Equal or Up Rule: 1031 Exchange Series Part Seven

In the final article of our seven-part series on the basic requirements of a 1031 Exchange, we will be discussing the last requirement; reinvestment of cash, also known as the Equal or Up Rule. While it’s the last stretch and you’re almost home free with tax deferment, the final requirement is just as important, if not more so, than the rest. Here we will explain exactly how the reinvestment of cash works and what the Equal or Up Rule is. If you follow along with the series, and this last requirement, you’ll be on your way to a successful 1031 Exchange!

Reinvestment of Cash / Equal or Up Rule

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In order to defer all capital gains tax with a 1031 Exchange, you must put all of the cash proceeds from the sale into the next purchase. There is a way to do what is referred to as a partial exchange but we’ll cover that more further below. If the goal is to defer all tax, then all of the cash must be used toward the next purchase. If you touch any of that cash, it becomes taxable. Reinvestment of the cash isn’t the only thing you have to worry about though. You must also keep in mind the Equal or Up Rule.

The Equal or Up Rule refers to the fact that your new property purchase must be equal to or greater than the value of the property you sold (the net sales price once you pay commissions and closing costs). If you buy down, or purchase a property that costs less, it is considered to be the same as taking a profit. If you take a profit, then you won’t be able to defer all of the capital gains taxes and will have a taxable event.

The easiest way to calculate your reinvestment goal is to look at the bottom of your settlement statement. You’ll see the cash you received at the end of the sale, plus the amount of mortgage paid off. Those two numbers added together are your reinvestment goal. To make it simple just keep in mind that:

CASH + MORTGAGE PAY OFF = REINVESTMENT GOAL.

 

Partial Exchange and Taking Cash Out

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When completing a 1031 Exchange, there may come a time where you need to take some cash out. If you need cash now, it is possible to do this and still complete your exchange. Remember, the reinvestment of cash requirement states that in order to defer all tax, you must use all of the cash and purchase at least as much as you sell. Therefore, taking some cash out or purchasing for less than what you sell does not jeopardize your exchange. However, it does create a taxable event. If you purchase less than what you sold or take some cash out, the IRS considers this to be “boot” and tax it as profit (don’t ask where the term boot came from…).

Some have asked about refinancing the property before selling and I don’t recommend it. The IRS does not look kindly upon refinances immediately before a sale. Though what you can do is start a 1031 Exchange, leave all of the proceeds in, complete the exchange and then immediately refinance the new property. This is considered borrowing against equity. If you leave all of the proceeds in, then refinance after the fact, you can get the cash you need and it will be tax-free.

 

Equal or Up Rule Summary

As you have learned by now, the IRS has very specific rules and requirements that you must follow for a 1031 Exchange. The Equal or Up Rule or the reinvestment of cash is straightforward and easy to follow. It simply means that the purchase of your new property must be equal to or greater than the property sold. The reinvestment amount is your net sales price. This is the contract price minus the closing costs of the net sale but before the mortgage is paid off. As long as cash is reinvested, all capital gains taxes will be deferred.

If you need cash right away, you can purchase a property for less than what you sold for. This is called a partial exchange. The amount you take out or buy down is taxed as profit while the rest remains tax-deferred in the exchange. It is also possible to refinance the property after you have started a 1031 Exchange. With this method, you leave all of the proceeds in and then pull tax free equity out of the new property by refinancing.

If you have any questions at all about any of these requirements, contact me and my team at 850-889-1031. We’re happy to help with any questions you have regarding your 1031 Exchange.

 

Article originally published at: https://www.biggerpockets.com/member-blogs/12255/91279-equal-or-up-rule-1031-exchange-series-part-seven

Title Requirements: 1031 Exchange Series Part Six

Welcome back to our seven-part series on the basic requirements of a 1031 Exchange! In our last article, we discussed the need for the Qualified Intermediary during the exchange. In this, part six, we are going to move on to title requirements. As we’ve now learned, the IRS is very detailed when it comes to the rules and regulations of a 1031 Exchange. Part of those regulations include very specific title and taxpayer requirements. Now we are going to discuss what those requirements are and the best way to avoid any title issues during the exchange.

Title Requirements in a 1031 Exchange

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While there might be a lot of complicated statutes to understand during a 1031 Exchange, the title requirements are relatively straightforward. This requirement states that in the same manner the taxpayer holds title to the old property that is how the taxpayer must take title to the new property. Essentially this means that the taxpayer of the old property has to be the taxpayer of the new property. Therefore, if you are the taxpayer for a piece of property and sell it through a 1031 Exchange, then you must also be the buyer of the new property to qualify for the tax deferral.

Any tax paying person or entity that owns real estate is able to do a 1031 Exchange. That means you, as an individual, as well as any corporation, LLC, partnership, or trust could do an exchange. However, that doesn’t mean that an individual can complete a 1031 Exchange on property that is owned by an organization. The basic rule of thumb here is to check the tax returns. The name on the property and tax return will usually match. But the most important consideration is whose tax returns report the activity of the property.

Avoiding Title Requirement Issues

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In a 1031 Exchange, title requirements are met when the taxpayer who owned the old property is also the taxpayer on the new property. We have also been asked if people should be added to the title before a sale. The answer to that is no. For example, Sue owns a rental property and she is currently the only one on the title. She may want to add another individual to the title right before she sells it. This is not recommended. By doing this another taxpayer has been added to the property. The IRS could then come around and ask why this person took title to the property. Did they take it to hold it for productive use? Or did they take title to primarily facilitate the sale? These are small details that could jeopardize a 1031 Exchange if they are not sorted out properly.

But this also illustrates another facet of the consistent taxpayer. What if that individual that the person above wanted to add to the deed happened to be her husband? If they file a joint tax return then the IRS actually perceives both of them to be the same taxpayer by virtue of the joint tax return. In that event adding her husband to the deed right before sale does not change the taxpayer and would be permissible.

As we mentioned above, entities such as corporations and an LLC can own real estate. While there are many different people involved in this process, the title requirements state that the taxpayer names must match. Therefore, you as an individual cannot complete a 1031 Exchange with property that is owned by another entity, even if you are a part of that entity. Your best bet is to always check the tax returns to be sure.

Do You Have Questions? We have Answers!

While the title requirements in a 1031 Exchange seem simple enough, we’ve seen clients accidentally trip over this step more than once. Always make sure you check the title and the tax returns to be sure. The taxpayer of the old property has to be the taxpayer of the new property. And it’s not as simple as simply matching the deeds. There are going to also be lending issues and certain state tax issues that can get in the way and trip you up if you don’t have an experienced guide as a QI.

If you have any questions at all about these requirements, contact me and my team at 850-889-1031. We’re here to help with any questions you have regarding your 1031 Exchange.

In the next and last part of our series on the basic requirements of a 1031 Exchange, we will be discussing the reinvestment of cash or the equal or up rule. This is a very important last requirement, so don’t miss out!

 

This article first appeared on the BiggerPockets website: https://www.biggerpockets.com/member-blogs/12255/91178-title-requirements-1031-exchange-series-part-six

Qualified Intermediary Requirements: 1031 Exchange Series Part Five

If you’ve been following along with our seven-part series on 1031 Exchange basics, you know that we’ve already covered the first three of the six basic requirements. Now, we are moving on to the fourth requirement, using a Qualified Intermediary. The IRS requires the process of a 1031 Exchange to be documented and managed by the Qualified Intermediary. In this article we will discuss the requirements for a Qualified Intermediary (QI). Both their role in the exchange process and what to look for your QI.

1031 Exchanges Require a Qualified Intermediary

The IRS has a strict set of rules and time limits that you must stick to in order to qualify for a 1031 Exchange. Using a Qualified Intermediary to document all the transactions of your exchange and hold your proceeds is part of those rules. The IRS code states that an unrelated third party must document and manage just the 1031 Exchange part of the transaction. During the exchange process, you will use the services of your usual and familiar real estate professionals. This may include a real estate attorney, a title company, an accountant for tax reporting, and probably several real estate agents. A Qualified Intermediary is simply another professional that is added during a 1031 Exchange. In addition to their mandated role, a good QI will also act as your guide through the process.

Something important to note here is that the Qualified Intermediary MUST be involved before the closing of the sale of your investment property. A 1031 Exchange starts with the sale of a piece of investment real estate and ends with the purchase of replacement property. But this only works if your Qualified Intermediary is in place prior to the sale.

 

Who Can Be Your Qualified Intermediary?

The Qualified Intermediary is an unrelated third party. While we have mentioned a “third party” before, it’s important to emphasize that the Qualified Intermediary must truly be a third party. It cannot be your attorney, real estate agent, husband, or wife, etc. It has to be a completely unrelated party where all they do for you is document and manage your 1031 Exchange.

While the statue isn’t completely clear on what “qualified” is, it is crystal clear on what disqualifies someone from this role. That is: if there’s an agency relationship, a business relationship or a family relationship, the person or entity would be disqualified. This essentially means that as long as you haven’t purchased used tires from the used tire shop down the road, they could technically act as the Qualified Intermediary. However, that’s clearly not in your best interest. To understand why, let’s take a look at exactly what the Qualified Intermediary does.

What does the Qualified Intermediary Do?

The Qualified Intermediary will work alongside you and the rest of your regular professionals to document the entire 1031 Exchange and hold the proceeds from your sale. At a minimum, this includes:

  • Creating an exchange agreement (between QI and the investor)
  • Providing the assignment of contract rights (signed by the investor and enacted by the title company)
  • Giving notification (all parties to the transaction have to be notified – no standard of when)
  • Receiving and maintaining sale proceeds during the transition into the new investment/until the end of the exchange

Let’s take a closer look at these official aspects of the QI’s role.

EXCHANGE AGREEMENT

There will need to be an exchange agreement between you and your Qualified Intermediary that lays out all of the requirements we discuss in this article series. This agreement will specify what your role is going to be, what you’re going to have to do to finish the exchange, and what the Qualified Intermediary is going to do for you. This exchange agreement will be your contract with them.

ASSIGNMENT OF RIGHTS

As part of the process of using the Qualified Intermediary, there must be an assignment of rights. This is where you assign your rights to the sell the property to your Qualified Intermediary. Many states and jurisdictions already have real estate contracts that have check the boxes or default cooperation addendums for a 1031 Exchange. If that is not the case with your contract, we recommend you simply make your contracts assignable if possible. Regardless, this assignability and the exchange documents prepared by your QI allow the title company to direct deed the properties from the exchanger to the buyer and from the seller to the exchanger.

Note that your QI should never take title to either the relinquished or replacement properties. The QI is the assignee only on the settlement statement. This is an aspect of the assignment of rights that should be discussed in your Qualified Intermediary selection process (see more below).

NOTIFICATION

The statute does not specify how or when the parties to the exchange must be notified, only that it is required. Some exchangers have experienced more aggressive bargaining situations when the seller realizes a 1031 Exchange is in process. As a result, most QIs opt to provide this required notice as part of the closing process.

RECEIPT AND MAINTENANCE OF PROCEEDS

For an exchange to be valid, the investor may not have actual or constructive receipt of the proceeds from the sale of their relinquished property. Remember how we said before that you must have the Qualified Intermediary before you close the sale of your investment property? Part of the reason why is that after the closing of the sale, your proceeds must go into an exchange account with the Qualified Intermediary. The IRS considers funds in escrow with the title company constructive receipt by the seller, so the funds must be transferred to the QI. Then, when you purchase your replacement property, the funds will be transferred by the QI directly to the title company for closing.

