Creative Uses for 1031 Exchanges in a Challenging Real Estate Market
With real estate values plummeting and bank financing more difficult to obtain, sellers and buyers are looking for novel uses of 1031 exchanges to help them buy and sell properties. The following outlines some of these approaches, including partial exchanges, taking cash out at closings, seller financing alternatives, and refinancing following the exchange. None of these are particularly new techniques, but many property owners are either not aware that they are available, or are unsure how to maximize their use.
To fully defer the entire gain on the sale of a relinquished property, the entire sales proceeds (not just the net cash proceeds or the gain) must be spent. If the exchanger purchases a property of lesser value, some gain will have to be recognized. The important point is that the exchange does not fail.
A trade down in value results in either cash coming back to the exchanger or incurring less debt on the replacement property. Either way, the taxpayer has received non-like-kind property, known as boot. The tax laws require gain to be recognized if boot is received. As long as the total gain exceeds the boot received, an exchange is still generally advisable.
Exchangers consider partial exchanges for several reasons. Even though a small amount of taxes will be paid, these exchangers are still willing to receive the boot in order to pay necessary expenses, unrelated to the exchange, such as credit cards. Other times, taxpayers were ready to forego the 1031 exchange because they were under the misimpression that the exchange would fail completely if they traded down in value. Once they understood that trading down was not a major problem, the exchange went through.
So, when contemplating an exchange, contact your CPA to fully understand your basis and how a 1031 exchange will work. Also, contact your Qualified Intermediary (QI), such as All States 1031 Exchange Facilitator, LLC, to make sure you fully understand your options.
Taking Cash at the Closing
A corollary to the discussion above occurs when an exchanger wants to take cash out of the closing of the relinquished property. The exchanger may want to pay off credit cards, medical bills, pay down their primary residence mortgage, or pay for a child's wedding. If so, timing is critical because once the cash is received by the QI, restrictions are placed on the ability of the exchanger to receive any money.
Once the QI has received the exchange funds, the taxpayer generally cannot receive those funds until after the 45-day identification period expires, with certain exceptions. If the exchanger identifies replacement properties during the 45-day period, then the exchanger cannot touch the money until all the properties have been acquired, or the expiration of the 180-day replacement period, whichever comes first. Click here for a detailed discussion of these IRS mandated restrictions.
So, if the exchanger wants some of the sales proceeds from the sale of the relinquished property, the closing attorney and the QI must be notified and arrangements made to receive the desired funds at the closing. The amounts received will be taxable, but at least the exchanger will be able to receive them right away.
Seller Financing Alternatives
Sellers who want to exchange often face difficulties with buyers qualifying for financing. As a result, sellers may consider financing all or a portion of the selling price. In many instances, a seller will still be able to achieve full or partial deferral of the taxes through a 1031 exchange, if handled properly.
In one scenario, the seller can hold a mortgage from the buyer and recognize a portion of the gain as each payment is made using the installment method of accounting. The balance of the sales price can be paid to the QI and exchanged for a replacement property.
Another scenario is to have the promissory note made payable to the QI. If so, then the buyer can pay off the note during the exchange period, thus allowing the full sales price to be used to acquire the replacement property. Or, the promissory note could be sold by the QI to an unrelated third-party buyer thereby providing cash for the QI to acquire the replacement property. Similarly, the QI could transfer the note to the seller of the replacement property, if such seller would accept the note. If so, then the entire gain can be deferred.
A final scenario is for the exchanger to purchase the promissory note from the QI using other funds thereby allowing the QI to have all of the exchange proceeds available to acquire the replacement property. The exchanger will not recognize any income upon receipt of payments under the note, except for any interest paid.
While all of these scenarios are legal and viable, an exchanger contemplating seller financing should contact their tax advisor prior to beginning substantive negotiations.
Refinancing After the Exchange
Exchangers have the ability to refinance the replacement property following the closing and to receive the loan proceeds tax-free. Timing is crucial in that the loan must be made after the close of the exchange. No particular time period after the close of the exchange is required, as long as the loan transaction is separate and apart from the exchange. An exchanger who receives cash in any manner from the closing of the purchase of the replacement property could be subject to tax for receiving boot in the exchange. By waiting until immediately after the exchange, the IRS will have a difficult time asserting that the exchanger received boot.
Many nuances exist in this area. An exchanger should discuss any type of financing in connection with a 1031 exchange with their CPA or tax advisor and their QI. These ideas may help exchangers save taxes by understanding more fully the options available to them. Like many provisions of the tax law, the general rules are complicated by many exceptions and exceptions to exceptions. But, in the end, a fully informed exchanger has many tools available to them.