1031 EXCHANGE RULES AND DELAYED EXCHANGE
The Section 1031 Exchange Rules are contained in Internal Revenue Code Section 1031(a)(1) and Treasury Regs Section 1.1031(a)-1.
These are excellent for litigating issues in court, but these are not the 1031 Rules you need for your own 1031 Exchange.
And you won’t have to worry about them.
The Section 1031 Exchange Rules that you need are the ones that I will list below.
I will also show you how they work, if you scroll further down the page, with actual transactions.
At this point you should check my credentials at About.
1031 EXCHANGE RULES SUMMARY
There are nine basic rules and seven additional rules. Let’s start with the basics.
1.) Like Kind Property. The property that you sell, your Relinquished Property, will be either real property or personal property, or both.
The property that you buy, your Replacement Property, will be either real property or personal property, or both.
The real properties must be “like-kind” and the personal properties must be “like-kind” to each other.
This does not mean that the real properties are “like” in appearance, but are “like” in their use or characterization, such as both being used as business or investment properties.
For personal properties, it does mean that they are like in appearance, as well as every other way.
2. Business or Investment Property. The next 1031 Exchange Rule requires that the Relinquished Property be “property held for productive use in a trade or business or for investment.”
The Replacement Property must be property “which is to be held either for productive use in a trade or business or for investment.”
3. Replacement Property Price. The price that you pay for the Replacement Property must be equal to, or greater than, the sales price of the Relinquished Property.
4. Net Sales Proceeds. This is the amount that you are entitled to receive at the closing on the sale of your Relinquished Property.
The 1031 Exchange Rules require that all of your Net Sales Proceeds be used in the purchase of your Replacement Property.
If you take out part of the Net Sales Proceeds, that part will be taxable to you as “boot.”
5. Same Taxpayer. The name that goes on the deed when you receive the Replacement Property must be the same name that was on the deed for the Relinquished Property. It can be you as an individual, or an LLC, a C or sub-S corporation, a Partnership, etc.
However, if you sell the Relinquished Property as an individual, and you buy the Replacement Property in the name of an LLC in which you are the sole member, and you have elected to be treated by the IRS for tax purposes as a Disregarded Entity, the seller and buyer are considered to be the same under the 1031 Exchange Rules.
It's Like A Seminar In A Book
6. 45-Day Period. This is the first of the two 1031 Exchange Timelines.
The date on which you close on the sale of your Relinquished Property is called the “Exchange Date.”
Within 45 days from this date, you must identify the property that you intend to purchase as your Replacement Property.
You have three ways to do this.
First, you can identify up to three properties without regard to the value of each, or the total value of all three.
Or, you can identify as many properties as you want as long as the total value of all of the properties is not more than 200% of the value of the Relinquished Property.
And finally, the most complicated of the 1031 Exchange Rules, you can identify as many properties as you want, without regard to the “200%” limitation, as long as you end up closing on enough of the properties to represent 95% of the total value of all of them.
7. 180-Day Period. This is the second of the two 1031 Exchange Timelines.
Within 180 days after the Exchange Date, you must close on the purchase of your Replacement Property.
If you do not close within this time,
- the entity holding your Net Sales Proceeds will distribute those funds to you,
- you will not be permitted to engage in a Section 1031 Exchange, and
- you will pay Capital Gains and Depreciation Recapture Tax on the sale.
The IRS will not impose penalties or interest.
8. Related Party. The 1031 Exchange Rules say that you cannot sell your Relinquished Property to, or buy your Replacement Property from, a person related to you, a related party, without having certain conditions imposed.
A “Related Party” is your spouse, your brother, your sister, your child, your grandchild, your parent, or your grandparent.
It also includes a corporation, partnership, Limited Liability Company, or similar business entity in which you own more than 50% of the interest. This percentage includes your spouse’s ownership.
Related Parties are allowed to do a direct swap of properties, but each party must hold the acquired property for a period that is more than two years after the date of the last transfer.
Each Related Party must continue to file Form 8824 for two years following the year of the Exchange.
You can sell your Relinquished Property to a Related Party, but the Related Party is required to hold the property for the two year period described above.
If the Related Party fails to do so, the transaction will be declared invalid under the 1031 Exchange Rules, and taxes, penalties, and interest will be imposed on both parties.
You will be held to the same two year filing requirement for Form 8824, except that it could turn into three years for you because the period will start to run from the date that you acquire your Replacement Property, and this could be 180 days after the first closing, and could cover three tax-filing periods.
You are not prohibited from buying Replacement Property from a Related Party, with the same two year reporting requirement for Form 8824, but it almost guarantees that the IRS will audit the transaction because this is where they find most of the abuse of the Section 1031 Exchange, family members trying to game the system.
9. Qualified Intermediary. The most important of the 1031 Exchange Rules is that you cannot have actual receipt of, constructive receipt of, or control over the Net Sales Proceeds.
You must sign an Assignment of Benefits of your sales contract on your Relinquished Property to an independent third party.
Usually this is a Qualified Intermediary.
The name does not mean that the individual or entity is “qualified” in any way to do anything, and they often are not qualified.
A Qualified Intermediary (QI) is an entity that is not disqualified from providing the service by reason of having had a family or business relationship with you during the past two years.
So the only reason that they are called qualified (intermediary) is that they are not disqualified by the definition.
It has nothing to do with their ability to do the job.
The QI is not licensed, or even registered, by the IRS, or any other federal, state, or local government regulatory agency.
Their activities are completely unregulated.
The IRS, in their Tax Gap series fact sheet, even warns about them:
“Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligation to the taxpayer. These situation have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.”
This is the IRS telling you that if you turn over $400,00 from the sale of your Relinquished Property to your QI to be used in the purchase of your Replacement Property, and the money disappears, you not only lose out on the Replacement Property, you’ve lost your Relinquished Property, your money is gone, and you still owe the IRS the Capital Gains Tax.
You can read an example of disappearing Escrow Account funds here.
ADDITIONAL 1031 EXCHANGE RULES
1. Elections. When you sell your Relinquished Property, you will still have some basis in it that you have not depreciated (unless you have held it for 27.5 years, which you probably have not.)
You are permitted under the 1031 Exchange Rules to continue to claim depreciation on this amount even though you no longer own the property.
But you must make an IRS “Election” on how you want to do it.
You can either continue with your current depreciation schedule and claim whatever depreciation amount you are entitled to each year. Call your depreciation schedule “Old Basis.”
You would now have a new depreciation schedule for your basis in the Replacement Property and call it “New Basis.”
Or, you can combine the basis in the Relinquished Property, it is called Transferred Basis, with the basis in the new Replacement Property, and start a completely new depreciation schedule.
But you must tell the IRS which one you are doing. You do that by checking the appropriate box on your Form 4562 that says, “Election Made Under Section 1.168(i)-6T(i).”
2. Debt Replacement. There is a mistaken belief that the mortgage on the property that you buy, your Replacement Property, must be at least as much as the mortgage that was paid off on the property that you sold, your Relinquished Property.
This is incorrect.
A complete reading of the rule shows that it says that the difference can be made up by adding cash.
Well, if you think about it, this will have to happen anyway. After putting all of the Net Sales Proceeds (or as much as you intend) into the Replacement Property, the rest of the purchase price will have to be made up of either debt or cash.
If your seller is willing to finance your purchase, see Seller Financing.
You can read the rule at Treasury Regulation 1.103(d)-2.
3. Partially Tax Deferred Exchange. The 1031 Exchange Rules also permit an Exchange that is not fully tax deferred. If you take a distribution of part of your Net Sales Proceeds, that part will become taxable to you, while the remainder can still be used in the Like Kind Exchange. All of the other rules still apply.
The portion that is taxable will be taxed as Capital Gains and the tax due will be determined by the amount of Depreciation Recapture you are liabile for, because that will be applied first, before the capital gains tax.
And the Depreciation Recapture tax rate applied first will be the rate for the Accelerated Depreciation that you claimed, if any.
After that, the tax rate for Straight-line Depreciation Recapture will be applied, and, finally, the standard captial gains tax rate.
4. Personal Property. Your Relinquished Property will probably include some personal property on which you have claimed depreciation, such as furniture, fixtures and appliances.
Normally, you would be required to identify the real property and the personal property separately and account for the basis of each.
However, the IRS will permit you to lump all of the property together as real property, provided that the fair market value (FMV) of the personal property is not more than fifteen percent (15%) of the total value of the two combined.
However, as you will read elsewhere on this site, this is a terrible idea.
5. Assumed Mortgages. The 1031 Exchange Rules permit you to assume the existing mortgage on the property you buy, your Replacement Property, just like it permits you to sell your Relinquished Property and have the Buyer assume your mortgage.
If the Buyer assumes your mortgage, you have received “boot” in the amount of the mortgage balance, and this is taxable to you.
However, this amount can be offset by the amount of any mortgage that you assume when you purchase the Replacement Property, or by any new cash that you put into the purchase.
You can assume the mortgage on property that you buy, and you will not be penalized, as long as you follow all of the other rules, such as using all of your Net Sales Proceeds in the purchase.
6. Seller Financing. If you take back a note, full or partial, when you sell your Relinquished Property, that note is considered “boot” and will be taxable to you the same as cash.
Since it will be an Installment Note, each payment will be a combination of interest and principal, and will be taxable income in the year received.
The interest will be taxable at your ordinary income tax rate. But the principal will be taxable based on what it represents, Depreciation Recapture or Capital Gains.
If you only finance a portion of the sale price, the remainder can be qualified as a Section 1031 Exchange.
Under the 1031 Exchange Rules, there is a way that you can do seller financing and still not have to pay taxes, and I will discuss it in detail below.
But briefly, it would involve making the note payable to your QI instead of payable to you.
Then you can arrange for the Seller of your Replacement Property to take the note as part of the purchase price.
Alternatively, you could make the note payable in less than 180 days, and when you close on your Replacement Property, your QI will have cash instead of a note.
7. Boot. This is what the IRS calls anything that you receive in exchange for your Relinquished Property that is not like kind property and is not cash.
It will usually be taxable to you.
We have discussed how an assumption of your mortgage can be boot, but there are other possibilities. You might receive a coin collection, a boat, or a motor home.
None of these qualify as like kind property, and they are not cash, so their value will taxable as boot.
The only good thing about this is that you and the other party can generally agree on what the fair market value of the item is, and the IRS will usually accept this valuation.
But, as stated earlier, you can offset the boot by adding an equivalent amount of cash to your Net Sales Proceeds in purchasing your Replacement Property.
In fact, you can even add something other than cash, like a boat, and then you can “net the boot.”
1031EXCHANGE RULES EXAMPLE
Knowing the rules is one thing, understanding them is another.
The best way to understand the rules is to see them applied in real-life situations, so that’s what I will do below.
The most basic of the Section 1031 Like Kind Exchanges is the Delayed Exchange. A Delayed Exchange occurs in two stages, first you sell the Relinquished Property and then, later, you buy the Replacement Property.
When people talk about a tax deferred exchange, they are talking about a Delayed Exchange.
There is also a direct swap, referred to as a Simultaneous Exchange, but it rarely happens, and we won’t cover it here.
The 1031 Exchange Rules apply to all of them.
Previously, on the Home Page, we told you about all of the Players and Terms in a Section 1031 Exchange. You need to read that.
And on the Capital Gains Tax Page, we walked you through a basic real estate transaction in order to produce all of the numbers we need to explain how a Section 1031 actually works.
Look at those if you need a refresher, although I’ll repeat the numbers below.
By the way, if you are not familiar with any of the terms used here, check out our 1031 Dictionary.
This is the scenario that we will use in the application of the 1031 Exchange Rules:
:: Alan Adams bought a Duplex ten years ago for $200,000 cash.
:: He assigned a value of $20,000 to the land, $180,000 to the building.
:: He began depreciation the $180,000 building.
:: He spent $30,000 cash on two garages, began depreciating them.
:: He spent $20,000 cash on furniture and began claiming depreciation.
:: He has claimed $65,400 in straight-line depreciation on the Duplex.
:: He has claimed $7,644 in straight-line depreciation on the garages.
:: He has claimed $15,200 accelerate depreciation on the furniture.
:: His total overall depreciation claimed is $88,244.
:: His Basis in the property is $161,756 (200,000 plus 30,000 plus 20,000 minus 88,244).
:: Now he wants to do a Section 1031 Delayed Exchange, and Bob Baker has offered him $400,000 cash for the Duplex.
:: If he accepts, his Capital Gains will be $238,244 (400,000 Sales Price minus 161,756 Depreciated Basis.
:: $15,200 of the $238,244 will be Accelerated Depreciation Recapture, taxed at 39.6%, resulting in $6,019 tax.
:: $73,044 of the $238,244 will be Straight-line Depreciation Recapture, taxed at 25%, resulting in $18,261 tax.
:: $150,000 of the $238,244 will be regular Capital Gains (400,000 minus 200,000 minus 30,000 minus 20,000) and will be taxed at 20%, resulting in $30,000 tax.
:: His total tax liability will be $54,280 (6,019 plus 18,261 plus 30,000).
Alan Adams does not want to send the IRS a check for $54,280 and he will use a Section 1031 Like Kind Exchange to keep that money, and use the IRS’s money to add $271,400 to his investment portfolio, much like the situation we described in Free Money.
The process is referred to as a Delayed Exchange.
And he will follow all of the 1031 Exchange Rules.
Let’s walk through the steps involved.
SUMMARY: Adams finds a Fourplex to buy for $700,000 as his Replacement Property and begins his Delayed Exchange. In the process he learns:
- that he can’t just reinvest his Capital Gains, that he must reinvest his Net Sales Proceeds,
- there are 2 ways to depreciate his Replacement Property, which is best, and how to file his “Election” with the IRS,
- how to do a Partially Tax Deferred Delayed Exchange,
- what a “bundle of incomes” is,
- the 3 taxes the IRS can apply to the funds he keeps,
- the definition of “like kind,”
- the definition of “net sales proceeds,”
- how to compute “carryover basis,”
- how to determine basis in his new property,
- how to use Personal Property depreciation to nearly double his total depreciation allowance,
- the fallacy of the Assumed Mortgage,
- how to “net debt,”
- the meaning of “boot,”
- how to “net the boot,” and
- how to do Seller Financing inside a Section 1031 Exchange.
READING TIME: Approximately 30 minutes.
1031 EXCHANGE RULES FOR NET SALES PROCEEDS
Adams wants to “exchange up” from his $400,000 Duplex, and he is now looking for a Fourplex to buy as his Replacement Property.
He found seven Fourplexes in his area that were not listed for sale, and talked to the owners. Three of the owners were interested enough to show him the properties and invite him to make an offer.
Adams has not identified the three properties to his QI as part of his obligation to do so within the 1031 Exchange Timeline 45-day rule because the 45 days within which he must identify according to the 1031 Exchange Rules will start to run when he closes on the sale of his Relinquished Property, and he has not closed yet.
This transaction will be done as a Delayed Exchange.
His Buyer for the Relinquished Property, Bob Baker, has presented him with a signed sales contract with an Earnest Money check attached, and Adams has three weeks to sign the contract and accept, and then the contract provides for a closing date within thirty days, but with conditions to delay it by either party. So Adams has built in plenty of flexibility for himself in finding his Replacement Property.
All three of the properties he is considering are appraised on the property tax rolls at about $700,000 and Adams has talked to his loan officer and the bank is willing to loan up to $560,000 on the one he decides to buy, because Adams has a very good loan history and payment history with the bank.
Adams is very excited. He knows that the 1031 Exchange Rules require that the price of the Replacement Property must be equal to, or greater than, the Selling Price of the Relinquished Property, and all of these properties meet that qualification.
He is still learning how the process works, and thinks he only needs to reinvest his $238,244 of Capital Gains, using that as a Down Payment if he takes out the loan, since the other $161,756 of the Net Sales Proceeds represents the return to him of what is left of his original purchase price for the Relinquished Property, and that he will just be getting it back.
He is thinking about buying a boat with that $161,756. A really nice boat.
He contacts his QI to discuss his plans, and finds out that this is not going to happen the way he thought.
1031 EXCHANGE RULES: REPLACEMENT PROPERTY
To be completely tax deferred, all of the Net Sales Proceeds that the Exchangor is entitled to receive from the sale of the Relinquished Property at closing must be used to purchase the Replacement Property in a Delayed Exchange.
The Exchangor cannot receive any of the money.
The Section 1031 Exchange process will, in effect, convert the equity in the current investment into cash, and put all of the cash back inside the next investment.
Adams thought he only had to reinvest his $238,244 in Capital Gains, but he learns that he must also reinvest the rest of it, the $161,756 that represents his basis in the Relinquished Property.
In other words, the entire $400,000 of Net Sales Proceeds from the sale of the property must be put into the Replacement Property.
By the way (and we’ll discuss this in detail elsewhere) the people who tell you that you can follow the law by putting all of your Net Sales Proceeds from the sale of the Relinquished Property into the Replacement Property in a Delayed Exchange, and then immediately get the money back out with a refinance, are simply ignorant, and you should be very leery of all of their claimed expertise.
So, Adams will be sticking to the 1031 Exchange Rules by using all of his $400,000 Net Sales Proceeds as a Down Payment, and that means he will be getting a bank loan for $300,000.
And that brings up another subject that should be discussed.
In addition to the requirements that:
- the value of the Replacement Property must be equal to, or greater than, the value of the Relinquished Property, and
- all cash received from the sale of the Relinquished Property (“net sales proceeds”) must be put into the Replacement Property,
there is a third requirement that everyone talks about in a Delayed Exchange that is not really a requirement at all, and you should not be sidetracked by it if you see it mentioned somewhere.
The confusion comes from an incorrect reading of Treasury Regulation 1.103(d)-2 which talks about “Treatment of Assumption of Liabilities.”
Some people mistakenly believe that this section requires that the debt placed on the Replacement Property (the money you borrow to purchase it) must be at least equal to the debt paid off on the Relinquished Property, or the difference must be made up by adding cash.
Now, let’s look at this a little closer and see if it makes sense.
Assume a very simple situation where you sold a rent house for $100,000 and paid off a loan of $99,000. (I know that’s not possible, but bear with me for the lesson). And you received $1,000 cash and this must be reinvested.
But you must purchase a Replacement Property for at least $100,000 to qualify for a Section 1031 Like Kind Exchange. So, you must either:
- get a new loan for $99,000 to go with their Net Sales Proceeds of $1,000, or
- use $99,000 of your own money, or
- some combination of new loan and new cash.
So, the very dynamics of doing a Delayed Exchange will require that you either get new financing equal to the debt that was paid off, or add your own money. There’s no other way it will work.
