1031 Exchange Question - Posted by David_NJ

Posted by Nate on January 16, 2001 at 20:55:16:

I am not a lawyer or a CPA, so my comments have no basis in law or regulation. My limited understanding, which is based mostly on Robert Bruss’ columns, is as follows:

To do a 1031 exchange, you must exchange LIKE KIND property. This means, you must exchange real property held for investment, for other real property held for investment. You cannot get any “boot” (the legal term) or unlike-kind property. For example, you could not do a tax-deferred exchange from a rental property into property that would be used as your personal residence, nor into a boat or an airplane.

I guess the question, then, is whether or not the sale qualifies. On the one hand, I could see it not being allowed. You are trading real property for real property, but you are also getting “boot” (i.e. a note, which is an asset that is NOT real property). That is not allowed.

I don’t know if characterizing the sale as an installment sale changes anything or not. I hope your CPA or attorney comes up with an answer that is in your favor.

Good luck,
Nate

1031 Exchange Question - Posted by David_NJ

Posted by David_NJ on January 16, 2001 at 20:08:32:

I’ve got an offer on a 4 plex I have up for sale. The buyer said he will get a new first mortgage which will payoff my first. However, he wants me to carry a 2nd mortgage for 10 percent of the purchase price. I’d be getting monthly payments for 36 months, when the note comes due in full. I’d like to do a 1031 exchange. The bulk of the money I’d get at closing… about 100,000, would go into a replacment property. I know all the rules about getting a larger property, the time limits, ect… However, I’m not sure how accepting a 2nd would affect the tax deferred status of the sale. Would the entire sale be taxed, if I accepted a 2nd… or would just the 2nd be taxable? My 1031 exchange company said they could not give me advice on the matter, and suggested I call my CPA. My CPA said he wasn’t sure and would have to research it. I also called several tax attorneys. They said they weren’t sure, and would have to research it as well. Of course they wanted a retainer before starting any work. I have no problem paying the taxes on a small second of about 22,000… but I don’t want to lose the tax deferred status on the bulk of the proceeds. Does anyone know how such a transaction would fly with the IRS? Thanks.

Why sell? - Posted by Bud Branstetter

Posted by Bud Branstetter on January 17, 2001 at 13:55:55:

You indicated that the new first would pay off your first. Then you comment about getting 100K at closing. So I take it you have 122K of equity.

You could refi the property to get out most of your cash. Then put the 4plex into a PACtrust and lease it to him for any payment you want. You did not sell. When the trust terminates in three years and he refi’s you then exchange your interest via 1031.

Correction-ignore last sentence of previous post - Posted by Rick Vesole

Posted by Rick Vesole on January 16, 2001 at 23:48:54:

  1. How much is your gain? Check this out with your new CPA, but my understanding is that the gain gets allocated to the boot first. So, for example, on a $122,000 sale, if your basis was $100,000 and your gain was $22,000 - all the gain would get attributed to the second mortgage - thus an exhcange would do you no good. To the extent your basis is lower than $100,000, you would have some deferred gain, but again your gain would be applied first to the note and only the amount of the leftover gain would be deferred under the exchange.

  2. I had a similar situation and here’s what I did. My brothers and I owned some apartments as partners. I got my father’s trust to lend the money to the buyer on the second mortgage - thus my brothers and I got the full amount of the sales price in cash and were able to exchange the whole thing and my father’s trust received payments on the note. Maybe you could find a relative or friend to do the same thing. You could even guarantee the note, so that if the buyer defaulted, you would buy the note from your friend or relative and bear the risk of any loss, just as though you had taken the note back yourself.

2 thoughts - Posted by Rick Vesole

Posted by Rick Vesole on January 16, 2001 at 23:47:59:

  1. How much is your gain? Check this out with your new CPA, but my understanding is that the gain gets allocated to the boot first. So, for example, on a $122,000 sale, if your basis was $100,000 and your gain was $22,000 - all the gain would get attributed to the second mortgage - thus an exhcange would do you no good. To the extent your basis is lower than $100,000, you would have some deferred gain, but again your gain would be applied first to the note and only the amount of the leftover gain would be deferred under the exchange.

  2. I had a similar situation and here’s what I did. My brothers and I owned some apartments as partners. I got my father’s trust to lend the money to the buyer on the second mortgage - thus my brothers and I got the full amount of the sales price in cash and were able to exchange the whole thing and my father’s trust received payments on the note. Maybe you could find a relative or friend to do the same thing. You could even guarantee the note, so that if the buyer defaulted, you would buy the note from your friend or relative and bear the risk of any loss, just as though you had taken the note back yourself.

That would mean for example that if you had a $22,000 gain, you would not defer any of the tax since it would

Re: 1031 Exchange Question - Posted by JPiper

Posted by JPiper on January 16, 2001 at 22:23:11:

David:

First, allow me to say that if I were you I’d fire my CPA, those tax attorneys, AND your qualified intermediary/exchange company. This question is a rather straightforward question.

Taking back a second does not disqualify your deal from it’s deferred status under 1031. There are several options though which will determine just exactly what happens.

One option is that YOU can take the second…in which case you will pay tax on this on an installment sale basis, basically paying tax as the principal is received in proportion to your profit, and paying tax on the interest. Again, nothing in this causes you to lose the tax-deferred status of the rest of the transaction.

Another option is that you could include the note in your exchange. That is, you would name your qualified intermediary as the beneficiary of the note (I’d get a new one since this one could tell you nothing).

If you take this latter option you then have several possibilities. One would be to use the note as part of the purchase of your new up-leg property. The qualified intermediary would then assign the note to the seller of the up-leg property at closing.

Another possibility is that you could buy this note from the qualified intermediary with your own cash (from outside the sale of your property). Your cash is then used in the acquisition of the new up-leg property.

You could also sell this note to a notebuyer. The qualified intermediary would then assign this note at closing to the new notebuyer, who would deposit cash, which would then be used in your new acquisition. The problem here is that if it’s a high LTV note, then the note buyer’s are probably going to be non-existent.

If you were unable to implement any of these alternatives, then the qualified intermediary would assign you the note at closing, and you would pay tax on an installment sale basis.

Since this is a relatively small note, and you’re coming into your new deal with plenty of cash, if I were you I would try to offer it right along with your cash as part of your downpayment…thereby deferring the tax on the note as well.

But either way, worst case scenario is that you tax on an installment basis on the note. Best case is that you can include it in your exchange. And nothing in the acceptance of a note harms the 1031 process.

By the way, I’m neither a tax professional nor a CPA…and therefore normally I would suggest that you run all this by your CPA…LOL. In your case, well, I better leave that to you to decide.

JPiper

Re: 1031 Exchange Question - Posted by Dave T

Posted by Dave T on January 16, 2001 at 22:05:48:

Your situation is simply a matter of coordinating the IRC Section 1031 rules with the IRC Section 453 installment sale rules.

Basically the bottom line is that the 2nd mortgage in this scenario will be treated as taxable gain (boot received) and may be reported on the installment method. The like-kind property received in the exchange is not considered an installment payment, and, 1031 treatment applies to this portion of the transaction.

Point your CPA to Sections 453(f)(6)© and 1.1031(k)-1(j)(2)(iv) of the tax code.

Make sure that the exchange company escrows the installment note. The safe harbor rules apply here too. See Section 1.1031(k)-1(j)(2)(i),(ii).

Good luck.