1031 News

Happy Good Friday 1031 Clients and Friends! I hope this email finds you well.

Good news: the IRS has granted extensions for 1031 Investors who have like-kind exchange deadlines between April 1, 2020 and July 15, 2020. The IRS issued new guidance on April 9, 2020 that granted all taxpayers, including “trusts, estates, corporations and other non-corporate tax filers” a filing extension until July 15. Notice 2020-23: https://www.irs.gov/pub/irs-drop/n-20-23.pdf is an update to Notice 2020-18.  The new Notice 2020-23 doesn't address like-kind exchanges specifically, but tax experts agreed they are covered under the broadening of the extension. This give investors with a 45-Day identification deadline or a 180-Day Exchange Purchase deadline between April 1, 2020 and July 15, 2020 an automatic extension to July 15, 2020.

There are always issues with closing costs associated with 1031 exchanges. All exchangers want to have their closing costs paid with 1031 proceeds without creating a taxable event. Some closing costs paid by exchange proceeds are allowable by the I.R.S., while others are taxable. The I.R.S. Revenue Ruling 72-456 specifies, for example, that if exchange funds are used to pay a broker’s commissions, it does not ruin a 1031 exchange. 

Here’s a list of specific exchange expenses that are allowed by most tax advisors:

Sometimes an investor exchanging multiple Old Properties into a single New one can have timing issues if one of the sales falls through. For example: say an investor begins the 1031 exchange process by selling two Old Properties, but one of the sales falls through due to an inspection or mortgage loan issue. If this failure happens right before the New Property purchase date, it can cause major dilemmas.

But there’s a solution! To gain an extra 180 days to complete the sale of the Old Property you can set up a Reverse Exchange within a simple deferred exchange transaction, thus saving your exchange!

If you do a number of 1031 exchanges every year, you should be aware of the Dealer/Developer issues. To qualify for a 1031 exchange, a taxpayer must be able to prove their “intent” at the time of purchase was to hold the property for investment.

According to the I.R.S., real estate held as “stock in trade or other property primarily for sale” is excluded from the tax benefits of Section 1031. Listed here are some factors the IRS uses to determine if there was intent to hold property for investment:

• Length of Ownership The nature and purpose for buying the property.

• Consistent with Investment Activity Has the tax-payer’s investment income and expenses on tax returns been consistent with investment activity? (It’s a good idea to NOT file a Schedule C for the 1031 property, or classify it as “inventory” or “held for development.”)

Once again, it seems that many real estate investors are buying distressed properties, fixing them up, and putting them back on the market right away. And then they call us and want to do a 1031 exchange and roll the gain over into the next property. But can they?

To qualify for a 1031 exchange, (which rolls the gain from the sale of the Old property to the New), both properties have to be held as an investment or used in a trade or business. Held for investment means holding the property for future appreciation. Used in a trade or business means income producing, such as used in a business or used as a rental property. Typically with a fix and flip, you’ve never rented the property, so it’s not income producing. So the critical question then becomes: “did you hold it for investment?”

Suppose several years ago you did a 1031 exchange and bought a charming rental property in a nice urban area as your replacement property. Now you’re planning retirement and are considering downsizing, making your rental property your residence. Will the IRS let you? If so, are there strings attached?

...Now you’re considering downsizing. Will the IRS let you? If so, are there strings attached...?

Section 1031 allows you, subject to certain rules, to sell an investment property and roll the gain over to a replacement investment property. The new property must be an investment property, so no – you couldn’t sell your rental and buy a different house that would be more comfortable for you to immediately move into.

I'm constantly amazed at how many millions, probably billions, of dollars are paid in taxes each year by people who could avoid all of the tax on the sale of their property by taking a few simple steps. Section 1031 is such a beneficial part of the Internal Revenue Code that it’s a shame most tax and legal professionals don’t know about it. And many of those who are aware of it don’t really understand it.

Section 1031 is a code section—its law, not some theory or gimmick. It allows you to roll the gain from the sale of your “old” investment property into the purchase of your "new" investment property. In other words, you defer the gain until some point in the future when you are ready to pay the tax. And yes, there are ways that will result in you having to never pay the tax.

One of the most confusing and misunderstood parts of Section 1031 is how debt is handled in an exchange. Recently some of our clients have had to deal with the pain of overleveraged property and, not surprisingly, want as little a debt as possible when they make a new purchase. And because loans are harder to get right now, some lenders require much larger down payments. The net result is that questions about the required amount of debt on the new property are common.

Someone, after Congress rewrote Section 1031, made the statement that the debt on the new property had to be at least equal to the debt that was paid off on the sale of the old property. History doesn’t reveal to us who first said it, but it has since been repeated so many times it’s now considered ‘fact’ by many exchange professionals, including many CPAs and attorneys.

Section 1031 is an IRS code section that lets you defer tax (in some cases a LOT of tax). Of course, they don’t make the deferral easy, but it's not impossible, either.

One of the rules that causes a lot of angst, especially in a fast-moving real estate market like we have now, is the requirement that within 45 calendar days you must identify a list of properties you might want to buy. Whatever you buy to complete your exchange must be on this list. The identification is made on a form provided to you by your Qualified Intermediary (the 1031 specialist that the law requires you use to guide you through this process).

Although Donald Trump has been President for less than 50 days (as I write this), certain things about him and his agenda are becoming clear: he has a very clear vision about what he wants to accomplish, and he is very determined to push his changes through. 

Tax reform is high on his agenda, and because he has a Republican majority in both the House and the Senate, it’s likely there will be some form of tax legislation proposed later this year. Since I’m a retired CPA and I make my living in the Section 1031 tax arena, I’m very concerned about the possibility of changes to this Code Section and how these changes would impact my clients.