Tips for 1031 Exchanging Residential Rental Properties

Many people may think CPEC1031 facilitates only large or complex transactions, but we also act as the third party administrator for 1031 exchanges of smaller residential rental properties.

Like-Kind Exchanges of Residential Rental Property

Here are some tips for conducting a like-kind exchange of residential rental properties:

• Put language in the sale and purchase contract evidencing your intent that the sale/purchase is part of a 1031 exchange and obtain the other parties cooperation.

• Let your real estate agent and title closing/escrow agent know early that you are conducting a 1031 exchange and ask them to coordinate with the qualified intermediary.

• Get set up with your qualified intermediary well prior to the closing of your sale. If you wait until after the sale has occurred, it will be too late to insulate yourself from receiving the proceeds or giving the requisite written notice to the other parties.

• Start exploring your replacement property purchase options early so you can get a jump on the 45 day identification period. 

We are fast, and responsive to client inquires even if the transaction is small, because it’s important to the people involved.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Alternatives to the 721 Contribution

Sometimes a developer will approach a seller and say: “I don't want to buy your property, I want to become partners with you. Rather than giving you cash for your property I'd like to give you a partnership interest in my new development entity. All you have to do is to contribute your property to my partnership.”

Section 721

Under Section 721 of the Internal Revenue Code when you contribute property to a partnership and you receive back partnership interest, that can be a tax neutral or untaxed transaction. However, there's a lot of traps for the unwary with regard to 721 contributions.

One very important one is the problem of mortgage over basis (or MOB). Mortgage over bases his when you're debt on the contributed property exceeds your basis. To the extent that you have debt relief over and above your basis you may inadvertently trigger the recognition of gain.

721 Contribution Alternatives

So what's the alternative to doing a 721 contribution? The alternative is to do a cash sale. Tell the developer you're not interested in being his partner but you'd happily sell the property in a cash transaction using your qualified intermediary to do a 1031 insulate you from receiving that cash so you can redeploy it into other unrelated replacement properties. Sometimes being in a partnership isn't all that it's cracked up to be.

• Start Your Exchange: If you have questions about 721 contributions, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Exchange Wealth Building Tips

In this article, we will offer a few tips for building your wealth over time with a 1031 exchange.

Real Estate as a Wealth Building Vehicle

Real estate is a preferred vehicle for wealth building because you can defer your gains and continue to compound and build your wealth over time.

For example, let's say that we start off by purchasing a single-family rental. We're good stewards and managers of that property, and guess what? It goes up in value after a few years and we've acquired quite a bit of equity in that property.

Single Family to Multi-Family Property

Now, we're not complacent so we're not going to stay in that single family rental property. Instead we're going to defer the gains on its sale and acquire a fourplex or four unit multi-family property. We're going to take all of our proceeds from that single family rental, roll them tax-free into the new apartment building. Again, we're going to be good stewards and that property will continue to go up in value. After a few years of managing that property, it will have increased our equity position again.

Fourplex to 16-Unit Apartment Complex

Now, we're not complacent and we're going to continue to compound and build our wealth so we're going to dispose of the fourplex using a tax-deferred 1031 exchange and buy a 16 unit apartment complex. Again we're going to compound and build our wealth tax free over time. We're going to be good stewards and operators of that apartment complex and over time again we're going to build equity.

Parlay Your Investment Over Time

We're always going to be buying a bigger, better, more expensive property. Over the course of time we're going to parlay our initial investment from a single-family rental property into perhaps a hundred plus units. The reason that we’re able to do that is twofold:

1. We’re using a very tax-efficient strategy where we’re able to keep our wealth building and compounding for us

2. We’re using other people's money (OPM) to finance the bulk of our acquisitions. With only a little bit down (say 20%) we can take down a much more expensive property. The interest that we pay to the bank is tax deductible. Who really ends up paying the debt service anyway? It's our tenants. The tenants are paying the rent and we're using the rent to pay the debt service.

By building wealth through real estate we’re able to amass so much wealth tax-deferred so much more quickly than we could if we were burdened with laborious taxes.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Tips for Dealing with 1031 Property Received in a Divorce Settlement

When a spouse purchases property in a 1031 exchange, they have a lower basis (than a normal cost basis) in the property to the extent that they have deferred gains and rolled over into the new replacement property. This may be called a substituted basis or reduced basis due to the taxes that were deferred in the exchange.

Depreciation Deductions

If, in addition to starting with a lowered basis, the spouse then took depreciation deductions for the wear, tear, and exhaustion of the property, then the remaining basis would have been further reduced each year incrementally as these depreciation deductions were taken.

Section 1041

Years later, if the spouse gets divorced and transfers the replacement property to their ex-wife/husband (former spouse) as part of a divorce property settlement, then the former spouse will take the property with a straight carry-over basis under IRC Section 1041 (transfers of property between spouses or incident to divorce), so they get the property with a super low basis, being whatever remaining basis the transferor had left in the property. Section 1041 makes transfers between spouses tax-neutral, in that the receiving spouse just takes the transferred property subject to the other spouses basis.

Section 121 Exclusion

If the former spouse moves into the property and makes it their principle residence, they may be able to take a partial exclusion under IRC Section 121 once they have owned and lived in the property for two years; however, the amount of the exclusion allowed is a fraction based upon the ratio of the time the property was used as a rental and the amount of time it was used as a principle residence. Further, IRC Section 121 is inapplicable to deprecation recapture. So, the former spouse will only get to use a fraction of the principle residence as it relates to the appreciation (or natural increase in value over time), but will not be able to exclude any gains attributable to the past depreciation that was taken by either or both spouses.

Unrecaptured Depreciation

Unrecaptured depreciation may be taxed at a maximum rate of 25% on most US real property. While normal long term capital gains are taxed at a maximum rate of only 20%.

In summary, if you receive property in a divorce property settlement that was originally purchased to complete a 1031 like-kind exchange…you may be receiving the property with an unexpectedly low basis and additional potential tax complications. These tax complication may be compounded by the limitations imposed in Section 121 for the principle residence exclusion that carve-out from the exclusion the deprecation recapture

PROTIP:  Let the entrepreneurial spouse keep the old low basis property, and have the other spouse receive cash!  Cash is king.

• Start Your Exchange: If you have questions about tax implications of property in a divorce, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

If Congress Repeals Section 1031, will Previous Exchanges Still Hold?

If section 1031 is repealed by Congress the question arises: “what about previous 1031 exchanges that were already completed? Will those still hold up even if the like-kind exchange is removed from the tax code?”

Date Certain

Congress typically sets a date certain when a tax change will be implemented and any 1031 exchanges you have been previously completed before that date certain will probably be just fine. The unfortunate situation will be for 1031 exchanges that are in the works and can't be completed before that effective date or change occurs. Those exchanges may not be able to be completed even though they are going through the motions.

Contact Your Reps

We don't know if Congress will eliminate the 1031 exchange. We hope that it doesn't. But if they do affect the change we’re hoping that all previously commenced 1031 exchanges will be respected, even if they're completed after the transition date.

Congress is currently working on tax reform. If you want to make sure that the 1031 exchange is preserved in this reform, contact your representatives and let them know where you stand.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved