Hi Kathy:

I purchased a two-bedroom condominium six years ago as an investment property. In your last article you talked about it being a seller’s market. I am thinking that I could sell at a good time and upgrade to a higher priced home, but I am not familiar with the 1031 exchange rule. I only know that it would allow me to save on capital gains tax. Someday, I would like to leave this rental for my children. I paid $350,000 for this condo in 2009, and last month the same condo, same size, and floor plan sold for $500,000. If my unit sells for the same, am I responsible to pay tax on the entire $150,000 if I do not reinvest in another exchange property? Could you help me to understand?

—Amir

Hi Amir:

You are not alone when it comes to 1031 exchanges and understanding the benefits. I would be happy to explain some of the benefits of this tax code, but I always recommend that you speak to a certified tax expert when considering any options where tax law is important.

A 1031 exchange refers to the Internal Revenue Service (IRS) tax code Section 1031. It is a tax code that was set up to allow a real estate investor a way to defer capital gains tax on the sale of investment property. Capital gains in real estate refers to the gains or profit that would be made on the sale of income, investment or business property. Capital gains taxes in California can run between 30 percent and 40 percent when considering both federal and state taxes, depreciation recapture, and a possible healthcare surtax that would be taken out.

Many financial planners and real estate investors use this as a wealth-building tool to defer taxes until they are ready to cash out, or even to avoid them altogether upon death. If investment property is tax deferred and the owner of the 1031 exchange dies, the beneficiaries of the property inherit it without having to pay accumulated capital gains tax. Many estate planners help their clients spare their beneficiaries of having to pay taxes on part of their inheritance. (Another catchy phrase, “swap till you drop”)

Let’s use your example where you purchased a condominium rental and had a $150,000 gain. If you have a $150,000 profit and deduct an average of 35 percent for total capital gains tax, that would be $52,500 in taxes. That leaves you $97,500 for a 25 percent down payment and a 75 percent loan to value on the purchase of another property that is not exchanged. This would qualify you for a purchase price of $390,000. But if you take the whole $150,000 profit and put the $150,000 back into investment property assuming the same down payment and LTV, you can purchase a home with a purchase price of $600,000.

After a few years, you do the same thing, sell, make a profit and reinvest and you can see how your investment can grow and build. If the last property you purchased was valued at $900,000, then you pass away, and your designated beneficiary inherits this and then decides to sell it for $1 million, they now only have to pay taxes on the difference between the $900,000 and the $1 million, and forego paying on any accumulated capital gains tax. That would be $100,000 worth of capital gains tax avoiding all of the taxes that would have accumulated from the initial purchase price of your condominium at $350,000.

Can you see how this can be beneficial for estate planning and/or wealth building?

According to Steve Decker, vice president at IPX1031 Exchange Services: “Our exchange business has increased over 40 percent just in the past year. In 2009, ’10 and ’11, when the real estate market was challenged and prices were down, it was the investors that came in and purchased a majority of the foreclosures, short sales and value-priced properties. Now, with interest rates at historically low levels and it being a seller’s market, our investors are selling and reinvesting into more valuable property; property that will generate more cash flow or that is in an area of greater appreciation in property value.”

Amir, there are strict timelines involved with exchange properties and other guidelines in order to qualify for a 1031 exchange. Also, a third-party exchange administrator who facilitates the transaction called a Qualified Intermediary would also come into play. A great exchange specialist who is knowledgeable is worth a king’s ransom. In order to get a clear understanding of these timelines and to see if your property qualifies and receive the maximum benefits, seek professional advice from your CPA, a wealth planner, and a 1031 exchange specialist.

Ben Franklin said, “In this world nothing can be said to be certain except death and taxes.” Ben would smile down on a 1031 exchange!

—Kathy McSherry is a veteran Realtor in Mission Valley with Coldwell Banker West. Email questions to her at [email protected].