1031 Exchange Loophole

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Real Estate Broker/Owner with Broker Owner (The Watz Team)
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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Rainer
38,274
Ray Perry
CPS Country Air - Kelseyville, CA
Realtor, CRS, GRI, e-PRO
Sounds a bit shady to me.
July 11, 2007 12:16 AM #1
Rainmaker
123,089
Vicki Watzlawick
Broker Owner (The Watz Team) - Algonquin, IL
Illinois Foreclosure Expert, The Watz Team
Thanks Ray,  I'm hoping a few loan offices check in on this one.
July 11, 2007 12:18 AM #2
Rainer
68,978
Todd Murphy
Fitts Agency - Tuscaloosa, AL
Vicki, he may use up his equity, but when he sells his property, the IRS is going to want to know what he bought it for, versus what he's sold it for.  You can't hide that.
July 11, 2007 06:45 AM #3
Rainmaker
123,089
Vicki Watzlawick
Broker Owner (The Watz Team) - Algonquin, IL
Illinois Foreclosure Expert, The Watz Team
Todd  He told me they never ask.  So when would they check on this?
July 11, 2007 08:39 AM #4
Rainer
68,978
Todd Murphy
Fitts Agency - Tuscaloosa, AL
The closing attorney reports the HUD settlement statement to the IRS.  They know.
July 11, 2007 09:00 AM #5
Anonymous
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 #6
Rainer
19,277
The TaxMan
Self Employed - Oakland, CA

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 #7
Rainmaker
123,089
Vicki Watzlawick
Broker Owner (The Watz Team) - Algonquin, IL
Illinois Foreclosure Expert, The Watz Team

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 #8
Anonymous
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 #9
Rainmaker
130,709
Bill Exeter
Exeter 1031 Exchange Services, LLC - San Diego, CA
1031 Tax-Deferred Exchange Expert

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 #10
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Rainmaker
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Vicki Watzlawick

Illinois Foreclosure Expert, The Watz Team
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