AN ANALYSIS OF THE BENEFITS ALONG WITH BASIS AND TAX CALCULATIONS
Selling one property and acquiring several replacement properties in a tax deferred exchange can have significant advantages over a simple trade of one income property for another. The following discussion describes some of those advantages and certain tax rules relating to exchanges involving multiple replacement properties.
To set the stage, let’s take a hypothetical case of an exchange scenario involving the acquisition of multiple replacement properties. Suppose a real estate investor in Los Angeles, California is selling a single family rental (SFR) that she acquired more than a decade prior. She is under contract to sell the SFR for $600,000. For the sake of simplicity, let’s assume she has no debt on the property and will pay no closing costs. She has an adjusted basis in the SFR of $200,000. If she simply sells the property, rather than engage in a tax deferred exchange, she would incur a tax in the amount of $114,700.¹ Given the potential tax, this investor desires to engage in a 1031 exchange. In the process, she decides that she would also like to diversify her real property investments, take advantage of differing market conditions and improve her cash flow. Accordingly, she decides to acquire 6 replacement properties in Sunbelt states, 3 in Arizona and 3 in Florida.
IDENTIFICATION OF REPLACEMENT PROPERTIES – 200% RULE
The Treasury Regulations under Section 1031 (“Regulations”) require that an exchanger identify in writing replacement property to be acquired in a tax deferred exchange within 45 days following the closing of the sale of the relinquished property. These Regulations establish 3 different sets of rules that may be used to identify qualified replacement property. The rule most commonly used by real estate investors is the so called “3 property rule.” Under that rule, an exchanger can identify up to 3 like-kind properties as replacement property without regard to value. Since our investor intends to acquire more than 3 replacement properties, the 3 property rule would not work. The second identification rule is the so called “200% rule.” Under that rule, an exchanger may identify any number of replacement properties provided that the aggregate value of all property on the identification list does not exceed 200% of the value of the relinquished property. In this scenario, the relinquished property is worth $600,000, so our investor could identify any number of replacement properties provided that the aggregate value of identified properties does not exceed $1,200,000. Thus, if our investor desires to acquire 3 rental properties in Phoenix, Arizona – each worth $100,000, and 3 rental properties in Vero Beach, Florida – each worth $100.000, she would have identified replacement property worth $600,000, well within the limit imposed by the 200% Rule. Accordingly, our investor might identify alternate properties as fall back properties that would be available to her if any of her specific target properties do not pan out. Click here for more information on the Rules of Identification – the “3 property rule,” the “200% rule” and the “95% rule.”
BASIS CALCULATION IN REPLACEMENT PROPERTIES
Now, let’s assume that our investor successfully acquires her 6 replacement properties in a 1031 exchange utilizing a qualified intermediary to hold the sales proceeds. Since she has exchanged into 6 replacement properties, she must apportion her original basis in the relinquished property (recall that her adjusted basis in the relinquished property was $200,000). Under the Treasury Regulations, an exchanger must generally allocate basis among replacement multiple replacement properties ratably, in proportion to their relative respective values. Since the values of the replacement properties in this simple example are all the same, each replacement property would receive a basis equal to 1/6th of her original adjusted basis² — in this case, $33,333.³ For more information on calculating the replacement property basis, click on Replacement Property Basis Calculation. So what has our investor achieved?
- 100% tax deferral on the sale of her relinquished property;
Potentially increased cash flow since the six replacement properties can be rented for more total rental income than the single relinquished property;
- With six tenants, instead of one, more income is maintained when one tenant moves out.
- Diversification into 2 real estate markets in different states, one in the West and one in the East;
- Purchased at or near the market bottom for considerably more appreciation potential;
- Increased flexibility – e.g., if the exchanger decides to sell for cash down the road, she could sell 1 of the rental properties to generate cash while recognizing gain on only 1/6 of her original investment.
¹ Depreciation recapture at 25% on the $175,000 = $43,750; plus Federal capital gain taxes of 15% on the remaining economic gain = $33,750; plus state taxes in California at 9.3% on the $400,000 gain = $37,200. $43,750 + $33,750 + $37,200 = $114,700.
² 6 properties x $100,000 = $600,000
³ $200,000 basis in relinquished property / 6 replacement properties = $33,333 basis in each of the six replacement properties.