During 35 years of investing in real estate, Roland and Marvella Bradford had acquired a multi-building folio. The couple wants to sell the properties so they can retire. However, their accountant tells them that the tax consequences would deplete the value of their assets by more than 50%.

When the concept of a 1031 exchange was first presented, the couple was reluctant. However, giving Uncle Sam 55% of sales proceeds was not an option they wanted to consider. In the case of a multi property portfolio with extremes of equity and debt, the couple was advised to bundle as many properties as possible. This required an analysis of how the properties were titled and the outstanding debt and equity.

An inventory of titles revealed five of the properties were held jointly, one held jointly with 50% owned by a non-related party, and one was titled in the husband's name and another was titled in the wife's name. Five others were titled in various partnerships. The analysis revealed that the properties held individually and jointly by the Bradford's could be bundled.

The properties owned by partnerships and corporations formed by the couple presented a different challenge. The couple had disbanded the partnerships and simply reported the income from the properties on their Schedule E. However they had never changed the title. Because three of the properties had not been in a partnership for 15 years and had been reported on the couple's joint tax return, they also could be bundled with the other properties.

To have a successful 1031 exchange, you must replace your property with a real estate asset of equal or greater value. As long as you maintain equal or greater equity, you can increase the price and the debt.

You can always replace debt with equity. Of the $5.4 million total portfolio value, 41% was debt. The exchanges we contemplated were 35% equity to 65% debt. They were safe overall. Nevertheless, in a 1031 exchange, you need to be cognizant of individual properties' debt to equity ratios. In this case, they ranged from less than zero to 100%. One property worth $300,000 had $325,000 of debt and another worth $580,000 had zero debt.

A deal was structured for the owners to sell 10 of their properties to a sole owner who agreed to provide 20% of the purchase price in cash, obtain 55% in financing and for the Bradford's to take back 25% of the value as deferred purchase money mortgage as a first trust on two of the properties. In an exchange, you can either exclude the deferred purchase money mortgage note and pay capital gains under the installment method or include the note by initially showing the Qualified Intermediary as the beneficiary. Including the note in the exchange means selling it during the 180 day period. The sellers in this case elected to keep the note.

One property settled November 10. The sellers identified the same three replacement properties for the buildings that settled February 5. The sellers elected to be cautious. They designated the February 5 settlements as an exchange separate from the November 10 building, even though they were identifying the same replacement properties.

On March 28, the Bradford's settled on a warehouse distribution center as a first replacement property. The equity to debt ratio in this purchase was 34% to 66% with the total dollars being the same. Of the three buildings that went into this replacement property, one was all debt and one was all equity. Through bundling their equity-rich building with their heavily indebted building, the Bradford's avoided a tax bill generated by a settlement with no proceeds. To reset the 180 day clock to February 5 from November 10, the date of the first settlement, the proceeds from the building sold on November 10 were bundled into the purchase of the distribution center.

One of the couple's properties held in partnership with their children with a debt to equity ratio of 28 to 72% settled on March 30. Proceeds were used to buy a new property with a debt to equity ratio of 45 to 55%. The total dollars were 33% more in this case. By increasing the tax basis of the new purchase by adding additional debt, the partnership will be able to add new depreciation write offs and shelter additional cash flow.

The third exchange property identified was a shopping center where the lender required that tenants in common owners to be a single purpose entity. In order to acquire this property within the guidelines of the 1031 program, each Bradford had to form their own LLC and they both had to settle the same day.

The lender stated the sale had to close by May 25. The Bradford's were one building short and needed to do a reverse exchange. The reverse is legally and technically complicated. The practical aspects are quite simple, however. None of the financing in place is altered. The eventual settlement of the property by the Bradford's purchaser would be the same and the money that the Bradford's would receive from the settlement needed to be provided by them without encumbering their relinquished or replacement property. The Bradford's used cash for the reverse and purchased the shopping center by the lender's deadline.

This exchange has many benefits for the owners. First, they have upgraded the quality of their real estate assets. Second, they have diversified their portfolio geographically and by product type. Third, and perhaps most importantly, they have the financial wherewithal to enjoy their retirement without financial pressures. For every $100,000 they did not have to pay in taxes, they will initially receive between $8,000 and $8,500 in income annually. Finally, they will continue to use 1031 exchanges. Upon their death, their children will inherit the properties with a step up basis. Uncle Sam and the State tax collector will never collect deferred capital gains tax.

A 1031 Exchange is a transaction in which a taxpayer is allowed to sell one property and buy another without a present tax consequence. The transaction is authorized by Section 1031 of the IRS Code. It is the best strategy for the deferral of capital gains tax that would ordinarily arise from the sale of real property.

In 1997, we had a reduction in the capital gains rate. It also changed depreciation taken on real estate from the capital gains rate to the personal property depreciation recapture rate, usually 25%. In Maryland there is no capital gains tax rate, the capital gains portion is taxed as ordinary income, usually a combined 8% for all jurisdictions.

Taxation of an Outright Sale;

No matter how you cut it, when you sell an investment property outright you will pay through the nose. Some of your clients cannot afford to sell because the taxes and the mortgage indebtedness would exceed the cash coming from the sale.

A 1031 exchange will keep the IRS and the State of Maryland out of your client's pockets and he will be able to reinvest $500,000 instead of $238,000. To do this, your client:

1. Arranges for the sale of his property and either includes 1031 exchange language in his contract or before settlement notifies the purchaser of his intent to exchange.
2. At closing directs proceeds to go to a Qualified Intermediary.
3. Within 45 days identifies up to three potential exchange properties.
4. Closes on one or more of the three identified properties within an additional 135 days (180 days total).

Under the 1031 exchange rules your client can choose to "bundle" properties. He can sell two properties and exchange the proceeds for one property. The sale of his first property determines his time limits for both.

To the extent that your client does not exchange even or up and/or exchange even or up in equity and debt, he will receive nonqualified property ("boot") in his exchange. If he receives boot, tax is owed on the amount of gain on the sale or the amount of boot received, whichever is lower. As indicated by up, your client can always add cash to the new investment or incur greater debt.

To effect a 1031 exchange your client must exchange for a Like-Kind property. In 1991, the IRS clarified what Like-Kind is. Your client can exchange any real estate investment for any other type of real estate investment. To state the extremes, vacant land can be exchanged for a high rise office building and vice versa. To complete the exchange he must never touch any of the cash held by the Qualified Intermediary and in settling on his identified property he must receive a deed in fee simple.

An often overlooked candidate for a 1031 exchange is the small business owner selling a business that owns substantial real estate. Sam and Jenny Jones over 24 years have built up an antique concession business. They plan to sell their business and use the proceeds for retirement income. The building and grounds in which the concessions operate are the business's main asset. They sell for $2,000,000. With a 1031 exchange Sam and Jenny can have more fun in their retirement by receiving income from the reinvested $2,000,000 instead of the $1,476,000 left over to invest after paying the tax due from an outright sale.

Others in this overlooked category are garden centers owners, businesses with warehouses, businesses run out of commercial townhouses and, of course, the family farmer. To determine what amount of the sale the farmer can exchange he has an appraiser determine the value of the family home and surrounding yard and subtracts that value from the sale price.

With the availability of Tenant in Common ownership interests and triple net lease purchases from such investment grade corporations as 7Eleven, Sam and Jenny and the garden center owner can exchange, never be burdened with managing the exchange property and truly retire. In this electronic age, they don't even have to walk to the mail box to pick up the check. It can be EFT' d directly into their bank account.

Most people forget that by deferring tax in a 1031 exchange Sam and Jenny avoided losing all the future earnings of the tax forever. For every $100,000 of tax, at 10% net return on investment, Sam and Jenny and their heirs avoided losing $10,000 each year on each $100,000. In other words, over the next twenty years they would have lost a total of $672,750, for every$ 100,000 of tax paid, if they had chosen to pay the tax.

Ultimately, when Sam and Jenny die, their heirs will inherit the property with a step up in basis. Uncle Sam and Aunt Maryland will never receive any tax from the deferred capital gains. YES! The estate will be worth more and there will be more estate tax to pay. However, heirs receive more after 55% of $4,000,000 is paid than after 40% of $2,000,000 is paid!