1031 Exchange FAQ - PAYING

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Common 1031 Exchange Questions

With a 1031 Exchange, can I defer my depreciation recapture?

Do I have to use the same debt and equity ratio on each Replacement property?

I have a 1031 Exchange Property that I bought last year, how soon before I can resell it?

What is an Earnest Money Clause?

How safe in your money in an escrow account for a 1031 Exchange?

Can I 1031 Exchange rental property and reinvest it into rental property without paying capital gains tax?

Yes. But in order for there to be a 1031 Exchange, you need to make certain that both properties are of "like-kind", meaning they qualify for 1031 Exchange. Failure to do so will collapse your 1031 Exchange and you will end up paying the capital gains tax.

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What is the difference between Capital Gains and Equity?

Answer:  Don't confuse them, they are not the same.

Equity is the money left over once you sell a  property and pay off all the liabilities including mortgages.

Capital gain on a property would be the difference between your basis and your adjusted sales price. If you bought property for $20k (your basis) and sold it for $100k, after paying off the liabilities you would have a capital gain of $80k.

If you sell instead of doing a §1031 Exchange, you would be obligated to pay a capital gains tax on the entire $80k.

Be extremely careful not to trap yourself with a regular sale.

Related Info: equity, gains, capital, difference, gain, basis, liabilities, $80k, paying


Some 1031 companies say “defer”, some say “don’t pay” capital gains tax with a 1031 Exchange. Which is correct?

Answer:  When you sell your property and purchase another property with a like-kind property you are conducting an IRS 1031 Exchange. "Defer" or "Don't Pay" is simply marketing language intended to get your to consider a 1031 Exchange if you have property to sell. With a 1031 Exchange the reality is that "some day" you will be paying the capital gains on your property but with a 1031 Exchange you are really "deferring" it to some other time. We have had customers defer their capital gains several times by buying and selling the same piece of land. Since land almost always qualifies, under the 1031 Exchange rules you can do this. The question is with a 1031 Exchange are you saying that you will "never" pay your capital gains tax. In our 20 plus year experience with the US Internal Revenue Service we learned to "never say never".

Related Info: correct, gains, capital, defer, companies, land, buying, selling


Some 1031 companies say "defer", some say "don't pay" capital gains tax with a 1031 Exchange. Which correct?

Answer:  When you sell your property and purchase another property with a like-kind property you are conducting an IRS 1031 Exchange. "Defer" or "Don't Pay" is simply marketing language intended to get your to consider a 1031 Exchange if you have property to sell. With a 1031 Exchange the reality is that "some day" you will be paying the capital gains on your property but with a 1031 Exchange you are really "deferring" it to some other time. We have had customers defer their capital gains several times by buying and selling the same piece of land. Since land almost always qualifies, under the 1031 Exchange rules you can do this. The question is with a 1031 Exchange are you saying that you will "never" pay your capital gains tax. In our 20 plus year experience with the US Internal Revenue Service, we ha

Related Info: correct, gains, capital, defer, companies, land, times, buying


How many replacement properties can I have?

There are 3 rules:

The one most people use is the 3-Property Rule because they can identify 3 1031 Exchange Replacement Properties without regard to fair market values of the properties. You figure fair market value of Replacement Property as of the end of the identification period.

The next rule is the 200 percent rule which allows you to identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all Relinquished Properties. You figure fair market value of Relinquished Properties as of the date you transfer them.

The final rule is the 95 percent rule which allows you to identify any number of Replacement Properties if during the Exchange Period you actually received identified Replacement Properties having a fair market value equal to or more than 95 percent of the total fair market value of all identified Replacement Properties.
Beware of the 200 percent rule and the 95 percent rule. If you are choosing to follow these rules, we suggest you get help from your CPA or Tax Attorney. If they are not conducted properly as of the end of the identification period and you have identified more properties as replacement properties than permitted, you are treated as if no Replacement Property has been identified. Which means the IRS could decide that no 1031 Exchange occurred and you would end up paying the capital gains tax.
This is why most people follow the 3 property rule, it is easiest to understand with lessor risk.

Related Info: properties, replacement, rule, market, fair, value


How long does a 1031 Exchange take?

Generally, 1031 Exchanges can happen rather quickly, depending on your needs. If you are closing on your 1031 Exchange Relinquished Property today, you can generally close on a 1031 Exchange Replacement property tomorrow. There are some deadlines to be aware of both of which begin on the date you close on your Relinquished property.

45 day Identification Deadline. This date ends 45 calendar days after you close on your Relinquished property. Basically, this is a letter to the IRS that officially announces the Replacement properties on which you intend to close sale. Any of these properties you Identify can be revoked before the 45 day deadline has been reached. You would just re-write your announcement letter. Realty Exchangers, Inc provides you with the Identification form that you will need to give to the IRS when you close on your Relinquished property. If you close on any Replacement Property before your 45 day deadline is reached, you do NOT have to Identify them with the form.

180 day Closing Deadline. This deadline also begins when you close on your Relinquished property. You have half a year to close on your Identified Replacement properties, which should be ample time to complete this task. If you do not close on all of your Identified Replacement Properties before this date is reached, you could end up paying Capital Gains Tax on all un-spend proceeds.

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How do I figure out real estate interest for 1031 exchange?

Here is a “nutshell” approach to figuring out how each kind of real estate interest (excepting your personal residence) is classified for tax purposes and how each is treated on the tax return.

There are three major classifications of interest on the Federal individual income tax return. Each classification is subject to different rules. Because of this, great care must be given to determine the correct classification of each interest item. It’s the only way to figure what is deductible and where to deduct it.

1. Business interest

(a) Interest on rental income real estate
(b) Interest on business indebtedness

2. Investment interest

3. Personal interest

(a) Consumer interest
(b) Qualified residence interest.

Borrower's Cost of Getting Loan
Borrowers may incur substantial fees and charges when a mortgage loan is funded. These costs include legal fees, "points", appraisal fees, escrow fees, service charges, surveys, real estate commissions and title costs. These financing costs must be analyzed and divided into two categories:

1. Costs that do not qualify as interest.
2. Costs that do qualify as interest.

Costs That Do Not Qualify As Interest
Costs that do not qualify as interest are treated as lending service costs. If the mortgage was obtained to acquire real estate used in business or held for profit, the costs are deductible by amortizing them over the life of the loan. If the mortgage was obtained to acquire real estate held for personal use, lending service costs are not deductible.

Amortization of loan costs is always taken using the straight-line method. Amortization is continued until all costs are written-off or the loan is paid off or assumed. If there is a balance in the unamortized loan costs account, and the loan is paid off or assumed, the tax treatment of the balance depends on the classification of the property. In cases of rental income and other business property, the balance is deductible as an operating expense of the property.

For example, 10 years ago you bought an apartment house and paid loan costs of $20,000 to acquire the 25-year mortgage loan. You now sell the property as part of a 1031 exchange. During the last ten years you deducted your loan costs by amortizing them at the rate of $800 per year ($20,000/25 years). Your deduction totaled $8,000 for the ten years ($800 per year times 10 years). The unamortized balance of $12,000 is deductible at the time of the sale as an operating expense of the property. Do not take it as a selling expense of the property - if you do, you could lose the entire deduction.

Costs That Do Qualify as Interest
Costs that qualify as interest are treated as prepaid interest - capitalized and amortized straight-line over the life of the loan.

The term "points" is used to describe the interest charges you pay as a borrower to a lender when you take out a mortgage. Lenders have different names for points: loan origination fees, premium charges, etc. But what they call them doesn't matter. If the payment for any of these charges or points is for the use of money, it is interest.

