Historically, real estate transactions were not uncommon amongst family and other related parties. Given this and prior history of taxpayers utilizing family or related parties to manipulate the existing IRS regulations on 1031 exchanges, Congress amended the code section to include Related Party rules in relation to 1031 exchanges. Due to today’s booming real estate market, it is even more popular for family to try to help the younger generation start their real estate investment journey, which makes it more important than ever to understand the Related Party rules outlined below.
Background to the Related Party rules
Tax deferral under section 1031 of the U.S. tax code is very taxpayer-friendly, potentially allowing taxpayers to defer capital gain, depreciation recapture, healthcare tax, and state tax. However, to take advantage of this code section, taxpayers have to play fair and strictly follow the rules. In the past, it was possible to manipulate the rules to achieve a favorable outcome by bringing a party related to the taxpayer into the transaction. In 1989, Congress amended the code section to stop this abuse. The amendment prohibits taxpayers from entering into transactions with related parties, subject to a few limited exceptions. According to the legislative history of §1031(f) “if a related party exchange is followed shortly by a disposition of the property, the related parties, have in effect, cashed out of the investment.”
This new section, 1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—
(i) the related person disposes of such property, or
(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”
What was the abuse that gave rise to the Related Party rules?
Take as an example “Parent Company” which has Property A for sale with a lot of built-in gain and no need to acquire a replacement property. Its affiliate, “Subsidiary Company” owns Property B of similar value with a high basis. In any exchange, the basis is carried over from the relinquished property to the replacement property. So rather than sell the properties outright, the two companies enter into an exchange with one another to defer taxes. Parent Company holds Property B indefinitely, but shortly after the exchange, Subsidiary Company sells Property A. Since Subsidiary Company has a high basis in Property A, there is little tax effect to it upon the sale. This was a common occurrence prior to the 1989 Related Party rules addition to section 1031.
Can any part of a taxpayer’s exchange transaction involve a related party?
Often a taxpayer will sell the relinquished property to a related party while acquiring replacement property from an unrelated party. This structure is not prohibited by the Related Party rules since it does not involve the taxpayer carrying over tax basis into the property sold (it is carried over into the property being purchased), and therefore there is no opportunity for the tax abuse that the rules seek to curb. Between 2007 and 2010 there were a series of
Category: 1031 Exchange General
-
1031 Tax Deferred Exchanges Between Related Parties
-
1031 Tax Deferred Exchanges Between Related Parties
Historically, real estate transactions were not uncommon amongst family and other related parties. Given this and prior history of taxpayers utilizing family or related parties to manipulate the existing IRS regulations on 1031 exchanges, Congress amended the code section to include Related Party rules in relation to 1031 exchanges. Due to today’s booming real estate market, it is even more popular for family to try to help the younger generation start their real estate investment journey, which makes it more important than ever to understand the Related Party rules outlined below.
Background to the Related Party rules
Tax deferral under section 1031 of the U.S. tax code is very taxpayer-friendly, potentially allowing taxpayers to defer capital gain, depreciation recapture, healthcare tax, and state tax. However, to take advantage of this code section, taxpayers have to play fair and strictly follow the rules. In the past, it was possible to manipulate the rules to achieve a favorable outcome by bringing a party related to the taxpayer into the transaction. In 1989, Congress amended the code section to stop this abuse. The amendment prohibits taxpayers from entering into transactions with related parties, subject to a few limited exceptions. According to the legislative history of §1031(f) “if a related party exchange is followed shortly by a disposition of the property, the related parties, have in effect, cashed out of the investment.”
This new section, 1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—
(i) the related person disposes of such property, or
(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”
What was the abuse that gave rise to the Related Party rules?
Take as an example “Parent Company” which has Property A for sale with a lot of built-in gain and no need to acquire a replacement property. Its affiliate, “Subsidiary Company” owns Property B of similar value with a high basis. In any exchange, the basis is carried over from the relinquished property to the replacement property. So rather than sell the properties outright, the two companies enter into an exchange with one another to defer taxes. Parent Company holds Property B indefinitely, but shortly after the exchange, Subsidiary Company sells Property A. Since Subsidiary Company has a high basis in Property A, there is little tax effect to it upon the sale. This was a common occurrence prior to the 1989 Related Party rules addition to section 1031.
Can any part of a taxpayer’s exchange transaction involve a related party?
Often a taxpayer will sell the relinquished property to a related party while acquiring replacement property from an unrelated party. This structure is not prohibited by the Related Party rules since it does not involve the taxpayer carrying over tax basis into the property sold (it is carried over into the property being purchased), and therefore there is no opportunity for the tax abuse that the rules seek to curb. Between 2007 and 2010 there were a series of -
1031 Tax Deferred Exchanges Between Related Parties
Historically, real estate transactions were not uncommon amongst family and other related parties. Given this and prior history of taxpayers utilizing family or related parties to manipulate the existing IRS regulations on 1031 exchanges, Congress amended the code section to include Related Party rules in relation to 1031 exchanges. Due to today’s booming real estate market, it is even more popular for family to try to help the younger generation start their real estate investment journey, which makes it more important than ever to understand the Related Party rules outlined below.
Background to the Related Party rules
Tax deferral under section 1031 of the U.S. tax code is very taxpayer-friendly, potentially allowing taxpayers to defer capital gain, depreciation recapture, healthcare tax, and state tax. However, to take advantage of this code section, taxpayers have to play fair and strictly follow the rules. In the past, it was possible to manipulate the rules to achieve a favorable outcome by bringing a party related to the taxpayer into the transaction. In 1989, Congress amended the code section to stop this abuse. The amendment prohibits taxpayers from entering into transactions with related parties, subject to a few limited exceptions. According to the legislative history of §1031(f) “if a related party exchange is followed shortly by a disposition of the property, the related parties, have in effect, cashed out of the investment.”
This new section, 1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—
(i) the related person disposes of such property, or
(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”
What was the abuse that gave rise to the Related Party rules?
Take as an example “Parent Company” which has Property A for sale with a lot of built-in gain and no need to acquire a replacement property. Its affiliate, “Subsidiary Company” owns Property B of similar value with a high basis. In any exchange, the basis is carried over from the relinquished property to the replacement property. So rather than sell the properties outright, the two companies enter into an exchange with one another to defer taxes. Parent Company holds Property B indefinitely, but shortly after the exchange, Subsidiary Company sells Property A. Since Subsidiary Company has a high basis in Property A, there is little tax effect to it upon the sale. This was a common occurrence prior to the 1989 Related Party rules addition to section 1031.
Can any part of a taxpayer’s exchange transaction involve a related party?
Often a taxpayer will sell the relinquished property to a related party while acquiring replacement property from an unrelated party. This structure is not prohibited by the Related Party rules since it does not involve the taxpayer carrying over tax basis into the property sold (it is carried over into the property being purchased), and therefore there is no opportunity for the tax abuse that the rules seek to curb. Between 2007 and 2010 there were a series of -
1031 Exchanges for Condominium Deconversions
Condominium deconversions have been taking place quite frequently in the greater Chicagoland area and elsewhere. For reasons including the ones set forth below, a condominium deconversion takes place when 75% (or in some jurisdictions a higher percentage) of the owners choose to sell the building to someone interested in converting it to use as an apartment building. A deconversion can be precipitated by one or more factors. Rental properties may be in short supply in the area and converting the building to apartments may be far more valuable than the aggregate value of the individual condo units. Also, as the building gets older and requires more regular fix ups, unit owners are reluctant to continuously pay for special assessments that might otherwise keep the property in proper condition. Furthermore, the need for ongoing special assessments may make it difficult to sell the unit or at the very least have a negative impact on the price.
Requirements for a 1031 Exchange
Like any other sale of real estate, those who utilized their unit as an investment or business use property and are seeking to use a tax deferred exchange have to adhere to the specific governing regulations. One such requirement is that the exchange company, known as a Qualified Intermediary (QI), has to take tax ownership of the property from the property owner and to transfer that ownership to the buyer. Click to learn more about QI services. This can be accomplished by the taxpayer deeding the property to the QI and the QI deeding to the buyer. Another permitted way to accomplish this is for the QI to be a party to the sale agreement, meaning that the QI has a legal obligation to cause legal title to be conveyed to the buyer. These two options are somewhat cumbersome. In order to make that process as simple as possible, the Treasury Department provided a shortcut in the regulations to accomplish tax ownership of the relinquished property passing through the QI.
(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.
In short, sellers’ “rights” in and to the sale agreement have to be assigned to the QI and all parties to the agreement have to receive written notice of this assignment. However, meeting this requirement in a sale of an individual owner’s unit presents a practical problem since typically when it comes to condominiums the sale agreement is signed only by the condominium association, and not by the actual unit owner.
Meeting 1031 Exchange Rules on a Conversion Property
In this blog writer’s shop, we attempt to bridge this gap by having slightly different language on this Assignment of Relinquished Property when it involves a sale due to conversion. The italicized part of the assignment document appears below:
Assignment. The undersigned (“Exchanger”) hereby assigns to Accruit, LLC (“Accruit”) all of Exchanger’s rights (but not Exchanger’s liabilities or obligations), referred to hereafter as the “Assignment”, under that certain Purchase and Sale Agreement (the “Relinquished Property Contract”) between the ____________ Condominium Association as Seller, of which ___________ is a condominium unit owner as to her percentage ownership in the comment elements in the ______________ Condominium Association pursuant to 765 ILCS 605/15 of the Illinois Condominium Property Act, the unit owner being the Exchanger and Relinquished Property Buyer being the buyer (identified above). If not previously provided, simultaneously with the execution of this Assignment by the parties, Exchanger shall promptly provide Accruit with a copy of the Relinquished Property Contract.The challenge is assigning the rights to the unit owner’s sale of the unit in a situation where the unit owner is not a direct signer nor party of the agreement. Instead, the taxpayer is assigning the rights in his or her derivative capacity as an owner in the property being sold to the party seeking to change the property into an apartment building. Notice of the assignment is also given to the parties to the contract, usually by tendering it to their lawyers as the agent for the parties.
