Can you do a 1031 Exchange on a Property with a Mortgage & HELOC?

Here’s a relatively common 1031 situation that many people have questions about. Imagine you have two mortgages on the property you’re selling - one is the primary mortgage for 250K and the other is a 90K HELOC. Let’s say you want to do a 1031 exchange on this property and the purchase price on the new replacement property is a lot higher than that of the relinquished property. Can you count the HELOC against the equity? In other words, can you wait and pay the HELOC at closing so you have less money than required in order to maximize the 1031 benefit?

Questions to Consider

These are all great questions and there is a lot to consider before making a decision, such as:

• Are both mortgages liens against the Relinquished Property?

• In order to give the buyer clear and marketable title, wont both mortgages liens need to be satisfied by the title company?

• Are these debts encumbering the Relinquished Property?  If they are, then they will probably have to be full paid-off and released from the Relinquished Property.

Running Up Debt Before an Exchange

In general, it is NOT advisable to run-up the debt on the Relinquished Property in anticipation of the exchange.  The IRS has challenged such transactions.

Form the IRS perspective, if you extract the equity out of the Relinquished Property just prior to disposing of it in a 1031 exchange, it is effectively the same a s taking out the boot at the time of closing.

Check out this video for additional information: 

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Maximum Tax Rates if You DON'T Do a 1031 Exchange

Many people want to know the maximum capital gains tax rates if you do not do a 1031 exchange on your property.

Maximum Tax Rates

Here are some of the tax rates you face when selling real property in the state of Minnesota:

• State of Minnesota Tax on the Entire Gain: 9.85% (this can vary slightly, depending on where the relinquished property is located).

• Federal Capital Gains Tax on the Appreciation: 20%.

• Federal Deprecation of Section 1250 Recapture: 25%. Could also have some section 1245 depreciation recapture if the property is treated as ordinary income to the extent of depreciation. 

• Federal Net Investment Income Tax: 3.8% on amounts of gain over certain thresholds depending on your filing status ($250,000 Married filing jointly / $200,000 filing Single).

Defer These Taxes with a 1031 Exchange

These taxes can really add up. A 1031 exchange allows you to defer your capital gains taxes on the sale of real estate and keep your money working for you over time.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Sample Text for 1031 Exchange Sale & Purchase Agreements

In a 1031 exchange, it is a very prudent practice to ‘shout it from the mountaintops’ at every juncture that you intend to conduct a 1031 exchange. That way if there is ever a misstep, mistake or problem, everyone knows what you are trying to accomplish, and will give you the benefit of their understanding. Here is some sample text that you may use or adapt for your sale and purchase agreements:

When Selling Relinquished Property

The Buyer herein acknowledges that it is the intention of the Seller to conduct an IRC Section 1031 Tax-Deferred Exchange and that the Seller's rights under this Purchase Agreement shall be assigned to CPEC1031, to facilitate such exchange. However, any warranties that may be expressed in this contract shall remain and be enforceable between the parties executing this document. Buyer agrees to cooperate with the Seller and/or its assigns in a manner necessary to enable the Seller to initiate said exchange at no additional cost or liability. This Purchase Agreement is part of an integrated, interdependent, mutual and reciprocal plan intended to effectuate an exchange by Seller of a like-kind real properties pursuant to and in accordance with the provisions of Section 1031 of the Internal Revenue Code. The Buyer shall execute and provide to Seller prior to closing, an acknowledgement, that Buyer has received written notice of the assignment of the Seller’s rights under this Purchase Agreement to CPEC1031.

When Buying Replacement Property

The Seller herein acknowledges that it is the intention of the Buyer to complete an IRC Section 1031 Tax-Deferred Exchange and that the Buyer's rights under this Purchase Agreement shall be assigned to CPEC1031 for the purpose of completing such exchange. However, any warranties that may be expressed in this contract shall remain and be enforceable between the parties executing this document.  Seller agrees to cooperate with the Buyer and/or its assigns in a manner necessary to complete said exchange at no additional cost or liability. This Purchase Agreement is part of an integrated, interdependent, mutual and reciprocal plan intended to effectuate an exchange by Buyer of a like-kind real properties pursuant to and in accordance with the provisions of Section 1031 of the Internal Revenue Code. The Seller shall execute and provide to Buyer prior to closing, an acknowledgement, that Seller has received written notice of the assignment of the Buyer’s rights under this Purchase Agreement to CPEC1031.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Is There a Difference Between Income vs. Investment Property in a 1031 Exchange?

Is there a difference between income and investment property? Do both fall within the 1031 exchange guidelines? That's our topic for today's article.

What is the Held for Requirement in a 1031 Exchange?

Section 1031 provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind that is to be held either for productive use in a trade or business or for investment. 

Whether the property exchanged is held for productive use in a trade or business or for investment is a question of fact. The manner in which the relinquished property is held at the time of the exchange controls, not the manner in which it was held when acquired - see Wagensen v. Commissioner, 74 T.C. 653 (1980).

Neither the Internal Revenue Code nor the Income Tax Regulations under § 1031 provide further guidance concerning the phrase “held for productive use in a trade or business or for investment” (the “held for” requirement).   

Rev. Proc. 2008-16

The Internal Revenue Service (the “Service”) deals with this issue in Rev. Proc. 2008-16, 2008-10 I.R.B. 547 in the context of properties in a rental pool that may be used sparingly for personal use.

Rev. Proc. 2008-16 provides circumstances under which the IRS will not challenge whether a dwelling unit qualifies as property that meets the “held for” requirement even though the property is occasionally used for personal purposes. If the safe harbor provisions of the Rev. Proc. are met, the entire property meets the “held for” requirement for purposes of § 1031. The Rev. Proc. provides the following:

The Service recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. In the interest of sound tax administration, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under § 1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes. 

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Related Party 1031 Exchange Best Practices

In a related party 1031 exchange, you must hold the replacement property (that you receive from the related party) for two years. However, the other big requirement is that the exchange cannot be part of a transaction (or series of transactions) structured to avoid the imposition of the tax. If both you and your related party seller are not paying any tax (because the seller is taking a Section 121 principal residence exclusion), then you may be deemed to have crossed into the category of avoiding the imposition of the tax in 1031(f)(4).

Special Rules for Exchanges Between Related Persons

In general, If—

• (A) a taxpayer exchanges property with a related person,

• (B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and

• (C) before the date 2 years after the date of the last transfer which was part of such exchange—

  • (i) the related person disposes of such property, or

  • (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,

there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.

Certain Dispositions not Taken into Account

For purposes of paragraph (1)(C), there shall not be taken into account any disposition—

• (A) after the earlier of the death of the taxpayer or the death of the related person,

• (B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or

• (C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

Related Person

For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1).

Treatment of Certain Transactions

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved