The concept of a 1031 exchange comes up a lot. With this idea, you’re exchanging one property (property number one) for another (property number two). Today, we’re discussing the advantages of a 1031 exchange, and some of the requirements you need to be aware of.
What Is a 1031 Tax Exchange?
The mechanics involve an exchange trust at an escrow company. The proceeds from the sale of property number one go into the exchange trust and then that trust purchases property number two on your behalf, with the title in your name. This is how the tax exchange works.
Advantages of a 1031 Exchange
Why do people do it? Maybe you purchased property number one for $800,000, and you’ve used depreciation to get it down to $500,000 for tax purposes, and the property is now worth $1.1 million. If you go to sell property number one, you’re going to have a gain of $600,000, and you’ll have to pay taxes on that. Maybe those taxes are $200,000. So, you’ll only have $900,000 to purchase property number two if you operate outside of the exchange. But, if you do a 1031 exchange, you’ll have the full $1.1 million from property number one to go and purchase property number two. So, the advantage is having more money available to purchase another property.
Taxes are Deferred, Not Deleted
But, there are details that some people don’t understand about tax deferred exchanges. Maybe you bought property number one for $800,000, depreciated it down to $500,000, and you want to do an exchange for a second property for $1.1 million. Now, your tax basis in property number two is the same as property number one, or $500,000. So, you aren’t getting away with paying no taxes. The basis for property number two is not $1.1 million. It’s going to be the $500,000 of property number one.
These 1031 exchanges are called tax-deferred exchanges because you’re not avoiding the taxes, you’re deferring the tax you didn’t have to pay on the first property. But, in this example you’re getting the advantage of using $1.1 million to buy a new property rather than getting $900,000 if you were to sell and use the after-tax proceeds to buy another property.
1031 Exchange Rules California
There are a couple of requirements involved in a 1031 exchange. One requirement is that you identify a replacement property within 45 days of closing on the property you sell. You need to send a formal statement to the person in charge of the escrow exchange and identify that property. The second requirement is that you close on property number two within 180 days from closing on property number one.
One exception to the tax deferment is if you die. Your heirs will get a cost basis in property number two of $1.1 million. When people ask how to get out of the taxes, I explain that the only way to do that is to die. That’s not an answer anyone likes.
If you have any questions about tax deferred exchanges or anything pertaining to real estate investing in San Diego, please contact us at Mercer Properties.
Craig V. Castanos is a Certified Financial Planner and Certified Public Accountant located in San Diego, CA. He can be reached at 619.235.2131 or ccastanos@cvccpa.net.