All Forum Posts by: Account Closed

Mike:  I am a former Tax Examiner for the Internal Revenue Service; a former Tax Accountant for a Big Eight Accounting Firm; and I built and operated a Title Insurance Company for over 20 years, being a Certified Title Attorney with eight national Title Companies.  I am also a Real Estate and Tax Attorney, with over 34 years experience, licensed in Texas, North Carolina, Virginia, and the District of Columbia. Now for your question.

If the owner borrows $300,000 on the debt-free property, that is not a taxable transaction, is not reported, and he can just put the money in his pocket.  He can then make the note payments from the income from the property.

If you then buy an interest in the property, you will be entitled to receive a portion of the income, and if you use your portion to help pay his debt, you are still facing the situation where you are gifting him an amount of money, but it might not be a large enough amount per year to trigger a Gift Tax situation.  People don't usually worry about Gift Tax, and it is not an area that is closely monitored by the IRS, but it is still the law.

Also, it is less likely that he would face a problem with selling you a fractional interest for exactly (or close to) what his basis is in that fractional amount, because the fair market value of that fractional amount is lower because the debt has reduced the amount of equity you are actually buying.  

I hope this helps.  Let me know if you have a follow-up.  

If the owner of the property has a property with a $200,000 basis and a $400,000 market value, and he sells you a 50% ownership for $100,000 instead of the $200,000 FMV, he will report the sale on his tax return as showing no capital gains. Then both of you borrow $300,000 on the $400,000, each of you would be entitled to $150,000 of the loan proceeds. This is not a taxable transaction and is not reported on your tax return. But when the owner receives all of the $300,000 of the loan proceeds, you are, from a legal standpoint, making him a gift of your $150,000. This will trigger a Gift Tax situation. Reporting this and paying the tax will by your obligation. The original owner would only have a problem is he fell into a Random Audit, and the Agent saw that he avoided capital gains by selling below market. The Agent might even add the $150,000 that the owner received as part of the actual agreement to the $100,000 that you paid, and re-form the transaction to show that the owner actually had a $150,000 capital gains and assess a 25% tax on depreciation recapture, and a 10-15% tax on the capital gains. I just picked these numbers to walk through the deal, yours might be different, but the rules are the same.

Fine, Bill, if you think the purpose of the Forum is to just provide an answer to the specific question and nothing else.

Her question was: "What are the rules for improving on 1031 exchanged property?"

The answer is: "There are none."

If you think she is best-served by that answer, then let's leave it there, and acknowledge that she does not need to know the manner in which she is holding title to the lot, or whether she needs to divide it out from the larger tract first, or how much of the transferred undepreciated basis and deferred capital gains tax liability now reside in the ownership of the lot.

These are too complicated to think about and have nothing to do with her question, and I should not have tried to help her.  OK?

By the way, who died and left you in charge?

Susan Douma, congratulations on your project.  it sounds very exciting.

Dave Foster, I guess we can at least agree that we disagree.

I don't think "the fact that this property is the product of a past 1031 exchange is irrelevant."

And I don't think it is "irrelevant" whether the Replacement Property is one parcel or several parcels.  In fact, I think it is critical.

And I never mentioned "zoning" or "building regulations."  Those are irrelevant to this discussion.

My point is that in formulating a plan to move forward with building on the lot, the first step is to go back and identify the parcel you intend to build on, then identify how you are holding title to that parcel, and then describe the unique characteristics of that parcel due to the fact that it was Replacement Property in a 1031 Exchange, such as the deferred capital gains tax.

These are not questions that "need to be asked of any property."  These are questions to be asked about Replacement Property from a 1031 Exchange.

The answers to all of those questions might turn out not to be determinative (although the bank loan officer might disagree), but the questions themselves are relevant.

At least, that's the way I do business.  I acknowledge that there are other ways, and I respect anyone who uses a different business model. 

Bill Exeter:

Susan Douma said the Replacement Property is "a home with several unimproved lots,"  and that she would like to "build multi family on these lots."

The purpose of determining how title is held should be obvious.  Suppose the Replacement Property was described as one tract of land, and the conveyance to her was for one tract of land, and the one tract of land is securing a mortgage on the home.  If they spend $800,000 of their own money building on one of the so-called "lots," it is already encumbered by a first lien security interest.

If the Replacement Property was actually four properties- the home, and then each of three adjacent lots, with four separate deeds, or four separate parcels identified on one deed, then the answer to her question would be different.

But her question is "What are the rules for improving on 1031 exchanged property?"

It seems that the first rule would be to determine exactly how you are holding title to the property you plan to build on and whether or not it is encumbered by a lien.

If she received title to each separate lot, and the lots were not included in the financing of the Replacement Property, then the answer is that she should proceed with the project.

If the lots are just behind and adjacent to the house, on the single piece of property, then the answer is that she needs to separate out the lot she intends to build on before doing anything.  (Sometimes a city's master plan will identify "lots" on paper that never actually become lots.)

All of the comments are correct, I'm just pointing out that an actionable answer is not possible without the additional information of knowing whether her Replacement Property was one property or four properties, and how the financing was structured.

Bill Exeter,

Thank you for your comment.

