section 1031 exchanges mancy jane parker real estate consultant martocchia & company realtors...

Section 1031 Exchanges

Mancy Jane ParkerReal Estate ConsultantMartocchia & Company RealtorsMobile: 781-608-3879Fax: 781-893-4039Email: mancyjane@realtor.comWebsite: martocchia.com

Special thanks to:Jim Livesey, Vice PresidentChicago Deferred Exchange Corporation877-811-1031 Toll Freewww.chicagodeferred.com

This presentation is also available at: martocchia.com

Every Section 1031 Exchange MUST include:

1. At least one sale and one acquisition of Qualifying, ‘Like-Kind‘’ property; AND

2. Both the sold and the acquired properties must satisfy the IRS requirement ‘Held for productive use in a trade or business or for investment.’

Introduction to Section 1031 Exchanges

Like-Kind Requirement for Real Property

The Like-kind requirement for real property is fairly easily satisfied:

1. All properties in the exchange must be considered real property under applicable state law, and

2. All properties in the exchange must be ‘held for productive use in a trade or business, or for investment.’

Note: U.S. property is not considered like-kind with non-U.S. property with the exception of the U.S. Virgin islands, which is considered like-kind with U.S. property.

1. Section 121(d)(10): Five-year hold requirement to qualify for the Section 121 (principal residence) exclusion if the residence was acquired as Replacement Property for a Section 1031 Exchange.

2. Teruya Brothers vs. IRS, Feb. 2005: Buying Replacement Property from a related party may jeopardize the exchange (Rev. Rul. 2002-83).

3. Federal District Court Case: Be consistent -- is it Investment Property or Personal Use Property?

What’s New in Section 1031

Misconceptions

• Exchanges = Simultaneous property trade between two individuals

• Residential property does not qualify

• Exchanged properties must be of equal value

• Exchanges always involve two properties

• Exchanges must involve the same category of real property (e.g. land for land, etc.)

• Only the gain must be reinvested

Acceptable for an Exchange

• Land

• Residential Rental Property -- Single or Multi-family Homes, Condos, Apartment Buildings. Second or Vacation Homes may or may not qualify.

• Owner occupied multi-unit buildings

• Commercial -- Retail, Office Properties

• Industrial / Warehouse Properties

• Tenant-in-Common Interest -- qualified property.

• Primary Personal Residences. Second or Vacation Homes may or may not qualify.

• ‘Inventory’ -- Includes Property held for sale or acquired for resale. Issue for Developers / Traders.

• Stocks (REITS included), bonds, notes, or securities.

• Certain Intangible Ownership Interests (Interests in partnership or multi-member LLCs, and some trust interests).

Not Acceptable for an Exchange

Section 121 Exclusion

Capital Gains Tax on Principal Residences:

• First $500,000 of gain for married couples filing a joint return is not subject to tax.*

• First $250,000 of gain for single taxpayers is not subject to tax.*

• Gain in excess of the exclusion is subject to tax.

• For second homes, every dollar of gain is taxable.

• Section 121 exclusion can be taken no more often than once every two years.

*If a principal residence for two of the prior five years.

Principal Second Investment Residence Home Property

• Section 121 Exclusion Yes No No

• Section 1031 Exchange No Yes / No* Yes

(*) Yes, if ‘Used in a trade or business, or held for investment.’ No otherwise.

Tax Code Assistance When Selling Real Estate

Accounting Terms

• Taxable Gain = [Property Sale Price] - [Property Basis / Tax Book Value]

• Basis = [Orig. Purchase Price] - [Accumulated Depreciation]

• Depreciation = An allowance for wear and tear to a business property. It is an annual non-cash expense that reduces taxable income.

Basis / Gain Calculation

• Sale Price $500,000

• Original Purch. Price $250,000 Less Depreciation: -(100,000)

• Tax Basis / Tax book Value -($150,000)

• Taxable Gain $350,000

[Note: Gain and Cash from the sale are NOT the same]

Capital Gains Tax Computation

• Taxable Gain $350,000• Depreciation Recapture $100,000 x 25% = $25,000• Capital Gains $250,000 x 15% = $37,500• MA Capital Gains

$350,000 x 5.3% = $18,550

• Total Tax = (23.16% of Gain) = $81,050

Accounting After an Exchange

RelinquishedReplacement

Property Property

Sale Price: $500,000 $500,000

Original Cost: $250,000 - Depreciation: -(100,000)

Tax Basis: $150,000 $150,000

Accounting After an Exchange

Relinquished Replacement Property Property

Sale Price: $500,000 $600,000

Original Cost: $250,000 - Depreciation: -(100,000)

Tax Basis: $150,000 $250,000

Accounting After an Exchange

Please Note:

• Basis of Relinquished Property is carried over to the Replacement Property.

• Basis of Replacement Property is adjusted upward for additional equity or debt.

• Depreciation of Replacement Property is calculated on the basis of the Relinquished Property, as adjusted.

Types of Exchanges

Forward (or Deferred) Exchange: Sell first, then buy. Most common form of Exchange, often the easiest. Funds held on deposit by QI between these two transactions.

Reverse Exchange: First acquire, then sell. Slightly more complex. Parked property held by the QI between the sell and the buy transactions.

Construction Exchange: Involves Replacement Property that is under construction or renovation. Can be a Forward or Reverse Exchange. Sometimes referred to as a ‘Build-to-Suit’ Exchange.

IRS Guidelines for Forward Exchanges

1. Two Important Forward Exchange Deadlines :

A. Replacement Property ID Statement - 45 Days.

B. Acquisition of the Replacement Property must occur within the earlier of :

-- 180 Days of the sale of the Relinquished Property;

-OR-

-- The due date (including extensions) of the Taxpayer’s return for the year in which it transfers the Relinquished Property.

IRS Guidelines - II / Forward Exchanges

2. Replacement Property Identification Rules:

a. Any three Properties;

-OR-

b. More than three properties, provided that their aggregate value does not exceed 200% of the sale price of the Relinquished Property.

Reverse Exchanges

Applicable when the Property Owner must or desires to buy first, then sell:

– Unique opportunity to purchase a desired property.

– Sale of Relinquished Property falls apart and purchase of the Replacement Property cannot be delayed.

– Property Owner is overly concerned with the 45-day and 180-day deadlines on the ‘buy’ side.

– Remodeling/construction is necessary to first increase the value of the Replacement Property.

Reverse Exchanges II

Property Owner cannot own the ‘buy’ and the ‘sell’ properties simultaneously. One property, usually the Replacement Property, must be ‘parked’ with the QI.

Owner must finance the acquisition of the Replacement Property before selling the Relinquished Property. Sometimes creates lender issues.

Safe harbor provisions under Rev. Proc. 2000-37:

• QI must hold the parked property no more than 180 days.

• QI and the Property Owner must each treat QI as owner of property for tax purposes — no depreciation by Property Owner while the parked property is held by the QI.

Construction / Build-to-Suit Exchanges

Involves Replacement Property that first must be constructed or renovated before it is acquired by the Property Owner to complete the Exchange.

Can be structured as a Forward or Reverse Exchange.

Replacement Property is generally held by the QI during construction/renovation period, then conveyed to the Property Owner upon the earlier of:

(i) Work is completed, or(ii) 180 days to preserve the Exchange.

Payments to the Contractor are made by the QI as instructed by the Property Owner.

Boot

• Boot is any consideration the property owner receives back in addition to his Replacement Property:

• cash;• net debt reduction; or • non like-kind property.

• The value of Boot received by the Property Owner is subject to tax. Boot does not disqualify an exchange.

Boot

To Avoid Boot:

Replacement Property Value must equal or exceed the Relinquished Property Value;

AND

The Taxpayer cannot take cash from the sale. All cash MUST be reinvested in the new property.

Boot - Examples

Relinquished Replacement Property Property Boot

Equity $1,000,000 $950,000 $50,000Debt - -

Equity $500,000 $500,000 NoneDebt $500,000 $550,000

$1,000,000 $1,050,000

Equity $500,000 $550,000 NoneDebt $550,000 $500,000 $1,050,000 $1,050,000

Boot - Examples

Relinquished Replacement Property Property Boot

Equity $500,000 $500,000 $50,000Debt $550,000 $500,000

$1,050,000 $1,000,000

Equity $500,000 $450,000 $50,000Debt $500,000 $550,000

$1,000,000 $1,000,000

Why Some Exchanges Fail

• Property Owner buys or sells before engaging a QI and setting up the Exchange.

• Property Owner fails to identify Replacement Property within 45 days.

• Property Owner fails to close on the Replacement Property within 180 days.

• Either Property does not qualify as like-kind.

• Owner (or his agent) takes possession of sales proceeds.

• The Exchange is not documented properly.

Exchange Strategies

An Exchange creates a deferral, not a forgiveness of, the capital gains tax.

Recommended Strategies:

- Continue Exchanging

- Death and Taxes

- Convert to Personal Residence - New rule: Five-year hold period for the Replacement Property to later qualify for the Section 121 exclusion.

Summary

• Exchanges fit nearly every circumstance when buying and selling an investment property.

• The property owner -- your client -- achieves outstanding economic benefit by remaining fully invested in real estate.

• Use exchanges as a strategy when your clients plan to trade-up, change location, diversify, or consolidate their holdings.

Thank You!

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