Tom Gustafson

What a Lender Should Know About a 1031 Exchange

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Recently I spoke with a mortgage office about 1031 exchange basics and the circumstances where they would typically see one. Here’s a quick read for those new and old to the mortgage industry.

1031 Exchange Basics

Who: Individuals, trusts, partnerships, corporations both domestic and foreign are eligible for the tax deferral.

What: Real property held for investment or for use in a business are eligible for 1031 consideration. Property is sold and replaced. Real property can be replaced with any kind of real property. U.S. can be replaced by U.S. based property while international property is replaced with international property.

Why: A 1031 exchange enables the titleholder to defer federal and state capital gains and recaptured depreciation taxes representing upwards of 40% upon sale of the old property.

When: The tax deferred exchange must be signed prior to or at the closing of the first property. The Exchangor must complete their tax deferred within 180 calendar days post the first closing.

How: The use of a qualified intermediary is required to effect a 1031 exchange, except in a two party or “pure” exchange. Given the moderate intermediary fee, it is well worth an accommodator facilitate the exchange.

Forward and Reverse 1031 Exchange

There are two primary types of exchanges, a forward and a reverse. Forward exchanges are when the old or relinquished property is sold first followed by the acquisition of the replacement property. In a reverse, the replacement property is purchased first, with 180 calendar days to sell the old property.

Here’s where you come into the transaction. The Exchangor needs to acquire the replacement property first. In a reverse 1031 exchange, the Exchangor is not allowed to own both the new and the old at the same time. The qualified intermediary creates an Exchange Accommodator Titleholder (EAT) in the form of a single member limited liability company to take title to either the new or the old property for the duration of the 1031 exchange.

If the EAT takes title to the new property that the Exchangor is financing with you, the EAT signs a non recourse note, guaranteed by the Exchangor. Payments continue as normal with the EAT temporarily on title. The Exchangor signs a triple net lease with the EAT to cover insurance, taxes and expenses of renting the property. Once the old property is sold, title for the new property is transferred to the Exchangor.

If the EAT takes title to the old property, the new property financing continues as normal. With the EAT on title to the old property, mortgage payments continue to be paid by the Exchangor. The property is marketed and sold with the Exchangor signing the settlement statement under “Read and Approved” while the EAT signs as the Seller. The 1099 bears the name and address of the Exchangor.

If the old property fails to sell, the property parked with the EAT is conveyed to the Exchangor by the 180th calendar day.

Many of my referrals come from mortgage brokers seeking a seasoned qualified intermediary to accommodate reverse 1031 exchanges. If you have a question, feel free to reach out via the links above, or call our office at 1-800-227-1031.

Farmland Auction Insights

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Farmland Auction InsightsAtlas 1031’s Andy Gustafson attended a farmland auction held by Schrader Auctions and shares his insights into the bidding process. He learned there are two types of bidders simultaneously accessing the value or price points. The individual bidder considers one or a combination of tracts while the whole bidder is analyzing price points for the whole or entire farm. Each has their value point they will not exceed. It is a fair and expedient process pitting the sum of the individual bids against bids for the whole.

In a large banquet facility located on the Boone and Hamilton County line, a couple hundred registered bidders and interested bystanders listened to veteran auctioneer Rex Schrader, CEO of Schrader Auctions, cover auction procedures. For the next two hours, a 681-acre farm parceled into thirteen tracts representing high quality cropland, fenced pastures, woodland and streams, recreation areas and ½ mile rows with good frontage and updated drainage would be the focal point of competitive bids for the whole and individual tracts.

The room was laid out with a large screen showing a map of the farm in parcels numbered 1 – 13. Next to the map was a spreadsheet, continually updated with the parcel number, bid, bidder’s number, and price per acre. To the left and right of the screen, large whiteboards were used to show the bids by parcel number, combination of parcel bids, bids for the whole and current sum of parcel bids. The auction team began their orchestrated movements starting with updating the whiteboard when Mr. Schrader opened the auction for a bid on tract number one.

“$300,000 …, now $325,000,”rang the call of the auctioneer. “Now $350,000 for a 75 acre tract with 60 acres high quality cropland and 15 acres nice woodland.” The tract has county drainage tile and new drainage improvements. Indiana farmland has been sold for $7,000 and higher per acre. The current $4,666 per acre bid would later be replaced with a winning bid of $480,000 or $6,400 per acre.

Schrader Auction agents walked the bidders’ tables, talking specifics with bidders and notifying  Mr. Schrader that they had a new offer. The spreadsheet and whiteboards were updated with the bid and the bidder’s number. The process would repeat itself over and over with individual bids, updates, combination parcel bids and ultimately, bids for the whole. It was a well coordinated event run by professionals that clearly understand the auction process. Mr. Schrader was helpful highlighting those undervalued parcels encouraging additional bidder consideration. When the whole parcel bid exceeded the sum of the individual bids, Mr. Schrader would suggest to the individual bidders to consider increasing their bids by $10,000, not to meet but rather exceed the whole bid.

I sat next to one of the eventual winning individual bidders. He came to the auction with financing and down payment in place to bid and not exceed his value point. When his combination parcel bid was exceeded, he would counsel with a Schrader agent to confirm his new bid would be sufficient to exceed the current bid. In the end, his bid was increased beyond his value point and he quickly placed another bid for a combination of two tracks he had walked the day before as a contingency tract. His intent is to build a home and possibly sell a portion of the land for residential lots. His tracts represented 38 acres with 14 acres cropland for hay and 24 acres woodland on both sides of a creek. What he bought for $4,800 per acre contrasts with the $25,000 per acre zoned R1 or residential asking price within eye site in Boone County, a northern suburb of Indianapolis.

New Zealand International 1031 Exchange

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A 1031 exchange defers the federal and state capital gain when a taxpayer sells real property held for rental outside the US and replaces with like-kind real property of greater value internationally. Navigating the social norms with attorneys, banks and closing entities can be a huge challenge given those entities know very little if anything of a 1031 exchange. When the words, Internal Revenue Service are mentioned, many entities may elect to not participate or say no to the accommodator’s requests.

A recent international exchange for real property held in New Zealand was successfully exchanged for real property in Canada. The challenge from the beginning was to have the closing entity wire funds to the local New Zealand bank and then to wire to Canada for the replacement property, while including the facilitator in the process. One of the closing entity’s concerns was that the deferred exchange had the cloak of a drug deal. In addition, there has been much concern regarding the prices of real estate in countries like New Zealand, Australia, and Canada, and the authorities in New Zealand have warned about heightened scrutiny for all large transactions. In the end the exchange funds were successfully wired directly to the bank in Canada to wait for the time to apply towards the closing.

Recently Canada implemented a new regulation taxing non Canadian citizens a fifteen percent tax on metro Vancouver real estate purchases. At this point in the exchange, was it still worth the deferred taxes? Fortunately, the spouse of the New Zealander is Canadian and the tax requirement was not applicable given the husband/wife live in the community property state of Texas.

Another consideration was that the purchase in Canada was for an unfinished condominium. The closing was delayed due to construction delays multiple times, eventually being closed only a month before the 180 day closing date limit.­

There were many challenges to this exchange. The Exchangor had a can-do attitude and the Escrow Holder was willing to be flexible, so with a lot of effort and follow thru we achieved the final outcome of a successful 1031 exchange.

Quote from the Exchangor:

“Andy was fantastic from the start. There were a number of obstacles that we had to overcome, and with his experience, he was always there to suggest legal alternatives that helped us work through banks and lawyers that were sometimes afraid to participate due to their unwillingness to work with foreign tax issues. I would not hesitate to work with Andy again.”

D.W.,

Dallas TX

Deductible and Non Deductible Selling Expenses in a 1031

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What selling expenses in a real estate transaction are not taxable if paid from the 1031 exchange proceeds? Specifically, in a 1031 exchange, what selling expenses can be paid from exchange proceeds without triggering a tax?

Deductible Selling Expenses

Selling expenses that are not taxable typically include:

  • Commissions
  • Finder’s fees
  • Title charges
  • Title search fees
  • Title examination
  • Notary fees
  • Title insurance
  • Document Prep
  • Courier fees
  • Escrow fees
  • Tax certification
  • Pest inspection
  • Testing fees
  • Survey
  • Gov’t recording
  • Home warranty
  • Legal and 1031 fees
  •  QI fees

Minor repairs required for the sale can be paid from exchange proceeds directly to the contractor.

