By: William L. Exeter President/CEO of Exeter 1031 Exchange Services, LLC.
WHAT HAPPENS IF MY 1031 EXCHANGE FAILS?
Q: I’m looking at doing a 1031 exchange on a property that I’m selling on a short notice due to an unexpected offer. I am nervous about finding the “perfect” investment replacement with only a few weeks to identify the property. Let’s say I go this route and I don’t find a property that I’m interested in during the specified time period. I would imagine that the intermediary would simply cut me the check and then I would pay capital gains on the earnings? Is it easy to access my money if I have an issue going through with the exchange?
A: Section 1031 of the Internal Revenue Code (1031 Exchange) works in conjunction with Section 453 of the Code (Installment Sale Treatment).
This means that when (or if) your 1031 Exchange fails it is taxable under the installment sale rules because you do not have immediate access to your 1031 Exchange proceeds. The year in which you will recognize and realize the tax will depend on when you have the right to receive the funds. The Treasury Regulations are very clear that a Qualified Intermediary is not permitted to release the 1031 Exchange funds unless certain events have occurred such as the 45 calendar day identification period passing or the 180 calendar day exchange period passing.
So, in the example above, if you close on the sale of your relinquished property after November 16th, your 45th calendar day identification deadline will fall in the next tax year. You would not have the right to receive your net proceeds until after the 45th day. This assumes that your Qualified Intermediary includes the correct language in your exchange agreement and follows the rules. Your capital gain would therefore be taxable in the following tax year.
Furthermore, your depreciation recapture cannot be deferred under the installment sale rules, so in the example above, your capital gain would be deferred into the following year, but you would pay your depreciation recapture taxes in the year of sale. You have to be careful and plan your cash flow accordingly so that you can afford to pay the taxes. You can also elect to take the tax hit in the current year instead of treating it as an installment sale if that turns out to be better for you.
The Qualified Intermediary must follow the Treasury Regulations in order to properly handle a cancelled or failed Exchange.
WHAT HAPPENS AT MY DEATH AND MY DAUGHTER INHERITS MY PROPERTY?
Q: We are a married senior couple. In addition to our primary residence, we own a 3-unit apartment and a rental house in Orlando, Florida. We understand when one of us passes on, the surviving one would have a stepped up basis on all properties. What would be the tax consequences if the surviving one sells the apartment and the FL rental house – (1) Will depreciation have to be recaptured? (2) What if our daughters eventually inherit the properties and sell, any difference taxwise?
We thought of 1031 exchange also. Would it be wise to – (a) do it while we are both living? (b) wait till one is gone? or (c) let the heirs do it?
A: You should consult with your accountant to make sure that you will receive a full step-up in cost basis when the first spouse passes. There are certain requirements that must be met in order to get a full step-up in cost basis and your accountant should be able to quickly confirm that you will get a full step-up in cost basis or whether you need to make any changes in order to make sure that you will receive a full step-up in cost basis.
Assuming that you do receive a full step-up in cost basis, then upon the first spouse’s passing there would be no capital gain or depreciation recapture taxes to worry about. The surviving spouse should be able to sell the properties immediately and have no tax consequences, or if the surviving spouse holds the properties for a period of time, they would only be responsible for the taxes on any capital gain or depreciation recapture after the date the first spouse passed.
The kids should also receive a full step-up in cost basis upon the second spouse’s passing and they could sell the properties immediately and have no tax consequences, or if the kids hold the properties for a period of time, they would only be responsible for the taxes on any capital gain or depreciation recapture after the date the second spouse passed.
The timing of the 1031 Exchange is really up to you and your personal preference. If you are happy with the properties today and there is no reason to sell, then I would hold and do nothing. If you want to make changes and diversify your portfolios, you can do the 1031 Exchange now and reposition into properties that you prefer (or you can ask your kids what they would like to inherit and exchange into those now).
SELLER CARRY-BACK NOTES AND 1031 EXCHANGES
Q: I’m selling a small apartment complex and providing owner financing in order to close the deal. The buyer will make a 20% cash down payment plus monthly payments for three years, with a balloon payment due at the end of three years. Is there any way to 1031 the remaining balloon payment received at the end of the three-year period?
A: The initial answer is no. The sale of your real property occurred (closed) upfront (now). The owner financing, also referred to as seller carry-back financing, is merely the financing structure or strategy used to help the buyer acquire and pay for the purchase of your real property. The payoff of the note (and receipt of the principal by you) at the end of the three- year term is not a sale of real estate. It’s just a note payment. Therefore it does not qualify for 1031 Tax Deferred Exchange treatment.
However, there is a way to structure a 1031 Tax Deferred Exchange upfront when your real property is sold and the seller carry-back note is initially drafted. The seller carry-back note must be drafted so that the Qualified Intermediary is listed as the beneficiary (“lender/owner”) of the installment note. This way the Qualified Intermediary ends up owning the seller-carry back note inside of your 1031 Tax Deferred Exchange. The Qualified Intermediary will receive the net cash proceeds from the sale of your relinquished property and will hold the seller carry-back note inside of your 1031 Tax Deferred Exchange account.
The cash AND the seller carry-back note must be used to acquire your replacement property through your 1031 Tax Deferred Exchange. The note generally has to be converted into cash in order to acquire the replacement property and complete the 1031 Tax Deferred Exchange.
The most common method used to accomplish this is to have the taxpayer contribute cash into his or her 1031 Tax Deferred Exchange account equal to the face value of the seller carry-back note. The 1031 Tax Deferred Exchange account is now holding all cash (as well as the seller carry-back note) and is in a position to complete the 1031 Tax Deferred Exchange by acquiring the replacement property.
The seller carry-back note would be assigned to the taxpayer AFTER the 1031 Tax Deferred Exchange transaction has been completed. The entire sale transaction, including the seller carry-back note, is tax-deferred (assuming they meet all of the other 1031 Tax Deferred Exchange requirements) because the installment note was structured inside the 1031 Exchange.
The only portion of the seller carry-back note that would be taxable is any interest income paid under the terms of the installment note. The receipt of principal through the payoff in three years would not be taxable if the seller carry-back note is structured as part of the 1031 Tax Deferred Exchange as outlined above. If the note is drafted in the taxpayer’s name instead of the Qualified Intermediary’s name (i.e., the seller carry-back note is outside of the 1031 Tax Deferred Exchange), then the balloon payment and corresponding receipt of principal in three years will trigger any remaining deferred capital gain.
Your questions are always welcome; we invite you to submit them to us at email@example.com or by posting them to the Exeter Discussion Board at exeterboard.com.
William L. Exeter is President/CEO of Exeter 1031 Exchange Services, LLC. He’s been in the fiduciary services industry since 1980, began specializing in real estate tax strategies in 1986 with a specialty emphasis in 1031 and 1033 Exchanges, Self-Directed IRAs, and Land Trusts. Bill has written and lectured extensively on 1031 and 1033 Exchanges, Self-Directed IRAs, and Land Trusts and is a frequent guest expert on San Diego Radio Shows “The Financial Advisors — Money Talk Radio Show” on AM 600 KOGO and on “Inside Business Radio Show” on AM 1000 KCEO. You can email your questions to firstname.lastname@example.org, call (866) 393-8370, fax to (866) 393-8371 or mail to 402 West Broadway, Suite 400, San Diego, CA 92101, exeter1031.com. We have Answers; Go Ahead, Ask!