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Getting A Handle on 1031 Exchange Rules

By
Real Estate Agent with Integrity Realty

 

 

Getting A Handle on 1031 Exchange Rules

 by Clifford A. Hockley

Most buyers and sellers of real estate look at 1031 exchanges as an option as they consider their investment agenda. They figure that they defer paying state and federal capital gains taxes and depreciation recapture until they die and their estate goes to their spouse, charity, their children or grandchildren. They may also be able to stave off the alternative minimum tax that might sneak up on them if they were to sell a prope

But how do 1031's really work?

George Columbus was an Ohio investor. George learned from his broker that he would have to pay capital gains taxes when he sold his 10,000 sq foot warehouse. George wanted to defer his taxes and found out that if he bought more real estate and followed the Internal Revenue Service's 1031 rules he could do so successfully.

But his broker warned him, there are rules ... many rules. Failure to comply with any of them could jeopardize your 1031. The Broker sent George to a real estate attorney and a CPA with experience in real estate transactions.

The Accommodator (or qualified intermediary)

Both of these professionals told George he would need to use an accommodator. In 1991, the IRS issued definitive guidelines that clarified 1031 exchanges and the role played by facilitators, accommodators or as they are technically known qualified intermediaries. These companies are unrelated to the seller, and in that way participate in the tax-deferred, like-kind exchange to facilitate the transaction so that it complies with the 1031 regulations.

In the sale transaction (also called a "Forward Exchange") the accommodator takes control of the funds from the sale and then releases the funds to the next deal, so that George does not take constructive receipt of the funds. Specifically, in order to create an "arm's length" transaction, the agreement between the George and Accommodator allows George to deed the property he is selling property to the Accommodator who then conveys the property to the Buyer. The Accommodator then holds the proceeds from that sale in an interest bearing account in favor of the George until an upleg property is purchased. Once again, in accordance with the agreement, the Accommodator then acquires the upleg property and conveys it to the George.

It is critical to have an accommodator in place before you close on the sale of your property to preserve your 1031 exchange.

Identification of new property

In order for George to have a proper 1031 exchange not only did he have to buy a like in kind property, he also needs to identify the next property he intendeds to purchase within 45 calendar days after he closed on the sale of his warehouse. The 45 day rule timing can also be tricky at the end of the year with all of the holidays like Thanksgiving, Christmas and New Year's. Here are the three IRS mandated rules:

  1. Three property rule: George can identify three properties of any value or

     

  2. 200% rule: George may identify more than three properties if the total fair market value of what is identified does not exceed 200% of the sale price of the relinquished property or;

     

  3. 95% Rule: If George exceeds the 3 property rule and the 200% rule the exchange will not fail if he purchases 95% of the aggregate fair market value of all identified property.

Realistically, the key to property identification will tie into the realities of what properties are available in the marketplace that he can purchase given current financing considerations. Most investors chose the three property rule so they can go through the due diligence on three properties to find the one that works for them and that can actually close.

Identification must be delivered no later than the 45th day:

  1. In writing

     

  2. Delivered to a party to the exchange (escrow or accommodator)

     

  3. Must be unambiguous and signed by George

     

  4. It would be best to submit a couple of days early if a winter storm or a summer hurricane is looming on the horizon.

Debt

George must reinvest all of his debt on his existing property. He owed $150,000 in a mortgage on the warehouse that he sold. When he sells he will pay off that mortgage. When he buys the next property he needs to buy a property that will enable him to carry his debt position forward. He can borrow more money if he wants. Failure to replace the $150,000 debt is deemed "debt relief" to him and this becomes "mortgage boot" treated much like "cash boot" in other words he will be taxed on it.

Closing the deal

The exchange period is 180 days or the date George must file his tax returns, for the year of the transfer of the relinquished property (including extensions), whichever occurs first. Remember, if George relinquished property after October 18th, he actually has less than 180 days in which to complete his exchange unless he files for an extension.

Important facts

  • George cannot set up an exchange after a deal has been closed.

     

  • An exchange cannot be back dated.

     

  • Funds in the accommodators account can be used to fund an earnest money or down-payment, as long as George does not touch any of the money.

     

  • George cannot take cash out or receive cash in a 1031 Tax Exchange without creating a taxable event. If he elects to take some of the equity out of the sale proceeds in the way of cash or a note, this is called BOOT and is taxable (he will be subject to paying federal and state capital gains taxes on the amount of cash or boot received plus he will be paying 25% of the depreciation recapture).

Summary

We have reviewed many of the rules regarding 1031 exchanges in this article. It is critical to use an accommodator. There are many accommodators we recommend and we have listed three that we have closed with below. These are excellent companies with great reputations and knowledgeable leaders (often attorney's) at the helm. If you chose to complete a 1031 exchange you must use an accommodator. Take the time like George did to get a handle on the rules.

One final tip. If you need money out of an exchange, refinance at least one year and a day before your closing, otherwise the IRS will likely disallow your exchange.

Published: January 7, 2008

Comments (5)

Leo Namiot - LeoLends.com
Canopy Mortgage - Leo Namiot - Saint Augustine, FL
More than just great rates

Hello Frank,

   Welcome to active rain, it's a great online comminuty, Enjoy!

Leo Namiot

Benchmark Mortgage

http://www.benchmarkct.com/

Jan 13, 2008 06:08 AM
Angie Vandenbergh
Crye-Leike, Realtors - Memphis, TN
A Crye-Leike Blogger

Hi! Welcome to the site. I see this is your first post.

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Also check out Resources for the Active Rain Newbie.

Good luck!

Jan 13, 2008 11:46 AM
Find a Notary Public needAnotary
QEC Internet Services - Long Beach, CA

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Jan 13, 2008 04:39 PM
Anonymous
Mortgage Insurance Tax deduction Extended

 

 Mortgage Insurance Tax Deduction Extended

by Broderick Perkins

The same new federal law that offers relief from mortgage debt forgiveness taxes, also extends tax benefits for many more homeowners who pay mortgage insurance.

Effective January 1, 2008, according to the "Mortgage Forgiveness Debt Relief Act of 2007," for those eligible, no taxes will be owed on any mortgage debt forgiven or written off as part of a short sale, foreclosure, renegotiation, bankruptcy or other such action on a principal residence.

Before the law was passed, such forgiven debt was typically taxed as income.

The relief act came on the heels of a housing and mortgage crisis after risky subprime and non-traditional home loans blew up in the faces of many homeowners and spilled foreclosure ash over the economy.

The relief act's debt forgiveness portion protects up to $2 million of indebtedness from taxation if the debt is secured by a principal residence and if that debt stems from the acquisition, construction or substantial improvement of the principal residence. This special relief is available retroactively for eligible debt discharges from Jan. 1, 2007, through Dec. 31, 2009, for those who qualify.

While the debt relief portion of the relief act is making all the headlines, another provision that extends a mortgage-related tax deduction is likely to benefit more homeowners.

The relief act also extends federal tax relief for homeowners with low down payment mortgages who pay mortgage insurance. The extension allows eligible homeowners to continue to deduct the cost of their government or private mortgage insurance premiums for three more years. The original one-year provision was set to expire Dec. 31, 2007.

A tax deduction, by the way, reduces taxable income, leaving less income to tax.

Now, qualified borrowers will be able to take the deduction if their insured mortgage originates between 2007 and 2010, instead of just for the year of 2007. Qualified borrowers are families with an adjusted gross income of $100,000 or less. Families with incomes up to $109,000 are eligible for a partial deduction.

Lenders levy mortgage insurance to protect themselves from risk when a borrower's down payment is less than 20 percent of the purchase price and other loans are not used to make up the difference.

The homeowner pays the premium (averaging $50 to $100 a month, for the national median priced home), but the insurance protects the lender from the risk of financing more than 80 percent of the cost of a home. Studies show borrowers with smaller starter equity stakes have more problems than those who have larger equity stakes.

To protect mortgage insurance consumers, the federal "Homeowners Protection Act of 1997" gave homeowners disclosure rights and broader insurance cancellation rights they can use once they reach certain equity levels.

The mortgage insurance provision of the new relief act may be the federal law's best provision, in terms of the number of homeowners who will benefit.

Economy.com estimates that forgiven debt tax relief could apply to 750,000 homeowners, but would likely end up benefiting only 250,000.

During the first year of the mortgage insurance tax deduction, the Mortgage Insurance Companies of America (MICA) estimated 2 million families would benefit from the deduction, resulting in an average tax savings between $300 and $350.

"Continuing this tax deduction will help low- and moderate- income consumers, particularly first-time home buyers who are unable to put down 20 percent," said Kevin Schneider, MICA president.

Even with home prices declining in many areas, many families find it difficult to accumulate a 20 percent down payment. The need for insured mortgages with low down payments continues to grow and the mortgage insurance method for meeting the needs of certain borrowers, has a better track record than subprime loans.

Suzanne Hutchinson, MICA's executive vice president says, "As risky, exotic loans are no longer considered viable housing finance options, more secure loans with private mortgage insurance remain readily available for qualified borrowers."

Published: January 9, 2008

Jan 14, 2008 04:12 PM
#5