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Exchange Blog
Earnest Money Deposits and 1031 Exchange
In a 1031 exchange, real property earnest money deposits, extension or option payments are recognized as an act of good faith of the Buyer’s intent to acquire the subject property. Following guidelines is especially important in a 1031 exchange so as not to violate the g(6) limitations of constructive receipt of the Internal Revenue Code Section 1.1031. Constructive receipt is when the taxpayer has access or possession of the funds at the time of the exchange as denoted by the closing date and the fact that property ownership has been conveyed to the Buyer. One of the primary roles of the Qualified Intermediary is to hold the earnest money deposit and exchange proceeds for the taxpayer and use them towards the replacement property purchase.
Relinquished Property Sale
When the taxpayer or exchangor sells their relinquished or old property, they will typically receive an earnest money deposit. The taxpayer has two options. The first is to hold those funds and at closing either deposit with escrow, the title company, Qualified Intermediary or keep them. Once the closing is completed and the earnest money deposit is kept, the earnest money deposit is taxable.
In a 1031 exchange, if the goal is to defer 100 percent of the realized gain, then the net equity plus the debt retired must be replaced in the new property. If this is not the intent, then the best time to receive cash is at the closing in what is referred to as a partial 1031 exchange. Whenever the replacement property is 50 to 60 percent of the relinquished property, it probably does not make sense to initiate a 1031 exchange. The tax on the 50 to 40 percent will be close to the tax that would be paid if a 1031 exchange is not initiated.
Replacement Property Purchase
In a 1031 exchange, the taxpayer will acquire replacement property and place an earnest money deposit with escrow or title company. The funds can come from the taxpayer or wired from the exchange proceeds. If adequate exchange funds are available, the earnest money deposit can also be reimbursed at closing given the taxpayer made the deposit with non-exchange proceeds. Should exchange funds be used to provide the earnest money deposit, the taxpayer must sign an Assignment of the Purchase and Sale Agreement with the Qualified Intermediary prior to the disbursement. If the sale were to fall through and the earnest money deposit was provided from exchange proceeds, then the earnest money deposit should be returned to the Qualified Intermediary to avoid constructive receipt.
Soft Costs
In addition to the earnest money deposit, the taxpayer may also ask for the Qualified Intermediary to make other payments associated with the replacement property purchase. Only capitalized expenses associated with the replacement property are to be paid either by the Qualified Intermediary or at closing by escrow or title company. It is best to confirm with your CPA whether the expenses are recognized as capitalized costs. These soft costs typically include architectural, appraisal, environmental and permits. If the CPA is not sure, then it is best to pay these with non-exchange fees to avoid the possibility of taxable boot. If the expenses are typically found on the closing statement, then they may be paid by the Qualified Intermediary without a taxable impact.
There are many rules to follow when initiating a 1031 exchange. Those taxpayers who take a cautious approach will help themselves avoid the potential of a taxable outcome. To learn more about 1031 exchanges, download a free “1031 Exchange Checklist” by clicking here.
1031 Like Kind Exchange Explained
The 1031 like kind exchange target persona is an individual or corporation who owns real or personal property held for productive use in a trade, business or investment and subject to US federal and state capital gain taxes. The target market will defer $3.7 billion in federal capital gain taxes in 2013 according to the Joint Committee on Taxation. Do you own land, improved property or tangible and intangible personal property, including aircraft, construction equipment, livestock, gold and silver bullion, collectibles, vintage cars or artwork? When selling, is your intention to replace with another like kind property? If selling real property, like kind means any type of real property, including a lessee’s interest in a thirty year lease. If selling personal property, the replacement personal property must be like kind or like class, as in bull for bull, gelding for a male horse or silver bullion for silver bullion.
2013 Capital Gains Tax and Impact on 1031 Exchange
Internal Revenue Service Section 1031 exchange has garnered renewed interest from CPAs, tax attorneys and individual investors as a result of higher federal capital gain tax rates effective January 1, 2013. A 1031 exchange defers the federal and state capital gain and depreciation recapture taxes when selling real and personal of equal or greater value property productively used in a trade, business or investment and replaced with like kind property within 180 calendar days of the initial closing. Real property such as land, condominium, multi-unit apartment complexes, shopping malls can be exchanged for other real property while aircraft, equipment, livestock, vintage or collectible cars, artwork and precious metals must be exchanged for like-kind personal property.
Clawback and Withholding Requirements in a 1031 Exchange
In a conventional sale of real property, the seller realizes a gain upon the sale of the property – at least that is the objective. That realized gain is then subject to the payment of capital gains tax at the federal, and in some cases the state, level. To avoid the payment of capital gains tax, taxpayers often structure a transaction as an exchange instead of a traditional sale.
Qualified Intermediary Role
Under Section 1031of the Internal Revenue Code, an exchange of property may qualify for a deferral of capital gains tax if a number of requirements are met. One of those requirements is that a Qualified Intermediary, or QI, is used to facilitate the transaction. Also referred to as an exchange accommodator or exchange facilitator, the QI serves as an intermediary throughout the entire exchange process. All funds used during the transaction are held by the QI who then releases them to the appropriate party at the appropriate time.
A taxpayer who has completed a Section 1031 Exchange during the tax year will claim a deferral of capital gains tax due on the transaction when it comes time to file federal taxes for the year. Most taxpayers, however, are also required to file state tax returns. Moreover, individual states implement their own tax laws, meaning that a taxpayer who has participated in a Section 1031 Exchange must also understand the state laws relevant to the transaction to determine if any tax is due. Those same state laws will also dictate what a QI’s obligation is with regard to state tax obligations. Finally, all of this becomes even more complicated if the taxpayer relinquished a property in one state but was a resident of another state and/or the taxpayer relinquished a property in one state and exchanged it for a property in another state. How are all of these issued handled by California, Oregon, Montana and Massachusetts?
Clawback Tax on Realized Gain
There are several steps required in analyzing your potential state tax liability if you are an out of state resident involved in a Section 1031 Exchange. First you need to determine if the state where the property is located typically taxes the gain realized on the sale of real property. California, Oregon, Montana, and Massachusetts all tax realized gain on the sale of real property. Next, you need to consider if your transaction qualifies for an exemption from the payment of state capital gains taxes. In other words, does the state tax code recognize the transaction as a Section 1031 Exchange and, therefore, exempt the transaction from the payment of state capital gains tax? Again, all four states exempt a Section 1031 Exchange from state capital gains taxes. The exemption notwithstanding, the QI involved in your exchange may still be required to withhold funds. In California, for example, a QI is required to withhold 3 1/3 percent of the sale price on equity boot or cash received by an individual and forward the funds to the Franchise Tax Board. In addition to the withholding requirement found in some states, a non-resident taxpayer in all four states is required to file an annual report or return with the state tax authority regardless of whether or not taxes are due and/or whether or not funds were withheld. California Assembly Bill 92 effective January 1, 2014 requires the taxpayer who exchanged property in California in a Section 1031 Exchange for a replacement property outside California to file a return with the Franchise Tax Board for each year the property is held.
The obvious question at this point should be “Why would a QI be required to withhold funds on an Exchange that is exempt from state capital gains tax?” The reason is that although many states treat a federal Section 1031 Exchange transaction the same for the purpose of state capital gains tax, they eventually recapture the tax due through “clawback” provisions. In essence, a “clawback” provision allows the state to collect capital gains tax when a replacement property in a Section 1031 Exchange is eventually sold in a traditional sale. Remember, a Section 1031 Exchange only defers the payment of capital gains tax, it does not exempt the transaction entirely.
If you decide to enter into a Section 1031 Exchange as an out-of-state resident in any state be sure that you have a thorough understanding of the state tax laws relating to the transaction as well as your obligations under the state law.
To learn more about 1031 exchanges, download “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking here.
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.
Depreciation and 1031 Exchange
Depreciation can be a confusing and difficult concept to understand. Individuals and businesses need to have a working knowledge of how to use depreciation to maximize their profits. More importantly, they need to understand the tax consequences of recaptured depreciation and how to effectively defer the tax in a 1031 tax deferred exchange.