Explaining The Principal Residence Exclusion as it Relates to 1031 Exchanges

Many people that are selling a duplex, triplex, or property that they've lived in as their principal residence will be able to avail themselves of two important tax code provisions.

What is the Principal Residence Exclusion?

The first is the principal residence exclusion, which allows you to take up to $500,000 tax free if you're married filing a joint tax return, or $250K if you're single, and exclude that portion of the gain that relates to your relinquished property.

So on the sale of a duplex, half of the relinquished property that the owner occupied, that portion of the proceeds would be eligible for the exclusion. The other half of the duplex may be eligible for section 1031 where we can defer the gain.

Keep the Allocation Consistent

Now the portion of the proceeds that relates to the rental side, the gains are only deferred. The important thing to remember is that however you've treated that duplex or triplex in the past, in allocating the business and depreciation and portion of the property that you treat it as a rental, you want to stick with the same allocation when you go to sell the property. So whatever allocation you made in the past should be consistent with your split of the proceeds when you sell this duplex or triplex.

1031 Exchange Resources

For more information on 1031 exchanges of real estate, don’t hesitate to reach out to the qualified intermediaries at CPEC1031. We have decades of experience facilitating exchanges of all shapes and sizes and can help you defer capital gains on your next transaction.

• 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.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

What to Do if You Want to Stop Your 1031 Exchange After You Start the Process?

When you're doing a 1031 or even contemplating doing a 1031 exchange, the name of the game is to keep all of your options on the table as long as possible. When you're selling a relinquished property and you know you've got a looming tax bill, you may not know what you want to buy for a replacement property but you do know it's worth your while to try to defer those gains.

Identification of Property

So you'll set up your 1031 exchange and hope and pray that you can identify a replacement property or properties that you want to purchase. So you may identify one, two, or three properties in hopes that you can acquire those properties. But if it turns out that you can't or do not want to buy those identified properties, then you're going to ask yourself – “well if I’m not going to buy these exchange properties, can't I just get my money out of the exchange account, fold up my tent and go home?”

The answer is if you’ve paid a qualified intermediary to provide you a service and that service is to insulate you from receiving your exchange funds, can you just pack up your tent and go home? Or do the treasury regulations require the intermediary to continue to hold the funds until you receive the properties you designate, or the 180th day.

Qualified Intermediary

Your qualified intermediary really should hold your funds until the end of the exchange period. That way they legitimize their role in the transaction as a neutral third party that’s simply acting as a vessel to facilitate the exchange, and to the extent that you had received any replacement property that your exchange is valid as to those replacement properties.

The two times that you can tank your exchange are at midnight of the 45th day. If you choose not to do a 1031 exchange simply don't identify any replacement properties and the exchange will fail for lack of an identification. Alternatively, wait until the end of the 180 days and get back your unused surplus exchange funds after the exchange.

• 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.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

A Few Important Things to Know About Bank Financing in a 1031 Exchange

Many taxpayers conducting a 1031 exchange have questions about bank financing in a 1031 exchange transaction. Here are a few tips and things to know when it comes to bank loans and 1031 exchanges.

Bank Loan Agreement

The banks’s loan agreement may require the exchangor (through the intermediary) to exhaust the 1031 funds for the purchase of the replacement property and for the first construction draws before the banks loan funds will be disbursed. The bank cannot take a security interest in the 1031 funds held by the intermediary.

The taxpayer conducting the exchange may co-sign or provide a personal guarantee of the bank’s loan.

The ‘due on sale clause’ in the loan may need to be modified to allow for the transfer of the replacement property to the exchangor during the 180 day exchange period.

Depending on the number of exchangors, the 1031 exchange may be completed by:

1. deeding the replacement property from the LLC to the exchangors (with a corresponding mortgage assignment/assumption); or

2. by the intermediary assigning 100% of the membership interest in the LLC to the exchangor (which may negate the need for a formal mortgage assignment/assumption).

Items to Request

In a 1031 exchange with bank financing, you should request the following items:

• Prior Exchange Documents. Copy of the signed relinquished property 1031 documents from the sale with confirmation of the amount of funds held by the intermediary (we need to confirm who and how the old relinquished property was vested in title). The 1031 identification of replacement property should include a description of the new land plus the to-be-built improvements.

• Fresh LLC to hold title to the Replacement Property. Copy of the LLC articles, certificate of organization, operating agreement and authorizing resolution appointing the officers (this LLC will likely be 100% owned by the intermediary);

• Title Commitment for the new Replacement Property.

The loan documents may need to be modified to limit the liability of the intermediary.

• 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.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Consider 1031 Exchanges in Your Estate Planning

Many people that are getting up there in years are concerned about their estate planning as part of their 1031 exchange. Many people will own their old relinquished property in their own individual names but would prefer to take title to the replacement property as Trustees of their own revocable trust.

Taking Title to the Replacement Property

From the IRS’s perspective, when you take title to the replacement property as Trustee of your own revocable trust the IRS really doesn't make any distinction between John Doe individually and John Doe as Trustee of his own trust.

However, irrevocable trusts are a different and distinct animal and will not be viewed by the IRS as the same taxpayer, so we need to be very cautious as we do our estate planning as part of the 1031 exchange to make sure that we have the circuit completed. That the owner of the relinquished property either individually or as Trustee of the revocable trust receives title to the replacement property.

Continue to Hold the Property for Investment Purposes

Thereafter, the taxpayer that completes the exchange needs to continue to hold their replacement property for investment or business purposes for a long and substantial period of time, which means that as soon as you complete the exchange it would not be prudent to start giving away interest in the replacement property because giving away the property would be antithetical or opposite of holding the property for the qualified purpose of investment or business purposes.

• 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.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

A Brief History of the Reverse 1031 Exchange

1031 exchanges come in several different forms. There are real estate exchanges, build-to-suit exchanges, and more. In this article, we are going to offer a brief overview of the reverse 1031 exchange and how it can be used as a vehicle for tax deferral when selling real estate.

The Reverse Like-Kind Exchange

A reverse 1031 exchange is a like-kind exchange in which the taxpayer acquires their replacement property first, before selling their relinquished property. This is essentially the reverse of the standard order or operations. Reverse exchanges are often utilized in competitive real estate markets, where you might need to lock down a property before someone else does.

Reverse Exchange Guidelines

There are many guidelines that you have to be aware of when doing a reverse like-kind exchange. Here are a few of the most important rules:

• 180 Day Time Period. In any 1031 exchange you only have 180 days total to complete your exchange. If your exchange is not complete within this time period, it will fail.

• Like-Kind Requirement. All property involved in the exchange must be like-kind.

• Held For Requirement. You must also hold your property for business or investment purposes. You cannot 1031 exchange property held primarily for your own personal use.

• Value, Equity, Debt. Your replacement property has to be equal to or greater than your relinquished property in terms of value, equity, and debt.

Minnesota 1031 Exchange Professionals

At CPEC1031, we work with investors and taxpayers across the country on all sorts of real estate transactions. If you are interested in learning more about the tax benefits of a 1031 exchange, contact us today!

• 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.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved