By David Silverstein
If it weren’t for IRC Section 1031 “like-kind exchange” allowing sellers of investment property a tax deferment from capital gains and other tax obligations, as property traders we would be burdened with a tax hit of between 22% and 45%, depending on our tax bracket and very few of us would ever sell. These percentages take into account the tax bill from the feds as well as those from our friends in Sacramento.
For better or worse we would be married to our properties for life. Sales of investment properties would come to a speedy halt, allied businesses would shutter their doors, prices would roll back due to decreased demand and a myriad of other negative consequences would affect our AAGLA membership and the world economy. Commercial property data company CoStar tracked 31 Billion dollars’ worth of commercial property transactions, in Los Angeles County, from January 2015 until July 2016.
If it weren’t for IRC Section 1031 “like-kind exchange” our economy would be a very different. The 1031 Exchange is an economic stimulus that works. According to the National Association of Realtors website, a full 39% of transactions facilitated by Realtors involve a 1031 Exchange. The majority of Realtors sales are primary residences.
A good time for most landlords to complete an exchange is after 7 to 15 years of ownership and after they have taken a significant portion of their depreciation, and of course appreciation, although there is never a one size fits all solution. It often makes sense to upgrade into a larger property with greater potential. If you are netting out $10,000.00 a month now with a 10 unit building, why not exchange up to a 20 unit building, even if it nets the same? Over time you will be much better off. The most common 1031 Exchange misconception I hear in my business is about the “like for like” rule, which is loosely defined as any property held for investment, for any other property held for investment. I know using ‘loosely” isn’t a word often associated with the IRS, but that’s the way it works. If you sell a 12 unit multi-family building, it doesn’t mean you need to buy another 12 unit building, or even another multi-family property. I can sell your 12 unit multi-family property for you and help you replace it with a shopping center or even a single family home, held for investment. The single family home can’t be your primary residence, second home or vacation home. However, I will have more to say on this later. Other common misconceptions evolve around vacant land and the 1031 guidelines for “build to suit”. The short answer is both are A-Okay. We can sell your vacant land and replace it with an apartment building or viceversa. Yes, you can build and do construction within an exchange and use exchange funds to do it. Most apartment building owners know the two main time frames for completing exchanges and they are, 45 days to identify and 180 days to close on the new property, starting from the day you close on the exchanged property. If you are going to “build to suit” or enhance, you would need to be finished with the improvements within 180 days. New construction would be a tall order for us locally; however, it’s not impossible, with good planning and the right team to do significant improvements within 180 days. In my opinion, the “build to suit” option within the 1031 parameters is underutilized. The “build to suit” rule allows us to buy at a lesser value than we sold for as long as with improvements the fair market value within 180 days is equal to or greater than the property being exchanged. Currently, the inventory of investment properties on the market in Southern California is very low and the IRS 1031 “like for like” has a perfect tool to help us with this issue. The rules allow for a reverse exchange, where as we can close on the replacement property first and then sell the property being exchanged. The same 45 and 180 days apply, but in reverse… The fees paid to the exchange accommodator for a reverse exchange are in the neighborhood of $5,000 vs $700 for a “delayed exchange” or what I call a traditional exchange. The level of planning available with a reverse exchange makes the extra fee a non-issue. Common reasons sellers want to complete a reverse exchange are:
- Take advantage of an unexpected opportunity to secure a new property (Great Deal)
- A property which may generate more income as opposed to the one currently owned 3. Acquire in a better location or neighborhood
- A property with less “deferred maintenance”
- Better tenants
- Different property type
If there is a challenge with reverse exchanges it’s securing the cash and or financing for the replacement asset, without having sold the property you are exchanging. Cash is always king and if you have enough cash on hand for a down payment on the replacement property, there are no issues. What do you do, if all your funds are tied up in the exchanged property? What you don’t do is worry, because there are options:
- Private money (AKA Hard Money)
- Swing or Bridge Loans
- Lines of credit on property you own
- Personal loans from friends or family
This is a powerful tool when you are sure your property will sell quickly and have uncertainty about finding a suitable exchange property.
This blog is about real property exchanges, but did you know, IRS 1031 “like for like” is suitable for personal property sales and sales of businesses? In these instances the “like for like” rules are very specific. If you sell a plane, train or automobile, you need exchange into the same. If you sell a gas station business, you need to buy another gas station business.
As a cheat-sheet to remember the important points of completing an exchange, remember the following:
*45 days to Identify
*180 days to close on one or more of the properties Identified
*Equal or greater value needs to be replaced
*Debt and Equity must be replaced
*Up to three properties can be identified with no ceiling on the replacement properties value
*Any number of properties can be identified as long they are all closed on with no ceiling on value
*If more than three properties are identified and not all are closed on, the total value of the replacement properties can’t exceed 200% of the exchanged properties sales price.
*You are able to use the properties you buy in an exchange for your personal use for up to 14 days a year or 10% of the time you have them rented, whichever is greater. The days you stay for maintenance and repairs and upgrades are bonus days.
In regards to personal residences, vacation homes and second homes they do not qualify. However, I have a crazy idea for you. It’s a bit of a fun fantasy; I would like to help someone accomplish. As I stated above, the IRS gives us 14 personal days a year to use the properties we purchased in an exchange or a quantity of days equal to 10% of the days we have the property rented. If we were to exchange into 10 rentals all around the country in exotic places and rent them all for an average of 300 days a year that would give us 300 days to use the homes as we pleased. It’s probably a bit far-fetched and decadent for most people’s tastes but it’s possible within an exchange and could make for a fun life of travel and exploration. The only exception to the 14 days or 10% rule are for those days when you are staying at the property to complete repairs or upgrades. These repair days are in addition to. In essence these days are extra days.
There are a myriad of ways in California to hold title to real property with other people. The good thing about Tenants In Common over all other forms of ownership, in regards to an exchange, is this form of ownership allows a seller to exit independently of his/her partners and complete an exchange.
I hope you found this blog article useful and I hope to post many more tidbits of information supporting our landlord community. It takes a village to raise a landlord and AAGLA supports our village.
About the Author: David Silverstein is a California licensed real estate broker with nearly two decades of real estate sales experience. He has a BSL in Sociology. He has been in the high top 2% of all Realtors Nationwide for units sold and commissions earned. David isn’t burdened by a large corporate structure and can extend special commission pricing and a value added experience to AAGLA members. Before opening New Frontier Realty, in 2007, he was the number one agent at Osman Realtors in Beverly Hills, for 2006 and focused mostly on commercial transactions and higher-end residential. David is an AAGLA member; a member of its Product Service Council, exhibitor at its Multi-Family Expo and Conference, an occasional sponsor of AAGLA events and frequent participant at AAGLA gatherings. He is a landlord in Los Angeles and San Bernardino. His mission as an AAGLA member is to help foster a greater landlord community. He believes in takes a village to raise a landlord…