irc §1031 tax deferred exchange strategies claudia kiernan, esq. certified exchange specialist®

IRC §1031 Tax Deferred Exchange Strategies

Claudia Kiernan, Esq.Certified Exchange Specialist®

Course Objectives

• IRC §1031 Rules-Review

• Tax Updates

• Recent changes to IRC §1031

• Advanced Issues in IRC §1031

Internal Revenue Code Section 1031

“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.”

Tax Update

Higher Capital Gains Tax

New 3.8% Healthcare Tax

Depreciation Recapture Tax

State Taxes

Higher Capital Gains Tax

Single investors exceeding the $400,000 income threshold and married couples exceeding the $450,000 income threshold now pay the new 20% capital gains tax rate.

3.8% Healthcare Tax

The Healthcare and Education Reconciliation Act added a new 3.8% Medicare surtax on “net investment income.”

Applies to individual earning over $200,000 and married couples earning over $250,000

Net investment income includes: dividends, capital gains, retirement income and income from partnerships.

Depreciation Recapture Tax

Depreciation is a way to obtain a tax deduction by spreading the cost of the real estate over period of time.

As a result, depreciation reduces the properties adjusted cost basis.

Upon sale, the part of the gain that is related to depreciation will be taxed at the rate of 25%.

State Taxes

Certain states, such as California,have a 13.3% top tax rate

Run The Numbers§1031 permits deferral of:

• Capital Gains Taxes of (15%/20% Federal and __% State)

• Depreciation Recapture (25% Federal)

• Medicare Surtax (3.8%)

Example: Selling $1,000,000 property that has no debt and has been fully depreciated. Using an assumption of a 30% combined taxes between capital gains and depreciation

recapture. Purchasing replacement properties with a 75% LTV ratio.

SALE VS EXCHANGE

NET EQUITYCAPITAL GAIN TAXEQUITY TO REINVESTPROPOSED ACQUISITION

1,000,000300,000700,000

2,800,000

1,000,0000

1,000,0004,000,000

Tax Deferred Exchange terminology may be confusing to those who are unfamiliar with these transactions. The following are some of the typical exchange terms and phrases, with their interpretation.

Exchanger: The property owner(s) seeking to defer capital gain tax by utilizing a Section 1031 exchange.

(The Internal Revenue Code uses the term “Taxpayer.”)(The Internal Revenue Code uses the term “Taxpayer.”)

Basis: Original cost plus improvements, minus depreciation taken.

Taxable Gain: Selling price minus Basis.

Boot: Fair Market Value of non-qualified property (i.e., property that is not of “like-kind”) received in an exchange. (Examples: cash, notes, seller financing, furniture, supplies, reduction in debt obligations)

Constructive Receipt: Control of proceeds by an Exchanger (even though funds may not directly be in the Exchanger’s possession).

Tax Deferred Exchange Terminology

Like Kind Property: This term refers to the nature or character of the property, and not its grade or quality. Generally, real property is “like kind” as to all other real property, as long as the Exchanger’s intent is to hold the properties as an investment or for productive use in a trade or business. The “like kind” rules for personal property, however, are more restrictive.

Qualified Intermediary: The entity that facilitates the exchange for the Exchanger. The term “facilitator” or “accommodator” is also commonly used, although the Treasury Regulations specify the term “Qualified Intermediary.”

Relinquished Property: The property “sold” by the Exchanger. This is also sometimes referred to as the “exchange” property or the “downleg” property.

Replacement Property: The property acquired by the Exchanger. This is sometimes referred to as the “acquisition” property or the “upleg” property.

Tax Deferred Exchange Terminology

Exchange Myths

Exchangers have to find someone with property who

will swap property with them.

Exchangers have to complete the exchange in one

simultaneous transaction.

Exchanges are expensive, difficult, and only for large

property owners.

Exchange Myths

Exchangers will be audited if they exchange property instead of selling it.

Exchangers who live on part of their property cannot do an exchange.

Exchangers do not need to hire an intermediary; they can simply have their attorney hold the exchange funds until the replacement property is purchased.

Cashflow: Sell vacant land; acquire improved property to generate cash flow.

Depreciation: Exchange from fully depreciated property to a higher value property – the additional value can be depreciated.

Appreciation: Dispose of property in a slow market area and acquire property in a hot market area.

Conversion: Acquire property suitable for future conversion to primary residence or vacation home.

Joint Ownership Problems: Acquire separate properties so that co-owners can separate interests.

Reduce Management Burdens: Acquire management-free property.

Estate Planning: Dispose of one property and acquire several properties (example: distribute one replacement property to each family member).

Use in Profession: For example, a doctor sells a rental house and acquires a medical building to support the practice.

Exchange Motives

Why do a 1031?

No. 1 Diversification

SELL BUY1031

Sell One

Buy Multiple

SELL BUY1031

Multiple properties

One larger property that is easier to manage or

no management

Apartment complex, commercial strip center, DST

T.I.C., DST, etc..

No. 2 Consolidation

No. 3 Move Markets

SELL BUY1031

Sell in CaliforniaBuy in FL

SELL BUY1031

Heir #2

Heir #1

Heir #3

No. 4 Estate Planning

Delayed Exchange Time Limits1. 45-Day Rule: The Exchanger must identify the potential replacement

property or properties within the first 45 days of the 180 day Exchange period.

2. 180-Day Rule: The Exchanger must acquire the replacement property or properties within 180 days, or the date the Exchanger must file a tax return (including extensions) for the year of the transfer of the relinquished property, whichever occurs first.

3. There are no extensions for Saturdays, Sundays, or holidays.

4. The time limits begin to run on the date the Exchanger transfers the relinquished property to the buyer.

5. The “date of transfer” will be the date of recording or transfer of the benefits and burdens of ownership, whichever occurs first.

Disaster Extensions

Since September 11, 2001, Congress has permitted 120 day extensions for taxpayers affected within federal disaster areas by presidential order. The rules are complicated, but generally the Exchanger receives the extension if one of the following is within the affected area:

• Exchange Properties• Exchanger’s Principle Residence• Exchanger’s Tax Preparer• Qualified Intermediary

Exchange Identification Rules

1. Three Property Rule: The Exchanger may identify up to three properties of any value.

2. 200% Rule: The Exchanger may identify more than three properties if the total fair market value of what is identified does not exceed 200% of the fair market value of the relinquished property.

3. 95% Exception: If the Exchanger identifies properties in excess of both Rule 1 and Rule 2, then the Exchanger must acquire 95% of the value of all properties identified.

Procedures for Property Identification

2. It must be in writing and signed by the Exchanger.

4. It must be delivered, mailed, faxed, or “otherwise sent” within the 45 days.

1. The property identification must be delivered to a party to the exchange that is not a disqualified party (e.g., the Qualified Intermediary).

3. It must be “unambiguous” (site specific).

5. An identification can be revoked within the 45 days, but the revocation must also follow steps 1 through 4.

In an I.R.C. §1031 real property exchange, you can exchange real property

for any other real property in the United States or its possessions, if said

property is held for productive use in a trade or business or for

investment purposes.

What is Like-Kind Property?

1031 Property

Condos

Raw Land

Apartments

Single

Family

Industrial

Property

Commercial

% Interest

as a TIC

Retail

1. “Like-kind” refers to the nature or character of the property, and not its grade or quality.

2. Generally, all real property is “like-kind” to all other real property.

3. Real property can be improved or unimproved, because this only relates to the grade or quality – not to its kind or class.

4. The Exchanger’s intent must be to hold the replacement property as an investment, or for productive use in a trade or business.

Like-Kind Property (cont’d)

Personal Property Exchanges

• The “like kind” requirement for personal property exchanges is more restrictive than real property exchanges.

• The relinquished and replacement assets must be either “like-kind” or “like class”.

• “Like-kind” refers to assets that are the same, such as an airplane for an airplane or a backhoe exchanged for a backhoe.

• “Like-class” refers to tangible, depreciable personal property that falls within the same General Asset Class or within the same Product Class (sharing North American Industry Classification System (NAICS) codes)

IRC §1031 shall not apply to any exchange of:

• Stock in trade or other property held primarily for sale (i.e. property held by a developer, “flipper” or other dealer)

• Securities or other evidences of indebtedness or interest

• Stocks, bonds, or notes

• Certificates of trust or beneficial interests

• Interests in a partnership

• Choses in action (rights to receive money or other property by judicial proceeding)

• Foreign property (real or personal) for U.S. based property

• Goodwill of one business for goodwill of another business

Qualified Purpose Test

1. Not Held for Sale • Inventory

• Other instances of “Held for Sale”

“Held for use in Trade or Business or for Investment”

2. Not Held for Personal Use• Residences

• Second Homes

3. Test is at time of Exchange

4. Holding period

How long do I need to own something before I can do a 1031 Exchange?

• 1989-U.S. House of Representatives passed a one-year holding requirement before and after exchanging a property. This did not reach the final version of the Revenue Reconciliation Act of 1989.

• Nonetheless, prudent to hold a property in use for at least one year (long term gain). A taxpayer might note that Congress did include in the Act a two-year holding period of any property received in a “related party” exchange.

• The more conservative professionals and commentators speculate that this two-year hold might be a more appropriate holding period.

Vacation and Second Homes

• In Moore v. Commissioner, T.C. memo 2007-134, the Tax Court held that properties held for personal use with the mere hope or expectation of gain did not establish investment intent.

• Effective for all exchanges on or after March 10, 2008, Revenue Procedure 2008-16 creates a safe harbor (meaning the IRS will not challenge the exchange) for “dwelling units” that meet the following criteria:

Vacation and Second Homes

• The relinquished property: 1) was owned by the taxpayer for 24 months prior to the exchange and 2) was rented for 14 days or more in each of the two 12 month periods preceding the exchange and 3) the Taxpayer’s personal use in each of those years did not exceed the greater of 14 days or 10 percent of the number of days the property was rented at fair rental rates.

• The replacement property must meet the same criteria.

• The exchange must meet all the other Section 1031 requirements.

• It is unknown how the IRS will view properties that do not fall within this safe harbor.

Combining IRC Sections 1031 and 121

• IRC §121 permits an exclusion from capital gain realized of $250,000 for a single person and $500,000 for a married couple on the sale of a home used as a primary residence for any two of the past five years.

• If, however, the residence was acquired as a replacement property in a §1031 exchange, the Exchanger must have held the property for a total of FIVE years before it qualifies for the §121 exclusion when it is sold. (HR 4520 October 22,2004)

Combining IRC Sections 1031 and 121

• Effective January 1, 2009, the §121 exclusion will not apply to gain from the sale of a residence that is allocable to periods of “nonqualified use”. (Housing Assistance Act of 2008)

• If a primary residence is converted for use as rental, it may qualify for both a §1031 exchange as property used in a trade or business and also for the §121 exclusion when it is sold (Revenue Procedure 2005-14)

Housing Assistance Tax Act of 2008• Amends §121 to further restrict its exclusion benefits

• $250,000/$500,000 no longer applies to periods of “Non-qualified” use.

• Non-qualified use: “Any use other than primary residential” by the taxpayer. Thus no exclusion allowed for portion of ownership that was either:– Rental (Investment) or Personal Use (Second or Vacation Home).

• Effective January 1, 2009 the exclusion will not apply to gain from the sale of the residence that is allocable to periods of “nonqualified use.”

• §121 Exclusion is now allocated based on ratio of qualified use period to

ownership period.

• Non-qualified use prior to January 1, 2009 is not taken into account for the non-qualified use period (but is considered for the ownership period).

Exchange Contract Cooperation ClausesTo provide the other party to the transaction with notice of the exchange the Exchanger should have an exchange cooperation clause in the purchase and sale agreement for both the relinquished and replacement properties:

Relinquished Property

Buyer hereby acknowledges that it is the intent of the Seller to complete a tax deferred exchange under IRC Section 1031 which will not delay the close of the purchase transaction or cause additional expense to the Buyer. The Seller’s rights under the purchase and sale agreement may be assigned to a Qualified Intermediary of the Seller’s choice for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and the Qualified Intermediary in a manner necessary to complete the exchange.

Tax Court Decision Confirms Need for Qualified Intermediary

Crandall vs. Commissioner of Internal RevenueNo QINo Exchange AgreementCourt held that the taxpayers had constructive receipt of the proceeds

and were required to pay not only capital gains taxes on the sale of the property but also a hefty accuracy-related penalty.

“it is well established that a taxpayer’s intention to take advantage of tax laws does not determine the tax consequences of his transactions…Congress enacted strict provisions under section 1031 with which taxpayers must comply.”

Qualified Intermediary

The use of a Qualified Intermediary is essential to completing a valid delayed exchange. The Qualified Intermediary performs several vital functions in an exchange.

Acts as a Principal

The IRS stipulates that a reciprocal trade or actual exchange must take place in each IRC §1031 transaction. This means the Exchangers must assign to a Qualified Intermediary (1) their interest as seller of the relinquished property and (2) their interest as buyer of the replacement property. The Qualified Intermediary should be an Independent Party (not DISQUALIFIED) to the transaction.

The use of a Qualified Intermediary allows for “DIRECT DEEDING” of the properties involved in the exchange. This is only allowed with the use of a Qualified Intermediary.

Holds Exchange Proceeds

If the Exchanger actually or constructively receives any of the proceeds from the sale of the relinquished property, those proceeds will be taxable as boot.

