© Copyright 2001-2011  Landlord.com

By Bob Cain
www.rentalprop.com
Copyright 2000 Cain Publications, Inc., used by permission

The 1031 Exchange is one of the most valuable investment tools available for real estate investment property. If you don't know about it, a brief explanation follows. If you do know about it, skip over the explanation to the section that talks about a major pitfall you need to be aware of.

What it is
The 1031 Exchange provides big tax savings for real estate investors who are trying to conserve their estates by "trading up" without sharing their profits with the government. An understanding of tax-deferred exchanges makes the tax-deferred exchange message loud and clear. Whenever you want to sell your investment property in order to buy other property, always first consider a tax-deferred exchange before making a traditional sale and purchase.

Here's how a tax-deferred exchange works. Suppose you own an investment property, call it property "A," which has a market value of $400,000. You have owned it for some time and the cost basis is $150,000—including the price you paid and capital improvements. You want to become a bigger real estate investor, so you are looking to buy a larger, better property. In fact you have your eye on another property, call it property "B." You figure you can make more money on property "B," as well as advancing toward your investment goals.

You decide now is the time to make your move. You locate a buyer for your property, that's property "A," his name is Mr. Jones. So far, so good. But here's where the problem starts: when you sell your property, "A," to Mr. Jones you will have to pay a capital gains tax of $70,000 (28% tax on the $250,000 capital gain).

Nobody likes paying this tax, except possibly a few gung-ho IRS agents. Also, you discover, if you pay the tax, you won't have enough cash left over to buy the property you have your eye on.

Discouragement sets in. You say to yourself, "there's no way this is going to happen, they're out to get investors, we don't get a fair shake," and so on. All that may be true, but all is not lost: there is a way around the problem: the 1031 Tax-Deferred Exchange.

There are a couple of ways of going about this.

One is to talk to the owner of property "B" to see if he will simply directly exchange one property for another. If he will, great, have your attorney go to work drawing up the agreement so it doesn't attract the wrath of the IRS. (As with the next type of exchange we're going to talk about, if you do anything that isn't to the letter of the law, including forgetting any "t" crossing or "i" dotting, you could end up with a tax bill.)

If Jones can't or won't go along with your plan—he might be doing an exchange himself—all is not lost. You can do what is known as a "Starker Exchange," so named for the man who fought the IRS and won, thus enabling all of us to do tax-deferred exchanges today.

First, you get the property you want. Second, you defer $70,000 in taxes, and conserve 100 percent of your equity. Third, Mr. Jones also ends up with exactly the property he wants.

Because of the complexity of doing the exchange, and the arcane, Byzantine rules that accompany it, you need to get professional assistance to carry it off, including the use of an accommodator from a real estate exchange company. Look under "Real Estate Exchange" in the Yellow Pages.

A Huge Pitfall
What we are going to look at here is one of the biggest pitfalls: boot. Under the IRS 1031 Exchange rules, only property held for business or investment can be exchanged, while deferring capital gains taxes, for other property held for business or investment. That is, of course, exactly what rental property is.

It also must be like-kind property, that is, real property that is traded for other real property. That is where the pitfall shows up. There are a number of things that, if they are included as part of the exchange, that can trigger a capital gains tax bill on the portion of the exchange that they represent. These are called "boot."

"Boot" is anything that is in the trade that is not like-kind property. You would be surprised how often it comes up in an exchange and the real estate investor ends up unwittingly creating a tax bill for himself.

The most common types of boot are mortgage boot and cash boot.

Mortgage Boot
Mortgage boot becomes an issue when the mortgage debt on the property you buy is less than the mortgage debt on the property you are selling.

As a general rule, the debt on the replacement property, "B," has to be equal to, or greater than, the debt on the relinquished or exchange property, "A." If it is less, you'll have what is called "overhanging debt" and the difference will be taxable.

For example, say you are selling your property for $375,000 and it has a mortgage of $250,000. At closing, the mortgage will be paid off and the balance of $125,000 will be held by your accommodator.

Suppose that you then find a new property costing $350,000, with a mortgage of $225,000 that you will assume. The assumption of the $225,000 debt, along with your exchange trust fund of $125,000 will complete your purchase. Under this example you would have to pay tax on $25,000 of capital gains because your debt decreased by that amount.

There are two ways around this problem.

1. Have the seller of the property you are buying refinance and you assume the new, higher debt. Or you could finance it, either through a new loan or a land-sale contract.

2. Add cash to the deal. Cash "added in" offsets debt relief on the property you are selling. Ask your accommodator how this works.

The rule of thumb is that you must end up with at least as much debt on the new real estate as you had when the exchange began.

Cash Boot
Cash boot, likewise, reflects any cash or other value received that is not real estate investment property, including a promissory note. Example: you are selling a property for $750,000 that has an adjusted cost basis of $100,000. The buyer is going to pay you cash in the amount of $600,000 while you take back a $150,000 purchase-money second mortgage payable over ten years. The note is treated as cash boot. You would pay capital gains tax on the principal payments on the note over the next ten years. In addition, the interest you receive would be taxed as regular income,

There are perfectly legitimate work arounds to avoid paying taxes on notes. Check with your accommodator to find out how to do it.

Other cash boot involves repairs. Say the property you are buying needs a new roof. The seller agreed to pay for lender-required repairs, and the roof is required by the lender. The amount the seller paid for the roof is considered cash boot and thus, taxable. Perfectly legal work arounds are available for this situation, as well.

Several other kinds of boot could affect your exchange, as well.

Personal Property Boot
Many times when you buy an investment property it includes appliances, such as washers, dryers, ranges and refrigerators. If you draft the sales agreement improperly, you could end up paying capital gains taxes on the appliances. They are not like-kind property.

Make sure that you note in the sales agreement that appliances and other personal property are not part of the sale, but are being sold separately. The best way to head off paying boot in this case is to create a separate bill of sale for all personal property for one dollar, detailing the inventory in whatever way makes you and the seller feel most comfortable. You can hide the actual price of the personal property in the sale price of the property. Just don't show it as part of the sale of the real estate.

Personal Residence Boot
Personal residences and investment real estate are not like-kind property. That means that if you were to trade a rental property for a four plex and you made one of the units your personal residence, one-quarter of the property would be boot, and thus, taxable.

If you plan to do something like that, wait until the exchange is completed and you have paid your taxes for the year of the exchange before you move into the unit.

Dealer Property for Rental Property
Dealer property and property held for rent are not like-kind property. Dealer property is purchased to be resold, and not held for investment. Legally, it is considered inventory. As such, it cannot be exchanged. That would include houses you buy to fix up and resell, buildings you build in a subdivision, an apartment house you change to condominiums, and any other property that you are not going to use as a rental.

If you were to exchange for a dealer property, you would have no tax consequences, since it is what you are going to use the acquired property for, as opposed to what it was before you acquired it, that matters. The "dealer property" challenge only kicks in when it is the property you are disposing of.

Yes, the exchange will work. And as long as the IRS never looks at it closely, you will never have a problem. The problem will arise if you are audited by the IRS. They could, if the audit is thorough enough, disallow the exchange and make you pay taxes and penalties on the sale of the dealer property.

For example, you purchased a "fixer" house for $100,000 and spent $20,000 improving it. You then sold the property for $150,000 as part of an exchange. You have a net profit on the sale, then, of $30,000. It is profit, not capital gain, because the property is inventory, just as the items on the shelf in a grocery store are inventory. Thus, the exchange would be disallowed, because you exchanged inventory for investment property—not like-kind property.

A 1031 tax-deferred exchange is a valuable tool that enables you to keep the proceeds of your investment. Just make sure when you do the exchange that you follow the rules to the letter. Do that, and your investments will grow. Don't do that, and you end up giving your hard-earned investment equity to the government.

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Robert Cain is a nationally-recognized speaker and writer on property management and real estate issues. For a free sample copy of the Rental Property Reporter call 800-654-5456 or visit their web site at www.rentalprop.com.

Related articles:

Becoming the New Landlord.  An outline of how to approach the most important problem you will have after the purchase.  (See “How Would You Like To Be the Landlord?” for an in depth treatment.) 

How Would You Like To Be the Landlord?  An in-depth analysis of the process of assuming control of your new rental property.

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