VII. WHAT WOULD THE TAX CONSEQUENCES LOOK LIKE IN A HYPOTHETICAL EXCHANGE?

Suppose John Smith owns investment real estate worth $175,000 and he wants to sell and re-invest in other property. Also suppose that John purchased his property several years ago for $100,000, made $20,000 worth of capital improvements and has taken $45,000 in depreciation deductions. John's adjusted basis in his property would be $75,000 ($100,000 plus $20,000 minus $45,000). Also assume that after purchasing his current property, John re-financed it and currently owes $125,000 on his mortgage.

If John decides to sell his investment property without the benefit of Section 1031 , all of his capital gain of $100,000 ($175,000 minus his adjusted basis of $75,000) will be recognized, resulting in a Federal capital gains tax of $20,000, plus a State capital gains tax of about $5000. After paying off his mortgage, his net proceeds will be $50,000, but he will have to set aside approximately $25,000, or one-half of these proceeds, to meet his federal and state tax obligations, effectively netting for himself only approximately $25,000 to be used for his re-investment objectives.

If John structures his sale as an "Exchange" under Section 1031 , he will still realize a total capital gain of $100,000, but the gain will not be taxable, so long as he successfully completes his exchange, In an Exchange, therefore, John would not have to set aside $25,000 to pay capital gains taxes but would be able to use the full (after mortgage payoff) net proceeds of $50,000 to acquire new property.

In order to complete his Exchange, John will trade up or equal in value and equity when he acquires his replacement property; that is, he will buy property of an equal or greater market value and equity investment than the property he relinquished. He will do this by directing the Intermediary to use the net proceeds of sale to acquire the replacement property which he chooses, and he will make up the difference by obtaining financing in an amount equal to or greater than the financing he paid off when he conveyed his relinquished property, or will use other funds.

John's basis in his new investment property will be what he pays for the property, minus an amount equal to the capital gains not recognized. If John acquires investment property for $250,000, his basis in his new property would be $150,000 (the purchase price of $250,000 minus "gain not recognized" in the sum of $100,000).

VIII. HOW SHOULD I PROCEED IF I WANT TO DO AN EXCHANGE?

It is important to keep in mind that you cannot convert a sale into a valid exchange after a closing. If you want to take advantage of the benefits of Section 1031 , do not convey your deed or attend a closing before contacting us.

a. You will negotiate and sign a Purchase and Sale Agreement for your sale property, in the normal manner. No special language indicating an intent to do an Exchange is needed in your contract of sale.

b. The Exchange begins after you sign your sales agreement. Call 1031 Exchange Services, Inc., before closing on any contract, and we will ask you to forward to us a copy of the agreement. We will prepare all of the documentation necessary to convert your sale into the first phase of a Tax-Deferred Exchange. We are able to convert a sale into an Exchange with very little lead time on an emergency "rush" basis, but 10 to 14 days notice prior to the closing is preferable and more typical.

d. After the closing on your relinquished property, we will guide you through the identification process and requirements for your replacement property , and coordinate the exchange aspect of your eventual acquisition with the closing agent on the buy side.