Can Excess In 1031 Be Used For Property Improvements

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I am doing a 1031 exchange. The property I am purchasing is less than I am selling so I will have excess $money that will be taxed. Does anyone know if I can I keep the excess left over from the exchange with the intermediary and draw it down during the 180 days after the transfer to make improvements to the property I am purchasing?

Comments(10)

  • DaveT12th October, 2003

    apctjb,

    Just to clarify the timeline. Your 180 clock starts on the day you go to settlement on your relinquished property.

    The exchange is over when you fail to identify a replacement property within the 45 day identification period, or,
    acquire a replacement property within the 180 day exchange period, or,
    allow the 180 day exchange period to expire without acquiring a replacement property, or,
    file your tax return for the year that includes the sale of the relinquished property. If you receive the replacement property after you file your tax return for the year that includes the sale of the relinquished property, the exchange is not allowed.
    Since all of the proceeds of the sale of the relinquished property must be applied to the acquisition of the replacement property, there would not be any "excess" unless you owned your relinquished property free and clear.

    If you really have money left in the exchange escrow account because the total of the purchase price, settlement costs, and exchange escrow fees is less than the balance of the account, then you have taxable boot.

    To avoid this situation, you will have to empower your exchange agent to take title to the replacement property directly from the seller, make all the necessary renovations, then convey title to you when the work is done -- all within the exchange timeline. In this case, if the purchase and renovation uses up all the money in the escrow account, you avoid taxable boot. Be prepared, for this will likely increase your exchange fees.

  • CarolTheGreat12th October, 2003

    DaveT
    It sounds like you are an expert. Im confused about sometihng that you probably understand. I read section 1031 and I think it says that the replacement property must have greater value than the replaced property, not that all equity in the replaced property go into the replacement property. In other words that if you have 100k equity in a 200k property, moving that 100k into a 150k property doesnt solve your problem. I hope Im wrong
    Carol

  • DaveT12th October, 2003

    Carol,

    Let's take a look at the language again.

    Sec. 1031. - Exchange of property held for productive use or investment (a) Nonrecognition of gain or loss from exchanges solely in kind
    (1) In general

    No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
    (b) Gain from exchanges not solely in kind

    If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property. Subparagraph (b) is the one that governs the discussion here. If you walk away from the exchange with any money in your pocket from the proceeds of the sale of the relinquished property, then you have received property "not solely in kind". Cash is not "like-kind" property and cash received from the proceeds of the exchange is taxable. By inference, to avoid receiving taxable proceeds from the exchange, all of the exchange proceeds must be reinvested in the acquisition of the replacement property.

  • apctjb12th October, 2003

    DaveT;

    Thanks for the response. In this case the property is owned free and clear and has a value approx $30K higher than the property I am exchanging into. The closing on the property I am selling occurs 5 days prior to the property I am purchasing. I have been advised that I will pay tax on the $30K remainder but the amount that goes to purchase the replacement property will be deferred. My question is could the $30K be held by the exchange agent and used to pay for improvement to the replacement property so that the tax on the $30K could also be deffered. Perhaps the better way would have been to have the seller make the improvements and raise the purchase price but its too late for that now. Thanks

  • CarolTheGreat12th October, 2003

    I'm eager to see DaveT's answer but I think the answer is yes. You are buying from the transfer agent and I believe he can upgrade the property before he sells it to you. The improvements don't even need to be done bofore the 180 day time limit as I understand from paragraph 1031.(k)-1(e)"... will not fail ... merely because ... not in existence...".
    What is essential is that the cash never touch your account. Right Dave?
    Of course you can also buy a second property - some land for example, or a rental house.

  • DaveT12th October, 2003

    Quote:My question is could the $30K be held by the exchange agent and used to pay for improvement to the replacement property so that the tax on the $30K could also be deffered.I tried to answer this question in my earlier post. As Carol points out, you have to empower your qualified intermediary to take title to the property, and complete the rehabilitation. When the qualified intermediary then conveys title to you, the exchange is closed.

    This exchange is sometimes called a construction exchange. Even though you are not dealing with new construction, the exchange mechanism is the same for the improvements you want to accomplish.

    The exchange is closed when you take title to the replacement property. Any money left in the exchange escrow account at that time is disbursed to you and becomes taxable boot.

    Let me clarify Carol's point about the status of the improvements at the end of the exchange period. It is true that the entire schedule of improvements do not have to be competed before the property title is conveyed to the exchangor and the exchange is closed.

    Let's say that you did enter a construction exchange, your exchange escrow account ran out of money before all the scheduled improvements were completed, and you are 178 days into your exchange timeline. At this point, your qualified intermediary will deed the property to you to close the exchange within the 180 day exchange window. For the exchange to be tax deferred, however, the "as is" appraised value of the replacement property must still be greater than the value of the relinquished property, even though you have not completed all the improvements.

    Buying a second replacement property under the exchange umbrella will also allow you to defer the capital gains tax on your "excess" $30K. You must identify the property to be purchased in writing within the 45 day identification period following the sale of your relinquished property and complete the acquisition within 180 days following the sale of the relinquished property.

    Thank you, Carol, for suggesting a much simpler solution.

  • apctjb12th October, 2003

    I think I have it. Thanks to both Dave and Carol for help on this!

  • GeneralSnafu14th October, 2003

    [quote]
    On 2003-10-12 12:28, DaveT wrote:
    apctjb,

    <snip>
    Since all of the proceeds of the sale of the relinquished property must be applied to the acquisition of the replacement property, there would not be any "excess" unless you owned your relinquished property free and clear.

    <snip>

    Are you saying that, if I were to borrow enough against the property before the sale of the relinquished property, I could do the 1031 exchange routine, and not have any *boot*? Then I could put the borrowed money into improving the newly acquired property thus raising my basis in it? Will this work?

  • apctjb14th October, 2003

    This is a case where I own the property free and clear and am selling it for more than the cost of the replacement property. The property I am trading into needs work and I was hoping to use the "excess" to make the repairs prior to having the exchange agent transfer title to avoid taxes on the excess amount.

  • DaveT14th October, 2003

    Quote:Are you saying that, if I were to borrow enough against the property before the sale of the relinquished property, I could do the 1031 exchange routine, and not have any *boot*? Then I could put the borrowed money into improving the newly acquired property thus raising my basis in it? Will this work? GeneralSnafu,

    Your basis in the replacement property is not affected by the size of the mortgage loan you had on the relinquished property.

    Yes, you can refinance your investment property to take tax free cash out of your equity. This property is still eligible to participate in a 1031 like-kind exchange.

    Alternatively, you can refinance the replacement property after the exchange to also take tax free cash out of your equity.

    You potentially have cash boot when the replacement property costs less than the sale price of the relinquished property. The cash from the sale of the relinquished property that is not applied to the exchange is taxable boot.

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