1031 Exchange Blog
In this whiteboard video, we talk about the concept of "boot" in a 1031 exchange.
If you enjoyed this video, check out our other whiteboard animation videos:
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.
© 2016 Copyright Jeffrey R. Peterson All Rights Reserved
Many people conducting 1031 exchanges are concerned about getting 1099’d on the sale of their relinquished property. They are worried that if the IRS is notified of their sale, that it will jeopardize their exchange.
Title companies, escrow companies, attorneys, mortgage brokers, real estate brokers, and other people involved in closing real estate transactions (the "Reporting Person") for the “sale or exchange” of real estate must report these transactions to the IRS under 26 U.S. Code § 6045(e). Penalties are imposed if the Reporting Person fails to comply with these rules.
Under Treasury Regulation 1.6045-4(b)(1), the term “sale or exchange” includes any transaction properly treated as a sale or exchange for federal income tax purposes, whether or not these transactions are currently taxable. So the requirements of § 6045 also apply to 1031 tax deferred exchanges under § 1031 of the Internal Revenue Code as reportable transactions.
At the outset of a 1031 tax-deferred exchange, the Reporting Person conducting the closing of the sale of the relinquished property may not know if the exchange will be fully completed, or if the like-kind replacement property will be received by the taxpayer within the 180 exchange period, or even if the replacement property will qualify for tax-deferral. None of that matters though because the Reporting Person is still legally required to report the transferor’s proceeds to the IRS using form 1099-S.
Typically, the "Reporting Person" is the taxpayer who:
Transfers or sells the property being sold
Conveys the property to the buyer
Would be entitled to the payment of the proceeds or to whom the proceeds is credited to such person’s account.
The term “transferor” includes any persons conveying “ownership interest” in real estate such as:
Fee simple interests
Life estates
Reversions
Remainders
Perpetual easements
Lease-hold estates of 30 years or more, including any period for which such rights may be renewed at the option of the holder.
In a standard forward exchange, the proper person to be issued the 1099 is the taxpayer conducting the exchange — the seller conducting the exchange — and not the qualified intermediary.
After the exchange is completed the seller or exchanger will inform the IRS of the connection between the sale of the relinquished property and the purchase of the replacement property on IRS form 8824 with their federal tax return. This allows the IRS to understand how the first 1099 relates to the tax-deferred exchange, and the full story of events will be revealed.
Start Your Exchange: If you have questions about the 1031 exchange and 1099 reporting, feel free to call me at 612-643-1031.
Defer the tax. MAXIMIZE your gain.
© 2016 Copyright Jeffrey R. Peterson All Rights Reserved
In a 1031 you need to move your equity to your replacement property to defer all of the gain. If you use some of the proceeds to loan back to the buyer through a seller-backed note or a contract for deed, your equity is not available to you to redeploy into the replacement property.
The first thing I tell people is if you want a simple 1031 exchange, ask for cash on the barrelhead. Tell the seller not to be the bank. Instead, let the buyer go out and get their own financing. That’s fine sometimes, but other times the seller has to give the buyer some type of incentive in order to buy the property and has to engage in seller backed financing.
An easy way to fix that problem is to come to the closing table with a sufficient amount of money to loan directly to the buyer. If you do this that means all of your net proceeds are available to be sent to your 1031 escrow account (because you are adding in the cash to loan to the buyer out-of-pocket).
Another possibility is to loan the money to the buyer but have the note (or other debt instrument) run in favor of the qualified intermediary. That way your QI gets the cash and non-cash proceeds. But what do you do about the non-cash proceeds? We need to at some point sell that note so the QI has all-cash in their exchange account and can use that to apply it to the purchase of the replacement property.
So at some point in the process you’re going to probably have to buy that note from the QI. One way to do that is take out a temporary unsecured loan from a bank, put the money into the QI account, close on the replacement property, and in a post-exchange transaction, you can go back to your banker and increase the indebtedness on the replacement property (to pay back the unsecured loan). But that has to be done after the exchange is over in a separate post-exchange transaction.
Start Your Exchange: If you have questions about seller financing, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
© 2016 Copyright Jeffrey R. Peterson All Rights Reserved
In the US, we have different tiers or levels of taxation. Here is a brief explanation of some of those tiers, and a specific examination of capital gains taxes and rates.
Ordinary income is typically the highest taxed level of income. Currently, this goes up to 39.6% at the federal level.
Other types of income have a more preferential or lower taxation. In particular, the sale of a capital asset, such as real estate that’s used for investment or business purposes, is taxed at a lower rate. Capital gains rates are at a max now of 20% in the US. Juxtapose that with an ordinary income tax payer who may be paying 39.6% in income taxes. So it’s a higher rate of taxation for earned income, compared to the sale of a capital asset.
The maximum deprecation recapture tax rate on the portion of the gain attributable to depreciation deductions taken over the years is 25% at the federal level. The tax code won’t allow taxpayers its most favorable capital gains rates on the portion of the gain relating to these prior depreciation deductions that were taken for the theoretical wear and tear on the property.
On January 1, 2013, to fund the new health care laws, Congress created a new 3.8% Net Investment Income Tax (NIIT) as a direct new tax to fund the Affordable Care Act. This extra level of tax applies to taxpayers with net investment income above certain applicable threshold amounts.
The 3.8% tax applies to the excess of modified adjusted gross income over the following threshold amounts: ◦
$250,000 for married filing jointly or qualifying widow(er) with dependent child
$125,000 for married filing separately
$200,000 in all other cases
Start Your 1031 Exchange: If you have questions about capital gains, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
© 2016 Copyright Jeffrey R. Peterson All Rights Reserved
Note: In this article, we hear from guest contributing blogger Kip Dunkelberger (kdunk@venturemortgage.com), the President and CEO of Venture Mortgage Corporation. Kip leads this trusted, dynamic commercial real estate mortgage banking firm, and he himself is known as an experienced and resourceful problem solver in the realm of commercial real estate financing.
Today’s savvy investors, particularly those looking to defer tax consequences by taking advantage of 1031 exchanges, are wisely looking for ways to secure a replacement property before selling the soon-to-be-relinquished property. These investors need to know that once they close on the sale of their old property, they have a new property investment to exchange into.
They are rightly concerned, because the deadlines for a normal forward exchange require you to identify your replacement properties within 45 days and close on them within 180 days. 45 days to identify in a hot (seller’s) market presents a potentially formidable challenge. Here in the Upper Midwest, where the competition for choice replacement multi-family properties is particularly fierce, the process of identifying and trying to close on a replacement property in a normal forward exchange is not always a realistic possibility. That’s where a reverse 1031 exchange, combined with a creative, problem solving commercial real estate mortgage banking firm with access to a wide variety of lenders, can make all the difference.
Many investors are turning to these reverse exchanges to increase their chances of completing a 1031 exchange. In a reverse exchange, an investor can have their replacement property purchased for them by a qualified intermediary before closing on the sale of their old relinquished property. The qualified intermediary (“QI”) then creates a new LLC to be the purchaser of the replacement property and holds title (or “parks the ownership”) for up to 180 days while the investor sells the relinquished property. The ability to finance the purchase of the replacement property before you have the proceeds from your sale is where the need for innovative financing comes in.
At the first closing of the replacement property, on the deed from the seller to the LLC, the lower right hand portion can be filled out to tell the county to mail the property tax statement directly to the investor’s address, rather than to the QI or its LLC. That way the investor receives the bills and statements for the property taxes directly.
The insurance certificate for the liability insurance should list the lender, the LLC, and the investor all as insured parties. That way, if there is a claim, all of the parties with an insurable interest in the property are protected.
If you have questions about obtaining a mortgage or financing for a reverse exchange or any other commercial real estate investment, you are invited to call Kip Dunkelberger at (952) 843-5125, or email him at kdunk@venturemortgage.com.
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