The role of debt in a 1031 exchange

The role that debt plays in an exchange is probably one of the most misunderstood areas of 1031 law. Many people (including qualified intermediaries, CPAs, and attorneys) believe that you are required to have debt on your New Property in an amount equal to or greater than the debt that was paid off on your Old Property. This is NOT, In fact, a requirement for a 1031 exchange.

The actual requirement is two fold: you must buy equal or up, and you must reinvest all of the cash. Assume for example that you sell a purple duplex for $100,000 and you buy a replacement property for $90,000. You did not buy equal or up; in fact you bought down. As a result, the $10,000 buydown is taxable—yes, the entire $10,000 is taxable, and you do not apportion any of the original cost of the duplex to this gain.


Multi-Ownership issues in 1031 exchanges?

You and your co-partners, Fred and Sue, have decided to sell the small apartment building that you boght a few years ago. You got it for a steal and you've got a nice profit in it. It's not been on the maket long and you now have a full price offer.
You've always assumed that when you sold this property the three of you would roll into the purchase of another property, but Fred just told you that he wants to take his share and buy a new pickup. Yikes – and now Sue isn’t she so sure that she wants to buy another property. You don’t want to cash out because you’re pretty sure that Uncle Sam will take all your gain in taxes. Maybe selling the building wasn’t such a great idea.


A reverse exchange could be your solution in this current real estate market

The One problem that comes up in almost every conversation I have with clients right now is how hard it is to find a replacement property. There’s very little inventory, and worthwhile properties get scooped up immediately. As a result, many of my clients are afraid to pull the trigger on their sale. A reverse exchange could be their solution in this dilemma.

Just as its name implies, a reverse exchange allows you to take advantage of the tax benefits of a 1031 exchange, but instead allows you to purchase your new property before you sell your old one. In a reverse exchange, your qualified intermediary takes title to the new property and holds it until you close the sale of your old property. This allows you to tie down the purchase of your new property before you pull the trigger on the sale of the old.


What's the future of 1031 exchanges?

There is still talk coming out of Washington, DC, concerning tax reform of some type that might yet happen during the two and a half years Obama has left in his term. Certainly the landscape has changed now that the Republicans control both the House and the Senate, and yet the talk continues. It seems unlikely at this point that Congress and the White House would ever agree on any type of individual tax reform; however there seems to be some middle ground for reforms involving entities (corporations, partnerships, trusts, etc.).


Refinancing 1031 Property In An Exchange


To refinance or not to refinance: this is the common question many 1031 exchangers ask.

By refinancing, exchangers are usually hoping to pull money (cash) out of their sale transaction to use for purposes other than investing in new 1031 property.

To answer the question, we need to understand the timing of the refinance. Based on the whether you, the taxpayer, are pulling money from the old relinquished property or from the new replacement property, the IRS has varying positions. 

When refinancing the old property, a key 1031 exchange requirement drives the IRS’ position. The taxpayer cannot receive, touch or control the funds generated from the sale of the old property during the period until the purchase of the new property. Does refinancing the old property right before the exchange constitute “receiving money”?


Bare Bones Basics of a 1031 exchange

1031 exchanges, at least as we know them today, have been around since 1991. Most people in the real estate industry have heard of them and seem to have a good working grasp of how they work, and what the requirements are. Occasionally we get calls from someone who has not heard of a 1031 exchange, or has no clue what the rules are. So now would be a good time to do a refresher course, if you will, on the basic rules of an exchange.

Rule #1 – Both the Old Property and the New Property must be held for investment or used in a trade or business. Many people think that if you sold a purple duplex, you must buy a purple duplex. This is not the case – you can buy any other kind of investment real estate: you could buy an apartment building, an office building, a warehouse or bare land.


1031 In a Nutshell

What is a 1031 Exchange?

People ask, “Why should I do a 1031 exchange?” I can answer this question in two words: "Financial Leveraging." By doing a 1031 exchange, the taxes you would have paid to the government are now working to earn you money.

A 1031 exchange allows a taxpayer to postpone their long-term capital gains tax when selling an investment property by exchanging both the basis and the gain into a new investment property. This gives an investor financial leverage. If you have a property used for investment or business and you plan on buying another property used for investment or business, then yes, you need to do a 1031 exchange.


Common 1031 Misconceptions

In simple terms, a 1031 exchange moves the gain from the sale of an old investment property into the purchase of a new investment property. By moving the gain into a new property, you defer paying tax on that gain into the future.

For example, suppose Jane Doe sells her rental house for $200,000. She bought it five years ago for $150,000. Now using a 1031 exchange, she buys another investment property for $200,000. By following the IRS’s requirements, she is able to transfer all her gain into her new property instead of paying taxes on the sale.

Since the most recent real estate boom, people have become more aware of 1031 exchanges than ever before. Even with this increased awareness, there are still some prevalent misconceptions about this specific section of the tax code. As a 1031 exchange consultant, I hear these misconceptions everyday. Here are the most frequent three I hear:


Why do a 1031 Exchange?

1031 is a section of the tax code that allows you to sell your investment property (almost any property other than your personal residence), buy a new investment property and defer all of the capital gains taxes from the old property to the new one.

This does three things for you:

  1. you don't have to turn over to the government upwards of a third of everything you made on the property

  2. you now have all that extra money to spend on the new (replacement) property

  3. it may help you avoid the dreaded Alternative Minimum Tax (AMT). In short, its way of preserving your working capital as you build your real estate empire.

all the money you would have paid to the government is now available to buy a better condo...


Getting More by exchanging rather than selling

If you own business or investment property, you may be able to save thousands of dollars by exchanging your assets instead of selling them.

A like-kind exchange under Internal Revenue Code Section 1031 allows you to defer the taxes on capital gains by exchanging rather than selling. This tax deferral is available for both real estate (dirt and everything screwed into it) and personal property (things you can pick up and move). This can save you in Federal and State taxes anywhere from 15% to 35% on each dollar of gain realized, depending on your state’s tax rates.

There are a few basic steps that will be required under code section 1031 to enjoy this great financial advantage.