So, it’s not really a “requirement” of Section 1031, not one of the 1031 Exchange Rules, it will have to happen that way anyway.
Now, back to Adams.
He sells his Relinquished Property and he buys his Replacement Property. Now he has some decisions to make.
IRS TAX ELECTIONS IN A DELAYED EXCHANGE
Alan Adams buys the Fourplex for $700,000.
His QI wires the $400,000 that he is holding from the sale of the Relinquished Property to the Title Company.
Then the “delay” occurs that makes it a Delayed Exchange. Remember the 1031 Exchange Timeline.
At closing, Adams signs the bank’s loan documents for $300,000 and the bank wires those funds to the Title Company.
The Title Company gives the $700,000 to the Seller of the Fourplex.
(I am aware that these numbers and the procedure are not exact, I’ve done over 2,000 closings. But we are using simple numbers to explain a process).
Adams now owns the Replacement Property.
At this point we need to discuss what the IRS calls “Elections.”
1031 EXCHANGE RULES ON ELECTIONS
In some situations you are given the choice of doing things one way or doing them another way. The IRS doesn’t care, they just want you to commit to whatever you are doing so that you can be held to it.
Concerning the Replacement Property, Adams has the choice of continuing to depreciate his basis of $161,756 in the Relinquished Property, even though he no longer owns it, because the basis has now been transferred into the Replacement property.
He will refer to it on his Depreciation Schedule as “Old Basis,” and then he can begin depreciating his basis in the Replacement Property of $300,000 representing his bank loan, and refer to that on his Depreciation Schedule as “New Basis.”
In fact, the Income Tax Regulations assume that Adams will continue to handle his depreciation in this manner unless he makes an “Election” to roll the basis in the Relinquished Property into the Replacement Property along with his newly-created basis there, and start a new Depreciation Schedule for the Replacement Property for the entire $461,756 less $40,000 which he will allocate to the land.
On Form 4562, filed with his Form 1040 for the first tax year in which he owns the Replacement Property, Adams will make the election by checking the box that says “Election Made Under Section 1.168(i)-6T(i).”
Then his $161,756 basis in the Relinquished Property is transferred as basis into the Replacement Property. But it is increased by the amount of new money he put into the property, the $300,000, to make his total basis now $461,756 in the Replacement Property.
Another way to compute his basis in the Replacement Property, and arrive at the same number, is to take the price he paid, and subtract the amount of capital gains that was deferred.
This is $700,000 minus $238,244. Still $461,756.
Adams will assign a $40,000 value to the land, and begin depreciating the remaining $421,756 immediately for the 27.5 year period, and his depreciation allowance will be $1,278 per month, or $15,337 per year.
The $238,244 capital gains, which he did not pay taxes on, also transfers to the new property simply as tax-deferred capital gains, and the number will reside there inside the Replacement Property until he does another Section 1031 Exchange and it is increased by the deferred amount involved in the new transaction, or he makes it go away, which I will explain to you later.
All of these numbers are in simplified form. I am aware that they do not reflect a “real world” transaction exactly. I have used them for the purpose of explaining the concept of the transactions in the simplest way possible.
Now that you understand the concepts, we will start using the more realistic numbers and situations that you are likely to encounter in your own Section 1031 Like Kind transaction.
PARTIALLY TAX DEFERRED EXCHANGE
We have been talking about what Alan Adams must do for a fully Tax Deferred Exchange under the 1031 Exchange Rules.
But Adams might want to consider an exchange in which part of the Exchange is tax deferred, and part of the Exchange is taxable.
This is permitted under Section 1031, it is simple enough to do, and it will not endanger the entire Exchange.
Suppose that Adams will be involved in a different transaction during the same year in which he is selling a capital asset at a loss. If that loss is a long-term capital loss, and he has no other long-term capital gains to subtract it from, he will not be allowed to subtract that loss from the rest of his ordinary income.
He will only be permitted to deduct $3,000 of the long-term capital loss on his tax return this year, and each succeeding year.
This has nothing to do with the 1031 Exchange Rules.
The reason for this is that he would be deducting from ordinary income a capital loss which, if it were a capital gain (income), would be taxed at 20%. The IRS does not like for taxpayers to deduct capital losses from ordinary income because they involve two different tax brackets, and amounts of cash. Capital gains income is taxed at a maximum of 20% and ordinary income is taxed at a maximum of 39.6%.
So, let’s assume that Adams has a capital asset that has gone down $100,000 in value that he would like to sell if he can get some benefit from doing so.
He can take $100,000 cash at closing on the sale of the Relinquished Property and have the other $300,000 of his Net Sales Proceeds sent by the Title Company to the QI, and Adams will increase his bank loan to $400,000.
How will this change his transaction?
BUNDLES OF TAXABLE INCOME
Since the contract to sell the property was assigned by Adams to his QI, the 1031 Exchange Rules require the QI to deal with the Title Company, and instruct them to disburse $100,000 of the Net Sales Proceeds to Adams in the first part of the Delayed Exchange, and instruct them to wire the remaining funds to the QI.
At the closing, Adams will receive a Cashier’s Check for $100,000 and his portion of his Net Sales Proceeds will be subject to long-term capital gains tax, and he can still qualify the other $138,244 of his capital gains for tax deferral treatment.
He has already met the first qualification of Section 1031 by not touching the other $300,000.
And he plans to purchase a Replacement Property for $700,000, which is equal to or greater than the $400,000 Net Sales Proceeds from the Relinquished Property.
His next qualification for complete tax deferral under the 1031 Exchange Rules is that he must put all of the Net Sales Proceeds of $400,000 into the Replacement Property. But he cannot do this, because the QI is only holding $300,000 of the $400,000.
Therefore, the Section 1031 Delayed Exchange will only defer taxes on the $138,244 of the capital gains that is part of the $300,000 that he does reinvest in the Replacement Property. The other $100,000 that Adams received at closing will be taxable to Adams.
So we now need to decide how that $100,000 will be taxed.
If Adams had another transaction in which he incurs a $100,000 long-term capital loss, this loss will offset the gain when both are reported on his Schedule D, and the $100,000 will not be taxed at all.
Another possibility is that Adams has been operating the Duplex at a loss but he is a high-income individual, which he is, and has not been permitted to deduct the losses and has accumulated “Suspended Passive Activity Losses” that he can deduct from the $100,000. If you are in this situation you must have your tax professional walk you throught the steps.
But if Adams does not have a $100,000 capital loss to use to offset the taxes, and he just wanted th money to buy a boat and is willing to pay taxes on the money, how will the $100,000 be taxed? At the 20% capital gains tax rate?
THE IRS TAX PYRAMID
Well, the $400,000 that he received from the sale represented his $161,756 basis left in the property, that is transferring to the Replacement Property, plus his $238,244 capital gains on the deal.
So, which one of those does his $100,000 belong in for tax purposes?
It is the position of the IRS that when you receive money from the sale of a capital asset, the first dollar you get represents your profit, and that continues until all of the profit is accounted for, and then the next dollar your receive represents the return of your investment.
So the $100,000 will not be deducted from his basis. It will be considered part of his capital gains of $238,244 and Adams will have to report it as a capital gains.
Now we have the question of what does the $100,000 represent in terms of income; that is, which income tax bracket does this $100,000 belong in?
We know that the $100,000 he received is part of his $238,244 capital gains, which was actually broken down as $150,000 true capital gains, $73,044 straight-line depreciation recapture, and $15,200 accelerated depreciation recapture.
And remember that true capital gains is taxed at 20%, Section 1250 Depreciation Recapture (straight-line) is taxed at 25%, and accelerated depreciation is taxed at the taxpayer’s ordinary income tax rate, which is 39.6% for Adams.
Now, here is a rule that you must always remember.
This applies to Delayed Exchanges and all other Exchanges.
It is the position of the IRS that when taxes are assessed on a “bundle” of income, like deferred capital gains in this instance, the IRS starts with collecting the highest tax first.
So, $15,200 accelerated depreciation recapture will be taxed at 39.6%, which is $6,019.
Then, $73,044 of straight-line depreciation recapture will be taxed at 25%, which is $18,261.
And the remaining $11,756 of the $100,000 that he received will be considered pure capital gains, and taxed at 20%, which is $2,351.
His total tax on the $100,000 is $26,631, which turns out to be an effective tax rate of 26.631%. He would only end up with $73,369 of the $100,000 in his pocket.
Now, back to the other numbers.
His basis in the Replacement Property will be $561,756 which will be the $161,756 carried over from the Relinquished Property plus the new $400,000 borrowed from the bank and used in the purchase.
His loan went up from $300,000 to $400,000 because he took out the $100,000 at closing and only had $300,000 of Net Sales Proceeds left.
He must now assign $40,000 to the value of the land, leaving $521,756 depreciable basis in the new property.
His depreciation allowance will be $1,581 per month, or $18,973 per year.
His yearly depreciation allowance actually went up by $3,636 because he took out the $100,000 of profit and borrowed that much more.
Notice that $3,636 multiplied by 27.5 years equals $100,000.
All of the numbers in a transaction are related.
This is why it’s critical that you learn the 1031 Exchange Rules. When you do, it will put you miles ahead of your competition.
TYPICAL DELAYED EXCHANGE TRANSACTION
We are at the point where you understand the Section 1031 Exchange process well enough to start using real numbers and real situations, those that you are likely to see in your own transaction.
The Examples will gradually become more complex, but because you understand the basic concepts, they will not become more complicated for you.
Let’s recap, and then move forward. We changed some numbers.
- Alan Adams bought a Duplex ten years ago for $200,000 cash.
- The price was allocated $20,000 land and $180,000 building.
- The furniture and furnishings were of negligible value, none assigned.
- He put the building on his Depreciation Schedule at $180,000 for 27.5 years.
- He has taken $65,400 straight-line depreciation on the building.
- He spent $30,000 capital improvements on two garages.
- He borrowed the $30,000 from the bank and put a lien on the property.
- His balance on the note is now $18,000.
- He has taken $7,644 straight-line depreciation on the garages.
- He spent $20,000 cash on new furniture and furnishings.
- He has taken $15,200 accelerated depreciation on them.
- His capital improvement total is $50,000 (30,000 + 20,000).
- His total depreciation is $88,244 (65,400 + 7,644 + 15,200).
- His basis in the property is $161,756 (200,00 + 50,000 – 88,244).
- Bob Baker, the Buyer, has offered him $400,000 cash for the Duplex.
- His total cost of the sale will be $10,000 closing costs.
- Adams has found a Fourplex to purchase from Carl Carter for $700,000.
- The value of the land is $40,000.
- The value of the furniture and furnishings is $20,000.
- His total other costs of acquisition will be $5,000 closing costs.
What questions must we answer at this point?
DELAYED EXCHANGE QUESTIONS
IS THIS DELAYED EXCHANGE PROPERTY “LIKE KIND” PROPERTY?
The first question to answer in any Section 1031 Exchange is whether the Replacement Property is “like kind” under the 1031 Exchange Rules.
We are tempted to say that it is, because it is just a bigger building of the same type, and because the current owner is holding it “for productive use in a trade or business.”
That analysis is incorrect.
The language of Section 1031 says that, for the Exchangor, the Replacement Property must be “property of like kind which is to be held either for productive use in a trade or business or for investment.”
In other words, it does not matter at all what the Seller is doing with the property.
Since the Seller is not a Related Person, he has nothing to do with whether or not the Exchangor can qualify this property under the 1031 Exchange Rules.
In this Example, Adams intends to continue with the rental activities when he becomes the owner of the Fourplex, and that is all he must do in order to qualify the Replacement Property as “like kind.”
That shows his “intent.”
Of course, intent alone is not enough.
He must continue to hold the property for productive use in a trade or business for at least a year and a day, and preferably two years, to completely satisfy the requirements of Section 1031.
So, yes, the property is “like kind” property.
IS THE EXCHANGE REPLACEMENT PROPERTY PRICED HIGH ENOUGH?
The next question is whether the Replacement Property Price is equal to, or greater than, the sales price of the Relinquished Property.
We know by looking at the numbers that it is, but we always do the math.
The sales price will be the Gross Sales Price of $400,000 minus the cost of the transaction, which is the $10,000 closing cost. So Adams will net $390,000.
The Replacement Property Price will be the Gross Purchase Price plus any other costs of acquisition, which will be the $5,000 closing costs. So, the Replacement Property Price is $705,000.
Therefore, the Replacement Property Price of $705,000 is greater than the net sales price of the Relinquished Property of $390,000 and complies with that requirement of the 1031 Exchange Rules.
