Wondering how to transition into multifamily? While you may know that 1031 Exchanges let you defer capital gains taxes and depreciation recapture when you move from one property to another – did you know that you can use this same strategy to consolidate multiple smaller property sales into one larger one without paying taxes?
Owning quite a few smaller properties can leave you spread over a large area trying to maintain multiple locations. What if you could exchange all of those properties for one large multifamily unit without sacrificing any of your gain to Uncle Sam? The good news is, with consolidation 1031 exchanges, you can!
What is a Consolidation 1031 Exchange?
To put it simply, a consolidation 1031 exchange starts with the sale of investment real estate and ends with the purchase of investment real estate. As long as the property valuations work out, consolidation 1031 exchanges allow you to sell multiple units and combine their value into a larger purchase.
For example, if you have four single-family homes selling for $250,000 each, they could be sold and combined to purchase a property worth $1 million. This does require additional planning as the timing of your sales and replacement purchase must fall within the IRS mandated time frames. Coordinating extended and/or rapid closings with your purchasers and entering into a contract on your replacement property may require extra effort and negotiation.
Why do I need a Consolidation Exchange?
One of the main benefits of using a consolidation 1031 exchange is the deferment of taxes. Typically, when you sell your investment property, any gain is subject to taxation. Also, whether or not you took advantage of the available depreciation deductions while you owned the property, you will still be subject to “depreciation recapture” taxes. However, this is not the case when using a 1031 exchange.
Consolidation 1031 Exchange Example
Some clients of mine recently completed a consolidation 1031 exchange. They sold three properties in the Midwest and replaced them with one higher value vacation rental property in California. First, they identified both their replacement property. Then, they found a purchaser for all three of their original rentals. Then they sold the three original rentals over the course of three weeks. They purchased their replacement property just three weeks later. Not all transactions will happen as neatly or swiftly as theirs, but it is an indication of what advance planning can accomplish.
Consolidation Can Add Up
When you use a consolidation 1031 exchange, you can sell your investment real estate and purchase replacement investment real estate while indefinitely deferring payment of the tax that would normally be due on the sale. This can significantly increase your buying power as well as your opportunities for compound growth and reinvestment.
For accredited investors looking to move from active to passive investing, there are opportunities to 1031 exchange real estate investments into passive DST (Delaware Statutory Trust) investments without paying tax. DSTs are becoming a more common route to passive investing as the market matures. Here we will clearly define a DST and give a few of the advantages and disadvantages of moving into this type of passive real estate investing using the 1031 exchange.
What is a DST?
A Delaware Statutory Trust (DST) is a passive investment opportunity that allows investors to own fractional shares of properties held by the trust. Within the DST, a trustee (also known as the sponsor) holds title to assets that benefit the trust interest owners.
Accredited investors are beneficiaries of the Delaware Statutory Trust. The IRS treats DST interest as direct property ownership, thus qualifying it for a 1031 exchange. DSTs were formalized as qualifying replacements for 1031 exchanges in 2004 with the adoption of Revenue Procedure 2004-86.
Examples of DST investments are portfolios such as commercial buildings (from retail to storage), multifamily complexes, and various other types of industrial, commercial, and residential real estate.
What is a 1031 Exchange?
A 1031 exchange allows real estate investors to defer their capital gain taxes when they sell. To qualify, they must transition into another investment property. The IRS tax code has several other steps that an investor must take to use the 1031 exchange, as explained in the series The Six Basic Requirements of a 1031 Exchange.
What are the Advantages of a DST?
There are many advantages to investing in DSTs. First, for the accredited investor, they are able to move into a completely passive mode and no longer have to deal directly with bank finances and property management. No more trash, toilets, and tenants to manage.
Second, DSTs offer investors access to higher-quality assets that are typically only available to large institutions. And this still provides investors with all of the benefits of regular real estate ownership including cash flow, appreciation, and tax write-offs such as depreciation.
Another benefit is that debt within DSTs is non-recourse. Most DSTs already carry institutional-grade debt. The investor assumes their pro-rata share of the debt but does not have to qualify for it. This debt is non-recourse to the investor, which means that the DST investor is not personally liable. The non-recourse debt inside the DST can free up leverage capability for the investor allowing them to be more aggressive in their borrowing outside the DST. It is also important to note that investors do reserve all rights of real estate ownership, including the ability to 1031 exchange back into fixed real estate when the DST matures, typically in 3-6 years. Current rates of return are generally 4-7.5% on the cash invested. All of these advantages make DSTs popular with investors wanting passive investments.
What are the Disadvantages of a DST?
A disadvantage with DST investments are lack of control, which can be deemed a hurdle to those used to handling all decision-making. Property upgrade, for example, is left up to the sponsor, who is responsible for making decisions on the investors’ behalf. Another downside to DSTs is that the amount of debt is not controlled by the investor. Even non-recourse debt can leave the asset at risk. However, there are restrictions on new borrowing in DSTs, as DSTs cannot raise new capital. This can be either a protection or a disadvantage for the investor. The sponsor cannot irresponsibly take on more debt. But, if the property needs updating, years of profits may have to be used and could reduce property cash flow for the investors. Both advantages and disadvantages need consideration before investing in DSTs.
A Final Word on DSTs
To recap, DSTs may provide a solution for accredited investors looking to invest their time on something other than managing their properties. The move to DSTs could be spurred by a desire to travel or spend time with family, or to off-load the increasing work on an aging property. There is no shame in wanting to step into a more passive role.
There are advantages and disadvantages to DST investments. Return on cash invested is typically superior to leveraged investments that are high in appreciation and low in cash flow. Alternatively, there is a loss of control in return for the freedom from hands-on management. Above all, investors should research the operators, properties, and legal structure of DSTs. Seek advice from a professional financial advisor. They can help assess if a DST investment is an appropriate investment for individual financial circumstances and goals.
While we enjoy a rising market, it’s always a smart move to consider the eventual dip in the cycle that can severely cripple an investor if they are not forward-thinking in their preparation. Here are several strategies to help insulate your investments and mitigate financial fallout when the market takes a downturn. To recession-proof your investments, consider the properties in your portfolio. Identify where you have made wise investment choices with appreciation that you can reallocate and put to better use.
Here are my recommendations on how to make that gain profitable while recession-proofing your holdings.
- First, stagger your sales. Sell the properties with the least amount of gain, depreciation, and the highest cash equity. For these particular properties, do not 1031 exchange, pay the tax. The properties with high-gain and low-cash equity are the properties you will want to 1031 exchange.
- Use the cash from the taxed sales to pay down your debt on 1031 exchanged properties so that you can recession-proof those properties with a lower debt load.
Pro Tip: You can allocate your proceeds in any way you want in a 1031 exchange. So why not buy two replacement properties – one for cash and one with maximum leverage. Enjoy the recession-proofed debt-free property and the extra ROI (Return On Investment) bang from maximum leverage on the other.
Remember depreciation recapture is taxed the highest. Capital gains are taxed the lowest. Equity is not taxed at all (unless it is profit). So, when trying to reshape your portfolio while minimizing tax, sell the properties that have the least depreciation recapture and the highest amount of equity (lowest debt). If you sell those and pay the tax while 1031 exchanging the others, you will minimize your taxes while sheltering the optimal assets.
For growing your recession-proof portfolio, another recommendation would be to let the market speak on each sale. There’s no penalty in starting and not completing a 1031 exchange. So let your 1031 exchanges commence on each sale, and if you find quality replacements in the 45-day identification period, then finalize your 1031 exchange. If not, then don’t turn in a list and let your 1031 exchange die on Day 46. Sure, you will have to pay the exchange fee to start a 1031 exchange, but there is no penalty from the IRS for not completing one. You pay the tax and a slightly reduced 1031 exchange fee (as it is a deductible cost of the sale). You would want to think of the exchange fee as buying you the identification period while you see if you can find suitable replacements.
Pro tip: If you happen to be selling toward the end of the year and start an exchange, then let it die after Day 45, you will receive the proceeds early the following year, which means you won’t have to pay the tax until April of the year after that. So, for the price of a 1031 exchange, you will get to look at potential properties, and you will defer taxes for an additional year.
My best advice to recession-proof your REI portfolio – keep your options open! Spreading out the tax by selective 1031 exchanges gives you a runway to do what you want with your properties. Look at each property individually, keep the investments with the best NOI (Net Operating Income), sell those with the least amount of gain, depreciation, and the highest cash equity. Look for investments in up-and-coming areas with low maintenance or reinvest in a different property type (if that is what you are looking to do). In the end, remember, no one ever went broke paying tax on profits. (It just feels like you do!)
For help deciding which properties work best for you to 1031 Exchange, see my article: How to Build Wealth Now, Pay Taxes Later with a 1031 Exchange.
*Originally Posted on BiggerPockets.com
This topic is one on which I have often meditated. As a Christian, how should one tithe on their income as a real estate investor? Gross profits before expenses work differently when it comes to a real estate portfolio. The Bible tells us to tithe on a tenth of our gross income. Do we include appreciation? How do we honor God when real estate investing does not produce a straightforward income?
There are many ways to interpret tithing from a scriptural lens, so here are my two cents on how God has called me to live. First, there’s no right or wrong way in budgeting or giving. The right or wrong is in your attitude and agenda. Dave Ramsey and I agree that tithing is giving! In the boom years leading up to ‘08, my income was very unpredictable but pretty high. My family had a hard time budgeting our giving (welcome to REI). So, we tithed what we knew was coming in every month as a fixed base. Then we committed to banking 10% of everything else (a tithe above a tithe, I guess) and prayed separately for places to give. It was so fun! We bought cars for single moms, dug wells for orphanages, and bought gifts for AIDS camps in Jamaica. In early 2008, I was told to give it all for six months to a couple I had known for a long time who had suffered some catastrophic setbacks. That family got the last check—and that was also the last time we ever had a tithe above a tithe. The market crashed, we lost several zeros—but what a joyful and fulfilling experience of giving we had!
Now for some sad news and a reality check: Tithing and charitable giving have been hijacked by the government and the church. Giving for a tax write-off is giving to receive, and that’s not offering first fruits. In the same way, many churches want to guilt you into giving directly to their institution (mostly because they have initiatives that they feel are important). There’s nothing inherently wrong with that but the tithe is God’s, not the church’s. There is a distinction. Part of that distinction is that our greatest call is to give to the disadvantaged and those in real need, such as widows and orphans. This can be a great departure from the tithe to pay for gyms, lobbyists, or stained glass windows.
It seems like the question shouldn’t be “How much do I need to tithe?” but, rather, “How little can I keep?” Look for opportunities to give and where He wants you to give. The rest is all noise.
In the final article of our seven-part series on the basic requirements of a 1031 Exchange, we will be discussing the last requirement; reinvestment of cash, also known as the Equal or Up Rule. While it’s the last stretch and you’re almost home free with tax deferment, the final requirement is just as important, if not more so, than the rest. Here we will explain exactly how the reinvestment of cash works and what the Equal or Up Rule is. If you follow along with the series, and this last requirement, you’ll be on your way to a successful 1031 Exchange!
Reinvestment of Cash / Equal or Up Rule
In order to defer all capital gains tax with a 1031 Exchange, you must put all of the cash proceeds from the sale into the next purchase. There is a way to do what is referred to as a partial exchange but we’ll cover that more further below. If the goal is to defer all tax, then all of the cash must be used toward the next purchase. If you touch any of that cash, it becomes taxable. Reinvestment of the cash isn’t the only thing you have to worry about though. You must also keep in mind the Equal or Up Rule.
The Equal or Up Rule refers to the fact that your new property purchase must be equal to or greater than the value of the property you sold (the net sales price once you pay commissions and closing costs). If you buy down, or purchase a property that costs less, it is considered to be the same as taking a profit. If you take a profit, then you won’t be able to defer all of the capital gains taxes and will have a taxable event.
The easiest way to calculate your reinvestment goal is to look at the bottom of your settlement statement. You’ll see the cash you received at the end of the sale, plus the amount of mortgage paid off. Those two numbers added together are your reinvestment goal. To make it simple just keep in mind that:
CASH + MORTGAGE PAY OFF = REINVESTMENT GOAL.
Partial Exchange and Taking Cash Out
When completing a 1031 Exchange, there may come a time where you need to take some cash out. If you need cash now, it is possible to do this and still complete your exchange. Remember, the reinvestment of cash requirement states that in order to defer all tax, you must use all of the cash and purchase at least as much as you sell. Therefore, taking some cash out or purchasing for less than what you sell does not jeopardize your exchange. However, it does create a taxable event. If you purchase less than what you sold or take some cash out, the IRS considers this to be “boot” and tax it as profit (don’t ask where the term boot came from…).
Some have asked about refinancing the property before selling and I don’t recommend it. The IRS does not look kindly upon refinances immediately before a sale. Though what you can do is start a 1031 Exchange, leave all of the proceeds in, complete the exchange and then immediately refinance the new property. This is considered borrowing against equity. If you leave all of the proceeds in, then refinance after the fact, you can get the cash you need and it will be tax-free.
Equal or Up Rule Summary
As you have learned by now, the IRS has very specific rules and requirements that you must follow for a 1031 Exchange. The Equal or Up Rule or the reinvestment of cash is straightforward and easy to follow. It simply means that the purchase of your new property must be equal to or greater than the property sold. The reinvestment amount is your net sales price. This is the contract price minus the closing costs of the net sale but before the mortgage is paid off. As long as cash is reinvested, all capital gains taxes will be deferred.
If you need cash right away, you can purchase a property for less than what you sold for. This is called a partial exchange. The amount you take out or buy down is taxed as profit while the rest remains tax-deferred in the exchange. It is also possible to refinance the property after you have started a 1031 Exchange. With this method, you leave all of the proceeds in and then pull tax free equity out of the new property by refinancing.
If you have any questions at all about any of these requirements, contact me and my team at 850-889-1031. We’re happy to help with any questions you have regarding your 1031 Exchange.
Article originally published at: https://www.biggerpockets.com/member-blogs/12255/91279-equal-or-up-rule-1031-exchange-series-part-seven
Welcome back to our seven-part series on the basic requirements of a 1031 Exchange! In our last article, we discussed the need for the Qualified Intermediary during the exchange. In this, part six, we are going to move on to title requirements. As we’ve now learned, the IRS is very detailed when it comes to the rules and regulations of a 1031 Exchange. Part of those regulations include very specific title and taxpayer requirements. Now we are going to discuss what those requirements are and the best way to avoid any title issues during the exchange.
Title Requirements in a 1031 Exchange
While there might be a lot of complicated statutes to understand during a 1031 Exchange, the title requirements are relatively straightforward. This requirement states that in the same manner the taxpayer holds title to the old property that is how the taxpayer must take title to the new property. Essentially this means that the taxpayer of the old property has to be the taxpayer of the new property. Therefore, if you are the taxpayer for a piece of property and sell it through a 1031 Exchange, then you must also be the buyer of the new property to qualify for the tax deferral.
Any tax paying person or entity that owns real estate is able to do a 1031 Exchange. That means you, as an individual, as well as any corporation, LLC, partnership, or trust could do an exchange. However, that doesn’t mean that an individual can complete a 1031 Exchange on property that is owned by an organization. The basic rule of thumb here is to check the tax returns. The name on the property and tax return will usually match. But the most important consideration is whose tax returns report the activity of the property.
Avoiding Title Requirement Issues
In a 1031 Exchange, title requirements are met when the taxpayer who owned the old property is also the taxpayer on the new property. We have also been asked if people should be added to the title before a sale. The answer to that is no. For example, Sue owns a rental property and she is currently the only one on the title. She may want to add another individual to the title right before she sells it. This is not recommended. By doing this another taxpayer has been added to the property. The IRS could then come around and ask why this person took title to the property. Did they take it to hold it for productive use? Or did they take title to primarily facilitate the sale? These are small details that could jeopardize a 1031 Exchange if they are not sorted out properly.
But this also illustrates another facet of the consistent taxpayer. What if that individual that the person above wanted to add to the deed happened to be her husband? If they file a joint tax return then the IRS actually perceives both of them to be the same taxpayer by virtue of the joint tax return. In that event adding her husband to the deed right before sale does not change the taxpayer and would be permissible.
As we mentioned above, entities such as corporations and an LLC can own real estate. While there are many different people involved in this process, the title requirements state that the taxpayer names must match. Therefore, you as an individual cannot complete a 1031 Exchange with property that is owned by another entity, even if you are a part of that entity. Your best bet is to always check the tax returns to be sure.
Do You Have Questions? We have Answers!
While the title requirements in a 1031 Exchange seem simple enough, we’ve seen clients accidentally trip over this step more than once. Always make sure you check the title and the tax returns to be sure. The taxpayer of the old property has to be the taxpayer of the new property. And it’s not as simple as simply matching the deeds. There are going to also be lending issues and certain state tax issues that can get in the way and trip you up if you don’t have an experienced guide as a QI.
If you have any questions at all about these requirements, contact me and my team at 850-889-1031. We’re here to help with any questions you have regarding your 1031 Exchange.
In the next and last part of our series on the basic requirements of a 1031 Exchange, we will be discussing the reinvestment of cash or the equal or up rule. This is a very important last requirement, so don’t miss out!
This article first appeared on the BiggerPockets website: https://www.biggerpockets.com/member-blogs/12255/91178-title-requirements-1031-exchange-series-part-six