How to Keep Your Money Safe In a 1031 Exchange

In a typical delayed 1031 exchange, you assign to your qualified intermediary (or “QI”) the rights to take your money from the sale of your old relinquished property. This makes many taxpayers feel uneasy. Do you really know what happens to your money while your QI is holding it for you? In this article, we will offer some tips for keeping your money safe and your mind at ease during your 1031 exchange.

The Answer is 100% Transparency

100% transparency means complete openness and clear communication in your 1031 exchange agreement. Your QI should agree in writing that:

• Your money will not be mixed or commingled with any other customers funds or with the operating account of the QI;

• Your money will be deposited directly (immediately after closing of the sale) into a separate segregated FDIC insured bank account; and

• Your exchange agreement will state what rate of interest (if any) will be credited to your exchange account.

More Safeguards - Adding a Qualified Escrow Agent

The treasury regulations say that you can use more than one safe harbor in the same 1031 exchange. Most people just use the qualified intermediary safe harbor in Treasury Regulation 1.1031(k)(1(g)(4).

However, a better, safer arrangement can be set up by requiring your qualified intermediary to deposit your 1031 money directly with a qualified escrow agent. Treasury Regulation 1.1031(k)(1(g)(3) sets out another safe harbor for qualified escrow agents.

Your FDIC insured bank can be the depository AND act as your qualified escrow agent. Even better, you can have a special written escrow agreement that states that two signatures are required to withdraw any money from the bank’s qualified escrow account:

1. your qualified intermediary’s signature; and

2. your signature.

Your qualified escrow agent cannot be a disqualified person and the written escrow agreement must incorporate the G(6) limitation that you can not have any right to receive, pledge, borrow or otherwise obtain the benefits of the escrowed money during the exchange period.

• Start Your Exchange: If you have questions about keeping your money safe 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

6 Tips for Finding a Great Qualified Intermediary

Before you hire a qualified intermediary for your 1031 exchange, you should do some checking around to make sure that they have a good reputation and solid track record of satisfied clients. Here are some easy ways to verify that your dealing with a reputable, experienced QI.

1. Online Directories

If your QI is a licensed attorney, you can easily check with their state’s board of attorney professional responsibility and state bar association. For example, in Minnesota, you can go to the MN State Bar Association website and confirm that your QI is a member of the Minnesota State Bar Association. Other states have similar online directories.

2. Better Business Bureau

Contact the Better Business Bureau (BBB) and see if your QI has a good reputation in the business community and if your QI BBB accredited. You can also check online at: https://www.bbb.org

3. Secretary of State

Check and see how long your QI has been in business with the Secretary of State’s office. 

4. Special Certifications

You can also ask your QI if they have a fidelity bond, errors and omissions (E&O) or other special certifications.

5. Ask Around

Ask around with other investors, attorneys, bankers and title-closer; they will know who is good to work with.

6. References

Lastly, you can and probably should ask your QI for references. If they can’t or won’t give you the names of some people that can vouch for them, then it's time to move on.

Saving money in taxes is a strong motivator. I hope this information helps you safely and successfully navigate through the 1031 tax deferral process.

• Start Your Exchange: If you have questions about finding a qualified intermediary for 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

Gifted Property & 1031 Exchanges

Many people are unaware that you can conduct a 1031 exchange of property that you received as a gift. If you held the gifted property for a qualified purpose, which is for investment purposes or for use in your trade or business, then you should be able to defer the federal capital gains taxes.

In a 1031, both your old property (relinquished property) and your new like-kind property (replacement property) will qualify for 1031 exchange treatment if they are considered to be qualified use property.

Proving Your Intent to Hold for a Qualified Purpose

It is important that you intend to hold your properties for investment purposes in order to qualify for 1031 tax deferral. This means that your property involved in the exchange must be held for investment or used in your trade or business. If you used the property for personal use (such as your home) or held the property as inventory or stock in trade (i.e. they are held for sale), then they may not qualify for 1031 exchange.

