Hold Open Title Policy Can Benefit your 1031 Exchange

What is a Hold Open?
A Hold Open is a title insurance term used for real estate transactions where the title company that insures the initial sale agrees to insure another sale of the same property within 24 months of the original sale. They are used in reverse 1031 exchanges to avoid the cost of two separate policies. Investors might also use them in a "flip" transaction.

There are three parties involved in a completed Hold Open transaction: the original seller, the middle buyer (the person requesting the Hold Open or, in the case of a reverse exchange, your Exchange Accommodation Titleholder or EAT), and the final purchaser (the exchanging client. Hold Opens are often associated with reverse 1031 exchanges and fixer-upper properties, but this is not a requirement for a buyer to request a Hold Open. Investment properties can be held open from one sale to the next and Hold Opens are also available for short-term owners who simply know they will be selling the property within two years.

Benefits of a Hold Open
A Hold Open ultimately saves money for the buyer in a 1031 exchange. Since the buyer knows that the purchased property will be resold within two years, the title company can hold the file open for the resale at a fraction of the cost the buyer would have paid — even with a discounted reissue rate — in title insurance premiums.

The process works like this: The original seller pays the applicable title insurance premium for the initial sale to insure the middle buyer. The middle buyer then pays only a small percentage (depending on the underwriter) of the full basic premium charge in order for the title company to keep the file open, and no title insurance policy is issued at this time. In the case of a reverse exchange, the client pays all closing costs associated with the initial purchase so they ultimately save title cost on the subsequent exchange.

When the middle buyer (EAT) sells the property (back to the exchanging client), they pay the difference in premiums between their purchase price and the selling price on the second half of the Hold Open. A title policy is issued only to the final purchaser.

For example, a Denver residential property purchased for $250,000 would have a full premium of $1,265. The buyer (via the EAT) would pay an additional Hold Open fee of $126 to keep the file open. Upon the sale of the relinquished property in the exchange, the EAT sells the house back to the taxpayer for the same price. While this second sale would normally trigger the need for new title insurance (costing another $771 at the standard 50% reissue rate), the up-front, 10% payment of the Hold Open policy would result in no additional title insurance premium.

In the case of a fix and flip, hopefully, the property was sold for more. Let's say it was subsequently cleaned up and sold for $300,000. In this case, the seller would pay the difference in premiums, which would be $92. His total title charge would be $218 ($126 for the Hold Open and $92 for the increased coverage over the original $250,000 purchase), saving $553 over the $771 he would have paid if he had simply used a standard 50% reissue rate.

Conditions for a Hold Open
A property is eligible for Hold Open status only if the following conditions are met:

• A commitment to insure the final purchaser is issued after recording the initial conveyance to the middle buyer. This is in lieu of a policy of title insurance to the middle buyer, or EAT. Any adverse matters that are recorded or become known to the title company must be satisfied before the policy is issued.

• There must be a single resale transaction of the exact property as reflected on both the original commitment to the middle buyer (EAT) and the final policy to the final purchaser (the exchanging party). For example, the purchase of a duplex must be sold as a duplex, not sold as two separate units in the final conveyance.

• The middle buyer (the exchanging party's EAT) must sign an affidavit acknowledging that he is aware the property must be sold within two years or the Hold Open charge will be forfeited and the policy issued to the middle buyer.

• Both transactions must be insured through the same title company. The final purchase for the transaction initially held at one title company cannot be insured by another title company.

Property Value Increases
The Hold Open charge is based upon full value of the real estate or interest at time of the initial conveyance, with an additional charge of 10–25% (depending on the underwriter) of the basic premium based on the full value of the real estate or interest.

Upon closing of the resale within two years, the owner’s title policy will be issued to the final purchaser without additional cost. If there is an increase in the liability between the initial conveyance and the ultimate sale, a charge will be made based on the difference between the two liabilities calculated at the applicable schedule of rates.

Additional stipulations
The Hold Open is available only one time per transaction. If the resale to the final purchase is not recorded within 24 months of the date of the original sale, the policy of title insurance will be issued insuring the purchaser in the initial
sale in the amount originally committed. The Hold Open charge will be forfeited.

A potential drawback of the Hold Open procedure is that the middle buyer is not insured for any warranties of title that may be given in the deed to the final purchaser, since no owner’s policy is issued to the middle buyer.

Kyle Snyder of Land Title Guarantee Company has graciously provided much of the above information. If you have questions about Hold Open title policies, give Kyle a call at 303-393-4945. For your reverse exchange needs, please contact us at 888-367-1031.

The Rules of Boot in a 1031 Exchange

"Boot" is a term that you won't find in the Internal Revenue Code. But, if you talk to your accounting professional, you might find it is something he or she uses when discussing the tax consequences of a Section 1031 tax-deferred exchange. I use this short comparison in some of the courses we teach to describe boot..."two cowboys meet out on the range and decide to trade horses. One horse is worth more than the other, so the cowboy with the lesser valued horse, throws in his six shooter "to boot" in the trading of horses.

In modern times, Boot is basically any money or the fair market value of any non-like kind or "other property" received in an exchange. When talking about money, in this context, it should be understood that this includes cash or any cash equivalents - including any debt or obligation the taxpayer assumed by the other party or liabilities to which the property exchanged by the taxpayer is subjected. "Other property" is property that is not like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or "non-qualified property." "Other property" also includes such things as a promissory note received from a buyer (Seller Financing).

Any boot received is taxable (to the extent of exchange gain realized). This is fine when a selling taxpayer desires some cash - and is willing to pay some taxes. Otherwise, boot should be avoided to fully defer the gain in a 1031 Exchange. Boot can sometimes inadvertently appear at closing from a variety of factors. It is important for the exchanging party to understand what miscelaneous items can result in boot if taxable income is to be avoided.

The most common sources of boot include cash boot received during the exchange, debt reduction boot (from trading down in value) and sale proceeds being used to service costs at closing which are not closing expenses. We covered this recently in our article about Closing Costs and 1031 Exchange.

As a recap, the following are examples of some of the non-transaction costs which should be paid with cash brought to closing to avoid "boot":

rent prorata items

utility escrow charges

tenant security or damage deposits

loan acquisition costs

For complete information on the issue of boot, please look at the Rules of Boot section of our Exchange Manual found on the 1031 Corporation Exchange Professionals website.

Closing costs deductions on 1031 Exchange

We are often asked this question. Or perhaps it is asked, “Do I have to replace the net sales price or full sales price of the property I am selling to fully defer my tax?” Unfortunately, very little guidance (and it is fairly dated) has been provided in determining the deduction of transactional costs from any realized and recognized gain. Internal Revenue Service Form 8824 provides for transactional costs that are referred to as “exchange expenses” that can be deducted. But what are transactional costs?

Exchange expenses are those expenses which result solely as a result of the sale or acquisition of property and other costs directly related to the sale or acquisition of real estate or in connection with the 1031 Exchange (transaction expenses). These may include: real estate commissions, closing or escrow fees, title insurance premiums, legal fees, transfer taxes as well as such items as notary fees, recording fees and even the fee paid to your Qualified Intermediary.

One thing is clear. Costs related to obtaining financing should not be deducted from the proceeds to determine the "net sale price." Other transactional items typically found on a closing statement are not exchange expenses and probably do not reduce the amount realized or recognized and are not added to the basis of the replacement property. Items such as property taxes, utility escrow deposits or charges, homeowners' association fees, hazard insurance premiums, tenant security deposits and prepaid rents are items to look for on a closing statement.

When completing your tax return and determining how to report closing cost deductions, it will be extremely helpful to have your settlement statement as well as a form such as 1031 Corporation's Form 8824 worksheet. Of course, a taxpayer should review their individual transaction and closing costs with their tax and/or legal advisors to determine whether costs related to the closing are exchange expenses or not.