Auctioning 1031 Exchange Property

Sometimes in a 1031 exchange, tax payers want to sell their old relinquished property at an auction. This happens most often in the realm of personal property like business equipment or muscle cars held for investment purposes. The taxpayer takes the property to an auction, puts it up on the auction block and hopes it sells. There are a few things to keep in mind when you’re buying or selling 1031 property at an auction.

Notify the Auctioneer

If you’re selling property at an auction it’s a good idea to have the auctioneer notify the bidders that this sale is part of a 1031 exchange and that whomever the winner is, they will have to sign an acknowledgement that states that the seller has assigned their rights in that purchase agreement to their QI (Qualified Intermediary). It’s a simple request, but you need to let the buyer know that they will need to cooperate with the 1031 exchange.

Buying Replacement Property at Auction

The same situation exists when you’re trying to buy your replacement property at an auction. You go to the action and tell the auctioneer that you’re doing a 1031 exchange and that you want the ability in your purchase agreement to assign it to your QI. So talk to the auction company and ask if you can include a 1031 cooperation clause in your purchase agreement (if you are the winner) so that you can elicit the seller’s cooperation. This helps evidence that you’ve satisfied the treasury regulations requirements for a 1031 exchange. In particular that you’ve assigned the contract to the intermediary and that you’ve given written notice to all the parties of the purchase agreement.

The problem with auctions is that you’re a person removed from actually dealing with the specific buyer or seller. So you need to have good and effective communication with the auction house so they can facilitate your request.

• Start Your Exchange: If you have questions about 1031 exchanges and auctions, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

The Napkin Test: Simple Rules for a 1031 Exchange

The napkin test boils down complex 1031 tax concepts into an easy to understand set of rules of thumb that help you decide if you’re going to defer all of your gains in a 1031 exchange. The napkin test sets up three benchmarks that must be satisfied in a 1031.

Value

The first benchmark of the napkin test is value. When you’re doing a 1031 exchange you need to have a continuation of investment into a new, bigger, better property. Imagine if you sold a property for a million dollars and acquired only a $10K replacement property. The surly IRS agent would look at you cross eyed and say:

“Hey, where’s your continuation of investment here? You’re $990k short of equal or greater value replacement property.”

So the first benchmark if you want to defer the tax is to acquire a replacement property of equal or greater value. Going up in value fixes a lot of problems that can occur from a tax perspective.

Equity

The next benchmark is equity. If you bought a million dollar replacement property but only reinvested $10K of proceeds (putting $990K in your pocket), again the IRS agent will say

“Hey, where’s your reinvestment of the equity. I see $990K in your pocket. We’re going to make you pay taxes on that.”

In order to satisfy the napkin test all of your net proceeds need to be reinvested into the replacement property. So we need to redeploy the equity instead of putting it in your pocket.

Debt

The last benchmark is debt. Imagine you pay off a $500k mortgage at the sale of your relinquished property and you’re taking the debt backpack off for the first time in years. That debt relief will trigger gain in your 1031 exchange unless you offset that debt relief by either taking out new debt of an equal or greater amount or by reinvesting cash out of your own pocket into the replacement property.

If you win the lottery on the way to closing on your replacement property, you could pay cash for the replacement property. That new cash-in will offset the debt relief dollar for dollar. Most taxpayers don’t win the lottery on the way to the closing and have to take on new debt on their replacement properties.

Here’s a hypothetical:

• We sell a property for a million dollars

• We pay off $500K of debt

• We net $500K in proceeds

If we buy a replacement property for 2 million dollars so we’ve gone up in value, we offset the debt relief of $500k with a 1.5 million dollar mortgage. We also redeploy all of our $500K proceeds. We have satisfied the napkin test by going up in value, equal in equity, and we’ve offset our debt.

• Start Your Exchange: If you have questions about the napkin test, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

How Many Replacement Properties can you 1031 Exchange Into?

There are many rules that regulate 1031 exchanges. In this article, we will talk about how many replacement properties you can designate in a 1031 exchange.

Good News, Bad News

The good news is you can in theory purchase any number of replacement properties to complete your 1031 exchange.

The bad news is that there are restrictions on how many replacement properties you can designate or identify in writing during the first 45 day identification period.

Key Restrictions

The key restrictions that are imposed on the number of properties which may be identified as potential replacement properties are listed below. More than one potential replacement property can be identified as long as you satisfy one of these alternative rules:

• The Three-Property Rule - Up to three properties regardless of their market values. All identified properties are not required to be purchased to satisfy the exchange, only the amount needed to satisfy the value requirement.

• The 200% Rule - Any number of properties as long as the aggregate fair market value of all replacement properties does not exceed 200% of the aggregate Fair Market Value (FMV) of all of the relinquished properties as of the initial transfer date. All identified properties are not required to be purchased to satisfy the exchange, only the amount needed to satisfy the value requirement.

• The 95% Exception - Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified. In other words, 95% (or all) of the properties identified must be purchased or the entire exchange is invalid.

You can read the exact text of the applicable Treasury Regulations in our 1031 Identification Primer.

• Start Your Exchange: If you have questions about how many replacement properties you can exchange into, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Replacement Property Closing Costs

One of the key concepts when you are completing a 1031 exchange and closing on your new replacement property is to re-invest all of your 1031 exchange funds into your new like-kind replacement property, rather than to pay for non-qualifying transactional expenses.

For example in a real estate exchange, if you use your 1031 funds to pay for a car (which is not like-kind to real estate), then the money applied for the car would trigger the recognition of gain.

Qualifying Transactional Expenses

Taxpayers are allowed to pay for some ‘qualifying’ transactional expenses such as real estate agents commissions, attorney’s fees (related to the 1031 and real estate), recording costs, qualified intermediary fees and customary transactional expenses that would normally appear on closing statement in the area where the property is located.

Non-Qualifying Transactional Expenses

As a pointer for 1031 purposes, when a taxpayer is purchasing their new Replacement Property, the taxpayer/buyer should not use 1031 proceeds to pay for non-qualifying transactional expenses. Instead, he or she should give the seller a separate check (from non-1031 funds) for those costs.

Some of the most common non-qualifying transactional expenses are:

• Costs of assuming or putting on new debt, mortgages or deeds of trust (the IRS looks at the debt like it is a separate non-qualifying asset);

• Charges for rent proration (this is typically an operational expense that should be paid with non-1031 funds);

• Charges for property tax proration (this is typically an operational expense that should be paid with non-1031 funds);

• Large amounts of personal property, such as movable items of equipment and furniture (this is not like-kind property)

The key idea is to apply the full amount of the taxpayer/buyer’s 1031 proceeds to pay the purchase price for the like-kind real estate.

• Start Your 1031 Exchange: If you have questions about replacement property closing costs in Minnesota, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Does a 1031 Replacement Property Have To Be Larger In Value?

You can do a partial 1031 into a lesser valued replacement property, but if you want to defer 100% of the gain, you typically need to continue your investment into an equivalent or more valuable replacement properties (see the napkin test).

3 General Rules

There are three general rules of thumb to quickly see if you will defer all of the recognition of gain in your 1031 exchange:

1. Typically you will acquire replacement property that is “up or equal” in value (price).

2. You will roll over all of your equity (net proceeds) from the relinquished property into your replacement property.

3. And to the extent that you were relieved of liabilities and debt, such as mortgages on your old relinquished property, the debt relief is offset by:

   1. new liabilities or mortgages taken on in conjunction with your purchase of the replacement property; OR

   2. by investing additional cash in the replacement property equal to the amount of liabilities and debts that were discharged.

Partial Victory Is Better Than None At All

If you have a low basis, you may be satisfied to defer part of your gains and to pay your taxes on the difference, this is often called a partial 1031 exchange.  Generally this occurs when a taxpayer wants to buy only a replacement property of lesser value, or prefers not to re-invest all of their equity (1031 funds) from the disposition of their old relinquished property into their new replacement property. 

1031 Post-Exchange Refinance Alternative

If you are considering holding back some money from your exchange (taxable boot) and only re-investing a portion of your equity (1031 funds), then be sure to call me first, as we may be able to discuss some other ways to get you the same amount of cash without triggering the recognition of gain during your 1031 exchange.

Tax Treatment of Loans

One option to consider is to complete your exchange by re-investing ALL of your equity (1031 funds) into a replacement property of equal or greater value; and then later in a subsequent (separate post-exchange) transaction, pull out some equity by refinancing your replacement property to access some of the equity.  Generally, borrowing money is not considered income because you have a corresponding obligation to repay the loan.  When tax rates are high and interest rates are low, it doesn’t take a rocket scientist to figure out that by delaying your gratification until later after your exchange is over you can save a significant amount in taxes.

• Start Your Exchange: If you have questions about 'partial 1031 exchanges' or how to refinance after the exchange to get your money out tax-free, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved