By Bob Cain
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.
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
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
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
There are a couple of ways of going
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
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.
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" 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 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
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
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
Several other kinds of boot could
affect your exchange, as well.
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 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.
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
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.
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
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
Would You Like To Be the Landlord? An in-depth analysis of the process of assuming control of
your new rental property.