From First Tuesday
No limitations are placed on size, value or location of the properties involved in a §1031 reinvestment plan, as long as the properties are located within the United States.
For a partially qualified §1031 transaction, a portion (but not all) of the profit is exempt from taxes. Part of the profit on the sale is reported and taxed. While the entire remaining cost basis in the property sold is carried forward to the replacement property, only the portion of the profit untaxed is shifted to the replacement property. In a partial §1031, the investor withdraws some capital. Thus, capital withdrawn in a §1031 reinvestment plan includes:
- cash or a carryback note received by the investor at closing on the sale of the property sold, or by the receipt of unqualified property, called cash items or cash boot; and/or
- a lesser amount of mortgage debt assumed or originated to finance the acquisition of the replacement property than the amount of the mortgages on the property sold (and not offset by the investor’s contribution of cash), called net debt relief or mortgage boot. [IRC §1031(b)]
A delayed §1031 exchange results when the investor’s purchase escrow for the replacement property will close after the closing of the investor’s sales escrow.
To qualify the investor’s profit on their sale for the §1031 exemption in a delayed exchange, the investor needs to:
- avoid receipt of the net sales proceeds from the property sold when the sales escrow closes;
- identify the replacement property within 45 days after closing the sales escrow; and
- close the purchase escrow acquiring the replacement property(ies) within 180 days after the sales escrow closes. [See first tuesday Form 174]
Prior to closing the sales escrow, the buyer is requested to cooperate and establish a trust naming a trustee appointed by the investor, the reason for the provision calling for buyer cooperation in the sales agreements. The trustee will receive and hold the net sales proceeds from the property sold. The investor selects an unrelated person as the named §1031 trustee to administer the funds. Thus, the trust arrangement prevents the investor’s constructive receipt of the net sales proceeds on closing. The net sales proceeds of cash and any note carried back on the property sold by the investor are made payable by escrow to the §1031 trustee and delivered to the trustee on closing.
The §1031 trustee, under the trust agreement, impounds the cash funds in an interest-bearing trust account and collects installments on any carryback note.
Later, on the investor’s instruction, the §1031 trustee disburses the money and assigns any carryback paper used by the investor to fund the purchase of the replacement property.
To close out the §1031 reinvestment plan, the replacement property purchased is deeded directly to the investor.
Prices, and thus the equities and mortgages on properties sold and purchased in a 1031 reinvestment plan, rarely are of the same dollar amount. As a result, the investor purchasing replacement property which has an equity greater than the net sales proceeds from the property sold needs to contribute money (cash or execute a carryback note) or other property, collectively called cash boot. The process is called balancing the equities –– when an actual exchange of properties between owners takes place. Cash contributions come from savings or mortgage financing taken out on the property purchased, including executing carryback notes.
Cash boot received on the close of the escrow for the property sold, which cannot be offset on the purchase of a replacement property, includes:
- the receipt of cash proceeds from the investor’s mortgage refinancing of the property sold in preparation for its sale or exchange; or
- the investor’s receipt of some or all of the net sales proceeds from the property sold prior to acquiring the replacement property. [Revenue Regulations §1.1031(k)-1(f)]
Mortgage debt relief on the closing of the sales escrow may be offset on the acquisition of the replacement property on a delayed 1031 transaction, unlike cash boot which cannot be offset if received on closing the sale in a delayed exchange.