But let's be clear what this discussion has been about - the immediate cash-out refinancing of a Replacement Property with the admitted purpose of the taxpayer getting his hands on the net sales proceeds that he was forced to use to purchase the Replacement Property in order to get the tax deferral.

Remember, the IRS does not know about the cash-out refi.  This information is not included on the Form 8824 reporting the 1031 Exchange, and, not being a taxable transaction, is not reported to the IRS.

So, the IRS has not "accepted" this technique.

And, I think it is highly likely that in an audit situation, the immediate cash-out refi would either be recharacterized as "boot" or be declared a "sham" transaction, and the entire 1031 Exchange disallowed for violating the spirit of the law.

It would be tragic if one of the Forum members ended up in that situation.

And I have never said that the Replacement Property cannot eventually be refinanced.  Of course it can, and it probably should.  That's just good investment strategy.

But the decision should be just that, a reasonable business decision, based on other market factors, and not part of a plan to use the net sales proceeds to avoid paying taxes, and then get them back in a transaction hidden from the IRS.

A conservative recommendation for a waiting period would be one year and a day, the same period recommended to prove that the Replacement Property is actually what it was represented to be when the intent was first demonstrated.

But in an acceptable situation such as needing to do emergency repairs on another investment property, the equity could probably be accessed 7-8 months out with no problem.

The key is not showing intent to invest in the Replacement Property.  The key is to show that you are not just trying to get your hands on the net sales proceeds.

By the way, you have a great website, outstanding content!

Dave Foster, let's use an example.

Say I bought a Duplex ten years ago for $200,000 cash and now I am selling it for $400,000.

I assigned a $20,000 value to the land and claimed $60,000 depreciation on the $180,000 building.

Ignoring incidental costs for the sake of simplicity, I will have $260,000 in capital gains.  $200,000 of this is pure capital gains (400,000 - 200,000) and $60,000 will be depreciation recapture.

The $200,000 will be taxed at my tax rate of 20% for a $40,000 tax liability, and the $60,000 will be taxed at 25% for a $15,000 tax liability.  The total will be $55,000 in taxes.

So, if I don't do a Section 1031 Exchange, I will walk away from the closing table with $345,000.

But, if I do a Section 1031 Exchange, I am required to put all of my $400,000 net sales proceeds into the purchase of a Replacement Property, say a Fourplex, and I walk away with no money, but with title to a Fourplex.

But you are saying that I can arrange to borrow $400,000 with the Fourplex as security, a cash-out refinance, schedule it back-to-back with the first transaction, and walk away from the table with both my $400,000 net sales proceeds from the sale of the Relinquished Property back in my pocket, and title to the Replacement Property, the Fourplex.

The Replacement Property contains none of my $140,000 transferred basis from the Relinquished Property, and none of my $200,000 deferred capital gains on the sale of the Relinquished Property, and none of the $60,000 unrecaptured depreciation from the Relinquished Property, all of which make up the very foundation of the Section 1031 Like Kind Exchange statute.

Treasury Regulations Section 1.1002-1(c) concerning Sales and Exchanges, referring to Section 1031, says "The underlying assumption ... is that the new property is substantially a continuation of the old investment unliquidated."

If I have $400,000 in my pocket and no equity in my Replacement Property, I think I've liquidated the first investment, and Section 1031 has no relevance.

The purpose of a Section 1031 Like Kind Exchange is to allow the taxpayer to sell the Relinquished Property and put the money representing the capital gains into the Replacement Property and therefore not have to pay capital gains taxes on that money.  You cannot then immediately refinance the Replacement Property to get that money out.  While there is no statutory holding period, the holding period and the renting out is what demonstrates to the IRS the necessary intent that the Replacement Property will be "held for productive use in a trade or business or for investment" as required by the language of Section 1031.  If the capital gains could be accessed a month after closing by refinancing, there would be no reason for Section 1031 to exist.  If part of the "net proceeds" from the sale of the Relinquished Property which were put into the Replacement Property are taken out through refinancing in less than one year, and for a reason that is not a legitimate business reason, the IRS will characterize the funds the same as "boot" received at closing.  They will be taxable, and the entire transaction might be denied. 

I'm very interested in knowing how this turned out, since April 15 has passed and presumably you have filed your tax return and completed the Form 8824 detailing the transaction for the IRS.

What kind of Exchange was this: a Delayed Like Kind Exchange, a Reverse Exchange, or a Construction/Improvement Exchange?

Why was there an Exchange Accommodation Titleholder (EAT) involved?  What exactly did it do?

When did you close on your Relinquished Property and when was the Replacement Property acquired by the EAT (I assume)?

What is the 180-day period you talked about?

You must have a lot of great information to share after what you have accomplished.

Thanks.

You might want to go back and determine exactly how you are holding title to the lot, and exactly how you reported to the IRS that you received the lot as your "Replacement Property" in your Section 1031 Like Kind Exchange.  To do this, pull your tax return for that year and look at your attached Form 8824 "Like Kind Exchanges."  On the first page, Part I, Line 2 "Description of like-kind property received:" you either described the property as one piece of property which would have included the home and the lots, or you described the home as one piece of property and each lot as a separate piece of property.  Now look at the deed or instrument putting the property into your name.  Is there one legal description which includes the home and all of the other land, or do you have separate legal descriptions for home and for each of the lots?  By the way, are you planning to build a separate multi-family on each lot?