1031 EXCHANGE FAQ
If you browse this 1031 Exchange FAQ page, you will probably find that it is the one best way to learn everything about the Section 1031 Exchange process.
The questions below will take you to pages where you will find a concise, yet complete, answer. If you need more, use the Search function, scan the Categories, or cruise the tabs.
Yes, you can.
And you have 3 choices of how to do it.
Section 1031 permits you to sell your investment property, called the Relinquished Property, and defer taxes on your Capital Gains and Depreciation Recapture if you purchase another investment property, called the Replacement Property.
Section 1031 requires that the value of the Replacement Property be equal to, or greater than, the value of the Relinquished Property.
You can actually purchase a Replacement Property of lesser value, but then you will only be doing a Partially-deferred Section 1031 Exchange.
Section 1031 Rules also require that you use all of the Net Sales Proceeds from the sale of the Relinquished Property in the purchase of the Replacement Property.
There are, of course, more Section 1031 Exchange rules and you can read them here.
Your question is whether you can purchase your Replacement Property and have the Seller of that property take back a note for part of the purchase price.
Here’s how that would work.
Let’s use an Example, with simple numbers.
You bought an investment property for $130,000 with a $90,000 mortgage.
You have claimed $30,000 in Depreciation so your Depreciated Basis in the proeprty is now $100,000 and you have paid the note down to $80,000.
Now you are selling the property for $300,000.
You have $200,000 in profit, the difference between the Selling Price and your Adjusted Basis.
$170,000 of this profit is true Capital Gains, the difference between what you paid for the property ($130,000) and what you sold it for ($300,000).
The other $30,000 of your $200,000 profit represents your claimed Depreciation.
When you close on the sale, your $300,000 Gross Sales Proceeds will be reduced by the mortgage payoff of $80,000 and you will have Net Sales Proceeds of $220,000.
Let’s say you purchase a Replacement Property for $410,000.
You must use the $220,000 of Net Sales Proceeds toward the purchase of the property, leaving $190,000 in funding that you must provide.
You can use your own cash for all or part of that amount.
You can use bank financing for the entire $190,000.
You can sign a note back to the Seller for $190,000.
Or, you can use any combination of the three.
As long as you buy a Replacement Property of equal or greater value, and use all of your Net Sales Proceeds in the purchase, it does not matter where or how you finance the rest of the purchase.
Seller financing is completely acceptable.
It's Like A Seminar In A Book
No, there is actual written requirement in the Internal Revenue Code that you use an entity referred to as a Qualified Intermediary.
There is a requirement that in order to qualify for the tax-deferral of Capital Gains Tax and Depreciation Recapture Tax offered by a Section 1031 Like Kind Exchange, you must not have actual or constructive receipt, or control over, the Net Sales Proceeds from the sale of the Relinquished Property.
There is another provision in Section 1031 that provides for a “safe harbor.”
This means that the IRS will assume that you have met this requirement if you engage an entity called a Qualified Intermediary to receive the Net Sales Proceeds and hold them until they are provided to the claosing agent for the purchase of your Replacement Property.
But you are not required by statute to use a Qualified Intermediary.
And, by the way, the term “qualified” in the title “Qualified Intermediary” does not mean that the entity is actually qualified, in the sense of having any ability, to do anything.
It just means that they are not “disqualified.”
A person or entity is disqualified from acting in this capacity if it or they have been your agent, or have provided professional services to you, within the prior two years.
Everyone else in the world is qualified to be your Qualified Intermediary, although you should probably choose someone with experience doing this, and someone with something to lose, such as a license, if they screw it up or an employee steals your money. I recommend someone like an Attorney or an Accountant.
Would using a Section 1031 Exchange make me a bad real estate investor?
This is typical of the misinformation rampant on the web about the Section 1031 Exchange.
Here are the facts:
In 2010, the last year for which the IRS has compiled the information, there were 158,299 Section 1031 Exchanges reported by Individual taxpayers on Form 8824.
The total amount of Capital Gains reported was $3,470,728,000.
Of this, $2,723,076,000 was deferred, and $747,652,000 was recognized.
Partnerships filed 18,887 Forms 8824 and reported almost twice the dollar amount.
Partnerships reported total Capital Gains of $7,682,352,000.
Of this, they recognized $1,555,981,000 and deferred $6,126,371,000.
For Corporations the 2010 numbers are not available, but the 2009 are.
Corporations reported 61,231 Section 1031 Exchanges.
Their total reported Capital Gains were $28,826,264,000.
Of this, they recognized $1,156,639,000 and deferred $25,678,583,000.
The average Capital Gains deferred per Individual was $17,200.00.
For Partnerships, the average Capital Gains deferred was $324,370.00.
For Corporations, the average Capital Gains deferred was $419,370.00.
Section 1031 is absolutely the best section of the Internal Revenue Code!
When can you use a Section 1031 Exchange in real estate?
Section 1031 of the Internal Revenue Code allows you to sell “property held for productive use in a trade or business or for investment,” in other words, Investment Property, and avoid paying taxes on your profit, your Capital Gains, if you reinvest the Net Sales Proceeds in a “property of like kind which is to be held either for productive use in a trade or business or for investment,” in other words, another Investment Property.
You can read about the Rules and how the process works at 1031 Exchange Rules.
The taxes are not forgiven, they are just deferred for as long as you own the second Investment Property, and when you sell it the taxes can be deferred again, etc.
All top Real Estate Investors use Section 1031 instead of paying taxes on Capital Gains and Depreciation Recapture.