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Category: 1031 Exchange General

  • 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.

  • 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.

  • 1031 Exchanges: Unique Examples of Real Property

    1031 Exchanges: Unique Examples of Real Property

    Over the years we have written many posts on a variety of technical aspects of IRC Section 1031 Like-Kind Exchanges. We have written about 1031 Exchange basics; reverse and build-to-suit/improvement exchanges; and about various complex issues in 1031 exchanges. In recent years, new regulations regarding the definition of real estate were evoked, and we covered those in another recent post.
    We must remember, that Congress limited the application of Section 1031 to real property, by eliminating personal property, with the passage of the Tax Cuts and Jobs Act of 2017 (TCJA). Effective as of January 1, 2018, only transactions involving interests in real property qualify for 1031 exchange treatment.
    Recently, we have encountered some rare situations involving unique investment opportunities. Despite leaving real estate as the only asset class, sometimes it is not immediately clear if a type of asset owned is like-kind to conventional real estate ownership. While the majority of 1031 exchanges involve the exchange of one building for another building, or one tract of farmland for another tract of farmland, the term “like-kind” does not mean that the properties being exchanged must be identical in form. Here are some examples of recent transactions involving some less common real property being exchanged. Note that all of these examples were properly structured as 1031 exchanges.
    Less Commonly Known Real Property Examples
    Boat Slip
    Mary sold a multi-family rental property but did not want to reinvest in a similar property. She was considering various replacement property strategies and ultimately acquired a boat slip. Her plan is to treat the boat slip much like an Airbnb or VRBO for short-term rentals. The boat slip she acquired is in Florida, where such properties are transferred by a deeded interest in the property.
    Mobile Home
    Nicholas sold a rental condominium, and wanted to get away from the rigors of complying with condo association rules. He identified and acquired a double-wide trailer in a mobile home community. Nicholas will be using this mobile home as a rental property. Mobile homes are typically towed into place on their own axles and are initially registered and licensed as motor vehicles. Nicholas’ mobile home was acquired in Florida, where the law allows the mobile home to be affixed to a foundation and utilities, and for the mobile home to then be treated as real property under state law. This “de-titling” process affords similar treatment for mobile homes and manufactured homes in many other states.
    Floating Home
    Tom sold a small mixed-use property near the beach. He likes that the property is near the water, but the mixed-use nature of the property often resulted in conflicts between the residential tenants and the commercial tenants. Tom found a floating home for sale in a nearby community and wondered whether that would qualify as real property for 1031 exchange purposes. This floating home is moored in a harbor, and loosely attached to water, sewer, and electric lines provided by the harbor. Fortunately for Tom, California, and a couple of other states, classify these floating homes as real property for tax purposes, and generally treat them like real estate. Upon completion of the purchase, Tom will rent out the home, using it entirely as an investment/business use property.
    Easement to Delaware Statutory Trust
    Susan owned a commercial property at a busy intersection in her town. Around the corner, there was another small commercial property where the parking lot floods every time there is any substantial rain. To access the nearest storm sewer, that owner needed access across Susan’s property. Susan negotiated for the sale of a perpetual easement for the drain across her property. Susan was advised that the sale of the easement would be fully taxable as capital gains, so she structured the sale as part of a 1031 exchange. Working with her advisors, she reinvested the entire sale price into a Delaware Statutory Trust (“DST”). Read more about DSTs.
    Conservation Easement
    Joannie owned one of the few family farms left in her part of the county. Encroaching development and increasing costs put pressure on her to sell the property. Because developers placed such high value on the property, there would be a substantial tax bite if she sold the property outright. After consulting with her advisors, Joannie learned about conservation easements. Read more about conservation easements in 1031 exchanges. Upon further investigation, Joannie sold a conservation easement restricting future development of her family farm. The sale was structured as part of a 1031 exchange, and she reinvested the proceeds in a nearby condo that she will use as a rental property.
    RV Resort
    Nancy and her spouse owned a recreational vehicle resort. Management and maintenance of the resort was a full-time, year-round job. Nancy finally convinced her spouse that they should sell the resort and spend some time traveling around the country. They successfully negotiated the sale of the resort, and on the advice of their tax and legal advisors, structured the sale of the real property portion of the resort as a 1031 exchange. They reinvested the proceeds into several condos near a university, and enlisted the aid of a property management firm to minimize their management responsibilities
    Wind & Solar Farms
    David owned a rental condo near his home. His tenants advised him that they would not be renewing the lease, and David had to investigate his options. In the process, his real estate agent presented an offer from a buyer, even before the property was listed for sale. David liked the idea of getting out of the residential landlord business, but did not want to pay the taxes that would be due upon the sale. Working with his advisors, David bought fractional interests in several operating solar and wind farms in several states around the country. The sale and purchase were part of a properly structured 1031 exchange, and took David from one property to a portfolio of properties with existing long-term tenants.
    These are examples of a few of the unique opportunities our clients have explored recently. There are many other unique opportunities out there for creative investors, such as oil and gas royalties, mineral rights, water rights, and transferrable development rights, which also qualify for 1031 exchange treatment. Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
    Some of the strategies discussed here may not work in all states, and some states may impose special rules on some of these transactions. As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified Intermediary, such as Accruit, before closing on the sale of the relinquished property.

  • 1031 Exchanges: Unique Examples of Real Property

    1031 Exchanges: Unique Examples of Real Property

    Over the years we have written many posts on a variety of technical aspects of IRC Section 1031 Like-Kind Exchanges. We have written about 1031 Exchange basics; reverse and build-to-suit/improvement exchanges; and about various complex issues in 1031 exchanges. In recent years, new regulations regarding the definition of real estate were evoked, and we covered those in another recent post.
    We must remember, that Congress limited the application of Section 1031 to real property, by eliminating personal property, with the passage of the Tax Cuts and Jobs Act of 2017 (TCJA). Effective as of January 1, 2018, only transactions involving interests in real property qualify for 1031 exchange treatment.
    Recently, we have encountered some rare situations involving unique investment opportunities. Despite leaving real estate as the only asset class, sometimes it is not immediately clear if a type of asset owned is like-kind to conventional real estate ownership. While the majority of 1031 exchanges involve the exchange of one building for another building, or one tract of farmland for another tract of farmland, the term “like-kind” does not mean that the properties being exchanged must be identical in form. Here are some examples of recent transactions involving some less common real property being exchanged. Note that all of these examples were properly structured as 1031 exchanges.
    Less Commonly Known Real Property Examples
    Boat Slip
    Mary sold a multi-family rental property but did not want to reinvest in a similar property. She was considering various replacement property strategies and ultimately acquired a boat slip. Her plan is to treat the boat slip much like an Airbnb or VRBO for short-term rentals. The boat slip she acquired is in Florida, where such properties are transferred by a deeded interest in the property.
    Mobile Home
    Nicholas sold a rental condominium, and wanted to get away from the rigors of complying with condo association rules. He identified and acquired a double-wide trailer in a mobile home community. Nicholas will be using this mobile home as a rental property. Mobile homes are typically towed into place on their own axles and are initially registered and licensed as motor vehicles. Nicholas’ mobile home was acquired in Florida, where the law allows the mobile home to be affixed to a foundation and utilities, and for the mobile home to then be treated as real property under state law. This “de-titling” process affords similar treatment for mobile homes and manufactured homes in many other states.
    Floating Home
    Tom sold a small mixed-use property near the beach. He likes that the property is near the water, but the mixed-use nature of the property often resulted in conflicts between the residential tenants and the commercial tenants. Tom found a floating home for sale in a nearby community and wondered whether that would qualify as real property for 1031 exchange purposes. This floating home is moored in a harbor, and loosely attached to water, sewer, and electric lines provided by the harbor. Fortunately for Tom, California, and a couple of other states, classify these floating homes as real property for tax purposes, and generally treat them like real estate. Upon completion of the purchase, Tom will rent out the home, using it entirely as an investment/business use property.
    Easement to Delaware Statutory Trust
    Susan owned a commercial property at a busy intersection in her town. Around the corner, there was another small commercial property where the parking lot floods every time there is any substantial rain. To access the nearest storm sewer, that owner needed access across Susan’s property. Susan negotiated for the sale of a perpetual easement for the drain across her property. Susan was advised that the sale of the easement would be fully taxable as capital gains, so she structured the sale as part of a 1031 exchange. Working with her advisors, she reinvested the entire sale price into a Delaware Statutory Trust (“DST”). Read more about DSTs.
    Conservation Easement
    Joannie owned one of the few family farms left in her part of the county. Encroaching development and increasing costs put pressure on her to sell the property. Because developers placed such high value on the property, there would be a substantial tax bite if she sold the property outright. After consulting with her advisors, Joannie learned about conservation easements. Read more about conservation easements in 1031 exchanges. Upon further investigation, Joannie sold a conservation easement restricting future development of her family farm. The sale was structured as part of a 1031 exchange, and she reinvested the proceeds in a nearby condo that she will use as a rental property.
    RV Resort
    Nancy and her spouse owned a recreational vehicle resort. Management and maintenance of the resort was a full-time, year-round job. Nancy finally convinced her spouse that they should sell the resort and spend some time traveling around the country. They successfully negotiated the sale of the resort, and on the advice of their tax and legal advisors, structured the sale of the real property portion of the resort as a 1031 exchange. They reinvested the proceeds into several condos near a university, and enlisted the aid of a property management firm to minimize their management responsibilities
    Wind & Solar Farms
    David owned a rental condo near his home. His tenants advised him that they would not be renewing the lease, and David had to investigate his options. In the process, his real estate agent presented an offer from a buyer, even before the property was listed for sale. David liked the idea of getting out of the residential landlord business, but did not want to pay the taxes that would be due upon the sale. Working with his advisors, David bought fractional interests in several operating solar and wind farms in several states around the country. The sale and purchase were part of a properly structured 1031 exchange, and took David from one property to a portfolio of properties with existing long-term tenants.
    These are examples of a few of the unique opportunities our clients have explored recently. There are many other unique opportunities out there for creative investors, such as oil and gas royalties, mineral rights, water rights, and transferrable development rights, which also qualify for 1031 exchange treatment. Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
    Some of the strategies discussed here may not work in all states, and some states may impose special rules on some of these transactions. As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified Intermediary, such as Accruit, before closing on the sale of the relinquished property.