Understanding §1031 Tax Deferred Exchange Identification Rules

Occasionally we receive a frantic call from an investor who is in the middle (sometimes at the end) of their 45-day identification period. Understanding the identification rules prior to entering a potential exchange may be the preferred path.

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
June 9, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

The 1031 clock starts ticking upon the closing of the relinquished property. The 45 days are calendar days and no matter what day of the week the 45^th day falls the identification period ends. Even if the 45^th day is a weekend or holiday.

The investor (along with a financial advisor, real estate broker or other parties) will start evaluating potential replacement properties during the 45 days. One point to make clear is that during the 45 days the investor may change the properties on the 45-day list. Changes may be necessary especially if the intended replacement property is no longer suitable for the investor, is acquired by other investors or under other circumstances.

Without a QI, nothing else matters.

The qualified intermediary (QI) is a critical player in the exchange process. We cannot stress enough the importance of engaging a QI as soon as the investor has decided to sell the property referenced as the relinquished property. If the investor has sold the property without a QI being part of the transaction the exchange cannot be executed. Even if the title company is holding the sales proceeds in their escrow account. We would also strongly encourage language in the sales contract (of the relinquished property) to reflect the seller intends on executing a 1031 tax deferred exchange and the buyer shall not object to the process. Once the property is sold and the QI has received the proceeds of the sale the QI typically will send a form to the investor to fill out and send back to the QI. The IRS requires this form to be submitted to ensure that properties ultimately acquired were reflected on the form.

Identify by putting it in writing.

There are specific requirements set out in section 1031 regarding the acknowledgment or commitment to a certain list of potential replacement properties. The investor is referred to as the Exchanger and is required to submit a signed document to the QI. The QI is handling the details of the exchange sale. There are different acceptable methods of submitting the list to the QI. Some Exchangers may hand deliver the list. Other Exchangers will use email or fax to send the list. A text message is not a preferred method of communication. This list must be received by the QI by the end of the 45^th day. We have worked with Exchangers who engaged with a QI on the west coast and have pushed the envelope so to speak with submissions. Best practices would encourage the Exchanger to have the final 45-day list submitted so that the QI may acknowledge receipt of the document.

If there is a change in the makeup of the list, we strongly encourage the Exchanger to send the new list with a notation that this current list supersedes or voids any previous list submitted on a previous date and list the previous document date. If there are a number of changes during the 45-days, the exchanger may want to title the list with a version number (v.1. v.2) and when the ultimate list is submitted mark the list FINAL.

ID Details matter.

Depending on the property the identification may be very easy or complicated. In the case of a single property there may be only one address and a tax identification number supplied by the property appraiser office. When purchasing land as a replacement property the legal descriptions may be more involved and have meets and bounds description. Clarity is the key for the identification. In the case of fractional ownership such as Tenants in Common (TIC) or a Delaware Statutory Trust (DST) many QIs (and the IRS) would prefer to have a percentage of ownership especially if not purchasing the entire property. Even in a partnership interest a full description and percentage of ownership is required to eliminate any confusion or challenge if there is an IRS audit on the exchange.

Reviewing the financial requirements

As a brief review of the financial requirements the Exchanger needs to :

Replace the relinquished property with equal or greater value
Replace any debt that was paid off on the relinquished property.
Use all the cash the QI is holding.

Let’s review the rules for identifying properties.

The first rule (and potentially most often used) is the Three Property Rule.

This may be the simplest of the rules for filling out the list. You may identify three properties no matter what the fair market value may be. For example, if your relinquished property was sold for $500,000 you may identify three properties with a total value of $1,500,000.

If you have identified three properties that were less than the replacement price you may acquire more than one property. If buying only one property, the other identified property will be back-ups if for some reason the first property falls through.

Potential greater flexibility with the 200% Rule

The 200% rule can be confusing at times when attempting to calculate the values. In simple terms you may identify as many properties as you want, as long as the total value does not exceed 200% of the fair market value of your relinquished property. What complicates this to a certain degree would be that the identified properties will include the total acquisition price including any debt that is being replaced. If we use the same $500,000 in the example above and if it is an all-cash transaction you may list as many properties as you want up to a total of $1 M. If you are financing part of the replacement properties, you will need to evaluate the specific LTVs on each property and then identify as a total price.

Seldom used 95% Identification Rule

In all our years of dealing with 1031 exchanges (including DST replacement) we have not seen any investor utilize the 95% Rule. This enables an investor to identify as many properties as they wish regardless of value, as long as they purchase 95% of all properties identified. Anything less would jeopardize the exchange.

Next steps

The first step to a successful exchange may start with hiring the right Qualified intermediary (or accommodator). While the cost may vary a few hundred dollars, you want an experienced QI. Understanding your replacement options prior to entering into an exchange is an important step. Each of the rules has positives and drawbacks.

DST Flexibility.

Delaware Statutory Trust (DST) has provided a solution for many investors who become exchangers. The DST options provide for diversification of replacement properties and can satisfy debt replacement with non-recourse debt. There is also flexibility in balancing the debt with certain DST properties enabling the exchanger to potentially spread risk out over a diversified portfolio of properties. The same $500,000 property example from above may enable an investor to invest in a DST portfolio of three to four properties with different asset classes as well as geographic diversification.

Final thought.

We opened this article with a frantic call from investors who were in the middle or end of their 45-day identification period. We have successfully assisted investor/exchanger who had only two days remaining in their identification period. While this is not the preferred timing, we have access to a wide variety of DST replacement properties. Investor who have spent time reviewing the DST alternative can make a decision on moving forward.

DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin -Sherwood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.

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Social Media platforms are solely for informational purposes. Advisory services are only offered to clients or prospective clients where the advisory firm and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by NAMCOA unless a client service agreement is in place.

Thank you.

NAMCOA® – Naples Asset Management Company®, LLC

What are the Basics for Calculating Your Basis

When an investor sells an investment property there is the ability to defer paying capital gains taxes (taxed at 0%, 15%, or 20%) as well as the recapture of depreciation (taxed at 25%) for payment at another time. The IRC §1031 enables you to exchange the property you are selling for another property.

By Al DiNicola, AIF®, CEPA™
April 20, 2023
Adinicola@namcoa.com
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD

This may be referred to as a like kind exchange. For the purposes of this writing, we will address investment property and not primary residential property. We are not providing tax advice and investors are encouraged to consult their own CPA.

Understanding basis in a 1031 exchange.

There are several types of basis, including:

Original Cost basis;
Adjusted Cost Basis;
Depreciated Basis;
Tax Basis;
Carried Forward Basis; and
Step up in Basis.

The confusion may begin with an investor wondering what happens to their basis when the property is sold. When the topic of depreciation arises there are a variety of questions. What happens to depreciation while I own the property? How long does it take to use up all the depreciation? How can I start depreciation over again with a new property? If I use up all the depreciation and I still want tax advantaged real estate, what do I do? Does the entire property get depreciated? All of these questions and more may be traced back to the original property to establish your basis. There may be a long paper trail needed if you do multiple exchanges.

Hypothetical example

Jack & Diane are selling a rental house in New Jersey. They paid $175,000 for the property in January 2002. They also paid 15,000 in closing costs. They invested another $25,000 to add a garage. They accept an offer for $400,000 on the property (December closing 2022). They have owned the property for ten years. They have located a property in Daytona Beach for $400,000.

Original Cost Basis

The original cost basis is the original purchase price, associated closing cost at the time of acquisition of the relinquished property. The original cost basis in the home would be $190,000 ($175,000 original purchase price, $15,000 in closing cost).

Adjusted Basis

The adjusted basis would be the original cost basis plus the $25,000 for the garage. If there were any other major renovation or cost that adds to the value of the home those cost or investment would be added. For this example, the total adjusted cost basis would be $215,000.

Depreciated Basis

Depreciation is an interesting situation. The IRS assumes you have taken the depreciation whether you utilized that depreciation or not. The property was depreciated each year. The depreciation schedule is 27.5 years for residential property (commercial property is 39 years). However, the entire purchase price of $175,000 is not depreciated. Only the structure can be depreciated and not the land. For this example, we will assign a land value of $25,000 to the property and $150,000 for the structure plus the closing cost of $15,000 and addition of the garage $25,000 for a total of $190,000. The depreciation taken was $6,900 each year for a total of $138,000. In this case the property has a depreciated basis of $77,000. In some cases, the depreciated basis may be zero if the property was held for the entire depreciation period.

Original Purchase	$175,000
Closing Cost	$15,000
Original Cost Basis	$190,000
Garage Addition	$25,000
Adjusted Cost Basis	$215,000

Depreciation taken (rounded)	$138,000
Depreciated Basis (rounded)	$77,000

Tax Basis

One of the first items an investor may want to know is the tax basis in order to determine if the investor wishes to enter into a 1031 tax deferred exchange. The tax basis would be used to establish the capital gains on the property as well as the recapture of the depreciation over the years. The New Jersey home has an adjusted cost basis of $215,000 and sold for $400,000. The cost of selling the New Jersey home was $20,000 and that is subtracted from the selling price to arrive at the net selling price used to determine the capital gains. This would be $380,000. The net selling price on the property would be $380,000 minus the $77,000 depreciated basis taken for a Tax Basis of $303,000. For federal tax purposes this amount is divided into recapture and capital gains. There will be recapture of the $138,000 depreciation taken is taxed at a rate of 25%. The remaining $165,000 would be taxed at the capital gains rate. This would depend on the individual tax payer (0%, 15%, 20%). Individual states such as New Jersey have taxes that are also due upon the sale and would use the entire $303,000 for calculations. There may also be (depending on tax payer income level) a 3.8% NIC tax on gain. These taxes would be deferred if utilizing a 1031 tax deferred exchange.

Carry Forward Basis

The $77,000 depreciated basis is the carried forward basis. The property in Daytona Beach is the same price as the New Jersey home being sold. This is a very important fact because the price of the new property is a big factor that affects many items. Actually, they are buying equal. Because they bought equal the basis in the new property is the same as the remaining basis in the New Jersey home. The basis rolls forward to the new Daytona Beach property.

The original date (2002) of the New Jersey home is what appears on the future depreciation schedules. The depreciation schedule carries over as if they were still depreciating the New Jersey home. In this case there is no additional depreciation time other than what is remaining on the $77,000. That would be seven- and one-half years remaining.

If you had a mortgage on the relinquished property this will be noted.

The depreciated basis on an investment property can appear to be allusive to determine. One of the most important factors is the purchase price of the replacement property. This dictates many items that will affect you.

How to increase basis in replacement property.

The question many investors ask is how do you change the dynamics on the exchange and potentially increase tax favored write offs? One strategy would be to purchase up, meaning a more expensive replacement property. Rather than buying a $400,000 property in Daytona Beach hypothetically they purchase a $500,000 property. Their basis in the property would be increased by $100,000. This is a combination of the rollover $77,000 plus the $100,000 for a total of $177,000. There would be 7½ years remaining on the $77,000 and the $100,000 would start on a 27 ½ year depreciation schedule. The updated depreciation schedule shows the continued depreciation of the New Jersey homes (as if they still owned it) and the acquisition of the Daytona Beach property portion as of the date they closed on the Daytona Beach property.

Bring more cash or acquire more debt!

In order to increase the purchase price, the investor would need to bring additional cash or arrange for a mortgage or loan for the $100,000. This may involve applying for a loan. In most cases the investor would need to sign for and be liable for the loan. To avoid personal liability for a loan, some investors utilize Delaware Statutory Trust (DST) as a replacement property especially when leverage is present. DST have non-recourse debt. This eliminates the need for Jack & Diane to apply for or be liable for any of the assigned debt on the new acquisition. We have guided investors who have fully depreciated their investment properties who acquired a DST with 50% Loan to Value. This would increase the basis by an additional the amount of the debt assignment ($400,000 for example). Acquiring additional debt is not for all investors. If the investor utilized a future 1031 exchange the acquired debt (or balance paid off) needs to be replaced. The other consideration would be the overall goals of the investor when acquiring a property and in this example the Daytona Beach property may have other uses in the future.

Step Up in Basis

The final basis would be referenced as the step-up basis. This strategy benefits the heirs of the investor. When the investor passes away there is an adjustment from the original basis to the current market value. If the original property was purchased for $175,000 fully depreciated (over 27.5 years) and now worth $750,000 that is the new basis. The basis has been stepped up to current value. If the property is sold there would be no capital gains taxes due and there would be no recapture of depreciation taken. This strategy may be utilized to build generational wealth.

As previously stated, we are not CPA. We have guided many investors with a list of questions for their CPAs and assisted in countless 1031 exchange consultations. We have also assisted in the acquisition of DST utilizing the 1031 process. Call with any questions you may have. DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

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NAMCOA® – Naples Asset Management Company®, LLC

Be aware of potential impact of “Boot” in a 1031 Exchange

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
February 17, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

Tax deferred 1031 Exchanges and Boot

When faced with selling an investment property besides the amount of proceeds to pick up at closing the investor may consider the taxes that may be due. Investors may utilize a tax deferred 1031 exchange for all or part of the transaction. If you take proceeds off the table, the proceeds are referenced as boot. In addition, if you are doing an exchange and do not replace the loan that was paid off (either with another loan or fresh cash) you will be liable for mortgage boot. Understanding your overall tax liability should be a starting point.

The Internal Revenue Code does not formally use the term “Boot”. It is used in discussing the tax implications of a 1031 Exchange. In searching for a potential meaning here is a reference. Boot is an old English term meaning “Something given in addition to.” “Boot received” is the money or fair market value of “Other Property” received by the taxpayer in an exchange.

Many consultants and investors agree that when done properly a 1031 exchange can provide a host of benefits to the investor today and in building an investment portfolio. The major benefits would be the deferral of capital gains as well as the deferral of recapture of depreciation.

There are situations where an investor believes they are executing a 1031 exchange but may fall short for a few reasons and end up owing money to the IRS.

When do you create Boot.

Cash boot.

You acquired your relinquished property for $400,000 and sell your relinquished property for $1,000,000. (For this example we will not attempt to account for any commission or cost of sale). If the replacement property is $800,000 and you collect a check for $200,000 that would be considered boot and taxes would be due. This is income and would be taxed at the taxpayer capital gain rates. It is extremely advisable to contact your CPA. It may become more involved in determining your exact tax responsibility based on other factors such as recapture of depreciation taken under what maybe referenced as a partial exchange.

There is also another situation where mortgage boot may be present.

You acquired your relinquished property for $400,000 and sell your relinquished property for $1,000,000. There is a balance of $200,000 on the relinquished property. (For this example we will not attempt to account for any commission or cost of sale). Once the mortgage is satisfied you have $800,000 in cash. If the replacement property is $800,000 and you pay cash for the property without a loan the $200,000 loan that was paid off would be subjected to what is known as mortgage boot (debt reduction) and taxes would be due. Again, it is extremely advisable to contact your CPA. There is another consideration on this example which we will cover later in this article under Delaware Statutory Trust reference.

Rule Compliance.

IRS rules for 1031 tax deferred exchange compliance are straightforward. Boot would be created in several scenarios. There are basically three main IRS rules or stipulation on being eligible or complying with the 1031 rules. That compliance would enable the exchanger to fully defer capital gains taxes.

The basic rules are:

The replacement property needs to meet or exceed the market value of the relinquished property.
The investor must use all the proceeds from the relinquished property to purchase the replacement property.
If there is a debt satisfied (mortgage) upon closing, then the same amount of debt must be replaced, or the investor can substitute additional cash into the exchange.

Utilizing the rules from above.

Meet or exceed market value. IF you are selling a property for $1,000,000 you must purchase a property for $1,000,000. There would be an offset for closing cost, commission and a few other items that would reduce the replacement price of the property.
Use all the proceeds. If you receive $1,000,000 in proceeds all the proceeds need to be used.
Replace debt. IF you are selling for $1,000,000 and have a loan paid off of $200,000 you need to have $200,000 in debt on the replacement property and use the additional $800,000 in proceeds towards the replacement purchase.

Exchange Guidance

Exchange guidance may be available from the Qualified Intermediary (QI). Many Qis assist investors with the required forms and adherence to the dates mandated for identification of the replacement properties. In addition the QI may also be able to provide some guidance on balancing the exchange if they understand the terms of the purchase. Technically this may fall outside their scope of services. When an investors submits the replacement list to the QI the entire market value for the replacement property is stated with out the breakout of cash (equity) invested and the debt component making up the full value. CPAs and Financial advisors who deal with 1031 exchanges on a regular basis may be better suited for balancing the exchange.

There will be Boot can I still exchange?

If you did not satisfy all the requirements for the IRS for a full deferral you can still enter into and execute an exchange. The 1031 tax deferred exchange is not an all or none strategy. Partial exchanges are possible.

Delaware Statutory Trust (DST) may assist with mortgage boot issues.

There are times in an investors life when they simply don’t want to apply for, sign for, or be financially responsible for another loan on the replacement property. Recently we assisted an investor with and interesting challenge. The exchange was rather large and started with the sale of an apartment property. The sale was for $6.1 million but conceptually can be utilized in a lot of situations. Upon the closing of the relinquished property the investor retained $300,000 to pay for personal items. This would be recognized as boot and taxes due. Taking boot occasionally serves a purpose especially when there are other financial needs. There was a loan paid off on the property of over $2M. The investor wanted an additional cash extracted from the exchange in the amount of $400,000. This created an issue with balancing the remaining cash and satisfying the replacement of debt. The solution was to create a diversified portfolio of DSTs with Non-recourse debt to the investor that balanced the total exchange. The investor was seeking a solution that would avoid signing for any debt responsibility. DST are all structured with non-recourse debt. The balancing exercise blended DSTs with a variety of loan to value property enabling the investors to avoid any potential taxes on mortgage boot. There would be taxes on the cash taken out of the transaction. In addition, we also balance the overall replacement market price of the relinquished property. One helpful addition to the solution was the investor’s CPA who we engaged with early on to fully understand the investor situation.

Final word

We welcome calls from investors and CPAs on the 1031 exchange process as well as how DSTs may simply the exchange process. If you are in the midst of selling your property and looking for a few suggestions, please contact us.

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Thank you.

NAMCOA® – Naples Asset Management Company®, LLC