Have you ever wondered if you could become a victim of your own success? Could you imagine a scenario in which you suffer a catastrophic loss, not as a result of someone committing fraud against you, but rather from your own decisions over a long period of time that end up doing harm? Surely this couldn’t be possible, or could it?
Most experienced real estate investors understand what a1031 exchange is, how it works, and how to use it for tax advantages. But not all have thought about how big of an impact this could have on their portfolio.
The following illustration tells the story of how an investor can use a 1031 exchange to grow their portfolio faster.
Assume an investor has $200,000 in gains and net proceeds after closing. Also assume an investor with this $200,000 capital gain incurs a tax liability of approximately $70,000 in combined taxes(depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $130,000 in net equity then remains to reinvest into another property.
A properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to beheld either for productive use in a trade or business or for investment.”
- If No 1031: a purchase loan using a 25% down payment with financing costs at a 75% loan-tovalue ratio, and the investor would only be able to purchase a $520,000 replacement property.
- If Yes 1031: the same investor chose to exchange, however, he or she would be able to reinvest the entire gross equity of $200,000 into the purchase of an $800,000 replacement property, assuming roughly the same down payment and loan-to-value ratios.
Rule #1 Let The Investment Be The Reason To Invest; Not The Tax Savings
This illustration at first appears to be very compelling. Who wouldn’t want to defer their taxes? After all, deferring taxes feels like not having to pay taxes! Not many people would like the idea of paying $70,000 if they can just kick the can down the road. The second benefit of the exchange appeals to the greedy side of our nature for MORE! If it’s a good thing to have a $520,000 property, then it must be even better to have an $800,000 property, right?
But dive a little deeper into this investment strategy and we uncover some challenges; starting with the investor basing their decisions solely on the benefit of tax deferral. This is simply wrong to do. The analysis of any investment should start with return on capital and safety of investment. Taxes should be taken into consideration only after the investment passes your first analysis.
Rule #2 Never Limit Your Options
The initial problem with the 1031 exchange is that your investment options are limited to like-kind properties. Would you like to go to a restaurant with your family and see all the great food just to be told, “Sorry, you may only have this one item.” Why? “Because this is the food item you have eaten before, so you are only allowed this one choice.” No one would do that! So why is it that people box themselves into a 1031 investment? Oh thats right, tax savings. There are so many options available for investing and they are not all created equal; the right investment for you is the one that meets your personal criteria for investing, any short term goals you may have, and that also meets your future income and retirement needs.
Rule #3 Do Not Invest Under Pressure
With a 1031 exchange you have another factor working against you. This is what I like to identify as “Time Pressure”. IRC Section 1031 (a)(1) states:
“TIMELINE REQUIREMENTS. Measured from when the relinquished property closes, the Exchangor has 45 days to nominate (identify) potential replacement properties and 180 days to acquire the replacement property. The exchange is completed in 180 days, not 45 days plus 180 days.”
What often happens with investors experiencing time pressure to purchase another property is that they are now inadvertently working against themselves. If they enter into negotiations to purchase a property and their offer comes in showing that the qualification of funds are coming from a 1031 exchange, the buyer has the disadvantage in delays (to the seller) and high sales price (to themselves). Time pressure can force the buyer to accept terms and conditions they normally wouldn’t if they were not under the gun to complete the sale.
In this case a person increasing their real estate holdings may also be focused on the size of the purchase versus evaluating if the investment is producing a sufficient return for the price. This is often overlooked amidst the pressure and people settle for lower yielding investments.
These challenges represent some of the ‘cons’ to the 1031 exchange, but not the trap. The trap is your own success. The bigger your property becomes, the less options you have on exchanging. How many 1000 unit apartment complexes are there to choose from? In the commercial world of exchanges it has been known for investors to start small and exchange their way up to eventually owning big box retail spaces like Walgreens, Best Buy, or Circuit City. Eventually, your 1031 exchange is so large that your options become limited.
True Story: A certain successful investor exchanged his way up to owning a building with Circuit City as the tenant. The tenant failed in business, the building went “dark”, and the loan payments were due. Even though the investor tried making the payments, the lender told the investor they were in violation of their loan provision stating the property must have a tenant at all times. The lender called the loan due. The investor was forced to sell his $7,000,000 building in a bad market for only $3,000,00. The resulting losses far exceeded all the years of tax savings.
Rule #4 Learn To See What Your Mind Is Overlooking
Remember the rules of the exchange? “No gain or loss shall be recognized on the exchange” I bet when you read the beginning of this article your mind skipped over “loss”. Losses can and do occur, yet you will be hard pressed to find any 1031 exchange company that will tell you what benefits you miss out on if you can’t recognize your losses.
Make a commitment today not to fall into any traps. Be aware of all the pros and cons and make sure your decisions are based upon sound investment strategies, not simply greed for more, or the fear of taxes. Capital gain taxes may actually be a small price to pay for 100% control over your real estate portfolio and the freedom to make the best investment decisions for your future.