Section 1031 of the Internal Revenue Code permits investors to defer the payment of tax on the gain and depreciation recapture from the sale of property held for productive use in business, trade or investment, provided that the property is exchanged for a “like kind” asset or assets. The section creates a “safe harbor” that permits the taxpayer to have assurance that the transaction will permit the deferral of the capital gain tax payment.
The IRS requires that the proceeds from the sale of the property (the “relinquished property”) be held by a Qualified Intermediary (a “QI”) until the replacement property is purchased. The taxpayer must assign to a QI their interest as seller of relinquished property.
An “exchange agreement” is executed between the taxpayer and e1031xchange.
It is important to include language in the contract of sale for both the sale of your relinquished property and the purchase or your replacement property that requires the counterparty to cooperate in the exchange. Typically this is not controversial, as the entire exchange is transparent to your buyer or seller, and there are no delays or costs to them in cooperating.
Here is a sample clause: “Buyer hereby acknowledges that it is the intent of the Seller to effect a Section 1031 tax deferred e1031xchange, which will not delay the closing or cause any additional expenses to the Buyer. The Seller’s rights under this agreement may be assigned to e1031xchange, a Qualified Intermediary, for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and e1031xchange to complete the exchange.”
Use the same clause in the purchaser contract, when acquiring a replacement property, just substitute Buyer for Seller, and vice versa.
Exchanger must notify e1031xchange in writing of potential replacement properties
But the deadline is sooner if tax filing is done before the 180 day expiration. For example, if you sell your relinquished property on December 15, 2011, and submit your tax filing for 2011 on April 1, 2012, then the acquisition of the replacement property must happen on or before April 1, 2012, and not the typical 180 days after sale. To avoid this trap, have your tax preparer file a timely extension.
At closing of the replacement property, assigns the rights in the contract to e1031xchange and e1031xchange then signs HUD as purchaser. Deed is direct to exchanger, e1031xchange never goes into the chain of title.
Any remainder is returned to the taxpayer and is taxable
Value of replacement property must be equal to or greater than the value of the relinquished.
This is the easiest to understand. Suppose the taxpayer sells the relinquished property for $1,000,000. The taxpayer decides to keep some of the proceeds for personal use, takes $100,000 of the proceeds and spends it on a car. That is, in its simplest form, “cash boot” and capital gains tax must be paid on this amount.
Also known as “mortgage boot”, this occurs when the debt on the replacement property is less than the debt on the relinquished property. Let’s take an example. Taxpayer sells property for $1,000,000 which has a $500,000 remaining mortgage on it. The taxpayer buys a replacement property for $1,000,000, but finances only $300,000 on the replacement property. The taxpayer does this by adding cash of $200,000 to the transaction. In this example, the taxpayer “received” mortgage boot of $200,000 and “gave” cash boot of $200,000. So is that a wash?
Stay with me here, because this is where we start to get a little advanced. The rules of netting boot are as follows: (1) cash boot paid offsets cash boot received at the same closing table, (2) cash boot paid offsets mortgage boot received, (3) mortgage boot paid offsets mortgage boot received, BUT (4) mortgage boot paid does not offset cash boot received. Huh?
Bob puts down $100,000 as a contract deposit for the replacement property from his own funds. At closing, the proceeds from his relinquished property are used to acquire the replacement property, and as a result he gets back $100,000 at closing. That is cash boot. But the boot received is offset by the boot paid (the $100,000 he put down) so these net out.
Bob sells his property for $1,000,000, which had $500,000 in mortgage owed. He buys a replacement property for $1,000,000, but pays all cash for this property. He has “received” $500,000 in mortgage boot, and “paid” $500,000 in cash boot, so these two can be netted.
Bob sells his property for $1,000,000 which had $500,000 in mortgage owed. He buys a replacement property for $1,000,000, but finances only $300,000 with a new loan. However he assumes the seller’s loan of $200,000 remaining on the property. In this case he paid $200,000 in mortgage boot by assuming the loan, and received $200,000 in mortgage boot by reducing the balance on his mortgage, so these will net each other.
Bob sells his property for $1,000,000 which had $500,000 in mortgage owed. He buys a replacement property for $1,000,000, but finances $700,000 in a new loan and receives at closing $200,000 back from the intermediary. Bob “paid” $200,000 in mortgage boot because his loan increased, and “received” $200,000 in cash boot because he got cash back at closing, but these cannot be offset against each other and he will be liable for tax on the cash boot.