1031 exhange question

[Art]

For a 1031 exchange is it always required that the properties exchanged be of equal FMV? Ie cash or “other property” would need to given (received) if the “qualified properties” are not of equal value? Can the 1031 exchange still go through? Would the difference be considered a gift? Bargain sale? Or do the above only apply if related parties are involved?

I raise these questions because I am dealing with a proposed exchange of farm parcels between related parties where one of the party’s personal residence is located on the farm parcel his is wanting to exchange. My understanding is that the personal residence is not qualifying property. Correct? The FMV of the farm parcel and residence is much larger than the FMV of the other farm parcel. Could the exchange still be reported on Form 8824? And a gift tax return filed for the excess value given up?

Alternatively, could (should) gift tax return be filed first for the difference in FMV and then proceed with the 1031 exchange?

[jainen]

>> is it always required that the properties exchanged be of equal FMV? <<

Section 1031 is extremely flexible. You can "trade up" by getting a loan or adding other money or property, and you can "trade down" by taking out cash, loan, or property boot for any purpose whatsoever. A common variation is to trade into multiple properties that can be sold off separately. Form 8824 is a horribly difficult worksheet, but it will strip out all the non-qualifying parts of the transaction and still give tax deferral.

As to whether you can gift a part of the taxable exchange values--the answer is yes, but it is a complex process that requires an expert's personal guidance. Such an advisor might be an EXPERIENCED Realtor, an attorney or accountant who SPECIALIZES in real estate taxation, or (for more general answers only) the Qualified Intermediary.

Although the portion of the property allocated to a personal residence is not of like kind for the transferor, it can still be 1031 property for the new owner if he will use it as rental, business, or investment property.

[joelgilb]

I was just about to answer this myself, but Jainen with his usual expertise did a superb job just minutes before I drafted a reply, therefore

as Stan Lee says

Nuff said

Oh and yes I am finally back!

[Art]

>> is it always required that the properties exchanged be of equal FMV? <<

Section 1031 is extremely flexible. You can "trade up" by getting a loan or adding other money or property, and you can "trade down" by taking out cash, loan, or property boot for any purpose whatsoever. A common variation is to trade into multiple properties that can be sold off separately. Form 8824 is a horribly difficult worksheet, but it will strip out all the non-qualifying parts of the transaction and still give tax deferral.

As to whether you can gift a part of the taxable exchange values--the answer is yes, but it is a complex process that requires an expert's personal guidance. Such an advisor might be an EXPERIENCED Realtor, an attorney or accountant who SPECIALIZES in real estate taxation, or (for more general answers only) the Qualified Intermediary.

Although the portion of the property allocated to a personal residence is not of like kind for the transferor, it can still be 1031 property for the new owner if he will use it as rental, business, or investment property.

Jainen

Thanks for your reply. I may be looking at this all wrong but I am still concerned about treating this as a single transaction to be reported on the 8824. Here are the specific facts:

Oray will transfer title to approx 120 acres of timber & hill ground with FMV of $ 240,000 (cost basis of $ 50,000) and the personal residence with FMV of $ 130,000 (cost basis of $40,000) in exchange for Ardel’s 40+ acres of prime farm ground with FMV of $ 185,000 (cost basis of $ 60,000) plus the $ 30,000 cash payment from Ardel. There are no mortgages or encumbrances on any of the properties.

When I work this through on the 8824 I find that Oray will have a recognized gain of $ 90,000 on line 14 Part III for his residence. Flowing down to line 19 he would normally have a realized gain of $ 165,000 ($ 30,000 cash + $ 185,000 FMV of Ardel’s parcel less Oray’s basis of $ 50,000). Under the Sec 121 exclusion and the instructions on page 3 of the 8824 it would appear that he can only exclude $ 90,000 (FMV 130,000 less $ 40,000) and the remainder of $ 30,000 would be taxable to him. Correct?

Ardel should be OK IF we are successful in treating the residence as investment property to him. His intention is to fix up the house and rent it to his granddaughter for a year or so and then she would purchase it at the supposed FMV at that time. I am concerned that we may not prevail if the IRS would examine the transaction. The result may be $ 130,000 of taxable gain to Ardel.

Alternatively, we could use the gifting approach you mentioned with a slight twist as follows:

1. Have Oray sell approx 23% interest in the home to Ardel for the $ 30,000

2. Have Oray gift the remaining 77% interest in the home to Ardel

3. Have Oray gift approx 23% interest in his farm parcel to Ardel.

4. Transfer the remaining portion of Oray’s parcel to Ardel in exchange for Ardel’s parcel. At that time these should be =FMV.

I assume all of these steps could be included in a single legal document, but perhaps it may be better to separate them.

This would avoid all income taxes. Oray would have to use about $ 155,000 of his gift/lifetime exclusion.

What specific problems do you see with this approach?

Thanks for you time & input

[jainen]

>>What specific problems do you see with this approach?<<

The main problem I see in your description is the total absence of the expert's personal guidance that I mentioned.

[Art]

>>What specific problems do you see with this approach?<<

The main problem I see in your description is the total absence of the expert's personal guidance that I mentioned.

Jainen

Sorry, I should have stated more clearly that I was wanting a response to my conclusion that Oray would have a recognized gain to report of $ 30,000 if this were treated as a single transaction as first outlined above.

I agree, the sale, then gift approcach is more complex and I would be seeking advice from an experienced real estate professional or attorney who specialzes in real estate law. It would appear to avoid the income tax problem to Oray and treat the residence in a separate transaction. Also, the 2 year waiting period for related party transactions in a 1031 exchange might be avoided?

[jainen]

>>Oray would have a recognized gain to report of $ 30,000<<

In most cases the tax code restricts transactions that are primarily motivated by tax avoidance. Section 1031 is a remarkable exception in that tax avoidance is the ONLY motivation.

It seems to me that Oray and Ardel have substantial other reasons for this trade, including providing permanent housing for a family member, and may do it regardless of the tax effect. You sound comfortable with the numbers, but truly they can only be evaluated in the context of the personal goals.

For example, if Oray wants to maximize Section 121 the tax-free exchange may interfere. He is trading $370,000 property for $215,000 cash & property. Since the house is 1/3 of the value, about $75,000 of the acquisition value must be allocated to the personal side, a gain of only $25,000, not $90,000. Meanwhile, the large gift element refutes the investment purposes necessary for a successful 1031 exchange.

The role of an attorney is not simply to fill out a form (and by the way, none would ever agree to set this up as "a single legal document"). To get this right, you need your client's attorney BEFORE you decide how to do it.