“In this world nothing can be said to be certain, except death and taxes.”
Benjamin Franklin, 1789
Could Mr. Franklin have been half wrong? The answer is yes for individuals willing to make systematic and disciplined use of tax deferred exchanges pursuant to Section 1031 of the Internal Revenue Code.
Why 1031 Exchanges are Popular
A “1031 Exchange” is simply a method by which a property owner exchanges a qualified property for another like-kind property while deferring any capital gain or loss which would have been recognized upon a sale. If the prescribed steps are followed, then Section 1031 allows up to 100% deferral of the realized gain while avoiding the payment of capital gains, which can be as high as 37.1% in California.
The Basic Requirements of a 1031 Exchange
While many books have been written on the subject, IRS Publication 544–Sales and Other Dispositions of Assets provides a great starting point. Here are the basic rules:
1. The section only covers investment properties, not your primary residence. However, a primary residence can be turned into an investment property. Consult a tax professional for guidance on the timeline for making this conversion.
2. The total purchase price of the replacement “like-kind” investment property must be equal to or greater than the total net sales price of the relinquished property. There is a limited exception if the property had previously been used as the owner’s primary residence.
3. All the equity received from the sale of the relinquished real estate must be used to acquire the replacement “like-kind” property. To the extent that not all equity is moved to the replacement property (e.g., when cash is withdrawn), the remainder will be taxed.
4. The proceeds from the sale must go through the hands of a “qualified intermediary”. This rule is absolute. If the proceeds are handled by the owner or his or her agents, then all the proceeds will become taxable.
5. The section generally applies to all classes of real property anywhere in the United States (e.g., rental properties, commercial properties, and raw land).
6. Timing is everything. There are two deadlines that are strictly enforced:
a. The replacement property must be identified within 45 days from selling the relinquished property.
b. The buyer must also take title to the replacement property within 180 days after selling the relinquished property.
c. There are no extensions possible for either deadline, even if the critical date falls on a weekend or legal holiday.
A Powerful Wealth Building and Estate Preservation Tool
A 1031 Exchange is also an important estate preservation tool. If an investor never sells, then his/her heirs inherit the qualified properties with a stepped up basis (which means the fair market value on the date of death). As a result, they can immediately sell without there being a taxable capital gain.
Silicon Valley Provides Unique Opportunities
Two-to-four unit income properties are a great vehicle for 1031 Exchanges, especially in the Bay Area. The Silicon Valley Business Journal recently reported that the nation’s top three performing rental markets are in the Bay Area. Rental rates rose 10.1% during 2013 in the San Jose Metropolitan Area (which includes Palo Alto, Los Altos, and Los Altos Hills). The vacancy rate during the same period was a low 3.0%, and the average rental rate was $2,153 per month.
Savvy investors and their investment advisers value the incredible combination of secure cash flow and continued appreciation that these properties provide. This conclusion is supported by the sharp decline in inventory of two-to-four unit income properties over the past three and a half years. Between 2011 and today, the average supply of inventory has declined year after year:
2011 6 months of inventory
2012 5 months of inventory
2013 3.24 months of inventory
2014 (YTD) 2.5 months of inventory
Indeed, the strength of the Bay Area economic fundamentals is the reason we project that there will continue to be above-average appreciation in two-to-four unit income properties in the immediate area.
It bears repeating that most real estate agents do not have expertise in the tax rules, and the tax treatment will vary significantly based on a seller’s circumstances and the deal structure. Thus, sellers should consult an expert.