Non Deductible Selling Expenses

Selling expenses that should be taxable as ordinary income include:

  • proration of rents;
  • property taxes;
  • property insurance premiums debited against the Exchangor;
  • reserves deposited with the lender and utilities;
  • any items payable in connection with a loan are considered taxable.

Reimbursement for major repairs, capital improvements and earnest money deposits are considered taxable. The Service views the first dollar paid out as taxable. In a 1031 exchange if you need to pull these funds out, a post exchange refinance is an alternative. After the replacement property has closed, secure a line of credit on the property. You can then pull out cash without triggering a tax.

Another alternative is to do a partial exchange, recognizing that any cash received is taxable. There is a point when the equity pulled approaches 50% that it does not make sense to initiate a 1031 exchange. Always seek the counsel of your accountant for tax planning strategies like 1031 exchanges.

Foreign Property, Virgin Islands and 1031 Exchange

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As is often the case during the cold winter months in North America, questions regarding whether a 1031 exchange is applicable to properties in the Caribbean surface for clarification. As a former Rio Mar resident in Rio Grande, Puerto Rico, the question and picture stirs memories of sand, aqua blue waters, a young family, good friends, deserted beaches, lechon asado, Metropol in barrio Hato Rey, Medalla and warm sea breezes.

Foreign Property

In 1989, Section 1031 was amended with Subsection (h)(1) stating that real property located in the United States is not considered like-kind with real property located outside the United States. Foreign real and personal property used predominantly in a foreign country is eligible for 1031 exchange tax deferral treatment when exchanged for real and personal property located in a foreign country.

Virgin Islands

Section 7701 of the Internal Revenue Code (IRC) defines the borders of the United States as all fifty states and the District of Columbia. The Internal Revenue Service defined the borders of the U.S. to include the U.S. Virgin Islands for 1031 eligibility given the Exchangor is:

(1) A citizen or resident of the United States and

(2) Has income derived from sources within the U.S. Virgin Islands, is effectively connected to the performance of a trade or business in the U.S. Virgin Island or files a joint return with an individual who derives an income or is connected to a trade or business within the U.S. Virgin Islands.

Both requirements must be satisfied to exchange real property in the fifty states and real property located in the U.S. Virgin Islands.

Puerto Rico and Guam

Puerto Rico, though a Commonweath of the U.S. is not eligible for 1031 consideration. Guam is eligible for 1031 tax deferrals. It has been suggested that Sections 932 and 935 of the Internal Revenue Code provide special rules that treat Guam and the U.S. Virgin Islands as part of the U.S. while Puerto Rico is not.

FIRPTA

US citizens and foreigners owning real property outside the US defer federal capital gains taxes with a 1031 exchange when replacing with real property located outside the US. Foreigners selling US located real property must comply with the Foreign Investment in Real Property Act of 1980 (FIRPTA).

A nonresident alien individual, foreign corporation (unless a valid election under Section 897(i) has been made), foreign trust, but not a resident alien individual is considered a foreign person according to Regulation Section 1.4445-2(b)(2)(i)(C).

For more information on FIRPTA or a foreign 1031 exchange call us at 800-227-1031.

Hurricane Michael: IRS 1031 Exchange Updates

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First and foremost, our thoughts and prayers go out to all of our friends in the Panhandle of Florida and beyond as Hurricane Michael makes landfall. Destin, Florida was home to us for many years and we have family, life long friends and great colleagues in the area.

As the storm has yet to fully pass through this region and others in its path, we wanted to post the IRS website for any of our friends, colleagues or exchangor’s in that region. In the coming days and weeks, this site will be updated with the most current information that might affect the timelines for 1031 exchanges in this area. Though this is the least of anyone’s concerns at this point (as it should be), we hope it will help and or make this time any easier for our friends in the area.

All current information that may pertain to tax relief in disaster situations by Hurricane Michael can be found here.

In the mean time, here are other ways to donate your time or funds to those affected by Hurricane Michael.

The American Red Cross

You can donate online to help people affected by Hurricane Michael.

Volunteer

There are many organizations and faith-based groups that have active disaster programs and need volunteers.

Here’s a link to volunteer in Florida.

Here’s a link to volunteer in Georgia.