Author Topic: 1031 exhange, anyone ever deal with one and how does it work  (Read 1969 times)

Fomerly known as something

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1031 exhange, anyone ever deal with one and how does it work
« on: October 05, 2016, 03:35:38 PM »
At some point in the next year I will likely be selling a vacation condo owned jointly with a family member.  We've owned the condo for years and have it available for rent most of the year.  Cash flow wise it's basically a wash, when all expenses paid. (with a large special assessment paid last year to fix a structural issue to outside balconies whipping out several years of profit).  We bought the place originally for ourselves with the rentals to offset the costs not for passive income.  I'm likely to end up with at least $100,000 when it's sold and would consider rolling the funds into a real rental property.  I know that I'd need to kind of need a place in mind ahead of time.  So Obviously I could have a nice down-payment or a possibility of buying something outright.  Does anyone have any experience with and exchange who has any tips about what needs to be done to actually conduct one.

CowboyAndIndian

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Re: 1031 exhange, anyone ever deal with one and how does it work
« Reply #1 on: October 05, 2016, 08:18:35 PM »
I had sort of similar issues, wanted to sell a rental I own and buy another rental which would finally convert to my primary residence

If you are interested, the link is here http://forum.mrmoneymustache.com/real-estate-and-landlording/questionsadvice-about-rentals-gt-1031-exchange-gt-rental-gt-primary-residence/

The post  (2nd one ) that cheddar points out has some information https://www.kitces.com/blog/limits-to-converting-rental-property-into-a-primary-residence-to-plan-for-irc-section-121-capital-gains-exclusion/

In a nutshell
  • You are exchanging like-for-like. You cannot sell a rental and buy a vacation home.
  • Very clear timeline when you sell one property and buy the other, 180 days
  • 90 45 days after the sale, you should identify the property you are buying
  • The money from the sale goes into escrow with a 1031 broker. When you are buying, it goes from broker to the seller.
  • You can buy first and then sell, but this exchange is much more rare and more expensive
  • It costs you money to do a 1031 exchange, so do this only if you are going to be hit by a high tax bill when you sell.

I am not an accountant. I am going thru the process now. Will sell the rental on Nov 1st, and buying hte new property in Jan/Feb 2017.

Edit: Fixed the identification time based on the excellent post by RobrBaron
« Last Edit: October 06, 2016, 07:04:38 AM by CowboyAndIndian »

waltworks

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Re: 1031 exhange, anyone ever deal with one and how does it work
« Reply #2 on: October 05, 2016, 09:16:39 PM »
First I'd determine what the potential tax bill is. Go back through your tax records and add up the depreciation for each year, as well as the capital gains you'll owe on appreciation, and see where you end up. You might not owe much and be better off having the money free and clear to invest in whatever you want. Or you might have a fully depreciated condo that has gained a ton of value and a 1031 is a no brainer.

Basically, without knowing how much tax/recapture the 1031 is helping you avoid, there's no way to know what the best move is.

-W

RobrBaron

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Re: 1031 exhange, anyone ever deal with one and how does it work
« Reply #3 on: October 05, 2016, 11:14:24 PM »
My wife and I navigated a 1031 for my In-Laws this year, and it worked out pretty well, given the potential pitfalls that come with it. It is really really really important that you work with a QI (qualified intermediary) that you trust, and who can help lay the groundwork with you, and can work with the title companies / closing agents that you as seller, and then you as buyer, are using.  There are very strict time limits that you need to follow.

I'll use our scenario as an example, and what we thought about:

My in-laws own rental properties, of which they owned their first one with a relative for about 40 years. The relative wanted to liquidate but my in-laws liked the cash flow, and it was putting a strain on the relationship, so when an offer to purchase came out of the blue, it was time to move. The property was 100% depreciated, and would result in significant (to them) tax liability. Plus, my in-laws wanted to maintain cash flow, so we decided to go the 1031 route. Run these numbers yourself to see if it makes sense for you.

What's the going rate?:
From my research, the cost is around $1000, which includes the first closing, and then if you buy multiple replacement properties, each additional closing is about $500. We replaced one property with 2 smaller ones, so our total was $1500 for the 1031 service.

Why is Trust in Your QI so important?:
In order for a 1031 to work, you CANNOT touch the money, full stop. Remember that we are creating a fiction of a like-kind-exchange, where we are trading one piece of property for another. Since these properties are going to be owned by at least 3 people, we need to facilitate this trade with cash, in addition to shifting dates of ownership. So the IRS says you need to have a QI accept the cash and hold it for you from the sale of Property #1, and then wire the money  to the seller of Property #2. This means all the closing documents and check that the seller presents at closing have your QI's name on it, not yours. This can be a little uncomfortable to watch a large sum of money pass in front of your nose, and you have very little recourse if things go sideways.  Now, you may be thinking to yourself, "hmmm, I wonder what fiduciary duty this QI has to me, or what assurances I have that he won't blow it all on boats and sports cars?" The answer: NONE. See: https://1031netex.wordpress.com/2008/03/20/man-behind-1031-exchange-scam-indicted-for-fraud/
You would have to file suit claiming breach of contract, and hope there was an entity that you could collect from to make you whole.

Now, of course, our QI was a nationally known big time title company, and they were super cool, and we had a wonderful experience with them. But remember, it doesn't cost a whole lot to buy some swank Google AdWords and get yourself some clicks to your website. Plus, I will mention that Title Companies, even really reputable ones, have some pretty atrocious websites, so it may be hard to separate the wheat from the chaff on looks alone.

What if I accidentially "touch the money?":
If you, your attorney, or your agent gets paid part or all of the funds, either on purpose or by accident, then you could disqualify the transaction. So, let's say you sell a fully depreciated property for 1 Million, and replace it with another property for 1 Million, but you do something that accidentally disqualifies the transaction. Then, you would owe long term capital gain on the 1 Million, but potentially not have the cash to pay the tax, because it is all tied up in a Million dollar building.  Granted, if you have your team in place, this shouldn't be a problem, but I mention this to STRESS that it probably isn't a situation where you might try to save a couple bucks by making your grade school best friend be your QI, and filling out the paperwork yourself.

So, what's The Time Line?: (See the IRS official explanation here, and where there might be discrepencies, TAKE THEIR WORD FOR IT: https://www.irs.gov/uac/like-kind-exchanges-under-irc-code-section-1031)
Day 1: sale of "relinquished property" and check paid to the order of QI.
Day 45: Identification deadline of "replacement properties." This is basically a worksheet that you send to the QI with a list of properties from which you'd like to purchase. You may have "maybe's" on this list, and you may have more value than the relinquished property, but there are number limits on both.
Day 180: Must have finished closing by this date.  There is a little wiggle room in the properties described, as the IRS states: "The replacement property received must be substantially the same as property identified within the 45-day limit described above."

What happens if I can't find anything I want to buy?:
If you don't find something you like to replace your relinquished property, then no harm, no foul. The QI will cut you a check (less their $1000 fee), and you'll pay taxes on the gain like normal. There is no additional tax burden for failing to complete a 1031. Note that the QI might want to hold onto the check for the full 180 days, depending on if you filled out a Day 45 Identification notice.

What else helps?:
Having a GOOD real estate agent that understands the time constraints of a 1031 is very very helpful. Also, your relationship with your title company, as well as their relationship with the QI is vital. We were lucky that they had worked together in the past, and it was incredibly seamless once the offers were accepted. What's nice about all cash deals is that you don't have a bank in the middle slowing things down.

In our situation, we had identified a couple of rental properties to purchase prior to closing on the sale of the Relinquished Property. As soon as closing occurred, we were conducting walk throughs, doing our due diligence on the leases, and putting together offer sheets on the replacement property. Unfortunately, the sellers didn't want to play ball, and after about a week of back and forth, we cut bait and started looking for other properties (as of today, still for sale. Tough stuff.). We actually found better options less than 2 weeks later, and had accepted offers prior to the 45 day deadline. The final closing occurred in July, and we have had 100% occupancy since August 1, and increased the Net Cash Flow by 40% over the Relinquished Property.

What if I want to buy a property that is worth more than my old one? Or, what if I want to spend less than I make on the old one?:
No problem! If you sell one building for 1 Million, and buy another for 1.2 Million, you can either pay out of pocket for the difference, or you can finance it.
Conversely, if you sell one property for 1 million, and buy another for $750,000, then the QI will cut you a check on day 181 (they usually hold it for the full 6 months) for the difference, and you pay tax on that difference.

These are my off the cuff observations. Was it easy? Kinda. Was it stressful? Sometimes. Would I do it again? Sure! Let me know if something wasn't clear, and I'll try to explain.

Rob

CowboyAndIndian

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Re: 1031 exhange, anyone ever deal with one and how does it work
« Reply #4 on: October 06, 2016, 07:05:37 AM »
My wife and I navigated a 1031 for my In-Laws this year, and it worked out pretty well, given the potential pitfalls that come with it. It is really really really important that you work with a QI (qualified intermediary) that you trust, and who can help lay the groundwork with you, and can work with the title companies / closing agents that you as seller, and then you as buyer, are using.  There are very strict time limits that you need to follow.

I'll use our scenario as an example, and what we thought about:

My in-laws own rental properties, of which they owned their first one with a relative for about 40 years. The relative wanted to liquidate but my in-laws liked the cash flow, and it was putting a strain on the relationship, so when an offer to purchase came out of the blue, it was time to move. The property was 100% depreciated, and would result in significant (to them) tax liability. Plus, my in-laws wanted to maintain cash flow, so we decided to go the 1031 route. Run these numbers yourself to see if it makes sense for you.

What's the going rate?:
From my research, the cost is around $1000, which includes the first closing, and then if you buy multiple replacement properties, each additional closing is about $500. We replaced one property with 2 smaller ones, so our total was $1500 for the 1031 service.

Why is Trust in Your QI so important?:
In order for a 1031 to work, you CANNOT touch the money, full stop. Remember that we are creating a fiction of a like-kind-exchange, where we are trading one piece of property for another. Since these properties are going to be owned by at least 3 people, we need to facilitate this trade with cash, in addition to shifting dates of ownership. So the IRS says you need to have a QI accept the cash and hold it for you from the sale of Property #1, and then wire the money  to the seller of Property #2. This means all the closing documents and check that the seller presents at closing have your QI's name on it, not yours. This can be a little uncomfortable to watch a large sum of money pass in front of your nose, and you have very little recourse if things go sideways.  Now, you may be thinking to yourself, "hmmm, I wonder what fiduciary duty this QI has to me, or what assurances I have that he won't blow it all on boats and sports cars?" The answer: NONE. See: https://1031netex.wordpress.com/2008/03/20/man-behind-1031-exchange-scam-indicted-for-fraud/
You would have to file suit claiming breach of contract, and hope there was an entity that you could collect from to make you whole.

Now, of course, our QI was a nationally known big time title company, and they were super cool, and we had a wonderful experience with them. But remember, it doesn't cost a whole lot to buy some swank Google AdWords and get yourself some clicks to your website. Plus, I will mention that Title Companies, even really reputable ones, have some pretty atrocious websites, so it may be hard to separate the wheat from the chaff on looks alone.

What if I accidentially "touch the money?":
If you, your attorney, or your agent gets paid part or all of the funds, either on purpose or by accident, then you could disqualify the transaction. So, let's say you sell a fully depreciated property for 1 Million, and replace it with another property for 1 Million, but you do something that accidentally disqualifies the transaction. Then, you would owe long term capital gain on the 1 Million, but potentially not have the cash to pay the tax, because it is all tied up in a Million dollar building.  Granted, if you have your team in place, this shouldn't be a problem, but I mention this to STRESS that it probably isn't a situation where you might try to save a couple bucks by making your grade school best friend be your QI, and filling out the paperwork yourself.

So, what's The Time Line?: (See the IRS official explanation here, and where there might be discrepencies, TAKE THEIR WORD FOR IT: https://www.irs.gov/uac/like-kind-exchanges-under-irc-code-section-1031)
Day 1: sale of "relinquished property" and check paid to the order of QI.
Day 45: Identification deadline of "replacement properties." This is basically a worksheet that you send to the QI with a list of properties from which you'd like to purchase. You may have "maybe's" on this list, and you may have more value than the relinquished property, but there are number limits on both.
Day 180: Must have finished closing by this date.  There is a little wiggle room in the properties described, as the IRS states: "The replacement property received must be substantially the same as property identified within the 45-day limit described above."

What happens if I can't find anything I want to buy?:
If you don't find something you like to replace your relinquished property, then no harm, no foul. The QI will cut you a check (less their $1000 fee), and you'll pay taxes on the gain like normal. There is no additional tax burden for failing to complete a 1031. Note that the QI might want to hold onto the check for the full 180 days, depending on if you filled out a Day 45 Identification notice.

What else helps?:
Having a GOOD real estate agent that understands the time constraints of a 1031 is very very helpful. Also, your relationship with your title company, as well as their relationship with the QI is vital. We were lucky that they had worked together in the past, and it was incredibly seamless once the offers were accepted. What's nice about all cash deals is that you don't have a bank in the middle slowing things down.

In our situation, we had identified a couple of rental properties to purchase prior to closing on the sale of the Relinquished Property. As soon as closing occurred, we were conducting walk throughs, doing our due diligence on the leases, and putting together offer sheets on the replacement property. Unfortunately, the sellers didn't want to play ball, and after about a week of back and forth, we cut bait and started looking for other properties (as of today, still for sale. Tough stuff.). We actually found better options less than 2 weeks later, and had accepted offers prior to the 45 day deadline. The final closing occurred in July, and we have had 100% occupancy since August 1, and increased the Net Cash Flow by 40% over the Relinquished Property.

What if I want to buy a property that is worth more than my old one? Or, what if I want to spend less than I make on the old one?:
No problem! If you sell one building for 1 Million, and buy another for 1.2 Million, you can either pay out of pocket for the difference, or you can finance it.
Conversely, if you sell one property for 1 million, and buy another for $750,000, then the QI will cut you a check on day 181 (they usually hold it for the full 6 months) for the difference, and you pay tax on that difference.

These are my off the cuff observations. Was it easy? Kinda. Was it stressful? Sometimes. Would I do it again? Sure! Let me know if something wasn't clear, and I'll try to explain.

Rob

Rob, excellent post for an off the cuff observations. Thanks.

I corrected my post with the correct information from here.

CowboyAndIndian

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Re: 1031 exhange, anyone ever deal with one and how does it work
« Reply #5 on: October 06, 2016, 07:49:15 AM »

Why is Trust in Your QI so important?:
In order for a 1031 to work, you CANNOT touch the money, full stop. Remember that we are creating a fiction of a like-kind-exchange, where we are trading one piece of property for another. Since these properties are going to be owned by at least 3 people, we need to facilitate this trade with cash, in addition to shifting dates of ownership. So the IRS says you need to have a QI accept the cash and hold it for you from the sale of Property #1, and then wire the money  to the seller of Property #2. This means all the closing documents and check that the seller presents at closing have your QI's name on it, not yours. This can be a little uncomfortable to watch a large sum of money pass in front of your nose, and you have very little recourse if things go sideways.  Now, you may be thinking to yourself, "hmmm, I wonder what fiduciary duty this QI has to me, or what assurances I have that he won't blow it all on boats and sports cars?" The answer: NONE. See: https://1031netex.wordpress.com/2008/03/20/man-behind-1031-exchange-scam-indicted-for-fraud/
You would have to file suit claiming breach of contract, and hope there was an entity that you could collect from to make you whole.

Now, of course, our QI was a nationally known big time title company, and they were super cool, and we had a wonderful experience with them. But remember, it doesn't cost a whole lot to buy some swank Google AdWords and get yourself some clicks to your website. Plus, I will mention that Title Companies, even really reputable ones, have some pretty atrocious websites, so it may be hard to separate the wheat from the chaff on looks alone.

I saw this list at a QI, seems like a good check list.

There are safeguards a taxpayer should consider when selecting a Qualified Intermediary. 
These safeguards include:
(1) depositing the taxpayer’s funds in FDIC insured accounts;
(2) depositing taxpayer funds in accounts that are principal preserved and liquid;
(3) depositing taxpayer funds in segregated accounts under the client’s name and federal identification number;
(3) requiring dual signatures within the Qualified Intermediary company and, where practical, the signature of the taxpayer for any withdrawals;
(4) ensure the proper wording is contained in the Exchange Agreement to protect the taxpayer’s funds from a Qualified Intermediary bankruptcy;
(5) the use of a Qualified Escrow and Trust Agreement;
(6) the use of a Security or Guarantee Arrangement; and/or
(7) deposit taxpayer funds in a financial institution selected by the taxpayer. 

RobrBaron

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Re: 1031 exhange, anyone ever deal with one and how does it work
« Reply #6 on: October 06, 2016, 08:35:00 AM »
That is a fantastic list! Without knowing it, my QI checked all those boxes (I used First American Title's 1031 Department), but I wish I had that list to ask pointed questions (instead of sounding like an idiot when I cold-called).

When I was researching 1031s prior to our deal, I looked at the requirements for becoming a QI, and there are none. The IRS has rules about a different kind of QI (holding foreign assets in the US for corporation purposes but not being taxed as US entities) but not for 1031's. (If you're being nerdy, here's the link for more info on the OTHER kind: https://www.irs.gov/businesses/corporations/qualified-intermediaries-qi)

The Okun case that I linked above was highlighted on an episode of American Greed (and ironically turned me on to 1031s in the first place), and that episode shocked me for a couple of reasons: (1) there are a TON of mom and pop 1031 companies out there that this guy bought out (126 million dollars worth, and the folks interviewed seemed like decent people who had a pretty slick side hustle), (2) that the QI can invest the money in short term investment strategies because "it's their money," which can include boats, cars, planes, houses, or whatever, and (3) so long as you keep the Ponzi scheme running, and there is new money coming in to cover the losses on your investments in time for prior client closings, nobody will ever find out, regardless of what your 1031 Exchange Contract says. Okun got caught only because he couldn't close on new deals... and that was AFTER the money was gone.

Rob