How to maximize cash flow with 1031 tax deferred

Possible exchange scenario 1031 ,

Suppose you bought residential property in the San Francisco Bay area for $ 250,000 twenty years ago. Since the property is in a good area, its value is estimated at $ 1 million. Over the years, you refinanced your original loan to consolidate your other debts and currently have a mortgage loan in the amount of 300 thousand dollars. Every month you collect 3000 dollars of rent. After you paid $ 1,800 per month for the loan, $ 400 per month for real estate taxes and $ 60 per month for insurance, you get $ 500 from cash flow per month after paying property management and maintenance costs .

As you get older, you realize that you need a second source of reliable income, so you are not completely dependent on your salary. You are also unhappy with only $ 500 cash flow per month for $ 750 thousand. Capital in your investment in the lease. Therefore, when you see an attractive multi-user strip for purchases in the Dallas suburbs of the middle class, 100% rent NNN from $ 195 thousand / Year net operating income (income after all expenses except the mortgage payment) in the market for 2.6 million. Doll. US 7.5% caps, you worry!

Since the residential property market in the Gulf area was very profitable for sellers, you can sell your rental property to buy this strip for purchases. You estimate that you will have to pay about 250 thousand US dollars in the form of taxes on federal and state taxes in the amount of 800 thousand dollars. Capital gains (US $ 1 million net of $ 250 thousand. USD and sale prices, plus $ 50 thousand. In the form of depreciation). You just do not like to pay 250 thousand dollars to the government - money that can go to your down payment in the shopping lane. There is a better way - a way to defer income tax.

What is a 1031 tax deferral?

Section 1031 of the Internal Revenue Code usually provides that, regardless of profit or loss, it is recognized if qualifying property is transferred for other qualifying property of this kind. In the above scenario, you can defer a payment in the amount of 250 thousand US dollars for both federal and state duties if you acquire another investment property with equal or more debt and equal or large capital. In other words, if you buy another investment property for $ 1 million or more, using all net proceeds as a down payment, you can set aside $ 250 thousand of taxes. In fact, the government provided you with $ 250 thousand. Without interest. And you can repeat this deferment and never pay income taxes.

How do you feel about the exchange of 1031?

You must follow a few strict rules. Failure to comply with any of the rules will result in disqualification of your transaction from the 1031 tax deferral of the exchange.

1. You must trade. The property that you buy (removable property) must have equal or more debt and an equal or greater amount of capital than the property you sell (property disclaimer). This means that you must place all net income from the abandoned property in the replacement property. The fair market value (FMV) of the replacement property should also be greater than the FMV of the abandoned property.
2. The qualifying property must be the same. Discarded and replacement properties must be stored for productive use in a trade or business or for investment before and after the exchange. And one type of property cannot be changed for a property of another type. For example, you cannot exchange residential property for a lease that you intend to take as your main residence - not a qualifying property. And you can not exchange the plant for equipment, not for the look. On the other hand, residential and commercial real estate has the same appearance. Thus, you can exchange residential rented property for a shopping center.
3. In case of a delayed exchange, you must identify the replacement property within 45 days and receive it within 180 days from the closing date of the refused property or within the prescribed period of the tax return (with extension), whichever comes first.
4. You can identify up to 3 substitution properties and close the escrow from at least 1 out of 3. As an alternative, you can identify as many properties as you want if the total value of these properties does not exceed 200% of the cost of giving up.
5. You must purchase property for investment purposes and not basically resell for profit. While the IRS does not tell you how long you hold the property before you can get the right to exchange 1031. Most tax advisors believe that two years is a sufficient period for investment purposes. You should check with your tax accountant if the investment period is shorter to make sure your 1031 can withstand an IRS audit.
6. You must have an exchange broker who has income from the sale of abandoned property. Most investors use the exchange company as a qualified intermediary for the slow-motion exchange 1031.
7. If you exchange property with an associated person (your children, parents), then both parties cannot dispose of the property for 2 years.
8. If proceeds from the sale are deposited in a percentage account during the exchange, you must receive interest AFTER closing the deposit of the replacement property.

What expenses are permissible?

