How is a partial 1031 taxed?

Question

I was planning to buy 2 replacement properties as part of a 1031 exchange. Now one of the replacement property purchases may fall through.

How would taxes be computed on a partial exchange, where I would be buying down in price (by about $200k) and then either A) taking a smaller mortgage than I had on the relinquished property and using all the sales proceeds or B) taking a larger mortgage but generating cash at closing?

I guess what I'm asking is if it's possible that I'd have to pay taxes on the price difference plus the mortgage boot plus the cash boot.

Bill Exeter · Answer

I wanted to jump in here any make some follow-up comments.  There are some good potential solutions discussed here.  The one point that I wanted to make sure was understood is that the improvements, whether paid before, at or after closing must be paid under the control of the Qualified Intermediary and the corresponding improvements must be completed before you take title to the property in order to be counted as "real property" for like-kind property requirements and qualify for tax-deferred exchange treatment.  Payments merely made to a vendor or items credited in/through escrow/closing do not qualify as real property unless the corresponding improvement have also been completed.

Dave Foster · Answer

Well there's still hope.  Here's a couple other ideas.

1. An improvement exchange is a complicated and expensive process.  Certainly doable but really not necessary in this case.  Your QI is right you can't escrow funds.

2. How about a simple extension of closing on the contract till the repairs can be completed.  Then see if the seller will agree to complete the repairs and reflect that in the sales price.  You could even use your 1031 funds as non-refundable earnest deposits if the seller doesn't have the money to complete repairs but watch out.  You need to have a good working relationship with the seller and you need to be very sure you can close on the property.

3. See if your QI would accept repairs placed on the settlement statement as purchase concessions with checks cut directly to the vendors.  This way there is no need to escrow repair money.  It is all accounted for on the settlement statement.  And 20K would fall under the "deminimus" property guidelines from the IRS.  This is done quite frequently.

4.  If all the work can't be completed could most of it???  You still may be able to minimize the amount you're paying in tax.  Also,

Dave

Lori F. · Answer

Thanks for the response, Dave. We are past the 45 day identification period. The problem with the second property is that it needs at least $20k in repair work. The QI says no escrowed funds at closing and repairs need to be made before closing. Not all the work can be done by then. QI suggested an improvement exchange as a possibility but lender will not allow the QI to hold title to the property until repairs are made. We don't have the funds to pay for the repairs after closing, unless we take cash boot. It's a tricky situation.

Dave Foster · Answer

Hi Lori,

Sorry to be the bearer of bad news but you will have a taxable event.  Any amount you buy less than what you sell (net sales price) even with a larger mortgage, or any cash to you from a smaller purchase price and you will pay tax on the difference.  Your QI should confirm this and your accountant can tell you exactly how much because there may also be some recapture of depreciation as well.

Roughly,  If you're buying down in price by about 200K then you will pay tax on all of it or until it equals the full amount of your profit.  If the total amount of your gain was 200K then  you'll pay tax on all 200K.  If your gain was 250K then you'll pay tax on 200K and shelter the gain on the remaining 50k.

We're asked everyday about the return of original down payment, taking cash out of buying less than what the investor sold.  It is called boot and is taxable.  However there may be a couple of possibilities for you to explore.

1. are you still in your 45 day window for identification?  If so there may be another property that would work for you.

2.  Can some concessions be made on the 2nd property to resurrect the sale?  It may be worth paying a little more for the 2nd property in exchange for saving the 1031.

3. Are there any repair items that need to be taken care of on the first property? There may be a way to fold some of those into the purchase and minimize the tax bill.

Bummer of a way to end a 1031 but I spose the best news is that there has to be profit before there can be tax.

Dave

How is a partial 1031 taxed?

Most Popular Reply