If you own property as part of your business and you’re considering selling your company, you may want to think about using that real estate to help you put off paying any capital gains taxes you may owe. The 1031 Exchange has been around for several years. However, many entrepreneurs are not familiar with the ins and outs of this provision of the IRS tax code. Chris Cali is a business attorney and an expert in commercial real estate matters. On this edition of “Deal Talk,” Mr. Cali explains the 1031 Exchange in detail and clarifies which situations and what kinds of property qualify for the provision. The 1031 Exchange may not eliminate taxes, but it could possibly save you tens of thousands through tax deferrals.
For a lot of small business owners, particularly if you've owned a piece of property for a long time, or even for a few years depending on your market, and you have significant appreciation, you can be hit with a pretty significant tax bill.
- Chris Cali
Jeff: Chris, some folks already know a little about something called 10/31 Exchange. The majority of people probably don't. I don't know that much about it, in fact, and that's why I've called you. Can you tell us exactly what section 10/31 is, or what the 10/31 Exchange is, its other name.
Chris: Sure, absolutely. First, it's great to be on. I just have to give a quick little blurb regarding this discussion we're going to have today that this can't be taken as full tax advice. I will advise all your listeners to speak with a CPA about the specific tax implications for their particular situation. The 10/31 Exchange is referring to Section 1031 of the Tax Code. What this is dealing with is not necessarily the avoidance of capital gains tax but the deferral of capital gains tax. And capital gains tax is a tax that you're going to have when you sell your property after you've held it for how many years.
I will advise all your listeners to speak with a CPA about the specific tax implications for their particular situation. The 10/31 Exchange is referring to Section 1031 of the Tax Code. What this is dealing with is not necessarily the avoidance of capital gains tax but the deferral of capital gains tax. And capital gains tax is a tax that you're going to have when you sell your property after you've held it for how many years.
Jeff: I think that's really important that you made that distinction, Chris. It's a deferral of capital gains taxes but not the outright avoidance. There are some people who are probably like me. I'm not the sharpest tool in the shed on most nights, Chris, who've heard of the 10/31 Exchange, and they go, "This is just something for rich folks to shelter them from having to pay taxes," but that in fact is not the case. What we probably need to know a little bit now, Chris, is who qualifies for this? It's those individuals we know who happen to own their own property there perhaps where their business is located, but what other qualifications need to be met?
Chris: Sure. It's funny. The real question here isn't who qualifies, it's what qualifies for a 10/31 Exchange. Because a 10/31 Exchange is an exchange of like-kind property. And in this context of what we're talking about, it’s real estate. What qualifies as real estate is most types of real estate except for your personal residence, property that you're going to purchase for resale. For example, if you're a developer and you are going to buy a lot, build a property on it, and then resell it, and you're in the business of doing that, it does not qualify for that. But almost any other real estate, an apartment building, an office building, a farm land can qualify. And the nice thing about the 10/31 Exchange and like-kind property, and what people usually get confused when they hear that is, it's like-kind property, meaning real estate for real estate. If you sell an apartment building you can buy farm land and qualify for a 10/31 Exchange. There's other types of property, personal property, minerals, other types of things that will qualify for a 10/31 Exchange. And again, if you're going to do that, it's the same thing. You got to buy something similar. But it just has to be in the same category, it doesn't have to be the same type.
There's other types of property, personal property, minerals, other types of things that will qualify for a 10/31 Exchange. And again, if you're going to do that, it's the same thing. You got to buy something similar. But it just has to be in the same category, it doesn't have to be the same type.
Jeff: That's really interesting then. If I want to sell my company, or if I'm looking at selling the property that maybe a business is located on, whether it's my business or somebody else's business. And then I go and I purchase that like-kind property, what does like-kind really refer to? Because I'm confused, you just talked about how you could take and essentially sell an apartment, a building, and then go out and buy a piece of farm acreage, but tell me how the like-kind factors into it.
Chris: It's real estate, so it's real estate for real estate.
Jeff: That's what like-kind means?
Chris: That's what like-kind means. So if you're selling real estate, you've got to buy your real estate. If you're selling gold, you got to buy gold, that's the like-kind aspect of it. Anything that qualifies as real estate with the exception of, like, your personal residence. Anything that you're doing as an investment or for business, as long as it's one piece of real estate, if you sell an office building, you go and decide you want to start a farming business and buy a farm, and it's two pieces of real estate it all qualifies.
Anything that you're doing as an investment or for business, as long as it's one piece of real estate, if you sell an office building, you go and decide you want to start a farming business and buy a farm, and it's two pieces of real estate it all qualifies.
Jeff: So 10/31 is not for personal use but some personal property in fact does qualify. Is that right?
Chris: Correct. And actually that's a little bit outside of the scope of the discussion we’ll have here because for most of your listeners it's not going to be applicable. The only type of 10/31 darker exchange, which is a name that people who have heard about 10/31 has probably heard that name, will be in the real estate context.
Jeff: OK, very good. That sounds fine Chris. We can go ahead and kind of work within those boundaries. So if I go ahead and they decide this is something that I want to take advantage of, we're talking about potential savings of thousands of dollars, it could be even more than that, really, tens of thousands of dollars depending on what kind of properties that I have that I own. Do I have to go out and buy another piece of property right away? Am I held to a time limit?
Chris: You are. And I think before we get into the type of exchange, I'll give a quick example of what it is that you're trying to defer, what is the capital gain that you're trying to save. For a lot of small business owners, particularly if you've owned a piece of property for a long time, or even for a few years depending on your market, and you have significant appreciation, you can be hit with a pretty significant tax bill. For example, just easily run the numbers here, you're figuring out here your capital gains. Let's say you're on a building and you bought it for $100,000. And then you're going to put in some improvements, you're going to take depreciation out and you get your kind of a net adjusted basis. Then when you go to sell the property you're going to take the sales price, you're going to subtract your net adjusted basis, and then you're going to also subtract your cost of sale, commission fees, etc. What you have at the end of that is your capital gain. The biggest thing that people run into when it comes to their capital gain is you may have capital gain even if you don't take any cash out of the property. For example, if you highly leverage your business, which a lot of small businesses do because they take the equity out of their property in order to have cash for other things. If you pay off a loan and you got a capital gain of $50,000 but since you took out so much money you don't have any additional cash to put in your pocket after you pay off your loan, you still had a capital gain. The government doesn't look at the debt that you've paid off, and that's taxed to 20% now, it used to be 15%. Now for long term capital gains it's 20%.
So the example we can go through as we talk about this is a client that I just had last year who was a franchise owner. He owns a bunch of fast food franchises, and he was selling a property. He happened to be looking to buy another one. Based on what he was selling it for he would be looking at about a $40,000 payment to the IRS in capital gain taxes. That $40,000 that he needed to write a check to the government now as oppose to reinvesting in his business. The first part is figure out if you're going to have a capital gain when you go to sell your property. You may not depending on how much it's appreciated or other things, deductions you may or may not have taken. But if you're looking at a significant capital gain and you want to take that money and pay it later you can defer it. And basically you can keep doing this. You can keep buying properties and deferring it almost indefinitely until you finally do a sale and then don't defer the capital gain anymore. So you could buy a property to a 10/31 Exchange, hold that for five years, do another 10/31 Exchange, keep deferring the taxes until the end. When you're starting this you're looking at "Do I have a capital gain?" If I do, then we can talk about the next step, which is, what is exactly a 10/31 Exchange?
The biggest thing that people run into when it comes to their capital gain is you may have capital gain even if you don't take any cash out of the property.
Jeff: OK. If you wanted to invest in multiple properties all at once, let's say, Chris, and then you use those proceeds to spread them out over three or four properties, is that allowed?
Chris: Yeah, that gets us into the next part of this. So why don't we talk about that.
Jeff: OK, sounds good.
Chris: There's a few basic types of exchanges. There's a simultaneous exchange, a delayed exchange, a reverse exchange and then approvement exchange. The most common type of exchange is going to be your delayed exchange. It's where you're going to sell your property before you selected the property you want to replace it with. There are time limits that you do have to abide by when you're doing this. The time frames are actually pretty short.
For a delayed exchange you got 45 days from the date that you sold your property to identify three replacement properties. There's some other ways we can deal with them. The most standard one is three replacement properties. Within those 45 days you've got to get under contract for one of those replacement properties, and then you have to close on that replacement property either 180 days from the date that you sold the property that you're exchanging, or the due date for the tax return and including all extensions on when your taxes are due. So there is a time frame. You can't just sit on this for a year or so and look at this. If you're thinking about selling and you know you're going to buy something else, and you're looking at a 10/31 Exchange, you kind of have to be in the market for your sale and your purchase relatively quickly.
There's a few basic types of exchanges. There's a simultaneous exchange, a delayed exchange, a reverse exchange and then approvement exchange.
Jeff: So we have some clarification. One important yard marker milestone is 45 days. You need to be in a contract for the purchase of another piece of property within 45 days. It doesn't have to close that but within 45 days you at least have to be in a contract.
Chris: Correct, and you've got 180 days to close. There's little subcategories you can do when you talk about can you buy multiple pieces of property if you sell one, and the answer is actually yes. One way to do it for your identification period is the 45-day period called the identification period. There's a three property rule where you can select up to three properties regardless of their market value, and we'll talk about what happens if you buy a property that's less money than the property you're selling. But you can select three properties regardless of the market value. There's the 200% rule, so you can select any number of properties as long as their aggregate market value does not exceed 200% of the fair market value of the property you're exchanging. So we see in the examples that is if you're selling a property for $100,000 you could select a bunch of properties that were $50,000 and close on four of them and you'd still be within your exchange mechanism.
The other rule which I mention but is a little bit less used is the 95% rule, where basically you select any number of replacement properties if the fair market value of the property actually received at the end of the exchange period is at least 95% of the properties you identified. That's kind of a carved in rule that was put in there that most people don't use. Most people who are going to be doing a 10/31 Exchange are going to use the three property rule. So they're going to select new properties because they kind of know what they're getting into and where they're looking. They're not looking to buy multiple properties, they're maybe upgrading their warehouse to a bigger warehouse. So they want to buy one warehouse, so they'll select three and then get in their contract under 45 days.
Jeff: Chris Cali is an attorney specializing in real estate business, corporate planning and transactions with the firm that is Latimer, LeVay and Fyock in Chicago, Illinois. My name is Jeff Allen. You're listening to Deal Talk. Chris, does it matter to the IRS because they obviously, they are the body that kind of overseas section 1031, it's part of the IRS tax code. Does it matter whether or not you are actually operating a business within that property that you own, or you just simply have to own it and you can operate as the landlord and lease it out to other people?
Chris: That's correct. The IRS, for purposes of tender you want to exchange, you do not have to be operating the business side of it. You could do this if you got investment property. If you're holding it, you have a shopping mall strip center that you're leasing out and then you're going to sell and buy another one, absolutely. You don't have to be operating your business side of it.
Jeff: Just to clarify, if you receive any cash whatsoever after the sale of your property, it is not something that is subject to 1031 but in fact it's taxed, it's that correct?
Chris: That's correct. And that's where if you were going to take the cash yourself. So this kind of gets us into how to do a 1031 exchange. What happens is you hire what's called a qualified intermediary to act as the holding company for the money that you get. Because if you sell a property and that cash from the property, any money from that property, goes into your personal bank account, you destroyed your ability to do a 10/31 Exchange. It doesn't matter if you immediately write a check to your qualified intermediary who's going to hold the money for you while you try to find another property, that money is taxable. What happens is when you sell your property you walk away with zero, and the money that you would've walked away with gets held to a third party. There's companies out there, title companies and other companies that all they do are 10/31 Exchanges and they will hold the money for you in trust and escrow while you go to select your other properties. An important thing to note is it may be that you still need a little bit of cash for some reason and you don't mind paying the capital gain on it. The nice thing about the 10/31 Exchange is you can decide to take a little bit of cash, pay a little bit of capital gains tax now and defer the rest. So it's not an all or nothing proposition, you could, what's called “boot,” when you're doing a 10/31 Exchange, it’s the money you may receive that's not deferred. So you can do this and keep some boot, pay some tax on it, but then have some cash up front. It's very flexible on how you want to do it.
Jeff: Just to be clear, the intermediary, they're holding the money only but they're not actually involved in the property search process to find that replacement property are they?
Chris: No, basically all their job is is to hold the money while you find the replacement property. Or if you're doing a reverse exchange it's the opposite. They're holding title to the property that you buy because the most straightforward exchange when you sell property, you take that money and you put it with your qualified intermediary. And then once you buy your property now that you're going to replace your relinquish property with, the qualified intermediary will wire that money to your closing.