A good way to prove that you have the proper intent to hold for a property for qualified purpose is to keep your properties for a substantial period of time, so that you can show you had the intent to hold for investment. During this holding period you can do things with your property that are consistent with investment or business. (i.e. renting them out for market rate lease). However, there is no mandatory minimum period of time that you must own property before conducting a 1031 exchange.

If you have a few years of tax returns showing that the property was held consistent with business or investment (i.e. showing rental income, deprecation or other business expenses) you will able to prove your case much better if you are ever audited.

• Start Your 1031 Exchange: If you have questions about gifting property after 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 Real Estate Exchanges

One of the most popular uses for a 1031 exchange is in the sale of real estate. 1031 real estate exchanges are popular and easy because the like-kind requirements are very broad in the world of real estate.

Like-Kind Real Estate

Nearly all real property within the USA is considered to be like-kind. The types of real property that may be exchanged include property held in fee, ground leases (with remaining terms of 30 years or more), undivided interests in real property held as tenants in common (TICs) and interest in “DSTs” or Delaware Statutory Trusts. Here is a partial list of some of the kinds of properties that qualify for 1031:

• Apartment Buildings

• Farms

• Shopping Centers

• Airport Hangers

• Condos and Town Homes

• Raw Land

• Single Family-Rentals

• Industrial Property

Another reason people often structure the sale of real property as 1031 exchanges is because improvements (such as buildings) have been depreciated down over time, subjecting the sale to a maximum of 25% depreciation recapture rates (C corporations can be as high as 35%) on the portion of the gain that is attributed to the depreciation.

Depreciate your Investment Property

As a real estate investor, you can depreciate your real estate business and investment property. The maximum 20% capital gain rate is generally known as the long-term capital gains rate and is the maximum rate that applies to real estate that you have held for at least 366 days (more than one year).

There is also the Net Investment Income Tax (“NITI”) which is imposed by IRC Section 1411 and applies an extra rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts (2015 amounts: Married filing jointly = $250,000; Married filing separately = $125,000; Single = $200,000). 

The long-term capital gain tax is typically a lot less than what you pay on your regular income. If your holding period has been for less than one year, consider deferring the gain on the sale through a 1031 exchange so that you can meet the greater-than-one-year period before cashing out on a later sale.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Does a 1031 Replacement Property Have To Be Larger In Value?

You can do a partial 1031 into a lesser valued replacement property, but if you want to defer 100% of the gain, you typically need to continue your investment into an equivalent or more valuable replacement properties (see the napkin test).

3 General Rules

There are three general rules of thumb to quickly see if you will defer all of the recognition of gain in your 1031 exchange:

1. Typically you will acquire replacement property that is “up or equal” in value (price).

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.

Partial Victory Is Better Than None At All

If you have a low basis, you may be satisfied to defer part of your gains and to pay your taxes on the difference, this is often called a partial 1031 exchange.  Generally this occurs when a taxpayer wants to buy only a replacement property of lesser value, or prefers not to re-invest all of their equity (1031 funds) from the disposition of their old relinquished property into their new replacement property. 

1031 Post-Exchange Refinance Alternative

If you are considering holding back some money from your exchange (taxable boot) and only re-investing a portion of your equity (1031 funds), then be sure to call me first, as we may be able to discuss some other ways to get you the same amount of cash without triggering the recognition of gain during your 1031 exchange.

Tax Treatment of Loans

One option to consider is to complete your exchange by re-investing ALL of your equity (1031 funds) into a replacement property of equal or greater value; and then later in a subsequent (separate post-exchange) transaction, pull out some equity by refinancing your replacement property to access some of the equity.  Generally, borrowing money is not considered income because you have a corresponding obligation to repay the loan.  When tax rates are high and interest rates are low, it doesn’t take a rocket scientist to figure out that by delaying your gratification until later after your exchange is over you can save a significant amount in taxes.

• Start Your Exchange: If you have questions about 'partial 1031 exchanges' or how to refinance after the exchange to get your money out tax-free, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved