It is unfortunate that it takes a tragedy like the melt down of the sub-prime mortgage industry to bring a popular form of TAX-FREE investing out of the closet, but this is just exactly what is happening!

The “Tax Free” procedure (Actually in is really considered a “tax deferred”) is called the Internal Revenue Code Section 1031, also known as a “1031 Exchange”. A 1031 Exchange permits the deferral of capital gains taxes on the sale of property held for investment or productive use in a trade or a business.

There are three basic types of exchanges, however, the most popular, the Forward Delayed Exchange, will be discussed in this article. This type of Exchange is where property is sold (called Relinquished Property) and the proceeds are used to purchase another property (called the Replacement Property) within certain timelines. To qualify for safe harbor tax deferral, the sale proceeds must be held by a Qualified Intermediary between the sale of the Relinquished Property and the purchase of the Replacement Property.

This procedure, a 1031 Exchange, permits the deferral of federal capital gains taxes (15%), depreciation recapture (25%) and state taxes (generally 8 to 9% where applicable).

Here is an example (and the benefits of) a 1031 Exchange. Charlie bought a duplex in North Fulton County 10 years ago for $75,000. With the change in the North Georgia market, this duplex is now worth $500,000. I recommended that Charlie should engage in a 1031 Exchange, thereby deferring payment of capital gains taxes. I found Charlie several foreclosure properties worth a total of $1,700,000 as his “Replacement Property”. The transaction was successful and as a result Charlie did not have to pay $63,750 in capital gains taxes (15% Capital Gains tax on profit of --- $500,000 - $75,000 original cost = $425,000 x 15% = $63,500). Charlie was therefore able to purchase the foreclosures leveraging the net proceeds from his duplex.

                                   Sale                   Exchange

Net Equity                   $425,000              $425,000

Capital Gains Tax        $63,750                 0

Equity to Reinvest        $361,250             $425,000

Proposed Acquisition*  $1,445,000           $1,700,000

(Presuming 25% Down payment this allowed Charlie to buy another $255,000 worth of property!)

With the market flooded with Foreclosures, this gave Charlie the opportunity to buy more properties and at under market prices that he can turn into additional profitable 1031 exchanges, while collecting rents for the additional homes that he was able to purchase using the 1031 Exchange method. Of course, he could have purchased raw land, office Buildings, shopping centers, Motels, farms, apartment buildings or even 30 year leases which are all considered “Like-Kind” by the IRS.

Per Dan McCabe of the Investment Exchange Group in Denver, “It used to be that the average user of 1031 Exchange was a big real estate player. Now it’s more mom-and-pop types. An added factor is that more money is flowing into real estate as opposed to the stock market.”

In the early years of the Section 1031 era, the rules for the exchange necessitated simultaneous closings, a bear of a requirement that severely limited the number of qualifying transactions. Treasury regulations were eventually changed, and Delayed Exchanges were created. Delayed Exchanges are the most common type of exchange today; they allow a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property.

This time gap, however, means that the property owner could possibly receive funds from the sale of the Relinquished Property, and the moment actual or constructive receipt of the proceeds occurs the exchange disappears according to Uncle Sam.

Thus was born a new type of financial professional, the Qualified Intermediary (QI). A QI is an independent third party that facilitates a 1031 Exchange. This is vitally important! By holding the proceeds from a sale of the Relinquished Property and then applying them to the purchase of the Replacement Property, a QI makes sure that actual or constructive receipt NEVER OCCURS. No taxable liability is therefore generated. Needless to say, a good QI is worth their costs, whatever that might be.

It is important to note, that part of choosing the right Real Estate agent, is picking one that can get you in touch with a good QI. It is also VERY important to note, that if you are considering establishing a 1031 Exchange you should ALWAYS use a Buyer’s real estate agent that understands your market and knows about 1031 Exchanges and their nuances.

TAKING ADVANTAGE OF A 1031

According to the Federation of Exchange Accommodators, some of the advantages of exchanging your property versus an outright sale include:

An exchange can postpone or potentially eliminate taxes due on the sale of qualifying properties.

More money is available to invest in another property. In effect, you receive an interest free loan from the federal government in the amount you would have paid in taxes.

Any gain from depreciation recapture is postponed.

An exchange enables one to acquire and to dispose of properties in order to reallocate your investment portfolio without paying tax on any gain

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For example, you cannot sell a property, stick the cash in the bank, and then go buy another one the next day. The properties MUST be exchanged, which is where a 1031 savvy real estate agent and a good QI come in.

As real estate prices appreciate, we are seeing more and more 1031 exchanges. And with the foreclosure market booming (not to mention the selling of distressed homes in pre-foreclosure), this provides a great opportunity to increase and diversify an investment portfolio.

Anyone who plans on selling a piece of property for a gain and buying a replacement would be foolish NOT to consider a 1031 Exchange. However, in order to defer taxes the acquisition cost of the Replacement Property needs to be equal to or greater than the cost of the Relinquished Property, and all the equity from the first property must go into the second. In other words, don’t expect a 1031 Exchange to be a vehicle to pull out tax-free cash from a property.

Doug Davisson is a licensed Georgia Real Estate Agent working for Alpharetta Realty, one of the oldest Commercial Agencies in Georgia and specializes in commercial real estate sales and the representation of Buyers and Buyer/Investors. If you need help or just want to ask him questions, please call him at 678-248-2222 or email him at doug@dougdavisson.com.