By Steve Venuti
In many parts of the country real estate prices are still declining. If you have investment property that you have owned for a long time, typically there will be large capital gain, not only from appreciation, but also from recapture of depreciation. Perhaps this property is located in one of these declining markets. On the other hand, there are still “emerging markets”, where property prices have excellent upside potential for appreciation.
While discussing these markets is beyond our scope, there is the strategy of selling your investment property via a 1031 exchange and rolling over the proceeds into a replacement property in one of these emerging markets. For the property you are selling, you may have to cut your price because of the slower market. However, reducing your price by 5 to 10% can mean the difference between a slower sale versus a quicker one. Moreover, the price cut can be more than offset by two things: (1) The savings in capital gains taxes because of the 1031 exchange and (2) the potential for more income or appreciation from the replacement property in the emerging market.
For example, suppose you own an investment property worth $300,000 with a tax basis of $100,000 or $200,000 gain that would result in a $60,000 tax liability if you sold without doing a 1031 exchange. You determine that the market has slowed down and it will take a while to sell at $300,000. You cut the price to $285,000 and are able to sell it quicker via a 1031 exchange. While the price cut of $15,000 reduces your deferred tax liability to $55,000, it’s still a hefty tax and offsets the $15,000 price cut by over 3 ½ times. Furthermore, you have the use of the $55,000 savings as a down payment which, along with leverage, will give you much more buying power. For instance, $55,000 as a 20% down payment would allow you to acquire an additional $275,000 of real estate. Factor in the appreciation from the emerging-market property, and you can end up not only beating the down market, but substantially increasing the value of your portfolio.
With 1031’s, there are 45 and 180 day time constraints. Therefore, you should have a definite plan of which property you want in the emerging market even before you exchange your relinquished property. Moreover, a properly structured reverse “Starker” exchange can totally bypass these time constraints.
When undertaking such transactions make sure have the advice of competent real estate and 1031 exchange professionals.
Steve Venuti is president of CPA Exchange Services, Inc. (CESI), a full-service QI who we highly recommend for your 1031 exchanges. He is also a real estate tax specialist. To set up a no-charge, no obligation consultation with Steve, call 1-800-351-1031.