I’m going to tell you about how an experienced real estate broker who thought he was doing a 1031 exchange, messed up, and it cost him almost $500,000. His accountant had told him to do a 1031 exchange, but he missed one specific step.
Because here’s the problem: This real estate broker tried to do it himself and thought he was doing it right, but he missed a specific step. And if you miss a step it may cost you a lot of money.
And real quick, a 1031 exchange is when you sell one rental property and buy one or more other rental properties according to IRS rules and timelines. By doing this, you can save money by deferring your taxes, sometimes forever, and you can use that money to build equity and to build generational wealth for your family.
So today I’m going to tell you about a $550,000 mistake. This was a transaction done by a real estate agent on his own properties. He should have known better.
This is the story:
He sold a rental and he bought a rental. The new property that he bought was at equal or higher price, and equal or higher down, meaning that his loan was higher than the original loan that he had just closed.
All of the funds that he had gotten from the old property went into the new property.
He closed escrows within the proper timetable according to the IRS. And the funds went directly from the sale to the purchase.
So, where was the mistake? Remember, this was an experienced real estate agent who had done lots of residential transactions. His accountant said you can’t just sell your rental property, it will cost you a lot of money in taxes. You must do a 1031 exchange.
And what happened was the agent didn’t ask all the questions of what is involved in a 1031 exchange, and his accountant didn’t give him a detailed list of the process.
And what happend was this agent didn’t get a full idea of what the process was in a 1031 exchange. His accountant told him he needed to do one. He had heard of the elements of the exchange, but he didn’t know all of them, and he didn’t have a checklist, and didn’t have proper help.
So where’s the mistake? Easy answer. There is no qualified intermediary in this transaction.
The IRS is very specific on the definition of a Qualified Intermediary.
The IRS even puts out a bulletin explaining who can or can’t be a Qualified Intermediary. You can’t be your own Qualified Intermediary. You can’t use anybody that has worked for you, like your attorney, your escrow officer, your accountant, your colleague who’s a real estate broker. You must use a 100 percent independent party.
And, you can’t use a relative either, even if the relative is an attorney or an accountant. And you can’t use anybody who’s been employed by you in the last two years. So what is a Qualified Intermediary? The one that you probably want to use is a company that does just that kind of work, often a subsidiary of a title insurance company, and you want them to have deep pockets. Because in this case, they would have been holding $1,200,000 of your money to buy your next property, and you certainly don’t want to use someone that doesn’t have deep pockets.
Because the way a qualified intermediary works is they take your proceeds from the property you sell, hold it for you until you’re ready to close the property that you’re acquiring, in this case the $2,650,000 property, and then they transfer the money so that you can buy that property.
You don’t ever touch the money, your escrow doesn’t touch the money, your cousin doesn’t touch the money, your accountant doesn’t touch the money. But this particular person didn’t remember that rule and so it’s going to cost him $550,000, per his accountant.
He sold a property for $1,700,000 that had a $500,000 loan on it. Thus he had $1,200,000 in equity to use for his next property. He had owned this property for almost 10 years. The property he bought cost $2,650,000. He used the net equity from the other property that he had just sold, $1,200,000, for the down payment, and he got a loan of $1,450,000. So the taxes on that for federal, federal capital gains taxes will be $280,000. This is California, so California also has a capital gains tax. And in this case, $186,200. There’s federal Depreciation Recapture tax, $25,000.
And surprisingly, California also has a Depreciation Captured Tax. However, it’s calculated differently. So in this case, $5,735.
And, there’s the Net Investment Income Tax, commonly known as NIIT or the Medicare tax. And in this case it will be $53,200, for a grand total of $550,135.
Okay. This is obviously going to cost this agent, Phil, a lot of money.
Phil’s accountant gave him these numbers and said, yep, he would have saved these taxes if he had used a Qualified Intermediary. And there’s another issue. He used all of his cash proceeds from the original transaction and put it into the new property. So now how is he going to pay the tax? So he has to borrow money to pay his taxes and even pay the quarterly.
So, please, please, please do not make this mistake. Get good help before you start your exchange. Don’t do it yourself, even though you think you know what you’re doing, and get help. Plan ahead.
Oh, and if we haven’t met, my name is Maxine Golden. I’m a longtime real estate broker, and I started the 1031 Exchange Lady channel because I believe you deserve the same tax breaks as the big investors. The law says you do, and you do. But don’t just take my word for it. Ask your accountant or ask the IRS.
They will tell you the same thing.
so I specialize in helping rental property owners like yourself across America to do 1031 exchanges. I either help you myself or I refer you to a qualified real estate broker experienced in 1031 exchanges. So, ask your questions in the comments below, or see the descriptions below and book an appointment so we can discuss your specific needs.