Many investors are aware of the value of Section 1031 exchanges in their real estate portfolios. These investors use 1031 exchange to reposition their investments to other neighborhoods or other states, or to reallocate their investments to different asset classes.
The Situation
Andrea currently owns a mixed-use building with 5 residential units above a retail storefront. The property also has ample off-street parking on a 1½ acre lot and is situated near a busy commuter road. Nonetheless, her income from the property is limited due to the market rate for this type of property in her community. Andrea acquired the property about ten years ago for $500,000. A developer is interested in the converting the property into a convenience store and gas station, and has offered Andrea $700,000, which she is considering accepting.
The Problem
Andrea has grown disillusioned with the property because her state imposes stricter regulations on properties with five units or more, as well as the limited cash flow potential. She had been considering selling the property anyway, but her accountant has just told her that she will have a sizeable tax bill if she sells outright. In round numbers, Andrea can expect to pay taxes as follows:
Depreciation recapture tax
($128,000 x 25%)
$32,000
Capital gains tax
($200,000 x 20%)
$40,000
Estimated state capital gains tax
$26,240
Affordable Care Act tax
($328,000 x 3.8%)
$12,464
Total estimated tax owed
$110,704
Selling the property outright would net Andrea approximately $589,000 after the taxes. While Andrea wants to get away from the burdensome restrictions imposed on her by the state, and the developer’s offer is tempting, the prospect of losing nearly 16% of the sale price to taxes is less palatable than dealing with the state rules and regulations and limited cash flow.
The Solution: A 1031 Exchange into Multiple Short-term Rental Properties
Andrea will structure the sale of the building as part of a Section 1031 Like-Kind Exchange. After consulting with her attorney and a Qualified Intermediary (“QI”) like Accruit, Andrea now understands that “like-kind” does not require her to replace the old property with a multi-family or mixed-use property.
Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Andrea’s QI to be held on her behalf until the purchase of her replacement property. This is necessary because a person doing an exchange cannot come in actual or constructive receipt of the net sale proceeds while the exchange is pending.
Within 45 days after the closing on the sale, Andrea properly identified five furnished rental condos for approximately $150,000, for a total investment of $750,000. (Learn more about basics of Forward Exchange, which you may review with your tax and legal advisors.