3-Way Tax-Deferred Exchanges
What are these transactions?
If you own a parcel of real estate that has greatly increased in value over the years, it is imperative that you consider this as a form of preserving your wealth. The capital gain taxes on the gain on the sale of your real estate asset can be tremendous. There is both Federal Capital Gains Tax and State Capital Gains Tax. In 2013, the federal capital gains rate is as high as 20% but will vary with your individual tax situation. See your accountant for the latest updates.
The state capital gains rate in Oregon is 9.9% and in Washington is 0%.
The Combined State and Federal Tax rates as analyzed by the Tax Foundation (www.Taxfoundation.org) for 2013 for Oregon is 31% and for Washington is 23.8% depending again on your situation. Of course, in this economy, these rates can change depending on what is proposed in the tax codes in the state or in DC. Again...see you accountant on this as rates vary depending on your several factors. This page is simply a heads-up to you that you should at least consider it.
One of the biggest mistakes I have seen was a forest landowner who had an estate worth about $4,000,000 and his cost basis was close to zero. He wanted to liquidate. It was at the end of his investment holding period so he decided to harvest the timber from his property first and then... put the land on the market to sell it. If you harvest the timber from the property and convert it to logs, it will not qualify for an exchange under the IRC 1031 rules. It would have been better to sell the land and timber in one lump sum and treat the entire capital gain under the IRC 1031 rules. This particular owner ended up paying close to $1,000,000 in capital gains tax! I asked him what he was going to do with his funds and he said he was going to go and buy more real estate! I could have saved him over a million dollars in taxes had we discussed the benefits of a 3 way tax-deferred exchange! As an alternative we could have easily directed this investor into approximately 80 multi-family units with a gross income of over $500,000 per year! Net income would have been above $325,000 per year yielding an 8.1% capitalization rate. Take the time to understand this process to preserve the hard earned wealth that YOU have created.
As a success story, I was involved in the sale of a property in the mid 90's for a forest landowner that netted the owner about $4,000,000. Because it had been in the family for about 40 years there was very little cost basis and the entire sale would have been taxable income. They saw the value of the 3-way tax-deferred exchange. This particular owner decided to split the cash in half and invest half of it in California and the other half in Colorado. This just happened to be where her children lived. The idea was to buy income producing property via the usage of a 1031 tax deferred exchange. Then the children could manage the property themselves and provide income for the elderly parent. This not only taught the children (which were actually responsible adults) about managing income producing property but they were also managing their inheritance for the future. The family preserved their wealth and was able to provide a continued stream of income for the elders in their retirement. In addition, should the family want to acquire additional property—they had adequate security in place for any loan needs. They took the time to understand the 1031 process.
Another Oregon landowner owned 80 acres with a very low cost basis. I sold the property for the family for approximately $2,500,000 and one of the family members wanted to "do a 1031" and the other didn't. The equities were split and the individual who did the 1031 exchange bought several houses in Sun River as rentals and also some houses on the coast of Oregon. He then rented them out as vacation homes. The value of those properties have almost tripled since then. If he decided to sell one of his rental homes...he could in turn continue doing the IRC 1031 exchanges and build the families wealth. The basis of the original 80 acre parcel becomes the new basis for the replacement properties. Nonetheless, this owner continues to preserve and grow his families' wealth.
Here are the Basics
1) If you have owned your real estate for over 1 year.
(establishes the real estate as a capital asset)
2) If you have used it for investment purposes in your trade or business-(meets the Qualified Property requirement)
3) If you have a low cost basis on it and it has greatly appreciated in value. (establishes that there is a potential capital gains tax liability)
4) If you intend to sell the property and buy more real estate
(meets the Like Kind requirement)
Then you should seriously consider the benefits of an IRC 1031 tax-deferred exchange.
3-Way Exchange
When some real estate owners hear the word "Exchange" then they think they need to find somebody who wants to do a two-way trade. They think "if I want to sell my timberland...then how I am going to find someone who owns an apartment building to trade me for it?" The fact is---you don't have to find someone to do a direct swap—the 3 way exchange exists to make it easier—but there are some fairly stiff rules and time frames that must be followed. There is no gray area in this issue.
From my experience, the 3-Way property exchange is the most common form of exchanging. Here is how it works:
Assume that you own a parcel of timberland. You are landowner A.
1) Landowner A puts his property up for sale
(the "Relinquished" property)
2) Buyer A makes an offer to buy it.
3) Landowner A agrees to sell
(must include specific IRC language!)
4) A Qualified 3rd party Intermediary is contacted and paperwork is transferred to them on behalf of the seller.
5) Buyer A pays cash into Landowner A's account held by the Intermediary and closes the transaction.
6) Landowner A has 45 days to identify a "Replacement property". There are specific requirements in identifying these properties and in making offers on other properties!
7) Landowner A has 180 days from the close of the Relinquished property to close on the Replacement property.
I have simplified this process as there are additional specific requirements by the IRS that your tax professional or a qualified intermediary can answer. I have done several of these and can also walk you through the process.
Benefits of an IRC 1031 exchange into income producing property
1) Preservation of equity
2) Cash flow is derived from 100% of your re-invested equity.
3) The investor can get annual appreciation of real estate if properly invested.
4) Can get a loan against income producing properties easier than other types of real estate assets.
5) Liquidity is beneficial if another "good buy" comes along
Most common problems in the IRC 1031exchange
1) The 45 Day time rule : It is a good idea to start early to find a Replacement property or properties. We can help you locate adequate replacements in Oregon or Washington and are experienced at moving quickly in any county. The 45 day time frame goes by quickly! There is no time to dawdle once a property is relinquished. The exchanger needs to "identify" property within 45 days of closing on their relinquished property. I once had an offer on a replacement property and on the 44th day the sellers decided they did not want to sell! I hurriedly went to another county and bought a 10 unit apartment building. Now...I actually want to close my transactions prior to the 45th day even though the exchanger has 180 days from the sale of the relinquished property to close the transaction.
2) Managing the new income producing property: There are some good multi-family property managers in the real estate industry that charge anywhere from 6-10% of the gross income to collect rents, handle tenant issues and the like. Some owners prefer to manage their own properties. I like to manage my own property and have people available for emergencies in the event those exist. If a larger project is purchased the property owner can find a good on-site manager to handle the issues. Some banks take direct deposits from tenants and then post the tenants name on the internet that they have paid rent. This makes it easy for both the tenant and the landlord. If you are considering buying a multi-family property, feel free to give me a call to discuss this issue.
Other exchanges
There are a couple of other exchanges available for the investor. I will not discuss these in detail because information on these can be reviewed thoroughly with a Qualified Intermediary. They are the:
1) Reverse Exchange—this is an exchange where the property owner buys a replacement property first with other cash or with loans, then they sell their relinquished property within the 180 day time frame. The relinquished property needs to be identified within the 45 day time frame of closing on the replacement property. This would be a good technique to use if you have the spare funds to buy additional property outright and if you know, for a fact that you would be able to sell your relinquished property within the 180 day time frame.
2) The Build to Suit Exchange—Once a property owner relinquishes their property they can also apply the proceeds to a new construction project. Deadlines of 45 days to identify and 180 to close or finish on the project can be the major issue to overcome. If you have a project that is shovel ready and you can fast track the permitting and construction project to meet the timelines then it might be something to consider. The exchanger uses an Exchange Accommodation Titleholder to hold the property while improvements are being made. Give me a call and I can refer you to a very good accommodation firm that I have used for 20 years.
Other examples: Some landowners own and live on their timberland or agricultural property and wonder how they can take advantage of the exchange process. Recall that the real estate needs to be used for investment purposes in their trade or business. On one occasion, we sold an 80 parcel that had a nice house on it. We isolated the house and I believe 5 acres and treated that as a personal sale of property in which the landowner used his home exemption to avoid paying the taxes. Then we sold his remaining 75 acres plus his timber in a lump sum and the landowner utilized those proceeds in an IRC 1031 exchange and bought some additional property out of state in an area that he wanted to retire. The Qualified Intermediary helped structure the transaction so that it complied with all IRS rules.
This paper is intended to assist you in understanding the fundamentals of the IRC 1031 tax-deferred exchange. At James M. Worl Investment Real Estate our goal is to help you preserve your families' wealth. I have seen how hard people have worked to create their wealth on their timberlands or to preserve their estates. I am here to assist you in the sale of your property and the reinvestment of your proceeds into a property that will work for you. Feel free to give me a call and we can discuss these possibilities in detail.
Jim Worl, Forester and Broker
James M. Worl Investment Real Estate LLC
PO Box 310
Colton, Or. 97017
360-751-1440
jmacworl@aol.com or james@realtyinvestorstoday.com
