Reasons to Exchange
In addition to the desire to defer the capital gains tax on the disposition of investment properties, there can be other underlying reasons an investor might want to exchange one property for another. The motives often fall along standard risk-reward or cash flow-appreciation scales. The following are examples of typical motives to exchange:
Relocation of Investments – Relocation of a taxpayer’s investments can be accomplished in a “like-kind” Exchange. For example: a taxpayer is moving to another state for a job relocation or for retirement plans. In a tax-deferred exchange, the sale proceeds from investment property in one part of the country can be exchanged into investment property located in another state.
Diversification: Multiple Replacement Properties – A “like-kind” exchange can facilitate a taxpayer’s plan to diversify into several investment properties. Proceeds from the sale of one (1) property can be tax-deferred and reinvested into a number of replacement properties. For example: a taxpayer inherits a “family homestead” property, which has significantly appreciated in value. Substantial sales proceeds may permit the taxpayer to reinvest in a large commercial real estate project. Nevertheless, family members frequently ignore large, complex investments in preference to more understandable, smaller-scale properties such as multiple residential properties or smaller commercial properties.
Consolidation of Properties – A taxpayer can utilize a “like-kind” exchange for consolidation purposes. For example: a taxpayer, over the course of time, acquires a number of small investment properties and now prefers, in order to receive a “credit tenant” cash flow, to have one major investment property. In a 1031 Exchange, the taxpayer is permitted to sell multiple properties, defer the capital gains on each and invest the total proceeds into one replacement property. When using Exchange Accommodators to complete your 1031 Exchange, careful attention is dedicated to the 45-day identification and the 180-day replacement periods.
Convert to Income-Producing Properties – Undeveloped real estate acquired through inheritance or through a “raw land” investment program may result in a burdensome, non-income producing portfolio to the taxpayer. A positive income stream is a frequent “like-kind” exchange goal. Under IRC Sec. 1031 the taxpayer can exchange underdeveloped property for income-producing real estate. This may yield potential increased deductions for the depreciable components of the replacement property (to the extent of rollover basis, together with any added basis due to “new money” or additional indebtedness incurred by the taxpayer).
Debt/Equity Ratio Consideration – Available leverage (i.e. equity ratios) can be enhanced in a “like-kind” exchange, by making more liquidity available to fulfill a lender’s “borrower’s equity” requirement for the replacement of property. For example: a property selling for $500,000, subject to $250,000 of capital gain recognition, will incur approximately $50,000 of capital gains tax (based upon a net cumulative tax rate of 20%). In this example, the property is subject to a 70% loan-to-value amount of debt, meaning that there is an existing mortgage loan of $350,000. In a “like-kind” exchange, the available reinvestment proceeds from the sale would be in the amount of $150,000, as opposed to the after-tax net of $100,000, where no exchange occurs. The available “borrower’s equity” fluctuates markedly with the amount of leverage. The more highly leveraged the relinquished property, the greater the “liquidity impact” of a “like-kind” exchange.
Reinvesting to Accommodate Market Trends – Real estate investing is not generally viewed as closely following the fluctuating consumer trends of retailing activities. The ability to follow demographic trends has become increasingly important in real estate development, particularly with “neighborhood” retail facilities. An exchange can also allow for a modification of the taxpayer’s risk/return portfolio strategies. Rental residential properties command a different rate of return from commercial real estate such as “stand alone” box tenant facility or a franchised drug store facility.
Convert from Management Intensive Property –
Although rental properties create cash flow, they also require constant
management and administrative attention. “Like-kind” exchanges
can facilitate a taxpayer’s plan to migrate a real estate investment
portfolio into commercial properties with professional, third party
Partial Deferral – A “like-kind” exchange will permit a partial realization of the cash/tax impact. For example, the taxpayer sells a piece of commercial real property for $250,000, and for liquidity purposes, the taxpayer directs the accommodator to “except” the amount of say, $50,000 from the sales proceeds from the exchange escrow. This cash can be directly received by the taxpayer (causing a taxable event on only the “excepted” amount).
It is important to note that all of the above scenarios culminate into one significant power: THE ABILITY TO CREATE PYRAMIDING WEALTH ACCUMULATION IN REAL ESTATE OWNERSHIP.