How Do You Determine Property Ownership in a 1031 Exchange?

When you do a 1031 exchange the taxpayer that owns the old relinquished property has to receive the new replacement property. That begs the question: “who owns the relinquished property?”

Who Owns the Relinquished Property?

Often, people aren't sure exactly who the official owner of the relinquished property is. They may have a vague recollection that they bought it when they were not married and then later became married and they're not sure if their new spouse is in title on the property.

Additionally, they may have done some estate planning and created an irrevocable trust and they're not sure if this asset got put into the trust. And they may be in certain corporations or partnership and may or may not have contributed this property officially into the business entity.

Finding the Owner

Step one in a 1031 exchange is to determine who is the taxpayer that's going to do this exchange. That's the taxpayer that has officially owned and held the property for investment or business purposes. There's two ways to investigate this. First we can pull a copy of the last vesting deed for the subject property and see who in the public records is shown as the owner of the property.

Next, we can work with the taxpayer and the accounting firm to look at their previous tax returns to see how this property has been dealt with on their tax returns. For example, Susan and Martha may own the property as tenants-in-common on their public record on their deed, but Susan and Martha may have also filed partnership tax returns showing the asset as being in their business entity in their partnership. So we need to delve into this to determine who is the taxpayer that should do the exchange.

• 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

Essential Actions to Take After a 1031 Reverse Exchange

After a reverse exchange is completed and a replacement property that was parked by the intermediary has been conveyed to the taxpayer, the business may not be done. There may still be some administrative tidying up that needs to be done.

Change of Address

For example, the LLC that parked and held title to the replacement property may have been assigned to the taxpayer, but the records with the Secretary of State may still reflect the intermediary’s address as the business address of the LLC and as the registered agent. One administrative step after the reverse exchange is done is to file a new annual report with the Secretary of State reflecting the correct address and who is the new registered agent of the LLC.

If the address where the county tax statements are being sent to is showing as the intermediary’s address, the local county may continue to send the tax bills to the intermediary’s address rather than to the taxpayer. So another item to tidy up is to file or notify the local tax assessor where you want your tax statements and tax bills to be sent to in the future.

Notify the IRS

It may also be prudent to contact the IRS and notify them that the ownership of the LLC has substantially changed and request a new EIN number for the LLC.

These are little administrative items that are prudent to take immediately after the reverse exchange has been wrapped up. It's important not to delay too long because otherwise correspondence and important communication may be routed to the wrong address and the taxpayer may not receive that information for some time.

• 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

Remember to 1031 Exchange into Replacement Property of Equal or Greater Value

1031 Exchange Question: should you consider exchanging into one or more properties so you have continued investment into properties of equal or more VALUE?

Getting the Most Tax-Efficient Outcome

To get the most tax-efficient outcome, you may want to take on some more debt and buy more than you ordinarily would. One trick is to go into investments with non-recourse debt (that you are not personally liable for) to get to the requisite value, but without the personal liability.

3 Rules of Thumb for 1031 Exchanges

There are three general rules of thumb (also known as the napkin test) to quickly see if you will defer ALL of the recognition of gain.

1. Typically you will acquire replacement property that is “up or equal” in Value* (price); {*net of sales commissions and customary transactional expenses}

2. You will roll over all of your Equity (net proceeds) from the relinquished property into your replacement property.

3. And to the extent that you were relieved of liabilities and DEBT, such as mortgages on your old relinquished property, the debt relief is offset by (1) new liabilities or mortgages taken on in conjunction with your purchase of the replacement property; OR (2) by investing additional cash in the replacement property equal to the amount of liabilities and debts that were discharged.

You can have a partial tax deferral if you miss these general benchmarks. A 1031 exchange is not an all or nothing deal, and you can complete a partially tax deferred exchange; but you will probably recognize gain to the extent that you buy down in value.

Be sure to check with your CPA about these general rules of thumb, to make sure they apply to your specific situation.

• 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

Accounting Requirements & Potential Problems in a 1031 Exchange

In a 1031 exchange, there are three general accounting benchmarks that you want to be cognizant of - value, equity, and debt.

Value, Equity, Debt

• In order to cover all of the gain you have to buy your replacement property of equal or greater value.

• The next benchmark is you have to reinvest all of your equity or net proceeds into that new replacement property.

• Finally, to the extent that you are discharged or relieved of debts associated with the relinquished property, you need to acquire a replacement property and take out new debt sufficient to offset the old debt relief. Or if you're flush with cash you can also invest additional cash out of your pocket to offset some or all of that debt relief.

Potential Problems

The problem comes when people sell their relinquished property and they engage in seller-backed financing. Perhaps the buyer doesn't have enough money for the down payment and they say to you “hey why don't I borrow $10,000 or $15,000 from you and I'll give you a note at the time of closing for that amount?"

Well if the seller that's doing the exchange receives any property other than like-kind real estate as part of the exchange that is called boot, and boot is taxable. If the seller receives a note for $10,000 or $15,000 they’ve just received $10,000 or $15,000 worth of boot.

Insulating the Seller

In order to insulate the seller from receiving that boot we would have all of the proceeds (both the cash and the non-cash proceeds) go to the qualified intermediary so that it can be applied for the purchase of the new replacement property. If the seller of the new replacement property likes the idea of receiving the cash but isn't so enthralled with receiving the note you can then have the exchangor substitute in cash into the exchange account for the face value of the note so that the intermediary has all cash in the exchange account to apply for and use to purchase the 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

The Impact of Recaptured Depreciation on a 1031 Exchange

One of the joys of owning real estate with improvements is that you get to take a non-cash loss or deduction on your tax return for the theoretical wear and tear on the property. A residential rental property or apartment building is depreciated over 27 and a half years, and a commercial building is depreciated over 39 years. Every year, even if the property is going up in value, you get to take a tax deduction for the wear and tear.

The Downside

The downside to recaptured depreciation is that incrementally each year your basis is being reduced in the property. So at the end of that 27 and a half years, your apartment building will have a zero basis on the improvements because you depreciated it down to zero (unless you add basis by making capital improvements).

Impact on a 1031 Exchange

So how does this impact a 1031 exchange? The answer is that if you weren’t to do a 1031 exchange, all of that gain that’s attributable to the depreciation is taxed at a higher rate than normal capital gains rates. The maximum depreciation rate is 25% federal (compared to the maximum normal capital gains rate of 20%), so you pay the piper at a higher rate for all of that depreciation you’ve taken.

The good news is you can defer that gain, even the depreciation gain, by doing a 1031 exchange and keep all of your hard earned equity working for you by rolling it into a replacement property to defer the gain.

1031 Exchange Practice Tip

Most real property is Section 1250, however, if you have some components of your relinquished property that are classified as 1245 property for more rapid deprecation such as sheds, out-buildings, barns, agricultural storage bins, pens and silos then you need to be careful to match up enough like-kind 1245 replacement property to fully defer all of your gains.

• 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