Piggybacking the 121 Exclusion with a 1031 Exchange

Let's say that you do a 1031 exchange - you sell an investment or business property and you buy a property that is a single family rental and you rent that property out for a number of years to substantiate the property for investment or business purposes to qualify it for 1031.

Well after you’ve held the property for a substantial period of time it may occur to you that you could see yourself living in it as your principal residence.

So sometimes folks will kick the tenants out of that investment or business property and move into it as their principal residence. Timing and intention are important factors to consider in this scenario.

Timing & Intention

First you probably want to wait a year or two before you kick the tenants out so that you satisfy the requirements of 1031 that you were actually holding the property for investment or business purposes.

Section 121 Exclusion

Then after you kick the tenant out you can move into the property and make it your personal residence. Now there's an interesting interplay between section 121 of the Internal Revenue Code and section 1031 that says you must wait 5 years after completing the exchange before you can avail yourself of the section 121 principal residence exclusion on the sale of your principal residence.

Furthermore you don't get the entire exclusion, you get a fraction of it based on the qualifying used as your personal residence as a ratio against the time that it was used for rental purposes.

So theoretically if you rented the property for 2 years and you lived in it as your personal residence for 3 years you would be entitled to three fifths of the exclusion. For married couples the exclusion is normally $500,000, but in this situation you would be entitled to three fifths of that or $300,000 which is pretty good exclusion amount.

Depreciation

One consideration is that under section 121 you're not allowed to exclude the depreciation. So to some degree it's a partial victory because you still have to deal with the un-recaptured depreciation that may have carried over into the property and also the depreciation on the current principal residence.

Nevertheless this is an awesome tax planning technique and if you look at the interplay between section 121 and 1031, this is a rather frequently used combo of piggybacking the 1031 exchange with the 121 exclusion and putting them together after 5 years.

• Start Your Exchange : If you have questions about the interplay between section 1031 and the 121 exclusion, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

How to Unwind a 1031 Exchange

Sometimes taxpayers contemplating a 1031 exchange will say “what if we don't identify any replacement properties, or what if we can't jump through the hoops - how do we unwind a 1031 exchange?”

Set Up the Exchange

At the beginning of this process you may not have all of the mysteries solved, but you know that you want to keep your options open and you want to keep them open as long as possible.

So the first thing to do is to set up the 1031 exchange before the sale of your old property so that the proceeds don't go to you and become taxable immediately, but instead go to the qualified intermediary.

Then you have 45 days to identify replacement properties. So you can use all of the time before closing and 45 days thereafter to figure out if this is something you want to do. If it's something you want to do, you’ll identify replacement properties to keep hope alive for the remaining 135 days in your exchange period.

If You Don't Identify

If you don't identify no big deal. We'll return the exchange funds to you on the next business day after the 46th day and get you your exchange funds back and you'll just pay taxes on it as if it was a taxable sale. The most you're out is a little bit of brain damage and the minimal exchange fee that we would have charged at the first closing.

Keep all of your options open as long as possible. Investigate all of these potential outcomes and hopefully you get the most tax-efficient result at the end of this process.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

The Importance of a Purchase Agreement Damages Clause

When you identify a replacement property you may pin all of your hopes of tax deferral on that one property. But when you sign the purchase agreement with the seller you may want to look closely at the damages clause in your purchase agreement. What if you sell the relinquished property, park all of your proceeds with the intermediary, and then the seller refuses to honor their commitment to you in the purchase agreement to perform and close on the sale of your replacement property?

A Prickly Damages Clause

You may need to make sure that the purchase agreement that you’ve signed contains a prickly enough damages clause that you could sue the seller for strict performance that is to give you the benefit of your bargain to receive that unique property. All of your tax deferral is hinging upon your receipt of that property within the 180 day exchange period.

Consequential Damages

Also you may want to look at how that damages clause deals with consequential damages - damages that result as a consequence of your inability to close on the replacement property. If you have a broadly written clause that includes potential consequential damages (i.e. the tax liability that you're going to have to pay in the event that the seller defaults and you can't receive your replacement property within the time frame) you may have what we call a big stick. That is a very strong enforcement mechanism in the terms of the purchase agreement to force the seller to honor their commitment to you and to perform within the times allowed for your exchange.

• Start Your Exchange: If you have questions about purchase agreement damages clauses, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Same Taxpayer Requirement in a 1031 Exchange

In this 1031 FAQ video, Jeff Peterson talks about the same taxpayer requirement in a 1031 exchange. Watch more 1031 educational videos here.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

How to Mitigate the Consequences of a Failed 1031 Exchange

What are some ways that you can mitigate the adverse tax consequences of a failed or partially failed 1031 exchange? In this blog, we'll offer some strategies by examining a recent transaction that one of our clients did in Rochester, MN.

A 1031 Example

Recently we had a transaction in Rochester Minnesota where the taxpayer sold a $2,000,000 replacement property, and identified four million dollars of new replacement properties. After the 45th day had elapsed, their due diligence investigation of the replacement properties turned up some issues that made them rethink whether they really wanted to buy that replacement property.

In the end, those folks in Rochester Minnesota decided not to buy the replacement property, and so they were stuck thinking “well if we don't buy the replacement property we're going to have to recognize that gains on the sale of our old relinquished property. What are some things that we can do to alleviate the potential tax hit that we've got coming this year?”

Mitigating the Gain

A couple of different strategies can be used to offset or mitigate the tax gain. One of them is to use your exchange funds to buy interests in oil and gas exploration - what are called intangible drilling expenses.

By buying investments that have an immediate tax deduction for the intangible drilling rights you may spend a dollar but receive back $0.75 or $0.80 of immediate tax deduction. If you invest heavily enough in oil and gas exploration that you're allowed at least enough deductions to offset the gains that you’re incurring, you may be able to offset or wash all of the gains that you experience from the sale of your relinquished property by manufacturing immediate tax deductions through the intangible drilling rights.

• Start Your 1031 Exchange: If you have questions about how to mitigate the consequences of a failed exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved