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.

1031 Exchange Boot: Equity and Mortgage Boot Explained

Posted on | by Tom Gustafson | Leave a Comment on 1031 Exchange Boot: Equity and Mortgage Boot Explained

From QI to “like kind” to boot, there is a lot of jargon that is used when executing an Internal Revenue Code Section 1031 Exchange. If it doesn’t make a lot of sense to you, that’s okay; you’re in the majority. We’re going to take a brief look at a few different examples of 1031 exchange boot in this article and how it’s an important term to understand when you’re considering a tax deferred exchange.

What is a 1031 Exchange Boot?

Firstly, let’s review the definition of 1031 exchange. A 1031 exchange allows resident and non-resident United States federal taxpayers to defer capital gains and recaptured deprecation taxes when exchanging real property held for productive use in a trade, business or for investment for like-kind real property held for productive use in a trade, business or for investment. The tax otherwise paid in a traditional sale is deferred indefinitely until the replacement property is sold or another 1031 exchange is initiated. Why would you want to do this? A 1031 exchange gives you the opportunity to utilize funds that would be otherwise unavailable for the acquisition of new investment or business-related real property. Think of it as an interest free loan from the US government.

One of the primary requirements in a 1031 exchange is that in order to fully defer all capital gains taxes and depreciation recapture due, the equity and debt in the replacement (new) property must be equal to or greater than the equity and debt of the relinquished (old) property. Bearing in mind that a partial exchange is possible where the debt and equity is not replaced, the vast majority of Exchangors are executing 1031 exchanges with the intent of fully deferring the taxes due.

By not fully replacing the equity or debt in your replacement property, you would trigger a taxable consequence on the underutilized funds known as Boot. Though there are multiple types of boot, the most common are mortgage boot and equity boot.

What is Mortgage Boot?

Mortgage Boot occurs when the property you acquire has mortgage debt less than the property you relinquished. For example, if you sold an investment property for $300,000 and it had a mortgage worth $125,000 that was paid off at closing and your new replacement property mortgage is only $100,000, you would be subject to taxation on the $25,000 difference. The simplest way to avoid this is to be aware of what your debt requirement is from the beginning and factor it into the replacement property you’re acquiring. One unique aspect of mortgage debt is that it can be offset by additional cash, meaning in the previous scenario, if you were to bring $25,000 worth of non-exchange related funds to the closing, it would satisfy your obligation. Cash can offset debt, debt however cannot offset cash.

What is Equity Boot?

Equity or Cash Boot occurs when equity, cash or any cash equivalent received as part of the sale of the relinquished property is not replaced fully in the replacement property. In some instances, Exchangors will receive equity at the closing of their relinquished property as part of their overall strategy; the portion received is subject to taxation and is considered Equity or Cash Boot. For example, if you sold your investment property for $300,000 and paid off the $125,000 mortgage, after closing costs you would determine your net sales proceeds. Let’s say that the net sales proceeds for this sale are $150,000. The Exchangor is welcome to receive any portion of those funds at closing, but by receiving them will trigger a taxable consequence. Keep in mind that the more funds received reduces the benefit of the 1031 exchange and could potentially render the 1031 exchange useless. Being aware of these common types of boot from the onset of your exchange will help you determine if you want to strategically utilize boot or avoid it at all costs in your 1031 exchange. Once your relinquished property sells, it is a best practice to review the equity and debt requirements with your Qualified Intermediary so that you’re well aware of what needs to be reinvested in the replacement property.

Atlas 1031 Exchange has been accommodating tax deferred exchanges of all kinds for more than 16 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange whether you want to receive boot or avoid it at all costs. 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 form.

1031 Exchange Identification Rules: The Basics of How to Identify

Posted on | by Tom Gustafson | Leave a Comment on 1031 Exchange Identification Rules: The Basics of How to Identify

In any I.R.C. § 1031 Exchange, the correct and timely identification of replacement property is essential. Though there are a litany of 1031 exchange identification rules and regulations that must be followed exactly, there are some basics that must be understood from the beginning in order to execute a successful exchange. In a Forward (Delayed) Exchange, the Exchangor has a 45-day window after the closing of their relinquished property to identify potential replacement properties.  This is commonly known as the “Identification Period.”  Continue reading →

1031 Exchange: Seller Financing

Posted on | by Tom Gustafson | Leave a Comment on 1031 Exchange: Seller Financing

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

Posted on | by Tom Gustafson | Leave a Comment on Capital Gains Tax Deferral for the Investor and Dealer

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

Posted on | by Tom Gustafson | Leave a Comment on Tax Implications of Unwinding a 1031 Exchange

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

Posted on | by Tom Gustafson | Leave a Comment on Farmland Auction Insights

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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