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Frequently Asked Questions of 2018 - Part II

October 2018

 

Frequently Asked Questions of 2018 - Part II

Toija Beutler, Attorney

 

Continuing from last month's newsletter...

 

I want to be free and clear.

1031 is not a good opportunity to get debt free.

 

For example, the client is selling a property for $1.0m and after paying off the loan will net cash of $600k. They want to be debt free and propose buying rural land for $600k. Not good. Why not?

 

1031 comes with two important reinvestment rules. First, the client needs to

apply all the cash toward the purchase of the replacement property.

Second, they also need to obtain equal or greater replacement debt. In this

case that means buying replacement property(ies) worth $1.0m.

 

The rationale is best explained by looking at the tax policy behind 1031. It

is an incentive program for Taxpayers who are selling and pulling $1.0m out

of the American economy (rental, commercial, or land). If they sell they owe

tax. If they don't want to pay tax they need to drive back into the American

economy the entire $1.0m. If they only reinvest $600k they have, as I put it,

"shorted America" by $400k. Taxable on the $400k.

 

If they don't want replacement debt they do have the option of "adding cash

in." For example, they buy property(ies) that aggregate to $1.0m but instead

of a loan for $400k they bring an additional $400k of cash to the closings.

 

I only have to reinvest my gain, right?

This is similar to the misunderstanding about replacement debt. Of course,

the whole point of an exchange is not to pay tax on gain. However, to get

the best tax savings the client needs to fully reinvest in the American

economy...not just reinvest the gain.

 

Can I have a partial exchange?

Yes! As long as the client doesn't mind paying some tax they can take cash

out of the sale. Caution, however, against taking out so much cash that the

exchange fails to shelter any gain. The tax advisor would need to analyze

this.

 

Reverse exchanges

With the current limited inventory of available properties clients are having

to shop early and hard for replacement properties. What if they find the

perfect property before their relinquished property has sold? If they have

the financial wherewithal to purchase the replacement property first, a

reverse exchange may be an option.

 

While reverse exchanges report on a tax return exactly the same as a

forward exchange, they are structured very, very differently. The rules allow

the client to purchase first and sell later, but they are not allowed to be the

owner of both properties at the same time. One of the properties must be

"parked" with the exchange company.

 

In a forward exchange the exchange company is "pretending" (my word, not

the IRS's) to sell the relinquished property and buy the replacement

property. Because this is a paperwork fiction the fees are rather nominal.

In a reverse exchange we lose the fiction. With the exchange company

owning one of the properties, the structuring is much more complicated.

Each reverse exchange is customized to the particulars of that transaction.

Exchange fees will be higher. There may be additional transactional costs

to consider - lender, title, recording, LLC formation, attorney, CPA, etc.

 

The client must weigh these additional costs (and a certain amount of

hassle factor) against the tax bill. Is it worth undertaking the reverse

exchange? Often their best course is to offer the Seller of the perfect

property more earnest money, or make the earnest money non-refundable to

buy their patience until the client can get their relinquished property sold

and closed.

 

Can I buy and add a child to the ownership?

A number of parents are looking at 1031 as a way to help an adult child buy

a home. Perhaps the child has some down payment money and would like

to also own so they can qualify the house as a primary residence. This is

doable.

 

There are a few things to keep in mind:

            1. The child must bring some cash to closing as their down payment.

            2. The parent/child ownership must be a ratio of their respective down

payments. If Dad is bringing 90% of the down payment and Son 10%

then they would own the property 90/10 as tenants-in-common.

            3. Son needs to pay Dad fair market rent for the 90% owned by Dad.

How long? Conservative advice suggests 24 months.

 

The lender will generally be perplexed by this arrangement. They know

1031 exchanges are for rentals, not personal use properties. This will be a

rental...as to Dad's share.

 

Not a subject for this article, but Dad and Son should look to the future and

consider how they will ultimately extricate themselves from this

arrangement. There is always a future...

Kelci Paiva