What is a 1031 Improvement Exchange?

A 1031 improvement exchange is an exchange where you’re selling a piece of relinquished property at a large value (say a million dollars), and you want to acquire new replacement property but the initial land cost of your replacement property is less than the relinquished property value (say $500K). That’s not enough replacement property to defer all of your gains in a 1031 exchange. But you’re planning on constructing $500K worth of like-kind improvements on top of that new acquisition. How do we construct an exchange with these factors?

Bloomington Coca-Cola

There’s a case called Bloomington Coca-Cola that stands for the proposition that once the taxpayer acquires their new land, the exchange is over and any improvements that you construct won’t count towards your 1031 exchange.

Thankfully, there is a way around this issue. You need to have the improvements constructed and exist as like-kind property before you receive them. Often people will engage in a build-to-suit exchange, wherein their Qualified Intermediary forms an LLC to acquire the raw land and the LLC owns that land while the $500K of improvements are constructed. Then once the like-kind property exists and is valued at least as much as the relinquished property, the replacement property can be transferred to the taxpayer.

But guess what? You don’t have a lot of time for construction (only 180 days) so you’re not going to be able to construct the Taj Mahal. You’re only going to have time to make modest improvements and repairs during the exchange period. A partially completed Replacement Property can still count for your 1031 exchange, so long as there is enough existing like-kind real property improvements existing and completed by the 180th day of your exchange period.

• Start Your 1031 Exchange: If you have questions about 1031 improvement exchanges and build-to-suit exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Exchange Timeline

Let’s talk about the timeline for a typical 1031 exchange. For simplicity, we have broken the timeline down into a handful of stages.

Sale of Your Relinquished Property

The first stage of the transaction is the sale and marketing of your old relinquished property.

Closing

Once you have found a buyer, a closing occurs. This closing is day zero in your 1031 exchange. We draw a line out from that date to 180 days thereafter. That is the total timeframe that is available to you to complete your 1031 exchange.

45 Day Identification Period

But within that timeframe the first 45 days are called the identification period. In the 45 day period, you have to make a written designation or identification of your replacement property. Any properties that you purchase during that first 45 days are deemed to be identified because you closed on them, you own them.

However, any properties that you are going to buy in the remaining 135 days will not be considered like kind unless they were designated and identified during the first 45 days.

Most taxpayers work really hard to sell their relinquished property, then they work really hard during the 45 day period to designate their three best guesses, crossing their fingers that they’ll be able to close on one or more of those properties in the remaining 135 days.

All of this is stressful. But knowing the deadlines in advance allows you to work ahead on these benchmarks. Wouldn’t it be nice if you entered the identification period with a replacement property in your sights or locked up with a purchase agreement? These deadlines are strictly enforced, so thinking ahead like a chess player will help you navigate the 1031 process with as little stress as possible.

• Start Your Exchange: If you have questions about the 1031 exchange timeline, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

What is Cash Boot in a 1031 Exchange?

There’s a term of art in 1031 exchanges called “boot.” In this article, we will define boot and discuss some examples that you might run into during your 1031 exchange.

Boot Defined

Boot is basically any non-like-kind property you receive during a 1031 exchange. For example, let’s say you exchange an apartment building for another apartment building, but you don’t reinvest all of your cash. That cash is boot (i.e. non-like kind property you received during the transaction).

Another way to get boot is if you engage in seller-backed financing on the sale of your old relinquished property. If the buyer gives you a promissory note for 10% of the purchase price and you put it in your pocket, you’ve just received some non-like-kind property in the exchange process. So seller-backed financing can be a tricky area. You want to work with your QI to find ways to redeploy all of your net proceeds (cash and non-cash) into your replacement property.

Personal Property

Boot can also come in the form of personal property that might come along with the real property. Usually small incidental amounts of personal property are not a big deal. But if you’ve got a large amount of personal property (maybe forklifts or other business equipment in a real estate exchange), those items of personal property might trigger some boot.

One way to fix this issue is to have separate purchase agreements for the personal property and to pay for that with non-1031 funds. That way you are able to keep your 1031 monies apart from any other assets that might not be considered like-kind.

Mortgage Boot

There is also another term called "mortgage boot." If the property you are selling has debt encumbering it, that relief of the debt may be considered boot to you when the relinquished property is sold and the debt is discharged (or assumed by the buyer). In order to off-set this potential mortgage boot and so you do not have to recognize gains due to the debt-relief, you should either take-out an equivalent or greater amount of debt in conjunction with the purchase of your new replacement property (equal to or greater than the old debt that was satisfied or assumed by the buyer of your old relinquished property). You may also invest additional non-1031 cash for the purchase of the new replacement property.

• Start Your Exchange: If you have questions about boot in a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

2 Critical Deadlines in a 1031 Exchange

In a 1031 exchange there are two critical deadlines you need to know about:

1. The 45 Day Identification period

2. The 180 Day Exchange Period

When you begin a 1031 exchange, the day of closing is considered day zero. After that you have 180 days to complete your exchange. But the critical time frame is the first 45 days of that 180 day period because that’s the time you have to designate (or identify) your replacement property or properties. Determine your 45 day / 180 day deadlines using our calculator.

IRS Curveball

This all sounds simple – 45 days to identify, 180 days to complete, with both clocks running concurrently. But wait a minute. The IRS throws you a curveball. They say:

“We don’t want to wait until next year’s tax return to see the full picture. We want this all reported to us on one tax return.”

So you might have 180 days to complete your exchange, but if your deadline for filing your federal tax return (April 15 for individuals, March 15 for corporations) pops up within that 180 day period, they shorten your 180 days to your federal tax filing deadline. That’s a big trap for the unwary. But it’s an easy problem to sidestep.

All you need to do is ask your CPA to file for an extension of your federal filing deadline. For example, an individual who files on April 15th can get an automatic extension of the deadline to October 15, thus enabling them to use all of their 180 day exchange period.

• Start Your 1031 Exchange: If you have questions about 1031 time frames, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

Can You Cancel a 1031 Exchange after Starting the Process?

Sometimes taxpayers are on the fence, and they’re not sure what they want to do when selling property. What if you want to cancel your 1031 exchange after the process has started?

Keep your Options on the Table

If you’re on the fence I suggest keeping all available options on the table. If you sill your property and take the cash, you’re going to have to pay the taxes. So rather than take the cash, set up the 1031 exchange and use the first 45 days (the identification period) to evaluate your options and see if you want to designate any replacement property. During those 45 days you can decide if you want to continue with the 1031 or not. If you don’t identify any replacement property by midnight on the 45th day, your exchange will fail and your QI should return the funds to you on the next business day.

After the 45 Day Identification Period

If you want to keep your options open after the 45th day all you need to do is make a valid written identification of what your replacement properties may want to purchase and then use the remaining 135 days to do your due diligence. You are still in the driver’s seat and can decide if you want to close on those properties. If you do you can use your exchange funds at any time to acquire the identified property. If you don’t want to close on them, it’s not a big deal. All you need to do is wait until the end of the 180 day period and receive your unused exchange funds at that time.

Contingency Identifications

Sometimes taxpayers want to make an identification with a material contingency. For example, you can identify a property but state that you don’t want to buy it unless it’s re-zoned commercial by a specific date. If the property is not rezoned by that specified date then the identification is void. The beautiful thing about making a contingent identification is that it gives you the option to fold up your tent and terminate your exchange if the contingency doesn’t occur.

Here’s a note though – you can’t make it contingent upon your negotiating a purchase price with the seller because that’s a contingency that’s in your control. You could just negotiate in bad faith and make the contingency not occur. The contingency has to be something that’s out of your control like getting a permit approval or zoning control.

• Start Your Exchange: If you have questions about cancelling 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved