Tips for Buying Replacement Property with Little or No Funds in Your 1031 Exchange Account

One common question that some taxpayers run into during the course of a 1031 exchange is: “how do you buy a replacement property when you have little or no funds in your 1031 account?” In this article, we are going to offer a few tips for buying replacement property when funds are low.

Down Payments & Offsetting Debt Relief

It may be necessary for you to come up with some cash so that you have a down payment to make on the replacement property.

Furthermore, you may be limited in what replacement properties you can buy because you're going to need to offset a lot of debt relief. That means you're going to have to acquire a more highly leveraged replacement property to offset all of the debt that you’re freed of when you give back the old relinquish property to the bank.

Fortunately, there are some syndicated replacement property options designed to fit the needs of a debt exchange. These products typically have higher leverage that hyper-amortize to accelerate the pay down of the loan and build-back equity (and stability) more quickly.

Section 1031 Exchanges of Real Property

Under IRC section 1031, any taxpayer in the US is able to defer capital gains taxes on the sale of real estate, provided they meet the requirements. At CPEC1031, our qualified intermediaries have decades of experience working with taxpayers on their exchanges. Contact us at our Minneapolis offices today to learn more about our services and get your exchange up and running!

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

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

How do Loan Documents Change in a 1031 Reverse Exchange?

In a typical 1031 exchange, the replacement property will be titled in an LLC (exchange accommodation titleholder) that is 100% owned by the QI for up to 180 days. This significantly changes the way the loan documents are prepared by the lender for a reverse exchange:

Mortgagor Changes

The QI’s LLC has to be the mortgagor on the mortgage (because it is the title-holder or owner of the encumbered property), and the investor merely guarantees or co-signs the loan.  Thankfully, one of the “permissible agreements” that is specifically allowed by the IRS in Revenue Procedure 2000-37 is that the taxpayer doing the exchange can guarantee some or all of the obligations of the LLC, including secured or unsecured debt incurred to acquire the property.

Due-on-Sale Clause Changes

At some point in the 180 day period, the QI will assign 100% of its membership interest in the LLC to the investor to complete the 1031, or alternatively, the LLC will deed the replacement property directly to the investor (subject to the lender’s mortgage). Typical, run-of-the-mill loan documents prohibit any part of the encumbered property from being sold or transferred, so when completing a reverse exchange, the lender needs to change the due-on-sale clause to allow the LLC to transfer the parked replacement property to the investor.

Prepayment Allowed

Most institutional commercial loans come with pre-payment penalties or restrictions on making any extra principal reductions. In a reverse exchange, the QI is going to receive the net-proceeds from the sale of the old relinquished property. In order to defer the taxes, this money needs to be re-invested into the parked replacement property before the property is given to the investor to complete the exchange. The QI needs to have the right in the loan documents to make a principal pay-down of the debt to the Lender so that, from an accounting perspective, all of the equity from the old property is redeployed into the replacement property.

QI not Liable for the Loan

When a QI is assisting an investor by having its LLC take title to the parked replacement property, it is doing so as an accommodation for the investor, not as an economic participant in the deal.  The QI should not be expected to have any real liability for the representations, warranties, or indemnities in the loan documents.  That being said, the lender may require the mortgage to be stated as full recourse to any borrowers, guarantors or co-signers, ensuring proper risk protection for said lender during the interim time period.

Investor Leases the Parked Replacement Property

While the LLC is the official owner of the replacement property for tax purposes, the IRS allows the day-to-day responsibilities of ownership to be shifted to the investor though a triple-net lease from the LLC to the investor. This means that during the 180 day grace period, the lease can provide that all loan payments, taxes, insurance, and any other carrying costs will be paid directly by investor.

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

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

What is the Holding Period for Determining Long-Term Capital Gains in a 1031 Exchange

If you receive a new business or investment property in exchange for old like-kind business or investment property as part of a tax-deferred 1031 exchange, your holding period begins on the day after the date the original (or old) property was acquired. This is because your basis in the new property is augmented by the deferred gains from your old property.

Remember, only real estate that you intend to use for Investment or for use in a trade or business qualifies for 1031 tax deferred treatment. The two main areas to be careful of are:

Personal Use

If you use real property for personal use such as your personal residence or vacation home, it may not qualify because it is not used for a qualified purpose (investment or business).

Dealer Property held Primarily for Sale

If you hold property as inventory or as your stock in trade it may not qualify for 1031. Ask yourself how frequently you sell residential lots or convert buildings to condominiums and sell the units, as part of your business. If you are doing enough of this type of activity, you may be a dealer and the real estate may be considered to be inventory. Flippers and rehabbers beware.

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

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Can I Revoke or Revise My 1031 Exchange Property Identification?

Many taxpayers considering a 1031 exchange want to know if they can change their property identification at any point throughout the exchange process. That’s our topic for today’s article.

The First 45 Days

During the first 45 days after the closing of your relinquished property (the Identification Period), you are free to revoke or change your 1031 Replacement Property Identification provided that it is done in writing, signed by the taxpayer and it is sent to the qualified intermediary (or other person involved in the exchange that is not disqualified) that you identified to previously.  If you do revise your Identification to add new properties to your list (to remove and replace other previously listed properties), then you may want to make it clear that your subsequent Identification supersedes and replaces any prior designations by writing that on the last Identification. Otherwise, it may be unclear if your subsequent Identification is intended to add more properties (potentially pushing you over the Three-Property Rule or 200% Rule).

After Day 45

After the 45th day of the exchange, the only properties that will be considered like-kind (once the 45th day has elapsed and the Identification Period is over) are those properties that were properly designated. You are not allowed to change your 1031 Replacement Property Identification after the 45th day, so if a better property comes along that you would prefer to purchase, you are S-O-L (Statutorily Out of Luck).

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

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

How to Take Title to a 1031 Replacement Property with Your Spouse

Many taxpayers have questions about how to take title to their 1031 exchange replacement property with their spouse.

Taking Title with a Spouse

Let’s consider an example where taxpayer “A” wants to bring their spouse (taxpayer “B”) into the replacement property as a co-owner. If taxpayer “A”  alone owned the relinquished property that may create an inconsistency for tax purposes. If taxpayer “A” alone owned the relinquished property and taxpayer “A” and their spouse (taxpayer “B”) want to buy the replacement property there could be a dilution of taxpayer “A” equity so that they are deemed to only have received 50% of the replacement property and only used 50% of their exchange funds for their purchase…the rest could be treated as taxable boot given to taxpayer “B”. Questions to ask in this situation are:

• Was the relinquished property owned in a community property state and was the property considered to be owned by the two jointly?

• Are they in a non-community property state in which only taxpayer A is considered the sole owner?

I advise clients to take title to the replacement property without their non-titled spouse so they complete the exchange (exactly as they owned the relinquished property) and everything looks matching. Then at some point in the future they can make a new recording that includes their spouse on the title. In the interim they can provide for that titling inconsistency in their will or estate planning.  Sometimes I have to provide marriage counseling in the process, because the non-titled spouse may feel uneasy about being kept off title for the new replacement property.

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

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved