Discussion:1031 exchange with replacement property financing

FMV relinquished property = 2,192,400

Exchange expenses = 95,156

Cash received at closing = 50,174

Mortgage payoff at closing = 74,159

FMV replacement property = 1,983,463

Exchange expenses = 3,001

New loan to purchase the replacement property = 505,000

Does the financing of the replacement property = boot? I am finding conflicting guidance on this. There was seller-financing on the relinquished property so my client did not receive the excess funds in cash.

Any thoughts?

(if you choose to purchase, drop me an email and I can refer you so you can get a discount)

Was this a deferred (3-party) exchange?

How much money was transferred through the QI?

You said there was seller financing. How much of the sales price did your client finance?

Was the new loan on the replacement property taken out at closing or did this happen after the fact?

How much cash did your client get out of the replacement escrow?

I have a hunch your client has a big pile of boot.

I have seen you post on many of the 1031 discussions and you seem to be quite knowledgable in this area. I would really appreciate some insight as this is a big client and we have a big realized gain at stake.

This was a deferred exchange.

There were 2 properties given up in the exchange, both were seller-carry for a combined total of 1,979,500. The QI is the note-holder and has been receiving the payments.

My client obtained a line of credit to provide the funding for the replacement property (substitute for equity in notes). She transferred 500,000 to the QI to purchase land. She then used 978,463 from the line of credit to construct a house on the land. She bought a commercial property for 175,000 (seller-financed) and a condo for 330,000 (bank financed).

The new loans (not the line of credit) were included in the closings of the replacement property. My client did not get any cash out of the repaclement escrow.

Thoughts???

The QI is the note-holder and has been receiving the payments. See details above. I think we are ok on the seller-carry???

I think this is where I run into a snag. It appears to me that the QI will be left with funds that were not reinvested. That is why I am concerned about the 505,000 of new loans.

I am afraid the QI may not have executed this exchange properly.

Bad News: As Taxteck stated above, the $1.9+ seller carryback is boot and gain will be recognized under the Installment Sale rules. Unless your client's basis in the relinquished property is < $220K, then your client received no real benefit from structuring this as an exchange.

Any chance that line of credit was obtained by the QI as the agent for your client? Or does that line fully belong to your client? If it was obtained by the QI and the QI will be using a portion of the balloon payment to pay it off, then maybe there is some relief. But that would require some research, as I have never seen this type of transaction. Especially past the 180 day exchange period.

BTW, $978K to construct a house? Smells like personal use property to me. Your client may not even have a qualified exchange in the first place.

Riley2 & I do not always see eye to eye on exchanges. You should try to get his point of view on this transaction, too.

I understood that you could prevent the seller carryback from being classified as boot if the QI takes the note into the exchange account and the exchangor later replaces the note with cash. Boot paid out (the note) should be offset by cash boot paid in. I really don't understand why the QI is holding the note until payoff, this doesn't appear to be necessary to me.

The only document I have on the line of credit is a loan history from the bank which does have my client's name on it. I am not sure about any of the underlying documents. I think I need to follow-up on this.

The worksheets that I have used all end up with the new loans as boot and so does Lacerte, could they be wrong?

The newly constructed home is not a personal residence. It is a "spec house" that my client will not be living in.

Hopefully Riley2 will see this discussion, if not I will try sending him a message.

Was the $500K land purchase assigned by the QI to your client before or after your client spent the $978K in construction costs? Did your client also deposit this money (the $978K) with the QI, and then the QI paid the construction bills? Was the construction completed before the 180 days? If your client and the QI did everything right with this, then this should offset the boot from the installment note, too.

I think best case scenario is that your client will have $548,777 of boot. ($50,741 cash out from sale + $1,979,500 installment note - $500,000 cash in for purchase of land - $978,463 construction costs [this issue still not resolved] - $3,001 replacement property expenses).

This same result can also be achieved using the "top down" equity balancing calculation method such as the Tax Tools Exchange Worksheet. Although, you should always proof this worksheet using the "bottom up" boot calculation method as I did in the prior paragraph. The equity calculation method has a flaw that I have spoke about many times.

Editorial note: This is a great textbook example of an advanced exchange transaction. I think this has everything in it.

The construction was completed before the 180 days.

The combined basis of the relinquished properties is only 137886.

Yet another instance where it would be quite handy to turn back the hands of time :)

she may be a realtor full time, but she is a builder part time

now that I have made that arguable statement, there have been many discussions here about whether 'flipping' is a business or a capital gain transaction. You might want to read those.

do note that his article link is 13 years old, and is of interest only. it is not authoritative

Back to the spec house - My client is not thrilled with the idea of renting the property. If she held the property for an extended period of time, could I ever make the argument that it is investment property?

I talked with QI this afternoon, he said the line of credit technically belongs to him and that my client was only on the loan as a guarantor. He took the advances and deposited them into her account and then she wrote the checks for the construction. He is supposed to send me all the loan documents. He claimed he has done several of these "mirroring" notes and that they have worked fine.

Riley2 - I have been reading a lot of 1031 discussions the last few weeks. You seem to be quite knowledgeable in this area, do you see a problem with the way the seller carry-back was handled? What are your thoughts on the home that was constructed?