1031 Exchange

Core benefit:

• Defer capital gain tax, today’s money is more valuable than that in the future. 
• Only pay tax at the last time of selling after a series of transactions. 
• When transferring the properties to children, Step up basis is applied so that all the deferred tax is waived.
• Combine with the tax policy on primary residence to maximize the tax reduction.  
• Might be a tool to reduce tax when the primary residence is transferred between Parent and Child; Grandparent and Grandchildren after Proposition 19 became effective. 

Proposition 19:  effective on Feb. 16, 2021, significant modifications on  Propositions 60/90 – 55 and over, Proposition 110 – Disabled Person, and Propositions 58/193 [Transfers Between Parent and Child; Grandparent and Grandchild]

A 1031 Exchange Does a Lot More Than Defer Taxes

• Any commercial/investment real properties
• Rental properties: IRS does not specify the minimum days of rent before selling. It is suggested by 1031 exchange companies that you rent out at least one year plus at least one day and you have two consecutive tax returns showing the rental income. (You can rent your house to your children who is not on the title for comparable market rent. )
• Vacation home: in last two years, it is rent out at least 14 days, and you have not used it for yourself. Or you used it less than 10% of time it is rent out. 
• Office part in your primary home: You have two consecutive tax returns showing this.
• Number of properties: it is OK to exchange one for multiple properties or multiple for one property. 
• Locations: as long as replacement properties and relinquished properties are located in the US. 
• Frequency: no limit, you can do 1031 exchange as many times as you wish.

Exchanger must be the same tax payer as far as IRS is concerned. 

To get full amount of tax defer,  

The replacement properties must be equal or greater in value and equity than the relinquished properties. Fresh cash can be put in to offset the loan. 

• Pay tax
• Death
• Seller’s financing???
• Exchange into investment, later converted to Retirement home???
• Estate planning
• Exchange into low maintenance assets???
  • Tenancy in Common （TIC）
  • Delaware Statutory Trust (DST)
  • Triple Net (Net Lease) Commercial

Moving In

The replacement property needs to be purchased with the intent of being a business or investment property. In 2008 the IRS issued a safe-harbor (Rev. Proc. 2008-16) that defines how to treat your replacement property for the two-year-period after the exchange in order to safe-harbor your exchange. A common belief is that you can then convert it to personal use. However, any type of conversion needs to be discussed with your tax advisor first. (ref. Key Information by IPX )

In addition, a rental property can be rented to your children. As long as the residents are not the owners, the property can be counted as an investment.  Rent has to be at market level and you need to file tax on this rental income. 

If you plan to make improvement, renovation, or even full new construction, the time might be counted into two-year-period. In this case you might not need to rent it out before you convert it into personal use. Again please confirm with your 1031 intermediary and your tax advisor. 

What IRS looks at: rent must be market rate and can be a little bit lower if you only rent out for partial year. Rental to family members don’t have to advertise. The most important document is your tax filing (a lease might be only requested upon auditing ). 

• Convert 1031 property to primary resident use

Must use a QI. Usually you need to have your QI involved before you close the first transaction and to request the other party’s cooperation in purchase agreement. 

QIs:  Best QI 2021 | 6 Best QI 

QI: must be neutral and not advising in past 2 years. All monies held until exchange closes. 

• IPX1031
• First American Exchange:

• Three Property Rule: The Exchanger may identify as potential Replacement Property any three properties,
• 200% Rule: The Exchanger may identify as potential Replacement Property any number of properties, provided the aggregate fair market value (as of the end of the Identification Period) of all of the identified properties does not exceed 200% of the aggregate fair market value of all of the Relinquished Properties.
• 95% Exception: If the Exchanger identifies more potential Replacement Properties than allowed under either the Three Property or the 200% Rules, the Exchanger will be treated as if no Replacement Property was identified. However, this does not apply with respect to any Replacement Property received before the end of the Identification Period and any properly identified Replacement Property received by the end of the Exchange Period if worth at least 95% of the aggregate fair market value of all of the identified Replacement Properties. Treas. Reg. 1.1031(k)-1(c)(4)(ii). For this purpose, fair market value of the aggregate Replacement Property is determined as of the earlier of the date the property is received by the Exchanger or the last day of the Exchange Period.

Exchange Agreement, Assignments of Purchase and Sale Agreements, Notices of Assignment to the respective buyer and seller, and provide a blank Replacement Property Identification Notice, among other form documents.

Pros: To buy first then sell. No pressure to locate properties in 45 days especially in a seller’s market. You only get QI involved once you are ready to move forward with the purchase.

Cons: You might need cash for purchase because getting a loan can be a problem.

Deadline: You have to sell your property within the same 180 day window as a regular 1031.

Either park the replacement property with a triple net lease or park the relinquished property by providing finance in the EAT. Which one is easier and less costly? 

***Our fee is the same, about $6000, including the cost of the LLC. We suggest we take title to the replacement property.  This way we can just assign the LLC to you at the end, instead of having to go through another escrow.

***If you are subject to FIRPTA, doing an exchange will not prevent escrow from having to do their withholding (which is usually 15%).

Depreciation recapture: 

For example, if business equipment was purchased for $10,000 and had a depreciation expense of $2,000 per year, its adjusted cost basis after four years would be $10,000 – ($2,000 x 4) = $2,000.

For income tax purposes, the depreciation would be recaptured if the equipment is sold for a gain. If the equipment is sold for $3,000, the business would have a taxable gain of $3,000 – $2,000 = $1,000.

It is easy to think that a loss occurred from the sale since the asset was purchased for $10,000 and sold for only $3,000. However, gains and losses are realized from the adjusted cost basis, not the original cost basis. The reasoning for this method is because the taxpayer has benefited from lower ordinary income over the previous years due to annual depreciation expense.

*** Regarding the repairs/improvements you made on the property before it was sold:  anything you do with the property before you sell it is not part of the exchange, whether it was a week before or ten years. If you want to “pay yourself back” for the money that you put out, that cash will be viewed as taxable “boot”. There may be some offsetting tax deductions for working on the property, but that would have to be addressed with your tax advisor. From an exchange point of view, any money that comes back to you at the close of escrow is a potential tax liability.

Delaware Statutory Trust (DST):

• The Basics May 2021 by First American Exchange
• Key Information by IPX 
• Key Steps by IPX
• Qualified Intermediaries
• 1031 Exchange Topics with notes
• 1031 Exchange Reverse Topics
• FAQ： WHAT CLOSING COSTS CAN BE PAID WITH EXCHANGE FUNDS AND WHAT CANNOT?

Reverse and Improvement 1031 Exchange

Pros: To buy first then sell. No pressure to locate properties in 45 days especially in a seller’s market. You would only get QI involved once you are ready to move forward with the purchase.

Cons: You might have to put forward funds for purchase for getting a loan can be a problem.

Deadline: You have to sell your property within the same 180 day window as a regular 1031.

Pay all cash to purchase the replacement property will be much easier than having a finance. 

Either park the replacement property with a triple net lease or park the relinquished property by providing finance in the EAT. Which one is easier and less costly? 

***If you are subject to FIRPTA, doing an exchange will not prevent escrow from having to do their withholding (which is usually 15%).

In REVERSE 1031 Exchange, is 45 days to ID new property still the same? You need to have 1031 intermediary come in for the purchase. 

agent should put “cooperate with 1031 exchange “ in the sale contract

how long should we wait before moving in 1031 investment as my primary home? at least 2 years and discuss with CPI

Biden’s Tax Proposal in Real Estate

• The top rate on long-term capital gains would rise from 20% to 39.6%. 
• Eliminate Step-up in Basis: ‘step-up in basis’ rule that enables families to pass property down from one generation to another without ever paying any tax on the increases in the property’s value over time. 
• “Carried interest” will pay ordinary income tax rate instead of current capital gain rate. 
• Real Estate 1031 Exchanges:  the deferral would end for capital gains in excess of $500,000.

(Some items probably will be passed into bills in Sep./Oct 2021.)