As the velocity of real estate sales picks up, questions surface regarding how best to repair the replacement properties in a 1031 exchange. There are two acceptable strategies and one not acceptable strategy. Before reading more, for those not familiar with a 1031 exchange and you are selling real property held in a business or for investment, continue to press forward. In the era of tax deferrals or for those who wish to minimize their tax bill, learn now, rather than when your accountant asks if you are familiar with a 1031 exchange, when it may be too late.
1031 Exchange
A 1031 exchange is a section of the Internal Revenue Code and a Treasury Regulation that allows the deferral of recaptured depreciation, federal, state and local capital gains taxes when property held for the proper intent is sold and replaced within 180 calendar days. Taxes can add up to 40 percent of the property sales price. The code applies to real property only. Examples of real property include any type of property from land, single family residential rentals, condominiums, commercial, oil and gas royalties to fractional interests in commercial properties.
Repairs
Repairs can be made to the replacement property using the exchange proceeds, given the property is owned by an Exchange Accommodator Titleholder (EAT). An EAT is a single member limited liability company that enters into a Qualified Exchange Accommodation Agreement and other exchange agreements to pay the approved contractor invoices. Either before the 180th calendar day or by the 180th day post the old property closing, the improved property is conveyed to the taxpayer. A warranty deed is created, signed, notarized and recorded with the County Clerk of Court for real property.
A second strategy, one that is difficult and unlikely to secure, is allowing improvements to be made before the closing. At the replacement property closing, the contractors are paid for work completed as itemized expenses on the settlement statement and not for future services. Most Sellers will not allow this and most Buyers don’t want to commit to improvements before they own the property. But it may be possible.
As implied, exchange proceeds cannot be used to pay for repairs after the closing unless the closing is set up as an improvement exchange. Given real property is sold, then real property must be the replacement property and not materials and labor.
An improvement exchange adds a layer of complexity and a higher Qualified Intermediary (QI) fee. The QI will try to make the numbers work but when less than $30,000 of repairs is needed, it may be best to pay the capital gains tax and use the funds as needed.
What is to prevent the taxpayer from having a contractor paid at closing for work to be done? Hopefully, the QI will let the taxpayer know that should their tax return be audited the IRS will quickly determine the incorrect use of the exchange funds. A penalty may be due, not to mention the tax and interest on the tax to be paid in addition to the time and effort involved with the audit, is not worth it.
Do you qualify for a 1031 exchange? Download this free three page PDF by clicking here.
