1031 Exchange And Boot
Help....we sold an investment property for 420k, less than a yr owned, doing a 1031 exchange. The exchange property is 400k and needs repair and updating. The seller agreed to put the purchase price on contract as 420 and give us 20 k back towards repairs. Seller cannot take the money and write check back to us, it is a trust and the family will tap into the extra 20. Is there a way through escrow that we can have a check written directly to the repair contractor's without touching the money and not getting taxed on it? Someone, please, we close Monday, and how would you write the line item on the escrow closing papers?
Thanks,
Martina
Martina,
This is typically done as a "construction exchange". Given enough time, your exchange escrow agent pays for the repairs and improvements from your exchange escrow account. At final settlement, all money left in the exchange escrow account is applied to the purchase of the replacement property.
Let's assume that you don't have the time to complete the improvements before settlement. Do you have a property manager? Does your property management agreement specify that the property manager can "supervise" approved repair, maintenance and improvement projects? If so, do you have the improvements already identified and have you received cost estimates that total $20K or more?
Option 1. If the answer to this question is yes, then you are all set. Give your property manager the approved estimate and have the exchange escrow agent distribute the $20K directly to the property manager. The balance of the exchange escrow account will be forwarded to the settlement attorney for the replacement property purchase.
Option 2. Have the exchange escrow agent hold back funds for a repair escrow. As the repairs/improvements are completed, the escrow agent pays the bills from the exchange escrow account. Caution: Any money left over is distributed to you as taxable boot.
In the end, you have applied all the proceeds from the sale of the relinquished property to the acquisition and improvement of the replacement property. No constructive receipt, no taxable boot, no need to reengineer the contract with your seller.
By the way, your strategy of increasing the sale price and receiving cash at settlement in the form of a seller concession is still constructive receipt of the exchange proceeds. If you had received the $20K in this fashion, the money would have been taxable as boot received. If the repairs/improvements had been completed prior to settlement, the settlement attorney could have paid the bills at settlement and reflected the disbursements to the contractors on your HUD-1, keeping the exchange umbrella intact for the repair funds.
As a post script, exchange proceeds applied to certain settlement costs for the replacement property acquisition are still covered by the exchange umbrella.
Martina,
As I reread your original question, you say that you are doing a 1031 exchange, but you are not really clear who is holding the proceeds from the sale of your relinquished property.
Out of curiosity, what was the property you sold and how was it being used at the time of sale?
Hi DaveT,
Actually, your option 1 and option 2 will not work. If the money is placed with the property manager and the property is deeded to the exchangor, the 1031 exchange has been completed and the funds held in the property manager's account is for "services to be performed in the future" and will not qualify as like kind property. In order to qualify as like kind property, it must be considered to be real property under state law at or before conveyance of title (not afterward).
You can arrange to have your Qualified Intermediary hold title to your relinquished property (build-to-suit 1031 exchange) and complete the build-out during the time your QI holds the property, but this typically must be structured as such up front and involves different exchange documentation.
[addsig]
Thanks for the heads up Bill.