Charges or points paid for the use of money are deductible as mortgage interest. They are treated as prepaid interest and subject to the prepaid interest rules. Amortization of points is figured using the straight-line method and is continued until the points are all written-off or the loan is paid off or assumed. For example, if you are charged $2,000 interest points for a 20-year loan, the $2,000 is considered prepaid interest. Under the prepaid interest rules, you must spread your interest deduction over the tax years in which it belongs. In other words, you can only deduct in each year the interest expense for that year. $2,000 prepaid interest for a 20-year loan must be deducted over 20 years at the rate of $100 per year.

If there is a balance in the unamortized points account, and the loan is paid off or assumed, the tax treatment of the balance depends on the classification of the property. For rental income and other business, the balance is deductible as an operating expense of the property. For your personal residence, the balance is deductible as qualified residence interest, if otherwise qualified.

An easy to determine what kind of interest you are dealing with is this simple rule:
Interest deductions follow the money. Just ask this question for each interest amount - where did the money I'm paying interest on go? That's where the deduction goes. For example, you borrow money to buy a computer for your business. The interest is business interest - that's where the borrowed money went. Here’s another familiar example. You borrow a hard-money second nd on one of your rental properties and use the money to buy a new personal automobile.

Is the interest deductible? If yes, where do you deduct it? If not, why not?
Just ask the question -where did the money go? Since the money was used to buy a personal asset, the interest is not deductible. Wait a minute, you say. I borrowed the money on my rental property. Why can’t I deduct it against my rental property as an operating expense on Schedule E? The collateral has nothing to do with the use of the money you borrow so don't let it get in your way. The test is: Where did the money go?


Loan proceeds used to acquire:. ->Interest is deducted as:
Rental Property......................................->Rental Expense
Investment Property.............................->Investment Interest
Personal residence..................................->Itemized deduction (if qualified)
Farm property........................................>Farm expense
Dealer property......................................>Business Expense

Related Info: interest, estate, real, figure, loan, costs, money, deductible, expense


I heard I could take boot from a 1031 Exchange and defer the tax. How does that work?

Yes. There is an ingenious tax strategy which will permit you to take back boot in a 1031 exchange without paying tax on it now. The Gain from the boot can be deferred into future tax years. It's done by taking back a purchase money installment note from the “buyer” of the Relinquished Property to balance all or part of the equities. When structured correctly, the taxable gain in the note may be reported using the installment method of tax accounting.

If you are an exchange specialist, be sure to tell your clients about this marvelous tax saving strategy. They will love you for it—all the way to the bank.

Related Info: work, defer, boot, strategy, method, accounting, installment, gain


Can I 1031 Exchange my un-divided interest in a rental, without my partners?

Yes. If it says on your property deed that you have an un-divided interest in a property, you may 1031 Exchange into another property without paying the capital gains tax.

The first thing to examine is the legal status of the investor. For example, tenants in common can split up without dealing with outsiders and get §1031 treatment in the split-up. Under Rev Rul 73-476, the IRS approved this transaction. Three investors owned an undivided interest as a tenant in common. There were no mortgages on the property and the property was held for investment. Each of the three investors exchanged his undivided interest in the three separate parcels for 100% ownership of one parcel.

Sometimes, however, the investors are partners rather than tenants in common. If this is the case, the investors should seek expert legal and tax counsel regarding a tax-free liquidation in kind of the partnership properties to the investors. Then, as tenants in common, they could do a 1031 exchange.

Caution: This procedure can be risky but if the savings are substantial, it’s worth checking out with couns

Related Info: partners, rental, interest, un-divided, investors, common, three, tenants, undivided


Can I 1031 Exchange my property with no mortgage for one that has one?

You are talking about a 1031 like kind exchange of unencumbered property for encumbered property. Proceed with caution and make sure you know what you are getting into. Here is some important information to consider with your tax advisor.

If you do not assume the mortgage on mortgaged property received in a 1031 exchange, you are taking the property subject to the mortgage. You are treated as if you assumed the mortgage.
If the mortgage you assume is less than the mortgage on the property given up, the net liability—called mortgage relief is counted as boot received by you.
If the mortgage you assume is more than the mortgage on the property given up, the excess is counted as boot paid by you.
If you transfer unencumbered real estate in exchange for mortgaged real estate, you have paid boot equal to the amount of the mortgage. The payment of mortgage boot does not result in recognition of gain or loss to the person paying it.

Related Info: mortgage, boot, assume, real, estate, given


How does my mortgage transfer in a 1031 Exchange?

You take on their mortgage and they take yours.

In a 1031 exchange, the assumption of a liability by the other party (or transfer of your property subject to a liability) is treated as boot received by you. It's called mortgage relief. In figuring your net mortgage relief, you may offset against it your assumption of a liability (or transfer of property subject to a liability).

The assumption of a liability or the transfer of a property subject to a liability is treated as boot.

If the other party assumes your liability—or your property transferred subject to the liability—you have received boot. You will be treated as if you received cash in the amount of the liability. The party assuming the liability, or acquiring the property subject to the liability, gives boot.

If you transfer unencumbered real estate in exchange for mortgaged real estate, you have paid boot equal to the amount of the mortgage. The payment of mortgage boot does not result in recognition of gain or loss to the person paying it.

Related Info: transfer, mortgage, liability, boot, treated, party


Can I take a note instead of cash with a 1031 Exchange?

Yes, you can take a note for installment payment instead of cash for a 1031 Exchange. There are some opportunities here, see our article from our 1031 Exchange Knowledge Base.
"Taxpayers are always looking for tax saving opportunities when selling appreciated property. That's why the deferred exchange is so popular with smart real estate investors and professionals. It permits them to sell property and buy Replacement Property without recognizing taxable capital gains. However, if they “exchange down”, boot taken back to balance the equities is taxable. And it’s taxable right now. This makes everyone except the IRS very unhappy.
Fortunately there is an ingenious tax strategy that permits you to take back boot in a §1031 exchange without paying tax on it now.Gain from the boot can be deferred into future tax years. It's done by taking back a purchase money installment note from the “buyer” of the Relinquished Property to balance all or part of the equities. When structured correctly, the taxable gain in the note may be reported using the installment method of tax accounting.
If you are an exchange specialist, be sure to tell your clients about this marvelous tax saving strategy. They will love you for it—all the way to the bank.
If your sale or exchange involves both like-kind property and boot in the form of an installment sale note, the rules of both §1031 and §453 (dealing with installment sales) apply. Under §1031, no gain will be recognized on the like-kind property involved. However, the installment sale note is boot and gain is recognized on the net boot received.
Under the installment sale rules of §453, fair market value of like-kind property received is not recognized as part of the Contract Price or as payment in the “year of sale.” This results in a Gross Profit limited to the installment note and any other boot received. (To keep life simpler, let’s assume no other boot.) The outcome is the Contract Price and Gross Profit are the same amount.
Figuring the Installment Sale Percentage (Gross Profit Percentage) is easy. Since the two amounts are equal, the Installment Sale Percentage is 100%. Now comes the best part.
Since you have entered into an exchange and traded down, taking back an installment note to balance the equities, you enjoy the benefits of both the exchange and installment sale rules. Under §1031 rules, your recognized gain is limited to the installment note taken back as boot. And under §453 installment sale rules, you are permitted to report this gain using the installment method of tax accounting and report the gain ratably over the time you collect it from the buyer.
The result is you have made a real estate exchange, traded down, taken back an installment note to balance the equities and recognize little or no gain in the year of the exchange."

Related Info: cash, installment, sale, boot, gain, rules, recognized


What are the legal fees associated with a 1031 Exchange?

As with any sale of real estate, often tax payers will consult an attorney to facilitate the creation of a Purchase and Sale Agreement for their 1031 Exchange. The fees associated with paying at attorney varies, though most have standard rates. A simple phone call to your attorney can help with this question. There should be no other legal fees associated with your exchange unless you are having an attorney facilitate the closing of sale on the property. Again, this is a question for your attorney and a simple phone call should suffice.

Related Info: associated, fees, legal, attorney, sale, facilitate, phone






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