Sales of condominium buildings are happening regularly, and many unit owners are seeking to receive tax deferral by utilizing a 1031 exchange opportunity. The manner in which the sale contract is signed presents a slight challenge to meet the requirements set forth in the 1031 exchange rules. However, the spirit of those rules can be followed with an assignment of rights whereby the language in the assignment is changed slightly to account for the lack of a unit owner’s being a direct party to the sale agreement.
-
1031 Exchanges for Condominium Deconversions
Condominium deconversions have been taking place quite frequently in the greater Chicagoland area and elsewhere. For reasons including the ones set forth below, a condominium deconversion takes place when 75% (or in some jurisdictions a higher percentage) of the owners choose to sell the building to someone interested in converting it to use as an apartment building. A deconversion can be precipitated by one or more factors. Rental properties may be in short supply in the area and converting the building to apartments may be far more valuable than the aggregate value of the individual condo units. Also, as the building gets older and requires more regular fix ups, unit owners are reluctant to continuously pay for special assessments that might otherwise keep the property in proper condition. Furthermore, the need for ongoing special assessments may make it difficult to sell the unit or at the very least have a negative impact on the price.
Requirements for a 1031 Exchange
Like any other sale of real estate, those who utilized their unit as an investment or business use property and are seeking to use a tax deferred exchange have to adhere to the specific governing regulations. One such requirement is that the exchange company, known as a Qualified Intermediary (QI), has to take tax ownership of the property from the property owner and to transfer that ownership to the buyer. Click to learn more about QI services. This can be accomplished by the taxpayer deeding the property to the QI and the QI deeding to the buyer. Another permitted way to accomplish this is for the QI to be a party to the sale agreement, meaning that the QI has a legal obligation to cause legal title to be conveyed to the buyer. These two options are somewhat cumbersome. In order to make that process as simple as possible, the Treasury Department provided a shortcut in the regulations to accomplish tax ownership of the relinquished property passing through the QI.
(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.
In short, sellers’ “rights” in and to the sale agreement have to be assigned to the QI and all parties to the agreement have to receive written notice of this assignment. However, meeting this requirement in a sale of an individual owner’s unit presents a practical problem since typically when it comes to condominiums the sale agreement is signed only by the condominium association, and not by the actual unit owner.
Meeting 1031 Exchange Rules on a Conversion Property
In this blog writer’s shop, we attempt to bridge this gap by having slightly different language on this Assignment of Relinquished Property when it involves a sale due to conversion. The italicized part of the assignment document appears below:
Assignment. The undersigned (“Exchanger”) hereby assigns to Accruit, LLC (“Accruit”) all of Exchanger’s rights (but not Exchanger’s liabilities or obligations), referred to hereafter as the “Assignment”, under that certain Purchase and Sale Agreement (the “Relinquished Property Contract”) between the ____________ Condominium Association as Seller, of which ___________ is a condominium unit owner as to her percentage ownership in the comment elements in the ______________ Condominium Association pursuant to 765 ILCS 605/15 of the Illinois Condominium Property Act, the unit owner being the Exchanger and Relinquished Property Buyer being the buyer (identified above). If not previously provided, simultaneously with the execution of this Assignment by the parties, Exchanger shall promptly provide Accruit with a copy of the Relinquished Property Contract.The challenge is assigning the rights to the unit owner’s sale of the unit in a situation where the unit owner is not a direct signer nor party of the agreement. Instead, the taxpayer is assigning the rights in his or her derivative capacity as an owner in the property being sold to the party seeking to change the property into an apartment building. Notice of the assignment is also given to the parties to the contract, usually by tendering it to their lawyers as the agent for the parties.
Sales of condominium buildings are happening regularly, and many unit owners are seeking to receive tax deferral by utilizing a 1031 exchange opportunity. The manner in which the sale contract is signed presents a slight challenge to meet the requirements set forth in the 1031 exchange rules. However, the spirit of those rules can be followed with an assignment of rights whereby the language in the assignment is changed slightly to account for the lack of a unit owner’s being a direct party to the sale agreement.
-
1031 Exchanges for Condominium Deconversions
Condominium deconversions have been taking place quite frequently in the greater Chicagoland area and elsewhere. For reasons including the ones set forth below, a condominium deconversion takes place when 75% (or in some jurisdictions a higher percentage) of the owners choose to sell the building to someone interested in converting it to use as an apartment building. A deconversion can be precipitated by one or more factors. Rental properties may be in short supply in the area and converting the building to apartments may be far more valuable than the aggregate value of the individual condo units. Also, as the building gets older and requires more regular fix ups, unit owners are reluctant to continuously pay for special assessments that might otherwise keep the property in proper condition. Furthermore, the need for ongoing special assessments may make it difficult to sell the unit or at the very least have a negative impact on the price.
Requirements for a 1031 Exchange
Like any other sale of real estate, those who utilized their unit as an investment or business use property and are seeking to use a tax deferred exchange have to adhere to the specific governing regulations. One such requirement is that the exchange company, known as a Qualified Intermediary (QI), has to take tax ownership of the property from the property owner and to transfer that ownership to the buyer. Click to learn more about QI services. This can be accomplished by the taxpayer deeding the property to the QI and the QI deeding to the buyer. Another permitted way to accomplish this is for the QI to be a party to the sale agreement, meaning that the QI has a legal obligation to cause legal title to be conveyed to the buyer. These two options are somewhat cumbersome. In order to make that process as simple as possible, the Treasury Department provided a shortcut in the regulations to accomplish tax ownership of the relinquished property passing through the QI.
(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.
In short, sellers’ “rights” in and to the sale agreement have to be assigned to the QI and all parties to the agreement have to receive written notice of this assignment. However, meeting this requirement in a sale of an individual owner’s unit presents a practical problem since typically when it comes to condominiums the sale agreement is signed only by the condominium association, and not by the actual unit owner.
Meeting 1031 Exchange Rules on a Conversion Property
In this blog writer’s shop, we attempt to bridge this gap by having slightly different language on this Assignment of Relinquished Property when it involves a sale due to conversion. The italicized part of the assignment document appears below:
Assignment. The undersigned (“Exchanger”) hereby assigns to Accruit, LLC (“Accruit”) all of Exchanger’s rights (but not Exchanger’s liabilities or obligations), referred to hereafter as the “Assignment”, under that certain Purchase and Sale Agreement (the “Relinquished Property Contract”) between the ____________ Condominium Association as Seller, of which ___________ is a condominium unit owner as to her percentage ownership in the comment elements in the ______________ Condominium Association pursuant to 765 ILCS 605/15 of the Illinois Condominium Property Act, the unit owner being the Exchanger and Relinquished Property Buyer being the buyer (identified above). If not previously provided, simultaneously with the execution of this Assignment by the parties, Exchanger shall promptly provide Accruit with a copy of the Relinquished Property Contract.The challenge is assigning the rights to the unit owner’s sale of the unit in a situation where the unit owner is not a direct signer nor party of the agreement. Instead, the taxpayer is assigning the rights in his or her derivative capacity as an owner in the property being sold to the party seeking to change the property into an apartment building. Notice of the assignment is also given to the parties to the contract, usually by tendering it to their lawyers as the agent for the parties.
Sales of condominium buildings are happening regularly, and many unit owners are seeking to receive tax deferral by utilizing a 1031 exchange opportunity. The manner in which the sale contract is signed presents a slight challenge to meet the requirements set forth in the 1031 exchange rules. However, the spirit of those rules can be followed with an assignment of rights whereby the language in the assignment is changed slightly to account for the lack of a unit owner’s being a direct party to the sale agreement.
-
Cash Out Refinance Before or After a 1031 Exchange?
Most taxpayers wish to defer tax in full when completing a 1031 exchange. In order to accomplish this, one simple rule of thumb is that the taxpayer must trade “up or equal” in value. Perhaps a better way to look at this is to make sure the net proceeds of sale (i.e. the amount held in the exchange account) are used in full and the taxpayer puts on equal or greater debt on the new property compared to the amount paid off at the time of closing on the sale. Another expression sometimes used is that the taxpayer should have “no net debt relief.” Any cash taken out at closing and any debt that is not covered could be subject to:
Capital gains tax
Recapture of depreciation
State taxes
Net Investment Income Tax (also known as Affordable Care Act tax)Oftentimes with exchange transactions, taxpayers wish to receive some cash out for various reasons. Any cash generated at the time of the sale that is not reinvested is referred to as “boot” and the amount is taxable. There are a couple of possible ways to gain access to that cash while still receiving full tax deferral.
Refinancing Relinquished Property Prior to Closing
For an owner of real estate, not engaging in a 1031 exchange, who wishes to refinance it at any time, any cash proceeds received are not subject to tax. However, in many cases, a taxpayer looking ahead to an upcoming exchange of his property may find himself with a high amount of equity and relatively low (or no) debt, this will require him to reinvest all the cash (and match debt). The taxpayer may wish to finance or refinance the property pulling cash out and later go to closing with higher debt and lower cash equity, as a result his reinvestment requirements for the replacement exchange property are suddenly very different. Essentially he walks away from the transaction with the debt on the property paid off, cash in his pocket, higher debt and lower equity in his replacement property and total tax referral The problem with this approach is that the IRS does not like it. It is almost like cheating. Essentially it is substituting new debt for cash taken out. Since the taxpayer cannot take out cash on a tax deferred basis at closing, essentially doing the same thing just prior to the closing should be disallowed as well. The IRS does not look favorably upon a step transaction, which basically means that if something is not allowed to be done in a direct fashion (taking out cash at closing), by taking a few additional steps to avoid the application of the rule, is not allowed either.
There are a couple of facts which may improve the IRS position on these refinance transactions. One of these is the impression that the refinance is not done in anticipation of the exchange of the property. In general, the more time that elapses between any cash out refinance and the eventual sale of the property is in the taxpayer’s best interest There is no bright line safe harbor for this, but at the very least if it is done somewhat prior to listing the property, that fact would be helpful. The other consideration that comes up a lot in IRS cases is the presence of independent business reasons for the refinance. Maybe the taxpayer’s business is having cash flow problems. Maybe the property needs a new roof, etc. To the extent that the refinance is done for other reasons and not solely to effect a favorable change to the debt and equity numbers, a taxpayer should be able to refinance even while contemplating a subsequent 1031 exchange of the property.
Refinancing Replacement Property After Closing
As was stated above, in the absence of any exchange transaction, a taxpayer who chooses to do a cash out refinance does not trigger any tax. The question then is whether that principle applies to refinancing to pull equity out after the acquisition of the replacement property is complete. Is that taxpayer in any different position from one who is doing a cash out refinance for property held but not part of an exchange transaction? Probably not and accordingly, the IRS does not seem to disallow these post-exchange refinancings. The American Bar Association Section on Taxation addressed these issues, and others, as part of an open report it prepared after the exchange rules came out. The committee concluded that in the case of pre-exchange refinance the taxpayer is no longer obligated to pay the debt once the loan is paid off at the closing, while still retaining the cash. In a post-exchange transaction, the taxpayer retains the cash but has an outstanding obligation to repay the debt. The committee concluded:“The key to the distinction between pre-and post-exchange refinancings is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for pre-exchange relinquished property refinancing upon transfer of the relinquished property. A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth.”
Consistent with this reasoning, one noted author used the term “nanosecond” to indicate how long a taxpayer needs to wait before entering into a cash out refinance on the replacement property. In other words, once a taxpayer owns the replacement property and refinances it incurring a repayment obligation, that taxpayer is in no different position than anyone else owning property and refinancing it. Most authors take a similar position, but caution not to have the cash out refinance done concurrently with the acquisition of the property nor to have it prearranged prior to the purchase of the property. Best practice would be to start the cash out refinance process any time after the replacement property acquisition.
Summary of Cash Out Refinance in 1031 Exchange
Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg of an exchange. Any sums paid to the taxpayer at closing are subject to taxation. As an alternative, a taxpayer may wish to refinance the relinquished property before the exchange or refinance the replacement property after the exchange. In the absence of mitigating factors, refinancing the relinquished property is generally discouraged, however refinancing the replacement property should not result in any tax issues and should not jeopardize the tax deferral on the transaction. The primary logic for these positions is that with the former, the taxpayer is able to pay off the loan debt at the closing, whereas in the second alternative the taxpayer retains the debt obligation as an offset to the receipt of cash.https://cta-redirect.hubspot.com/cta/redirect/6205670/54985636-c73e-4c3… alt=”Forward Exchanges Download” class=”hs-cta-img” height=”150″ id=”hs-cta-img-54985636-c73e-4c3d-9d46-a49349f9bf90″ src=”https://no-cache.hubspot.com/cta/default/6205670/54985636-c73e-4c3d-9d4…; style=”border-width:0px;” width=”1320″ />https://js.hscta.net/cta/current.js”> hbspt.cta.load(6205670, ‘54985636-c73e-4c3d-9d46-a49349f9bf90’, {});
Updated 3/21/2022. -
Cash Out Refinance Before or After a 1031 Exchange?
Most taxpayers wish to defer tax in full when completing a 1031 exchange. In order to accomplish this, one simple rule of thumb is that the taxpayer must trade “up or equal” in value. Perhaps a better way to look at this is to make sure the net proceeds of sale (i.e. the amount held in the exchange account) are used in full and the taxpayer puts on equal or greater debt on the new property compared to the amount paid off at the time of closing on the sale. Another expression sometimes used is that the taxpayer should have “no net debt relief.” Any cash taken out at closing and any debt that is not covered could be subject to:
Capital gains tax
Recapture of depreciation
State taxes
Net Investment Income Tax (also known as Affordable Care Act tax)Oftentimes with exchange transactions, taxpayers wish to receive some cash out for various reasons. Any cash generated at the time of the sale that is not reinvested is referred to as “boot” and the amount is taxable. There are a couple of possible ways to gain access to that cash while still receiving full tax deferral.
Refinancing Relinquished Property Prior to Closing
For an owner of real estate, not engaging in a 1031 exchange, who wishes to refinance it at any time, any cash proceeds received are not subject to tax. However, in many cases, a taxpayer looking ahead to an upcoming exchange of his property may find himself with a high amount of equity and relatively low (or no) debt, this will require him to reinvest all the cash (and match debt). The taxpayer may wish to finance or refinance the property pulling cash out and later go to closing with higher debt and lower cash equity, as a result his reinvestment requirements for the replacement exchange property are suddenly very different. Essentially he walks away from the transaction with the debt on the property paid off, cash in his pocket, higher debt and lower equity in his replacement property and total tax referral The problem with this approach is that the IRS does not like it. It is almost like cheating. Essentially it is substituting new debt for cash taken out. Since the taxpayer cannot take out cash on a tax deferred basis at closing, essentially doing the same thing just prior to the closing should be disallowed as well. The IRS does not look favorably upon a step transaction, which basically means that if something is not allowed to be done in a direct fashion (taking out cash at closing), by taking a few additional steps to avoid the application of the rule, is not allowed either.
