Can I Go Down in Value and Reduce the Debt on my Replacement Property?

Is it OK to go down in value and reduce the amount of debt I have on my replacement property in a 1031 exchange?

Value, Debt & Equity

Many taxpayers conducting 1031 exchanges don't want to buy a replacement property of equivalent or greater value, they just want to reinvest their equity. The reason is they don't want to get back on the debt-treadmill and have to worry about the downside risk of investing in real estate and making those debt service payments.

But if you want to do a 1031 exchange and defer every cent of tax, the regulations require that you buy a property of equal or greater value/equity, and that you offset your debt relief by taking out either new debt on the replacement property or by investing additional cash out of your pocket. To the extent that you don't hit these general rules of thumb then you will probably recognize gain dollar-for-dollar to the extent that you buy down in value or don't reinvest your equity or don't offset your debt relief.

Delaware Statutory Trust Option

If you are concerned about taking on additional debt, but still want to defer all of your gains, then you may want to consider buying a replacement property that comes with non-recourse debt that the investor is not personally liable for such as an investment into institutional grade property in a Delaware Statutory Trust.

• Start Your 1031 Exchange: If you have questions about reducing debt in a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

Farmland Capital Gains & 1031 Exchanges

Recently, a client came to me with a question about farmland capital gains and their 1031 exchange. The lender they spoke with was concerned that they wouldn’t be able to transfer farmland capital gains into a NNN lease retail store with a 1031 exchange.  Specifically he was worried about the like-kind definition. So is there anything taxpayers need to be aware of in this type of situation? Great question.

Farmland Improved Property

Generally “unimproved” farm land may be exchange for other “improved” real property with buildings. 

Section 1.1031(a)-1(b) of the Income Tax Regulations defines like-kind as referring to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under  hat section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only or the grade or quality of the property and not to its kind or class. See https://www.irs.gov/pub/irs-wd/0404044.pdf

Most real property that is exchanged is 1250 property, with slow depreciation schedules.

Sometimes farmers have some 1245 property (that has faster deprecation) mixed in with the Relinquished Property that is sold such as cribs, grain storage bins, and silos.  If a high amount of the purchase price is allocated to the 1245 property, then that could trigger some gain unless this 1245 property can be matched-up with a sufficient amount of new 1245 in the Replacement Property in order to defer 100% of the gain.

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

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

Can Seller Financing Jeopardize my 1031 Exchange?

In a 1031 you need to move your equity to your replacement property to defer all of the gain. If you use some of the proceeds to loan back to the buyer through a seller-backed note or a contract for deed, your equity is not available to you to redeploy into the replacement property.

Cash on the Barrelhead

The first thing I tell people is if you want a simple 1031 exchange, ask for cash on the barrelhead. Tell the seller not to be the bank. Instead, let the buyer go out and get their own financing. That’s fine sometimes, but other times the seller has to give the buyer some type of incentive in order to buy the property and has to engage in seller backed financing.

An easy way to fix that problem is to come to the closing table with a sufficient amount of money to loan directly to the buyer. If you do this that means all of your net proceeds are available to be sent to your 1031 escrow account (because you are adding in the cash to loan to the buyer out-of-pocket).

Have the Note Favor the QI

Another possibility is to loan the money to the buyer but have the note (or other debt instrument) run in favor of the qualified intermediary. That way your QI gets the cash and non-cash proceeds. But what do you do about the non-cash proceeds? We need to at some point sell that note so the QI has all-cash in their exchange account and can use that to apply it to the purchase of the replacement property.

So at some point in the process you’re going to probably have to buy that note from the QI. One way to do that is take out a temporary unsecured loan from a bank, put the money into the QI account, close on the replacement property, and in a post-exchange transaction, you can go back to your banker and increase the indebtedness on the replacement property (to pay back the unsecured loan). But that has to be done after the exchange is over in a separate post-exchange transaction.

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

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

What is a 1033 Exchange?

There are two cousins in the Internal Revenue Code. There’s Section 1031 for voluntary sales, and section 1033 for involuntary sales (i.e. condemnations, requisitions, seizure or losses that may occur through theft, destruction or an act of god).

1033 Involuntary Sales

1033 is the provision for the involuntary sale or loss and it’s actually more favorable to the taxpayer than 1031. In 1033 you don’t need to hire a qualified intermediary. You can hold onto your own proceeds. And you’re not limited to 180 days to complete your exchange – you have 2 years (in certain circumstances that can even be extended to a 3 year period).

Like-Kind & 1033

The like-kind requirement in 1031 is a little more flexible and loose than that for 1033. Generally under 1033 the replacement property must be “similar or related in service or use,” which is a more stringent standard than under 1031. There’s a case where under section 1033 a taxpayer disposed of a bowling alley and replaced it with a billiards parlor.* The IRS said that was not like-kind enough and the exchange failed. So 1033 is perhaps more complex when it comes to the like-kind standard.

Try 1033 First

I would always try to exhaust the 1033 option first because of the longer time frame and the fact that you don’t need a QI. You do however need to file for the election on your tax return to take advantage of the 1033.

Here’s the deal though – 1033 exchanges are rare occurrences. You have to be subject to a threat of condemnation or have suffered an involuntary loss. And many municipalities are gun-shy of litigation and would rather work out a voluntary sale, rather than bring out the big guns and take a condemnation action. I would say that 99% of exchanges are 1031s because voluntary sales are much more frequent than involuntary sales.

• Start Your 1031 Exchangee: If you have questions about 1033 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

*In Rev. Rul. 76-319, 1976-2 C.B. 242, the owner of a recreational bowling center that was destroyed by fire, attempted to replace the property with a recreational billiard center. It was determined that bowling alleys and bowling equipment were insufficiently similar to billiard tables and billiard equipment for the billiard center to qualify as property similar or related in use to the converted bowling center. Similarly in Rev. Rul. 76-390, 1976-2 C.B. 243, it was determined that the physical characteristics and end uses of a motel were insufficiently similar to those of a mobile home park for the motel to qualify as property similar or related in service or use.

The 1031 Strike Zone - Does My Property Qualify?

Whether or not your property qualifies for a 1031 exchange is determined by whether or not it fits in the IRS’s strike zone for a 1031. Inside this strike zone are properties held for investment or business purposes. We have talked at length about the various types of property that fall within this strike zone, but what exists outside the strike zone for 1031 exchanges?

Outside the Strike Zone

Outside the 1031 strike zone are 2 major categories:

1. Properties used primarily for personal use like a lake cabin or a ski chalet, or the car you use to drive to the grocery store. You are not holding these for investment or business purposes. They are for personal use.

2. Inventory or property you hold primarily for resale. Let’s say a taxpayer buys a big tract of land and chops it up into parcels that they then sell to the public to build homes on. Is that taxpayer holding that property for investment or business purposes or are they holding it for inventory for sale to the public? A surly IRS agent would say the latter and deny a 1031 exchange.

So condo converters, developers, and even house rehabbers or flippers don’t fit neatly into the 1031 strike zone. If you fall into one of these categories and are considering a 1031 exchange, contact a qualified intermediary to discuss your options.

• Start Your Exchange: If you have questions about whether or not your Minnesota property qualifies for a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved