1031 News

Wikipedia defines a small house as one ranging from 400 to 1,000 square feet.  A tiny house is one that is less than 400 square feet.  Do people really live in spaces that small? Actually, yes – and they’re more common and popular than you might imagine.  I don’t know if they’ve always been out there and I just never noticed (probably), or if it’s a completely new trend that just popped up and made popular by the numerous TV programs that have sprung up recently.

A 1031 exchange rolls the gain from the sale of your old property over to your new property. To qualify for an exchange, both the old property you’re selling and the new property you’re buying have to be investment property, so oftentimes rental property is what’s being sold and/or bought in the exchange. When you’re dealing with investment property in a transaction, you’re effectively buying or selling two things: the property itself, and the rental business. The money you receive (if you’re selling) for these two items, or pay (if you’re buying) is handled differently for tax and 1031 exchange purposes. To get to the proper handling of each item on a settlement statement, it’s helpful if you think in terms of selling or buying the property versus buying or selling the rental business.

When you sell your personal residence (the house you live in), the IRS says $500,000 of the gain ($250,000 if you’re single) is tax free. There are some things that you have to do to qualify for this benefit, the most important of which is that you must live in the house for at least two of the last five years.

There is a different code section, Section 1031, that says if you sell a house that’s been a rental for at least the last year (or two years in some situations), you can roll the gain from the old house to the new house and defer the tax on the gain until you sell the new house.

Sometimes these two IRS rules overlap. For example, when you sell your residence, it has to have been your residence for two of the last five years. Two of the last five… so what was happening during the other three years? Well, if you’ve lived in the house for all five years there’s no problem – just sell the property and $500,000/$250,000 of gain is forgiven.

Several years ago, the state of California adopted a claw-back rule for 1031 exchanges when the sale property is in the State of California and the replacemnet property is in a different state.

Like most states, California does not tax sales of real estate when the taxpayer does a 1031 exchange and rolls the gain over to a replacement property. Typically, when you sell a property in one state and buy in another state (doing a 1031 exchange), the selling state loses the tax revenue that would have resulted from the sale if it were not a 1031 exchange. 

Several years ago California broke with that tradition and revised their 1031 law to hold that when the taxpayer ultimately sells the property in the replacement state in a taxable transaction, the taxpayer must report the original gain to California and pay tax on it. For example, Sue sells a rental property in California and rolls a gain of $100,000 into a property in Denver, Colorado by doing a 1031 exchange. 

The role that debt plays in an exchange is probably one of the most misunderstood areas of 1031 law. Many people (including qualified intermediaries, CPAs, and attorneys) believe that you are required to have debt on your New Property in an amount equal to or greater than the debt that was paid off on your Old Property. This is NOT, In fact, a requirement for a 1031 exchange.

The actual requirement is two fold: you must buy equal or up, and you must reinvest all of the cash. Assume for example that you sell a purple duplex for $100,000 and you buy a replacement property for $90,000. You did not buy equal or up; in fact you bought down. As a result, the $10,000 buydown is taxable—yes, the entire $10,000 is taxable, and you do not apportion any of the original cost of the duplex to this gain.

You and your co-partners, Fred and Sue, have decided to sell the small apartment building that you boght a few years ago. You got it for a steal and you've got a nice profit in it. It's not been on the maket long and you now have a full price offer.
You've always assumed that when you sold this property the three of you would roll into the purchase of another property, but Fred just told you that he wants to take his share and buy a new pickup. Yikes – and now Sue isn’t she so sure that she wants to buy another property. You don’t want to cash out because you’re pretty sure that Uncle Sam will take all your gain in taxes. Maybe selling the building wasn’t such a great idea.

The One problem that comes up in almost every conversation I have with clients right now is how hard it is to find a replacement property. There’s very little inventory, and worthwhile properties get scooped up immediately. As a result, many of my clients are afraid to pull the trigger on their sale. A reverse exchange could be their solution in this dilemma.

Just as its name implies, a reverse exchange allows you to take advantage of the tax benefits of a 1031 exchange, but instead allows you to purchase your new property before you sell your old one. In a reverse exchange, your qualified intermediary takes title to the new property and holds it until you close the sale of your old property. This allows you to tie down the purchase of your new property before you pull the trigger on the sale of the old.

There is still talk coming out of Washington, DC, concerning tax reform of some type that might yet happen during the two and a half years Obama has left in his term. Certainly the landscape has changed now that the Republicans control both the House and the Senate, and yet the talk continues. It seems unlikely at this point that Congress and the White House would ever agree on any type of individual tax reform; however there seems to be some middle ground for reforms involving entities (corporations, partnerships, trusts, etc.).

To refinance or not to refinance: this is the common question many 1031 exchangers ask.

By refinancing, exchangers are usually hoping to pull money (cash) out of their sale transaction to use for purposes other than investing in new 1031 property.

To answer the question, we need to understand the timing of the refinance. Based on the whether you, the taxpayer, are pulling money from the old relinquished property or from the new replacement property, the IRS has varying positions. 

When refinancing the old property, a key 1031 exchange requirement drives the IRS’ position. The taxpayer cannot receive, touch or control the funds generated from the sale of the old property during the period until the purchase of the new property. Does refinancing the old property right before the exchange constitute “receiving money”?

Prior to 1986, taxpayers bought real estate for their tax losses as much as for their investment potential. I remember those days and it seemed that in many cases the investor was only interested in the amount of loss that a property could throw off. High-income individuals used these losses to reduce the tax on their high personal income.