1031 Real Estate Exchange Q's
I live in one side of a duplex and want to sell it and buy another duplex. I stand to net about 130k from the sale, of which 65k would be taxable from the rented side.
Question #1: Must your actual 1031 exchange property be one of the prospective properties you declared w/in 45 days?
Question #2. Also, what special considerations are there when engaging in a "reverse exchange" (buying the replacement prior to selling the existing property). Since I'm looking for a primary residence as well as an investment & there is a shortage of houses on the market, it may take longer than 180 days to find another property. I'd like to find it first and then sell this one.
Thanks in advance...
The best thing to do in your situation is to refinance your property at max LTV, make sure you get a no prepay--therefore profit taken out the property is not taxable, becuase it is not income but a loan, and you can write of the interest from the payments from the loan, while you wait to sell, of course you will be hit for some fees but that should be better than the capital gains hit, and you pay your closing cost on the sail fo the unit. Work out a deal with the title company or attorney, to let them know that you will be giving them future business and a reduction in fees is desired for next time around.
Thanks for the input...but I don't understand...
If I do a refi now, when I sell the property won't my capital gain still be on the difference between my original cost and the value at the sale? and I still need the 1031 shelter?
Thanks,
Lorenzo
Lorenzoe9
Question #1: Must your actual 1031 exchange property be one of the prospective properties you declared w/in 45 days?
Yes, your replacement property must be one (or more) of the properties you identified within 45 days after the sale of your relinquished property.
Question #2. Also, what special considerations are there when engaging in a "reverse exchange" (buying the replacement prior to selling the existing property).
I have never done a reverse exchange, but this is my general understanding of how it would work. In a traditional delayed exchange, the entire exchange must be completed within 180 days following the sale of your relinquished property. The clock starts on the day the relinquished property is sold.
In a reverse exchange, you purchase the replacement property before the relinquished property is sold. The purchase is really accomplished by your exchange accommodator. You give the accommodator the cash needed to purchase the replacement property, then the accommodator takes title to the replacement property. Once the relinquished property is sold, the accommodator conveys title to you to complete the exchange.
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Question #2. Also, what special considerations are there when engaging in a "reverse exchange" (buying the replacement prior to selling the existing property). Since I'm looking for a primary residence as well as an investment & there is a shortage of houses on the market, it may take longer than 180 days to find another property. I'd like to find it first and then sell this one.]
A: Since DaveT already answered the first question, I will focus on this second one. Generally on a reverse exchange, you need to sell the relinquished property (i.e, the old property) the earlier of 180 days after purchasing the replacement property (i.e., the new property), or the due date of your tax return (generally April 15th, with extensions, if the real estate is held by you individually).
I say "generally" because the statutory 180 day period only applies to forward exchanges (i.e., sell your property and have the qualified intermediary purchase a replacement property within 180 days), not to reverse exchanges. There is some case law where persons have gone beyond the 180 days limit and still had a good Section 1031 reverse deferred exchange. However, before relying on that, you should check with your CPA or tax attorney as these reverse exchanges are more complicated.
Nevertheless, the IRS issued Revenue Procedure last year which basically says that if you sell your old property within 180 days of purchasing your new property, it will qualify for a Section 1031 reverse exchange, since the Revenue Procedure is a "safe harbor" (meaning if you comply with all of the requirements of the Revenue Procedure, the IRS will not challenge your transaction). Unlike the forward exchange where if you go beyond the 180 days you definitely blow the 1031 exchange (note, the IRS cannot even waive this 180 day requirement because it is a requirement imposed by Congress in the statute, see Section 1031(a)(3)), the same is not true with reverse exchanges because Section 1031(a)(3) only addresses forward exchanges.
Given your situation though, I would try to stay within the 180 day time frame.
One question though, how can you have "$65k of taxable gain" on a duplex that is valued at $130k? That would generally mean that your basis in the property is zero (meaning you, or a family member that gifted it you, has owned the duplex for more than 27.5 years.
You may want to recheck your numbers, because the basis of the duplex must be pro rated between the principal residence side and the unit that is rented. The gain attributable to the principal residence is tax free if you meet the 2 out of 5 year ownership and use rule in Section 121 of the Internal Revenue Code. Thus, the sale price of the rental unit, after being pro rated, would be $65k, meaning to have a taxable gain of $65k your basis would have to be zero.
I am not saying that is not the case, but not many investors hold onto their properties for more than 27.5 years, so I thought I would just point out the odd situation so that you can recheck your figures.
Good luck,
Taxjunkie
Wow, thanks for all the info. This is an excellent site.
TaxJunkie, my profit on the bldg after repaying the present mortgage, broker fees, etc. will be around 130k, hence the 65K profit. The sale price will be around 260K.
So, it looks like I'd better find myself a good tax attorney, then. Any idea what someone might charge to handle all of this??
Check your taxable gain numbers. Your "net" is not necessarily your taxable gain. Begin by dividing the sale into two separate transactions.