You can use the 1031 proceeds to pay for certain expenses on the sale of the refused property and the cost of purchasing replacement property: insurance premiums for the title of the owner, escrow agent or commission for closing a lawyer, a real estate agent; transactions, 1031 exchange intermediary fees, taxes on the transfer of documents, registration fees and fees of tax consultants. You cannot use 1031 to pay for these expenses: fees / points for a loan, commission fees, mortgage insurance premiums, insurance premiums for the insured’s title, property insurance premiums, repair and / or maintenance costs.

Successful exchange strategies 1031

The following strategies are intended for investors who are looking for commercial real estate as a replacement.

1. You have 3 plans for exchanging 1031: A, B, and C with plan A, which is the best case, and plan C is the worst. At least one property for each plan.
2. Start looking for spare property before. Since you only have 45 days to determine replacement properties, you must make an offer as soon as the expropriated property is deposited. By the time you close your property deposit, you should have one offer accepted for replacement property. This first property does not have to be the most desirable property at the best price. Mentally, you should think of him as a Plan C for the worst-case scenario. So you do not wait until the last minutes to make an offer. It is also intended to take away your worries so that you can sleep well, for example, “My God, what if I can't find a replacement property?”.
3. Identify more than one replacement object. If something unexpected comes up with your first choice, for example, the soil is polluted, you have plan B and properties plan-C.
4. Indicate the 30-day review and cancellation of the contract. This will give you more time to specify more than one property.
5. Think twice about choosing a replacement property with a loan. It is much more difficult to get a lender’s permission to provide a loan than a new loan. Moreover, you only have one chance to get approval for a loan and much more to get a new loan. You do not want your credit request to be rejected by the lender after the 45-day identification period.

Questions for intermediate broker 1031

Technically, you do not need the exchange company 1031 to handle the exchange. Nevertheless, it is desirable that a specialist provide you with assistance. This company will enforce strict IRS regulations. To decide which company will help you, you should consider:

1. The fee is about $ 500- $ 750 per transaction. A company that charges less taxes tends to limit you to three substitute properties, and a company that charges more may not have this restriction.
2. No matter what your income will be deposited into a separate trust account, where your FDIC money is insured or combined with the main company account. In the case when a company goes under some of them during a recession, it is easier to show money in a separate trust account - this is your money, not the money of a stock exchange company.
3. No matter what your income will earn any interests and money insured.

What if you want to buy replacement property first?

For some investors, a strict 45-day identification period and a 180-day exchange period may be too short. In addition, some investors considered the possibility of exchanging 1031 only if they found suitable replacement properties. An alternative is to consider a reverse exchange, in which the purchased property is purchased first before the sale of the property sold. However, the property on the replacement should belong to the intermediary side during the period of exchange of this type until the taxpayer can sell the property belonging to it. Then the replacement property is replaced by the taxpayer. Reverse latency exchange is an advanced strategy with a different set of complex questions that are not meant for average investors. You should consult with a tax advisor who will help you.

What are some of the potential problems?

Due to time constraints in exchanging 1031, some people may want to take advantage of your situation. So, you must mentally recognize and accept the fact that as a 1031 buyer you cannot be in a better position to negotiate.

1. There are sellers or listing brokers who have a very positive attitude towards 1031 buyers. They reason that these buyers will have to buy and close the deposit or send a big check to Uncle Sam. On the other hand, some sellers or listing brokers feel negative about 1,031 buyers. They reason that 1031 Buyers will offer to buy 3 properties and close the deposit with one. And so, there is a 33% chance that 1031 buyers will close escrow. And therefore, these sellers may not be receptive to your offers.
2. Sellers know 1031 Buyers must close the deposit. And therefore, they may become less flexible in negotiations with 1031 buyers after concluding a sales contract. For example, you request a loan for repairs, which they can agree to in a normal transaction, but they can say no to transaction 1031. And therefore, just in case, it is important to have backup properties.
3. Some lenders may reduce the loan amount and / or require the Buyer in 1031 to place all the proceeds from the sale in the replacement property.

Successful exchange

Your offer of $ 2.6 million for the mall is accepted. The bank provides you with 1.82 million US dollars (70% LTV) at 4.5% percent, amortized over 25 years. After paying $ 10,116 / month for a mortgage, you still have a positive cash flow of $ 6,000 a month! This is a significant increase from $ 500 per month to the exchange of 1031.