In last week’s post, in which I interviewed Qualified Intermediary & 1031 Expert Bill Execter about 1031 exchanges, questions were asked and answered as to how to ensure a successful closing of an exchange transaction. But the reader could have very credibly inferred that 1031s are an either/or proposition, which is patently false. The fact is, you as an investor can indeed sell a property held for investment, defer some or most of the capital gain, and make use of other menu options you might not have known existed.
To be clear, I won’t be addressing the Section 453 Installment Sale treatment you might receive in the event of a failed 1031. Often, investors learn their cap gains taxes won’t be due ’til the following tax year. But again, that’s when the investor is unsuccessful in the execution of their intended tax deferred exchange.
The Planned Partial 1031 Exchange
There are many reasons an investor might eschew a pure exchange. We’ll address just two of ’em here.
1. Incorporating a partial installment sale (Section 453) makes sense — often on a few levels.
2. There could be, again as part of an overall Plan, the ability to offset a small to moderate amount of capital gains taxes.
Let’s say you’ve sold a fourplex for $400,000. Your loan balance is about $150,000. The terms called for an exchange, with the buyer putting 35% down to a new loan, but you wanted some cash out. You don’t need it right away, but will in the first quarter of 2014. Your CPA’s brow wrinkles in dismay, as he warns you of impending tax bills. Here’s a potential solution.
Lower the down payment from 35% to 25% — a $40,000 reduction. This allows you to carry back a 2nd note in that amount, secured by a trust deed on the property. The terms, since we’re near the end of the year anyway, could have half the note’s balance paid next January. This accomplishes a couple things. The last half would be due and payable in January of 2014. From the buyer’s point of view this is the same down payment he wanted anyway. Some of it was delayed, which is no skin off his nose. (Unless, that is, he’s acquiring the fourplex as part of his own exchange. 🙂 )
What this accomplishes for our investor seller is what he wanted. He gets his cash when he needs it — the beginning of 2014. He’s spread the tax hit over a couple tax years. If he knows for sure that either 2013 or 2014 will be a relatively low income year, he can structure the note to take advantage of that.
What about the taxes at payoff?
When opting for installment sales treatment, the IRC graciously supplies a formula to make it easy to compute the tax owed. All money received, payments and/or principal reduction/payoff, are divided into three categories.
1. The return of capital.
2. The return on capital.
Not all payments or principal reductions will include all three, though that’s certainly possible. For example, if the monthly payments were interest only, there’d be no return of or on capital involved. Or, if there was a scheduled principal reduction payment, there might not be any interest involved. Regardless of scenario, #1 isn’t taxed, as it’s simply the return of your invested capital. #2 is generally taxed as capital gain. #3 is taxed as interest is almost always taxed.
Another reason to execute a partial 1031
Many investors have had the foresight to have planned for this approach far in advance. I do it all the time. If you’ve experienced a capital loss which is allowed to offset a similar gain, you can then take cash from your ‘exchange’, knowing in advance the loss(s) will offset the gain, thereby avoiding the tax bite. My favorite strategy incorporating this approach is to make use of cost segregation, a type of depreciation. It’s not all that simple, but relatively speakin’, it ain’t rocket science either. Bottom line? The investor can take a ton of cash from an exchange, invoking their ‘unused’ depreciation to offset any gain or recapture. The last time I did this, due to a last minute request from a client, it was to accomplish two goals with one move. Replace his ancient pickup with a new one — thereby keepin’ his marriage intact. 🙂 We exited about $50,000 in cash, no harm, no foul. And they lived happily ever after.
Whether you’re choosing to take advantage of installment sale treatment or have one or more qualified losses to offset capital gains/recapture, a partial tax deferred exchange might be the arrow to pull from your Purposeful Planning quiver. I’ll take this opportunity to remind readers that this stuff shouldn’t be tried at home. Without a real estate investment broker and an experienced CPA, versed in the real estate related sections of the IRC, these strategies, executed incorrectly, can cause some serious heartburn.
Yes, Betty, partial tax deferred exchanges are not only possible, they’re preferred sometimes.
Photo: Bart Everson