HOW MUCH CASH MUST ADAMS PUT INTO THE DELAYED EXCHANGE?
This is not the question of how much the Net Sales Price will be.
This is the question of how much money Adams will be entitled to receive at the end of closing, which will be wired to his QI, and become the amount that the QI wires back to the Title Company to be used in the purchase of the Replacement Property when that closing takes place.
Remember, the Exchangor, Adams, cannot receive or have constructive receipt of any of the money if he wants the entire transaction to be tax deferred. So, the quick answer to how much cash (from the sale) Adams must put into the deal is “all of it.”
But we still need to arrive at the number. To compute this number, take the $400,000 and subtract the $10,000 closing costs, like we just did, and get $390,000.
But this is not the answer.
Adams would not be getting this amount if this were a regular sale without a Delayed Exchange, because he must pay off a debt on the property, which was originally $30,000, used to build the garages, and which he has paid down to $18,000.
So, the amount of cash that Adams would be entitled to receive at closing is $400,000 minus $10,000 minus $18,000, or $372,000.
This is the “net sales proceeds” and this is the amount that he must put into the Replacement Property.
That also means that his new loan amount will probaly be $333,000.
WHAT IS THE CAPITAL GAINS IN THIS DELAYED EXCHANGE?
We know that Adams’s basis in the property is what he paid for it, plus his capital improvements, minus his depreciation taken. This number is $161,756 (200,000 + 50,000 – 88,244).
So his Capital Gains would be the net sales proceeds of $390,000 ($400,000 sales price minus $10,000 closing cost) minus his basis in the property of $161,756, which is $228,244.
When this total capital gains number of $228,244 is carried over into the Replacement Property, it will retain the individual breakdown identifications of:
- $140,000 actual capital gains ($390,000 net proceeds minus $250,000 cost-plus-improvements),
- $73,044 straight-line depreciation recapture, and
- $15,200 accelerated depreciation recapture.
WHAT IS THE CARRYOVER BASIS, AND THE NEW BASIS?
The basis in the Relinquished Property is $161,756 so this will be carried over into the Replacement Property.
The Capital Gains is $228,244 and this will be carried over into the new property.
The rest of the $705,000 will be made up of newly created basis, or $315,000, which is the difference between the $705,000 purchase price of the Replacement Property and the $390,000 net sales proceeds on the sale of the Relinquished Property.
Another way to look at it is the new loan of $333,000 less the $18,000 of debt paid off.
The way I like to compute it is to take the $705,000 paid for the Replacement Property and take out the $161,756 that represents the transferred basis from the relinquished Property, and then take out the $228,244 that represents the amount of the capital gains on the sale of the Relinquished Property that was deferred by transferring it into the Replacement Property, and you have $315,000 left.
This is the amount of the new basis in the Replacement Property.
Add this newly-created basis of $315,000 to the transferred basis of $161,756 and you have the new basis of $476,756 which includes the land and the building.
EXCEPT THAT IT’S EVEN MORE COMPLICATED THAN THAT!
Now, stay with me on this, we can work through it, and you will be amazed at what you have learned.
This 1031 Exchange Rule will give you an understanding of the role that personal property plays in the Section 1031 Exchange.
And understanding the role that personal property plays in the overall transaction can save you more money than all of your other wheeling and dealing.
This is knowledge that you will use every day for the rest of your investing career.
WHAT ABOUT PERSONAL PROPERTY IN A DELAYED EXCHANGE?
Almost every transaction is made up of both real property and personal property.
“Personal property” as used here does not mean your hair dryer, not that kind of “personal.”
The IRS divides assets into “real property” and “disposable tangible personal property” (and others, but we will focus on these two).
The “personal property” that we are dealing with is the furniture and furnishings in the two properties, both the Relinquished Property and the Replacement Property. It is actually business property in our minds because it is being used in a business to create income, but the IRS calls it personal property, so we have to do the same. It is property on which you claimed a depreciation deduction from income.
Simply put, under the 1031 Exchange Rules, if it is part of the investment property, and it isn’t real property, the IRS calls it personal property.
If your Section 1031 Exchange involves personal property, it must be “like kind” just like the real property must involve “like kind” property. But, while almost all real property can be like other real property, personal property is almost never like other personal property.
Also, you must acquire new personal property that is not only like the personal property that you sold, but also of a value equal to, or greater than, the personal property that you sold.
And, most importantly, it must be accounted for separately.
If you don’t document the transaction in this manner, and the IRS later audits this transaction, they can attach any numbers they want to the personal property for valuation and you will have to accept them.
And don’t expect their numbers to be reasonable, or even make sense, because they never do.
On the other hand, this is an excellent opportunity for you to avoid a higher tax liability in favor of a lower tax liability, an opportunity you should always be looking for.
Here’s how that would be done.
For the first transaction involving the sale of the Relinquished Property for $400,000, Adams would do a Deed to Baker, without the price recited, but it would represent $395,200 for the building and the land, i.e., the real property.
Then he would do a Bill of Sale to Baker for the furniture and furnishings with a recited price of $4,800 which is Adams’s basis remaining in the furniture and furnishings.
This way, Adams will not have a capital gains on the personal property to report separately from the rest of the assets for recapture purposes, and can report them all together.
The advantage will come for Adams when he purchases the Replacement Property from Carter for $700,000.
Adams will have Carter do a Deed to him, without a stated price, but which will represent $680,000, for the building and the land, the real property.
And then he will have Carter sign a Bill of Sale to him for the furniture and furnishings for a price of $20,000.
This means that Adams will be able to depreciate this $20,000 of his investment over five years as “residential rental furnishings,” instead of 27.5 years, like the building, and thereby generate more depreciation to shield more of his ordinary income from taxes much sooner.
Since he is purchasing like kind personal property of equal or greater value than the personal property he sold, he has not jeopardized his Section 1031 Exchange.
Another part of the Internal Revenue Code, Section 1060, permits the parties involved to assign these values in transactions involving both real and personal property.
WHAT THE NEW EXCHANGE DEPRECIATION SCHEDULE LOOKS LIKE.
One of the major considerations of any investment decision, including this one, is how much depreciation will be available to shield your ordinary income, including the rental income, from taxes.
Since depreciation is not an out-of-pocket expense, it really just represents how much of the rent money you can put in your pocket without paying taxes.
