A Real World 1031 Exchange - Part 2: 1031 Exchange Explained??

A Real World 1031 Exchange                                          6/15/2014

Part 2: 1031 Exchange Explained??

DISCLAIMER: I am not a tax professional. The following is my interpretation of several podcasts, Web articles, and comic books. If you make decisions based on my skewed view of the world, you will go to jail.

For those unfamiliar with a 1031 Exchange, it is a way to DEFER (not necessarily avoid) taxes. The rules are fairly straight-forward, but get fuzzy along the edges. The idea of a normal 1031 exchange is that you do not receive the funds for the sale of your property. They are held by a middle-man called a Qualified Intermediary (someone recognized by the IRS to hold 1031 funds). Once you find a replacement property, the Q.I. does the actual purchase with your held funds. In theory, you have just exchanged one property for another because you never had possession the funds from the sale of your original property. In 1031 gobbledygook, you don't 'sell' your property, you 'relinquish' it, and you don't 'buy' a replacement property, you 'acquire' it.

The major rules:

You must contract with a Qualified Intermediary and specify in the escrow for the sale of your property that the funds go to the Q.I. rather than directly to you. You cannot decide to do a 1031 exchange after the escrow closes. Once the funds are in your name, you owe taxes.

In order to defer all taxes, you must acquire a total amount of property that costs at least as much as your relinquished property sold for, minus selling costs (commissions, title fees, etc), and the total cash you pay must be at least as much as you got for your property. You can finance the difference or add more cash from another source.

Our triplex sold for $1,290,000 with closing costs of $90,000 so we have to buy $1.2M worth of properties. Escrow paid off a $615,000 loan leaving $585,000 cash which went to the 1031 Q.I. We must spend at least $585k cash and will get loans totaling $615k. (You’ll notice that the 1031 rules don’t care how much you paid for the property. That is between you and your CPA.)

If you spend less than the total or less than the cash held by the Q.I., the difference is called ‘boot’, and you will have to pay taxes on it.

After your escrow closes, you have 45 days to identify your replacement property/properties, and you must complete the exchange within 180 days from the escrow closing date. (Weird caveat: if your escrow closes between Oct 16th and Dec 31th,, the exchange must be complete before you file your taxes, meaning you may have to get a tax extension. Apparently once you pay your taxes for the year of the sale, your exchange is over.)

The new property must be in the same entity name as the original property was sold in. In our case, we sold our property in my name and my wife's name so we have to purchase any replacement properties in the same names. We cannot now buy ten houses in my name and ten houses in my wife’s name. (See a professional for exceptions.)

Your entity name must be on the title for the replacement property. This does allow for some syndication/joint venture options. (Although most syndicators don't want to go to the trouble of learning how to set up a structure valid for 1031 exchanges.) It requires a Tenant-In-Common (TIC/DST) scenario where your name appears on title along with other partners.

You must exchange for 'like-kind' property. If you sell real estate, you must buy real estate. (If you sell a female horse, you must buy a female horse.) In real estate, 'like-kind' includes any combination of raw land, SFRs, condos, commercial properties, etc – any 'real' property where your name is on the title.

And you are limited to replacement properties in the United States, Guam, and the U.S. Virgin Islands. (I checked the V.I. You only have a chance to cash-flow if you move there to do the property management. They have a lot of vacant land for sale, but building costs are astronomical.)

If you are exchanging for one property, you can identify up to three possible properties to exchange into. You must send a list of the exact addresses of the properties to your Qualified Intermediary by midnight of your 45th day – no exceptions.

If, as in our case, you exchange from one property into several less expensive properties, you can identify up to double the fair market value of your relinquished property under the 200% rule. I take this to mean double the gross selling price, but I have been advised to use the net selling price after selling expenses.

There is a third option, but it is so unlikely that I won't go into it.

Although there don't seem to be any specific timing rules on holding the acquired property, the 1031 exchange is for long-term investing. (Flippers need not apply.) Your 'intent' should be to buy-and-hold. My CPA suggested that it is best to have at least one 'uneventful' tax year between the year of the 1031 acquisition and its relinquishment for the next property. There was a story of a man who used a 1031 to buy a property, then the next weekend was offered $1M more than he paid. I believe he took the deal, although he may have had to explain it at the local IRS office along with his previous seven years’ activities.

In the first paragraph, I pointed out that a 1031 exchange allows you to defer your taxes. In our case, we had $315k of taxable gain. That gets rolled over into our replacement property. If we sold that property for a $100k profit, we would now be on the hook for $415,000. However, we could do another 1031 exchange which defers the taxes once again.

You might say “But eventually you will have to pay taxes on all of those gains over the years.” Yes, in theory, but this is where you can pull a fast one on Uncle Sam. YOU CAN DIE! If you continue to do 1031 exchanges until you die, you can will your properties to your good-for-nothing kids, and their 'basis' becomes the current value of the properties. If they immediately sold all of your 1031 properties to give you the best send-off since Al Capone, they wouldn't have to pay any tax.

I want to thank Bill Exeter for his excellent site, where you can find much more accurate information. Also Bill reviewed this page before I posted it. I owe him a new red pencil.