Tax implications on a 1031 exchange

[Annie Le]

Hello everybody,

I am trying to figure out the tax implications, if any, for a client who is doing a 1031 exchange. I don't believe she should have any tax implications but would like a 2nd opinion.

Original rental property bought for $255K

Mortgage remaining: $166K

Sold this rental property for $380K

So in essence, her net profit is $125k

Bought a rental property through the 1031 exchange for $127k

So based on the above, she should be okay BUT here is what I'm not sure about:

When she sold her property for $380K, $166K was used to pay her mortgage and $214K went into her account with the Qualified Intermediary.

The purchase of the rental property as mentioned was $127K and with closing costs, fees, etc the total came out to $150K which they subtracted from the $214k in her account.

So she is left with $64K. The Qualified Intermediary withheld taxes for her at 10% and gave her proceeds of roughly $57K.

So the question is, does she have to report the proceeds that she is receiving? And if so, is she going to pay taxes on this amount? It would seem that she shouldn't have to since she technically did an even exchange.

Any input would be appreciated....thanks in advance!

[Bill Exeter]

Hi Annie,

I have bad news for you.

She did not do an even exchange.  She traded WAY down in value, so based upon the numbers that you provided the 1031 Exchange will provide NO tax-deferral at all.

In order for her to defer all of her taxes she must acquire replacement property that is equal to or greater in value based on the NET SALE PRICE (not her gain or profit). 

So, if she sold for $380,000, and her selling expenses were about $20,000, then her net sale price is $360,000, and she would have to acquire one or more properties valued at $360,000 or more. 

She has traded down by well over $250,000, which is more than her taxable gain, so she will recognize all of her taxable gain and pay all of her taxes.  Her qualified intermediary should have pointed that out to her. 

[Annie Le]

Hello Bill,

Thank you for your reply!

Wow! That is unbelievable! So, did her Qualified Intermediary screw up? Also, now that they've already distributed the balance of her money, can she still look to purchase another property?

Finally, you mentioned that she has to recognize all of her taxable gains so this would mean the original $125K from the sale of her original rental property?

Yikes!

[Bill Exeter]

Hi Annie,

It depends on what specific communications were had between her and the Qualified Intermediary.  The Qualified Intermediary knew what she sold her relinquished property for, and if the QI knew that she was only going to reinvest for $127,000, then the QI absolutely should have mentioned it to the client.  The client may have identified other property and the QI may have assumed that the client was going to buy more, but when the client asked for the QI to close out the 1031 Exchange and distribute the rest of the funds they should have warned them at that point in time. 

Unfortunately, most QI's take the position that they do not provide advice, they do not review documents, they do not review amounts, etc.  However, in this case, it would not really be providing advice or guidance, but rather warning the client to seek tax advice since they were trading down so far in value. 

It is too late to do anything else now since the balance of the funds have been distributed to the client.  The client now has actual receipt of the funds. 

Yes, the client will recognize any depreciation recapture and any capital gain from the sale of the property.  So, it looks like the capital gain of $125,000 plus any depreciation recapture. 

[Annie Le]

Hello Bill,

Okay so I got all the facts straighten out and I think it makes more sense now. I tried talking to the client and wasn't get straight answers so I spoke to the QI.

Here is what happened:

Original rental property bought for $255K

Mortgage remaining: $166K

Sold this rental property for $380K

2nd rental property cost was $343K

She put $127K down payment

She has a mortgage on the property for $216K

After all the fees, etc she received a check for $22K

I assume that this $22K is boot and fully taxable? 

Even though she received a bigger mortgage on the 2nd property? Does that matter?

[Dave Toelkes]

@Annie Le

For a fully tax-deferred 1031 forward exchange, there are only two rules to be satisfied.

1.  All of the net proceeds from the sale of the relinquished property must be reinvested in the replacement property acquisition, and,

2.  The value of the replacement property must equal or exceed the value of the relinquished property.

Just using the numbers you provided, the relinquished property value was $380K, while the replacement property value was $343K.  If the replacement property had been purchased for at least $380K, the exchange would have been tax free (trading equal or up in value).  However, your client traded down by $37K which created taxable boot.  Since only $22K was left in the exchange escrow account when it was closed, I will guess that selling expenses for the relinquished property were about $15K which reduces the net boot to $22K.  

From the facts you have provided, it appears that your client has $22K in taxable boot.

It is too late to salvage this situation, but there is still a tax pitfall ahead for your client in calculating the two components of the depreciation basis for the replacement property.  Strongly suggest your client consult a competent tax professional who will know how to establish the new tax basis for the replacement property and will also know to add the taxable boot back to the adjusted tax basis for the relinquished property.  

[Steve Babiak]

I concur with @Bill Exeter and @Dave Toelkes - there will be some taxes due. Some QIs are more knowledgeable and helpful than others unfortunately. 

[Annie Le]

Hey Dave and Steve...thanks guys! 

That was what we were afraid off but at least now we have an idea on how to proceed tax-wise.

thanks again!