At Summit, we frequently work on exchanges with special circumstances that can complicate the paperwork and the completion of the exchange. If any of these circumstances will affect your exchange, please contact our nearest office for a free consultation.
Seller Financing
Sometimes, the taxpayer may wish to take a seller financing note on the relinquished property in an exchange. It is recommended you have an experienced tax consultant who is very well versed in exchanges assess the tax implications. Gain must be paid on the taxable portion of the note, and in many cases 100% of the note will be taxable.
There are some non-taxable options if the seller financing note (trust deed note) goes to the QI as part of the exchange proceeds:
- When purchasing the replacement property, the taxpayer may be able to negotiate with the seller of the property to take the note. Although this is very unlikely, it has happened in some instances.
- Taxpayer can sell the note to a discount buyer, but this is usually not a good option since the discounters want a discount of 30% or more.
- The exchanger can buy the note out of the exchange for cash, and the note will end up being tax-free to the exchanger. This is the most likely option.
Getting Money Out of the Property (Refinancing)
The taxpayer cannot access ANY amount of cash at ANY TIME during the exchange period or the exchange will fail.
However, you may choose to leverage your property with a loan to pull cash out of the property before or after the exchange period is completed.
It is generally accepted that refinancing the replacement property after the exchange period is over is OK (after you have closed on the replacement property).
Although some people refinance their relinquished property before the exchange has begun, there could be more risk involved with this scenario. The refinance may be called into question if it appears the taxpayer accessed the cash in anticipation of the exchange. There is some risk that the money obtained could be reclassified as taxable boot. However, it can be argued that there should be no difference in treatment of a refinance before the exchange or after the exchange.
Related Parties
In general, you should try to avoid entering into an exchange with a related party. In 2002, Revenue Ruling 2002-83 says an exchange is invalid if ALL the following 3 things happen:
- The taxpayer purchases property from a related party
- The related party receives cash (or non-like kind property)
- The family unit pays less tax because of the exchange
Related persons are defined as Spouse, Siblings, Ancestors and Descendants. In-laws, Aunts, Uncles and "Step" relatives are not defined as related parties for purposes of an exchange. If there are related parties involved in an exchange and the exchange is valid because one of the criteria above is not met, you must still follow these additional requirements:
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You must identify that the exchange was with a related party on form 8824. If the replacement property was purchased from a related party, you must disclose why the principal purpose of the exchange was NOT the avoidance of tax.
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Both you and the related party are generally required to hold the property for 2-years. The 2-year period is extended if either party enters into a contract for sale or option that substantially diminishes risk of loss. Exception to the 2-year holding rule include death or involuntary conversion.
It may be possible to avoid these requirements if the related party also does an exchange OR if you enter into an exchange with in-laws. But, because regulations are strict in this area, it is best to consult with the experts at Summit if you have a related party involved in your exchange.
Partnerships
Partnership interests are NOT like-kind property to real estate for the purposes of a 1031 exchange. So, if you own property with a partner, you can both exchange into new property together (in which case you'd be trading one partnership interest for another) but you cannot each exchange your portion of the proceeds into different properties that you own individually own.
If partners do want to go separate ways, they need to distribute the real estate to the partners first by breaking the property into undivided interests so each partner has a separate deed, somewhat like a Tenant in Common Property (TIC). This technique is commonly referred to as the “drop and swap”. However, doing this may carry some risk if it appears the sole purpose of the change from a partnership to undivided interest was to avoid tax.
If any of the above complications exist, our experts can explain your options. As always, Summit offers free consultation for your exchange scenario. Make an appointment today...