Will a 1031 Property Exchange Solve Your Problems?
Posted by Paula Straub
Are you looking into 1031 property exchanges to defer your capital gains tax? Before you do a traditional exchange, find out how to come out even farther ahead with less headaches.
If your problem is listed below, a 1031 exchange may or may not be your solution.
1. Are you a landlord that doesn't want to manage property anymore?
2. Do you want to sell your investment property, but don't want to pay huge amounts of Capital Gains Tax?
3. Is your current income property not producing enough income?
4. Do you have a low adjusted basis and not much debt on your rental?
5. Is your credit rating less than perfect?
If you answered yes to any of the above 5 questions, a traditional 1031 property exchange into another like-kind property might just put you right back to square one!
Let's address each of the 5 problems one at a time.
1. If you exchange your current property for another of equal or greater value you still are faced with the same landlord/tenant problems that you currently have. Sure, you could hire a property manager, but why is it that you currently don't have one?
2. A 1031 property exchange into a like-kind property does defer the payment of Capital Gains tax if you carry over all your equity and at least the same amount of debt. However, since your new property costs you at least as much as you sold the last for, your property taxes will most likely increase. The cost of your new investment has probably just gone up.
3. If your positive cash flow is currently nothing to write home about, your new property will have to justify higher rents, be located in an area with lower property tax, or have fewer maintenance costs. Otherwise, the chances of additional passive income are very slim.
4. Your adjusted basis will carry over as is to the new property, so you will receive the same depreciation benefits as on the prior property, unless you pay more for your exchanged property. Most likely a wash.
5. A poor credit score may result in a higher interest rate or poorer terms on your new mortgage, assuming you don't own your current property free and clear. Again, this translates into higher ownership costs. You will also pay two sets of closing costs in the transaction.
One more thing to consider is the time it may take to sell your current property, find a replacement property and secure all funding. This must be done within the 1031 specific time frames. Think of the times that escrows have fallen through and loans have dragged on forever and sometimes never closed at all.
Considering your dilemma and possible pros and cons, will a 1031 property exchange put you farther ahead, further behind, or at best put you right back in the same boat you are in now?
If the answer to the last question was not "farther ahead", let me suggest that you look into a 1031 exchange that has a slightly different twist.
It's called a 1031 exchange into a tenant in common property. This might just put you in the "farther ahead" category and solve many of your problems. Instead of exchanging into another solely owned investment property, you will get a fractional proportionate share of an A grade commercial property. You will have a deeded interest equal to your share of ownership (your exchange amount).
If done properly:
1. You will no longer be responsible for the property management
2. All capital gains will be deferred.
3. You can get a contractual monthly income from the equity transferred (usually 6-7%)
4. Your carryover basis is the same, but you can acquire extra non- recourse debt without qualifying and receive a higher interest deduction on your monthly income, thus making it less taxable.
5. The debt you acquire with the TIC (assuming your debt/equity ratio is within the accepted guidelines does not require you to obtain a mortgage or pay it down. This is called non-recourse debt. Your credit score does not become a factor, and the closing can be done in a matter of days, not weeks or months.
Now, ask your self again. Would a 1031 exchange into a tenant in common solve your problems? If the answer is "yes", what are you waiting for?
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