Uncovering the 1031 Exchange – What EVERY Investor Should Know!

David Moore: But one of your question’s, a good one, especially in times, like we’re in, because as lending starts to tighten a little bit, you’ve got a situation where maybe the loan to values decrease and in recessionary times, which we’re certainly not in at this moment, but a year from now, we might be talking from that context to your equity evaporates also.

But when we look at what has to happen for an exchange, you need to satisfy what we call the napkin test. And the napkin test just simply says, you need to go across or up in value and equity. And I think what you’re asking me is people often think, well, gee, the equity, all the net proceeds, that’s my equity. That’s all I have to spend.

Tina Colson: And let me give you an example of this. So let’s say I have a property that I’m selling that is $700,000 and my equity, maybe 450 in that property. I want to downsize because I want to get rid of the debt. So I’m looking to purchase a property on the other side for 400,000, 450 to cover the full, equitable amount. So why is that a problem?

David Moore: Well, it’s a problem because the government wants you to be going across or up in value and equity. And the value and equity number is going to be net a closing cost. It’s not the gross. So you’re going to back out, maybe 750 nets to 720, something like that. But whatever the adjusted sales price is, that’s the bogey number. That’s the number you have to hit for total tax deferral and the net equity, whatever comes in that has to be spent. Now you hear people say all the time, you have to replace debt in anexchange, which is not true. Debt can go away two ways, one by going down in value and the other by adding cash. But your questions when it comes up all the time, because people think, well, gee, I only made this much on the property. This was what my gain is, or this is what my proceeds are.

And they’re just thinking that’s all I have to do. And that’s certainly far from the truth. You have to meet the value and equity requirements for total tax deferral. Now I want to stress once again, that it’s not all or nothing. So if you sold at 750 and 500 is a perfect replacement property, and let’s say your tax basis on the relinquish was 300. You’re still deferring the difference between the three and the five. So you’re deferring tax on 200, you’d have tax exposure on the difference between the five and the 720 or whatever that adjusted sales price is. And I think really in today’s world, more important than ever before, I really want people to understand it’s not all or nothing, defer what you’re going to defer and get what you want to get. Every dollar more you spend on something than what you have to cost you a dollar.

If you don’t spend it, maybe it’s 40 cents. So by what you want to buy and Tina’s question’s a great one. It’s not what you’ve got in net equity that needs to be spent. It’s not just your gain that needs to be spent. We call it the napkin test. And that just means you go across rope and value and equity for total deferral. And the easiest way to look at it when you’re starting to measure effectiveness of an exchange is every dollar spent really beyond your tax basis should represent tax-deferred gain. So buy what you want to buy and just to understand what the tax liability is going to be and be prepared to pay it.

Tina Colson: So the second question that I had today is if I have a sibling who is looking to sell property, and I want to purchase that property, and I’m the exchanger, the exchange rules state that I can sell to a family member, but I cannot purchase from a family member. So how does that rule come into place? And is there any way around that?

David Moore: So I think first off, we probably ought to look at who is a related party from the 1031 context. So we’ve got a sister company, IRA advantage, IRAadvantage.net.com, but we do self-directed retirement accounts there. And in that space, we’re concerned about two issues. What are you going to buy and who you’re transacting between her for the benefit of, in any transaction between her, for the benefit of the disqualified party is a prohibited transaction. Most of the time, disqualified parties, related parties, net situation. So if we look at related party transactions in the 1031 space, we’re typically looking at linear last sentence, the sentence there, spouses, or any legal entity owned in a controlling interest, buy one of those. So any transaction between her, for the benefit of one of those things, we’ve got to look at these rules.

So as Tina mentioned, in the 1031 space, we usually look out and say, okay, you can sell the related party. You can’t buy from a related party. You asked about a way around it, or maybe it’s an exception to that rule would be, there are two exceptions. Really.

You can do that transaction. If you can, document there was no intent to avoid any tax, which the argument there, as well as 1031, that effort in and of itself. I don’t know, talk to your tax people about it. But the other way they would allow you to buy your replacement property from a related party would be as if that related party was also going to do an exchange. So both the buyer and seller have to be doing exchanges and they have to buy and hold each of the respective replacement properties for no less than two years. Like I said, with the sole exception of, if you can document, there is no intent to avoid tax, that rule wouldn’t apply, but sell to one, that’s fine. Buying from one, typically a no. Just the way it is. Why is it that way? I don’t know some Senator. Right. That’s what I always like to say.

Tina Colson: There’s always a catch.

David Moore: Yes.

Tina Colson: All right. So let’s talk about a couple of scenarios where we blend investment property with a personal residence. So I want to sell my rental property, do a 1031 to purchase a primary residence with a large home office. So is that possible? And how do I allocate the funds to do that? What does that look like?

David Moore: So I think first off we got to look at, what’s like-kind in 1031. So like kind, when you’re looking at like-kind requirement, it refers the nature of the investment rather than the form. So any real property held for investments, is going to be like-kind with any real property acquired with intent of for investment. So the next question that comes up all the time, using what you’re talking about. If you’re giving up a property that is a pure investment, you want to go out and buy a replacement. It’s either going to be a piece or all residential, number one, you can’t move into it right away because that you wouldn’t satisfy the whole investment rationale. Now, with that said, there’s a court case about five years, six years ago. Now that allowed a transaction.

They bought it after four months moved into it. Okay. So that’s an example of taking a pure investment and moving into it. And the question that often comes up, does it have to be rented and whether property’s rented or not is really irrelevant, but that is possible. Now that’s not what your question was. Your question was, what if we’re talking about pieces of assets. So when we look at that like-kind requirement, any real property held for investments, like-kind with any real property acquired with the intent to hold for investment. What about a duplex? Let’s say it’s half owner-occupied, half non-owner occupied. What are you selling there? And we’re going to look at it really say half of it is 121, section 121 universal exclusion, the other half’s 1031. Well, if you look at it and that’s possible, why couldn’t you have a home that has a portion of it?

Let’s say you do childcare at home or you’ve got a large home office, or maybe it’s a ranch with working land and a farmhouse. All of these things are situations where you’ve got a single asset with allocations, different directions. So you’re going to have allocations section 124 in the universal exclusion and 1031. And you’re just mixing and matching what needs to happen. But to answer your question, you can have a single asset allocations going different directions. On the relinquish side, you can have the same thing happened on the acquisition side. But I think what you’ve seen recently is you’ve got a number of clients that want to take and move into immediately a portion of that asset, right? So if they’re going to move into a piece of this immediately, that thing is not of like kind.

So your choice, if you want to take 1031 money to go buy a property that ultimately you’re going to live in, you’re either going to have to wait to move into it. And that timeline is really, it’s not up to you or may it’s up to the taxpayer and their tax counsel, but anyone’s telling you more than a year. I wouldn’t buy it for any reason. One year, I think it’s a safe amount because it’s been proposed a couple of times. And the break between short, long-term tax rates on assets held for investment, at least for now, until our current administration makes whatever changes they’re wanting to make. But the idea is you’re just looking at single assets, allocations, different directions, and you’re going to work. This is why tax people are so critical. You want good tax people.

You want to talk to them. You want to sharpen your pencil on the allocations. You want to maximize the universe exclusion and anything what I mean by that is take full advantage of the 250 or 500 exclusion you’re entitled to. And then the overage would go 1031 and that’s on a disposition or acquisition. You’re going to look at those allocations, but on the down payment, you can’t say, “Hey, I’m using all 1031 money to buy this property. And the equity from the exchange, just going into the investment portion, I’m buying the residential portion, nothing down.” That does not work.

Tina Colson: And a part of what David is talking about, for those of you who are not familiar with the universal exclusion or the 121 as he’s referring to is personal residence and the exclusion of gain when you sell a personal residence. And so that is one piece that I just wanted to clarify to you.

David Moore: So section 121 came in in 1997, it replaced 1034. And for a property qualify for the 250 or 500, you have to have lived in it for an aggregative two out of the preceding five years. There’s not an elective proration of those numbers, but I would expect that going through this last year, we’ve probably got a lot of people that are through hardship, or maybe looking at prorations of that, and you might be able to have a proration if you’ve got some hardships. So once again, you and I are not going to make that decision on what fits or doesn’t the tax people are. So I cannot stress enough if you’ve got investment real estate, you’ve got much real estate out there. You need good tax counsel. I mean, there really are going to be worth their weight in gold to take care of you. We say you’ve worked hard for your money. We work hard to keep it yours. And their whole job is to do that too.