For the first, let's take your primary residence. Subtract the portion of the purchase price for the building that is attributed to your residence from the portion of the sale price attributed to your residence. If you meet the 2 year rule, your profit on this transaction is tax free.
For the second, subtract the remainder of the purchase price for the building that was not attributed to your residence from the balance of the sale price. The difference is your taxable capital gain. In the worst case, allot 20% of this amount to your capital gains tax liability. Next take the amount of depreciation taken during your holding period (or the amount of depreciation that you should have taken), and allot 25% of this amount to depreciation recapture taxes. Whatever you have left over, is your net proceeds after taxes.
I've got a pretty good handle now on how much I stand to gain (or keep from losing) by doing the 1031. Federal and state taxes will amount to between 18k & 22k if I sell outright. Ouch! At that rate, it would certainly pay to have an 'expert' handle this if I'm unlikely to be able to accomplish it on my own.
I guess my question now is this:
Is there a publication available anywhere that details the mechanics of a 1031 Exchange? I've read IRS Pub 544 which explains the requirements (and makes some things even less clear) but how exactly does one go about this?
Can I simply set up an escrow account at my bank and have the proceeds from the original house deposited there under the control of a friend?
Since I last posted here, I've consulted with an attorney, who referred me to an accountant, who referred me to a "1031 expert"! Is this so complicated that a reasonably intelligent person who does his homework can't accomplish it on his own?
Thanks all once again...
Just enter "1031" in your search engine. If you get through all the hits, you will know all you need to know.
For my exchange, I had my lawyer draft an escrow exchange agreement. I took it to the Trust department at my bank, and a trust officer agreed to act as my escrow agent.
You say that you have never done one of these before. Wouldn't it would be better to pay a lawyer a few dollars to get you on the right path than to make a mistake with a do-it-yourself approach and end up a disqualified exchange?
Well, I tried but as I said, each professional referred me to someone else. It seems they've all heard of 1031's but none has actually done one before. I did speak to someone who bills himself as a 1031 expert. According to him, the reverse exchange is far more complicated than the forward exchange-so much so that he would charge 4 times as much to do a reverse exchange-FYI
You might try the Board of Realtors in your area, asking if they have any affiliate member attorneys that do 1031 Xchanges. I can think of a couple times in the last year where we had 1031 experts give seminars at the board so they may also have a list of who they invited.
Also I have had closings where the attorney did the 1031 exchange, so I would say call attorneys and ask if they do 1031 Exchanges. If you really can't find one soon I will go to my files and hunt one up for you.
Quote:... the reverse exchange is far more complicated than the forward exchange-so much so that he would charge 4 times as much to do a reverse exchangeLorenzoe9,
I understand, but the cost of the exchange is really pennies when you have lots of dollars in the balance.
One reason the reverse exchange is more expensive is that the intermediary takes title to the replacement property. When the intermediary is in the chain of title, his liability exposure increases dramatically over the direct deed mechanics with a forward exchange. '
There are even provisions in the reverse exchange mechanics whereby the Exchange Accommodation Titleholder may lease the replacement property back to the Exchangor (taxpayer).
Quote:... Is this so complicated that a reasonably intelligent person who does his homework can't accomplish it on his own? It is not so complicated that a reasonably intelligent person could not become thoroughly familiar with the mechanics. Nevertheless, while you may be thoroughly familiar with the mechanics, you cannot act as your own qualified intermediary; otherwise, you have violated the rule against constructive receipt and your transaction becomes fully taxable.
Suggest you visit the folks at Asset Preservation Incorporated. It would appear that this group has a pretty good handle on the reverse exchange.
The reverse deferred exchange is not all that expensive. Generally, most exchange accommodators (the intermediary) will take title in a single member LLC. Although, exchange accommodators charge different prices, you can expect to pay about $3,000 for deals up to $500,000. That is not all that much money when you consider the amount of taxes you are saving.
Also, do not try this on your own. You absolutely have to have a person that is not your attorney, agent, accountant, or broker for the exchange to be given tax-deferred status by the IRS. This is because the regulations under Section 1031 of the Internal Revenue Code does not allow those persons to serve as your exchange accommodator. If you do it wrong, the gain you were trying to defer will be taxable.
Email me a private email and I can refer you to some very good exchange accommodators.
Taxjunkie
Once again, thanks to everyone for your constructive input. Lyn, that's a good idea. I really haven't exhausted all the possibilities for hunting down referrals locally. And DaveT, you're right. I will be saving so much in taxes...but the guy I did speak with said he'd charge $6,000 for the reverse exchange! Also, because I live in New Hampshire, which has a 7.5% tax on the transfer of property, I'd have to pay this tax twice on the reverse exchange-once into the trust/LLC and then again back out to me at the end of the exchange. His advice was to try very hard to do this as a forward exchange, offering the seller (of my replacement property) incentives to wait for me to sell my own property before closing on his. That sounded like reasonable advice. Anyway, there's lots to learn but criminy, the amount of tax to be dodged, er deferred, is amazing and well worth the effort. Hope this weekend was as glorious where you all were as it was in the White Mountains for us.......Lorenzoe9
1. Consider purchasing the "replacement property to add another property to your investment portfolio. If you need some downpayment cash to complete the purchase, consider refinancing your current property to get the needed cash.
