1031 News

Several years ago, the State of California adopted a claw-back rule for 1031 exchanges when the sale property is in the State of California and the replacement property is in a different state.

Like most states, California does not tax sales of real estate when the taxpayer does a 1031 exchange and rolls the gain over to a replacement property. Typically, when you sell a property in one state and buy in another state (doing a 1031 exchange), the selling state loses the tax revenue that would have resulted from the sale if it were not a 1031 exchange.

Several years ago California broke with that tradition and revised their 1031 law to hold that when the taxpayer ultimately sells the property in the replacement state in a taxable transaction, the taxpayer must report the original gain to California and pay tax on it. For example, Sue sells a rental property in California and rolls a gain of $100,000 into a property in Denver, Colorado by doing a 1031 exchange.

A basic rule of 1031 exchanges is that the taxpayer who owns the old property must be the one that does the exchange and takes title to the replacement property. For example, if Fred Jones owns the old property, Fred Jones must be the one who takes title to the new property—he can’t take title as Jones Investment Corporation because the corporation is a different taxpayer.

While that seems fairly straight forward, there are some aspects that can be confusing. For example, suppose Sue owns a rental condo before she and Fred got married but she didn’t add Fred to the title after they were married. Now she’s selling the condo and wants to exchange into another rental property and add Fred to the title of the new property. This exchange would be disallowed because the IRS could rule on audit that she only bought half of the new property (and Fred bought the other half).

I’m getting a lot of questions right now about who can do a 1031 exchange, so let’s take another look at the rules. Section 1031 says that the taxpayer is the one who sells the old property, buys the new property and reports the exchange. It sounds simple, but what does this mean?

A common question I get is whether you can rent an exchange property to a relative. Most typically the client wants to buy a replacement property that they can rent to their son or daughter. The answer is yes you can – provided that you strictly follow two basic rules: 1) the rent you charge has to be fair market value for that type of property, and 2) your rental agreement must be in writing and you must enforce the terms of the agreement (most importantly the clause dealing with the late payment of rent).

By far, the most important of the two rules is the fair market value requirement, and a recent court case shows just how important this rule is. 

I've written a couple of articles over the years about bifurcating a sale into at least two parts so that you can take advantage of Section 1031 and roll the gain over to a replacement property. “To Bifurcate” means to split something into two parts. For example, separating the sale of a ranch between the residence portion (which does not qualify for a 1031 exchange if you live in the residence) and the ranch land and outbuildings, which in most cases do qualify for a 1031 exchange.

But bifurcation also works when you buy a property. You can sell a rental house and use the 1031 exchange proceeds to buy ranch land and outbuildings as your replacement property, and use personal funds to buy the residence portion of the property to live in. Similarly, you could sell the rental house and buy a percentage of a large property (like an office building) as your replacement property, while a partner buys the balance of the property. 

Again, at this time of year, I'm writing my usual end-of-the-year prediction on where I see the 1031 exchange industry going in the coming year (which in this case is 2013).

Although mortgage rates are low right now, it’s hard for most people to get the type of financing they want when they buy a property. It seems the banks still don’t want to part with their money. The end result may be that you have a serious buyer who’s made you an agreeable offer, but who’s having trouble connecting all the dots on the mortgage. He may ask for your help with seller financing.

Financing the purchase of real estate is tough right now. Lenders are very picky and only a few buyers have come through the last few years without a ding or two to their credit ratings. As a result, it’s not uncommon for buyers to ask sellers to help with the financing of the purchase of the property. 

A recent 2012 Tax Court case, which allowed a coupleto move into their 1031 replacement property eight months after the purchase, will once again excite those investors who focus on intent, rather than a minimum holding period to qualify for a 1031 exchange.

Section 1031 says that to be eligible to do an exchange, you have to have intent to hold the property as an investment, and if your intent is to hold the property for resale, you're not eligible to do an exchange. The problem with all this is that Section 1031 does not define the terms intent, investment or resale.

A large body of investors and investment advisors hold that if your intent is to hold the property for a profit, then you qualify for a 1031 exchange regardless of the holding period. Over the years we've dealt with attorneys and CPAs who insist that if you have a profit intent, you should be able to exchange a property that you've owned for as little as a day or two.

Since this is tax season, it's a good time to remind you that if you have taken boot in a 1031 exchange transaction, it's absolutely critical you keep detailed records with your replacement property records.

"Boot" is what the IRS and the tax community calls the taxable part of an exchange. Boot typically arises when you buy down or take cash out of the exchange. The reason that records are so critical in this situation is that when you have boot, depreciation recapture is the first thing taxed, which reduces the future amount you have to recapture. Unless you keep track of the fact that you've already recaptured this amount in your records, and carry this notation forward from year to year until you sell your property, you could easily end up paying this tax again.