And just to clarify, in real estate, there is a tax code that allows us to actually exchange properties and circumvent the tax liabilities that are triggered on a standard sale.
The IRS Code Section 1031 allows us to swap properties and pay whatever differences in cost go along with them.
Exchanging is a pretty big topic, and a single article can’t really do it justice.
However, I’ll try to give you the essentials here.
Type of exchanges
When you exchange property, you have to exchange what the IRS calls “like kind” property.
So what is like kind?
It’s my rental house for your rental house.
It’s Jim’s 100 unit apartment building for your self-storage facility.
The rules of like kind are pretty broad. Basically, it has to be real estate for real estate.
There are 3 main types of 1031 exchanges:
- An A-B exchange – a simple direct exchange between two parties.
- The A-B-C 1031 exchange – I want your house, you want Jim’s apartment and Jim wants my self-storage. We enter into an agreement to swap these properties and pay whatever costs are involved.
- The A-B delayed exchange – this is the good one.
The 1031 A-B delayed or “Starker” exchange
Back in the 1970’s, a man named Starker went to the IRS and said, “Hey, government – sometimes we real estate investors don’t always know which property we want when we’re selling.”
So Starker along with several other real estate investors helped devise the new code 1031 A-B delayed exchange and this is the one that we almost always use.
Here’s how it works:
1. You decide to sell your property – property A.
2. You go ahead with the sale using a qualified intermediary.
3. This intermediary holds all of your funds while you look for a new property to buy. You have 45 days to identify the new property.
4. Once you’ve found it, you then have 180 days to close the deal.
5. Once the deal is closed and the intermediary releases the purchase funds to the seller, you’ve successfully moved from property A to B without incurring any tax liability.
It may sound a bit confusing, but it really does work and it’s really not that hard.
For one, before you even sell your property, you’ll already be looking for a new one.
180 days, or about 6 months is plenty of time to perform your due diligence on your new property and get the financing in order.
The benefits of exchanging
Exchanging helps you to preserve your wealth and to avoid paying capital gains as well as depreciation recapture income.
You buy that 200 unit apartment complex for $5.5 million with $1.4 million down.
Every year, you raise rents by $20 per unit, adding $48,000 to your NOI.
After 5 years, you’ve enjoyed the cash flow of the building and decide to sell.
Your current NOI is now $790,000 after 5 years, or to look at it another way, your apartment complex is worth $7.9 million given a cap rate of 10.
That’s a $2.4 million gain – imagine having to pay $600,000 in capital gains tax at a rate of 25%.
The Starker exchange eliminates all of that and keeps your money where it belongs – in your pocket.
Want to know more?
Give me a call or send me an email and I’ll be happy to talk about this or any other apartment investing topic you’d like.