All Forum Posts by: Sean Ross

@Javier Carrizosa,

Great question.  If you do an internet search, you'll probably find warnings about refinancing around a 1031 exchange.  While this can land you in potential audit risk, I think you're in the clear here. 

The tax courts have created a pretty effective standard for considering the legitimacy of refinances prior to a 1031 exchange.  There are usually three hurdles you should clear:

1. Independent or "separable" economic interest - basically, is the refinance for a legitimate purpose other than avoiding taxes. 

2. Refinance should not be appear on same closing statement as sale.  You don't want the refinance itself documented at closing.  Must be a separate transaction. 

3. Distance from closing.  The further out the refinance from sale, the better.  One year seems very reasonable. 

You should have a normal, run-of-the-mill exchange now (barring challenged with any other variables you haven't discussed here). 

@Dan Sundberg, congratulations on the successful conversion and creating a cash-flowing asset for yourself and your family.  

I'll just quickly second what @David Malott wrote.  Taxes are almost always the largest selling expense you'll face and can very quickly kill your investment's efficiency if you don't manage them intentionally. 

Again, great job!

@Derek Owen great job on the 1031 exchange.  Posts like this provide a lot of motivation for other investors.

@Sree Todu,

Your intuitions are dead right -- if you carry a note from your sale, the face value of that note is not automatically deferred with the 1031 exchange.  

The IRS doesn't consider the promissory note to be a "like-kind" asset to the real estate you're selling. 

If you proceed without any adjustments, the following will be true:

 - 50% of your potential depreciation recapture will be recognized immediately and become taxable in the year of sale. 
- Any payments made on the note will be recognized as income for you and subject to capital gains tax
- Interest accrued on the note will be subject to ordinary income tax rates in the year you receive the payments

How to navigate around this

1. If you're liquid, loan the funds to the buyer outside of closing.  Rather than carrying a 50% note, you will have a promissory note tied to a cash loan to the buyer.  The full value of the note can then be put into your 1031 exchange escrow account when you sell, and this can help you defer all of your taxes (assuming other rules are followed). 

2. Have the note made payable to your qualified intermediary. Work with a QI that's done this before. Make the note payable to the intermediary and then any payments made on the note during your 180-day exchange period can be added to the 1031 escrow account and improve your tax efficiency on the exchange. This works best if you're going to have a balloon payment within your exchange window. 

3. Have the note made payable to your qualified intermediary, then have the intermediary sell the note. You have the QI as the payee, then the QI can shop the note.  Any investor, including yourself, can buy the note from your QI.  The proceeds from sale of the note can go into your 1031 escrow account.   Be careful though -- you'll often take a very steep haircut on the face value of the note if you shop it in the broader secondary market.  Maybe 70 cents on the dollar. 

Finally, you could just exclude the note from the exchange and declare a 1031 on only 50% of your property.  This must be done carefully to provide maximum benefit. 

If none of these work, then consider finding another buyer or sourcing a hard money lender (there are many on BP) to help the buyer you want.  

It's not always an easy scenario, but we run into it frequently.  The mistake we tend to see most is not even asking the question in the first place, so you're already clearing that hurdle! 

@Sabrina Savillo,

I want to second what @Jacob St. Martin writes about measuring your current cash flow based on your current equity. It's not the only way to make an REI decision, but it's a very important metric to consider. How much could the same amount of equity earn you if it were redeployed? 

Our company specializes in 1031 exchanges, so we're big fans of them.  But they aren't right in every circumstance, and you may want to keep 1031s in your back pocket unless you have a well-thought out justification for going through the hassle of listing, selling, paying closing costs, searching for a new property under 1031 time constraints, and then buying two new properties. 

As @Patrick O'Sullivan points out, speaking with an accountant is a good idea so that you get a good idea.  Once you figure out return on equity, you want to take the step to figure out how your taxes are impacted by having two depreciable assets instead of one, etc. 

Maybe you try to refinance and keep the good property, buy a second property, and roll like that...?  There are plenty of options to think through, but I would recommend really nailing down what you want the most and then working backwards from there. 

 @Lesley Stoll, 

Look, buyers and sellers go through the full escrow process to clear away potential liabilities.  I would second @Bradley Buxton's point about speaking with a business escrow officer or @Jacopo Iasiello's advice to chat with a real estate attorney.  

From a 1031 standpoint, faster closing simply means faster exchange deadlines.  If you're a first time 1031 exchangor, just know that the 45-day identification deadline passes very quickly.  

When you're looking for possible 1031 replacement options, remember that you have a very wide net of potential assets to reinvest in.  Think broadly, chat with a QI (there are several of us here on BP), and try to get a gameplan together as quickly as possible (with backup options). 

@Noah Condon,

I want to add a few thoughts here before you set up an entire REI model on flipping that just happens to be structured in a way that let's you navigate around 1031 exchange rules:

The IRS wants to clearly distinguish between "dealers", such as residential home builders, and long-term investors. The IRS does not allow 1031 exchanges for dealers and developers. LT investors can use 1031s. If you want to do 1031s, your properties must be "held for investment" with the intent for long-term use. 

The regulations do not define "held for investment".  Simply holding a property for 12+ months does not guaranty anything in terms of qualifying for an exchange (although holding any given property for 24+ months and renting for at least 14 days per year does guaranty the IRS won't challenge you under Rev. Proc. 2008-16).   

If you sell property regularly as a primary business, or in the ordinary course of your business, you could be labeled as a dealer/developer and have your property classified as inventory rather than a capital asset. Inventory can't be exchanged via 1031.  It doesn't matter if the average age of your inventory is 12+ months. 

If you're not careful, you can have your entire gain converted into non-exchangeable ordinary income.  It's not common (because audits are rare), but this type of reclassification does happen and is messy when it does. 

That's all to say that you simply need to be careful.  It wouldn't hurt to hold onto some properties for the long-run and treat them as rentals year-after-year.   I would strongly suggest working with a good CPA if you plan to build a business around fixing/flipping. 

@Michael Cai,

Is your $450K owned free and clear? 

With borrowing rates as high as they are, it could be difficult to maximize income by 1031 exchanging into a rental that is both (a) financed, and (b) in an urban area where prices may still be close to 2023 peaks. 

Have you considered 1031 exchanging into any other types of cash-flowing assets if your goal is to a max out cash flow?

Amen, @Anna Catron.  The limitations around targeting your own property (or a relative's property) in 1031 exchanges are clumsy.  They're written to avoid basis switching and also reflect the IRS' general discomfort with non-arms-length dealings, but they end up limiting a lot of very valuable improvements. 

It is technically possible to 1031x into land that you already own and improve it.  The structure is most commonly called a "ground leasehold improvement exchange" and it's the very deepest end of the 1031 pool.  In all our years doing this work, we've only seen it successfully completed a handful of times because of how many hurdles you have to jump over and through.  

Remember @Costin I. that for any liquidating distribution of a partnership, such as the LLC, the distributions should be done pro rata.  Unless your two properties are exactly the same value, deeding one house to each of you is not going to result in a pro rata distribution.  If it isn't pro rata, then you end up with a partial sale from one partner to the other, which creates tax consequences.