1031 Tax Deferred Exchange
How To Do The Tax Defferred Exchange
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Jan 27, 2006, 09:40

Although never selling is my rule of thumb for successful real estate investing, there are rare instances when selling after an extended period of ownership is advantageous, particularly when a tax-deferred exchange can be made. Under Section 1031 of the Internal Revenue Code, like kind property used in a trade or business or held as an investment can be exchanged tax-free. The tax system, through the tax-deferred exchange, encourages sellers to buy similar properties of equal or greater value by making them tax exempt.

Many residential income property owners choose to make an exchange when, after owning a piece of real estate for over the 27.5-year depreciation period, they can no longer take a tax write-off because the pay per value of the building for tax purposes has reached zero. 
After owning the four-unit apartment building for 20 years and seeing its real value soar from $45,000 to $1 million (while its paper value dropped to nothing because of depreciation), I decided to sell it and make a tax-deferred exchange. With the profit I received from the sale, l traded my one property for three houses and a condominium.

I can now take the depreciation on those four properties and use it as a tax shelter--an investment that produces after-tax income that is greater than before-tax income. The old property, although worth a great deal, was only yielding a 5 percent annual return. Because the depreciation period had expired, it was in my best interest to exchange other properties that I could take depreciation on.

By selling one property and buying four others, I increased my assets without paying taxes on capital gains. If you buy enough property, the depreciation you can take will offset the taxable income you receive. It works out so you don't have to pay as much tax.

If you bought a property in a mediocre location with a huge structure on it, a higher dollar value would be allocated for the improvements, the actual building, than the land. Say you pay $100,000 for a property. For tax purposes, you make an allocation of the depreciable assets compared to the non-depreciable assets. Depreciable assets include the building, utilities, underground plumbing, sidewalks, fixtures, contents, everything except the vacant land, which isn't depreciable.

The higher the building-to-land ratio, the more depreciation you can take. For this reason I decided to buy apartment buildings on the oceanfront rather than single family residences. With apartments, you can allocate more for the buildings. he most desirable thing is to find a property that is overbuilt for instance, a multiunit legal nonconforming apartment building where you can't put back a building of similar density because of city downzoning. By buying the nonconforming building, you get a better depreciation write-off because you can allocate more for the building. In some instances, it is wiser to put money into improving a legal nonconforming building than investing in a teardown property or new development.

Industrial and commercial buildings have a longer depreciation period than residential dwellings. But an advantage to buying, say, an apartment building is that you can take many of the things that aren't considered construction items and put them in a separate category of furnishings and equipment. Items such as carpets, drapes, refrigerators, drop-in ranges, window air conditioners, portable heaters, swag lamp fixtures, gardening equipment, and pool and patio equipment can all be valued and depreciated over a short term.

For tax assessment purposes, I always segregate the purchase price into the land, the improvements, and the equipment. Assume you
paid $I00,000 for a property, say $90,000 for the real estate (including land and improvements) and $10,000 for the equipment that came
with the building. For tax assessment purposes, that $10,000 for equipment should not be assessed with the building. It should be a separate category.

I do this to achieve a lower assessed value. If you start at a lower base, your taxes are going to be lower. The mistake accountants make at the time of acquisition is that they take the assessed value ratio of the land and improvements for depreciation instead of going to the site and studying the problem. And when most county assessors establish property values for tax purposes, they distinguish between land and improvements, but they don't isolate the equipment value. It's important to be honest with everything you do. But if you know your facts and what to do, you can save some money here and there. If you own real estate, it's important to manage your investments as you would manage a business.

When you buy real property, the allocation for improvements is depreciable over a 27.5-year period. As the value of the physical building depreciates, some of the net income is sheltered for tax purposes. It's a loss, but a paper loss. Actually, the building will probably appreciate in value if the market goes up.

In the above example, say the land was allocated at $20,000, the improvements at $70,000, and the personal property at $ I0,000.
Assuming you can take $10,000 off the value of the building improvements attributable to depreciation over a few years, your basis
will then be $60,000. At the end of the fourth year, you decide to spend $20,000 on an addition. Your basis then rises to $80,000 on the improvements, plus $20,000 on the land, plus whatever amount you have not depreciated on the personal property, for a total of, say $105,000. Now, assume you trade up for a like property for an equal or greater value. You wouldn't have to pay any federal income tax on it; you simply exchange the basis to the new property and continue on. When you trade up, you change your basis-the purchase price less the depreciation taken on the improvements and the personal property, plus any added monies you put into the property.

A tax-deferred exchange is a way of extending your wealth and achieving your goal. You're deferring payment of taxes until the time you're through with all your exchanges, In a tax-deferred exchange, you sell your property and put it into an accommodator account. You then take the money from the sale and purchase another like-kind property of equal or greater value. The IRS looks at an exchange as if you were extending your first investment onto the next property as it increases in value.

Say you buy a duplex for $100,000, which has a $60,000 loan against it with $40,000 equity. If you trade that duplex for a $200,000 triplex or four-family flat, you're trading your equity into a new property. As long as you keep extending your investment and the price goes up, there's no tax to pay. But if you make the exchange and have to put in boot to make the payment-cash, rare coins, jewelry, cars, anything of value that isn't considered like-kind property--that's added cash, which you as the seller will have to pay tax on. Say you have $ 60,000 in equity in a duplex worth $100,000, which you trade for a $ 200,000 duplex that the seller on ly has $40,000 equity in. You're assuming his or her $160,000 loan. But if you have $60,000 equity to trade, he or she has to give you $20,000 boot to make the
deal. That's money the buyer has to pay taxes on. Although I have used it, the tax-deferred exchange was never much of a consideration for me because I always planned to never sell the property I bought. If you pick the right piece of real estate in a good location, you want to retain the property, not exchange it for something else. The best time to make an exchange is when you want to buy something better or
consolidate your properties.

When you are involved in making any kind of real estate exchange, it is essential that you consult a competent tax attorney and accountant to be sure that you are complying with the current rules and regulations of the IRS. Tax laws change rapidly and rules that are appropriate today might be drastically different tomorrow. It is therefore important to stay current and make adjustments that reflect changes in the tax laws.