Navigating 1031 exchanges can be a complex process. David Moore of Equity Advantage looks at the 1031 exchange rules and some common misunderstandings to help you understand the ins and outs of the 1031 exchange. Find out whether you can defer taxes on properties you own free and clear. Get the information you need to do things right from the very beginning.
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Can I defer taxes on property I own free and clear in a 1031 exchange?
The simple answer is yes. The tax consequence of your transaction has nothing to do with debt and equity. I believe one of the biggest misunderstandings in 1031 is what the requirements of an exchange are to be totally tax deferred. I hear many people say, “Well, you have to replace debt in an exchange,” and that’s totally untrue.
When we’re looking at basis and gain, that’s important to justify the transaction, but it really doesn’t tell us much about what has to happen. We use something called the Napkin Test, which was created by a gentleman named Marvin Starr out of San Francisco, and he wrote out this formula on a napkin during a break in a seminar. The Napkin Test says you must go across or up in value in equity. Debt can go away in two ways. One is by going down in value, which triggers tax because you went down in value. The other way debt goes away is by adding cash to a transaction, which is always fine. The government has no problem with you adding money. They just don’t want you pulling money out without a tax consequence.
In short, it doesn’t matter if the property has no equity or is owned outright—the exchange is going to defer taxes. If you look at the crash, during that crash period we did a number of transactions where there were foreclosures or short sales. No money would come in to us, yet the taxpayer had a question: Do I want to pay tax or do I want to come out-of-pocket roughly the same amount of money and go buy something?
When we do transactions, equity is irrelevant. You’re looking at basis and gain, which has nothing to do with your equity in a property; it’s merely a tax calculation.
What 1031 exchange rules should I be aware of?
The short answer is that you should be aware of all the rules, and be aware of them before you get started. As in anything, the more knowledge you have, the better to keep yourself out of trouble and do things right from the very beginning. It’s the best thing you can do.
People frequently ask me when I’d like to know about an exchange, and I say when they’re getting ready to buy a property because at some point they’re going to relinquish it, and it’s a good idea that they understand going into it what’s going on. Keep yourself out of trouble.
There are four rules you should be aware of in an exchange. First and foremost, it has to be an exchange, meaning it has to be set up as an exchange before close. If it closes and you follow up later— even if it’s later that day after you’ve had the ability to touch money, actual or constructive receipt—then you’ve got taxes. So, number one, it has to be an exchange.
Two, what’s given and received have to be of like kind. We’ve lost personal property with tax reform, so we’re just dealing with real property now. Any real property held for investments is like kind with any property you intend to hold as an investment. That means you can go out of that single-family rental into an office building, strip mall, or place at the beach to retire into, and all of those are fine.
Three, we have to satisfy that Napkin Test. And, finally, we’ve got to have continuity investing, which is the second biggest headache we’ve got in the exchange world after the timeline.
1031 exchanges are complex. Using an exchange accommodator like Equity Advantage puts a professional in your corner who knows all the rules. It just takes a phone call to get started, 503-635-1031.