1031 Case Study: Bank Rules & 1031 Exchange Protocol

Recently, a client came to us with the following 1031 exchange scenario. The client was looking to do a like-kind exchange on their condo. After crossing their t’s and dotting their i’s with 1031 exchange protocol, they discovered that the rules for 1031 did not coincide with the banking protocol.

The Importance of Qualified Purpose

In order to qualify for 1031 treatment, the client would have to rent the condo out for two years in order to satisfy the qualified purpose requirement. This did not gel with the banking protocol. The bank would not allow a regular loan if the client was to rent out their newly purchased property. This means that in order to qualify for 1031, the client must change it to an investment loan, have a different type of appraisal done, and acquire a higher interest rate for this new type of loan - all which is more than likely add time to the approaching 1031 deadline. 

Preparing for Your 1031 Exchange

The replacement property must be held for a qualified purpose of investment or business use; that may or may not necessitate an investment loan. To some degree the lender may be able to underwrite it as a regular loan. This is why it’s always a good idea to prepare for your 1031 exchange as early as possible to ensure it complies with all parties involved.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Funding Escrow in a 1031 Exchange - Cash vs. Sales Proceeds

In a 1031 exchange, can the seller use sales proceeds to fund the “escrow” account and still defer all taxes related to the sale, or does the seller need to bring cash to closing to fund the escrow? In this blog, we'll discuss this question through the lens of a client's recent 1031 situation.

Background

First, a little bit of background. In this case, the client had to get cash to the buyer at closing as part of a roof/HVAC concession. For the buyer’s financing reasons, he didn’t want it to come right off the purchase price. The client was hoping to get the cash to the seller as a “commission” expense to him since he was unrepresented. However, the buyer was financing through the SBA, and the SBA required an escrow account. Considering all of this, the client wanted to know if they needed to bring cash to the closing in order to defer the tax, or if they could use the sales proceeds to fund the escrow.

Transactional Expenses in a 1031 Exchange

Funds from the sale of the relinquished property may be used to pay customary transactional expenses including attorneys fees related to the disposition of the relinquished property and the 1031 exchange. However, if you have already paid the attorney the fees you typically may not be reimbursed with exchange funds during the exchange period.

The "G(6) limitations" impose stringent limitations on your ability to receive actually or constructively any proceeds from the relinquished property during the exchange period.

Unused Escrow Funds

If there are unused / unspent exchange funds remaining in the 1031 escrow account after the purchase of the last replacement property (at the end of the exchange period), these un-utilized proceeds may go back to you to reimburse you for expenditures you made for the exchange such as attorneys fees that you already paid.

You may want to discuss this with your CPA or tax advisor because reasonable people can differ in their approach to this topic.

• Start Your Exchange: If you have questions about escrow 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

1031 Case Study: Exchanging a Personal Residence

Recently, a client came to us with the following 1031 scenario. The client was looking to sell their personal current residence and 1031 into something different. They had only lived in the residence for 15 months and didn't plan to live in the replacement property. Is it possible to exchange this property in a 1031 transaction. If so, what are the implications?

Personal Residence Exclusion

Unfortunately, this situation does not qualify for 1031 exchange treatment. A personal residence may not qualify for section 1031 as it has not been used for investment for business purposes. However, there is another tax code section (section 121) that allows for an exclusion of up to $500,000 of gain if you're married or $250,000 if you’re single. That being said, you must have owned and use the property as your primary residence for at least two years.

Partial 121 Exclusion

Interestingly, there are certain exceptions that will permit a partial 121 exclusion in instances where the taxpayer moves for reasons that are beyond their control such as their employer transfers them to a different town.

Things can get very tricky when it comes to section 1031, 121 and the personal residence exclusion. It’s always best to speak with a tax 1031 tax professional about your situation to cover all of your bases.

• Start Your Exchange: If you have questions about section 121 and the personal residence 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 Offset Depreciation Recapture in a 1031 Exchange

If someone wanted to do a 1031 exchange strictly to offset depreciation recapture, is that allowed? That's our topic for this 1031 education article.

Depreciation Recapture Example

In this example - the person would be selling a property for $250,000 and basically have no excess cash once existing mortgages were paid off.

If the taxpayer did the 1031 exchange and identified/purchased properties of at least $250K or greater within the allowed time (and put $250K or more of mortgages on them) the taxpayer would just be able to carry forward his basis without any tax consequence? The qualified intermediary would sign the huds, but wouldn't really hold or transfer any cash in this scenario. Would this work?

Using 1031 to Recapture Depreciation

The short answer is yes. 1031 works for both gain from appreciation and also deprecation recapture.

The amount of debt they have is not necessarily related to the basis that they have for tax purposes, so even if they have little or no cash proceeds at closing, they may still have a big gain...and need to do a 1031 exchange.

• Start Your 1031 Exchange: If you have questions about 1031 exchange depreciation recapture, or anything regarding 1031, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Holding Periods & The Qualified Purpose Requirement

What if there's a seller that has a lot for sale that they have owned for one year - can they do a 1031 exchange on the sale of that lot?

How Was the Property Held?

The answer to the question really depends on how they have held the property.

If they purchased the lot intending to use it for investment or business purposes then they can probably do the 1031 exchange because they held it for the requisite intent.

However if they bought the lot intending to flip it, holding it primarily for resale, then the IRS could make the argument that the property doesn't qualify for 1031 because it's their inventory.

The Qualified Purpose Question

The real question is has the taxpayer held the property for a qualified purpose?

The longer that you have held it for that qualified purpose the better. The IRS has never mandated or given a bright-line ruling on how long you have to hold your property prior to a 1031 exchange. Because of that ambiguity there is a lot of uncertainty as to how long one has to hold the property.

Sometimes people want to hold it for a year. Sometimes people want to cross over into the next tax year so they have at least one tax return under their belt. Other folks are very conservative and want to hold it for several years before they dispose of it in a 1031 transaction.

• Start Your Exchange: If you have questions about qualifying purpose, the held for requirement, or anything regarding 1031, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved