1031 Exchange Tips for Real Estate Closing Agents

If you work as a closer for real estate transactions and you're notified that one of the parties to the transaction wants to do a 1031 exchange, it’s important for you to make note of that right away in the file and find out who are the people that are helping facilitate this exchange. Here are a few tips for closing agents who encounter 1031 exchanges.

Eleventh Hour Fire Drills

We often get calls from closers at the eleventh hour saying that nobody made arrangements for the 1031 exchange. Everybody involved thought it was someone else's job to do, and now we need to hurry up and get 1031 documents prepared for a closing that's imminent. We can do that, but it's a real fire drill.

Questions to Ask

The better arrangement is to contact the party that intends to do a 1031. Ask them the following questions:

• Is this your relinquished property that you're selling?

• Have you started your process with a qualified intermediary?

How a Qualified Intermediary can Help

If they haven't started with a qualified intermediary, have them contact CPEC 1031 right away. We can get a copy of the purchase agreement and title work from you; we can gather the specific details in particular that we need from the seller; and we can put together the 1031 and the closing instructions that you'll need to know how to prepare the settlement statement and what notices need to be given to the other parties. This allows all of the documentation to be dealt with up front well before the closing occurs so that we have a smooth signing ceremony.

• Start Your Exchange: If you have questions about closing documents related to 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

What is a Related Party When it Comes to a 1031 Exchange?

The IRS is paranoid of related party transactions and they're more so concerned about your buying your 1031 replacement property from a related party. So what is a related party in a 1031 exchange?

Blood Relatives

A related party can be related to you by their business affiliation or blood relationship. So your mother, your father, your sister, your brother - these are all people that are related to you by blood. Under the statutes, if you are acquiring the property from them you need to disclose that on form 8824 and there are complications that stem from your acquisition of the property from a related person.

First you have to hold the property for 2 years and there cannot be an intent to avoid the imposition of the tax which really means it can't be part of a scheme to avoid taxes.

Business Affiliates

Now the other way a person could be related to you is by business affiliation. So you could be buying your replacement property from a partnership that you are the majority partner in or a corporation that you're the majority shareholder in.

There are other situations in which the seller would be considered to be a related party. Here is a listing of what the IRS considers “related parties”:

• Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.);

• An individual and a corporation when the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;

• Two corporations that are members of the same controlled group as defined in §1563(a), except that "more than 50%" is substituted for "at least 80%" in that definition;

• A trust fiduciary and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;

• A grantor and fiduciary, and the fiduciary and beneficiary, of any trust;

• Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts;

• A tax-exempt educational or charitable organization and a person who, directly or indirectly, controls such an organization, or a member of that person's family;

• A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest, or profits interest, in the partnership;

• Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation;

• Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; or

• An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.

• Two partnerships if the same persons own directly, or indirectly, more than 50% of the capital interests or profits in both partnerships, or

• A person and a partnership when the person owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership.

Start Your 1031 Exchange: If you have questions about related parties 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

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