1031 Keys

[Mark Creason]

Having spent some significant time working with borrowers buying and selling property who are trying to complete a 1031 exchange, I thought I would post regarding my experience.

1031 keys:

1. Defer income tax.

When selling your property, federal and state taxes can be owed on your profit.  The IRS has capital gains taxes, recapture taxes, and a new Medicare tax.  Most states also charge capital gains taxes.

2. Buy and sell "like kind" property.

When choosing your new property, you want to choose “like kind” property.  Your new property should be for business or investment purposes and not personal use.  “Like kind” property can be different types of real estate.  If you sell an apartment building, you could buy an office building.

3. All equity (cash) must be reinvested to avoid boot.

All cash coming out of your sale must be re-invested in your new purchase(s).  Any remaining cash is considered “boot”.  If you receive “boot”, you could be obligated to pay taxes on that portion of your gain.

4. Purchase price needs to be higher than sales price to avoid boot.

The purchase price of your exchange has to be higher than the sale property’s sales price.  If not, then you receive “boot” for the difference.  You could be obligated for taxes on this “boot”.

5. Work with competent 1031 exchange Qualified Intermediaries.

A competent 1031 Qualified Intermediary will provide you with proper documentation going through the exchange process.  The 45-day and 180-day time frames are hard dates, so you want to make sure your QI keeps your paperwork straight.

6. Defer recapture tax (25%).

On the depreciation recapture taken on a property, the IRS charges a Recapture Capital Gains tax at a rate of 25%. This tax is a federal tax.  By using a 1031 exchange, this tax can be deferred.

7. Review financing to make sure numbers work.

Falkirk reviews the full financing package attached to the exchange property. With the tight time constraints in an exchange, understanding the true NOI, expenses, the rent roll, and the leases is very important to making sure that the deal works.

8. Help make contracts 1031 compliant.

When using a 1031 exchange, it is important to have the proper language in your contract.  Adding proper clauses to your contract will make sure your seller works with you to complete the exchange.

9. Understand time requirements of 45 days and 180 days.

Using a 1031 tax deferred exchange, there are certain date requirements.  After closing on a sale, the exchanger has 45 days to declare their exchange properties.  This date is a hard date.  If you do not declare by this date, then your exchange falls apart.  You also have 180 days to close the purchase(s) of your exchange property.  This date is from the closing of your sale.  Some people think it starts when you declare, which is not the case.  Also, there is an exception to the 180-day period.  The closing has to take place by the time you file your tax return.  If you close in late December, you could lose your exchange if you do not close by the time you file your taxes.

10. Avoid Mortgage Boot.

When you purchase your new property, you will need to encumber the same or more debt.  If your new mortgage is smaller than your old mortgage, the IRS would consider this receiving “boot.”  If you receive “boot,” you could be obligated to pay taxes on that portion of your gain.

Hopefully this helps anyone contemplating a 1031 exchange.  Please feel free to contact me about your 1031 experience.

Mark

[Dave Foster]

@David D'Ambrosio, You're right there is no statutory holding period.  What is critical is how you can demonstrate that your intent when purchasing and owning the property was to use it for productive use.  Your accountant is the person most equipped to help you document that.  They know you're whole picture.  The QI does not.  

The one year plus period is based on factors other than actual law.  Failed exchanges from holds greater than one year are very much outliers.  Holding a property more than one year straddles two tax years.  Usually holding an asset for more than a year would turn it into a "long term" capital gain in tax language of the past.  So there's reasons why that is a relatively safe recommendation.  But there's also reasons why you and your accountant might rightfully choose to be more aggressive.