1031 Exchange Tips for Closers

What do title closers, escrow officers, and closing attorneys need to know about what closing expenses can be shown on the closing/settlement statement when a taxpayer is selling relinquished property in a 1031 exchange?

Big Picture when you’re Closing the Sale of a Relinquished Property for a Seller’s 1031

The big picture topic here is that all of the net proceeds, all of the seller’s equity, needs to go to the intermediary. Only certain limited transactional expenses may be paid on the closing statement. For example the real estate agent's commission can be paid, the recording fee can be paid, and the title company closing fee can be paid.

Taxes, Rent, and Security Deposits

But more difficult topics can be found on the closing statement when it comes to the tax proration, rent proration, and the security deposit. Those items should be paid out of pocket by the seller and not be paid out of the proceeds from the sale of the relinquished property. The reason is that those amounts should already be in the operating accounts of the seller.

The rents for the month which would have been collected by the seller need to be paid over to the buyer at closing for the days that the buyer will own the property. The security deposits and rent deposits need to be given over to the buyer at the time of closing. And the proration. Taxes are typically paid out of your operating account, not out of sales proceeds.  Any days that the seller is obligated to pay the taxes should be paid out of the seller’s pocket, and not out of the sales proceeds. Again, big picture we want to take the net proceeds and move that equity into the new replacement property. We don’t want to raid the net proceeds for expenses that are not qualified for the 1031.

When in Doubt

When in doubt, it’s always better to pay unusual expenses out-of-pocket rather than dipping into the Seller’s sales proceeds and to send as much as possible to the 1031 exchange account.

Also, it’s a good idea to ask the seller’s accountant or CPA to review and comment on the closing/settlement statement before the closing is completed, because once the closing is done it's too late to change the disbursements.

• Start Your Exchange: If you have questions about closing on 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

Tips for Earnest Money in a 1031 Exchange

Can the earnest money deposit for the replacement property be paid from the exchange proceeds that are held by the qualified intermediary in a 1031 exchange?

Earnest Money in a 1031 Exchange

Many real estate Investors are real estate rich but cash poor. They don't have a lot of extra money in the bank account to make a substantial earnest money deposit. So if they want to make an offer that looks impressive, one that will catch the eye of the seller with a substantial earnest money deposit, they need to tap into the funds held by the qualified intermediary to advance that large deposit.

Treasury Regulations

Fortunately, the treasury regulations permit the intermediary to advance the 1031 funds to the seller or oftentimes to the seller's title company, provided that the intermediary is assigned into the purchase agreement and that proper notice is given to the other parties. In a competitive market and with the extra pressures of the exchange deadlines looming, exchangors often want to lock-in a replacement property under contract. They really want to make strong purchase offers. We frequently will help the taxpayer advance the 1031 funds needed for the earnest money deposit and help them be the winning bidder in this tight seller's market so that their offer is most advantageous and appealing to the seller.

• Start Your 1031 Exchange: If you have questions about putting down earnest money 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

How to Avoid Boot on the 1031 Closing Statement

Many closers and title professionals have questions about what expenses to put on the closing statement and what to keep off the closing statement so that the parties don't trigger boot. Here are a few tips for avoiding boot on the closing statement during a 1031 exchange.

3 Things to Remember

On the sale of the old relinquished property closers need to be careful about the security deposits that must be paid over from the seller to the buyer. Further, they need to be careful about the rents that have been collected by the seller, and which in-part need to be paid over to the buyer for those days that the buyer will own the property during the month for which the rents have been collected. Finally, closers need to be really careful about tax prorations, charges against the seller for real estate taxes that would normally be paid by the seller out of their operating account.

Dealing with these Expenses

So what's the most proven way to deal with these expenses on the sale of the relinquished property? It's to have the seller pay to the buyer or wire transfer money to the title company for those amounts and show them as paid-outside-of-closing (“POC”). That way all of the equity from the sale of the relinquished property can be moved into the new replacement property.

There are also some closing costs on the replacement property you need to be careful about, in particular any costs related to the new mortgage or deed of trust on the replacement property. Ideally the taxpayer (the buyer) doing the exchange will either get a no-cost loan from their lender, or will pay those loan origination fees and other loan related expenses out-of-pocket, rather than utilizing the exchange funds to pay for the lender costs.

• Start Your 1031 Exchange: If you have questions about avoiding boot on the closing statement, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

Rental Property 1031 Exchange Rules

A client recently came to us with the following 1031 situation:

We have named a property in Edina, which is priced at $450k. We plan to rent it out at the beginning, and move in later. Our question is, how long do we have to rent out the house before we can move in and convert it to our primary residence, without the profit gain penalty?

No Clear Answer

That is a very good question, for which there is not a clear answer.

We know from the Internal Revenue Code that your initial intention (mental state) must be to hold the Replacement Property for productive use in a trade or business or for investment. It is okay to have an “indeterminate” long term intention as to what you may do with it much later. However, I would not say with 100% certainty that you will be able to move in to it as your home at this time.

The Code

26 U.S. Code § 1031 - Exchange of property held for productive use or investment

(a)  Nonrecognition of gain or loss from exchanges solely in kind 

(1)  In general

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Holding Periods

There is not a bright line minimum time period that I can point you to. The safe answer is “The longer…the better.”  Two years of holding it for investment / business purposes may be sufficient for most taxpayers. Check with your CPA or tax adviser about your specific situation.

• Start Your 1031 Exchange: If you have questions about 1031 rental properties and holding periods, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

TIC (Tenancy in Common) 1031 Exchanges

TIC stands for a Tenancy in Common which is an old-fashioned way to own real estate. It's a co-ownership arrangement going back to Old English common law where the serfs got together and collectively pooled their money to acquire an estate. In this article, we explain the benefits of a TIC as they relate to 1031 exchanges.

Benefits of a TIC

If you're looking to redeploy some cash and you can't afford to buy a real estate investment on your own you can bring in a TIC co-owner - someone to invest with you on that replacement property. Each of you would have an ownership interest in the property proportionate to your contribution. So if you provide 45% of the down payment you would be entitled to 45% of the property. Your co-owner will then get the other 55% if they put down their proportionate share of the purchase.

Partnership Interests are Excluded from 1031

The reason that tenancy in common is so important is that in the Internal Revenue Code section 1031, partnership interests are excluded from 1031. So if I want to bring in money with me on a purchase I can't bring in a partner and own the property in a partnership.

But what I can bring in is an investor or investors as tenants in common and we can take down that property kind of like a pie chart for each of us has a proportionate interest in the property allocated based on how much can we contribute for the buy.

Practice Tip:  If you want to be treated as a tenancy in common, then do not file a partnership tax return with your TIC co-owners for the property, because that may undue all of your hard work in trying to arrange for your interest in the property to be treated as a qualifying interest in real property.

• Start Your Exchange: If you have questions about tenancy in common law, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved