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R. Klein, EA
R. Klein, EA, Enrolled Agent
Category: Tax
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Experience:  Over 20 Years experience
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Im selling some retail rental property to settle a divorce.

Resolved Question:

I'm selling some retail rental property to settle a divorce. The sale price is $750,000.00. I'm giving my ex $320.000.00 and paying the bank $300,000. That leaves $130,000.00.
Can I use the 1031 in kind exchange to use that money to purchase a convenience store building that I presently lease and avoid capital gains taxes?
Submitted: 1 year ago.
Category: Tax
Expert:  USTaxAdvising replied 1 year ago.

USTaxAdvising :

Hello, Thank you for using justanswer. I can assist you with your questions today.

USTaxAdvising :

Sorry to hear of your situation. But no, you won't qualify for the 1031 exchange because one of the criteria for the 1031 exchange is that you do not receive any cash. All the proceeds would have to be used to repurchase another like kind property in order to defer all the capital gains.

USTaxAdvising :

Having said that it would still be an option if to defer part of the gain. Meaning that you can receive cash you will just have to pay tax on the amount you receive. "If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property." - http://www.irs.gov/uac/Like-Kind-Exchanges-Under-IRC-Code-Section-1031

USTaxAdvising :

So no you cannot use the 1031 exchange to exclude 100% of the gain but you can use it exclude a portion of the gain (up to the extent that you actually invest in the replacement property) (cash received will be subject to tax)

USTaxAdvising :

I hope this provides the clarity you were looking for, please let me know if you have any further questions.

USTaxAdvising :

Best regards,

Customer:

By cash, you're saying the cash to pay my ex and the bank? The building I'm wanting to buy is rental property now so why wouldn't that be like kind?

Customer:

By cash, you're saying the money I would be giving my ex and the bank would be considered cash? The building I want to buy is rental property now so why wouldn't it be considered like kind?

Expert:  R. Klein, EA replied 1 year ago.
Thank you for contacting me about your Tax issue. I will work hard to help you understand the issue clearly.

Just as an amplification of the other expert's response, imagine the following case:

You purchase a rental building for $400K and sell it for $750K.

You took out a $300K loan, interest-only, to buy the original property, and you used $100K cash out of pocket for the remainder of the $400K purchase price.

From the sale proceeds, you pay back the bank $300K and put $300K in your bank account and have $150K left you want to invest in a new rental. Assume no closing costs and no depreciation taken or allowed since the property was raw land.

Based on the rules of a 1031 tax-free exchange, you would have an actual gain of (750-400) = 350K. However, you want to postpone as much gain as possible for tax purposes.

Since the total gain is $350K, but you are taking $300K out in cash, the maximum gain you can now postpone is $50K (350-300). The amount used to repay the bank loan is neither gain nor cash used outside of the transaction.

You would then have to pay tax on the $300K gain you took out as cash. Compare that to if you took the entire amount out and paid capital gains currently. Due to the size of the transaction, you will pay at least 15% and perhaps as much as 23.8% tax on the capital gain, so postponing tax on $50K saves you $7500 to $12000. Compare that savings to the cost of the exchange transaction itself to see if you are making much of a difference.

Since you did not indicate your cost basis in the rental or the amount of depreciation, I cannot determine whether you would have a gain that could be offset, or if the distribution of cash would exceed your entire gain. If the distribution of $320K is more than the entire gain, a 1031 tax-free exchange would have no value to you at all since there would be nothing to defer.

R. Klein, EA, Enrolled Agent
Category: Tax
Satisfied Customers: 2882
Experience: Over 20 Years experience
R. Klein, EA and 2 other Tax Specialists are ready to help you
Expert:  USTaxAdvising replied 1 year ago.

Hello,

 

Original expert here.

 

By cash, you're saying the cash to pay my ex and the bank? - yes exactly. The amount of cash proceeds you receive and give to your ex wife or the bank to pay down debt would not be used to reinvest in a like kind property, thus a portion of the proceeds received would be subject to taxation and not deferred through the 1031 exchange.

 

The building I'm wanting to buy is rental property now so why wouldn't that be like kind? - Yes it most likely would qualify.

 

The issue you have, as outlined above, is that all the cash proceeds must be used to qualify for 100% gain deferral should it exist. For example if you receive 100K in cash and give 50K to your ex wife and the bank to pay down debt, only 50% of any potential gain could be deferred. The remainder would be subject to taxation.

 

Make sense? Please let me know if you have any further questions.

 

Best regards,

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