have depreciated the property for 8 to 9 years. Your adjusted cost basis is the original cost basis less your depreciation taken plus any capital improvements that you have made. This is your starting point. As long as you buy something valued more than your adjusted cost basis, you will be getting some value from the 1031 Exchange.
Q: The city is forcing me to sell my small apartment building to them. My real estate agent said this transaction does not qualify for a Starker exchange. Why not? What can I do?
A: Let me first explain the term “Starker Exchange” for those who are not familiar with the name Starker. It is the name of the family (father and son) that structured a number of “delayed exchange” transactions in the 1960’s that were eventually audited and subsequently disallowed by the Internal Revenue Service. The Starker family appealed their decision all the way to the United States Tax Court. Their delayed exchange transaction was ultimately upheld (permitted) by the United States Tax Court.
The Starker family set the precedent for the delayed exchange, which is how most 1031 Tax Deferred Exchanges are structured today. A delayed exchange occurs when the real estate investor sells his or her relinquished property first and then acquires the replacement property within the 180 calendar day exchange period.
Now, getting back to the question at hand, your real estate agent is not correct. You absolutely do qualify for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code (“1031 Tax Deferred Exchange”) because you are selling (although not willingly) an investment property and wish to reinvest in another replacement property.
However, you probably also qualify for tax-deferred exchange treatment under Section 1033 of the Internal Revenue Code (“1033 Tax Deferred Exchange”) because the city is either exercising its “eminent domain” authority or has threatened you with eminent domain. This is considered an “involuntary conversion” or the taking of your property by a government agency for “the public good.” You would qualify for 1033 Tax Deferred Exchange treatment if they did exercise their eminent authority or if you can prove that you were threatened with eminent domain.
Investors often decide to structure a 1031 Tax Deferred Exchange in situations like yours in order to take advantage of the broad definition of like kind property under Section 1031. However, the 1033 Tax Deferred Exchange provides numerous planning benefits and/or opportunities that are not available under Section 1031.
For example, when structuring a 1033 Tax Deferred Exchange under an eminent domain action or threat of action you have three years to reinvest in like kind replacement property as opposed to 180 calendar days for a 1031 Tax Deferred Exchange. You are also permitted to pull cash out of a 1033 Tax Deferred Exchange transaction and do not have to pay capital gain taxes as long as the like kind replacement property(ies) that you acquire is(are) valued equal to or greater than the value of the property that was taken from you. You cannot pull any cash out of a 1031 Tax Deferred Exchange transaction without incurring capital gain taxes
Have 1031 Exchange or 1033 Exchange questions? We have answers. Go ahead, ask! Send your 1031 Exchange to questions to [email protected].William L. Exeter is President/CEO of Exeter 1031 Exchange Services, LLC. He’s been in the fiduciary services industry since 1980, began specializing in real estate tax strategies in 1986 with a specialty emphasis in 1031 and 1033 Exchanges, Self-Directed IRAs, and Land Trusts. Bill has written and lectured extensively on 1031 and 1033 Exchanges, Self-Directed IRAs, and Land Trusts and is a frequent guest expert on San Diego Radio Shows “The Financial Advisors — Money Talk Radio Show” on AM 600 KOGO and on “Inside Business Radio Show” on AM 1000 KCEO. You can email your questions to [email protected], call (866) 393-8370, fax to (866) 393-8371 or mail to 402 West Broadway, Suite 400, San Diego, CA 92101, exeter1031.com. We have Answers; Go Ahead, Ask!