1031 confusion re: credits

4 Replies

I've run into some confusion at the last moment with my 1031 exchange and was hoping to get lucky and catch someone who knows the right answer.

In short, I've got a settlement statement for an occupied multifamily property. That statement shows a price of X (some of which I've paid out of my own pocket as earnest money and wish to have reimbursed from the exchange), plus various expenses. Some of these (various recording fees, attorney fees, transfer tax) are also eligible 1031 expenses. Let's call those Y.

My understanding is that I should be able to use exchange funds for all of X+Y (purchase price plus eligible fees) without incurring tax liability.

Where the confusion comes in is because of credits from the Seller to me. Those credits are prorated property taxes (call it A) plus prorated rent for the month of April (call it B). So naturally, the amount that I owe at closing is reduced by A+B.

However, it does not seem logical that the eligible expenses from the 1031 are also reduced by A+B, because A+B (prorated taxes and rent) are funds which should legitimately be mine regardless. Ie, if the prorated April rent were one million dollars (dream big, right?) then it would reduce the sum due at closing by $1M. Would I then no longer be able to use that $1M from the exchange?

Thanks,
Allen

Hi @Allen B. ,

Your Qualified Intermediary should provide you with this information.

You can use your 1031 Exchange funds to cover X+Y. The Seller credits to you (A+B) effectively reduce the amount that you need to fund into the closing. This is not a problem if you are trading up in value and need to deposit additional funds into closing. However, it can result in some amount of 1031 Exchange funds not being used if you are trading equal or down in value, which would create a taxable event. If this last comment is the case, you can ask the closing agent to disbursement the prorated amounts to you at closing so that all or more of your 1031 Exchange funds can be used toward the replacement property.

Originally posted by @Allen B. :

I've run into some confusion at the last moment with my 1031 exchange and was hoping to get lucky and catch someone who knows the right answer.

In short, I've got a settlement statement for an occupied multifamily property. That statement shows a price of X (some of which I've paid out of my own pocket as earnest money and wish to have reimbursed from the exchange), plus various expenses. Some of these (various recording fees, attorney fees, transfer tax) are also eligible 1031 expenses. Let's call those Y.

My understanding is that I should be able to use exchange funds for all of X+Y (purchase price plus eligible fees) without incurring tax liability.

Where the confusion comes in is because of credits from the Seller to me. Those credits are prorated property taxes (call it A) plus prorated rent for the month of April (call it B). So naturally, the amount that I owe at closing is reduced by A+B.

However, it does not seem logical that the eligible expenses from the 1031 are also reduced by A+B, because A+B (prorated taxes and rent) are funds which should legitimately be mine regardless. Ie, if the prorated April rent were one million dollars (dream big, right?) then it would reduce the sum due at closing by $1M. Would I then no longer be able to use that $1M from the exchange?

Thanks,
Allen

Prorated property tax and rental credits do no affect the cost basis in which you are purchasing the property. You are correct in adding in the various closing expenses when calculating your basis, but the prorated tax and rent credits do not affect that number.  I.E., even with those credits, you should be able to get all your EM back and replace it with 1031 proceeds and still avoid boot.

@Allen B. , Prorations and prepaids are generally best paid outside of closing.  But many times that is not a possibility so they get lumped into the settlement statement.  As @Tony Kim , things that don't impact your adjusted cost basis (not actual costs to purchase) will not qualify as part of your 1031.  

However, you'll probably find that your accountant can get more mileage by expensing those currently and any change in basis gets locked into the 1031.  But a current year tax expense benefits you now.

The return of earnest money should be no problem at all.  Here's an article from BP that might help - https://www.biggerpockets.com/...

Thanks to everyone who answered on short notice. It sounds like in the future, life is just a little bit easier with rent and property tax prorations moved outside of closing. Will keep that in mind for the next time around, thanks!

In this case, I was closing on two different properties yesterday. It ended up that the second closing was able to absorb the balance of the 1031 (and a bit from my checkbook) even with the first closing not being "optimized" as discussed.

Oh, and Dave -- thanks for the accounting notes. I'll probably share them with my CPA just in case.

Cheers,
Allen