Top 10 Things You Should Know About Tax Deferred Exchanges
- The Exchange MUST be set up BEFORE closing.
a. An Exchange Agreement must be signed and the Contract of Sale must be assigned to the Qualified Intermediary at or prior to closing. - A 1031 Exchange only defers taxes, it does not eliminate them.
- An Investor can save 30% or more in federal and local taxes by taking advantage of a 1031 Exchange.
- Only Trade, Business and Investment Property can be exchanged.
a. A primary residence will not qualify (but see IRC 121);
b. A vacation home that is rented may qualify (see Rev Proc 2008-16);
c. Any type of investment real estate can be exchanged for any other type of investment real estate, i.e. an apartment building can be exchanged for a factory. - Property must be held for “investment” rather than “resale” to be included in an exchange.
a. There is no set holding period; it is only one factor in determining if property will qualify.
b. However, many advisors suggest that the property included in an exchange be owned by the Exchanger for a minimum of 1-2 years. - Strict deadlines apply. Running from closing of the sale, the Exchanger has
a. 45 days to identify Replacement Property; and
b. Up to 180 days to close on Replacement Property. - To defer all capital gain, an Exchanger needs to acquire Replacement Property that is equal or greater in value to their Relinquished Property, and spend all the proceeds from the sale.
- Investors can complete a partial exchange, and pay tax only on the excess sales proceeds or the reduction in mortgage debt.
- Through a Reverse Exchange, it is possible to close on a Replacement Property before selling a Relinquished Property, however the structure is more complex and requires advanced planning.
- Exchanges involving related parties warrant special care, and must be discussed with the investor’s tax advisor and their qualified intermediary well in advance.
Income Producing Property Analysis
| Gross Rental Income | $139,260 |
| (less vacancies) | ($6,963) |
| Net Rental Income | $132,297 |
| Less Operating Expenses: | |
| Taxes (from tax return) | ($24,178) |
| Insurance (from tax return) | ($8,040) |
| Utilities (from tax return) | ($3,744) |
| Maintenance (from tax return and estimate) | ($2,500) |
| Landscape (from tax return) | ($1,380) |
| Net Operating Income: | $92,544 |
| Annual debt burden (assume $6250/month) | $75,000 |
We analyze the debt repayment ability of Income Producing Property.
In order to give you an idea of the analysis that banks do for Income Producing Property, take a look at the following cash flow analysis example:
Debt Repayment Ratio: 1.23x (sufficient)
The most important number in the above analysis is the Debt Repayment Ratio (Net Operating Income / Total Annual Debt Burden). A smart borrower will know what kind of a debt repayment his property can carry in order to obtain the most money from the bank.
To calculate the maximum loan amount, you need to know the answers to the following questions:
- Your Net Operating Income
- The interest rate that the bank will charge
- The lowest debt-repayment ratio that the institution will accept (this is usually 1:20X)
- What kind of an amortization schedule is used for the type of facility
Let’s use the above information to find out the amount of money that can be borrowed:
a). The bank charges Prime + 1% for this type of facility when it is secured by a first mortgage, and Prime + 2% when it is secured by a second mortgage.
b). The Bank tries to approve loans with a debt repayment ratio of 1:25X, but some credit policies allow a low of 1:20X.
c). The Bank uses various amortization schedules, but the most favorable ones for this type of facility are based on a twenty-five (25) year amortization with a seven (7) year balloon.
Armed with that information you do some math:
- $92,455 / 1.20 = 77,045 <==== Maximum Debt Burden.
- Using an amortization table $734,000 at 9.5% (Prime + 1% as of July 1998) is the maximum debt based on a twenty-five (25) year amortization.
- With those numbers, you could go to the bank and ask for a 1st Mortgage in the amount of $734,000.
Finding out the Market Value of Income Producing Property
Obtaining a loan without an appraisal is very difficult, expect to have to pay for one (most commercial appraisals are at least $1,000 with the average being $1,500). A professionally-prepared appraisal will use all 3 methods to come up with an estimated value for the property.
There are 3 methods of estimating a market value for a property:
| This is the cost of building | $600,000 |
| You add the A/C system and other improvements | $100,000 |
| You deduct depreciation | ($50,000) |
| You add any tax or impact fee | $50,000 |
| Your reproduction cost | $700,000 |
| You add the land value | $300,000 |
| This is your value | $1,000,000 |