1031 Exchange Loophole

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Real Estate Team Leader with Broker Team Lead (The Watz Team) Century 21 Affiliated
I was a little surprised today when I was discussing a 1031 Exchange with an Investor client of mine, and he told me that he didn't need to do a 1031 Exchange.  He said his loan officer allows him to refinance his place and told him to use up the equity loan so when the attorney calls for a payoff, his property is showing no or little profit.  Is this really legal?  Can't the IRS go back a year or something to see if a refinance has been done?
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Anonymous #6
Anonymous
marga shefman
Profit and equity are two totally different things.  Capital gain tax is based on profit.  Euity is reduced by refinancing which has nothing to do with profit.
July 12, 2007 08:23 AM
Rainer
19,274
The TaxMan
Self Employed

I don't think the law is very clear on this one...

Sounds like a great idea, just refinance before 1031 and you can avoid a lot of boot and tax.

But it sounds too good to be true, I'm sure the IRS would come after you.

I would wait at least 2 years after refinancing before doing an exchange. 

July 12, 2007 03:45 PM
Rainmaker
121,511
Vicki Watzlawick
Illinois Foreclosure Expert, The Watz Team
Broker Team Lead (The Watz Team) Century 21 Affiliated

Todd   I know they fill out green sheets for the IRS, but I don't think they submit the HUDs to the IRS.  I'll ask one of my attornies.

Thanks Marga

Scott  Theres no need to do an exchange is what he is saying. 

July 12, 2007 09:58 PM
Anonymous #9
Anonymous
Chris Princis
I am a QI in the 1031 Exchange process.  You want to be VERY careful on these issues.  It is a no no to refinance BEFORE the exchange.  Let me know if there are any further questions.
August 10, 2007 04:48 AM
Rainmaker
129,423
Bill Exeter
1031 Tax-Deferred Exchange Expert
Exeter 1031 Exchange Services, LLC

The loan officer, the client and some of those who have posted here are confusing equity in the property with the capital gain calculation.

Equity is the amount of net cash that you would end up with after selling the property, paying the closing costs, and paying the mortgage off.  It has absolutely no bearing on the capital gain computation. 

The capital gain (or profit) is computed by taking the gross sales price and subtracting the closing costs, the amount originally paid for the property and any capitalized improvements that have been made to the property. 

You can refinance and pull your equity out anytime you like, but it will not change your cost basis in the property.  The IRS will recharacterize the transaction as a sale, will assess interest from the date your client should have paid the taxes, and will more than likely assess a 25% failure to report and a 25% failure to pay taxes penalties as well. 

I would be happy to to a join conference call with you and your client to help them understand this if you like.

November 10, 2007 12:41 PM
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Rainmaker
121,511

Vicki Watzlawick

Illinois Foreclosure Expert, The Watz Team
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Additional Information

Illinois REO Realtor 9 year Certified Foreclosure and Shortsale expert for Illinois foreclosures. Co-author "Should I Short Sale My Home?" www.vickisdreamhomes.com