Tom Gustafson

1031 Exchange: Seller Financing

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Given the current tight credit market, taxpayers who want to initiate a 1031 exchange may consider financing or carrying a note for a Buyer to acquire the relinquished property. A 1031 exchange is a strategy to defer the federal and state capital gains and recaptured depreciation tax when selling and replacing property held for productive use in a trade, business or for investment. The tax deferral represents an indefinite, interest free loan that can defer upwards of 40 percent of the sales price. 1031 eligible property includes real property such as timberland, self-storage units, commercial property, single family residential, oil and gas royalty interests as well as personal property including aircraft, precious metals, vintage cars, artwork and collectibles.

Structuring Seller Financing

The Buyer in a typical 1031 exchange acquires the relinquished or old property from the Exchangor with cash, debt or combination of the two. If the Buyer is not able to secure financing, the Exchangor may consider carrying the note. In effect, the note represents an installment loan; however, in a 1031 exchange, the Buyer’s note does not offset debt on the replacement property. The note must be converted into cash by one of the following methods:

  • Assigning the note to the seller of the replacement property as partial payment
  • Selling the note to a third party
  • The Exchangor or related party adding the cash equivalent of the note to the exchange as additional equity

The first two options may not be feasible, leaving the third option dependent upon whether the Exchangor has access to the note’s cash equivalent.

1031 Exchange Carry Back Note Steps

Given the Exchangor has the capital, the carry back note is negotiated between the Exchangor and the Buyer as normal. Prior to the relinquished property closing, the note is made payable by the buyer to the Qualified Intermediary. The relinquished property title is conveyed to the Buyer with a deed of trust and prior to the closing on the replacement property, the Qualified Intermediary sells the note to the Exchangor or a related party. Debt service payments, if any, are paid to the Qualified Intermediary and deposited into an escrow account along with the proceeds of the note sale used to acquire the replacement property. There is no tax when the Exchangor or related party receives principal payments on the note given they will have paid face value to acquire the note. Consequently, all payments other than interest are non-taxable.

One of the benefits of the carry back method described above is, should the replacement property not be acquired, the exchange fails and tax is reported on the installment method in the year the principal and interest payments are received.

Should the note be paid off to the Qualified Intermediary prior to the purchase of the replacement property, the proceeds are used towards the acquisition.

Contact our office at 800.227.1031 or send your questions by clicking on the request for a complimentary consultation below.

Capital Gains Tax Deferral for the Investor and Dealer

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Given today’s real estate market where the lure to fix and flip is a part of mainstream reality TV, a question often in the mix is whether a 1031 exchange will defer the capital gains taxes? With the newly renovated property, the next step is to either hold or resell. If the property is resold within a year of the purchase, the short term federal and state capital gains taxes can eliminate upwards of 40 percent of the gross profit. Can a 1031 exchange defer these taxes is now a question the investor or dealer must understand.

Intent and Facts

The Internal Revenue Code Section 1.1031 allows taxpayers to defer the gain or loss when property held in a trade, business or investment is exchanged for like-kind property held in a trade, business or investment. The proper intent to qualify for a 1031 exchange is that the property is held in a business or investment, unlike inventory held on the shelf at the auto parts store for profit or resale. Facts supporting proper intent include:

  • how long the property was held
  • whether or not it was rented
  • how was it itemized on the taxpayer’s federal tax return
  • amount of personal use

The shorter the hold, the more substantial the facts will need to be. The IRC does not specify a hold time, but the Internal Revenue Service has stated in writing that two years is sufficient.

Investor vs. Dealer

Enter another set of facts to understand: whether the taxpayer is an investor or a dealer. Before rationalizing the taxpayer is always an investor, it is important to understand how the courts are determining this outcome. An investor with the intent to defer gain in a 1031 exchange will hold the property to allow it to season as an investment, including renting the property at fair market rent. Personal use is limited to fourteen overnights per year. To be fully compliant with Revenue Procedure 2008-16, the property will be held for two years and in each of those years, the property will be rented fourteen overnights. The replacement property will also be held for two years and in each of those years, the property is rented out a minimum of fourteen overnights per year at fair market rent.

A dealer or the taxpayer who owns multiple properties can fix and flip, along with 1031 exchanges, given the two are accounted for separately. The court considers the following facts as provided by Klarkowski v. C.I.R., T.C. Memo. 1965-328:

  1. The purpose for which the property was initially acquired
  2. The purpose for which the property was subsequently held
  3. The extent to which improvements, if any, were made to the property by the taxpayer
  4. The frequency ,number and continuity of sales by the taxpayer
  5. The extent and nature of the transactions involved
  6. The ordinary business of the taxpayer
  7. The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property
  8. The listing of the property with brokers
  9. The purpose for which the property was held at the time of sale

The hard right decision, in the view of this qualified intermediary, is to pay the tax rather than pushing the envelope of a rationalized 1031 exchange. The surprise of an IRS audit is best offset with facts that support the proper intent.

Related articles of interest:

Tax Implications of Unwinding a 1031 Exchange

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Let’s face it. Times have changed. The tumultuous real estate market, renovations over budget, difficult tenants combined with the challenging job environment have resulted in questions about how to unwind a 1031 exchange. Imagine ten years ago, we survived the Y2K scare and were approaching the tech market bubble burst. Real estate appreciation was gaining traction. Washington was promoting regulations to help those interested in securing a home. Ten years is not a lot of time when you are young. But when you have experienced the depths of job loss, foreclosure and declining retirement portfolio your perspective changes questioning why not sell the rental property and cash out.

Three Reasons Why Unwinding a 1031 Exchange Makes Sense Before 2013

Every market is cyclical, which helps cleanse inefficiencies and to adopt new strategies. Adjusting to change is a maturing process requiring us to take note of the whole and the individual pieces. Three reasons why unwinding a 1031 exchange makes sense includes:

  • Historically low federal capital gains rate of 15% will sunset on December 31, 2012 to 20%. In 2013, federal capital gains will increase 3.8% Medicare tax for those earning over $200,000.
  • If in the ten or fifteen percent income tax bracket, your long term federal capital gains tax rate may be even lower than 15%.
  • Divorce and changing partnership interests: it may make sense to consider cashing out the partner and continue the tax deferral in another 1031 exchange if you want to continue holding real property.

Unwinding a 1031 Exchange

The first place to start is talking with your accountant to understand the tax consequences. If you are selling a replacement property purchased in a prior exchange, is you will have two sets of taxes, one due on the replacement property and a second set due on the original property sold. Questions to consider include:

  • What is your current federal income tax bracket?
  • Were the investment properties itemized on Schedule E?
  • Was depreciation taken on Schedule E of your tax return?

Your accountant will look to determine the adjusted basis of each property to determine the estimated recognized gain or tax due. The tax bill may not be as bad as you think. But not understanding the tax implication could also be quite risky.

If you would like to discuss the tax implications of unwinding your 1031 exchange, please contact us at office number 800-227-1031 or ask a question with the links above.

Farmland Auction Insights

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Atlas 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.

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1031 Tax Relief in Disaster Situations

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Floods, tornadoes, hurricanes, and other natural disasters can have an impact on the implementation of 1031 tax deferred exchanges. The Internal Revenue Service (IRS) provides written tax relief for disaster situations for taxpayers engaged in 1031 exchanges. If the exchange qualifies, the 45 and 180 calendar day time-lines can be extended. While our office was located in Destin, FL from 2003 – 2009, we had multiple experiences with exchange time-line extensions because of hurricanes including Ivan in 2004, Dennis, Katrina and Wilma in 2005, Humberto in 2007, and Gustav in 2008. It is important to have your accountant interpret the IRS notice to determine whether the exchange qualifies for extra time.

IRS Tax Relief in Disaster Situations

The IRS updates a page on their web site that lists the states and counties affected by the flood, tornadoes, hurricanes, and straight line winds. If you are in an exchange and either you, your qualified intermediary or replacement property are located in an impacted county, check the site to confirm whether you are eligible for an extension.

IRS Experience

A written IRS notice is crucial to utilizing a time-line extension. I witnessed a situation when the 1031 replacement property was in the county impacted by a hurricane. There was a lag in the time between when the notice was posted on the IRS web site and the action required. The action was taken based on the verbal response of the IRS agent stating that the extension would affect the exchange. However, it was not granted because of the absence of the written notice of the IRS.

Enlisting help from the experienced Certified Exchange Specialist® allows the property owner to avoid potential risks during 1031 exchanges and defer the capital gains tax successfully.

If you would like know whether you qualify for a 1031 exchange, download the free white paper below or contact our office.

Qualify for a 1031 Exchange?

Farmland Auction 1031 Bidder Insights

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The bidder’s position in the 1031 exchange cycle is one of the major factors affecting their bids behavior. Timing of the auction in relation to the 45th calendar day post old property closing can influence the bidder’s aggressiveness. Understanding the objective of a 1031 exchange and how it works should lessen the angst of competing bidders if the 1031 bidders are known. Ultimately, the bidding is not about the quantity of 1031 funds available but more importantly the bidder’s value point.

The 1031 Exchange Strategy

The 1031 exchange strategy allows for the deferral of the federal and state capital gains and recaptured depreciation taxes, which can represent 40% of the properties sales price. According to the Internal Revenue Code (IRC) Section 1031 “no gain is recognized when property held for use in a business or investment is exchanged for like kind property held for productive use in a business or investment.” Property refers to both real and personal property. The tax deferral serves as an interest free loan allowing for using those taxable dollars towards the purchase of a replacement property given the new property is equal to or greater than the property sold. The reward is that when the capital gains tax is ultimately paid, the risk of a higher tax rate is compensated for by either annual cash flow, a conservative appreciation or both on the replacement property.

What Affects the Exchangor’s Aggressiveness

Factors affecting the bidder with 1031 money, referred to as the Exchangor include:

  • Is the land adjacent to their existing property?
  • Quality of soil, history of crop production, topography, and water source
  • Has the Exchangor closed or in contract on their property?
  • If their property sold, is the auction before or after the 45th calendar day post old property closing?

Exchange Process

There are two types of exchanges, a forward and a reverse. In a forward exchange, which is the most common type, the old property is sold before the new property is purchased. In a reverse 1031 exchange, the new property is purchased before the old property is sold. A reverse is a bit more complex and expensive. The opportunity to defer the tax in the exchange can be lost if the old property does not sell within 180 calendar days. In addition, the farmer now owns two properties, and a Qualified Intermediary fee has been paid. The only reason the Exchangor may risk a reverse 1031 exchange is they have a buyer for their old property and a closing date scheduled. More importantly, they want to get the new property off the market now because it is undervalued or the Exchangor really wants the land.

Given today’s economy, many landowners would not favor taking a risk, and would prefer using a forward exchange. Consequently, they have two polar milestones:

  • Formally identify the replacement property to the Qualified Intermediary by the 45th calendar day post closing on the sale of their old or relinquished property
  • Close on the replacement property by the 180th calendar day post closing on the sale of their old property.

Knowing when the Exchangor closed on their old property and the sales price can provide valuable insights into their actions.

Sales Price of Exchangor’s Old Property

To determine the sales price, it is recommended to check with the Realtor, newspaper postings or County Clerk of Court web site. This will help to identify what the Exchangor needs to spend to defer their capital gains tax.

Closing Date of Exchangor’s Old Property

What was the date when the old property was sold? Once known, add 45 calendar days to understand where the Exchangor is in the identification milestone. If the auction date is before the 45th day, the Exchangor may be less aggressive bidding higher than their old property sales price because he may have time to locate other properties. If the auction date is after the 45th calendar day, the Exchangor has formally identified this property as one of potentially three properties (if using the three property rule) and will most likely be more aggressive.

Solution

The 1031 code defers the capital gains tax when property of equal or greater dollar value is acquired. If the Exchangor does not use all the exchange funds and debt retired on their old property, a tax is triggered on the difference. For example, a farmer sells land for $850,000. He will be looking to bid upwards of $850,000 for the new property. If the farmer spends $700,000, he will pay tax on the net difference less selling and purchase costs. If the competing bidders know the price and date the Exchangor’s old property was sold, they will be less likely to be frustrated at the price paid.

For those landowners who have 1031 funds to reinvest, there is no recourse but to hold the property for productive use in a business or investment. That implies but not limited to using the land for development, hunting, conservation and farming. If it is determined the property is used primarily for personal enjoyment, the IRS could question the 1031 exchange and potentially disallow the tax deferral resulting in an audit, penalty and taxes due.

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