Reverse 1031 Exchanges in a Rising Interest Rate Environment

When you do a 1031 exchange you’ve only got 45 days after the closing of your relinquished property to identify your replacement property and 180 days total to complete the exchange. That rule was created by the IRS, with power granted by Congress to write the treasury regulations. With this time frame, the IRS was trying to constrain the number of people completing 1031 exchanges. These identification deadlines are hard and fast. Unless you’re impacted by a federally declared disaster, these are unwavering deadlines.

Reverse 1031 Exchange Benefits

So what are savvy real estate investors doing to avoid a potential failed 1031 exchange? They’re finding their replacement property first, and lining up a sure thing whenever possible. This is otherwise known as a reverse 1031 exchange.

Logistically some sellers are entering into a purchase agreement with their buyer and saying “buyer, I’m happy to sell to you at this price, but I as the seller get to control the closing date.” This allows the seller to hold off on the closing until they’ve got a replacement property lined up. That works great when you’re not in a rising interest rate environment. But right now, we are in a rising interest rate environment where banks are not going to let potential borrowers get a rate lock for a long period of time. As a result, there is often a tension between the buyer and seller where the buyer is chomping at the bit to close the deal and the seller is reticent to take the plunge until they have a sure thing lined up.

• 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.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved

How Do you Calculate the Amount of Deferred Gain on a Partial 1031 Exchange?

In a partial 1031 exchange you’re only deferring gains to the extent that you’re buying replacement value over and above your transferred basis. Let’s say you sold a relinquished property for $2 million but you had a $250,000 remaining basis in the relinquished property. The first thing that happens when you buy a $1 million replacement property is that your $250,000 basis transfers over to the new acquisition, and you only defer gains over and above that transferred basis.

A partial deferral is better than no deferral at all but it’s not optimal. The best course of action to do a full 1031 exchange is to plan things out and make sure you have enough replacement property to defer all of your gains.

Can I Sell a Relinquished Property Worth $2 Million & Acquire a Replacement Property Worth $1 Million?

The answer depends on how low your basis is on your relinquished property. The first thing that happens when you do a 1031 exchange is that your old basis transfers to the new property. You only really start deferring gains to the extent that you buy real estate over and above your transferred basis. So if your basis was zero (you have a $2 million gain and you buy a $1 million replacement property) you’re going to defer half of your potential gain. This is what’s known as a partial 1031 exchange.

There are a few ways to fix that issue. One is to identify multiple replacement properties and close on enough of those properties so that you’re deferring all of your gains. The other is to do a build-to-suit exchange and construct improvements on that property using your exchange funds.

• 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.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved

Burying Your 1031 Exchange Proceeds in Raw Land

Normally raw land is non-depreciable. You cannot depreciate it, so it’s kind of like a cost of doing business. You have to put money into the dirt and you can’t recoup your outlay for the dirt until you eventually sell the dirt. What some investors are doing is they’re taking an apartment building that they’ve fully depreciated and they have maybe a $2 million gain from the sale of this apartment and they’re taking that $2 million and using it to 1031 exchange into a $2 million+ piece of dirt. In other words, they’re burying their gain in the dirt.

The nice thing about buying dirt with your 1031 exchange money is you’re burying your gain in an asset that could not have otherwise been depreciated. Then later you construct your improvements on top of the ground estate and you’d have completely fresh basis in your newly constructed improvements.

Do you Have to Build Improvements on Top of That Dirt for the 1031 Exchange to Succeed?

If the value of the dirt exceeds the net sales price of the relinquished property so you’re continuing your investment into property of equal or greater value, then no improvements are necessary for a successful 1031 exchange because you’ve already got the value. The reason you may want to do a build-to-suit exchange is when the unimproved piece of dirt isn’t of sufficient value and you want to construct improvements with your remaining exchange funds.

• 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.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved

In a 1031 Exchange, Are Closing Costs Backed Out of the Seller’s Taxable Gain?

If one were to hypothetically sell a property for $1M with 6% commissions and closing costs (or $60k) and it has a current tax basis of $800k, would the seller’s taxable gain be $200k or $140k? In other words, are commissions and closing costs backed out of the seller’s post sale taxable gain?

This is an excellent question that comes up a lot in 1031 exchanges. Certain transactional expenses reduce the “amount realized” on the sale or exchange of real property.

3 General Rules of Thumb

There are three general rules of thumb to quickly see if you will defer ALL of the recognition of gain.

1. Typically you will acquire replacement property that is “up or equal” in Value* (price); {*net of sales commissions and customary transactional expenses}

2. You will roll over all of your Equity (net proceeds) from the relinquished property into your replacement property.

3. And to the extent that you were relieved of liabilities and Debt, such as mortgages on your old relinquished property, the debt relief is offset by (1) new liabilities or mortgages taken on in conjunction with your purchase of the replacement property; OR (2) by investing additional cash in the replacement property equal to the amount of liabilities and debts that were discharged.

You can have a partial tax deferral if you miss these general benchmarks. Be sure to check with your CPA about these general rules of thumb, to make sure they apply to your specific situation.

For more information on this topic, check out this article.

• 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.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Exchanges Involving Seller-Backed Financing

This article discusses a specific 1031 exchange situation we recently dealt with involving seller-backed financing. Our client came to us with the following question:

• Can a 1031 exchangor complete their like-kind exchange by purchasing property with seller-backed financing on a land-contract, or contract for deed?

The short answer is yes. Generally speaking, in a 1031 exchange a taxpayer can purchase property on a land contract or contract for deed as the vendee.

Exchange Funds

Typically, all of the exchange funds are used to pay the down payment, and the remainder of the purchase price is financed by the seller.

For tax purposes, the vendee is deemed to be the equitable owner of the replacement property; and the seller is treated as a creditor holding bear legal title as an enforcement mechanism to ensure payment of the debt.

The Devil is in the Details

Contracts can be written in many different ways, and the devil is in the details…so before proceeding with a 1031 exchange in this situation, you will need to answer the following questions:

• Does the vendee have exclusive possession of the property?

• Is the vendee responsible for the property taxes and insurance?

• Does the vendee bear the risk of loss in the event the property is damaged or destroyed?

• Is the vendee effectively the owner of the property for all practical purposes except for financing?

These are all essential questions you’ll need to answer with the help of your qualified intermediary in order to ensure a successful 1031 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.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved