Why All 1031 Exchanges Are Not Tax-Free —- Here’s How to Avoid an Unhappy Surprise

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If your plan is to complete a 1031 exchange that results in no tax being paid, then you need to understand the target value of the replacement property you must acquire.  This may sound simple, but in practice, it trips up many investors—leaving them with tax to pay. Before we delve deeper into how to calculate what we refer to as the minimum target value (MTV) of the replacement property needed for total gain deferral, let’s review a couple of the basic exchange rules.

To accomplish 100% gain deferral in a 1031 exchange, you must buy property that is equal to or greater in value than what you sold, and you must invest an amount of equity that is the same or greater when you buy as well. Simply put, you must buy replacement property that costs the same or more than the relinquished property and you must use all of the cash proceeds from the sale in your purchase.  

For example, if you sell a property for $400,000 and buy a replacement for $400,000 or more, while using all the proceeds from the sale in the purchase, then, in general, you will have a tax-free transaction.  Seems simple enough, but that is not always the case.  Why?  To understand, we need to look a little closer at certain details in the transaction.  Specifically, you must make sure that earnest money and non-allowable 1031 closing expenses are handled correctly.


Earnest Money

Earnest money is a good faith deposit paid by the buyer to the seller or seller’s agent, that is credited against the purchase price at the closing.  But in some sales, the seller holds the earnest money— which can create a taxable issue if not handled correctly.  Although the seller can hold earnest money in a 1031 exchange, they may not be in possession of the earnest money after the relinquished closing is completed. If they are, then those funds will be taxable.

Thankfully, there is an easy solution.  The seller just needs to forward the earnest money to the closer at or before the closing.  Once the closing is complete, the earnest money becomes part of the cash proceeds that are forwarded to the 1031 account.  Alternatively, the seller could wire the earnest money funds to the 1031 account, but timing challenges and potential earnest money disputes make this approach much more problematic. Best to forward the earnest money to the closer prior to closing.


Nonallowable 1031 Closing Expenses

Certain closing expenses, and how they appear on the closing statement, can create potential taxable consequences—both when selling the relinquished property and when purchasing the replacement property.  To avoid unnecessary problems, let’s look at how to handle any thorny issues on both sides.

What to Avoid on the Relinquished Sale

In a typical closing, all the expenses that are attributable to the seller are recorded on the closing statement and shown as debits to the Seller.  They are totaled and subtracted from what would otherwise be the cash proceeds they would receive.  (In a 1031, these net proceeds are then sent to a 1031 account set up by the Qualified Intermediary for the exchanger.)  If those proceeds are reduced by nonallowable 1031 expenses, then the IRS will treat the funds used to pay those expenses as first being distributed to the Seller.   This will trigger tax due on those amounts. 

So what’s a viable solution?  When you are the seller, mishandling of prorated rents and the transfer of security deposits tend to cause the most problems.  It is cleaner and safer to forward the funds for these two items to the closer, who will then give the credit to the buyer.  This eliminates the deduction of these items from the cash proceeds- and keeps any tax related from being due.  

For example, Jenny has decided to do a 1031 exchange and is selling her relinquished property for $500,000.  There is an outstanding loan of $200,000 that must be paid off at closing.  The property is closing mid-month, and there is a tenant in place.  The rent proration is $1,500 and the security deposit is $3,000.  Other closing costs amount to $20,000.  Jenny is holding $5,000 earnest money from the buyer.

Jenny can properly handle and neutralize any taxes that might become due on the rent proration, security deposit and earnest money by wiring $9,500 at or before the closing to the closer.  The cash proceeds held by her qualified intermediary will then be $280,000 (calculated as the $500,000 price less both the $20,000 closing costs and the $200,000 loan payoff). 


What to Avoid on a Replacement Purchase

Let’s continue with our example and see what minimum target value is needed to defer all tax due.  In Jenny’s situation, you simply add the cash proceeds going to the 1031 account of $280,000 to the loan payoff of $200,000  and arrive at a minimum target of $480,000.  (Please note there may be some exceptions based on the intricacies of a given transaction.)

In order to truly have a tax-free exchange, Jenny needs to buy replacement property that costs $480,000 or more and use all $280,000 that is in the 1031 account. An item that can derail Jenny, who will probably be getting a loan to purchase the property, are the loan costs— which can trigger tax in a 1031 as they are considered nonallowable expenses.  If she buys property that costs more than $480,000,  she can stipulate that the loan costs were paid from extra funds borrowed from the bank (defined as being any loan amount greater than the $200,000 that was paid off at the relinquished property sale).  If the cost of the replacement property is below or equal to $480,000, then the loan costs amount will be taxable.

To illustrate, let’s say that Jenny has decided to buy a replacement property for a price of $600,000 using all of the funds in the 1031 account as the down payment.  She is responsible for $10,000 of buyer closing expenses, including $5,000 of loan fees for a new $330,000 loan.  With the assistance of her qualified intermediary, she works with the closer to insert a clause on the closing statement indicating that the $10,000 of buyer closing costs are being funded from the loan.  Because her replacement property costs $120,000 more than her relinquished property,  her closing expenses of $10,000 should not trigger any tax.

For more information on keeping your exchange tax-free, please visit How to Defer All the Tax.  Having to unexpectedly pay some tax is never a pleasant surprise. To review a more comprehensive list of what expenses cause issues, please see- Non Allowable Exchange Expenses)


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