Finding and Hiring the Right Qualified Intermediary

As your QI has to be an unrelated third party and will be holding significant cash on your behalf, we recommend you look for someone that meets these five criteria:

  1. Uses dual signatory segregated, qualified escrow accounts for your exchange funds (at no charge).
  2. Guarantees their exchange documentation.
  3. Provides support and documentation in the case of an IRS audit (at no charge).
  4. Is easily accessible to answer questions (at no charge).
  5. Has extensive, verifiable experience and a solid reputation.

While the exchange fee charged is a consideration, there is a range and a variety of potential additional charges among QIs who meet the above criteria. We recommend you check out our previous article on how much an exchange should cost to see what you should be paying and what your fee covers.

Don’t miss the next part of our series on the 1031 Exchange basics, when we’ll be talking about all of the necessary title requirements.

 

Originally posted on The Bigger Pockets Member Blog.

180-Day Rule: 1031 Exchange Series Part Four

So far in our seven-part series on 1031 exchange basics, we have discussed the six basic requirementsproperty being held for investment, and the 45-day identification rule. In the fourth part of our series, we are going to discuss more in depth the third requirement for a 1031 exchange which is the 180-day rule. If you’re curious about what this rule is and the timing requirements behind it, continue reading on to learn more.

The 180-Day Rule

As we have discussed in previous articles, there are two critical timing requirements when completing a 1031 exchange. This first is the 45-day identification rule which we discussed in part three of this series. The second is the topic we are discussing now, the 180-day rule. The 180-day exchange period runs concurrently with the 45-day identification rule. Therefore, if you haven’t read that part yet, we highly recommend it. However, here is a brief summary:

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Day one of the 45-day identification period starts on the day of your closing. You have 45 calendar days from the day of your closing to identify the replacement properties and take title to it OR produce a written list of the replacement properties that you’re going to use.

Similarly, the 180-day rule also starts on the day that you close your property. As we also mentioned, it runs concurrently with the 45-day identification rule. What this means is you have a total of 180 days to complete the entire 1031 Exchange transaction. While you may have 45 days to identify properties, you have a total of 180 days to close on the new property and accept the title to it. It’s important to note that the property you choose must be one of the properties from your 45-day list.

You Must Choose a Property from Your 45-Day List

One of the requirements of the 180-day rule is that you must choose a property from the45-day list you have turned in. This is a Federal IRS rule and there are no exceptions and no extensions. 180 days to complete an exchange sounds like a long time. It is the 45-day period is where most people get lost or fall behind. It is imperative you start looking for replacement properties as soon as possible and make a list of potential properties. In the end, when the 45 days are up, you are left to choose from that list and that list only. You will then have to close on one of those properties within the 180-day window.

You May Have Less than 180 Days

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If you’ve ever read over any federal laws, you know that they are very complicated and nuanced. Unfortunately, there is no exception here. With the 180-day rule, you actually have the lesser of 180-days or to the date of your next tax filing. The reason for this is the IRS wants your 1031 Exchange wrapped up and completed before you file your taxes. Therefore, it has to be reported on your next tax return.

For example, as everyone knows Tax Day is April 15th. If you sold your relinquished property on December 15th, you would have until April 15th to completely wrap and finish your 1031 Exchange by purchasing your replacement property or properties. This could be significantly less time than the allowable 180 days. You can easily avoid this by filing for an extension on your taxes. But, it’s a very important aspect to keep in mind. If you know you aren’t going to be able to complete your 1031 Exchange before taxes are due, go ahead and file for an extension.

Timing is Everything with the 180-Day Rule

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In the last two articles, we’ve discussed a lot about timing. The reason for this is because timing is everything in a 1031 Exchange. Properties must be identified within 45 days and you then have 180 days to close on one or more of those properties, and only those properties. However, keep in mind that you may actually have less than 180 days if you are due to file your taxes before then. If that is the case, you may want to request an extension on your taxes so you have time to finish your 1031 Exchange.

This article was originally posted at https://www.biggerpockets.com/member-blogs/12255/91039-180-day-rule-1031-exchange-series-part-four.