But what happens if you find a place you want to buy before you can sell your place? Well, you can do a reverse exchange. And in that case, and this is exactly what my client did last year, he found a place he wanted to buy, but his place that he was selling wasn't ready to sell yet or wasn't ready to close. So he bought his place, and then the title to the property was actually held in the name of the exchange company. And then once my client sold his place, that money was wired to the exchange company and the exchange company transferred title to my client, and that's called the reverse exchange.
Jeff: How much time did they give you to sell your other property?
Chris: It's the same time frame whether you're doing a delayed exchange or reverse exchange. If you're doing a delayed exchange you still have to close on your sale within 180 days.
Jeff: OK, very, very good. And I have one final question before we go to the break here, Chris. I was concerned that we weren't going to have enough material to discuss here, but quite frankly we do, and we could probably do a whole other show on it. But what if I still owe mortgage payments I have not paid for in full, my property that I plan on selling as part of this exchange, what happens then? Am I still liable for that cash that I have to send over to the lender for that first piece of property I own that I'm trying to sell?
Chris: Correct. You're talking about a reverse exchange situation. Yeah, you still have to pay the mortgage payments until you sell, you'd have to be in a financial position to be able to buy your replacement property without selling your relinquished property first.
Jeff: That's Chris Cali on the other end there once again. He's a guy who knows a little something about this, he’s an attorney specializing in real estate business and corporate planning and transactions in Chicago with the company called Latimer, LeVay and Fyock, a law firm there in Chicago, Illinois. This is Chris' second appearance on our program. We liked what he had to say so much, we had him back on again for more punishment. And we're going to get to your conversation on 10/31 Exchanges with Chris Cali when “Deal Talk” returns after this.
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We'd also like to know your thoughts about this program and about “Deal Talk” in general. What you like, what we need to work on, how we can make the show even better. I wouldn't be here, folks, if it weren't for you. So send us an email to email@example.com. That's firstname.lastname@example.org. There will be a test for you at the end of the program on all the emails and phone numbers we just gave out. My name is Jeff Allen with my guest Chris Cali, an attorney specializing in real estate business and corporate planning and transactions with Latimer, LeVay and Fyock, and he's joining us to talk about 10/31 Exchanges.
We've kind of already outlined for you if you would the definition, what qualifies, and how it all works, the 10/31 Exchange for commercial property owners. And now what we want to do, Chris, is we want to kind of turn the corner just a little but we want to still focus on the 10/31 Exchange but talk about pros and cons, why it's good, why it isn't good, why it may work at times and why it's not a good idea for other situations. Let's kind of get into that. If you could just outline for us maybe some of the best of the best pros as far as a 10/31 Exchange is concerned, obviously deferral taxes has got to be the first one.
Chris: Absolutely. Deferral of taxes and the ability to have that additional cash flow by not having to make that tax payment now. It's going to be the first one. Another one, if you're thinking about long-term wealth planning. We can talk a little bit about, it's a way to continue to build wealth and potentially, and this is where 1031 could potentially help you eliminate capital gains tax altogether, is when you're going to kind of pass on property to your children.
If you do a 10/31 Exchange, when you pass away, the property that you bequeathed to your heirs, this is called the step-up in basis to the data depth value. What can happen is you have property that's highly appreciated, you've been doing 10/31 Exchanges, and you pass it on to your children, and no capital gains tax is paid yet. If the step-up in basis goes to data depth, you may have eliminated the capital gains altogether in that situation. So it's a great wealth accumulation.
Jeff: Chris, when you mean step-up in basis, can you kind of just define that again so we have a clear understanding?
Chris: Sure, absolutely. What we're talking about before the basis so much for capital gains is calculated on. So for example, when we go back to my first example, $100,000, what you bought it for, and then you sell it for $150,000. So the new basis for the property, your capital gain is based on the $150,000 minus $100,000 is a really quick example. But if you have a piece of property, let's say you bought it for $200,000 and it's accumulated and appreciated over the years because you owned it for such a long time and it's now worth a million dollars. So when you go to your regular basis, if you were to go to sell that would be your million dollars minus the $200,000. It's an $800,000 gain. However, when you pass away, if you were to give that property to your children or whoever as an heir to you, that person gets the date of death value as the basis which is today a million dollars. So when they go to sell the property, it's not a million dollars minus $200,000, it's a million dollars minus a million dollars, which is zero capital gain. That's a step-up in basis.
Jeff: Again, a great wealth and asset accumulation tool, although not for everyone necessarily, but it sounds to me like it could be a part of the right individual's portfolio, depending on whoever you may be and what your financial situation is like. It also seems to me, Chris, that maybe one benefit that we haven't really talked about, a pro, if you would, of the 10/31 Exchange would be if you are the owner of property which has just seen better days and the maintenance cost, the cost for renovations, is just something that you don't want to have to deal with. You're talking about tens, hundreds or thousands of dollars to make these improvements, that this might be the right tool to kind of unburden yourself from having those types of responsibilities, is that right?
Chris: Absolutely. Basically, if you kind of want to trade up, sometimes you want to trade up for a nicer car. You can also trade up for a nicer piece of property. So absolutely, if you've got property that you've just been owning to rent out and get the income from and it's becoming a burden, absolutely. You can sell that, get yourself a nicer piece of property, and relieve yourself of the burdens from the previous piece of real estate, for sure.
Basically, if you kind of want to trade up, sometimes you want to trade up for a nicer car. You can also trade up for a nicer piece of property. So absolutely, if you've got property that you've just been owning to rent out and get the income from and it's becoming a burden, absolutely. You can sell that, get yourself a nicer piece of property, and relieve yourself of the burdens from the previous piece of real estate, for sure.
Jeff: The way that we've been talking about 10/31 here, it's like we're selling the heck out of it. Of course, Chris doesn't have any kind of interest in it whatsoever. He's just providing the information there. But we've talked about a lot of advantages. What are some disadvantages or reasons that maybe someone may want to think twice before they get into this?
Chris: A good one that's relatively recent is that you’re deferring your capital gains, what happens when capital gains rates go up? For a long time, long-term capital gains were at 15%. And just recently within the last 5 years or so they increased to 20%. So if you did a 10/31 Exchange then you are relatively close to the cusp. You may have ended up increasing your tax burden when you sell it because now you're paying a higher tax rate.
Jeff: That seems to me that would be a big one right there. Difficulty in meeting IRS rules and regulations, is that something that people often have a problem with? It seems to me that if you've got a handy CPA nearby he or she is going to be able to help get you through that, or at least give you some counsel as to whether or not this would be right for you.
Chris: Even when you have qualified people representing you on this, they're still tricky, and they're still complicated. Meeting the IRS rules and regulations, you may not be able to... What happens if you can't identify a property within 45 days? You can't close on it with 180 days? Now you've destroyed your 10/31 Exchange, and now that money becomes immediately taxable. You may have a great professional helping you set everything up, and you realize that if you sell this property and you buy another one you can defer $25,000 in capital gains taxes and you're going along. And all of a sudden you're sweating a little bit because you’re not finding that replacement property and you blow the exchange. Now you're not going to have that $25,000 that you may have already spent or may have already planned on having. The IRS is very, very strict on these dates. You cannot be off by a day when it comes to the 45-day identification period, or the 180-day close period. So for some people it sounds like a great thing when they start off on it, but due to circumstances they can't close on the property within the time frame, and now you've spent money setting this exchange up and you can't get the benefit of it.
Jeff: Chris, there are a lot more details here that we could probably cover. It would take us about 48 shows to go ahead and do that, and we're not in that business. You are, on the other hand, and I know that you'd be willing to help people out if they have any questions, and sit down and meet with them depending on where they may be, close to maybe the Chicago land area. Anyone has any questions, maybe you work with folks outside the area, Chris, and they'd like to reach out to you and maybe take some of your time to consult with them on 10/31 Exchanges, or if they have any other questions whatsoever about real estate with regard to their business, how can they get in touch with you?
Chris: Absolutely. We're licensed to practice law anywhere in Illinois, and we've got a great website with all our contact information. We can be reached at www.llflegal.com. My email address is email@example.com. We are Latimer, LeVay and Fyock, and we're happy to be of service.
Jeff: Chris, again, it's been a real treat. Thank you so much for agreeing to join us again, and I know that we're going to have you back on again in the future.
Chris: I really appreciate it. It's always a blast. Thank you.
Jeff: That's Chris Cali, attorney specializing in real estate business and corporate planning and transactions with Latimer, LeVay and Fyock in Chicago.
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