1031 exchange question

Kyle J. · 2012-12-06T08:39:12-08:00

A friend of mine is looking into doing a 1031 exchange on some property; however, he's getting some conflicting info on one aspect of it so I thought I'd ask the experts here. Here's the situation: He is selling some vacant land that he's owned for several years and is going to buy a rental property. He originally bought the vacant land for roughly $80k and is selling it for $140k. The rental property he is buying is $275k. He would like to only do the 1031 exchange using the $60k profit (capital gain) on the vacant land he's selling, and keep the other $80k (original purchase price amount for the land) for other purchases (possibly not real estate related). The 1031 tax company (intermediary) has told him that he must put the entire $140k (selling price of the land) towards the purchase of the new property. However, his tax preparer is saying that it would be okay for him to put just the $60k profit towards the new property. Clearly, both of these can't be true. My friend's argument is that he has already paid taxes on the original $80k he used to buy the land, so why can't he just roll over the $60k profit and avoid the captial gains tax on the whole amount. I wasn't sure one way or the other, so I thought I'd ask the experts here to see if anyone knows.

Steve Babiak

Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes

13y

The QI is correct.

How can you distinguish which dollars came from original purchase money and which are the profit? Not possible to do, so IRS says if you take money out of the sale, that money is considered to be from the profits; that's called "boot".

To do the split, he must do the identify 3 properties stuff and use ALL of the money to buy from those, and it must be done within the timelines to complete an exchange. Also, since this is year end, the tax filing deadline in April hits before the end of the one timeline, so an extension would be needed on that. There is also a provision where some of the proceeds can be set aside "in escrow" by the QI to perform repairs or improvements - but that will add to expense and complexity of an exchange; the amount of rehab dollars should be fairly large to even consider doing that in light of the fee expense and complexity.

And down the road, the acquired "replacement" property can be tapped to get cash - taking out a mortgage is still possible.

That accountant / tax preparer should be evaluated too ...

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Kyle J.

OP

Rental Property Investor · Northern, CA · Member since 2012 · 5k+ posts · 5k+ votes

13y

Thanks Steve Babiak.

I'm not well-versed in 1031 exchanges, so I'm not sure what it means when you say "he must do the identify 3 properties stuff". Can you explain?

Also, if it matters, all of the $140k sale price for the vacant land has already been put into an escrow account. The buyers aren't in a huge hurry to get the land, and are cooperating with my friend since they realize he needs to do a 1031 exchange. He plans on leaving the money in escrow until the short sale is finalized on the $275k rental property he is buying, since he knows that a short sale can take a while.

Thanks again for your advice.

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Steve Babiak

Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes

13y

This person should be interfacing with a QI and doing as instructed by the QI; identifying properties is part of the info that the QI will give to them. If they have received any funds from the sale of the "relinquished" property, the exchange may already have been invalidated by that; seller is not allowed to accept ANY funds from the "relinquished" property, except at the end of the exchange the QI will make such distribution if all funds have not been applied toward purchasing "replacement" property. Any funds the QI gives to the seller will be "boot", except for reimbursement of any down payment money contributed toward acquiring "replacement" property.

The 1031 corp website has lots of good info regarding all of this.

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Kyle J.

OP

Rental Property Investor · Northern, CA · Member since 2012 · 5k+ posts · 5k+ votes

13y

Thank you sir.

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Steve Babiak

Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes

13y

BTW - buying a short sale as a "replacement" property in a 1031 exchange might not be so wise, as there is a firm 180 day deadline ...

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Joel OwensBusiness Member

Moderator

Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes

13y

Don't use the "oh crap" method when doing 1031's. What do I mean by this is I get sellers asking me on deals to do the 1031 and hold funds etc. I tell them I can't do that. I have seen sellers try all kinds of crazy things in the past.

People do all kinds of things on bad or conflicting advice and then try to unring the bell later on when what they have done will not stand up to an IRS audit.

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Kyle J.

OP

Rental Property Investor · Northern, CA · Member since 2012 · 5k+ posts · 5k+ votes

13y

It sounds like he's doing it the right way by using an QI and not taking the proceeds from the land he is selling until he is close to closing on the other property.

I told him the same thing about short sales taking a while, but it's sounding like doing it within 180 days shouldn't be a problem. Of course, as wel all know with short sales, you never really know for sure until it's actually done.

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Steven Hamilton IIPro Member

Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes

13y

Kyle J.,

Steve Babiak is exactly correct. One thing to consider is the possibility of doing a reverse exchange. A reverse exhcange is where the replacement property is purchased through the QI first and then the property is relenquished within proper time frames. He should ask his QI about details. As there is way too much to try to explain here via a forum.

He needs to find a new friend/accountant. An accountant well versed in real estate should be used. He/She will be worth their weight in gold. They will also know 1031s.

-Steven the Tax Guy

[email protected]224-381-2660

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Kyle J.

OP

Rental Property Investor · Northern, CA · Member since 2012 · 5k+ posts · 5k+ votes

13y

Originally posted by Steven Hamilton II:

He needs to find a new friend/accountant.

-Steven the Tax Guy

I agree. In fact I told him the same thing earlier.

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Steve Babiak

Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes

13y

In my state (PA) a reverse exchange is too costly to even consider in most cases. Remember, the QI has to take title in a reverse exchange, even if it is only for a brief period of time. PA has transfer taxes that would have to be paid multiple times in a reverse exchange (up to 4% in some parts of the state).

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Bill ExeterBusiness Member

1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes

13y

Hi Kyle,

I thought I would chime in here. As already stated, the QI is correct. However, I wanted to clarify the exact amount that must be "reinvested." The general answer always provided is the sales price - in your case $140,000.

Technically, the correct answer is your "net sales price," which is your gross sales price less routine closing costs. Routine closing costs would be items such as real estate agent's commission, escrow fees, title insurance costs, recording fees, 1031 exchange fees, etc. Routine closing costs would NOT be operating items such as prorated rents, prorated property taxes, HOA fees, fees or costs paid to or required by the lender, security deposits paid to buyer, etc.

So, let's just say that your routine closing costs are $10,000. Your net sales price would be $130,000. Your client would need to trade equal or up in value based on the $130,000 value.

Lot's of taxpayers and accountants think that you only have to reinvest the gain being deferred. The requirement is that the taxpayer reinvest his investment. The $60,000 gain is not his investment. That's his profit. His investment is the $140,000 ($130,000 after routine closing costs) and that is what must be reinvested. If he only reinvests $60,000, then he has not reinvested his investment.

Taxpayers can always trade down in value (i.e. sell for $140,000 and reinvest for a smaller value), but they will pay taxes on the amount that they trade down by, and if they trade down too far they will recognize all of their gain and the 1031 exchange will provide no benefit.

Steve has also provided good advice regarding short-sale transactions and 1031 exchanges not mixing well. We have found over the last couple of years that lenders will often not allow the Purchase and Sale Agreement to be assigned to a QI in order to incorporate the property into the 1031 exchange. It should not matter, but it has been a problem.

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