A 1031 Exchange Example

Thinking of selling your investment property?

Wondering how much you’re going to owe Uncle Sam in taxes? Most real estate investors are well aware that they will owe taxes when they sell an investment property.  However, many are surprised to learn that they could owe 30% to 40% of their profits!  When the threat of losing a good portion of their profits, many investors consider a 1031 exchange as an efficient way to defer taxes and keep ALL of their hard-earned equity.

Have questions? Speak to an expert.

A 1031 Exchange Example

Let’s take an example couple, Ron and Maggie, who purchased a small apartment building in California 10 years ago for $1,500,000.  They invested $500,000 of their own money and financed the rest with a $1,000,000 mortgage.

Purchase Price

Cash Equity Paid by Investor $500,000
Mortgage Financing $1,000,000
Purchase Price $1,500,000
Step
1

Determine Adjusted Basis

After several years, Ron and Maggie’s adjusted basis in the property may look like this: 

Purchase Price $1,500,000
PLUS: Acquisition Costs (Example: Title Insurance) $10,000
PLUS: Capital Improvements (Example: New Roof) $65,000
LESS: Depreciation Taken During Ownership $(400,000)
LESS: Deferred Capital Gains $-
EQUALS: Adjusted Tax Basis at Sale $1,175,000
Step
2

Calculate Realized Gain

Ron and Maggie are contemplating selling their property.  They believe the property could be sold for $2,850,000.  Assuming $50,000 in closing costs, their “realized gain” may look like this:

Realized Gain

Sales Price of Relinquished Property $2,850,000
LESS: Closing Costs on Relinquished Property $(50,000)
EQUALS: Net Selling Price $2,800,000
LESS: Adjusted Tax Basis (From Step 1) $(1,175,000)
EQUALS: Realized Gain $1,625,000

 

Note that realized gain is different from cash received from the sale.  Assuming the mortgage has been paid down to $800,000, net cash received may look like this:

Net Cash Received

Sales Price $2,850,000
LESS: Balance on Mortgage to Pay Off $(800,000)
LESS: Closing Costs on Relinquished Property $(50,000)
EQUALS: Net Cash Received on Sale $2,000,000
Step
3

Estimate Potential Tax Liability

Next, Ron and Maggie estimate their potential tax liability from the sale.  Assuming a Realized Gain of $1,625,000 (see previous calculation), the sale would likely place the couple in the highest tax bracket, and their potential tax liabilities may look like this:

Federal Capital Gains Tax1 20.0% $245,000
Federal Tax on Depreciation Recapture2 25.0% $100,000
Affordable Care Act Surtax 3.8% $61,750
State Capital Gains Tax (CA)3 12.3% $199,875
TAXES DUE (Effective Tax Rate)4 37.3% $606,625

(1) Federal Capital Gains equal to Realized Gain less depreciation taken multiplied by the applicable rate.
(2) Based on amount of depreciation taken during ownership of the property. In this example,the amount is based on $400,000 of depreciation taken.
(3) Rate varies by state. Example assumes California.
(4) Effective tax rate depicted as a percentage of Realized Gain of $1,625,000 (from Step 2).

Step
4

Keep Your Equity!

By utilizing a 1031 exchange, Ron and Maggie may defer 37.3% in taxes and preserve all of the profit from the sale of their property.  This means they have more than $600,000 in additional equity to reinvest!

  With 1031 Exchange Without 1031 Exchange
Net Proceeds from Sale $2,000,000 $2,000,000
LESS: Taxes Paid $- $(606,625)
EQUALS: Equity Available to Reinvest $2,000,000 $1,393,375

How Much Time do I Have?

There are two critical deadlines; If you miss either, you will owe taxes. The IRS does not grant extensions on these deadlines.  You have 45-days from the date you sell your property to identify potential Replacement Property(ies).  You have 180-days from the date you sell your property to purchase your Replacement Property(ies).

What MUST I Buy?

In order to defer ALL of your capital gains taxes, the Replacement Property must have a purchase price AND mortgage balance equal to or greater than the Relinquished Property being sold. Note that investors are not required to reinvest 100% of their sales proceeds in replacement property. This is known as a “Partial Exchange” and the portion the exchange proceeds that are not reinvested are referred to as “Boot” and are subject to taxes. 

Ron and Maggie believe their property can be sold for $2,850,000. Assuming the mortgage balance will be $800,000, their evaluation of a suitable Replacement Property will look like this: 

Replacement Property   Relinquished Property
Purchase Price $3,975,000 > OR = Sale Price: $2,850,000
LESS: New Mortgage: 2,000,000 > OR = LESS: Mortgage Bal.: 800,000
ADD: Closing Costs** 25,000   LESS: Closing Costs: 50,000
EQUALS: Proceeds $2,000,000 > OR = EQUALS: Proceeds: $2,000,000

Closing Costs are considered part of your equity

What MAY I Buy?

Generally speaking, any type of investment property type may qualify for an exchange, except your primary residence. The IRS considers all “Investment Properties” to be “Like-Kind.”

  • Properties do not need to be the same type. For example, raw land can be exchanged for an office building, a warehouse can be exchanged for NNN retail property, or a rental house for a Replacement Property Interest in a 300-unit apartment complex.
  • Properties can be located anywhere in the US. For example, a property in California can be exchanged for one in Texas.
  • An exchange can be multiple properties. For example, you may sell one property and exchange into three and vice versa.
  • An exchange may be for Replacement Property Interests™ (RPI) where the investor owns a proportionate share of a property along with other investors. RPIs are an attractive option for many 1031 investors as they offer access to institutional-quality assets, NO landlord responsibilities, and long-term, recurring income.  Additionally, RPI’s can provide diversification as investors can efficiently exchange into multiple properties, property types and locations.

 

Where Can I Find Replacement Properties?

You’ve come to the right place!  Visit our 1031 Marketplace for a wide selection of 1031 exchange-eligible investments. 

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Have Questions?

If you are considering a 1031 exchange, contact us to discuss your questions, concerns, and needs. Realized would love to dramatically reduce the risk, time, costs, and complexity of completing your exchange.

 

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