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Inside Self-Storage Magazine: Second Thoughts About Tax-Deferred Exchanges

January 1, 2006

5 Min Read
Inside Self-Storage Magazine: Second Thoughts About Tax-Deferred Exchanges

What Is a 1031 Exchange?

Source: For1031.com

Under section 1031 of the Internal Revenue Code, a real property owner can sell his property and then reinvest the proceeds in ownership of like-kind property and defer the capital-gains taxes. To qualify as a like-kind exchange, property exchanges must be done in accordance with the rules set forth in the tax code and treasury regulations. The 1031 exchange can offer significant tax advantages to real estate buyers.

What Are the 1031-Exchange Rules?

1. The real property you sell and the real property you buy must both be held for productive use in a trade or business or for investment purposes, and must be like-kind.

2. The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.

3. All the cash proceeds from the original sale must be reinvested in the replacement property. Any cash proceeds you retain will be taxable.

4. The replacement property must be subject to an equal or greater level of debt than the relinquished property or the buyer will have to pay taxes on the amount of the decrease or put in additional cash funds to offset the lower level of debt in the replacement property.

These days, many self-storage buyers and sellers are either involved in or contemplating a tax-deferred exchange (Internal Revenue Code Section 1031). With long-term interest rates at historic lows and alternative investments offering lower returns than commercial real estate, theres a great deal of capital, debt and equity looking for adequate returnsand theyre looking hard at self-storage.

It seems obvious that if you can defer paying taxes on a long-term capital gain, you should. Some sellers feel so strongly about this that they wont sell their property unless they can participate in a 1031 exchange. Anyone selling real estate should examine this option. First, lets review the basics. To participate in a tax-deferred exchange, the seller:

  • Must direct all proceeds from the sale of the relinquished property to a qualified intermediary.

  • Has 45 days to identify up to three replacement properties in writing. Or he can identify any number of replacement properties as long as their aggregate value does not exceed 200 percent of the value of the relinquished property.

  • Closes on the exchange property within 180 days of the sale of the relinquished property.

Assuming the exchange propertyand the debt on itis of equal or greater value to the relinquished property, the transaction qualifies as tax-deferred. The seller can postpone the payment of capital gains associated with the sale. For most sellers, capital-gains tax rates run about 15 percent.

An Example

A simplified example will illustrate the potential savings. Lets say a seller purchased his property for $1 million and sold it for $1.5 million some years later. Ignoring depreciation, closing costs and capital improvements, hell enjoy a $500,000 gain, and his tax liability will be about $75,000. By participating in a tax-deferred exchange, however, he can defer payment of the tax and invest the total profit rather than give part of it to the IRS.

Now, at some point, the seller is going to have to pay the tax (unless the property is passed on to heirs upon his death). But if he chooses to reinvest using an exchange, its like getting an interest-free loan from Washington for the time he uses the funds. Thank about it: It would cost him $24,375 to borrow that same $75,000 for five years at 6.5 percent. This may be the closest thing to a free lunch an investor ever gets from Uncle Sam; but theres more to it than that.

Lets compare two different scenarios. In the first, the seller sells property 1 and pays the capital-gains tax before buying property 2. In the second, he replaces property 1 with property 2 through a 1031 exchange. In both cases, he sells property 2 five years later. While the before-tax internal rate of return looks significantly better when he uses a tax-deferred exchange, the after-tax benefit is so small as to be meaningless. Why? Because the tax basis of property 1 is rolled into property 2, making the gain realized at the ultimate sale much larger.

This is a complex analysis, so I encourage you to contact a professional tax advisor before making any decisions. There are several issues to examine before participating in a 1031 tax-deferred exchange:

  • Will the capital-gains tax rates be higher or lower when the tax is actually paid? Will you be better off paying today or in the future?

  • The adjusted tax basis of the relinquished property is carried forward into the exchange property. What is the effect of the lower cost recovery as a result?

  • Will you overpay or make a poor decision in regard to the exchange property due to the time limits involved? Does 45 days give you enough time to identify the most desirable property to acquire? Similarly, will you lose bargaining power in the sale of the relinquished property due to time pressure?

  • What are the pre- and post-tax effects of the exchange? How do they compare to the alternative of not participating?

  • How much flexibility could be lost by using a tax-deferred exchange?

A thorough analysis could be of great value in understanding whether to pursue this course of action. A thoughtful approach given your individual circumstances will help ensure you proceed with eyes wide open rather than blindly following a predetermined path.

Dale C. Eisenman, president and brokerin-charge of Midcoast Properties Inc., is a licensed real estate broker in Georgia and North and South Carolina. He has been an active commercial real estate investor for more 20 years and specializes in self-storage as an investor and affiliate of the Argus Self Storage Sales Network. For more information, call 843.342.7650; visit www.midcoastproperties.com.

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