2. When you have a buyer for your current investment property, then structure a 1031 exchange for other replacement property. Tip: Just because you are selling a multiunit property, you are not restricted to replacing it with another multiunit property. Condos, townhomes, and SFRs, may be easier to identify and acquire with the forward exchange window.
Thanks DaveT.
I contacted Asset Protection. They're affiliated with Stewart Title and happen to have an offfice fairly close to me. The good news is that they charge only $750 to do the forward 1031. I was curious that they were charging exactly half the price that another firm quoted me. They can do this because they keep the interest earned on your first property's earnings for the first 45 days from closing. That's okay by me. I'll still save a bundle. I also got a list of local accountants and attorneys who are familiar with the 1031 process from another QI.
I am in fact in the process of refinancing now. One caveat about that, though. I was told (by API) that there have been cases where the IRS didn't take kindly to seeing a refi just prior to doing a 1031 since it looks like a dodge to get cash in hand and still avoid the capital gains tax. (For the record...) this is not why I'm refinancing right now but it's worth noting.
Again, thanks for all the input.
I'm not sure of your situation or what you are trying to accomplish, but have you considered refinancing your duplex to buy the next one? You could probably get a 100% LTV refin loan on it, and perhaps a much better rate. 4 units are better than 2.
Quote:I am in fact in the process of refinancing now. One caveat about that, though. I was told (by API) that there have been cases where the IRS didn't take kindly to seeing a refi just prior to doing a 1031 since it looks like a dodge to get cash in hand and still avoid the capital gains tax. Lorenzoe9,
Ahh, prudent tax planning that the IRS does not like. But, I don't see much they can do about it either, except yell.
Perhaps Taxjunkie can refer to Garcia v. Comm., 80 TC 491 (1983), and the IRS acquiesence 1984-1 CB 1, then give us his opinion.
Quote:
On 2003-05-21 19:20, DaveT wrote:
Quote:I am in fact in the process of refinancing now. One caveat about that, though. I was told (by API) that there have been cases where the IRS didn't take kindly to seeing a refi just prior to doing a 1031 since it looks like a dodge to get cash in hand and still avoid the capital gains tax. Lorenzoe9,
Ahh, prudent tax planning that the IRS does not like. But, I don't see much they can do about it either, except yell.
Perhaps Taxjunkie can refer to Garcia v. Comm., 80 TC 491 (1983), and the IRS acquiesence 1984-1 CB 1, then give us his opinion.
DaveT:
The IRS acquiesence is limited to the facts of Garcia and since Garcia was handed down, in some situations the Tax Court has ruled that a refi immediately prior to the 1031 exchange disqualified the exchange. In addition, Garcia is a Tax Court case and there are contrary rulings in different circuits (the Tax Court must follow the rulings in the Circuit they are hearing a case if there is a case on point by the appellate court)
However, the most important thing to look at is the taxpayer's intent. The IRS and the Tax Court uses the "step transaction doctrine" to determine if the refi and 1031 exchange is, in fact, really receipt of taxable boot in a 1031 exchange. If you want to be very cautious, don't refi and pull cash out within 1 year of doing the exchange. Better yet, if you can wait, complete the exchange and then refi after the exchange is complete. The case law is pretty square on point that a refi after the exchange does not cause a problem.
A little rule of thumb is if you needed the cash out refi to complete the exchange, you may have some problems. (i.e., Ask yourself, if but for the refi, would I have done the exchange ... If the answer is no, you have problems).
Hope that helps,
Taxjunkie
Just a couple of follow-up comments. Reverse 1031 Exchange fees can range from $1,500.00 on the low side (buyer be very careful) to thousands of dollars depending on the value of the property held by the exchange company. Any exchange company that charges less than $3,000.00 should be examined carefully - most exchange companies, including us - charge a minimum of $4,000 or $5,000.
Second, regarding the duplicate transfer taxes. There is a private letter ruling out that allows the exchange company to include language that the exchange company is acting as the taxpayer's agent for all purposes except for federal income tax purposes. We use this PLR in order to get most second transfer tax assessments waived. I would be happy to get you a referrence if you are interested in the PLR. Your local 1031 exchange company should be aware of it.
Hope this helps.
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We have administered many forward, reverse and build-to-suit 1031 exchange transactions over the years. It is all we do, and I would be happy to walk you through the steps as well as the pros and cons of each structure. Call me at (866) 634-1031 or visit our web site at http://www.diversifiedexchange.com.
Best wishes.
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