3 Myths That Haunt 1031 Exchanges

Think tax-deferred 1031 Exchanges of real estate are too new, sketchy or scary to try? Every week, I talk to investors just like you who are surprised to learn that:

  • 1. 1031 Exchanges have been around longer than IRAs and 401(k)s;
  • 2. 1031 Exchanges are 100% legal; and,
  • 3. 1031 Exchanges can be completed by novice investors.

Here are some myths I confront every day:

Myth #1: 1031 Exchanges Are Too New To Be Trusted

In 1921, Congress enacted The Revenue Act which authorized the exchange of like-kind property without paying tax. It was added to the Internal Revenue Code (IRC) Section 1031 and “1031 Exchanges” were born.

These transactions were originally used by cash-poor farmers to allow for the “exchange” of investment real estate without paying tax on the gain. In the intervening 98 years, IRC 1031 rules and regulations have evolved to serve today’s real estate investors. As we approach the 100th anniversary of 1031 Exchanges, the myth of their novelty should be retired.

Myth #2: 1031 Exchanges Are Sketchy

1031 Exchanges are not a “tax loophole”. Like your 401k or IRA, the tax deferral benefits of a 1031 Exchange are government endorsed and sponsored. As times have changed, the ways in which 1031 Exchanges can be successfully conducted have been both clarified and refined. Your 1031 Exchange qualified intermediary can guide you through the specific steps of this legal transaction.

Myth #3: 1031 Exchanges Are Scary

Most investors I talk to tend to be annoyed by the restrictions imposed on their IRA or 401(k) rather than fearful of the tax-deferred retirement provisions in the law. Same with 1031 Exchanges – there are specific rules and regulations. Some of these are maddening and some of them are pesky, but millions of investors have navigated them successfully. If you have never completed a 1031 Exchange, don’t be put off or intimidated by unfamiliarity.

In the course of your real estate investing career, you may find yourself selling your appreciated or depreciated investment real estate and purchasing replacement investment real estate. Why not keep your taxes working for you in that transaction? Follow the 1031 Exchange rules and regulations and you can indefinitely defer payment of the tax that would normally be due on sale and grow your portfolio using Uncle Sam’s money. Its time tested, legal and entirely within your capabilities.

Myth busted!

To find out more about 1031 Exchanges and how they can benefit you call us at 850-889-1031 or use our online calendar to schedule an appointment with an exchange specialist.

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Choosing Your Qualified Intermediary

5 Things to Look For In Your Qualified Intermediary

Before you can begin your 1031 exchange, you will have to select a Qualified Intermediary (QI). A good QI can make or break your exchange. To ensure that everything goes smoothly it is important to make sure that your Qualified Intermediary is actually qualified. Here are five things to look for in a QI.

1.   They should use a segregated, qualified escrow account (at no charge)

Make sure that the QI you select does not have a pooled exchange account. It is important to ensure that your exchange account is not comingled with someone else’s funds. Your QI should have a segregated qualified escrow account so that only your money is in that account and it is identifiable to you.

2.   They should guarantee their exchange

Your Qualified Intermediary should do everything in their power to ensure that your exchange is successful. A good QI should be able to assure you that your exchange will be carried out without a hitch.

3.   Audit protection – providing support and documentation if needed (at no charge)

Make sure that the QI you select keeps their records and documents tidy. Should an audit occur, you want to be certain that your QI has all the documentation you need.

4.   They must be easily accessible to answer questions (at no charge)

Avoid Qualified Intermediaries with poor communication skills. You want your QI to be reachable and ready to answer any questions that you might have. Keep track of how long it takes them to answer phone calls and emails. They should be responsive to your inquiries as they are holding your hard earned profits.

5.   Experience

You want to look for a QI who has experience, a reputation in the industry, and who has demonstrable results. Do not select a Qualified Intermediary who does not have a history to back up their claims.

Selecting a good QI is a key step in ensuring that your 1031 goes as planned. If you select the right QI to guide you through the process, you can focus on your real estate investing as they handle documentation.

To learn more about how you can utilize the power of a 1031 Exchange call us now at 850-889-1031 or click here to schedule your free consultation.

How to Complete a Partial 1031 Exchange

A 1031 exchange doesn’t have to be an all-or-nothing move. It is possible to complete a partial 1031 exchange that allows you to either take cash out, purchase less than you sold, or both.

But there are tradeoffs. Completing a partial exchange creates a tax liability you will want to thoroughly understand before moving forward. This article will help you determine if it is a good fit for your personal and financial goals.

Join our partial exchange webinar! Or keep reading to find out what a partial 1031 exchange is and then walk through the process.

What is a 1031 Exchange?

A 1031 exchange allows you to defer all federal capital gains tax and depreciation recapture when you sell an investment property and purchase a replacement investment property of equal or greater value using all the cash proceeds in that purchase. 

What is a Partial 1031 Exchange?

A partial 1031 exchange lets you defer part of the federal capital gains tax and depreciation recapture that would have been due on sale. 

A partial 1031 exchange occurs when either the relinquished property proceeds are not all expended on replacement(s) or the value of the replacement(s) is less than the net sales price. 

The portion of the exchange proceeds not reinvested is called “boot” and is received by the exchanger as either cash or payment of costs not eligible for tax deferral. The difference is subject to capital gains tax and depreciation recapture.

You may have solid personal or business reasons to complete a partial exchange intentionally. With planning, it may be a good way to meet your objectives. When completing a partial exchange, you can opt to take some cash out or purchase a less costly replacement property and still defer some of the tax.

How Can You Do a Partial 1031 Exchange?

A partial exchange has the same basic requirements and steps as a regular exchange. However, at some point in the process, you decide to take cash out or purchase less than you sold.

Taking Cash Out

Because a 1031 exchange requires that you do not have constructive receipt of sale proceeds, once an exchange is initiated, there are typically just a few opportunities to take cash out. Those opportunities might be:

  1. At the closing table of your sale
  2. After day 45, whenever you finalize the purchase of all replacement properties and have funds left in your account
  3. The first business day after day 180

Note that these cash-out opportunities should be explicitly spelled out in the exchange agreement with your Qualified Intermediary (QI). If you intend to execute a partial exchange, make this aspect part of your QI selection process so your funds are not held up unnecessarily until after day 180.

At the Closing Table of Your Sale

If you know the amount you wish to take out in cash, the earliest opportunity to do so is at the closing table of your relinquished property sale. To receive cash back at that time, you would simply let your QI and closing agent know of your intent and specify the amount you wish to have distributed directly to you. The QI will typically prepare a “Boot Addendum” for you to complete at the closing table, and the closing agent will need information on where to transfer funds/how to make out the payment. 

However, if your goal is to put down a specific percentage on your replacement property, it is unlikely that amount will be known at the time you close your sale. In that case, you may choose to have all proceeds transferred to the QI and receive the cash back at the first allowable opportunity after closing on your purchase(s).

After Your 45-Day Identification Deadline and Purchase of All Identified Properties

Depending on the exchange agreement with your QI, after you have closed on all identified property, you may receive any remaining proceeds back as cash as early as the first business day after your 45-day identification deadline. 

If your purchase happened well before the 45-day identification deadline, receipt of remaining proceeds on the first business day after that deadline is likely—so long as you provide advance notice of your intent and supply all transfer details to your QI ahead of time. 

However, if your purchase happens close any time after your 45-day identification deadline, the transfer may not be possible for several days or weeks after closing, depending on when your closing agent returns all closing documents to the QI.

Purchase Less Than You Sold

The other way to complete a partial exchange is to purchase less than you sold. Even if you use all cash proceeds in the purchase, buying replacement property for less than the net sales price of your relinquished property constitutes a partial exchange and creates a taxable event.

Example: Cash-Out

An example of a cash-out partial exchange would be the net sale of relinquished property for $1,000,000 with $100,000 cash out at the closing table. Your exchange documentation would reflect that $100,000 went directly into your pocket. This creates two aspects of the sale: the $900,000 exchange portion and the cash out of $100,000. The $100,000 in your pocket is taxable. 

In this instance, your reinvestment target would be the net sales price of $1,000,000 less the $100,000 cash out, so you would need to purchase as much or more than $900,000 to defer the remaining tax on the gain and depreciation recapture.

Example: Reinvestment Purchase Less than Net Sale

An example of a purchasing less than the net sale partial exchange would be the net sale of relinquished property for $1,000,000 followed by the purchase of replacement property for a net $900,000. Your settlement statements would reflect this shortfall between sale and purchase, which typically results from taking on less indebtedness for the replacement property. This creates two aspects of the exchange: the $900,000 exchange portion and the taxable shortfall of $100,000.

Tax Consequences of a Partial 1031 Exchange

In the previous examples, you’ll be unable to defer the $100,000 cash out/reinvestment shortfall from taxation. That portion not reinvested is subject to capital gains and depreciation recapture taxes. The significance is that the IRS considers the first dollar out of the exchange profit. This means that regardless of your basis in the property, the first dollar you touch or the first dollar of the shortfall is taxable. The intent of a 1031 exchange is to defer, not forgive, taxes. 

As such, any amount removed from the deferral process won’t escape taxation. Once you receive the cash out of the transaction or fail to meet the reinvestment target, it constitutes a taxable event.

Determine If A Partial Exchange Is Right For You

Depending on your situation, a partial exchange may be a good fit. Remember that the same 1031 exchange rules and restrictions apply if you complete a partial exchange. To discover it is right for you, join one of our upcoming webinars on partial exchanges or book a free consultation with an exchange expert.

 

 

This article first appeared on The Bigger Pockets blog on August 27, 2022.