For example, if your rental property shows income of $5,000 after deducting all out-of-pocket expenses but before you deduct depreciation, you would be sending almost $2,000 of that to the IRS, leaving $3,000 for you.
But if your depreciation allowance is $5,000 for that property for that year, then you deduct that depreciation and pocket $5,000 instead of $3,000. That’s 67% more.
To do the Depreciation Schedule for the new property, the Replacement Property, we start with the price of $705,000.
We have assigned $40,000 of this to land value, which is not depreciated, and that leaves $665,000.
Then we separate out the $20,000 that we have identified as the purchase price of the furniture and furnishings.
It is not a new asset, so it will not qualify for Section 179 Bonus Depreciation, but Adams can depreciate this over a five-year period using the Double Declining Balance method and the MQ1 convention, and claim $7,000 the first year and $5,200 the second year.
The basis in the new building that we computed above was $476,756 but we have decided to sell the furniture and furnishings for $4,800 with a Bill of Sale, so that number changes to $471,956.
And we have decided to use $20,000 of the net sales proceeds to purchase the furniture and furnishings of the new Fourplex, so we must subtract that from the new computed basis, and we have $451,956.
After assigning a $40,000 value to the land, we have a depreciable basis of $411,956.
This is the amount that Adams will be depreciating over the 27.5 year period. He will be able to claim $14,980.22 per year in depreciation.
This amounts to $1,248.35 per month in depreciation on the building, and $583.33 per month on the furniture and furnishings ($433.33 the second year).
In other words, $1,831.68 of his monthly income will be tax free.
1031 EXCHANGE RULES FOR ASSUMED MORTGAGES
The lending rules that commercial banks, and some other lenders, must follow are very different from what they were a few years ago.
As a result, it is rare to have a transaction in which an existing mortgage, or any debt financing, is assumed by the purchaser, and also rare to have a bank agree to finance a purchase where the seller has taken back a note.
But there are still some rare situations where it might occur, so we will cover an example here and look at the Section 1031 rules that are in play.
Assume the same scenario as in the prior Example, except that:
- instead of Adams paying off the $18,000 balance due on his bank loan at closing, that mortgage was assumed by Baker, and
- when Adams purchased the Replacement Property, the Seller, Carl Carter, had a mortgage on the property with a balance of $100,000 and Adams agreed to assume that note and pay $600,000 cash.
Remember, this is highly unlikely, but the IRS uses examples like this often, so this will help you understand those examples.
The first item to look at here is the question of to whom Adams owes the note with a balance of $18,000 that Baker will assume.
In other words, who is the Payee in the Note?
And since the note will certainly have a “due on sale” clause, will the Payee agree to allow the new owner to assume the note?
The note was originally in the amount of $30,000 and the lender was a bank, so the bank was the Payee.
This could be a problem.
That bank obviously qualified Adams as the borrower of the $30,000 at the time the loan was made, and Adams has been making payments for ten years.
But what about Baker?
The bank doesn’t know whether or not he is a responsible or credit-worthy person, and if they plan to go through the process of qualifying him as a borrower so that he can assume the note, they will probably just insist that he get a new loan.
The process is almost the same. But this could delay the transaction, and if he does not qualify, it could jeopardize the deal.
But more importantly, if Baker also plans to get a loan for all or most of the remaining $382,000 of the purchase price, the new lender will want a first lien on the property.
That means that the bank holding the original $30,000 note with a balance owed of $18,000 will not only have to agree to let Baker assume the note, but will also have to agree to “subordinate” the first lien status of the note to second lien status, that is, put it behind the new note for collection purposes because the new note will be a first lien note.
This would mean that if Baker defaulted on the new first lien note of $382,000 and the property is foreclosed on, the proceeds of the foreclosure sale will first go to the holder of the new first lien note.
If there are any funds left over, they will go to the holder of the second lien note, the original $30,000 note with a balance owed of $18,000.
There are never any funds left over.
If the property is worth more than $400,000 the owner would sell it and pay off the notes instead of letting it be foreclosed on.
As you can see, there is about zero chance of the original lender agreeing to reduce his first lien to a second lien.
You can make the same analysis regarding Adams assuming the $100,000 note of Carter’s on the Replacement Property, and you will come to the same conclusion.
But, what if, by some miracle, the two assumptions did occur?
1031 EXCHANGE RULES FOR ASSUMPTION OF DEBT
How do these two assumptions affect the Section 1031 Exchange numbers?
In practical terms, Baker’s assumption of the note of Adams is the same as Baker giving $18,000 to Adams, and Adams paying off the note.
Adams no longer has the property and he no longer has the debt.
In that regard, it is the same as selling it for cash.
But the IRS does not look at it in this simple way. They must deal with everything in the abstract, and they have rules in Section 1031 for just this sort of thing.
The rule says that the assumption of the note by Baker is something being received by Adams in return for the property, and the “assumption” that is being received is “non-like kind” property to the property that Adams is purchasing as Replacement Property.
That is, the assumption is not like kind to the real property. It is not like kind to the personal property. And it is not cash.
Therefore, it is what is called “boot” paid to Adams.
It is something received in addition to cash which has a fair market value. So it must be treated as boot, and under the 1031 Exchange Rules, boot is subject to taxation.
But then, the rule says that the amount of boot received can be offset by the amount of new cash paid for the Replacement Property. In this case, the amount of new cash being paid for the property will be $333,000.
So, (and I’ve been waiting a long time to say this) the boot is moot.
But there is also a rule for situations where there is debt assumption involved in both transactions, the transaction involving the Relinquished Property and the transaction involving the Replacement property.
The rule requires the Exchangor to “net the boot” if there is also boot involved in the purchase of the Replacement Property, and then assign the receipt of the positive amount to the party receiving it, who must then treat it as boot if doing a Section 1031 Exchange.
In this example, Adams received $18,000 of debt assumption in the first transaction, but he assumed $100,000 of debt in the second transaction.
If we “net” the two amounts, Adams does not have a positive net amount of debt assumption received, because he received $18,000 worth of debt assumption and he provided $100,000 of debt assumption, so he does not have to report any boot.
The $18,000 of debt assumed is treated the same as cash received and becomes part of the number that represents the net cash received, which must be invested in the Replacement Property.
It also doesn’t change the amount of capital gains, carryover of basis, new basis, nor the depreciation.
Smart investors do not get involved in debt assumptions.
It is a pig’s breakfast.
1031 EXCHANGE RULES FOR SELLER FINANCING
When Adams was negotiating the sale of his Duplex, Baker offered to pay him $300,000 cash if he would take back a note for $100,000 in owner financing for ten years, then with a balloon payment of the principal balance remaining.
The note would be payable to Adams.
What does this change?
Well, again we are dealing with “boot” because the seller is receiveing something other than real property or personal property or cash.
When the Exchangor takes back a note from the Buyer, he is receiving property that is not like kind.
The property he is receiving is a promissory note. It is not like kind to real property, and it is not like kind to depreciable personal property, and it is not cash.
Therefore, the Exchangor is receiving boot, and the rules regarding boot will apply.
Boot is taxable up to the total amount received, or the gain on the transaction, whichever is less.
The entire $100,000 will be taxable to Adams because his capital gains is $228,244.
If he had only made $50,000 on the sale instead of $228,244, then only $50,000 of the note amount would be taxable.
Of course, none of it will be taxable if Adams puts at least another $100,000 of his own money into the purchase of the Replacement Property.
This is allowed under the 1031 Exchange Rules.
But this must be his own money, not just more debt on the property.
But let’s look at what the situation would be if he did not put in extra cash.
The note represents a portion of his long term capital gains, but since he will be receiving it monthly, it will not all be taxable at one time when he closes on the property, but rather as he receives it monthly. It will be reported under the Installment Sales provisions of Internal Revenue Code Section 453.
Each monthly payment will be part principal and part interest as laid out on an amortization schedule, and will be reported on Form 1040, the interest reported on Schedule B, and the capital gains reported on Schedule D.
Of course, the portion of the note amount that represents the recapture of depreciation must be reported as ordinary income in the year of the sale, even though he did not actually receive it.
In any event, it is not a good idea to have the note payable to the Exchangor, and we will cover that next.
ALTERNATE METHOD FOR SELLER FINANCING
One way to simplify this complicated problem is to have the $100,000 note made payable to the QI instead of Adams, the Exchangor.
What does this change?
Well, when the note is made payable to the QI, the Exchangor is not in actual or constructive receipt of it, and at the closing on the sale of the Relinquished Property, the note is sent to the QI, along with the rest of the Net Sales Proceeds.
What the QI does with the note determines whether or not it eventually will become taxable to the Exchangor as boot.
The QI can do three things:
- sell the note to an investor, probably at a significant discount, and use the cash in the purchase of the Replacement Property, or
- transfer the note to the Seller of the Replacement Property and it will be treated the same as cash, or
- sell the note, at full face value, to the Exchangor or a family member of the Exchangor, for cash, and then use the cash in the purchase of the Replacement Property. The principal portion of each payment will then be tax-free for whoever buys it because it will be repayment on a debt, return of principal, and only the interest portion will be taxable.
A better alternative to all of these is to have the Exchangor require that the note be made payable in less than the 180-day time period for closing on the Replacement Property, and the QI will receive the money in time to use it as part of the purchase price.
If the QI is still holding the note when the closing on the Replacement Property takes place, he will endorse it over to the Exchangor, it will become taxable boot, and the Exchangor will treat it as an Installment Sale as described previously.
1031 EXCHANGE RULES FOR BOOT
Could Adams still do a Section 1031 Like Kind Exchange if, instead of debt assumption, and instead of owner financing, he sold the Relinquished Property and received $360,000 and a boat worth $40,000?
Of course he could. But again, he has received what the IRS classifies as “boot.”
The $360,000 cash is fine. It will go to the QI and be used to purchase the Replacement Property. The tax on it will be deferred.
But the boat is personal property, not “depreciable personal property” that is allowed in an Exchange, but actually personal property, meaning not business property. It will not be held by Adams “for productive use in a trade or business.”
The boat would be considered boot and its value would be whatever price it would bring if it were sold on the open market.
The Buyer and Seller can agree on this amount, and as long as it is reasonable it will not be challenged by the IRS.
In this case, the agreed-upon price is $40,000.
So, Adams has received the equivalent of $40,000 cash and this will be taxed as part of the capital gains that he has in the Duplex.
The bad part of this, as you probably already realize because we talked about it earlier, is that the IRS first collects the highest tax due among the bundle of incomes that represent the total capital gains amount, and in this case it would be the accelerated depreciation recapture at 39.6% of up to $15,200.
The remaining $24,800 would be taxed at 25% as regular Unrecaptured Depreciation.
Adams would pay $12,219 in taxes for receiving the boat.
Adams can only avoid this tax consequence if he adds an extra $40,000 to the net sales proceeds of the sale of the Relinquished Property when he purchases the Replacement Property.
He cannot just add $40,000 to the new mortgage. He must actually add cash.
But if he has $40,000 cash available, a better plan would be to just buy the boat from Baker, and have Baker put that $40,000 with the other $360,000 and pay the full $400,000 in cash.
That would avoid payment of the $12,219 in taxes.
There are a number of ways of dealing with boot, but only one of them is good, and that is to avoid it.
EXCHANGE BOOT GOES BOTH WAYS.
Adams is thinking about boot, and he wonders if, instead of borrowing $333,000 to fund his purchase of the Replacement Property, he only borrows $300,000 and includes a travel trailer which Carter has agreed has a value of $33,000.
How does this affect his Exchange?
There are three things that Adams must do to qualify for Section 1031 treatment when he purchases Replacement Property, in addition to making sure it is like kind.
- all of the net sales proceeds from the sale of the Relinquished Property must be used in the purchase of the Replacement Property, and
- the value of the Replacement Property must be equal to, or greater than, the value of the Relinquished Property, and
- the Replacement Property must be “held either for productive use in a trade or buisness or for investment.”
The fact that Adams includes personal property in the consideration he pays for the Replacement Property, in addition to all of the net sales proceeds, does not affect his Section 1031 Exchange.
It does not constitute boot in the same way that it would be considered boot if he were to be the one receiving it.
We have now covered all of the concepts involved in doing a Section 1031 Like Kind Exchange, with the preferred choice being a Delayed Exchange.
You should be able to take this knowledge and structure your own transaction.
Any questions you have will probably be answered here on the site in other content.
Search the menu and the Categories.
You can also engage with me directly for a half-hour or hour through the Consultancy service.