1031 — Tax Deferred Exchanges — 200% Rule

One of the rules of a 1031 (tax deferred) exchange is called the 200% rule. Essentially, if he identifies more than three properties, the taxpayer cannot exchange into more than twice the value he relinquished. That can be a problem for some investors. What if you’re coming from getting a refund at Nordstrom’s and you have to spend all that cash at the Dollar Store? This is what happens to my San Diego clients sometimes. Try going from San Diego to Boise and not identifying more than three properties, or acquiring more than twice what you sold in value.

Obviously, this rule requires the investor to pay attention to how much property he’s acquiring in his exchange.

Even if you put 20% down in Boise, Denver, Ogden, Kansas City, Austin, and places like those, you can end up with more than three properties before you know it. This is true for folks who may have owned their San Diego properties long enough to have created a pretty high equity to value ratio. This, by the way, isn’t a bad problem to have, although you certainly should have exchanged that equity long ago in most cases.

What if you’re trying to leverage your new property as much as possible, and the new property(s) allow that approach without generating negative cash flow? Here’s what you do.

This approach assumes you’ve been able to accumulate unused depreciation. This happens because you make too much money working, or your depreciation is more than $25,000 a year — both result in the accumulation of unused depreciation. Let’s use a recent client’s experience to illustrate how you might work this.

In anticipation of a tax deferred exchange (1031), my client’s tax returns showed a truckload unused depreciation, carried forward over the holding period. When his San Diego property closed, using his CPA’s numbers, we pulled out that portion of his net proceeds covered by the unused depreciation — resulting in no capital gains tax on the cash taken.

We then concluded the exchange, acquiring more properties, but keeping their total value within the 200% rule. The truckload of tax free cash was used to buy more property — which was not part of the exchange. The properties bought with the cash also means it had its own brand new basis. This resulted in those properties producing even more tax shelter (depreciation) than if the cash had remained inside the exchange. Pretty cool, eh?

It’s not necessary to view buying at the Dollar Store an impediment to your tax deferred exchange — if you know what you’re doing.

If he needed to, he could have taken some of the cash out to add to his Sominex account, or a vacation, or a new car, or…….whatever. No strings attach to the cash.

The penalty for violation of this rule? If this is caught in an audit, your tax deferred status will be disallowed — ouch. I wonder how many investors have unknowingly violated this rule, while being represented by the agent who sold them their home? Having your (1031) tax deferred exchange disallowed, will result in an ugly and surely unexpected tax bill.

Those taking their equities from relatively high priced regions to much lower priced regions can find themselves in violation of this rule without trying too hard. Having a Purposeful Plan will allow for this possibility. This is a perfect example illustrating why paying attention is so important to the real estate investor.

Related posts:

1. Section 1031 Of The IRC – The Tax Deferred Exchange — Not Always The Right Tool
2. 1031 Exchanges Can Be Only Part Of A Transaction
3. Is It Always Advisable To Execute A Tax Deferred Exchange?
4. 1031 Exchange? Cost Segregation? Doing Things On Purpose
5. The Best Of All Worlds — Sell & Pay No Taxes — No 1031 Exchange