1031 EXCHANGE FAQ
Quite often, I find that the best way to learn about a subject is to browse the FAQ Section. I think you’ll find that to be true here.
With that in mind, I have written the Questions and Answers below so that you will be taken to other pages where you will find a concise and complete Answer.
And remember that you can also:
- Use the Search function,
- Scan the Category list, or
- Cruise the Tabs.
Yes, you can.
And the process of doing so is so flexible that you can choose to do it in one of three ways available to you.
Section 1031 permits you to sell your investment property, called the Relinquished Property, and defer taxes on your Capital Gains and Depreciation Recapture if you purchase another investment property, called the Replacement Property, within 180 days of closing on the sale of the Relinquished Property.
Section 1031 requires that the value of the Replacement Property be equal to, or greater than, the value of the Relinquished Property.
You can actually purchase a Replacement Property of lesser value, but then you will only be doing a Partially-deferred Section 1031 Exchange.
The very essence of Section 1031 is that you will use all of the Net Sales Proceeds from the sale of the Relinquished Property in the purchase of the Replacement Property.
There are, of course, more Section 1031 Exchange rules and you can read them here.
Your question is whether you can purchase your Replacement Property and have the Seller of that property take back a note for part of the purchase price.
Here’s how that would work.
Let’s use an Example, with simple numbers.
Let’s say you want to sell your current investment property and move up to a larger property, but you don’t have the funds needed to purchase the larger property, and your lender is not lending you any more until you pay down some of your current balance.
So, you bought an investment property for $130,000 with a $90,000 mortgage.
You have claimed $30,000 in Depreciation so your Depreciated Basis in the property is now $100,000 and you have paid the note down to $80,000.
Now you are selling the property for $300,000.
You have $200,000 in profit, the difference between the Selling Price and your Adjusted Basis.
$170,000 of this profit is true Capital Gains, the difference between what you paid for the property ($130,000) and what you sold it for ($300,000).
The other $30,000 of your $200,000 profit represents your claimed Depreciation.
When you close on the sale, your $300,000 Gross Sales Proceeds will be reduced by the mortgage payoff of $80,000 and you will have Net Sales Proceeds of $220,000.
Let’s say you want to purchase a Replacement Property for $410,000.
You must use the $220,000 of Net Sales Proceeds toward the purchase of the property, leaving $190,000 in funding that you must provide.
You could use your own cash for all or part of that $190,000 amount.
Or you could use bank financing for the entire $190,000.
Or you could sign a note back to the Seller for $190,000.
In fact, you can use any combination of the three.
As long as you buy a Replacement Property of equal or greater value, and use all of your Net Sales Proceeds in the purchase, it does not matter where or how you finance the rest of the purchase.
Seller financing is completely acceptable.
It is not true that you must obtain a new mortgage equal to the amount of the paid off mortgage.
It's Like A Seminar In A Book
IF YOU USE A DELAWARE STATUTORY TRUST, TRIPLE NET LEASE, OR A T-I-C, YOU MUST HAVE THIS EDITION.
No, there IS NO ACTUAL WRITTEN REQUIREMENT in the Internal Revenue Code that you use an entity referred to as a Qualified Intermediary.
There is a requirement that in order to qualify for the tax-deferral of Capital Gains Tax and Depreciation Recapture Tax offered by a Section 1031 Like Kind Exchange, you must not have actual or constructive receipt, or control over, the Net Sales Proceeds from the sale of the Relinquished Property.
There is another provision in Section 1031 that provides for a “safe harbor.”
“Safe harbor” means that the IRS will assume that you have met this requirement of not touching the money if you engage an entity called a Qualified Intermediary to receive the Net Sales Proceeds and hold them until they are provided to the Closing Agent for the purchase of your Replacement Property.
But you are not required by statute to use a Qualified Intermediary.
And, by the way, the term “qualified” in the title “Qualified Intermediary” does not mean that the entity is actually qualified, in the sense of having any ability, to do anything.
It just means that they are not “disqualified.”
A person or entity is disqualified from acting in this capacity if it or they have been your agent, or have provided professional services to you, within the prior two years.
Everyone else in the world is qualified to be your Qualified Intermediary, although you should probably choose someone with experience doing this, and someone with something to lose, such as a license, if they screw it up or an employee steals your money. I recommend someone like an Attorney or an Accountant.
Would using a Section 1031 Exchange make me a bad real estate investor?
This is typical of the misinformation rampant on the web about the Section 1031 Exchange.
Here are the facts:
In 2010, the last year for which the IRS has compiled the information, there were 158,299 Section 1031 Exchanges reported by Individual taxpayers on Form 8824.
The total amount of Capital Gains reported was $3,470,728,000.
Of this, $2,723,076,000 was deferred, and $747,652,000 was recognized.
Partnerships filed 18,887 Forms 8824 and reported almost twice the dollar amount.
Partnerships reported total Capital Gains of $7,682,352,000.
Of this, they recognized $1,555,981,000 and deferred $6,126,371,000.
For Corporations the 2010 numbers are not available, but the 2009 are.
Corporations reported 61,231 Section 1031 Exchanges.
Their total reported Capital Gains were $28,826,264,000.
Of this, they recognized $1,156,639,000 and deferred $25,678,583,000.
The average Capital Gains deferred per Individual was $17,200.00.
For Partnerships, the average Capital Gains deferred was $324,370.00.
For Corporations, the average Capital Gains deferred was $419,370.00.
Section 1031 is absolutely the best section of the Internal Revenue Code!
When can you use a Section 1031 Exchange in real estate?
Section 1031 of the Internal Revenue Code allows you to sell “property held for productive use in a trade or business or for investment” (in other words, Investment Property), and avoid paying taxes on your profit, your Capital Gains, if you reinvest the Net Sales Proceeds in a “property of like kind which is to be held either for productive use in a trade or business or for investment,” in other words, another Investment Property.
You can read about the Rules and how the process works at 1031 Exchange Rules.
The taxes are not forgiven, they are just deferred for as long as you own the second Investment Property, and when you sell it the taxes can be deferred again, etc.
All top Real Estate Investors use Section 1031 instead of paying taxes on Capital Gains and Depreciation Recapture.