There are a couple of facts which may improve the IRS position on these refinance transactions. One of these is the impression that the refinance is not done in anticipation of the exchange of the property. In general, the more time that elapses between any cash out refinance and the eventual sale of the property is in the taxpayer’s best interest There is no bright line safe harbor for this, but at the very least if it is done somewhat prior to listing the property, that fact would be helpful. The other consideration that comes up a lot in IRS cases is the presence of independent business reasons for the refinance. Maybe the taxpayer’s business is having cash flow problems. Maybe the property needs a new roof, etc. To the extent that the refinance is done for other reasons and not solely to effect a favorable change to the debt and equity numbers, a taxpayer should be able to refinance even while contemplating a subsequent 1031 exchange of the property.
Refinancing Replacement Property After Closing
As was stated above, in the absence of any exchange transaction, a taxpayer who chooses to do a cash out refinance does not trigger any tax. The question then is whether that principle applies to refinancing to pull equity out after the acquisition of the replacement property is complete. Is that taxpayer in any different position from one who is doing a cash out refinance for property held but not part of an exchange transaction? Probably not and accordingly, the IRS does not seem to disallow these post-exchange refinancings. The American Bar Association Section on Taxation addressed these issues, and others, as part of an open report it prepared after the exchange rules came out. The committee concluded that in the case of pre-exchange refinance the taxpayer is no longer obligated to pay the debt once the loan is paid off at the closing, while still retaining the cash. In a post-exchange transaction, the taxpayer retains the cash but has an outstanding obligation to repay the debt. The committee concluded:“The key to the distinction between pre-and post-exchange refinancings is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for pre-exchange relinquished property refinancing upon transfer of the relinquished property. A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth.”
Consistent with this reasoning, one noted author used the term “nanosecond” to indicate how long a taxpayer needs to wait before entering into a cash out refinance on the replacement property. In other words, once a taxpayer owns the replacement property and refinances it incurring a repayment obligation, that taxpayer is in no different position than anyone else owning property and refinancing it. Most authors take a similar position, but caution not to have the cash out refinance done concurrently with the acquisition of the property nor to have it prearranged prior to the purchase of the property. Best practice would be to start the cash out refinance process any time after the replacement property acquisition.
Summary of Cash Out Refinance in 1031 Exchange
Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg of an exchange. Any sums paid to the taxpayer at closing are subject to taxation. As an alternative, a taxpayer may wish to refinance the relinquished property before the exchange or refinance the replacement property after the exchange. In the absence of mitigating factors, refinancing the relinquished property is generally discouraged, however refinancing the replacement property should not result in any tax issues and should not jeopardize the tax deferral on the transaction. The primary logic for these positions is that with the former, the taxpayer is able to pay off the loan debt at the closing, whereas in the second alternative the taxpayer retains the debt obligation as an offset to the receipt of cash.https://cta-redirect.hubspot.com/cta/redirect/6205670/54985636-c73e-4c3… alt=”Forward Exchanges Download” class=”hs-cta-img” height=”150″ id=”hs-cta-img-54985636-c73e-4c3d-9d46-a49349f9bf90″ src=”https://no-cache.hubspot.com/cta/default/6205670/54985636-c73e-4c3d-9d4…; style=”border-width:0px;” width=”1320″ />https://js.hscta.net/cta/current.js”> hbspt.cta.load(6205670, ‘54985636-c73e-4c3d-9d46-a49349f9bf90’, {});
Updated 3/21/2022. -
Cash Out Refinance Before or After a 1031 Exchange?
Most taxpayers wish to defer tax in full when completing a 1031 exchange. In order to accomplish this, one simple rule of thumb is that the taxpayer must trade “up or equal” in value. Perhaps a better way to look at this is to make sure the net proceeds of sale (i.e. the amount held in the exchange account) are used in full and the taxpayer puts on equal or greater debt on the new property compared to the amount paid off at the time of closing on the sale. Another expression sometimes used is that the taxpayer should have “no net debt relief.” Any cash taken out at closing and any debt that is not covered could be subject to:
Capital gains tax
Recapture of depreciation
State taxes
Net Investment Income Tax (also known as Affordable Care Act tax)Oftentimes with exchange transactions, taxpayers wish to receive some cash out for various reasons. Any cash generated at the time of the sale that is not reinvested is referred to as “boot” and the amount is taxable. There are a couple of possible ways to gain access to that cash while still receiving full tax deferral.
Refinancing Relinquished Property Prior to Closing
For an owner of real estate, not engaging in a 1031 exchange, who wishes to refinance it at any time, any cash proceeds received are not subject to tax. However, in many cases, a taxpayer looking ahead to an upcoming exchange of his property may find himself with a high amount of equity and relatively low (or no) debt, this will require him to reinvest all the cash (and match debt). The taxpayer may wish to finance or refinance the property pulling cash out and later go to closing with higher debt and lower cash equity, as a result his reinvestment requirements for the replacement exchange property are suddenly very different. Essentially he walks away from the transaction with the debt on the property paid off, cash in his pocket, higher debt and lower equity in his replacement property and total tax referral The problem with this approach is that the IRS does not like it. It is almost like cheating. Essentially it is substituting new debt for cash taken out. Since the taxpayer cannot take out cash on a tax deferred basis at closing, essentially doing the same thing just prior to the closing should be disallowed as well. The IRS does not look favorably upon a step transaction, which basically means that if something is not allowed to be done in a direct fashion (taking out cash at closing), by taking a few additional steps to avoid the application of the rule, is not allowed either.
There are a couple of facts which may improve the IRS position on these refinance transactions. One of these is the impression that the refinance is not done in anticipation of the exchange of the property. In general, the more time that elapses between any cash out refinance and the eventual sale of the property is in the taxpayer’s best interest There is no bright line safe harbor for this, but at the very least if it is done somewhat prior to listing the property, that fact would be helpful. The other consideration that comes up a lot in IRS cases is the presence of independent business reasons for the refinance. Maybe the taxpayer’s business is having cash flow problems. Maybe the property needs a new roof, etc. To the extent that the refinance is done for other reasons and not solely to effect a favorable change to the debt and equity numbers, a taxpayer should be able to refinance even while contemplating a subsequent 1031 exchange of the property.
Refinancing Replacement Property After Closing
As was stated above, in the absence of any exchange transaction, a taxpayer who chooses to do a cash out refinance does not trigger any tax. The question then is whether that principle applies to refinancing to pull equity out after the acquisition of the replacement property is complete. Is that taxpayer in any different position from one who is doing a cash out refinance for property held but not part of an exchange transaction? Probably not and accordingly, the IRS does not seem to disallow these post-exchange refinancings. The American Bar Association Section on Taxation addressed these issues, and others, as part of an open report it prepared after the exchange rules came out. The committee concluded that in the case of pre-exchange refinance the taxpayer is no longer obligated to pay the debt once the loan is paid off at the closing, while still retaining the cash. In a post-exchange transaction, the taxpayer retains the cash but has an outstanding obligation to repay the debt. The committee concluded:“The key to the distinction between pre-and post-exchange refinancings is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for pre-exchange relinquished property refinancing upon transfer of the relinquished property. A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth.”
Consistent with this reasoning, one noted author used the term “nanosecond” to indicate how long a taxpayer needs to wait before entering into a cash out refinance on the replacement property. In other words, once a taxpayer owns the replacement property and refinances it incurring a repayment obligation, that taxpayer is in no different position than anyone else owning property and refinancing it. Most authors take a similar position, but caution not to have the cash out refinance done concurrently with the acquisition of the property nor to have it prearranged prior to the purchase of the property. Best practice would be to start the cash out refinance process any time after the replacement property acquisition.
Summary of Cash Out Refinance in 1031 Exchange
Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg of an exchange. Any sums paid to the taxpayer at closing are subject to taxation. As an alternative, a taxpayer may wish to refinance the relinquished property before the exchange or refinance the replacement property after the exchange. In the absence of mitigating factors, refinancing the relinquished property is generally discouraged, however refinancing the replacement property should not result in any tax issues and should not jeopardize the tax deferral on the transaction. The primary logic for these positions is that with the former, the taxpayer is able to pay off the loan debt at the closing, whereas in the second alternative the taxpayer retains the debt obligation as an offset to the receipt of cash.https://cta-redirect.hubspot.com/cta/redirect/6205670/54985636-c73e-4c3… alt=”Forward Exchanges Download” class=”hs-cta-img” height=”150″ id=”hs-cta-img-54985636-c73e-4c3d-9d46-a49349f9bf90″ src=”https://no-cache.hubspot.com/cta/default/6205670/54985636-c73e-4c3d-9d4…; style=”border-width:0px;” width=”1320″ />https://js.hscta.net/cta/current.js”> hbspt.cta.load(6205670, ‘54985636-c73e-4c3d-9d46-a49349f9bf90’, {});
Updated 3/21/2022. -
Cash Out Refinance Before or After a 1031 Exchange?
Most taxpayers wish to defer tax in full when completing a 1031 exchange. In order to accomplish this, one simple rule of thumb is that the taxpayer must trade “up or equal” in value. Perhaps a better way to look at this is to make sure the net proceeds of sale (i.e. the amount held in the exchange account) are used in full and the taxpayer puts on equal or greater debt on the new property compared to the amount paid off at the time of closing on the sale. Another expression sometimes used is that the taxpayer should have “no net debt relief.” Any cash taken out at closing and any debt that is not covered could be subject to:
Capital gains tax
Recapture of depreciation
State taxes
Net Investment Income Tax (also known as Affordable Care Act tax)Oftentimes with exchange transactions, taxpayers wish to receive some cash out for various reasons. Any cash generated at the time of the sale that is not reinvested is referred to as “boot” and the amount is taxable. There are a couple of possible ways to gain access to that cash while still receiving full tax deferral.
Refinancing Relinquished Property Prior to Closing
For an owner of real estate, not engaging in a 1031 exchange, who wishes to refinance it at any time, any cash proceeds received are not subject to tax. However, in many cases, a taxpayer looking ahead to an upcoming exchange of his property may find himself with a high amount of equity and relatively low (or no) debt, this will require him to reinvest all the cash (and match debt). The taxpayer may wish to finance or refinance the property pulling cash out and later go to closing with higher debt and lower cash equity, as a result his reinvestment requirements for the replacement exchange property are suddenly very different. Essentially he walks away from the transaction with the debt on the property paid off, cash in his pocket, higher debt and lower equity in his replacement property and total tax referral The problem with this approach is that the IRS does not like it. It is almost like cheating. Essentially it is substituting new debt for cash taken out. Since the taxpayer cannot take out cash on a tax deferred basis at closing, essentially doing the same thing just prior to the closing should be disallowed as well. The IRS does not look favorably upon a step transaction, which basically means that if something is not allowed to be done in a direct fashion (taking out cash at closing), by taking a few additional steps to avoid the application of the rule, is not allowed either.
There are a couple of facts which may improve the IRS position on these refinance transactions. One of these is the impression that the refinance is not done in anticipation of the exchange of the property. In general, the more time that elapses between any cash out refinance and the eventual sale of the property is in the taxpayer’s best interest There is no bright line safe harbor for this, but at the very least if it is done somewhat prior to listing the property, that fact would be helpful. The other consideration that comes up a lot in IRS cases is the presence of independent business reasons for the refinance. Maybe the taxpayer’s business is having cash flow problems. Maybe the property needs a new roof, etc. To the extent that the refinance is done for other reasons and not solely to effect a favorable change to the debt and equity numbers, a taxpayer should be able to refinance even while contemplating a subsequent 1031 exchange of the property.
Refinancing Replacement Property After Closing
As was stated above, in the absence of any exchange transaction, a taxpayer who chooses to do a cash out refinance does not trigger any tax. The question then is whether that principle applies to refinancing to pull equity out after the acquisition of the replacement property is complete. Is that taxpayer in any different position from one who is doing a cash out refinance for property held but not part of an exchange transaction? Probably not and accordingly, the IRS does not seem to disallow these post-exchange refinancings. The American Bar Association Section on Taxation addressed these issues, and others, as part of an open report it prepared after the exchange rules came out. The committee concluded that in the case of pre-exchange refinance the taxpayer is no longer obligated to pay the debt once the loan is paid off at the closing, while still retaining the cash. In a post-exchange transaction, the taxpayer retains the cash but has an outstanding obligation to repay the debt. The committee concluded:“The key to the distinction between pre-and post-exchange refinancings is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for pre-exchange relinquished property refinancing upon transfer of the relinquished property. A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth.”
Consistent with this reasoning, one noted author used the term “nanosecond” to indicate how long a taxpayer needs to wait before entering into a cash out refinance on the replacement property. In other words, once a taxpayer owns the replacement property and refinances it incurring a repayment obligation, that taxpayer is in no different position than anyone else owning property and refinancing it. Most authors take a similar position, but caution not to have the cash out refinance done concurrently with the acquisition of the property nor to have it prearranged prior to the purchase of the property. Best practice would be to start the cash out refinance process any time after the replacement property acquisition.
Summary of Cash Out Refinance in 1031 Exchange
Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg of an exchange. Any sums paid to the taxpayer at closing are subject to taxation. As an alternative, a taxpayer may wish to refinance the relinquished property before the exchange or refinance the replacement property after the exchange. In the absence of mitigating factors, refinancing the relinquished property is generally discouraged, however refinancing the replacement property should not result in any tax issues and should not jeopardize the tax deferral on the transaction. The primary logic for these positions is that with the former, the taxpayer is able to pay off the loan debt at the closing, whereas in the second alternative the taxpayer retains the debt obligation as an offset to the receipt of cash.https://cta-redirect.hubspot.com/cta/redirect/6205670/54985636-c73e-4c3… alt=”Forward Exchanges Download” class=”hs-cta-img” height=”150″ id=”hs-cta-img-54985636-c73e-4c3d-9d46-a49349f9bf90″ src=”https://no-cache.hubspot.com/cta/default/6205670/54985636-c73e-4c3d-9d4…; style=”border-width:0px;” width=”1320″ />https://js.hscta.net/cta/current.js”> hbspt.cta.load(6205670, ‘54985636-c73e-4c3d-9d46-a49349f9bf90’, {});
Updated 3/21/2022.