Lake Amistad Ranch located 25 miles north of Del Rio, Texas is an eligible 1031 exchange property. This 890 acre ranch has water access to the number one Bass lake in the United States, Lake Amistad. Owner has access to fish, swim, canoe or other water activities is available along with hunting for white-tail deer, quail, doves and javelinas.
1031 Exchange Blog
Over the past 17 years, we have had the pleasure of guiding thousands of Exchangors through the 1031 Exchange process. Our Blog draws from that experience and includes content ranging from the basics of an Exchange for first time Exchangors to detailed commentary on complex exchanges for the expert investor. If you do not find the topic or specific question you are looking for, reach out to us via email at info@atlas1031.com or call our office to speak with our team at 1 800 227 1031.
Deferred Taxes
Deferred taxes is the outcome of Section 1031 of the Internal Revenue Code for taxpayers in certain qualifying situations. The rules on deferred taxes are very strict, but if they are met, the benefits can be substantial. Section 1031 allows a property owner to defer the federal and state capital gains tax that would typically be due at the time of the sale of the property until a point in time in the future if the proceeds and debt retired from the sale are equal to or greater in the replacement property.
Capital Gains Tax
As most taxpayers already know, the sale of a capital asset potentially exposes the seller to a capital gains tax obligation. In order to avoid owing capital gains taxes, a basic understanding of capital assets and gains is in order.
Soft Costs in an Improvement 1031 Exchange
When a taxpayer sells property outright, any gain realized on the sale of the property is potentially subject to the typically high capital gains tax rates. One option for a taxpayer who wishes to avoid incurring a capital gains tax obligation is to enter into a “like-kind” exchange instead of a traditional sale. Under the Internal Revenue Code, Section 1031 allows such an exchange if all relevant conditions are met. In a simple Section 1031 Exchange, a taxpayer must designate a property to be relinquished as well as a replacement property to be exchanged. A Qualified Intermediary, or QI, is then used to facilitate the exchange, which must be completed within 180 days. Additionally, the properties involved in the transaction must be held either for productive use in a trade or business or for investment.
Improvement Exchange
Over the years since Section 1031 was created, like-kind exchanges have taken on many complicated forms that have required the Tax Court to rule on their eligibility. One such evolution is known as the “improvement exchange,” “built-to-suit exchange,” or “construction exchange.” In this type of exchange, improvements are made to the replacement property as part of the exchange. Often, an improvement exchange contemplates improvements made on real property that is already owned by the taxpayer in what is recognized as a Leasehold Improvement Exchange. Because Internal Revenue Service Revenue Procedure 2000-37 prohibits a taxpayer from simultaneously owning both the relinquished property and the replacement property, this type of exchange requires the replacement property to be “parked” with an Exchange Accommodation Titleholder, or EAT, throughout the 180 day period during which the improvements are taking place. One issue that a taxpayer may face when participating in an improvement exchange relates to “soft costs.”
Soft Costs
The overall goal of a Section 1031 Exchange is to avoid receiving any cash or assets directly, thereby avoiding capital gains taxes. If any money or property is received by the taxpayer, either directly, indirectly, or constructively, it is considered “boot” and is taxable. In an improvement exchange, there are a number of costs that could be considered boot. Understanding which of these “soft costs” are tax-deferred and which are considered “boot” is critical for a taxpayer contemplating an improvement exchange.
I.R.S. Private Letter Ruling 200329021 analyzed an improvement exchange where taxpayer was attempting to make improvements to land in which taxpayer had an ownership interest. In that case, taxpayer set up the transaction using both a QI and an EAT to facilitate the transaction, which allowed the replacement property to be “parked” during the improvement stage. The improvements were scheduled to be completed within the 180 day time frame. The ruling allowed the transaction and found that taxpayer would not be in possession of money or property that would subject taxpayer to payment of capital gains taxes, provided that the improvements were completed on time. In the event that improvements were made subsequent to the 180 day period, the value of those improvements would be considered boot and, therefore, be taxable. In addition, “to the extent the estimated cost of the Improvements is less than the qualified funds held by QI, if Taxpayer does not timely identify and acquire additional like-kind replacement property Taxpayer will receive the remaining qualified funds as boot.”
In a footnote, on page three of subject Private Letter Ruling, “soft costs,” including architectural and engineering fees, permit fees, attorney and CPA fees, incurred and paid months in advance of the EAT’s purchase of the replacement property, can be reimbursed to the Taxpayer by the EAT. Planning costs should be capitalized into the replacement property per Internal Revenue Code § 263(a)(1). Finally, improvements must actually be made to the existing structure, meaning that the value of raw materials that are simply delivered to the site and not installed are not tax-deferred.
As with all Section 1031 Exchange transactions, be sure to consult with an expert prior to moving forward to ensure that your transaction will meet the often complicated eligibility requirements.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
Reverse Exchange
Typically the taxpayer closes on their investment property before closing the new replacement property and a traditional forward 1031 tax exchange would be completed. Of course, that’s not always the case, especially when the housing market is improving, and in many areas of the country, multiple offers are received within days of listing. In 2000, the IRS enacted Revenue Procedure 2000-37, providing the guidelines for which the taxpayer may complete a 1031 reverse exchange. A reverse exchange is when the replacement is acquired before selling the relinquished or old property.
Unsecured Liabilities in a 1031 Exchange
When a taxpayer sells real property, any gain realized on that sale is potentially subject to the payment of federal and state capital gains and recaptured depreciation taxes. The rate at which capital gains are taxed is typically high, taxpayers often turn to alternative methods of acquiring property to avoid the payment of those taxes. One such method is through a Section 1031 Exchange of property. Any potential capital gains and depreciation recapture taxes that would otherwise be due are deferred if a transaction qualifies for Section 1031 Exchange status. At its most basic, a Section 1031 Exchange contemplates a taxpayer relinquishing one property and replacing it with another property of “like-kind.” Often, however, Section 1031 Exchanges are far more complicated than a simple exchange. Numerous issues come into play that can impact whether or not a transaction qualifies for Section 1031 treatment. One of those issues is the existence of “boot.”
Mortgage and Equity Boot
One of the basic premises of a Section 1031 Exchange transaction is that the taxpayer does not actually receive compensation for the relinquished property at any time during the transaction. A Qualified Intermediary, or QI, is used to facilitate the exchange, drafting documents and holding exchange funds on behalf of the taxpayer. If the property to be relinquished and the replacement property are of equal value, the exchange is easily completed. For numerous potential reasons, however, a Section 1031 Exchange may result in excess cash after the transaction is completed. If a transaction does net cash, or other compensation such as debt that is not replaced, it is referred to as “boot”. Any net boot remaining after a Section 1031 Exchange is completed is potentially taxable as capital gains.
What if the “boot” is used to pay off liabilities of the taxpayer as part of the transaction? Barker v. Commissioner of Internal Revenue, 74 T.C. 555, 1980 WL 4456 (1980) addressed that question. In a multiple-party 1031 Exchange agreement, boot was used to pay off mortgage liabilities of the taxpayer. In that case, the Tax Court held that:
“… boot-netting is permissible in a case where, contemporaneously with the exchange of properties and where clearly required by the contractual arrangement between the parties, cash is advanced by the transferee…to enable the transferor-taxpayer (petitioner) to pay off a mortgage on the property to be transferred by the taxpayer.”
The key in the Barker case was that the parties were contractually obligated to pay off the liabilities, meaning that the taxpayer did not have the option to simply take the cash and walk away from the transaction. For this reason, the Court did not find the “boot” to be taxable.
The Internal Revenue Code Section 1.1031(j)-1 provides specific instructions for exchanges involving multiple properties. For a taxpayer contemplating the payoff of secured or unsecured debt as part of a Section 1031 Exchange agreement, the code states:
“All liabilities assumed by the taxpayer as part of the exchange are offset against all liabilities of which the taxpayer is relieved as part of the exchange, regardless of whether the liabilities are recourse or nonrecourse and regardless of whether the liabilities are secured by or otherwise relate to specific property transferred or received as part of the exchange.”
In summary, both the IRS code and case law make it clear that paying off liabilities can be part of a Section 1031 Exchange; however, the payoff must be carefully structured and the parties must be contractually obligated to pay off the liability to avoid incurring taxable boot. There is no requirement that debt must be secured by the property. Given the debt is “traceable to the property” may be sufficient. At best, the taxpayer can use exchange proceeds to repay debt as liability relief boot offset in the form of liabilities assumed or additional cash paid on the replacement property.
Download four questions to ask a Qualified Intermediary when vetting a QI to accommodate your exchange.