The Nest

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Featuring real estate articles and information to help real estate buyers and sellers. The Nest features writings from Georges Benoliel and other real estate professionals. Georges is the Co-Founder of NestApple and has been working as an active real estate investor for over a decade.

How to do a 1031 Exchange in NYC: 2022 tax benefits guide

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1031 Exchange in NYCThis post will teach you how to execute a 1031 exchange in NYC. A 1031 exchange, also known as a “Like-Kind” exchange or a “Starker Exchange,” is a formidable tax-deferment strategy that savvy investors use in real estate dealings. In 2018, 1031 exchange rules and timelines were more and more common due to the perceived housing bubble developing. Thus, more and more people are looking to sell a property and make money but not get taxed on this money. Therefore, if you are considering what a 1031 exchange in NYC is, and thinking about executing one, look no further and continue reading!

  • Explaining what a 1031 exchange is
  • Rules of a 1031 exchange
  • When could a 1031 exchange benefit me?
  • Why is 1031 beneficial in the short and long-run?
  • How to execute a 1031 exchange right now

INTRODUCTION:

What is a 1031 tax-deferred Exchange? What are its benefits? Real estate investing can feel like a dream sometimes. Your property is appreciating; you claim depreciation on your income taxes. They’re cash-flowing and provide extra income for your family. Investors can be surprised to hear the taxes they’ll owe when they sell. With regular investments like stocks and bonds, you pay capital gains.

It is the difference between your purchase price and your final sale price. Unfortunately, there’s much more to consider regarding investment properties.

When investors sell, depreciation recapture is also taxed at higher rates! Not only will you owe capital gains and depreciation recapture, but you could also owe even more for attached items with a faster depreciation schedule. This article is for you if you’ve never heard of depreciation recapture. First, we’ll look at an example of the average real estate investor and the taxes they’ll owe.

Then, we’ll explain the 1031 exchange tax benefits in detail. You’ll learn how to reduce real estate taxes the next time you sell a property.

“Like-Kind” exchange or a “Starker Exchange” 1031 exchange

WHAT IS A 1031 EXCHANGE?

execute a 1031 exchangeFirst, let’s break down the name:

    1. The term 1031 comes from the IRS tax code, section 1031.
    2. The “exchange” part comes from taking capital gains from selling a property and putting that money into a “like-kind” property without paying taxes on those capital gains. (We will discuss what constitutes a “like-kind” property below.)
    3. Initially, the exchange came from literally trading your property for someone else’s, straight up – today called a “simultaneous” exchange. However, not only is that rare, most 1031 exchanges are “delayed” 1031 exchanges.

However, there are different types of exchanges, so let’s explore another relevant type before tackling the most common – “delayed exchange” – one.

“Improvement/Construction Exchange”

This exchange comes in handy when you want to improve an acquired property with the capital gains of your previous property without paying taxes on that money. There are a few rules with this exchange.

  1. The total exchange equity on the completion of the property by the 180th day
  2. If you do not spend the money for completed construction by the 180th day, you must have spent the money for a down payment on the property.

Rules of a 1031 (delayed) exchange

When most people talk about 1031 exchange rules, they talk about a “delayed” exchange. But, like most things, there are rules and regulations you must follow to execute 1031 in NYC properly.

1. LIKE-KIND PROPERTY

The property you are putting the capital gains into must be of a “like-kind.” The IRS describes a “like-kind property” as one “of the exact nature, character, or class.

Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property improved with a residential rental house is like-kind to vacant land”. In other words, you cannot relinquish machinery and use that money to fund a replacement apartment building.

But you could exchange:

  • Single-family home for an office building.
  • Multi-family complex for a rental home. And much, much more.

The IRS’s bottom line is pretty lenient regarding what like-kind property is as long as it is a property. An important note: All properties must, in the exchange, be U.S. property, not from a foreign country.

2. EQUAL OR GREATER VALUE

If the hope is to pay no tax on your capital gains, the IRS demands the (net) market price plus any equity to be the baseline for your next property. For example, let’s say you are selling a $1 million home with a mortgage of $250,000.

The “like-kind” property must be at least $1 million in value, and you will have to carry over the $250,000 mortgage. Any brokerage fees and real estate taxes also factor into this number.

3. INVESTMENT OR BUSINESS PROPERTIES ONLY

This rule is self-explanatory, but the one most people get tripped upon. The most common is you cannot swap primary residences. For example, let’s say you are moving from Wyoming to New York and cannot exchange your primary home in Wyoming for a new one in New York.

However, let’s say you own a rental property in Arizona.

You can swap that for a vacation house in California (of equal or greater value). Lastly, here are a few other types of property that do not fall under the 1031 exchange rules, such as:

  • Land under development
  • Inventory property
  • Property held for resale
  • Notes and bonds

4. SAME TITLE NAMES

Simply put, the relinquished property title names need to be the same on the acquired replacement property. For example, if a husband and wife own home and try to execute a 1031 exchange in NYC for a new home, they need to be deeded on the new property.

This is the same as LLC.s, corporations, etc., and the titles need to match regardless. Again a simple rule, however, one that stops some 1031 exchange rules from going through.

5. THE BOOT RULE

Let’s say you want to execute a 1031 exchange in NYC that is of lesser value. “Boot” refers to the difference between relinquished and replaced property. And that difference is taxable. This often happens when an investor wants to make money and is okay paying some taxes on the gains. For example, let’s say you want to sell that $1 million property, but the replaced property is only worth $750,000, and the $250,000 is taxable.

6. THE 45-DAY RULE (IDENTIFICATION RULE)

6 rules of the 1031 exchange

1031 exchange real estate

Another relatively simple rule that states post-closing the relinquished property, the investor has 45 days, calendar, not a business, to identify up to three like-kind properties. The key here is that they have to hit the requirements above monetarily.

This can become a challenge for some investors because properties are often over-priced, meaning that the EQUAL OR GREATER VALUE rule may not be satisfied when they close. This rule is nullified if one follows the 200% rule.

This is when you can identify four or more properties if they do not add up to 200% of the relinquished property value.

7. THE 180-DAY RULE (PURCHASE RULE)

This regulation states that you must complete the purchase in under 180 days or the due date of the tax return for that tax year (with extensions) in which the property sold, whichever is earlier.

In other words, if the 180-day limit is after when taxes are due, the exchange must close by the tax return due date, not whenever the 180-day limit is.

1031 tax-deferred Exchange Example – More Tax Benefits than you think

How much money can you save by using a 1031 Exchange?Let’s say a fictional investor, “Shayna,” is looking to sell her investment property. It’s a triplex in Kansas City, MO, that she bought ten years ago for $400,000. Shayna initially allocated $360,000 to the building’s value and $40,000 to the land.

Since you cannot depreciate land, $360,000 will be deducted in equal amounts for 27.5 years. For the past ten years, Shayna has taken $13,333/year of depreciation or $1,111/month.

The first ten years Shayna’s owned the property have been great! It has cash-flowed $200 a month and is appreciated a lot. The fair market value is now $600,000! Even better, Shayna has taken $133,333 in depreciation, which has reduced her income in the eyes of the IRS.

The only bad part is when Shayna goes to sell the property, and her accountant says her tax bill is $73,333.25. Shocked, Shayna wonders how this could be when the property only appraises by $200,000. She figured that since it’s a long-term capital gain, the tax rate is (.2*200,000)=$40,000.

Why is the tax higher than expected?

Shayna didn’t realize that when “The IRS giveth, the IRS taketh away.” Shayna enjoyed a depreciation-fueled tax break for the past ten years. Now, the IRS wants that money back upon sale. Here’s how the IRS figures this out:

Jar with cash - What is a 1031 ExchangeIn addition to regular capital gains (Sale Price – Original Price), the IRS says that any depreciation you take makes your “cost basis” lower. Using Shayna’s example, instead of the original cost basis of $400,000, the IRS “cost basis” is $266,667 (Original Price – Depreciation Taken).

To add insult to injury, depreciation recapture is taxed at your regular income tax rate, up to 25%. Our examples assume your long-term capital gains rate is 20%, and depreciation recapture is 25%.

So when Shayna sells her property, she should be accounting for the capital gain of $200,000, taxed at 20%. Then, she needs to add depreciation of $133,333 taxed at 25% to this total. Seem unfair? It might be, but the IRS isn’t in the morality game. They don’t care if you helped ten old ladies across the street last week; they want their money.

1031 Exchange in NYC real estate

1031 exchange real estate – 1031 exchange timeline

NOTE: There are never any extensions on this 180-day limit. If the exchange is not completed within these time frames, the exchange is null and void.

WHEN COULD A 1031 EXCHANGE BENEFIT ME

new constructions in new yorkIf you are currently investing in a property that you are looking to sell, this would be perfect for you.

Selling a property and putting that money directly back into another investment property without paying taxes saves you money and allows you to invest in a property that may otherwise be beyond your budget.

WHY IS A 1031 EXCHANGE BENEFICIAL IN THE SHORT RUN AND LONG RUN

couple buying a new constructionsIn the short run, executing a 1031 exchange could help you invest in a bigger and better property right now.

But, these 1031 exchange rules could be even more advantageous in the long run. The more you sell and then put your tax-free money back into property investment, the more properties you can invest in.

For example, let’s say you execute a 1031 exchange in NYC on a single-family home. You use that tax-free money to invest in another bigger property, a two-family rental home. As a result, you are now collecting more passive income than before.

This cycle could continue and give you more assets down the road and give you (and your partner/company) more assets.

1031 tax-deferred Exchange Tax Benefits

Who wants to pay $73k to the IRS when you sell a property? Not many hands up in the room.

Numbers on spreadsheets - What is a 1031 ExchangeFortunately, there’s a way to defer paying taxes upon sale, and that’s through the 1031 exchange. You can buy a “replacement property” and not pay a single dime to the IRS by arranging with a qualified intermediary. It is not a loophole, and it’s not a new technique. The 1031 exchange has been around since the 1980s, and investors have performed hundreds of thousands, if not millions. We’ll walk through the basics.

When you are preparing to sell your existing property, you should contact a qualified intermediary for a consultation. They’ll help you document all the necessary steps during the process. You should decide if a 1031 exchange is suitable for your situation before the sale of your current property is complete. If you think it is, you’ll need to identify replacement properties within 45-days of the sale.

Identification means that it’s a suitable property worth more than your existing property’s proceeds.

After identifying the properties, you must close on one of these replacements within 180 days of the sale. Once you’ve done this, you’ll submit form 8824 on that year’s taxes. There are quite a few steps that we’ve glossed over, but any reputable 1031 exchange company will help you through all of them.

You may ask, “won’t I just have a huge tax bill someday?” The answer is, “it depends.” There are ways to do 1031’s until you die continually, and the crazy part is that your heirs receive the properties on a step-up basis. It requires in-depth knowledge of 1031 and some help from CPAs and estate planners.

HOW TO DO A 1031 EXCHANGE NOW?

If you believe you are ready to sell an investment property (and have the foresight of another property you may want or location for a property), hire professional help: a broker to execute the sale and purchase and an attorney to structure it. NestApple is here for you, and you will save:

While this is an incredible rule in the IRS code, even life-long real estate investors need assistance. However, once assistance is acquired, the process is usually relatively smooth.



Written By: Georges Benoliel

Georges has been working in Wall Street for the last 16 years trading derivatives with hedge funds. He has been an active real estate investor for over a decade. Georges graduated from HEC Business School in Paris and holds a master in Finance from ESADE Barcelona.

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