We are scheduled to close on 5/25 on a duplex that we’re selling. The property is out of town - where we used to live. We’re doing a 1031 with the proceeds, and the buyers are purchasing the property with 1031 proceeds.
The people buying the property also own their own extablished construction company. They’re trying to use up all of the proceeds in their 1031, so we (foolishly) agreed to let them pay $10,000 more for the property and in return we’re to pay their construction company $10,000 for stuff their doing to the property. (They really are doing work finishing basements, etc.)
I have scoured web sites (even the IRS site) on 1031s, have receivied materials from probably 5 different companies who act as intermediaries. We selected a company and I got an overnight package from them which I just looked at today (was out of town). NOW, for the first time, it states that the $10,000 for improvements isn’t a deductable expense. So the way I read it, that $10,000 (which is basically a favor to them so THEY don’t have to pay taxes on that $$) is going to cost US $1500 in taxes…
Am I missing something here? Or is that accurate? Has anyone dealt with this? What would ANYONE recommend? I want to be fair to the buyers, but at the same time not shoot myself in the foot. My first call in the morning is to the title company to put this all on hold…what to do?
You say that your relinquished property is a duplex and that one side was your former residence. If the sale occurs no more than three years after you converted that unit to a rental, AND if you occupied the unit as your primary residence at least two years of the five years prior to sale, THEN the sale profit allocated to that unit should be tax free and excluded from the 1031 exchange umbrella.
The remaining unit can still participate in a 1031 exchange for the proceeds on the sale allocated to the investment unit Capital improvements you make to the unit prior to sale are adjustments to the basis. Repairs you make to the unit prior to sale are deductible expenses on your Schedule E.
There is such a thing as a construction exchange. I believe this exchange can also be used for improvements. To make it work, the buyer instructs his exchange agent to make certain repairs to the property with funds held in the exchange account. As long as the improvements are completed before the title transfers, the cost of the improvement is still under the exchange umbrella. No need to inflate the purchase price, because the buyer will be making the improvements rather than asking you to do it. If choosing to use his own construction company as a conduit for exchange funds is deemed to be taxable boot, then that is an issue for the buyer to address, but you would have no tax burden to contend with.
By the way, on the sale of investment property, depreciation recapture is paid first, then capital gains. So in your example, your $10K of taxable boot would be first applied to depreciation recapture at a 25% rate.
Did you close escrow on the 25th? Is it too late to change the terms of the deal? Did you live in one side of the Duplex or both?
The $10K is not taxable boot to you, it is merely an increase in the sales price at this point in time. It does however increase your deferred capital gain that will end up being taxable at some point in the future at what ever tax rate is in effect at that point in time. DaveT is also correct in that the gain is first applied to the depreciation recapture first and then to the capital gain, so at today’s tax rates you would be taxed at 25% for federal purposes and then what ever your state rate it for depreciation recapture.
The increase in the sales price does not help the buyer’s 1031 exchange either. The amount paid must be received as real property at the closing. If the IRS would find out that the price was increased by $10K and the actual construction was completed after the fact, they will collapse the transaction as a “step transaction” and tax the buyer’s $10K as boot. This does not affect you, only the buyer.
The $10K would ordinarily be an increase to your cost basis in the property if you were the party constructing the improvements to your property for your benefit. I would explore the possibility of adding it to your deferred cost basis in the new property. I’m not sure this is an option, but it is worth exploring. If there is a way to increase the deferred cost basis in your new property then the end result is an increase in the sales price and a corresponding increase in the cost basis that results in no change to the deferred capital gain amount and no increase in taxes to you.
We had lived there (on one side), but it’s been more than 5 years ago, so we can’t take advantage of the ‘2 of the last 5 years’ rule.
The people who bought the property actually have a separate construction company. They did actually do a great deal of work to the property and the work was completed prior to the close.
All of the money is going into a more expensive property, so it looks like everything is going to come out just fine.
I guess I was mainly shocked at how I just kept finding out more and more and more about the exchange rules as I went. I thought I had researched it totally and got a surprised thrown in my lap at the last minute. My accountant and a good investor/friend’s accountant have both assured me that everything is in order and we’re fine.
Having William Exeter on this site is HUGE asset. I know ALOT about 1031’s - he knows MORE. I cannot recommend him & his services strongly enough. He knows 1031 COLD - and that coming from a tax professional with accounting & legal background! William, I for one recognize the talent you bring to bear & appreciate it!
