Tax Deferred Exchanges 1032 

If you enter into an agreement to trade property you own, for all or a part of the equity in another piece of real estate, then you have accomplisehd a real estate exchange. 

Carl owns a residential lot in Las Vegas that he purchased 10 years ago, it is currently worth about $50,000. Carl wants to buy a strip shopping center near his house in Florida. The center is on the market for $250,000 and it is currently free and clear. Carl has pleans to fix the center up with refurbishment and and improve the rent and therefore double the value of the center.

Carl offers the seller the followin: $200,000 plus the lot in Las Vegas. The sellers goals have been reached, since he gets to sell the center and get a lot of cash at the same time the deal is accepted. Carl then gives the seller the lot and gets a loan for $200,000 to fix up the the strip mall. 

Other possibilities could have been included into this deal. Such as Carl could have asked the seller to hold a second mortgage (behind the new first Carl was going to get); this would have freed up additional capital for Carl to use on the fix up of the center, or to use elsewhere. 

1031 Exchanges 

The potential postponement of tax on a gain that comes with the IRC 1031 is limited to investment property held for production. This kind of transaction is often frerred to as a tax-free exchange. It is important for the user of this strategy can have this result if the technique is properly used. To be totally free of tax it is necessary for the owner to die while he osr she still owns the the real estate. The 1031 Exhcange cannot be used if you are selling or exchange your personal residence. 

The 1031 is also one of the best methods of moving equity and building wealth. Not all exchanges you will consider will  qualfiy for the 1031 provison. In some cases that actually do qualify it may not be advantageous for you to use the 1031 provision. Therefore a good understanding the bottom line along with the the future you have in mind for the asset, the investment portfolio or the new property. For example if you have very little or virtually no gain on a property you are trying to sell the 1031 exchange will have little benefit to you. However on the other side of the deal the seller may find that the 1031 provision of postponing tax on the gain may be critical to the transaction and might be a deal breaker whereby if the 1031 is not used the deal will not happen. Therefore if you can entice a reluctant seller into a transaction by showing him or her how to save money through a 1031 provision, you may make a deal that would otherwise escape you.

REQUIREMENTS FOR A 1031 EXCHANGE

The IRS Code 1031 says that if you make the like for like exchange, you dont have to pay the capital gains tax at the time of the exchange. This is correct only as long as you have done everything correctly, have not received any net mortgage relief and have not received any boot. "like for like", for the 1031 means investment for investment. Therefore you can exchange part of your inventory as a builder for an investment, or part of your farm land and have a 1031 exchange. Investment for investment is an important thing for you to remember. The major benefit of the 1031 is its ability to postpone any capital gains tax, with the ulitimate goal of avoiding it completely.

"Capital Gain" is the sum of everything you get in sale (or exchange) less your adjusted cost. In a sael or exchange, the main number you will need to know is your tax basis. the tax basis on a property is very similar to the book value. When you buy some real estate it has value. If something is built on the property and you can make certain deductions by removing any part of the improvements, or you can depreciating the assets over years as allowed by the IRS. In the tax law revision of 1986 the depreciation rules were revised drasitcally to reduce real estate as amjor tax shelter for investors. 

The tax law also changed the method of calculations for the basis. Basically when you depreciate a property you are artifically reducing its value, and therefore reducing the basis accordingly. However in reality, the depreciation will have little effect on the actual value. Therefore even though no money was spent the IRS allows deprecation to be treated as an actual expense and therefore in the year end accounting the year end earnings and profits will also be reduced. Consequently as earnings are reduced each year as a result of the depreciation. one will pay less tax as tax will not be paid on actual earnings but on the reduced amount. Since depcration is  allowable expense for investment property and income producing property the overall result is a reduced taxable income for that particular property. The result of this is that the owner is able to shelter income because while the taxable income has been reduced the actual income has not. 

Generally real estate losses are passive loses and will offset passive income. An exception to this could be an investor who owns say 10% or more of an amount of real estate investments and actively manages them. In this case he or she could apply for a passive loss of $25,000 to be set against his active income. 

Example 

Its say an investor earned a $100,000 in income from various souces, some of it passive and some of it active. but this investor also has $100,000 in depreciation from an active business. this casee the taxable earnings would be zero. and the investor would have no tax to pay. 

There were other changes also made to the code so now that if an investor takes depreciation faster than the straight line of 27.5 years, then that depreciation cannot be used to create a capital gain., and the gain which is equal to the overage will be the ordinary gain. 

For example, lets say an investor owns an apartment building worth $275,000 and owns some land worth $20,000 he depreciated that building over the 27.5 years. In this case the deprecation would be $10,000 per year as $275,000/27.5 =$10,000. At the end of 10 years the depreciation would total about $100,000 thereby the basis would be $175,000 + $20,000 for a total of $195,000. If the investor then sold the building for $400,000 he would then have a gain of 

$400,000 - Adjusted basis $195,000 which equals a capital gain of $205,000

However in exchanges there are often other things that must be taken into account. One of these things is Boot. Boot is a part of the exchange that will be taxable no matter what in a 1031 exchange. Boot is anything other than real estate. For example if the investor receives cash it is boot. If he receives a car, boat or airplane this would also be boot. An investor can qualify for a 1031 exchange with the receipt of boot, but he or she will be taxed on the boot position.

Formula to calculate boot

1. Total mortgage debt on the property offered to the exchange (original property)

2. Less toal debt on the new property.

3. Net relief of liabilities (cannot be less than 0)

4. Less any cash paid to the owner of the new property.

5. Less any boot given to the owner of the new property.

6. Plus any boot received or taken.

7. The results of the above transactions would be the net boot received in the exchange.

An example of a boot exchange is shown below. 

Richard Sinton

Bsc, IAD, Cemap, Cep 1

https://www.linkedin.com/in/richard-theo-sinton-cep-1-8b165522/