Patricia A. Flowers, CES®

When deciding whether to exchange, a taxpayer should review their basis in the investment property, how much in improvements they have made over the years that can be added to that basis, and how much the property is currently valued at if they decide to sell. Knowing your gain and what you will pay in capital gains tax at the state and federal level will allow you to make an informed decision as to whether you are willing to have a straight sale, receive the proceeds and pay the taxes due, OR to structure your sale as a 1031 Exchange to defer the 25-30% (or more) in taxes, using the taxes saved as equity to increase the investment in other real property.

Yes! Under the 1031 Tax Code, the main premise of an Improvement/Build-to-Suit (BTS) Exchange is that once the taxpayer takes title to the Replacement Property, the value of that exchange property is final, and used for reporting at tax time. Therefore if the exchanger is buying down in value but wants to make immediate physical improvements to the new property and have those construction funds count in the reported Exchange dollar values, IPX1031 as the Qualified Intermediary (QI) must become the Exchange Accommodation Titleholder (EAT), temporarily taking title to the new property while improvements are made, for a maximum of 180 days. This is referred to as a “parking” transaction. An Improvement Exchange is well worth it for investment property owners who will incur high capital gains/depreciation recapture tax upon their investment property sale, benefiting from the increase in value of the new Replacement Property before taking title. Planning ahead is key, and each taxpayer scenario is different. IPX1031 is available to suggest the best structure and work with you through the entire process.

Paying off a mortgage at the sale closing does not reduce the value of the Replacement Property needed to be purchased to be fully deferred.  Since the gain from an investment property sale is calculated by subtracting your adjusted basis from the net sale price, the gain is actually the same whether you have debt to pay off at the sale closing or not.  That is why the IRC §1031 regulations state to be 100% tax deferred you must use all the sale proceeds AND match the debt paid off with new cash and/or new debt in the new replacement purchase.

The great benefit of participating in a 1031 Exchange is that the taxpayer can sell and buy investment real estate anywhere in the U.S. and defer up to 100% of the state and federal capital gains tax otherwise due from sale. Many investors sell in one state and purchase in another. Later at a time when the taxpayer decides to sell their investment property outright, the capital gains taxes are due. In most cases taxes would be due to the state in which the final property sold is located. However some states including Massachusetts have a “claw back” provision (state regulation MA 830 CMR 62.5A.1 (3)(d) “Non-Resident Income Tax” Section). In this case the claw back allows Massachusetts to collect the capital gains tax on the previous appreciation gained during the Mass. property ownership that was previously deferred through the tax exchange. They refer to this as “MA sourced income.” Taxpayers should speak to their tax advisor to understand how this claw back regulation may impact them. Remember, as long as you continue to exchange from one investment property to another, the Massachusetts capital gains tax will remain deferred… you get to keep that equity working for you!

Often investment property sellers want to “pay themselves back” at the sale closing for their initial down payment and/or any personal funds they had used to make improvements over the years of ownership.  Unfortunately, any cash received at the sale closing, for any reason, will be considered “Boot” and taxed up to the amount of realized gain from the property sale.  It should be noted that receiving some cash at closing will not automatically disqualify the entire sale from the tax deferral.  It is possible to have a partial tax payment due and partial tax savings, referred to as a “Partial Exchange”.