1031 Bifurcation - it also works on the Buy side

I've written a couple of articles over the years about bifurcating a sale into at least two parts so that you can take advantage of Section 1031 and roll the gain over to a replacement property. “To Bifurcate” means to split something into two parts. For example, separating the sale of a ranch between the residence portion (which does not qualify for a 1031 exchange if you live in the residence) and the ranch land and outbuildings, which in most cases do qualify for a 1031 exchange.

But bifurcation also works when you buy a property. You can sell a rental house and use the 1031 exchange proceeds to buy ranch land and outbuildings as your replacement property, and use personal funds to buy the residence portion of the property to live in. Similarly, you could sell the rental house and buy a percentage of a large property (like an office building) as your replacement property, while a partner buys the balance of the property. 

So what do you have to do to make bifurcation work for you? Assuming that the portion you want to buy qualifies for a 1031 exchange (because it’s held for investment or used in a trade or business), it should be equal to or exceed the price of the property you sold. For example, if you sell the rental house for $200,000 and buy the ranch for $300,000, the portion that’s attributable to the land and outbuildings should be worth at least $200,000 in order to cover your exchange so that you don’t have to pay any tax. 

Secondly, you should make it clear how much you are paying for what property. I prefer that my clients have two contracts – one for the ranch and one for the residence. But in the real world this can sometimes be hard to pull off. If you don’t have two contracts, you’ll need an allocation clause. For example, you might say in the contract that you’re paying $100,000 for the residence and $200,000 for the ranch. The purpose of a clause allocating the price is to build a wall around your 1031 exchange so that the IRS can’t reallocate the purchase price later, making a portion of your exchange taxable. If you have one contract and don’t allocate the price, the IRS can come back to you and say that the land and outbuildings are worth less than what you say you paid for them. That would result in you paying tax. However, if the allocation is part of the contract, it’s almost impossible for the IRS to override the allocation. 

In most cases sellers will accommodate an allocation clause, but occasionally they won’t. If they won’t, I suggest you don’t put an allocation clause in the contract at all. If you do, but don’t follow it and get audited, the IRS will follow the allocation in the contract and you’ll end up paying tax for sure. Without the clause, they may simply accept your allocation in your tax return. 

If you sold the rental for cash and your intermediary is holding $200,000 for the purchase of the ranch, can you borrow $100,000 for the purchase of the residence portion? Yes, but your 1031 intermediary needs to show in the closing that the financing had nothing to do with your 1031 exchange. A good intermediary will know how to do this. 

Taking Title 
How you take title to the new property can occasionally become an issue. While it shouldn’t be in the purchase of the ranch, it can be if you’re buying a small slice of a large property. 

For example: if you, instead, decide to buy a 10% interest in a $2,000,000 building as your replacement property, it’s probable that the other partners are taking or holding title to the property as an LLC or a partnership. You can’t buy a 10% interest in an LLC or partnership since you have to take title to the property as you held it in the old rental. You would have to take title to it as a tenant-in-common with their entity, and this can create problems with the lender if there is a loan on the property, or if your partners try to get financing. 

A similar problem arises where only one person held title to the old property but now wants, or needs, to buy the new property with their spouse. For example, let’s say Sue owns the $200,000 rental property in her name, but wants to buy a $300,000 duplex as her replacement property and have her husband on the title with her. In this situation she’ll have to take title to an undivided 67% of the duplex while her husband takes title to the remaining undivided 33%. 

Bifurcating your purchase can add great benefits to your exchange and can also result in you being able to acquire a property that you normally couldn’t acquire with a 1031 exchange. As always, you’ll get the best results when you work with an intermediary that will take the time to plan it out for you.