Is There a Difference Between Income vs. Investment Property in a 1031 Exchange?

Is there a difference between income and investment property? Do both fall within the 1031 exchange guidelines? That's our topic for today's article.

What is the Held for Requirement in a 1031 Exchange?

Section 1031 provides that 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 the property is exchanged solely for property of a like kind that is to be held either for productive use in a trade or business or for investment. 

Whether the property exchanged is held for productive use in a trade or business or for investment is a question of fact. The manner in which the relinquished property is held at the time of the exchange controls, not the manner in which it was held when acquired - see Wagensen v. Commissioner, 74 T.C. 653 (1980).

Neither the Internal Revenue Code nor the Income Tax Regulations under § 1031 provide further guidance concerning the phrase “held for productive use in a trade or business or for investment” (the “held for” requirement).   

Rev. Proc. 2008-16

The Internal Revenue Service (the “Service”) deals with this issue in Rev. Proc. 2008-16, 2008-10 I.R.B. 547 in the context of properties in a rental pool that may be used sparingly for personal use.

Rev. Proc. 2008-16 provides circumstances under which the IRS will not challenge whether a dwelling unit qualifies as property that meets the “held for” requirement even though the property is occasionally used for personal purposes. If the safe harbor provisions of the Rev. Proc. are met, the entire property meets the “held for” requirement for purposes of § 1031. The Rev. Proc. provides the following:

The Service recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. In the interest of sound tax administration, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under § 1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes. 

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Related Party 1031 Exchange Best Practices

In a related party 1031 exchange, you must hold the replacement property (that you receive from the related party) for two years. However, the other big requirement is that the exchange cannot be part of a transaction (or series of transactions) structured to avoid the imposition of the tax. If both you and your related party seller are not paying any tax (because the seller is taking a Section 121 principal residence exclusion), then you may be deemed to have crossed into the category of avoiding the imposition of the tax in 1031(f)(4).

Special Rules for Exchanges Between Related Persons

In general, If—

• (A) a taxpayer exchanges property with a related person,

• (B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and

• (C) before the date 2 years after the date of the last transfer which was part of such exchange—

  • (i) the related person disposes of such property, or

  • (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,

there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.

Certain Dispositions not Taken into Account

For purposes of paragraph (1)(C), there shall not be taken into account any disposition—

• (A) after the earlier of the death of the taxpayer or the death of the related person,

• (B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or

• (C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

Related Person

For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1).

Treatment of Certain Transactions

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Tips for Deferring Taxes with a 1031 Exchange

1031 exchanges can save you a lot of money in capital gains taxes when you sell a piece of property. Here are three tips for deferring taxes with a 1031 exchange.

Start Early

The first tip is to get your 1031 exchange set up with a qualified intermediary well before you close on the relinquished property. Sadly, we often receive calls from folks that have already closed on the sale of their relinquished property, received the proceeds, and then decided they wanted to do a like-kind exchange. The horse is out of the barn if you don't get your 1031 exchange set up in advance of the sale.

Think Like a Chess Player

The next tip is to think like a chess player - two to three moves ahead at any time. You want to be thinking about “where am I going to land for a replacement property?” Real estate is kind of like a game of musical chairs. If you don't act quickly you may find that you don't have a chair to land on when the music stops. You want to be thinking ahead and locking up a replacement property before you have to identify during the 45-day identification period. Ideally it would be nice to lock up a replacement property even before you close on the sale of your old relinquished property.

Work with Your Team of Professionals

The third tip is to work with your team of professionals. Bring your whole brain trust together. Involve your accountant, your lawyer, your real estate professional, and your financial planner in this process. This may be one of the most important financial decisions that you ever make and by using your resources you can get the best advice and information.

• Start Your 1031 Exchange: If you have questions about the best way to approach your 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

Can you 1031 Exchange Property you Already 'Sold' on a Contract for Deed?

A client of ours recently sold a house under a contract for deed with the balloon going due in 2019. The client wanted to know if it would be possible to do a 1031 exchange on the property after receiving finial payment for it in 2019? That's our topic for this article.

Contract for Deed

If you already 'sold' a property on a contract for deed, can you do a 1031 exchange once you get paid-off on the seller-backed financing? Possibly not because the IRS may no longer view you as the equitable owner for tax purposes. Here are some questions to consider:

• Are you the holder of a lender's interest now?

• Who has the risk of loss if the property is damaged or destroyed?

• Who has the obligation to pay taxes and insurance?

• Who has the ability to depreciate or deduct expenses related to the property?

• Is the contract for deed vendee in exclusive possession of the property?

• If the contract for deed vendee constructed improvements on the property, who would own the improvements?

The answers to these questions will help you determine your viability of a 1031 exchange. As always, it's important to consult with a qualified intermediary about your 1031 situation.

• Start Your 1031 Exchange: If you have questions about contracts for deed, 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 Involving Your CPA in your 1031 Exchange

In a 1031 exchange, when you look at a HUD closing statement there a lot of confusing facts, figures, prorations, debits and credits, etc. These items can seem foreign and unfamiliar to many taxpayers. One of the concerns that many people have is “what if there are expenses on this closing statement that I'm not allowed to pay for with my exchange funds?”

Specifically, what about the following items:

• tax prorations

• security deposits

• rent prorations

• other lender related transaction expenses

The best course of action to take is to bring in your circle of advisers before you sign the closing statement. The way you can do that is to ask the title company to provide a preliminary closing statement and circulate it to your CPA or accountant for their review and comment. If you share the closing statement with them before closing you can adapt it and make some changes. But if you wait until April 15th of the next year to give them the completed signed closing statement there's nothing anyone can do after the transaction is closed.

• Start Your 1031 Exchange: If you have questions about involving your CPA in your 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