1031 Exchange Tips for Tenancy in Common Property

A lot of times people own real estate in a partnership or LLC that's taxed as a partnership. If the property goes up in value some of the partners may be inclined to sell the underlying real estate while other partners are not so inclined because they don't want to pay the taxes.

This divergent opinion between the partners can be exasperated if there's been a death of one of the partners and the heirs of the now-deceased step into the partnership with a stepped-up basis and perhaps a more cavalier attitude about selling the underlying real estate. Because they may not have much of a tax burden if the property is sold, they may be less concerned about the tax consequences of a sale.

Setting up a Tenancy in Common

Furthermore, they may not want to be in a partnership with all the other folks. So when this sort of divergent opinion exists it may be a prudent step to bifurcate the ownership of the asset so that rather than having a partnership we would have a tenancy in common. If a sale were to ever occur, the exchange minded folks could be in one entity, and the cavalier folks that have a high basis and are less concerned about taxes would be in a separate distinct tax-paying entity.

When the sale occurs, hopefully we have two sellers on the purchase agreement, and two sellers that are separately 1099’d by the title company. The exchange minded group can set up their proceeds to go with a qualified intermediary and defer their gain, while the cavalier high basis folks that are less concerned with the tax can simply take their share of the proceeds and go.

Give Yourself Time

When do you want to set up this bifurcation? Do you want to set up the split up on the eve of the closing right before you sell the relinquished property? Do you think the IRS will respect a last minute switch? Probably not. The better course of action is to have this conversation amongst the partners early, before there's even a tacit agreement to sell the property and to break up the property well in advance of any proposed sale. Let some time pass after the break up before you actually sell the property. The IRS is much more likely to respect a reconfigured ownership arrangement if it is done well in advance of any sale and some time has passed.

1031 Holding Requirement

Furthermore, remember there's a holding period requirement in section 1031 that the relinquished property must have been held for investment or business purposes. If you do a drop and then a swap immediately you may not have held your property for a sufficient period to satisfy the requirements of 1031.

• Start Your Exchange: If you have questions about 1031 exchanges of TIC property, 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 Cancellation Fees

If you call a qualified intermediary on short notice and ask them to prepare a set of 1031 exchange documents, they're going to jump through a lot of hoops – collecting information, reading the purchase agreement and title report, interfacing with the escrow and title company, and generating some very technical 1031 documents that are specifically tailored to your transaction.

Cancelling a 1031 Exchange at the Last Minute

What if the seller decides to not do a 1031 exchange after having this fire drill to prepare their 1031 documents? That's fine - you don't have to do a 1031 exchange. It's a free country. But you probably have a moral and perhaps legal obligation to compensate the qualified intermediary for stopping everything and working exclusively on your transaction to get the 1031 prepared.

It's common if the intermediary has prepared, circulated, and sent out your 1031 documents for the intermediary to charge a cancellation fee if, before the closing of the relinquished property, the taxpayer decides not to proceed with the 1031 exchange.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

The Importance of Notifying Your Qualified Intermediary in a Reverse Exchange

If you do a reverse exchange and you have the intermediary park the replacement property and hold it for your benefit, eventually (within 180 days) you need to sell or dispose of that old relinquished property so you can then acquire the parked replacement property.

Pro Tip

Here’s a pro tip - before you sell your relinquished property you need to notify the qualified intermediary so that they can prepare the appropriate 1031 documents, notices, and closing instructions related to the sale of your relinquished property. Just because you parked the replacement property doesn't mean that the intermediary’s job is done as it relates to the sale of your old relinquished property.

Assemble Your Team

Bring in your team, assemble them early, and give everybody notice of what's going on so you can get the best result on your 1031 reverse exchange.

• Start Your 1031 Exchange: If you have questions about reverse 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

Can I do a 1031 Exchange of Underwater Property?

Sometimes investors will buy a property, it'll go up in value and when the value is high they'll refinance the property and extract a lot of the equity. Oftentimes, the property will then decline in value such that the debt on the property exceeds the value of the underlying collateral property.

A Potential Tax Problem

So now if you sell that property or have an involuntary sale such as a foreclosure, you may find that you have a sale for tax purposes and that you have a gain on the disposition (because your gain is determined by the difference in the debt relief and your basis). So you may have a low basis, high debt amount particularly if you're giving the property back to the bank. You may have a tax problem because for tax purposes you've conducted a sale in which you have a gain, but in reality you have no cash proceeds because your property is under water.

1031 Exchanging Underwater Property

How do you do a 1031 when you're trying to defer a gain and you have no sales proceeds to reinvest into a replacement property?

The answer is you have to acquire a replacement property - typically the target would be highly leveraged replacement property in which you don't have to put a lot of cash down. Somehow you're going to have to scrape together enough financial resources to acquire a replacement property of equivalent or greater value and which would have enough debt associated with it that you'll be able to offset the debt relief on your old relinquished property.

You may have to scrape, scrimp, beg and borrow to acquire the down payment to get a sufficiently big enough replacement property to cover all the debt relief of the disposition of your old relinquished property. But the benefit of doing so is you keep the taxman at bay and defer those gains indefinitely into the new property.

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

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Can You 1031 Exchange out of Non Income Producing Property & into Income Producing Property?

In order to qualify for a 1031 exchange, the property that you're selling has to have been held for investment or business purposes. Sometimes people have been holding raw land, which may not actually generate any cash flow while holding the property.

Raw Land

If you buy raw land hoping that it will go up in value, your holding costs may be property taxes, insurance, and other expenses related to the property while you're not receiving any rental income.

Many people ask if they can exchange into cash flowing property out of property that they've held for investment purposes but which has not generated any cash flow.

Mental Intent

As long as your mental intent was to acquire and hold the old relinquished property for investment or business purposes, even if it didn't generate cash flow, you can still do a 1031 exchange into other like-kind property that will also be held for investment or business purposes.

As a bonus, it's okay if your replacement property generates cash flow. In fact it’s probably a good thing because it would substantiate that you're using the replacement property for investment or business purposes.

The reason that Congress created 1031 in the first place was to allow investors to move their capital to the most advantageous investment and to stimulate the economy by allowing investors to seize upon opportunities that both benefit them and the economy by redeploying their cash where the economy needs it.

• Start Your Exchange: If you have questions about 1031 exchanges of non-income producing property, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved