Can I do a 1031 Exchange of Underwater Property?

Sometimes investors will buy a property, it'll go up in value and when the value is high they'll refinance the property and extract a lot of the equity. Oftentimes, the property will then decline in value such that the debt on the property exceeds the value of the underlying collateral property.

A Potential Tax Problem

So now if you sell that property or have an involuntary sale such as a foreclosure, you may find that you have a sale for tax purposes and that you have a gain on the disposition (because your gain is determined by the difference in the debt relief and your basis). So you may have a low basis, high debt amount particularly if you're giving the property back to the bank. You may have a tax problem because for tax purposes you've conducted a sale in which you have a gain, but in reality you have no cash proceeds because your property is under water.

1031 Exchanging Underwater Property

How do you do a 1031 when you're trying to defer a gain and you have no sales proceeds to reinvest into a replacement property?

The answer is you have to acquire a replacement property - typically the target would be highly leveraged replacement property in which you don't have to put a lot of cash down. Somehow you're going to have to scrape together enough financial resources to acquire a replacement property of equivalent or greater value and which would have enough debt associated with it that you'll be able to offset the debt relief on your old relinquished property.

You may have to scrape, scrimp, beg and borrow to acquire the down payment to get a sufficiently big enough replacement property to cover all the debt relief of the disposition of your old relinquished property. But the benefit of doing so is you keep the taxman at bay and defer those gains indefinitely into the new property.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges of underwater property, 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 out of Non Income Producing Property & into Income Producing Property?

In order to qualify for a 1031 exchange, the property that you're selling has to have been held for investment or business purposes. Sometimes people have been holding raw land, which may not actually generate any cash flow while holding the property.

Raw Land

If you buy raw land hoping that it will go up in value, your holding costs may be property taxes, insurance, and other expenses related to the property while you're not receiving any rental income.

Many people ask if they can exchange into cash flowing property out of property that they've held for investment purposes but which has not generated any cash flow.

Mental Intent

As long as your mental intent was to acquire and hold the old relinquished property for investment or business purposes, even if it didn't generate cash flow, you can still do a 1031 exchange into other like-kind property that will also be held for investment or business purposes.

As a bonus, it's okay if your replacement property generates cash flow. In fact it’s probably a good thing because it would substantiate that you're using the replacement property for investment or business purposes.

The reason that Congress created 1031 in the first place was to allow investors to move their capital to the most advantageous investment and to stimulate the economy by allowing investors to seize upon opportunities that both benefit them and the economy by redeploying their cash where the economy needs it.

• Start Your Exchange: If you have questions about 1031 exchanges of non-income producing property, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Four Important Rules to Remember in a 1031 Exchange

1031 exchanges are excellent tools for deferring capital gains taxes on the sale of real property, but they come with a variety of rules and regulations. In this article, we are going to talk about four of the most important rules to remember when conducting a 1031 exchange of real property.

Rule 1 – Exchange Out of & Into Like-Kind Property

The like-kind property rule is perhaps the most important rule in any 1031 exchange. But what is “like-kind” property? When you’re dealing with real estate, like-kind has a very broad definition that includes basically all real estate (provided it’s held for the right purpose – more on that below).

Rule 2 – Hold Your Property for the Requisite Intent

Having the right intent or mindset is also important in a 1031 exchange. All of the property involved in the exchange needs to be held primarily for investment or business purposes, and not personal use. So your primary residence would be excluded from 1031 exchange treatment because of this rule.

Rule 3 – Finish Your Exchange within 180 Days

All 1031 exchanges (whether of personal property or real estate) need to be completed within 180 days after the sale of the relinquished property. The first 45 days of that time period are set aside for identification of the replacement properties into which you plan to exchange.

To figure out your 1031 deadlines, use our helpful calculator.

Rule 4 – Exchange Into Property of Equal or Greater Equity, Value, Debt

You also want to make sure that your replacement property is of equal or greater equity, value, and debt when compared to your relinquished property. This is also known as the “napkin test.”

• Start Your Exchange: If you have questions about 1031 exchange rules, 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 do a 1031 Exchange on a Property with a Mortgage & HELOC?

Here’s a relatively common 1031 situation that many people have questions about. Imagine you have two mortgages on the property you’re selling - one is the primary mortgage for 250K and the other is a 90K HELOC. Let’s say you want to do a 1031 exchange on this property and the purchase price on the new replacement property is a lot higher than that of the relinquished property. Can you count the HELOC against the equity? In other words, can you wait and pay the HELOC at closing so you have less money than required in order to maximize the 1031 benefit?

Questions to Consider

These are all great questions and there is a lot to consider before making a decision, such as:

• Are both mortgages liens against the Relinquished Property?

• In order to give the buyer clear and marketable title, wont both mortgages liens need to be satisfied by the title company?

• Are these debts encumbering the Relinquished Property?  If they are, then they will probably have to be full paid-off and released from the Relinquished Property.

Running Up Debt Before an Exchange

In general, it is NOT advisable to run-up the debt on the Relinquished Property in anticipation of the exchange.  The IRS has challenged such transactions.

Form the IRS perspective, if you extract the equity out of the Relinquished Property just prior to disposing of it in a 1031 exchange, it is effectively the same a s taking out the boot at the time of closing.

Check out this video for additional information: 

• Start Your Exchange: If you have questions about HELOC 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

Sample Text for 1031 Exchange Sale & Purchase Agreements

In a 1031 exchange, it is a very prudent practice to ‘shout it from the mountaintops’ at every juncture that you intend to conduct a 1031 exchange. That way if there is ever a misstep, mistake or problem, everyone knows what you are trying to accomplish, and will give you the benefit of their understanding. Here is some sample text that you may use or adapt for your sale and purchase agreements:

When Selling Relinquished Property

The Buyer herein acknowledges that it is the intention of the Seller to conduct an IRC Section 1031 Tax-Deferred Exchange and that the Seller's rights under this Purchase Agreement shall be assigned to CPEC1031, to facilitate such exchange. However, any warranties that may be expressed in this contract shall remain and be enforceable between the parties executing this document. Buyer agrees to cooperate with the Seller and/or its assigns in a manner necessary to enable the Seller to initiate said exchange at no additional cost or liability. This Purchase Agreement is part of an integrated, interdependent, mutual and reciprocal plan intended to effectuate an exchange by Seller of a like-kind real properties pursuant to and in accordance with the provisions of Section 1031 of the Internal Revenue Code. The Buyer shall execute and provide to Seller prior to closing, an acknowledgement, that Buyer has received written notice of the assignment of the Seller’s rights under this Purchase Agreement to CPEC1031.

When Buying Replacement Property

The Seller herein acknowledges that it is the intention of the Buyer to complete an IRC Section 1031 Tax-Deferred Exchange and that the Buyer's rights under this Purchase Agreement shall be assigned to CPEC1031 for the purpose of completing such exchange. However, any warranties that may be expressed in this contract shall remain and be enforceable between the parties executing this document.  Seller agrees to cooperate with the Buyer and/or its assigns in a manner necessary to complete said exchange at no additional cost or liability. This Purchase Agreement is part of an integrated, interdependent, mutual and reciprocal plan intended to effectuate an exchange by Buyer of a like-kind real properties pursuant to and in accordance with the provisions of Section 1031 of the Internal Revenue Code. The Seller shall execute and provide to Buyer prior to closing, an acknowledgement, that Seller has received written notice of the assignment of the Buyer’s rights under this Purchase Agreement to CPEC1031.

• Start Your Exchange: If you have questions about 1031 sale and purchase agreements, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved