Reinvesting With 1031 Exchange

Transcription

1 Reinvesting With 1031 Exchange SEMINAR OUTLINE: Introduction and Learning Objectives Exchange Rules: Myth or Fact?... 2 Non-Qualifying Replacement Property... 3 Exchanges with Special Challenges... 4 Money Issues... 4 Identification Tips... 5 Geographic Leverage... 5 Improvement Exchange... 6 Reverse Exchange... 7 Using Lenders in Reverse Exchanges... 8 Exchange Into Future Personal Use Property... 9 Personal Use Property Exchange Goals These materials were written by RHAWA Member Dennis Helmick, and edited by RHAWA staff. The materials provided by RHAWA for this course are for the use of the participants enrolled in the course. Copyrighted course materials may not be further disseminated. Formal legal advice and review is recommended prior to selection and use of this information. RHAWA does not represent your selection or execution of this information as appropriate for your specific circumstance. The material contained and represented herein, although obtained from reliable sources, is not considered legal advice or to be used as a substitution for legal counsel SW Andover St, Ste D207 Seattle, WA Rental Housing Association of Washington, 2017 Revised 1/22/2018 RHA SEMINAR: 1

2 INTRODUCTION AND LEARNING OBJECTIVES 1031 EXCHANGE RULES: MYTH OR FACT? 1. Exchanges are only for investment property or property held in a trade or business. FACT. You have to sell an investment property and buy an investment property. 2. A 1031 Exchange is tax free. MYTH. A tax deferred exchange is tax postponed. The tax is going to be paid when the new property purchased is ultimately sold. 3. The tax rate is only 15% on the gain. MYTH. The calculation of the tax on the capital gain has gotten far more complicated. Three rates can apply: 25%, 20%, and 15% and the Affordable Care Act Investment Income tax rate of 3.8%. The recognized gain can also affect other areas of the tax return. 4. You must buy even or up and use up all the cash from the sale, or the exchange won t work. MYTH. It is not all or nothing to the extent you trade down or pocket some cash you will pay some tax. 5. You must match the debt from the old property with the same amount or more debt on the new property. MYTH. For total deferral you must match or exceed the value you sold for (sales price - closing costs) and match or exceed the equity received (sales price - closing costs - debt payoff). Example: You sell an investment property for $550,000 with $50,000 closing costs and $250,000 debt. You buy a new investment property for $500,000 with no debt. There is total deferral because you matched value: $550,000-50, ,000 loan payoff = $250, ,000 of new cash you brought in to close on the $500,000 new price. 6. There are strict time deadlines for the exchange. FACT. Identification: The deadline starts when you close your sale. You must identify potential replacement property within 45 days of closing. In this tight seller s market it is far easier to sell than to buy. So, it is a very good idea to have a new property lined up before you commit to sell, or build in a right to extend the closing. It is safest to identify more than one new property to the facilitator because you have to buy at least one of those properties. It is safest to limit your identification to no more than 3 potential properties. Closing on new property: The deadline starts when you close your sale. You must close on new property within 180 days of closing. The closing deadline is usually not a problem unless you are doing an improvement exchange where value is being added to the target property before closing. 7. You can only sell first and then buy. MYTH. You can buy first and then sell with a Reverse exchange. The time deadline to close sale on the old property is 180 days from when your facilitator buys the new property for you. The facilitator acts as a straw man holding title until the old property sells. 2 RHA SEMINAR: Reinvesting With 1031 Exchange Rental Housing Association of Washington, 2017 Revised 1/22/2018

3 8. Identity crisis: You must finish the exchange the way you started. FACT. Separate Property vs. Communal Property. Joint Owners as Tenants in Common vs. Partnerships or Limited Liability Company. 9. I can start my exchange after the sale has closed as long as I haven t received any money. MYTH. The Exchange Agreement and other exchange paperwork must be in place before the property sale closes (Regular Exchange) or before the property purchase closes (Reverse Exchange). 10. Once I receive earnest money I can t do an exchange. MYTH. You can receive earnest money and put it back into escrow before the closing, or you can keep the earnest money or even some of the down payment at closing and just pay tax on the amount you keep, with the 1031 tax deferral for the rest. NON-QUALIFYING REPLACEMENT PROPERTY Property owned by a related party (Note: in some limited circumstances a related party exchange may qualify -call for information) Property located outside of the United States for Property located inside the United States Property which you intend to immediately sell, transfer or contribute into an entity such as a partnership, corporation, or an L.L.C. which is not a single member (disregarded) L.LC. Property which you intend to occupy at closing or shortly after closing. Property which a related party will rent from you at less than fair market rent Partnership and L.L.C. interests in an entity which owns real estate (unless all of the entity interests are acquired by the Taxpayer doing the exchange at the same time call for information) Stock in a corporation owning real estate Leasehold interests of less than 30 years Property held primarily for sale (such as property you intend to plat, divide into condominiums, remodel and/or improve and then immediately sell) Improvements on real estate you already own Property which is not real estate (or is not like-kind to the asset you are exchanging) Rental Housing Association of Washington, 2017 Revised 1/22/2018 RHA SEMINAR: Reinvesting With 1031 Exchange 3

4 EXCHANGES WITH SPECIAL CHALLENGES Improvement exchanges, where you must make improvements to the replacement property to add to the purchase price and/or use up proceeds for your exchange. Part Investment Part Personal Use property such as a duplex you occupy and rent and/or a new duplex that you intend to occupy and rent. Property owned in partnership where the partners do not want to go into a new property together. New Property to be acquired in joint ownership with another party you intend to develop, construct and/or remodel. A sale of your old property that involves a contract or note back to you from the buyer. A sale of old property owned separately by one spouse when the intention is to acquire the new property jointly with the spouse. A sale of several old properties you intend to combine into one exchange. MONEY ISSUES Prorated Rents and Security Deposits on the Relinquished Property: Whenever possible the rents and deposits should be paid from monies other than sale proceeds. If the rents and deposits reduce the Exchange Credit (cash available), it may be considered boot (taxable) taken by you at closing. You should deposit these amounts to escrow in the form of a certified check or wire, prior to closing. Earnest Money Deposits on Replacement Property: As long as your facilitator is holding exchange proceeds, they can use those funds to pay earnest money deposits. The process requires them to take an assignment of the Replacement Property Purchase and Sale Agreement and you must identify the properly by written notice to them. If there are excess funds available at closing, you may be returned all or a portion of the earnest money you deposited. Loan Fees: The exchange proceeds may be used to pay for customary costs normally incurred in an all cash transaction (without a loan). It is not clear whether we may pay costs associated with obtaining a loan in advance of closing. Those loan cost amounts will probably be taxable to you. It is recommended you advance loan deposits out of pocket. 4 RHA SEMINAR: Reinvesting With 1031 Exchange Rental Housing Association of Washington, 2017 Revised 1/22/2018

5 IDENTIFICATION TIPS The most difficult part of a delayed exchange is meeting the identification and designation deadline. It s not easy to find suitable replacement property within 45 days of closing of your old property. By and large, the IRS identification rules are not user friendly. We suggest that you start the search for your new property even before your old property sale closes. The 45 day deadline starts on the closing of the old property. Here are a few tips to follow when identifying the new property: Try to have at least one of the identified properties under a binding purchase agreement by the 45 day deadline. Include for each identified property two of the following items for that property: 1. Street Address 2. Legal Description 3. Assessor s Tax Acct.# Contact facilitator if your exchange involves property other than real estate (such as personal property or a leasehold interest). Identify any proposed property improvements including repairs and/or remodeling that are to be part of the exchange at the time you identify the property. Please attach a copy of the building plans, or a description of the repairs and/or remodeling, to the identification letter. It is safest to limit your identification to 3 properties. Make sure that each property you identify has only one assessor s parcel number or that property may deemed to be several properties. If you plan to identify more than three properties, review with facilitator, well in advance of the identification deadline, the fair market values of the properties you plan to identify to avoid exceeding the 200% rule. If you plan to acquire less than 100% of an identified property (a fractional share), such as a Co-Tenancy interest, you must identify the fractional share of the property. Review this question with facilitator before you identify. If you plan on identifying a property owned by a related party, contact facilitator for more information. Acquisitions of replacement property from related parties only work in rare circumstances. GEOGRAPHIC LEVERAGE Rental Housing Association of Washington, 2017 Revised 1/22/2018 RHA SEMINAR: Reinvesting With 1031 Exchange 5

6 IMPROVEMENT EXCHANGE You want or need to add value to the Property you are acquiring. The Rule: The Exchangor gets no exchange credit for any improvements made after you directly take title. So, this exchange is structured with the Facilitator Company acting as the Straw Man holding title to the to-be-improved property while the work is being done for the Exchangor. Example: Old Property sell for $430,000 less closing costs for $400,000 net cash The Steps: A. Sell Old Property and funds put into exchange qualified escrow account. B. Facilitator sets up a brand new Limited Liability Company owned by the Facilitator Company: 100 Oak Street LLC C. 100 Oak Street LLC buys the property to be improved which costs $300,000 using the exchange cash. D. 100 Oak Street LLC signs construction contracts approved by Exchangor. E. Work is done under supervision of and approval of Exchangor. Exchangor approves bills to be paid by 100 Oak Street LLC. Paid for improvements total $100,000. F. At conclusion of work, but no later than 180 days from date of closing of the old property sale, the 100 Oak Street LLC ownership is transferred to the Exchangor. Result: Total deferral sold for $400,000 bought for $400,000 ($300,000 + $100,000 improvements) Challenges: Work must be completed and paid for to the extent Exchangor is trying match the value within 180 days of closing of the old property sale. If bank lending involved, the lender must be willing to hold the loan in its portfolio rather than sell the loan in the secondary market. This type of an exchange is more expensive than a regular exchange. The fee typically runs 3 times a regular fee. Example regular fee $1,500 add $3,000 more for an improvement exchange. But, because the tax is deferred on the cash that was used to make improvements, the additional expense is often justified. 6 RHA SEMINAR: Reinvesting With 1031 Exchange Rental Housing Association of Washington, 2017 Revised 1/22/2018

7 REVERSE EXCHANGE You have to close on the new property before you close the sale of the old property. The Rule: The Exchangor cannot exchange into a property already owned by the Exchangor. So, this exchange is structured with the Facilitator Company acting as the Straw Man holding title to the New Property on behalf of the Exchangor until the Old property sale closes. Example: Old property to sell for $30,00 less closing costs for $400,000 net cash. The new property costs $500,000 and the Exchangor has $125,000 cash for a down payment + $10,000 closing costs and must borrow $375,000 to complete the purchase. The Steps: A. Facilitator sets up a brand new Limited Liability Company owned by the Facilitator Company: 100 Oak Street LLC B. Exchangor loans 100 Oak Street LLC $125,000 and the closing costs and receives a 2nd position Deed of Trust for $135,000 on the 100 Oak Street property as collateral. C. 100 Oak Street LLC borrows $375,000 from a portfolio lender (a lender who holds their loans) and deposits the $135,000 loan from the Exchangor and the loan proceeds to buy the 100 Oak Street Property. D. 100 Oak Street LLC signs a triple net lease with the Exchangor. The Exchangor has the right to all of the rental income and has the the obligation to pay all of the expenses of operating the property. E. The Old Property sells within 180 days of the time the New Property was purchased. F. The Exchange proceeds from the sale of the Old Property as used first to pay back the Exchangor loan for $135,000. Then, the balance of $265,000 is applied to the bank loan leaving a balance of $110,000. Result: Total deferral sold for $400,000 bought for $510,000 including the closing costs paid when the property was purchased. Challenges: Sale of the Old Property must be completed within 180 days of closing of the New Property purchase. Exchangor must have the funds to buy without selling. If bank lending involved, the lender must be willing to hold the loan in its portfolio rather than sell the loan in the secondary market. This type of an exchange is more expensive than a regular exchange. The fee typically runs 4 times a regular fee. Example regular fee $1,500 add $6,500 more for a Reverse Exchange. But, because the benefit of getting the New Property you want without the risk a 45 day find it identification deadline tax, the additional expense is often justified. Rental Housing Association of Washington, 2017 Revised 1/22/2018 RHA SEMINAR: Reinvesting With 1031 Exchange 7

8 USING LENDERS IN REVERSE EXCHANGES In a Reverse Exchange, someone other than the Exchangor, or someone other than a party related to or controlled by the Exchangor, must hold title to the new property until the old property sale closes. Normally a Facilitator Company will hold title to the new property ('warehouse the new property') until the old property sale closes. Issue #1: The Loan will be made to the Facilitator not to the Exchangor. Because the Exchangor cannot come into title on the new property until the old property sale closes, the loan must be closed in the name of the title holder, the Facilitator Company. The Lender must be willing to loan to essentially a "shell company" which will often be a single member and single purpose L.L.C. created for the exchange. This L.L.C. will have little or no assets other than funds loaned to it by the Exchangor. Issue #2: Ideally, the loan will be non-recourse to the Facilitator. Because the Facilitator is merely performing a service in facilitating the exchange, and has no economic interest in the transaction, other than its fee, the Facilitator will not be willing to be liable on the Note. The Lender may rely on the creditworthiness of the Exchangor and obtain a guarantee of the Note and Deed of Trust from the Exchangor. The Lender can have full recourse against the Exchangor on the transaction. Issue #3: The Facilitator will need the Lender to waive its due on sale clause for a transfer of the new property (or transfer of the units in the limited liability company owned by Facilitator) from the Facilitator to the Exchangor. The Facilitator is required to deed the new property to the Exchangor after closing of the sale of the old property or no later than 180 days from taking title to the new property. The Lender must be willing to waive its due on sale or due on transfer clause for any transfer of the property to the Exchangor or the units in a single member L.L.C. The due on sale or due on transfer clause can apply to any transfers other than to the Exchangor or to a single member L.L.C. owned by the Exchangor. Issue #4: Ideally, the Facilitator will not be required to sign any loan documents containing any warranties or representations concerning the new property. Because the Facilitator is merely performing a service in facilitating the exchange, the Facilitator is not in a position to make any warranties or representations regarding the new property. The Lender can obtain such warranties and representations from the Exchangor. Issue #5: The Facilitator will need the Lender to allow junior or subordinate financing on the new property. All of the cash to make the down payment on the new property will be loaned from the Exchangor to the Facilitator. The Facilitator will normally execute a Note and Deed of Trust on the new property to secure such loan. The Lender needs to allow the Exchangor to have a junior or subordinate lien on the property to secure the loan to the Facilitator. If subordinate financing is not permitted by the lender, the Facilitator may pledge all of the membership units in the limited liability company to secure repayment of the note to the Exchangor. The Lender can require that the only junior financing on the new property will be the loan from the Exchangor to the Facilitator. The above listing of unique Reverse Exchange issues is not exhaustive but does cover the majority of issues. With advance planning, these issues can be resolved. The result will be a loan that will meet the Lender's, Facilitator's, and Exchangor's needs. 8 RHA SEMINAR: Reinvesting With 1031 Exchange Rental Housing Association of Washington, 2017 Revised 1/22/2018

9 EXCHANGE INTO FUTURE PERSONAL USE PROPERTY Often an Exchanger will want to buy a primary home, second home, or vacation home as part of an exchange. There is a safe harbor to achieve that goal. The sting of a high priced new property may be lessened because you can ultimately use the property as your new home or vacation home. What does the Safe Harbor require to achieve the goal of converting an investment property into a primary home, second home, or vacation home? The Investment Property being sold has to be owned by the Exchangor for at least 24 months prior to sale and must be held for investment purposes during that period (which means the Exchangor can not violate the fair market rental and personal use tests described below). The new Property purchased by the Exchangor has to be used as an investment property for at least 24 months after the purchase. Also, for each of the two 12 month periods immediately after the exchange: A. The property must be rented to another person at fair market rental for 14 days or more a year ("fair market rental test''); and B. The Exchangor's personal use of the property must not exceed the greater of 14 days or 10% of the time the property is rented out at fair market rent during that 12 month period ("personal use test"). What constitutes personal use by the Exchangor which could disqualify the exchange? A. Use of the property by Exchangor, Property Co-Owner, or members of the Exchanger's family. But, if the family members are renting the property as their primary residence at fair market rent, family members' use will not be treated as personal use; B. Use of the property by someone with whom you have a time swap arrangement; and C. Use of the property by anyone paying less than fair market rent. Use by the Exchanger for Repair and Maintenance: Time spent by the Exchanger on the property for repairs and maintenance does not count as personal use by the Exchanger. But watch out! The standards for the time spent on maintenance and repair under Regulation 1.280A (d) (2) (4) are very strict. The Exchanger has to work on maintenance and repairs the lesser of 8 hours or 2/3rds of the time the Exchanger is on the premises. Conversion to Personal Use/Section 121 Gain Exclusion: After holding the Replacement Property for 2 years and not violating the fair market rental and personal use tests described above, the Replacement Property can be converted into a primary home, secondary home or vacation property. When you ultimately sell the replacement property you have converted into a residence, you may be able to exclude all or a portion of the gain on the sale provided you have owned the property for at least 5 years. New amendments to Section 121 do not allow you to exclude gain on the sale allocated to periods of "non-qualified" (rental) use. Under the new law, if you acquire a replacement property on or after January 1, 2009, rent it for 2 years, live in it for 3 years, and then sell it for a Rental Housing Association of Washington, 2017 Revised 1/22/2018 RHA SEMINAR: Reinvesting With 1031 Exchange 9

10 $300, profit, 40% of the gain realized (2 years of non-qualified use divided by 5 years of ownership) or $120, is not eligible for exclusion and 60% of the gain (3 years of use as a residence divided by 5 years of ownership) or $180, is eligible (but you can never exclude gain in excess of the $250, and $500, exclusion limits). Periods of non-qualified use prior to January 1, 2009 are not taken into account in making the allocation. So, if you bought a replacement property on January 1, 2007, rented it for 2 years until January 1, 2009, then moved into it for 3 years and sold it, all of the gain (up to the exclusion limits) would be eligible for exclusion. If property was bought on January 1, 2007, rented for 3 years to January 1, 2010, and then moved into for 3 years until January 1, 2013, only the 2009 rental use is non-qualified. In this example, 1/6th of the gain realized (1 year of non-qualified use divided by 6 years of ownership) is not eligible for exclusion and 5/6th is (up to the exclusion limits). These rules are very complicated and prior to converting your rental property you have exchanged for into a residence, it is important you consult with your tax advisor. 10 RHA SEMINAR: Reinvesting With 1031 Exchange Rental Housing Association of Washington, 2017 Revised 1/22/2018

11 PERSONAL USE PROPERTY EXCHANGE GOALS Revenue Procedure and Code Section 121 what to do and not to do. GOAL TO DO: DO NOT: 1: Exchange from Investment Property into Property Ultimately to Become Primary Home. Second Home or Vacation Property "The Really Cool Rental House" #2: Convert the former Investment Property to Primary Residence, Second Home or Vacation Property #3: Sell Primary Residence that was originally acquired by exchange (former Investment Property) and qualify for Section 121 Gain Exclusion #4: Convert Primary Home into Rental for part 1031 Exchange Treatment combined with Section 121 Exclusion For at least two years after acquisition through the exchange and for each of the two 12 month periods after the exchange: Rent to a Third Party 14 days or more a year at Fair Market Rent (FMR) or rent to a Relative only if paying FMR and the relative is using the Property as their Primary Residence. Make personal use of the property more than 14 days a year or 10% of the time property is rented at FMR, which is greater. Personal use, that could be disqualifying use for these purposes is use by: the Exchangor, the Exchangor s Family members, a Co-Owner, a person with whom the Exchangor has a Time Swap arrangement or use by anyone paying less than FMR. Fudge on Repair and Maintenance Day usage: 8 hours or 2/3rds of time the Exchangor is on the Property should be work on the property time. Meet the Test of Goal #1 above and use property more than 14 days a year or 10% of the time property is rented FMR. Meet all of the Tests of Rev. Procedure See Above but at least 2 years of Qualifying Investment Use Before Converting Property to Primary Residence. Own the property for at least 5 years. Occupy the property as a Primary Residence for at least 24 months out of the most recent 60 month. Keep accurate records of all capital improvements. Keep accurate records of depreciation taken because the amount of post 1997 depreciation will be taxed on the sale. For at least two years after converting the property to a rental and for each of the two 12 month periods after the exchange: Rent to a Third Party 14 Days or more a year at Fair Market Rent (FMR) or Rent to Relative only if paying FMR and the Relative is using the property as their Primary Residence. Occupy the property as a Primary Residence for at least 24 months out of the most recent 60 months. Keep accurate records of all capital improvements. Keep accurate records of depreciation taken because the amount of post 1997 depreciation will be taxed on sale. If the Property qualifies for Section 121 Gain Exclusion as of 1/1/2009 try to avoid converting the property back to rental use. This nonqualified rental use (post 2008 rental use) will result in a pro-rata reduction in the $250,000/$500,000 gain exclusion. This reduction is computed on a percentage arrived at by dividing years of post 2008 rental by total years of ownership. Forget that amount of post 1997 depreciation will be taxable on the sale. Make personal use of the property more than 14 days a year or 10% of the time property is rented at FMR, whichever is greater. Personal use, which could be disqualifying use for these purposes is use by: The Exchangor, The Exchangor's Family Members, a Co-owner, a person with whom The Exchangor has a Time Swap arrangement Or use by anyone paying less than FMR. Fudge on Repair and Maintenance Day usage: 8 hours or 2/3rds of time the Exchangor is on the Property should be work on the property time. Move Back into the property after conversion to a rental. This personal occupancy could result in disqualifying the property for treatment as an investment property under the Fair Market Rental Rules of Rev. Procedure and wipe out the 1031 exchange for part of the sales proceeds. Rental Housing Association of Washington, 2017 Revised 1/22/2018 RHA SEMINAR: Reinvesting With 1031 Exchange 11