1031 Exchange: Questions & Answers #6

By: William L. Exeter President/CEO of Exeter 1031 Exchange Services, LLC.

Q: We have a house which has been rented for many years and is eligible for a 1031 exchange transaction. I understand the process and how to go about setting up the sale of the relinquished property. The replacement property for the 1031 is where I need help. Our son and his father in-law have an LLC together, which has two properties in it. One of these two properties is owned 30% by our son and 70% by the father in-law. We would like to use the proceeds of the sale of our house, the relinquished property, to buy the 70% share of the one property owned by the father in-law in the LLC. Is this possible? If not, how would we go about obtaining that 70% with the money from the relinquished property sale? The house sale and the 70% would be about the same amount of money. The replacement property is a 4-plex.

A: The replacement property is currently held in a limited liability company. So it is critical that you are buying an interest in the real estate, and not buying an interest in the limited liability company (which would be considered a purchase of a partnership interest and not real estate). You should also have your tax advisor review whether there is a related party transaction and what options might exist if there is a related party transaction.

Q: I want to buy a residence for about $600,000. My father has offered to give me a cash gift of $300,000 toward that purpose and has that money in liquid assets now. He is also planning to sell an income property for the same amount as his promised gift (about $300,000) and wonders whether he could use the proceeds from that sale instead. One idea is that he would buy a portion of the property as a replacement income property and rent it to me. But can one house be part income property and part residential? Maybe he and I could form an LLC, buy the house together as an income property, and then the LLC can rent the house to me? Even if that is possible, maybe the higher commercial interest rate would cancel out the tax benefits of doing the 1031 exchange. Thanks for your thoughts on this.

A: Yes, it is possible for one property to be used partially as a primary residence on your part and partially as income property on your father’s part. He could structure a 1031 Exchange whereby he purchases an undivided percentage interest as a tenant in common with you, provided that you pay fair market rent to him for his portion of the property. He would have to acquire an undivided fractional interest as a tenant in common. The formation of a limited liability company would not work for his 1031 Exchange since the limited liability company would be considered a partnership for tax purposes and therefore a separate legal entity. If he is selling his property in his individual name, he must also acquire the fractional interest in his individual name.

Q: If I understand the rules correctly, I cannot take out a portion of the money for the property that I paid in full without paying capital gains tax. For example, say I paid $500,000 for a property and sold it 10 years later for $1,000,000. There normally is a capital gains tax on the $500,000 gain. Let’s say I buy a replacement property at $750,000. I understand there are adjustments for closing and buying costs, depreciation, and improvements, but I am keeping it simple. If I take out say $250,000 in cash at closing before a 1031 escrow, I will be taxed on that $250,000 even though I paid cash in full and had equity of $500,000, correct? Thanks for affirming this or clarification.

A: Yes, you are correct. Any time you trade down in value or pull some cash out of the transaction, the amount that you trade down by or pull out will first be applied toward your taxable items. Your cost basis is not prorated, so the amount that you trade down or cash out by would all be taxable up to the total amount of your gain. If you trade down too far in value or pull too much cash out, you would recognize all of your taxable gain and the 1031 Exchange would not provide you with any benefit.

So, in your example, you sold property for $1 million that has an original cost basis of $500,000. If you structure a 1031 Exchange and only acquire replacement property worth $750,000, you would recognize $250,000 in taxable gain (ignoring depreciation recapture) and you would defer $250,000 in taxable gain.

Each month we review some of the common questions we receive about 1031 Exchanges. Your questions are always welcome. Submit them to us at [email protected] or by posting them to the Discussion Board at exeterboard.com.

William L. Exeter

William L. Exeter

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 [email protected], 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!