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.

New Yorkers Are Fleeing High Taxes and Moving to Florida

Aside from the obvious benefits of having year-round sunshine and beach access, Florida also has the benefit of being a very tax-friendly state. With no income tax and waterfront views at a lower price, it is easy to see why New Yorkers are fleeing the frozen north. According to Businessinsider.com, millionaires from New York can save more than one million in taxes by relocating to Florida. In fact, mansion sales are on the rise in Florida. Florida has certainly come out quite nicely as a result of the recent tax cuts.

3 Myths That Haunt 1031 Exchanges

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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!

Fixer Upper: Can Taxes Make Your Deal A Flip Or Flop?

Why You Should Rent – Not Sell – Your Home

Our latest guest blog is live. Visit Bigger Pockets to learn how you can accelerate your real estate investing using your primary residence.

Do I Need An Attorney For A 1031 Exchange?

Do I Need An Attorney For A 1031 Exchange?

The IRS statute requires that you use a qualified intermediary (QI) to perform your 1031 exchange. While it is possible for an attorney to provide this service, it doesn’t have to be an attorney and it can’t be an attorney you have utilized for any other matters. This is because the IRS statute also requires […]

Discover how 1031 Exchanges can be used to keep the tax on your TIC working for you!

What To Do With Your Slice Of The Pie: 1031 Exchanges And Tenants In Common (TICs)

Tenants In Common (TIC) is a wonderful little arrangement wherein multiple owners each have a deeded interest in a property. That interest is a percentage or portion of the property. But can investors who hold an investment as Tenant in Common still take advantage of a tax deferred 1031 Exchange?

Long answer short: YES! When you sell your TIC, you can each decide what you want to do with your slice of the pie.

  1. You can stay together as one 1031 Exchange or
  2. You can 1031 Exchange your portion while the other(s) to take cash or
  3. You can each do a 1031 Exchange into separate properties with your portion.

You’ve got great flexibility in how you transition out of a property held as tenants in common. Because each situation and investor has unique circumstances, always consult with your financial adviser before proceeding.

1031 Exchange: The Most Important Thing to Know

Using a 1031 Exchange to grow your real estate portfolio faster using Uncle Sam’s money is a strategy that has helped millions of investors.

But of all the things you need to know about a 1031 Exchange, the most important thing is that it must be in place BEFORE you sell your investment real estate. The moment you receive your sale proceeds, it’s TOO LATE and you will have to pay the tax. Many investors new to this tax deferral method have discovered this after their sale and paid for it – literally.

The great news is that even if you are closing tomorrow or don’t know when you will close, it is quick and easy to start your exchange. Once you know what title company will be handling the transaction, the exchange can be initiated on your behalf by your Qualified Intermediary (QI).

Initiating your exchange with a QI prior to your sale is a rule that is a critical thing to keep in mind as you continue to learn about 1031 exchanges. I hope you will use the free online resources here at www.the1031investor.com as you explore this option.