Is a 1031 exchange a good option?

Question

I'm selling a property (land) and would like to defer taxes. I've been doing some research on 1031 and do not know if I even would qualify.

One thing I have read is that the title must mirror one another (sale and new purchase). The property I am selling is owned jointly with another person. The new property would be in my name only. Does this automatically disqualify me from doing a 1031 exchange?

Also, are houses being held for resale/renovation (i.e. flipping) excluded from 1031?

Are there any good books pertaining to tax considerations for real estate investing?

Dave Foster · Answer

@Konrad R.,  Qualified use of a property is determined by your use and intent - not the way it was used before you acquired it.  It could have been the seller's primary residence.  But if you are intending to use it for investment purposes then it would absolutely qualify.

Yes, you can do a "partial" exchange.  In order to completely defer all tax you must purchase at least as much as you sell (net sale after closing costs but before mortgage payoff).  And you must use all of the net proceeds in the next purchase.  However, you can purchase less than you sold or take some of the cash as what is known as "taxable boot".  You simply pay tax on the difference.

So, in your example, you could sell for 400K and use a 1031 to buy for 200K.  If your basis was 100K then of the 300K profit you would pay tax on 200K and shelter the tax on the remaining 100K.   However, you want to calculate carefully because if your basis is 200K then you would pay the tax on all 200K of profit so there would be no benefit to the 1031.

One possible alternative might be to use the entire amount in an exchange and sell for 400K and buy for 400k (thus sheltering all the tax).  Then immediately do a cash out refinance and pull the 200K cash out.  This way the 200K is not taxable.

Dave Foster · Answer

@Konrad R., While there are no specific requirement for contract wordage, there is a requirement for notification of all parties.  So at some point in the process the other party will be aware of the existence of the 1031.  Contract language satisfies this but most QIs also include notifications that are included in the closing packages.

One thing that can occasionally create some momentary angst is the issue of assignability.  Even though the deed is passed directly from buyer to seller, the usual method is for the contract to be assigned to the QI so the QI as intermediary for John Seller is listed as the actual seller.  Once in a while the party on the other side of the table will object to the contract being assigned the contract rights.  Usually the issue is resolved with a simple explanation.  After all the primary motivation of all parties is to make the deal.

There are a lot of investors out there who feel that they are at a disadvantage in negotiations if their 1031 intent is revealed.  So we usually recommend that you simply make the contract assignable and use the standard notifications at the closing table.  This allows for all contingencies.  And many standard association contracts already have a "check the box" option for assignability and in many cases for a 1031 exchange option as well.

Dave Foster · Answer

@Konrad R., sorry about the trigger finger.  Meant to say since the govt has nuclear weapons they win the argument.  If you want to take advantage of 1031 to your benefit you have to leave some or all of your basis in.

Dave Foster · Answer

@Konrad R., Thats correct.  It can be very frustrating and confusing but the IRS position is that any cash you're going to take out or buy down is going to be profit first.  That ensures that the first dollar you take out will be taxed.

You can say that you're only taking out your original capital and you'd be right.  They say you're taking out profit and since they have nuclear weapons

Konrad R. · Answer

Just to be clear. Your basis is always going to be rolled into the new property (100k). There isn't a way to just roll over the capital gains portion of the sale (300k) and cash out on the 100k basis.  Is that correct?

Konrad R. · Answer

I may be able to push back the closing. I'm waiting on a response from the buyer.

I do have a couple more questions, however.

-I read an old thread on this forum pertaining to 1031 exchanges. Someone mentioned that there must be a history of the newly acquired property being a rental/investment property. Can I purchase a home from someone that is using it as a primary residence and convert it into a rental property? What this satisfy the like kind requirement of a 1031?

-Can I allocate only a portion of the capital gains into the exchange? For example, if I am receiving 400k from the sale of the property, can I just use 200k for the 1031? I realize I will have to pay capital gains tax on the other 200k. If I am able to only do a portion of the capital gains on the sale, when can I take out the money not being rolled into a 1031? Do I need to place the whole 400k with the intermediary at closing?

Thanks again for all the help. It has definitely been a learning experience.

Bill Exeter · Answer

Hi Konrad,

Actually, there does not have to be any language in the contract regarding a 1031 Exchange.  Many advisors recommend that you include something like a "cooperation clause" so that all parties are aware of the 1031 Exchange and agree to cooperate, and it is probably a good idea to define what everyone means by cooperate.  But, if there is no language in the contract regarding the 1031 Exchange it will not prevent you from completing a 1031 Exchange nor invalidate it.

Konrad R. · Answer

Thank you for the help.

One last thing. I've read that the intent to do a 1031 exchange needs to be mentioned in the real estate contract. We haven't closed yet. Once the contract is finalized, is it too late to take advantage of a 1031 exchange if it wasn't mentioned in the contract?

Is a 1031 exchange a good option?

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