Tina Colson: Absolutely. And so along the same lines, a lot of folks now, again, because of COVID, we’ve got a lot of home offices that are being used as space. It falls into this same category. If I’m selling my personal residence, I’ve got 20% of my home as my investment that I’ve been claiming on taxes as my business space. And now I want to go purchase across and get another property and allocate that same amount. I think the deeper question that we need to look at is if I am selling a property and I’ve round numbers, so $200,000 sale, and we’ve got 20% allocated for the home office and I’m going across and I’m purchasing another property, I want to make sure that the funds that I am using for that exchange purpose for that office, when I go purchase the new property is going to meet that same criteria of the value. So I am not going down in value in that 20% of my new purchase. Can you maybe decipher a little more of that and clarify what that looks like?

David Moore: It’s really important when you’re looking at a piece of something, being a primary residence that you’re really covering those ratios. So whatever the ratio is on the investment components got to be really, should be the same on the residential component. Now we’re not scheduled to talk about this thing at this moment, but I will just mention that let’s say you’re buying an investment property tenancy in common, and you and I are going to go buy something jointly, which we can do. We can’t go exchange into a property that we jointly would own as a legal partnership, a limited liability company or something, but we can always go tenancy in common. And we use that same structure. If you’re wanting to combine IRA 401k funds with personal funds via 1031. We have to use TIC because 1031 requires that the retirement side does not.

But the issue that comes up a lot of times, you’ll have an organizing sponsor to this investment, which might be the broker or a builder-developer. And they’re saying, well, gee, I’m not putting cash in. You’re putting the cash in. So we’re going to have to complete the transaction for you. And then this other person maybe ends up a TIC owner and they might be coming in with zero cash coming in. It’s going to be in kind there. So you’ve got to always look at what’s happening. There’s lots of misunderstanding out there too, that a TIC would have to always be the same loan to value on stuff. Every member of that TIC. And that’s not an absolute, I mean, there were institutionally offered TICs. A decade ago that we did a lot of work with that everybody would have a different loan to value and the idea is it’s like a condo.

It’s like a condominium project, right? Every unit has a different loan to value. And through the TIC, theoretically, you can have different loan to values on those things, but you’ve got to really look at how you’re receiving what you’re receiving and by the way, through the broker, and you’re receiving a piece of it in lieu of commission, you got paid, so you’re getting something, right? So whatever you’re getting, it’s not like you get it for nothing.

Tina Colson: Got you. So just to recap on our conversation and make sure everybody is clear on what we’re discussing about blending an investment property with a personal residence. So one, we can allocate a specific percentage of a property that is a home office and purchase another specific percentage of a property as long as those dollar amounts match up on the other side for the purchase. But also the folks have to bring in the cash to cover their primary residence portion of that new property as well. Correct?

David Moore: Yeah, certainly. So if you’re looking at buying a mixed-use property or when you relinquish it, your tax people should have been taking depreciation on it, right? So those numbers should be there. The allocation should be there, but with that said, it never ceases to amaze me how often they’re not. And that’s where I’m going to, once again, stress gets good tax people because those numbers are not ambiguous they’re there. And the depreciation is based on it. And think about your return on investment depreciation, what you’re taking depreciation-wise. The more you jerk up, the value of the assets to depreciate, the better your return on investment is. So and that’s one of my biggest beefs is even on a rental house who makes the allocation jerk to improvements? And if you talk to our friend, Jonathan, who’s in the cost SEG world, then cost SEG is just allocations on steroids, right?

So you’re, front-loading a lot of depreciation, but you’ve got to look at that and that’s where the good tax people are going to make those allocations. So to your point, or what you’re trying to get me to talk about is the loan to value. We don’t want you to say, “Hey, I’m buying this property and all the 1031 money is going to the 1031 component on buying the residential component, nothing down.” That’s not something that’s going to work if you got audited. So our advice is going to be, you should mirror the LTV on the residential and income property components if that’s what we’re looking at. So make sure that that loan to value is the same. If you’re buying something and it’s three to one, you need to come in with the same ratio, a down payment on the residential component or the non-qualifying component, whatever that might be.

Tina Colson: Absolutely. And we also know that we can sell an investment property and purchase something that eventually will be our primary residence, but there are some additional rules to that as well. And so I know that you’ve got a purchase and investment on the other side, anytime that you’re doing a 1031, you’re holding that property for investment when you purchase it. So, David, why don’t you talk about the additional rules that apply? Should you choose to move into that property?

David Moore: So think about, for those of you out there that are of my vintage or older, probably you think about the situation wherein 1997, pre ’97, we had section 1034. And that said, if you lived in a home for two years, you had a one-time lifetime exclusion of was that $125,000, which didn’t do much for you, but it was an exclusion again. I mean, you had two years to buy a new home of equal or greater value. So with people buying up, it worked very well. It was just when you wanted to get out that it was going to hit you. So in ’97, when the 250 and 500 came in to replace that one-time lifetime of 125, everybody was very excited about it. Now, fast forward to 2021, and 250 and 500,000 in gain doesn’t mean much of anything for a lot of people.

So we’ve got lots of situations, number one, where you might have a residence, and we’ve got a class that I present and got a page. It’s like what are you selling? Actually, we’ve got a class coming up, we’re covering this. It’s like, what is it? What do you want it to be? Basically? What do you think it is? And what do you want it to be? Do you want it to be your home? It might be your home. Do you want it to be your home? Is an investment. Do you want it to be an investment? And the point of it is that you can take an investment converted to residents. You can take residents to convert to investment. I’m going to answer your question. So Tina asked about the acquisition, what has to happen and the path to homeownership from an investment you’re giving up the investment property, you’re going to buy a new property and you ought to hold it for investment, for whatever you and your tax people feel is a reasonable period.

I would say a year based upon two factors. One it’s been proposed several times to the break between short long-term tax rates on assets, held for investments at a year, at least for now. So I think that’s safe. Sometimes tax people say two years and well, it says two years in the code. Well, it doesn’t, if you and I are brother and sister, that’s a related party transaction. And we’ve got two years, but not an absolute, even in that scenario. But outside of that, there’s no state of required hold. And there is a court case, like I said earlier, where four months was deemed long enough. People bought a property, couldn’t rent it out, argued hardship, moved into it, and successfully defended it in court. So let’s say you do this, you make the acquisition, you move into it.

And the idea was, and it worked between ’97 and 2000. You could go and buy a property via 1031, hold it for a year, move into it, live in it for two, sell it, take the exclusion, get rid of all your gain.

Tina Colson: But that’s changed.

David Moore: Yeah. And then right around 2000, the government saw this happening and they said, okay, we’re going to put a five-year required, hold in place. Well, that slowed it down. And what that meant is if you bought a property and it still applies, if you buy a property via 1031, move into it, even though you’ve met the 250 or 500, the two years required for that. If you sold it inside five years acquisition, it’s going to be fully taxable sale. That’s loaded down. Go forward to 2008 and we’ve got the housing assistance tax act. Now we’re going through a whole bunch of tax measures right now.

David Moore: And I just love the way they title these things. The peoples’ relief act of whatever is. Well, the housing assistance tax act doesn’t assist you at all. It sticks it to you. So what it says is yes, if you acquire a property via 1031, hold it for let’s say whatever May this year, then you move into it. You hold it for more than five years. Because remember if you’re still inside five years to be fully taxable, you get outside the five years. That’s when the housing assistance tax act is going to kick in. And that basically is going to give you a proration of section 121 it’s 250 or 500. And that proration is based upon the gain attributable to the qualified versus non-qualified use periods from April of 2009 to the date of disposition.

David Moore: So let’s say you did a transaction now you’ve held the property from 2000. Well, whatever that thing was at 2009, from that date to the data conversions non-qualified use, and then if you’ve moved into it, then the time you’ve lived in it, it’s a qualified use. And you’re going to look at that ratio. So on the bright side, you can do it. And we have a pathway to it. So every time the government puts rules in place, they validated a process they’ve said, we can do it. The downside is you just have to wait a while to do it. And what I tell people today is it’s an end game. Don’t do it. If you think, hey, I’m just going to buy the property, hold it for a few years and then sell it, take the exclusion. I’m going to save all this money. It doesn’t work that way anymore. If you want to buy a place, retire into it, live on the beach, stay there for foreseeable future, then use it. It’s there and it works right.

Tina Colson:
And so thank you for all the answers to the questions. And yes, you call us. We have the guys with the answers. That’s the beauty of this.

David Moore: You are one of them.

Tina Colson: I’m one of the guys. And so what we have learned today is yes, you can purchase an investment property. On the other side, you can turn it into a principal residence someday. You will have that proration of tax. On that end, you can purchase from a family member. If that family member chooses to do an exchange as well. And we can also make sure that you sell the property and you are looking at the value of the property you’re selling and make sure that you’re purchasing at that same value or greater on the other side to be fully tax-deferred. And so I just want to thank you for joining us today. Again, I’m Tina Colson, David Moore Equity Advantage 1031exchange.com. And we have a lot of information on flyers, videos, and the resources that you need. If you have any questions, always reach out to us. 503 635 1031 or 1031exchange.com. Thank you again for joining us today.

David Moore: Thank you Tina.