Investors Corner
The primary objective of this webpage is to equip investors with a basic background regarding §1031 tax deferred exchanges, allowing them to dramatically improve their position in the real estate market and obtain a better return on their investments.
Background - IRC Section 1031 Tax Deferred Exchanges
Since 1921, savvy investors have been taking advantage of a powerful tax strategy created by Internal Revenue Code Section (IRC) 1031 - the tax deferred exchange. Investors can accumulate wealth and protect their assets by learning how to defer capital gain taxes when disposing of virtually any property “held for investment.” Thanks to IRC Section 1031, a properly structured exchange allows an investor to sell a property, reinvest the proceeds in a new property and defer all capital gain taxes. IRC Section 1031(a)(1) states:
|
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held for productive use in a trade or business or for investment." |
Section §1031 tax deferred exchanges continue to increase in
popularity as more Colorado investors discover the wide range of investment
objectives that can be easily met through exchanging. The real power of a tax
deferred exchange is not just the tax savings - it is the tremendous increase in
purchasing power generated by this tax savings! With the advantages of leverage,
every dollar saved in taxes allows a real estate investor to purchase two to
three times more real estate. Many investors are surprised to discover that
capital gain taxes are far higher than 15%. State taxes, which can be as high as
11% in some states, are added to the federal capital gain taxes owed. In
addition, depreciation deducted over the ownership period is taxed at a rate of
25%. The net result is often a large percentage of an investor’s profits going
directly to pay taxes. The following list highlights some of the more common
reasons for exchanging, while the next section #6 cites some additional
motivations.
1. Preservation of Equity
A properly structured exchange provides real estate investors with the
opportunity to defer 100% of both Federal and State capital gain taxes. This
essentially equals an interest-free, no-term loan on taxes due until the
property is sold for cash! Most often, the capital gain taxes are deferred
indefinitely because many investors continue to exchange from one property to
the next, dramatically increasing the value of their real estate investments
with each exchange.
2. Leverage
Many investors exchange from a property where they have a high equity position
or one that is “free and clear” into a much more valuable property. A larger
property produces more cash flow and provides greater depreciation benefits,
which therefore increase an investor’s return on their investment.
3. Diversification
Exchangers have a number of opportunities for diversification through exchanges.
One option is to diversify into another geographic region such as exchanging one
apartment building in Denver, Colorado for two additional apartments - one in
Los Angeles, California and the other in Dallas, Texas. Another diversification
alternative is acquiring a different property type, such as exchanging from
several residential units to a small retail center.
4. Management Relief
Some investors accumulate several single family rentals over the years. The
ongoing maintenance and management of what can be a far-reaching group of
properties can be lessened by exchanging these properties for one property
better suited to on-site maintenance and management. Exchanging into a single
apartment complex with a resident manager is a good example of this strategy.
5. Estate Planning
Often a number of family members inherit one large property and disagree about
what they want to do with it. Some want to continue holding the investment and
some desire to sell it immediately for cash. By exchanging from one large
property into several smaller properties, an investor can designate that, after
their death, each heir will receive a different property that they can either
hold or sell.
6. Non-Tax Motives for Exchanging
In addition to the deferral of capital gain taxes, there are many underlying
reasons an investor would want to exchange one property for another. These are
some of the typical non-tax motives for performing an exchange.
Exchange from depreciated property to higher value property that can be depreciated.
Exchange from property that cannot be refinanced, such as land, to improved property that will support a new loan thereby gaining the ability to obtain cash.
Exchanging from non-income land to improved property to create cash flow.
Exchange from already appreciated property, such as an apartment, to a high cash flow property, such as a retail center, to generate needed cash flow.
Exchange from cash flow property to property with faster appreciation for clients who do not need cash but wish to build their estate.
Exchange for a property or properties that may be easier to sell in the coming years.
Exchange to meet the location requirements of a client who has moved across the country or one who simply wishes to invest in a different part of the city.
Exchange to fit the lifestyle of a client, for example, a retiree may exchange for a property requiring reduced management in order to travel more.
Exchange from several smaller properties into a larger one to consolidate the benefits of ownership, or exchange from a larger property to several smaller ones to divide an estate among children or for retirement reasons.
Exchange to a property an investor can use in her own profession, for example, a doctor may exchange out of rental houses into a medical building she can use for her practice.
Exchange out of a partial interest in one property to a full interest in another.
Exchange into a singe family rental property that will initially be held for investment. At a later date the investor may decide to move into this property and convert it into their primary residence. Under current tax laws, after the investor has lived in the property as their primary residence for 2 out of 5 years, they are eligible for the tax exclusion benefits available under IRC Section 121.
Exchange into a rental property at a resort location that is desirable and where property values typically appreciate well in good economic times.
Exchange out of a management intensive ranch or farm operation for a lower management burden of an apartment complex with an on-site property manager.
What Is IRC Section §1031
Section 1031 of the Internal Revenue Code allows an owner of investment property to exchange property and defer paying federal and state capital gain taxes (20%+ applicable state taxes) if they purchase a “like-kind” property following the rules and regulations of the Internal Revenue Code. This allows investors to use all of their proceeds from their sale to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate into one property.
WHAT IS “LIKE-KIND” PROPERTY?
There is some confusion regarding what type of property qualifies for a §1031 tax deferred exchange. The Internal Revenue Code Section 1031 states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” “Like-Kind” property can include, but is not limited to, any of the following, provided it is held for investment:
• Single Family
Rental
• Duplex
• Apartment
• Commercial Property
• Raw Land
For example, a single family rental can be exchanged for raw land, or apartments or a commercial building. In addition, properties can be exchanged anywhere within the United States.
DOES AN EXCHANGE NEED TO BE SIMULTANEOUS?
No, contrary to what most owners envision, a §1031 tax deferred exchange is rarely a two-party swap. Most exchanges are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of their replacement property. They must identify the potential replacement property(s) within 45 days from closing on their relinquished property.
WHEN IS A 1031 EXCHANGE APPLICABLE?
It is applicable whenever a property owner intends to SELL any property that is not their primary residence (and falls under the definition of “like-kind”) and plans to BUY another “like-kind” property within 180 calendar days following the closing of their relinquished property. Paramount to any exchange is a competent and experienced Intermediary.
The real power of a tax deferred exchange is not just the tax savings - it is the tremendous increase in purchasing power generated by this tax savings! With the advantages of leverage, every dollar saved in taxes allows a real estate investor to purchase two to three times more real estate.
Many investors are surprised to discover that capital gain taxes are far higher than 15%. State taxes, which can be as high as 11% in some states, are added to the federal capital gain tax owed. In addition, depreciation deducted over the ownership period is taxed at a rate of 25%. The net result is often a large percentage of your profits going directly to pay taxes. Under the 4th calculation, the net equity times four (assuming a 25% down payment) is the value of property you could purchase after paying all capital gain taxes.
Under the 5th calculation involving an exchange, no taxes are paid, leaving the full purchasing power of the ENTIRE GROSS EQUITY to acquire considerably more real estate! In just one transaction, the Exchanger acquires far more investment property than a seller!
[Note: This information is not intended to replace
qualified legal and/or tax advisors. First Professional Realty Group cannot give
tax and or legal advice. Every taxpayer should review their specific transaction
and potential tax consequences with their own tax and/or legal advisors.]
| 1. CALCULATE NET ADJUSTED BASIS | ||
| Original Purchase Price | $ | |
| +Improvements | ||
| -Depreciation | ||
| = NET ADJUSTED BASIS | $ | |
| 2. CALCULATE CAPITAL GAIN | ||
| Sales Price | $ | |
| -Net Adjusted Basis | ||
| -Cost of Sale | ||
| = CAPITAL GAIN | $ | |
|
3. CALCULATE CAPITAL GAIN TAX DUE |
||
| Recaptured Deprecation (25%) | $ | |
| +Federal Capital Gain (20%) | ||
| State Tax (when applicable) | ||
| = TOTAL TAX DUE | $ | |
|
4. ANALYZE PURCHASE WITHOUT AN EXCHANGE |
||
| Sales Price | $ | |
| Cost of Sale | ||
| Loan Balances | ||
| = GROSS EQUITY | ||
| -Capital Gain Taxes Due | ||
| = NET EQUITY | ||
| Net Equity X 4 = | $ | |
|
5. ANALYZE PURCHASE WITH AN EXCHANGE |
||
| Capital Gain Taxes Due | $ 0 | |
| Gross Equity = Net Equity | ||
| Gross Equity x 4 = | $ | |
Analyze The Benefits Before Selling
The benefits of IRC Section 1031 exchanges can be tremendous! Investors are often able to defer thousands of dollars in capital gain taxes, both at federal and state levels. If the requirements of a valid 1031 exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it. This essentially results in a long-term, interest-free loan from the IRS.
AN EXAMPLE
An investment property owner sells a rental property for $400,000. The owner originally purchased the property for $200,000. There is $200,000 of debt and the property has been fully depreciated. The capital gain is approximately $350,000 (assuming 75% of the property is depreciable). If the investor does not do an exchange, federal capital gain taxes would be:
| $150,000 (depreciation recapture) |
x 25% = |
$37,500 |
| $200,000 (capital gain balance) |
x 15% = |
$30,000 |
| $350,000 Capital Gain |
Taxes Owed |
$67,500 |
The state taxes owed (where applicable) would need to be added to the federal taxes due. Assuming the property owner sold in California, the following additional taxes would need to be paid:
State level (CA) 9.3%, $350,000 x 9.3% = $ 32,550
Total Capital Gain Taxes (Fed. & State) $100,050
The next comparison analyzes the value of the new property that could be acquired in a sale versus an exchange. The comparison assumes an investor makes a 25% down payment and finances 75% of the property (75% loan-to-value ratio).
A SALE VS. AN EXCHANGE
Sale
Exchange
|
Equity $200,000 Capital Gain Tax $ 110,750 Cash to Reinvest $ 89,250 |
Equity $200,000 Capital Gain Tax $ 0 Cash to Reinvest $200,000 |
ASSUMING A 75% LOAN-TO-VALUE
|
New Property $357,000 |
New Property $800,000 |
This example illustrates that the real power of a tax deferred exchange is not just the tax savings - it is the increase in purchasing power generated by this tax savings!
ADVANTAGES OF AN EXCHANGE
1. Preservation of equity
2. Maximize return on investment
3. Increased cash flow from larger properties
To many real estate investors, the “buzz words” often used to describe different aspects of a tax deferred exchange can be confusing. For example, doesn’t something with two ‘downlegs’ and three ‘uplegs’ sound a lot more like a lopsided creature than an exchange transaction? Reflected below are brief descriptions of commonly used exchange terminology:
Actual Receipt: Physical possession of proceeds.
Boot: “Non like-kind” property received;
“Boot” is taxable
to the extent there is a capital gain.
Cash Boot: Any proceeds actually or
constructively
received by the Exchanger.
Constructive Receipt: Although an investor
does not
have actual possession of the proceeds, they are legally
entitled to the proceeds in some manner such as having
the money held by an entity considered as their agent or
by someone having a fiduciary relationship with them. This
creates a taxable event.
Direct Deeding: Transfer of title directly
from the
Exchanger to Buyer and from the Seller to Exchanger after
all necessary exchange documents have been executed.
Exchanger: Entity or taxpayer performing an
exchange.
Exchange Agreement: The written agreement
defining
the transfer of the relinquished property, the subsequent
receipt of the replacement property, and the restrictions on
the exchange proceeds during the exchange period.
Exchange Period: The period of time in which
replacement property must be received by the Exchanger;
Ends on the earlier of 180 calendar days after the
relinquished property closing or the due date for the
Exchanger’s tax return (If the 180th day falls after the due
date of the Exchanger’s tax return, an extension may be
filed to receive the full 180 day exchange period.)
Identification Period: A maximum of 45
calendar days
from the relinquished property closing to properly identify
potential replacement property(ies).
Like-Kind Property: Any property used for
productive
use in trade or business or held for investment; Both the
relinquished and replacement properties must be considered
“like-kind” to qualify for tax deferral.
Mortgage Boot: This occurs when the
Exchanger does
not acquire debt that is equal to or greater than the debt
that was paid off on the relinquished property sale; Referred
to as “debt relief”. This creates a taxable event.
Qualified Intermediary: The entity who
facilitates the
exchange; Defined as follows: (1) Not a related party (i.e.
agent, attorney, broker, etc.) (2) Receives a fee (3) Receives
the relinquished property from the Exchanger and sells to
the buyer (4) Purchases the replacement property from the
seller and transfers it to the Exchanger.
Relinquished Property: Property given up by
the
Exchanger; Referred to as the sale, ‘downleg’ or ‘Phase I’.
Replacement Property: Property received by
the
Exchanger: Referred to as the purchase, ‘upleg’ or ‘Phase II’.
Tax deferred exchanges have been a part of the tax code since 1921 and are one of the last significant tax advantages remaining for real estate investors. One of the key advantages of a §1031 exchange is the ability to dispose of a property without incurring a capital gain tax liability, thereby allowing the earning power of the deferred taxes to work for the benefit of the investor (Exchanger) instead of the government. In essence, it can be considered an interest-free loan from the IRS.
BASIC TAX DEFERRED EXCHANGE REQUIREMENTS
The IRS allows up to a maximum of 180 calendar days between the sale of the relinquished property and the purchase of the replacement property. Within the 180 day “exchange period,” the investor must also properly identify suitable replacement properties within 45 calendar days of closing on the sale of the relinquished property. There are a number of requirements which need to be met to qualify for tax deferral under the tax code:
Requirement #1: Both the “relinquished” and “replacement” properties must be held for investment or used in a business. The IRS uses the term “like-kind” to describe the type of properties that qualify. Any property held for investment can be exchanged for any other “like-kind” property held for investment. This definition covers a vast variety of developed and undeveloped real estate. Properties which are clearly not like-kind are an investor’s primary residence or property “held for sale.” The relinquished and replacement properties need not have identical functions (i.e both be residential rentals or commercial strip centers). The key issue is that the Exchanger can substantiate that both the relinquished and replacement property were “held for investment.”
Requirement #2: The IRS requires an investor to identify the replacement property(s) within 45 days from closing on the sale of a relinquished property. The 45 Day Identification Period begins on the closing date, and the replacement property(s) must be properly identified in a letter signed by the Exchanger and received by the Qualified Intermediary. Exchangers have a number of ways to properly identify properties. They may identify up to three target properties without regard to their total fair market value (Three Property Rule). Alternatively, they can identify an unlimited number of replacement properties, if the total fair market value of all properties is not more than twice the value of the property sold (200% Rule). As a final option, an Exchanger can break both of these rules if they acquire 95% of the aggregate fair market value of all identified replacement properties.
Requirement #3: Close on the replacement property
by the earliest of either: 180 calendar days after closing on the sale of the
relinquished property or the due date for filing the tax return for the year in
which the relinquished property was sold (unless an automatic filing-extension
has been obtained).
Example: If an Exchanger closes on the relinquished property on December 27, the 180 day period will end after April 15 (Tax Day). In this case, they would have to close on the replacement property (or request an extension of time to file their taxes) by April 15. Exchangers may choose to close both transactions within a shorter period of time, thereby avoiding the potential hardship of the 45/180 day time limits.
Requirement #4: The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved middleman called a “Qualified Intermediary.” The Qualified Intermediary actually documents the exchange by preparing the necessary paperwork (Exchange Agreements), holding proceeds on behalf of the Exchanger, and structuring the sale of the relinquished property and purchase of the replacement property. A National IRC §1031 “Qualified Intermediary.”
Note: To defer all capital gains taxes, an
Exchanger must buy a property or properties of equal or greater value (net of
closing costs), reinvesting all net proceeds from the sale of the relinquished
property. Any funds not reinvested, or any reduction in debt liabilities not
made up for with additional cash from the Exchanger, is considered “boot” and is
taxable.
Example: Stewart sells his duplex, which he held for investment, for $160,000. A hundred days later he closes on a different duplex, which he will hold for investment, for $110,000. Stewart banks the $50,000 in excess funds for his child’s education. Stewart must pay capital gain taxes on $50,000. (In this example, Stewart chose to take some money out of his exchange and pay the tax.)
WHEN ARE CAPITAL GAIN TAXES PAID?
Maybe never. Many investors mistakenly believe they will “have to pay the taxes sometime” so they might as well just sell. Quite often, this is a bad decision. The tax on an exchange is deferred into the future and is only recognized when an investor actually sells the property for cash instead of performing an exchange. Investors can continue to exchange properties as often and for as long as they wish, thus moving up to better investments and putting off the taxes for many years.
Exchanges Are A Powerful Tax Strategy
Although many Exchangers include language in their Purchase and Sale Agreement establishing their intent to perform an exchange, it is not required by the Internal Revenue Code.
CONTRACTS MUST BE ASSIGNABLE
It is important, however, that the Purchase and Sale Agreements for both properties be assignable. In order to structure a typical exchange transaction, Asset Preservation must be assigned in as the Seller of the relinquished property and also as the Buyer of the replacement property.
An Exchanger should review the contract to confirm they are not prohibited from assigning their position as either a “Seller” or “Buyer” to a Qualified Intermediary. When a typical exchange is initiated Qualified Intermediary is shown as the Seller on the Settlement Statement instead of the Exchanger being reflected as the Seller.
"LAST MINUTE” EXCHANGES ARE POSSIBLE!
Many real estate investors contact a Qualified Intermediary just minutes before closing on their transaction and successfully convert a sale into an exchange. In most situations, a successful exchange can be accomplished as long as the Qualified Intermediary is contacted prior to closing. Many Exchangers and real estate agents add exchange language to the contract for two reasons:
1.) It establishes their intent to perform a 1031 tax deferred exchange;
2.) To notify the other party in
advance of the need to assign the contract to an Intermediary.
The verbiage below is satisfactory in establishing the Exchanger’s intent to
perform a tax deferred exchange and releases the other parties from costs or
liabilities as a result of the exchange:
SALE OF RELINQUISHED PROPERTY
“Buyer is aware that Seller intends to perform an IRC Section 1031 tax deferred exchange. Seller requests Buyer’s cooperation in such an exchange and agrees to hold buyer harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Buyer agrees to an assignment of this contract by the Seller.”
PURCHASE OF REPLACEMENT PROPERTY
“Seller is aware that Buyer intends to perform an IRC Section 1031 tax deferred exchange. Buyer requests Seller’s cooperation in such an exchange and agrees to hold seller harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Seller agrees to an assignment of this contract by the Buyer.”
IRC Section 1031 does not limit “like-kind” property to certain types of real estate. The term refers to the nature or character of the property, rather than its grade or quality. Real property must be exchanged for like-kind real property. Real property is not considered like-kind to personal property.
WHAT IS EXCLUDED?
An Exchanger’s primary residence and property held “primarily for resale” (dealer property) are excluded from tax deferral under IRC Section 1031. [Note: Primary residences qualify for tax exclusion, with certain restrictions, under IRC Section 121.]
QUALIFYING REAL PROPERTY
The types of real estate which can be exchanged is extremely broad. Any real
estate held for productive use in a trade or business or for investment -
whether improved or unimproved - is considered “like-kind.” Improvements to real
estate refer to the grade or quality, not the nature or character of the real
property. Like kind examples:
• Unimproved for improved property
• Fee for a leasehold with 30+ years to run
• Commercial building for vacant land
• Duplex for commercial property
• Single family rental for an apartment
• Industrial property for rental resort property
QUALIFYING PERSONAL PROPERTY
Personal property that qualifies for a 1031 exchange must be “held for productive use in a trade or business or for investment.” In general, qualifying properties must both be in the same General Asset Class or within the same Product Class. The Standard Industrial Classification Manual provides categories for General Asset Classes of depreciable tangible personal property. It is critical to review any personal property transactions with tax advisors because the rules are far more restrictive than for real property.
EXAMPLES OF QUALIFYING PERSONAL PROPERTY EXCHANGES INCLUDE:
• Mexican gold coins for Austrian gold coins
• Aircraft for aircraft
• Restaurant equipment for restaurant equipment
• Computers for computers
HOW LONG MUST AN INVESTMENT PROPERTY BE HELD FOR THE IRS TO CONSIDER IT A "LIKE-KIND" PROPERTY?
IRC §1031 states that property “held for productive use in a trade or business or for investment” must be exchanged for like-kind property. There is much confusion and misinformation among real investors on the issue of what is viewed as “held for investment.”
WHY THE CONFUSION?
1.) Neither the IRS nor the Regulations provide a comprehensive definition of the
phrase “held for
investment.” (The regulations do state, however, that unproductive real estate
held by a non-dealer
for future use or future appreciation, is held for investment.)
2.) Many investors have been given incomplete, or worse, incorrect answers with
respect to this
question. For example, in the Forbes June 1999 article on §1031 exchanges, entitled Trading Places,
the author incorrectly states “you must rent out your new house for at least 12
months and a day…”
A MORE COMPLETE ANSWER
There is no safe holding period for property to automatically qualify as being
“held for investment.”
Time is only one factor at which the IRS looks in determining the Exchanger’s
intent for both the
relinquished and replacement properties. The IRS may look at all the facts and
circumstances of an investor’s situation to determine the Exchanger’s true intent for both properties involved in an exchange.
TWO ADDITIONAL PERSPECTIVES
In one private letter ruling (PLR 8429039), the IRS stated that a minimum
holding period of two years would be sufficient. Although a private letter
ruling does not establish legal precedent for all investors, there are many
advisors who believe two years is a conservative holding period, provided no
other significant factors contradict the investment intent. Other advisors
recommend that Exchangers hold property for a minimum of at least twelve months.
The reason for this is twofold: (1) A holding period of 12 or more months means
the investor will usually reflect it as an investment property in two tax filing
years. (2) In 1989, Congress had proposed a one year holding period.
Although this proposal was never incorporated into the tax code, some believe it
represents a reasonable minimum guideline. The investor’s “intent” in holding
both the relinquished and replacement properties is the central issue. Each
Exchanger and their advisors should be able to substantiate properties
relinquished and acquired in a tax deferred exchange were “held for investment.”
Factors The IRS May Examine
Real estate held as “stock in trade or other property primarily for sale” is excluded from the tax deferral benefits of IRC Section 1031. Stock in trade describes property which is included in the inventory of a dealer and is held for sale to customers in the ordinary course of business. The gain on the sale of this property is taxed as ordinary income.
SUBSTANTIATING THE INVESTMENT INTENT
To qualify for a §1031 exchange, a taxpayer must be able to support that their “intent” at the time of the purchase was to hold the property for investment. Listed below are some factors the IRS may review to determine whether or not the intent was to hold the property for investment. The burden of substantiating the investment intent is the responsibility of the taxpayer and the items below are not an exhaustive list but provide useful indicators in determining the taxpayer’s intent.
• The nature and purpose of the
acquisition of
the property and the duration of ownership;
• The extent and nature of the
taxpayer’s efforts
to sell the property;
• The number, extent, continuity
and
substantiality of the sales;
• The use of a business office
for the sale of the
property;
• The character and degree of
supervision or
control exercised by the taxpayer over any
representative selling the property;
• The time and effort the
taxpayer habitually
devoted to the sales.
CAN A “DEALER” PERFORM AN EXCHANGE?
The fact that a taxpayer is considered a dealer does not automatically disqualify them from performing an exchange. A dealer may segregate assets that they intend “to hold for productive use in a trade or business or for investment” from their dealer property. Some dealers have been advised by their attorneys to form a separate entity, such as an LLC, specifically to hold title to property that may be able to qualify for an exchange sometime in the future.
REVIEW WITH LEGAL AND/OR TAX ADVISORS
It is important that all taxpayers, and particularly dealers, review their
transaction with an attorney or accountant before proceeding with an exchange.
There are many issues not covered in this short discussion which may affect the
ability of a taxpayer to successfully defend an exchange transaction.
Q. Can the home be depreciated during the rental period and still qualify for
the §121 exclusion?
A. Yes, however, depreciation taken after May 6, 1997 must be recognized in the
year of the sale.
Q. If I convert my primary residence to a rental, how long does it have to be
rented to qualify for a §1031 tax deferred exchange?
A. There is no definitive answer in the tax code that directly addresses this
question. Under §1031, you may defer capital gain taxes when like-kind
properties, which are “held for investment,” are exchanged. Many tax and legal
advisors believe that at least one (1) year of ownership is a reasonable minimum
time frame. The owner must be able to support the fact that the home was
legitimately converted to a rental that was “held for investment.”
WHAT DOES THIS ALL MEAN? OPPORTUNITY!
1. Home owners (“empty nesters”) can downsize without a huge tax penalty.
2. The potential exists for tax-free dollars to be used for the purchase of
investment property.
3. Convert a vacation home into a primary residence and take advantage of the
tax exclusion in 2 years.
4. Serial homebuyers! Buy and live in a “fixer home” for two years and keep the
profit!
12.) PRINCIPAL RESIDENCE RULE UPDATE
Treasury Decision 9030 Clarifies Section 121 Exclusions
Section 121 of the Internal Revenue Code allows an exclusion up to $250,000 of the capital gain on a principal residence for single taxpayers and $500,000 for a married couple filing jointly. To qualify, the taxpayer must own and use the home as a principal residence for 2 of the 5 years prior to the sale. The ownership and use periods do not need to be concurrent. The two years may consist of 24 full months or 730 days. Treasury Decision 9030 clarifies a number of issues including exceptions to the two-year rules for use, ownership and claimed exclusion “safe harbors” when the primary reason for the sale is health, change in place of employment, or “unforeseen circumstances.”
Employment: Exception permitted if the new job site is at least 50 miles farther from the old home than the old workplace was from that home.
Health: Exception permitted if the primary reason is related to a disease, illness or injury or if a physician recommends a change in residence for health reasons. In addition, a qualified person for health reasons includes close relatives, so that sales related to caring for sick family members will qualify.
Unforeseen Circumstances:
• Death
• Divorce or legal separation
• Becoming eligible for unemployment compensation
• Change in employment that leaves the taxpayer unable to pay the mortgage or
reasonable basic living expenses
• Multiple births resulting from the same pregnancy
• Damage to the residence resulting from a natural or manmade disaster, or an
act of war or terrorism
• Condemnation, seizure or other involuntary conversion. Any of the first five
situations listed above must involve the taxpayer, spouse, co-owner, or a member
of the taxpayer’s household to qualify. The Regulations also give the IRS
Commissioner the discretion to determine other circumstances
as “unforeseen.”
MULTIPLE HOMES
The Regulations list several factors relevant in determining which home is the
“principal residence” of taxpayers who own more than one home:
• Place of employment
• Amount of time used
• Where other family members live
• Address used for tax returns
• Driver’s license
• Car and voter registration
• Bills and correspondence
• Location of the taxpayer’s bank, clubs and religious entities
DEPRECIATION
Taxpayers do not need to allocate the gain between the business and residential use if the business use occurred within the same dwelling unit as the residential use. Capital gain taxes must be paid on the total depreciation taken after May 6, 1997, but may exclude additional gain on the residence, up to the maximum amount. The principal residence exclusion may include capital gain from the sale of vacant land that has been used as part of the residence, if the land sale occurs within two years before or after the sale of the residence.
13.) SPLIT TREATMENT EXCHANGES
Use Two Tax Code Sections To Your Advantage
ONE SALE - TWO TAX BREAKS!
A property owner selling a duplex, triplex or four plex, where the owner lives in one unit and rents out the remaining units, can use two tax code sections and receive excellent tax advantages! The unit where the owner lives is considered their primary residence and can qualify for exclusion of capital gain taxes as described below under “IRC Section 121 - Benefits of Selling a Residence.” The capital gain taxes associated with the remainder of the multi-family property can qualify for tax deferral by performing a 1031 tax deferred exchange on the rental units. All this is possible even though there is one buyer for the entire complex.
§121- BENEFITS OF SELLING A RESIDENCE
Tremendous tax benefits are available on the portion of the property considered
the primary residence by the owners. The 1997 TAXPAYER RELIEF ACT provided
homeowners significant tax advantages on what is considered their primary
residence. Section 121 of the tax code allows a homeowner to exclude capital
gain taxes if they meet the following requirements:
• Couples filing a joint tax return can exclude up to $500,000 of the capital
gain on the sale of their primary residence, and single filers can exclude up to
$250,000.
• The home must have been the primary residence of both spouses for twenty four
(24) of the last sixty (60) months..
• This exclusion is available every two years.
§1031-BENEFITS OF EXCHANGING
Section 1031 allows an owner of property “held for productive use in a trade or business or for investment” to exchange for another “like-kind” property and defer paying capital gain taxes. The units that have been rented may qualify for these tax benefits.
ALLOCATION ISSUES
An accountant is generally needed to determine the value allocated to the residence portion and to the remaining units held for investment. A tax professional may use factors such as the square footage or the quality and value of improvements to each unit in determining what percentage is considered the primary residence and what percentage is allocated to the exchange portion. [Note: Proper closing techniques must be used.]
EXCELLENT INVESTMENT OPPORTUNITIES
Purchasing a duplex or triplex can be an ideal first investment because the owner can live in one unit and have tenants in the other units making payments, thus helping the owner qualify for the mortgage.
One Sale - Twice The Tax Breaks!
Sellers of farms and ranches are able to take advantage of two different tax code sections to minimize capital gain tax liabilities. By utilizing all the opportunities available in the tax code, many ranch and farm owners can both meet many of their investment objectives and defer - potentially indefinitely - capital gain taxes! The sale of a farm or ranch typically involves selling a house along with a significant amount of land used in the operation of the farm or ranch. The house, along with a limited amount of land, can qualify for tax exclusion as noted under the “Benefits of IRC Section 121.” The remainder of the farm or ranch land can qualify for an IRC Section 1031 tax deferred exchange. All this is possible even though there is one buyer for the entire property.
BENEFITS OF IRC SECTION 121
The 1997 Taxpayer Relief Act provided homeowners significant tax advantages on
the sale of a primary residence. Section 121 of the tax code allows a homeowner
to exclude capital gain taxes if they meet the following requirements:
• Couples filing a joint tax return can exclude up to $500,000 of the capital
gain on the sale of
their primary residence, and single filers can exclude up to $250,000.
• The home must have been the primary residence of both spouses two of the last
five years.
• The exclusion is available once every two years.
WHAT IS AN IRC SECTION 1031 EXCHANGE?
Section 1031 of the Internal Revenue Code allows an owner of property “held for
productive use in a trade or business” or “held for investment” to exchange for
another “like-kind” property and defer paying capital gain taxes. Although there
are some misconceptions this requires exchanging a ranch for another ranch, the
definition of “like-kind” property is very broad. For example, a property owner
can exchange out of a farm or ranch and acquire:
• Single family rental, duplex or triplex
• Apartment or commercial property
• Another farm or ranch property
• Vacation home primarily “held for investment”
WHAT IS NEEDED TO ACCOMPLISH THIS?
A good accountant or real estate attorney is often needed to determine the value of the residence portion of the transaction and the land used in the farm or ranch operation. An experienced “Qualified Intermediary” is essential to a successful exchange.
15.) VACATION HOMES
The Opportunity Exists For Successful Vacation/Second Home Exchanges
Property owners throughout the nation are obtaining the benefit of full reinvestment of equity under Internal Revenue Code §1031. Many investors exchange out of a single family rental, duplex, or any other type of investment property and into a vacation/second home. Many tax/legal advisors believe it is possible to perform an exchange on a vacation property which has no rental history but which still can be considered “held for investment.”
SUPPORT FOR VACATION HOME EXCHANGES?
In Private Letter Ruling (PLR) 8103117, the IRS did allow for tax deferral when a property owner intended to acquire property for personal enjoyment and as an investment. As stated in this PLR, “...the house and lot you acquire in this trade will be held for the same purposes as the properties exchanged: to provide for personal enjoyment and to make a sound real estate investment.” Although a PLR only applies to the facts and circumstances in a particular individual’s specific situation, it appears, in this instance, that “personal enjoyment” of a property does not prevent a property owner from benefiting from a tax deferred exchange.
EACH INDIVIDUAL CASE MUST BE REVIEWED
Note: There are no regulations, statutes, or court cases which give a definitive answer on the exchange of vacation/2nd homes. Each exchange must be reviewed on a case-by-case basis. To qualify for an exchange, the property owner should be able to support that the property was “held for investment.”
A BRIEF ANALYSIS
IRC Section 1031 provides for the non-recognition of gain on the exchange of property “held for productive use in a trade or business or for investment.” Is a vacation property considered “held for investment?” Reg. 1.1031(a)-1(b) states in the definition of “like-kind” that “unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale.” It appears that even property owners who have never rented their vacation property but can substantiate that they acquired and held the property because they expected it to increase in value (a wise investment decision) may qualify for a §1031 tax deferred exchange. IRC §165 and IRC §280, which address when losses may be deducted on vacation homes, may provide additional guidance to investors. It is a well known fact that many vacation areas have appreciated significantly and that often property owners purchase properties with the future appreciation in mind. A real estate investor should consult with their own advisors to discuss their specific situation and see if they may qualify for the benefits of a tax deferred exchange.
A Leasehold Interest Can Be Considered "Like-Kind"
Property
Leasehold interests may be either relinquished property or replacement property
in an exchange. [Reg. §1.1031 (a)-1 (c) (2)] A leasehold interest with a
remaining term of 30 years or more is considered “like-kind” property to a fee
interest in any other real estate held for productive use in a trade or business
or for investment. If a leasehold has an unexpired term of less than 30 years,
it is not treated as a qualifying §1031 property. However, if the lease provides
for optional renewal periods, these periods can be included in determining
whether the leasehold has 30 years or more remaining. In one case, a lease with
an initial term of 5 years and ten optional renewal periods of 5 years each was
held to be “like-kind” property since the taxpayer had the right to use the
property for up to 55 years. [R & J Furniture Co. v. Comm., 20 T.C. 857 (1953)]
GROSS VS. NET LEASEHOLD INTERESTS
A gross lease often obligates the
Lessor only to pay
a portion of expenses of the leased property. A net lease (often referred to as
a net, net, net or NNN lease) requires the tenant to pay, in addition to the
fixed rent, expenses of the property such as taxes, insurance, utilities,
maintenance, etc. The obvious advantage of a NNN lease to property owners is
that many of the routine management burdens of ownership are the responsibility
of the tenant.
WHY EXCHANGE
INTO LONG-TERM LEASES
Many real
estate investors have accumulated substantial real estate portfolios over a
period of many years. In many instances, these investors have performed a
§1031tax deferred exchange into replacement properties. The exchange transaction
has allowed them to eliminate the payment of capital gain taxes and rollover
equities into larger and better performing properties. Now that they
have met many of their long-term investment objectives, they desire to increase
their monthly cash flow and simultaneously reduce the management problems
typically associated with most real estate investments. An ideal solution is to
exchange into a net leasehold interest, providing excellent cash flow with very
few responsibilities associated with the ongoing management of the property.
ADVANTAGES OF NET LEASES
1.) Predictable cash flow, typically with standard
cost-of-living adjustments already built into the lease.
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17.)
IRC Section 1031 does not limit “like-kind” property
to certain types of real estate. The types of real estate which can be exchanged
is extremely broad. The term refers to the nature or character of the property,
rather than its grade or quality. In many cases, an easement can be exchanged
for a fee interest.
AS §1031 REPLACEMENT PROPERTIES?
2.) Tenant typically is a well-recognized national company, often with audited
financial statements which can be thoroughly reviewed by the lessee.
3.) Very few management headaches. Lessor is responsible for taxes, utilities,
maintenance and insurance.
4.) Allows a real estate investor to take advantage of an income stream without
triggering the recognition of capital gain taxes.
QUALIFYING REAL PROPERTY
Real property must be exchanged for “like-kind” real
property. Any real estate held for productive use in a trade or business or for
investment - whether improved or unimproved - is considered “like-kind.”
Like-kind examples: 1.)
Unimproved
2.)
Fee ]
leasehold with 30+ years to run
3.)
Commercial building ]
vacant land
4.)
Duplex ]
commercial property
5.)
Single family rental
]
an apartment
6.)
Industrial property ]
rental resort property
WHAT ABOUT EASEMENTS?
Although it is important to look to the treatment of easements under the applicable state laws, in many cases an easement is considered “like-kind” to any other “like kind” real property held for productive use in a trade or business or for investment.
QUALIFYING EXCHANGES OF EASEMENTS
An agricultural conservation easement in perpetuity
in a farm found to be real property, for a fee simple interest in real property. IRS Letter Ruling 9232030
An exchange of agricultural easements over two farms
for fee-simple title in a different farm. IRS Letter Ruling 9851039
A perpetual conservation easement encumbering real
property for the fee simple interest in either farm land, ranch land, or
commercial real property. IRS Letter Ruling 9601046
A scenic conservation easement, found to be real
property under state law, for a fee simple interest in timber, farm land, or
ranch land. IRS Letter Ruling 9621012
18.)
WHAT ARE THE
REQUIREMENTS FOR A FULL TAX DEFERRAL IN A 1031 EXCHANGE
Tax Deferral
Some real estate investors confuse what is required
for full tax deferral in an exchange with calculations involved in determining
their accumulated capital gain. The requirements for full tax deferral are
different than the capital gain tax and/or basis computations.
WHAT ARE THE REQUIREMENTS FOR
FULL TAX DEFERRAL IN AN EXCHANGE?
If an Exchanger intends to perform an exchange that
is fully tax deferred, they must meet two simple requirements:
(1) Reinvest the entire net equity (net proceeds) in
one or more replacement properties.
An alternative approach for complete tax deferral is
acquiring property of equal or greater value and spending the entire net equity
in the acquisition. One exception to the second requirement is that
an Exchanger can offset a reduction in debt by adding cash to the replacement
property closing.
WHAT IS “BOOT”?
The term “boot” refers to any property received in an
exchange that is not considered “like-kind.” Cash boot refers to the receipt of
cash. Mortgage boot (also called “debt relief”) is a term describing an
Exchanger’s reduction in mortgage liabilities on a replacement property. Any
personal property received is also considered boot in a real property exchange
transaction.
If the Exchanger receives cash or other property in
addition to like-kind property, this may result in a taxable event. To determine
the taxes that may be due, several steps are required. First, the Exchanger’s
tax advisor must calculate the realized capital gain. Second, the amount of
“boot”, money or other property received, along with any depreciation recapture,
must be determined. Finally, a tax advisor will review the Exchanger’s specific
situation to see if there are additional tax issues that may offset any current
capital gain tax liabilities.
- and -
(2) Acquire one or more replacement properties with the same or a greater amount
of debt.
19.)
THE EXCHANGE EQUATION
Realized Gain Vs. Recognized Gain
Whenever property is sold, it is important to make
the distinction between realized gain and recognized gain. Realized gain is
defined as the net sale price minus the adjusted tax basis. Recognized gain is
the taxable portion of the realized gain. The common objective in a tax deferred
exchange is disposing of a property containing significant realized gain and
acquiring a “like-kind” replacement property so there is no recognized gain. In
order to defer all capital gain taxes, an Exchanger must “balance the exchange”
by acquiring replacement property that is the same or greater value as the
relinquished property, reinvest all net equity and replace any debt on the
relinquished property with debt on the replacement property (although a
reduction in debt can be offset with additional cash.)
THE EXCHANGE EQUATION
The Exchanger can quickly calculate whether there
will be recognized gain based on the following principals:
• Taxable “boot” is defined as non like-kind property
the Exchanger may receive as part of an exchange. “Cash boot” is the receipt of
cash and “mortgage boot” (also referred to as debt relief) is a reduction in the
Exchanger’s mortgage liabilities on a replacement property. Generally, capital
gain income is recognized (and therefore taxable) to the extent there is boot.
• For a fully deferred exchange, an Exchanger must
reinvest all net equity and acquire property with the same or greater debt.
Compare the relinquished property with the replacement property in terms of:
1.) Value
2.) Net Equity (after deducting costs of sale)
3.) Debt
$450,000 $600,000 $200,000 $200,000 $250,000 $400,000 The Exchanger is acquiring property
of greater value, reinvesting the entire net equity and increasing the mortgage
on the replacement property. Analysis: There is no boot
and no recognized gain. $450,000 $600,000 $200,000 $150,000 $250,000 $450,000
The Exchanger keeps $50,000 of the exchange proceeds,
reinvesting only $150,000 as a down payment on the replacement property.
Analysis: There is $50,000 of “cash boot” which results in
recognized (taxable) gain. $450,000 $350,000 $200,000 $200,000 $250,000 $150,000 The Exchanger acquires property of a
lower value and while reinvesting all equity in the replacement property,
acquires less debt in the process. Analysis: The Exchanger
has reduced the debt by $100,000 (“mortgage boot”) which results in a recognized
(taxable) gain of $100,000.
20.)
PARTIAL TAX DEFERRAL
Defer Some Capital Gain Taxes And Obtain Cash Now
WHAT ARE THE REQUIREMENTS FOR
FULL TAX DEFERRAL IN AN EXCHANGE
If an Exchanger intends to perform an exchange that
is fully tax deferred instead of partially deferred, they must meet two specific
requirements:
1.) Reinvest the entire net equity (net proceeds) in
one or more replacement properties;
[One exception to the second requirement is that an Exchanger can offset a
reduction in debt by adding cash to the replacement property closing.]
WHEN NOT TO DO AN EXCHANGE
If the boot is greater than the amount of the capital
gain, then it’s not recommended to do an exchange. 21.) STAGES OF A 1031 TAX DEFERRED EXCHANGE
Follow These Simple Steps For A Successful Transaction
RELINQUISHED PROPERTY SALE (PHASE I) CONTRACT STAGE:
• Negotiate & sign contract as seller and/or assignee.
CLOSING STAGE:
• Call Qualified Intermediary after the Sale Contract is signed.
• Information needed by the Intermediary:
1.) Phone and reference number for closing agent.
• The Intermediary will contact the closing agent and forward the Exchange
Agreement and all necessary exchange documents to their office.
• Copies of all documents will be sent to Exchanger.
• The closing agent will obtain all signatures on the Exchange Agreement and all
exchange documents.
• Once all parties have signed and all closing conditions are met, the
transaction is closed.
• The Exchanger has 45 days from closing on the
relinquished property to identify replacement property.
1.) Recommendation: Since the “45 Day Identification Period” is not flexible, it
is advisable to begin looking for replacement property from the time the
Exchanger decides to perform an exchange.
2.) For an exchange to be 100% tax deferred, an Exchanger must acquire
replacement property of equal or greater value and reinvest all of the net
proceeds from the relinquished property.
3.) 45th day for the Identification Date Requirement.
4.) 180th day for the Exchange Period Requirement.
5.) Confirmation of receipt of exchange proceeds.
6.) “Replacement Property Identification Letter”
which outlines the specific identification rules.
• Mail or fax the “Replacement Property
Identification Letter” with the property(s) identified before midnight of the
45th date from closing the relinquished property.
CONTRACT STAGE:
• Sign the purchase contract as buyer and/or
assignee.
CLOSING STAGE:
1.) Phone and reference number for closing agent.
2.) Purchase Price.
3. )Will an earnest money deposit be needed?
• Intermediary will contact the closing agent and
prepare Addenda to the Exchange Agreement & Withdrawal Authorization.
• Copies of the Addenda and Withdrawal Authorization
will be forwarded to the Exchanger for review.
• The closing agent will obtain signatures on the
Addenda and the Withdrawal Authorization along with all other necessary exchange
documents.
• After all parties have signed and the Intermediary
receives the faxed Withdrawal Authorization from the closing agent, proceeds
will be wired to the closing agent’s account.
22.) IDENTIFICATION RULES
It's Essential To Adhere To These Requirements
The identification period in a delayed exchange
begins on the date the Exchanger transfers the relinquished property and ends at
midnight on the 45th calendar day thereafter. To qualify for a §1031 tax
deferred exchange, the tax code requires identifying replacement property: • In a written document signed by the Exchanger;
ADDITIONAL ISSUES
Exchangers acquiring a property which is being
constructed must identify this property and the improvements in as much detail
as is practical at the time the identification is made. Exchangers who intend to
acquire less than a 100% ownership interest in the replacement property should
specify the specific percentage interest. Exchangers should always consult with
their tax and/or legal advisors about the specific identification rules and
restrictions. Any properties acquired within the 45-day identification period
are considered properly identified. An investor has the ability to substitute
new replacement properties by revoking a previous identification and correctly
identifying new replacement properties as long as this is done in writing within
the 45-day identification period.
Although Exchangers can identify more than one
replacement property, the maximum number of properties that can be identified is
limited to:
A.) Three properties without regard to their fair
market value ( “3 Property Rule”);
B.) Any number of properties so long as their
aggregate fair market value does not exceed 200% of the aggregate fair market
value of all relinquished properties ( “200% Rule”);
C.) Any number of properties without regard to the
combined fair market value, as long the properties acquired amount to at least
ninety five percent (95%) of the fair market value of all identified properties
( “95% Exception”).
Relinquished Property
Replacement Property
VALUE
NET EQUITY
DEBT
Relinquished Property
Replacement Property
VALUE
NET EQUITY
DEBT
Relinquished Property
Replacement Property
VALUE
NET EQUITY
DEBT
- and -
2.) Acquire one or more replacement properties with the same or a greater amount
of debt.
• Include language in the contract to establish an intent to perform a §1031 tax
deferred exchange.
2.) Exchanger’s mailing address and phone number.
3.) Sales price and approximate debt amount.
4.) Legal vesting as reflected on title.
5.) Will the seller be “carrying a note” on the sale?
REPLACEMENT PROPERTY PURCHASE (PHASE II)
IDENTIFICATION STAGE
• Hand delivered, mailed, telecopied, or otherwise sent;
• Before the end of the identification period to;
• Either the person obligated to transfer the replacement property to the
Exchanger [generally the “Qualified Intermediary”] or any other person involved
in the exchange other than the taxpayer or a disqualified person. The
replacement property must be unambiguously described (i.e. legal description,
street address or distinguishable name). The type of property should be
described in a personal property exchange.
23.)
WHAT NOT TO DO IN A DEFERRED EXCHANGE
Lessons To Be Learned From These Failed Exchanges
Delayed exchanges, under IRC Section 1031, are the most common exchange format nationwide. The IRS has structured exchanges with strict guidelines for full tax deferral. In a delayed exchange, a property owner must meet a number of key time deadlines after closing on the sale of a relinquished (also referred to as the sale or Phase I) property:
1. Acquire the replacement property (s) within 180
calendar days, or the day the Exchanger’s tax return is due, whichever is
earlier (the “Exchange Period”)
- AND -
2. Either acquire all replacement properties or properly identify all potential
replacement properties within 45 calendar days (the “Identification Period”).
Listed below are three recent examples of what not to do in a deferred exchange:
CHRISTENSEN VS. COMM. (April 10, 1998)
What Happened: The Christensen’s filed their tax return on April 15 and acquired replacement property within 180 days, but this purchase closed after they had already filed their tax return. The Tax Court cited failure to comply with the deadlines, specifically the requirement to complete the exchange within 180 days OR the tax filing date, whichever is earlier, as the reason tax deferral was not allowed.
What Should Have Happened: They should have filed an extension prior to their closing to obtain benefit of the entire 180 day exchange period.
KNIGHT VS. COMM. (March 16,1998)
What Happened: On day 179, the Knight’s purchase of their replacement property fell apart. The Knight’s acquired another property after the 180th day and argued they made a “good faith” attempt to meet the time requirements. The Tax Court denied the exchange because the tax code clearly allows only a maximum of 180 days to complete the exchange.
What Should Have Happened: The Knights should not have postponed their acquisition to last moment, if at all possible. Had more time been available, they may have been able to acquire another properly identified property before their 180th day.
DOBRICH VS. COMM. (October 20, 1997)
What Happened: The Dobrich’s intentionally “backdated” an Identification Notice. This was discovered by the IRS and they were liable for $2.2 Million in capital gain taxes PLUS a $1.6 Million fraud penalty!
What Should Have Happened:
The Dobrich’s should have acquired only property identified within the 45 day
Identification Period. Under no circumstances, should investors ever backdate
Identification Notices!
Why Exchangers Can't Have Access To Exchange Funds
A “Qualified Intermediary” must limit the Exchanger’s ability to access funds held in the exchange account in order to meet the safe harbor requirements specified in the U.S. Treasury Regulations. Although the deferred exchange rules provide an Exchanger with the flexibility to take up to 45 days to identify and a maximum of 180 days to purchase a replacement property, there are specific restrictions placed on the Exchanger’s ability to access exchange proceeds in the possession of the Qualified Intermediary during the exchange period.
SECTION 1.1031(k)-1(g)(6)
In a deferred exchange, U.S. Treasury Regulations, Section 1.1031 (k)-1(g)(6), require stipulations in the exchange agreement which limit the Exchanger’s ability “to receive, pledge, borrow or otherwise obtain the benefits of money or other property before the end of the exchange period. The Exchanger may have rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property upon or after:
(a) The receipt by the Taxpayer of all replacement property to which the taxpayer is entitled under the exchange agreement.
(b) The occurrence after the end of the identification period of a material and substantial contingency that:
1.) Relates to the deferred exchange,
2.) Is provided for in writing, and
3.) Is beyond the control of the Taxpayer and of any disqualified person (as defined in paragraph (K) of this Section), other than the person obligated to transfer the replacement property to the taxpayer.”
WHAT IS THE IMPACT OF THESE RESTRICTIONS?
Although a thorough discussion is beyond the scope of this update, the following are two examples:
SCENARIO #1: The Exchanger identifies multiple replacement properties within the 45-day Identification Period, acquires one of these properties within the Identification Period, and they would like to receive the remaining proceeds (referred to as ‘cash boot’) in the exchange account.
A SOLUTION: Revoke the Identification of all other replacement properties, so the remaining proceeds can be released on day 46 by the Qualified Intermediary.
SCENARIO #2: The Exchanger identifies multiple replacement properties and acquires at least one, but not all of these properties. However, they are past the 45-day Identification Period, and they would like to receive the remaining proceeds.
A SOLUTION: The
remaining exchange proceeds must be held by the Qualified Intermediary until
either the end of the exchange period (day 181) or one of the occurrences
specifically cited in the (g)(6) restrictions.
Build New Or Improve An Existing Property
LET’S EXPLORE...
The improvement exchange allows an investor, through the use of a Qualified Intermediary, to make improvements on a replacement property using exchange equity. In other words, an investor can maximize investment opportunities using tax-free dollars while building or improving new investment property! This type of exchange is also referred to as a “construction” or “build-to-suit” exchange.
BENEFITS OF THE IMPROVEMENT EXCHANGE
Improvement exchanges offer an Exchanger a wide array of benefits which often result in a better investment than properties readily available on the open market. The ability to refurbish, add capital improvements, or build from the ground up, while using tax deferred dollars, can create tremendous investment opportunities. Due to the additional options provided by this variation and because the 1991 Treasury Regulations established specific parameters for improvements to be produced, improvement exchanges continue to become more common. Another benefit is that the new replacement property does not necessarily have to be fully completed within the 180 day exchange period. A certificate of occupancy is not required!
REQUIREMENTS OF AN IMPROVEMENT EXCHANGE
An Exchanger must meet three basic requirements in order to defer all of their gain in the improvement exchange format. The Exchanger must;
1.) Spend the entire exchange equity on completed improvements or down payment by the 180th day,
2.) Receive substantially the same property they identified by the 45th day and
3.) The replacement property must be of equal or greater value when deeded back to the Exchanger.
The final value of the replacement property is the combination of the original purchase price plus the capital improvements made to the property. [Note: The improvements need to be in place prior to the Exchanger taking title to the replacement property.]
You Can Purchase The Replacement Property First
REVERSE EXCHANGE BENEFITS
Revenue Procedure 2000-37 (the “Rev. Proc.”), provides guidelines for the taxpayer to acquire the replacement property before the sale of the relinquished property is completed. The reverse exchange can be the ideal solution if the taxpayer cannot delay the closing of the replacement property. The reverse exchange helps investors meet a number of objectives:
Seize the Moment: Don’t miss out on the buy of a lifetime! Immediately acquire a desirable replacement property prior to selling the relinquished property.
Protect Your Exchange: Eliminate the pressure-filled problems presented by the 45-day identification period.
Improve the Replacement Property: Use the parking arrangement to increase the value of the replacement property by making capital improvements.
Investors can take advantage of the current real estate market and still defer their capital gain by following the Rev. Proc. safe harbor guidelines for a reverse exchange.
REVERSE EXCHANGE STRUCTURES
The Rev. Proc. makes it clear that the Exchanger cannot own both properties at the same time. It describes the ownership process as a “parking arrangement” because either the ownership of the relinquished property or the replacement property is “parked” with an Exchange Accommodation Titleholder (“EAT”). To “park” the ownership actually means that a deed is recorded to transfer the ownership to the EAT so that the Exchanger owns one property and the EAT owns the other property.
ADDITIONAL ISSUES
Parking the Replacement Property: The EAT acquires title to the replacement property with funds the Exchanger causes to be loaned to the EAT. Within 180 days the Exchanger sells the relinquished property through the “delayed exchange” format and the EAT transfers the replacement property to the Exchanger.
Parking the Relinquished Property: The Exchanger conveys the relinquished property to the EAT and then the Exchanger acquires the replacement property under a “simultaneous exchange” format. During the 180 days, the EAT remains on title to the relinquished property until it is sold to a purchaser.
Reverse/Improvement Exchange: The EAT acquires the replacement property and makes improvements to this property. The improved property is later exchanged for the relinquished property within 180 days to complete the exchange.
All investors should thoroughly review any
contemplated reverse exchange transactions with their legal and/or tax advisors.
Comparison Of The Two Different Parking Arrangement Formats
BENEFITS OF A REVERSE EXCHANGE
The need for a §1031 reverse exchange arises when circumstances require that the replacement property be acquired before closing on the relinquished property. Often Exchangers may need to perform a reverse exchange in a “sellers market” where recently listed properties are quickly under contract with a buyer. Revenue Procedure 2000-37 provides guidelines for the Exchanger to perform a “parking arrangement” exchange within 180 calendar days from the Exchange Accommodation Titleholder’s (EAT) purchase of the replacement property.
REPLACEMENT PROPERTY PARKED
The EAT acquires title to the replacement property with funds the Exchanger causes to be loaned to the EAT. Within 180 days, the Exchanger sells the relinquished property through the “delayed exchange” format and the EAT transfers the replacement property to the Exchanger.
Positives of the
“Replacement Property Parked:
• Exchange equity need not be present.
• A deferred exchange may follow this format.
• Allows for multiple relinquished properties.
Negatives of the
“Replacement Property Parked
• Lender may have issues lending to the EAT.
• High costs - potential double transfer taxes and title insurance fees.
RELINQUISHED PROPERTY PARKED
The Exchanger conveys the relinquished property to the EAT and then the Exchanger acquires the replacement property under a “simultaneous exchange” format. During the 180 days, the EAT remains on title to the relinquished property until it is sold to a purchaser.
Positives of the
“Relinquished Property Parked”
• Loan and purchase of replacement property easier since the loan is directly to
the Exchanger.
• Possibly less expensive on transfer tax for relinquished property.
• Safer for EAT and Exchanger to hold title.
Negatives of the “Relinquished Property Parked”
• Equity and debt should match to avoid “boot”.
• Transfer to EAT may increase county property tax basis.
• Lender issues on relinquished property (due on sale clause and prepayment
penalties).
28.) PARKING ARRANGEMENT EXCHANGES
"Safe Harbor Finalized"
A reverse exchange is where the replacement property is acquired prior to selling or closing on the relinquished property.
Exchangers nationwide can now confidently proceed with a “reverse exchange” that adheres to the Revenue Procedure released on September 15, 2000. The new rules offer welcome clarification and will undoubtedly make this a more popular and accepted exchange variation!
HIGHLIGHTS OF THE REVERSE GUIDELINES
• The Intermediary through a “qualified exchange accommodation arrangement” (QEAA) may hold title to either the relinquished or replacement property.
• The Exchanger must have the requisite intent that the purchase of the replacement property by part of an exchange — including an agreement with the Intermediary no later than 5 days after the purchase. (Note: As a practical matter, most Intermediaries will want to have an agreement with the Exchanger prior to taking title to a property on their behalf.)
• Within 45 days of purchasing the replacement property, the Exchanger must “identify” (subject to the rules in the §1031 tax code) the relinquished property to be sold in the exchange.
• The reverse exchange must be completed within 180 calendar days.
• The Exchanger may loan or advance funds to the Intermediary for the purchase of the replacement property.
• The Exchanger may supervises improvements, act as a contractor or assume other management functions.
ADDITIONAL ISSUES
• If financing is involved, the lender should be consulted since the Intermediary must hold title to property.
• The Exchanger may enter into a lease agreement or management agreement with the Intermediary.
• The reverse exchange may be combined with an “Improvement Exchange” to allow for construction improvements to be included in the exchange. However, the 180-day time limit will apply.
• Reverse exchanges utilizing a “parking arrangement” outside this procedure may still be able to qualify for tax deferral.
EXPERIENCE IS PARAMOUNT!
Be sure to select an Intermediary that has extensive experience and a specialized staff dedicated to these complex transactions. It’s also critical to thoroughly scrutinize the way (i.e. a separate LLC for each Exchanger) the Intermediary holds title to property.
29.) HOW SECURE ARE THE EXCHANGE FUNDS
It's The Most Important Question To Ask An Intermediary
BEWARE!
Security of the exchange funds is paramount to all other aspects of an exchange. Many property owners are not aware that, with the exception of minimal regulations in the state of Nevada, “Qualified Intermediary” companies are not overseen by the federal government or any national regulatory entities! The bottom line is that you have to determine whether the company selected can provide sufficient protection and financial security, in writing, before proceeding with any 1031 exchange.
INVESTIGATE THE SECURITY PROVIDED
It is critical to examine the differences between “Qualified Intermediary” companies. Most investors are not aware that exchange companies can often hold millions, and sometimes hundreds of millions of dollars, at any point in time. It is important to compare the true security that can be provided in writing when comparing many “independent” companies versus a subsidiary of a large parent company. Does a bond, even one for $10 million or more, really provide a great degree of additional security? The answer is “no.” Any loss above the bond amount is not covered by the bond and can leave investors unprotected.
QUESTIONS TO ASK AN INTERMEDIARY
1.) Where will the exchange funds be held? (If held in a bank, are you aware that FDIC coverage is only for $100,000 per account?)
2.) In what type of account are the funds invested?
3.) Are separate accounts set up for each client?
4.) What are the requirements for the withdrawal of any exchange proceeds? (Is the Intermediary authorized to move funds without the Exchanger’s written approval?)
5.) Is the notarized signature of the Exchanger required for moving funds at all times? (What written documents specify this requirement?)
6.) Can a written “3rd Party Guaranty” be provided to all Exchangers? (Is this backed by a recognizable entity with an established track record and sufficient assets to cover a potential loss of exchange proceeds?)
30.) CLOSING 1031 TAX DEFERRED EXCHANGES
It's Painless With A Qualified Intermediary
Handling the closing of a 1031 tax deferred exchange is almost as easy as
closing a typical sale transaction! The main difference, though, is the
documentation provided by the Qualified Intermediary. These documents are
paramount to a successful 1031 exchange and must be executed prior to the
relinquished property closing.
QUALIFIED INTERMEDIARY DOCUMENTS
Once you call the Qualified Intermediary with the information needed to prepare
the exchange documents, they immediately forward the following for the
Exchanger’s signature:
1.) Exchange Agreement
CLOSING DOCUMENTS/STATEMENTS
To properly reflect a 1031 tax deferred exchange, some minor revisions to your
standard documents are required:
A. The Qualified Intermediary should be shown as the Seller on the Seller’s
Settlement Statement. For example, show the Seller as “XYZ Co., Inc., as
Qualified Intermediary for (name of Exchanger inserted here).” All other
documents which are common to the area (such as Escrow Instructions in some
states) should also show the Qualified Intermediary as the Seller.
Note: Settlement statements that show the Exchanger as the Seller, instead of
the Qualified Intermediary as the Seller, could be considered a potential “red
flag” to the IRS.
B. Have the Exchanger “READ AND APPROVE” all documents and statements prior to
having the Qualified Intermediary sign as the Seller.
C. Prepare the 1099S Form in the name of the Exchanger. Check Box #4 on the form
which indicates
that other property will be received as part of the consideration.
PREPARING THE DEEDS
Prepare the deed directly from the Exchanger to the Buyer.
2.) Assignment Agreement
3.) Notice of Assignment (also signed by the Buyer)
4.) Qualified Exchange Account Agreement
31.) EXCHANGING MULTIPLE PROPERTIES
Understanding The Requirements Is Critical
Real estate investors may take advantage of the tax code to exchange several properties into one replacement property. However, two basic rules can make planning for such an exchange challenging:
• The 45-day identification and 180-day exchange completion periods start when the first of several sales in the same exchange close.
• If several sales are grouped in the same exchange, the identification rules permit listing only 3 properties of unlimited value - OR - more than 3 properties whose combined values do not exceed 200% of the value of properties being sold.
If the goal is to exchange several properties into one or more replacement properties, the Exchanger must consider the prospect of completing all of the sales and then the purchase within a 180-day window. The first question is to decide whether there is an advantage to having only one exchan