1031 Exchange Rules (+6)

1031 Exchange Rules are not actually written in the tax law.

If you are interested in reading the content that makes up the Section 1031 Exchange Rules, it is contained in Internal Revenue Code Section 1031(a)(1) and Treasury Regs Section 1.1031(a)-1.

I previously wrote about the Top 10 Rules for a 1031 Exchange, and you can read it here.

Those basic rules are, for the most part, short and simple (except maybe the last one).

But there are six other Rules that you need to know about, they will require a little more discussion, and we’ll do those now.

A couple of them involve correcting some misinformation.

1031 EXCHANGE RULE #1: DEBT REPLACEMENT

A few days ago, in anticipation of writing this Blog Post, I searched the web to see what other content was ranking so that I could determine the most useful information for the article.

On the first page of the Google search, one of the major sites that people rely on for real estate investing information had an article saying that the amount of the mortgage on the property that you buy, your Replacement Property, must be at least as much as the mortgage amount that was paid off on the property that you sold, your Relinquished Property.

The writer even added that you cannot use your own cash, in case there was any doubt about what he was saying.

This is incorrect.

The IRS does not, and cannot, force someone to borrow money in order to do a Section 1031 Exchange.

A complete reading of the rule shows that it says that the difference can be made up by adding cash.

Well, if you think about it, this will have to happen anyway.  After putting all of the Net Sales Proceeds (or as much as you intend) into the Replacement Property, the rest of the purchase price will have to be made up of either debt or cash, or a combination of the two.

And if your seller is willing to finance your purchase, you can even do it another way, using Seller Financing.

But you certainly are not required by law to take out a new mortgage to buy your Replacement Property.

I am not trying to dump on anyone here, just trying to let you know that you should question everything that you read about the 1031 Exchange, especially where someone is “creating content,” but it turns out that the content is not really being created, it is just incorrect information being rewritten.

Anyway, the point is that there is no Rule that requires “debt replacement.”

RULE #2: PARTIALLY TAX-DEFERRED 1031 EXCHANGE

A 1031 Exchange usually refers to a transaction in which the Capital Gains taxes and the Depreciation Recapture taxes are deferred.

In other words, a tax-deferred exchange.

But you are also permitted to do an Exchange that is not fully tax-deferred.  If you take a distribution of part of your Net Sales Proceeds, that part will become taxable to you, while the remainder can still be used in the Like Kind Exchange.  All of the other rules still apply.

The portion that is taxable to you will be taxed as Capital Gains and the tax that you pay will be determined by the amount of Depreciation Recapture you are liable for, because that will be applied first, before the capital gains tax is assessed.

And the Depreciation Recapture tax rate applied will depend on your individual income tax bracket, because the tax rate will be your personal tax bracket for Ordinary Income, but not more than 25%, the cap.

After that, the standard capital gains tax rate will be applied and that will be either 0%, 15%, or 20%.

EXCHANGE RULE #3: PERSONAL PROPERTY

Your Relinquished Property will probably include some tangible personal property on which you have claimed depreciation, such as furniture, fixtures and appliances.

Normally, you would be required to identify the real property and the personal property separately and account for the basis of each.

However, the IRS will permit you to lump all of the property together as real property, provided that the Fair Market Value (FMV) of the personal property is not more than fifteen percent (15%) of the total value of the two combined.

However, as you will read elsewhere on this site, this is a terrible idea.

EXCHANGE RULE #4: ASSUMED MORTGAGES

The 1031 Exchange Rules permit you to assume the existing mortgage on the property you buy, your Replacement Property, just like it permits you to sell your Relinquished Property and have the Buyer assume your mortgage.

If the Buyer assumes your mortgage, you have received “boot” in the amount of the mortgage balance that you are no longer required to pay, and this is taxable to you (see below).

However, this amount can be offset by the amount of any mortgage that you assume when you purchase the Replacement Property, or by any new cash that you put into the purchase.

(I think this is where the misinformation about “debt replacement” got started a few years ago on a popular real estate forum where a very active QI was recommending using mortgage assumptions on the sale, and again on the buy, but he got it all screwed up, and the Moderator for the real estate forum site dumped on any of us who tried to correct it.)

Anyway, you can assume the mortgage on property that you buy, and you will not be penalized, as long as you follow all of the other rules, such as using all of your Net Sales Proceeds in the purchase.

EXCHANGE RULE #5: SELLER FINANCING

If you take back a Note, full or partial, when you sell your Relinquished Property, that note is considered “boot” and will be taxable to you the same as cash.

Since it will be an Installment Note, each payment will be a combination of interest and principal, and will be taxable income in the year received.

The interest will be taxable at your ordinary income tax rate.  But the principal will be taxable based on what it represents, Depreciation Recapture or Capital Gains, and if it is Capital Gains, then only a portion of it will be taxable, because only a portion of it represents your profit, referred to as you “ratio.”

If you only finance a portion of the sale price, the remainder can be qualified as a Section 1031 Exchange.

Under the 1031 Exchange Rules, there is a way that you can do seller financing and still not have to pay taxes, and would involve making the note payable to your QI instead of payable to you.

Then you can arrange for the Seller of your Replacement Property to take the note as part of the purchase price.

Alternatively, you could make the note payable in less than 180 days, and when you close on your Replacement Property, your QI will have cash instead of a note.

I’m working on a separate Blog Post to explain how this technique works.

EXCHANGE RULE #6: BOOT

“Boot” is what the IRS calls anything that you receive in exchange for your Relinquished Property that is not like kind property and is not cash.

Boot will usually be taxable to you.

We have discussed how an assumption of your mortgage can be boot, but there are other situations where boot might be created.  You might receive a coin collection, a boat, or a motor home as part payment for the Relinquished Property.

None of these qualify as like kind property, and they are not cash, so their value will be taxable as boot.

The only good thing about this is that you and the other party can generally agree on what the fair market value of the item is, and the IRS will usually accept this valuation.

But, as stated earlier, you can offset the boot by adding an equivalent amount of cash to your Net Sales Proceeds in purchasing your Replacement Property.

In fact, you can even add something other than cash, like a boat, and then you can “net the boot.”

CONCLUSION

Be careful where you get your information.

The facts are available.

Look very carefully at the source.

RESOURCES

I touch on this same concept in more than one of my books, but the one with the most detailed information is “How To Do A Section 1031 Like Kind Exchange” and the OMNIBUS EDITION of the same.  You can go here on this website to look at the first one, use the 3D Flip Reader to look at the Contents and read the first few chapters.

The paperback is available on my Amazon Author Page, along with my other books.

And I have related Articles about real estate investing and other real estate matters from other perspectives on my LinkedIn Page.

I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.

If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, then you will really appreciate the value of what we are talking about, and I have a lot of material for you to consider on my S1031 Exchange website.

You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography.  Here’s mine.

If you are undecided which of my books to start with, here are three that I recommend.

1031 exchange rules

Thank you.

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DISCLAIMER:  I am an Attorney licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia.  But I am not your Attorney.  I would be honored if I were, but I am not.  Reading this Blog does not created an attorney-client relationship between us.  Internet content should not be used as a substitute for the advice of a competent Attorney admitted or authorized to practice law in your state or jurisdiction.

 

April 7, 2022

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