For the uninformed, 1031 exchanges can be confusing, yet for those who have initiated them, they are an effective strategy to defer the federal and state capital gain and depreciation recapture. Some believe that all that is needed is for someone to hold the exchange funds. Nothing could be farther from the truth. If that is what you are being told you are potentially headed for trouble.
Since 2003, I have been accommodating exchanges, both simple and complex, forward and reverse and domestic and international. In that time, I have fielded thousands of incoming calls from experienced investors to the exchangor asking, “What do I need to know about a 1031 exchange?” First, you need to take ownership of what you may be undertaking and second, locate an accommodator or Qualified Intermediary who accommodates 1031 exchanges as their only source of income, rather than someone who merely fills in the blanks. By taking ownership, your questions will be that much better, plus you are the one who decides to initiate the 1031 exchange with the help of your CPA. The Qualified Intermediary is one who accommodates the exchange after you have made the decision to move forward.
Mortgage and Equity Boot
Many first timers have been told or believe that only the net proceeds from the sale needs to be reinvested to defer the gain. If the property being sold does not have a mortgage, then correct, only the net proceeds need to be invested in the replacement property to defer the gain and depreciation. If there is a mortgage, then the mortgage value also needs to be replaced, either by securing another mortgage of equal or greater value or offsetting the mortgage with additional cash. Beware though, that additional debt does not offset the cash or equity requirement.
If the decision is to replace with real property less than the net sales price, the IRS will assess tax on the difference, otherwise known as equity or mortgage boot. Many partial exchanges make sense but only after asking your CPA two questions: what is the tax consequence of the sale without a 1031 exchange and what is the tax consequence on that portion of funds not reinvested? Compare the two numbers. The outcome may be that the tax on the partial is close to the tax if an exchange was not initiated.
Same Taxpayer Requirement
The taxpayer who sells is the taxpayer who must buy. What happens if the wife is on title to the old or relinquished property and she wants to have her husband on the replacement property with her? In a community property state that will work. If the lender requires the husband to be on the mortgage and the replacement property deed, that will work. Otherwise, the wife should complete the exchange in her name and add her husband once the exchange is completed.
Merging the Tax Calculation with the Closing Statement
All too often, the first time exchangor believes incorrectly that the original earnest money deposit and funds used to make improvements to the relinquished property can be refunded at closing. After all, those funds were already taxed once. Surely not twice. The IRS has a different perspective. Cash can be taken at the first of two closings but is taxable.
First time exchangors are eager to explain their original purchase price plus the value of their improvements to support their understanding that funds should be returned to them. The best time to receive funds is at the first closing but they are taxable. What is relative is the closing statement reflecting the gross sales price—less the selling expenses, including sales commission, title, transfer and recording and qualified intermediary fees—equals the net sales price. The net sales price is made up of the outstanding mortgage that will be paid off at closing, if any, and the net equity or cash that is wired to your escrow account created under your tax identification number.
Caveat emptor or buyer beware applies to 1031 exchanges. Do your homework, search for answers on the Internet, ask your qualified intermediary questions and most of all, ask for insight from your CPA as to whether a 1031 makes sense.
