1

TAXATION

CHAPTER 14

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1031 EXCHANGES

I’ll exchange this house…

…for this fourplex.

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SELLING OR EXCHANGE

Mr. Walker has a 10-unit apartment building. The units sell for $700,000 with selling costs of $56,000. It has an adjusted basis of $244,000 and an existing loan of $200,000. Find the gain, taxes owed, and the net equity.

SP 700,000– SE 56,000= Net SP 644,000– AB 244,000= Gain 400,000

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Taxes owed:

Gain 400,000

x Tax Rate 15%

Taxes 60,000

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Net equity or cash out

Net SP 644,000

– Loans 200,000

Equity 444,000

– Taxes 60,000

Net Cash out 384,000

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G = SP - SE – AB

In disposition of investment property there are three ways to handle the gain:

1. Realize the gain.

2. Recognize the gain.

3. Defer the gain.

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TWO PARTY EXCHANGES

Most people think of a two-party exchange. This is where A and B exchange properties, and A gets B’s property and B gets A’s property

AB BA

In real life this seldom (or never) happens.

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THREE PARTY EXCHANGESIn a three-party exchange, we have a person

who wants to exchange (E), a seller (S), and

a buyer (B). There are two ways to complete

this exchange.

1. ES SE BE

2. S SBE ES

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When a client who wants a 1031 tax–deferred

exchange, in the listing, a statement should

include that the client wants to make a 1031

tax–deferred exchange and should be stated

in the multiple listing service (MLS).

S E B

Anybody can be the center (hub) of the exchange, except the exchanger.

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BUY–UP RULEIf the exchanger has traded up in value and up

in equity, then the exchange is totally tax

deferred.Trade-up means the new property must be equal to or greater in value than the old property. If the exchanger withdraws any cash, the cash withdrawn will be taxable.

Any trade down is a taxable event.

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Mr. Evans wants an exchange and Mr. Samson

wants to sell his property. Mr. Evans’ FMV is

$500,000 with loans of $300,000. Mr.

Samson’s FMV is $700,000 and loans of

$400,000. E S Trade

Down

FMV 500,000 700,000 0

– L 300,000 400,000

= E 200,000 300,000 0

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Mr. Evans went up in value and equity, thus E has a tax differed exchange.

13

Mr. Evans wants to make an exchange and

Mr. Samson wants to sell his property. Mr.

Evans’ FMV is $500,000 with loans of

$300,000. Mr. Samson’s FMV is $700,000 and

loans of $400,000. E S Trade

Down

FMV 500,000 700,000 0

– L 300,000 200,000

= E 200,000 200,000 0

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Mr. Evans went down in value of $100,000 and equity remained the same, therefore E has a taxable event.

15

Mr. Evans wants to make an exchange and

Mr. Samson wants to sell his property. Mr.

Evans’ FMV is $500,000 with loans of

$300,000. Mr. Samson’s FMV is $400,000 and

loans of $400,000. E S Trade

Down

FMV 500,000 400,000 100,000

– L 300,000 200,000

= E 200,000 200,000 0

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The trade–down in value of $100,000 will be a taxable event. The gain will be long–term Capital Gains, and will pay $20,000 in Federal Taxes.

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ENTITY RULE

The way the exchanger holds the property

going into the exchange is the way the

exchanger must hold the property coming out

of the exchange.

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There are three basic ways to hold property:

#1: Individual.

#2:Partnership

#3:Corporation

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A and B are in partnership, the AB Company.

They are not getting along, so they decide to

split. The partnership AB owns one building.

Each one finds another building they want. AB

Company exchanges one building for two

buildings. But the partnership now owns two

buildings.

So far, so good.

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As soon as the exchange is completed they

put title of the property in their own names.

This now becomes an invalid exchange.

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STEP-TRANSACTION

A step-transaction are two transactions where the second transaction would not have done without doing the first transaction.

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INVESTMENT PROPERTY RULE

The property must be held for trade or

business or resale.

Mr. Brown buys a building for his real estate business. Thus the building is being held for his trade. Thus, the building would qualify for a 1031 exchange.

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Ms. Knight buys a 10-unit apartment building

for investing. Thus, the building would qualify

for a 1031 exchange

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You can NOT exchange the following:1. Stock in trade or Inventory.2. Stock or bonds.3. Interest in partnership

The answer to what is an investment and

what is inventory is determined by the

taxpayer by the taxpayer’s intent and actions.

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Mr. Bullen buys 5 rental properties. He buys a

new property each year for 5 years. Lot 3, in

tract 35; lot 8 in tract 35, lot 13 in tract 35,

lot 21 in tract 35 and lot 6 in tract 35. He

exchanges lot 3 for another lot in Northern

California.

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1 2 3 4 5 6

789101112

13 14 15 16 17 18

192021222324TRACT 35

lot

1 2 3 4 5 6

789101112

13 14 15 16 17 18

1920212224TRACT 35

lotMr. Lentz owns the lots in the tract marked in green: 3, 6,8, 13 and 21. He exchanges lot 3 for another lot in Northern California.

1

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Is this a valid exchange?

What makes you think it is a valid or invalid exchange?

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NO.He has inventory. 5 lots in the same tract is a subdivision. Subdivisions are considered inventory, not investment property.

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LIKE-KIND RULEYou must exchange like-kind property.

The are two types of properties:

1. Personal Properties.

2. Real Properties.

Personal property and real property are NOT like–kind.

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PERSONAL PROPERTY

Three easy questions on like-kind personal properties.

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Question #1

Can you have a valid 1031 exchange by

exchanging gold coins for gold bullion?

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Question #2

Farmer Boise exchanges his bull for a cow. Is this a like–kind exchange?

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Question #3

Mr. Anderson has a bowling alley and wants to exchange it for a pool hall. Is this a valid exchange?

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ANSWERS TO QUESTIONS 1, 2,

& 3

Question 1 NO

Question 2 NO

Question 3 NO

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REAL PROPERTY

Three simple questions on like–kind real properties.

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.

Question #4

Mr. Ford wants to exchange an orchard for an office building. Is this a like–kind property?

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.

Question #5

Mr. Rooks wants to exchange a 50-year lease for a rental house. Is this a like–kind exchange?

50 year

Lease

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Question #6

Mr. Minor wants to exchange mineral rights for a commercial building, is this a like-kind exchange?

Minerals in the Ground

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ANSWERS TO QUESTIONS 4, 5, & 6

Question 4 YES

Question 5 YES

Question 6 YES

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REAL PROPERTY1. Vacant land.

2. Improved real estate.

3. Leases (30 years or more).

4. Mineral and Water rights.

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.

Simply stated, any piece of real property for any piece of real property, held for investment.

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NO-CHOICE RULE

The exchanger who qualifies for a 1031 tax-

deferred exchange has no choice: the

exchanger cannot recognize the gain or loss.

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Mr. Haydon exchanged a property that had a

$50,000 loss in 1992. He sold some stock that

had $75,000 gain. He would like to write his

loss of $50,000 off against his gain of

$75,000, leaving him with a net profit leaving

him with a net profit of $25,000 to pay taxes.

Since it was an exchange, he cannot write off

the loss.

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NO-LOSS RULE

In conjunction with the no-choice rule it

states that no loss can be recognized.

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MONEY CONTROL RULE

At no time can the exchanger have control

over the buyer’s money.

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DELAYED EXCHANGE

1. 45 days to designate new property.

2. 180 days to close escrow.

3. Cannot file tax return until escrow closes.

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BOOT

FMV Boot – difference in value.

Mortgage Boot – difference in loans

Equity – difference in loans