Prepares Legal Documentation

Several legal documents are necessary in order to properly complete an exchange. The Qualified Intermediary will prepare an Exchange Agreement, two Assignment Agreements, and Exchange closing instructions for each closer.

Provides Quality Service

Although the process is relatively simple, the rules are complicated and filled with potential pitfalls.

Qualified Intermediary (cont’d)

Balancing Act

How to Measure the Exchange

Balancing the Exchange

In order to obtain a deferral of the entire capital gain tax the Exchanger must:

1.Purchase property of equal or greater value.2.Reinvest all of the net proceeds from the relinquished property.3.Obtain equal or greater financing on the replacement property than was

paid off on the relinquished property. Replacement property debt can be offset with cash put into the exchange.

4.Receive nothing in the exchange but like-kind property.

To the extent the Exchanger fails to observe these rules they will be subject to capital gain tax


Value

Mortgage

Equity

Relinquished Replacement

Exchanger goes up in value, across in equity and up in mortgage:

$150,000

$ 50,000

$100,000

$225,000

$50,000

$175,000

Example I.

No Tax is due.


Value

Mortgage

Equity


Exchanger goes up in value, up in mortgage and keeps $10,000 of net proceeds:

$150,000

$ 50,000

$100,000

$225,000

$ 40,000

$185,000

Example II.

Tax is due on $10,000 of Cash Boot.


Value

Mortgage

Equity


Exchanger goes down in value, across in equity and down in mortgage:

$150,000

$ 50,000

$100,000

$125,000

$ 50,000

$ 75,000

Example III.

Tax is due on the $25,000 of Mortgage Boot.

Refinancing Issues

Refinancing prior to the relinquished property sale Refinancing after the purchase of replacement property – Better but

should have a time break/separate transaction.

To avoid the pitfalls of the “step transaction doctrine”: The refinance should not appear to be solely for the purpose of “pulling out equity”, refinance prior to listing relinquished for sale, document as separate transactions.

Examples:

Exchange Vesting IssuesWith few exceptions in an exchange, title to the Replacement property must be held in the same manner as title was held on the Relinquished property.

• Partnership ABE Acquires

• ACME, Inc. Acquires

• Individual Acquires

• Individual Relinquishes

• Partnership ABE Relinquishes

• ACME, Inc. Relinquishes

Except in limited circumstances, the same tax identification number should be used on both the relinquished and replacement phases of the transaction.

Exchange Vesting Issues

Grantor Trust (e.g. revocable living trust): Trustee takes title to replacement property as an individual and then transfers it later to trust. Trust is disregarded for tax purposes.

Death of Exchanger If Exchanger dies, Exchanger’s estate can complete exchange.Single Asset Entities: Exchanger who relinquished as an individual can acquire

replacement property in a single-member LLC. This entity is disregarded for tax purposes under “check the box” rules. (Rev. Proc. 2002-69 Husband and Wife in community property state – can choose disregarded treatment.)

A corporation merges out of existence in a tax-free reorganization after disposition of relinquished property, may complete the exchange and acquire the replacement property as the new corporate entity.

Exchange Structures with A Qualified Intermediary

• Delayed/Simultaneous

• Reverse

• Build-to Suit

• Reverse Build-to-Suit

What is Reverse Exchange?

A Taxpayer needs to close on the acquisition of the replacement property before the relinquished can close.

Because IRC 1031 requires an “exchange” the taxpayer cannot own both the relinquished and the replacement properties at the same time.

Typically, the reverse exchange involves a third-party “parking” title until the taxpayer can complete the exchange.

Intermediary holds title to Exchanger’s Replacement Property until the Relinquished is sold

Parking Title to the Replacement Property

& Assignment

Exchange Agreement

SellerSeller

CashReplacement Property

Phase One

Loan from Exchanger for Downpayment or Entire Purchase Price

Loan from Exchanger for Downpayment or Entire Purchase Price

CashCashQualified

IntermediaryEXCHANGER

Parking Title to the Replacement Property

ExchangerExchanger & Assignment

Exchange Agreement

Replacement Property

Cash

Used to Repay Exchanger’s Loan for Replacement PropertyRelinquished Property

Direct Deed


Buyer

Phase Two

Build-to-Suit Exchange

& Assignment

Exchange Agreement

CashRelinquished Property

Direct Deed

Step 1


Buyer

Exchanger

Step 2

Cash from Exchange Account

Replacement Property to be Improved

Intermediary holds title to the Replacement Property while it is being improved with Exchange Funds


Seller

Step 3

Completed Replacement Property

There can be no more than 180 days between steps 1 and 3 in order to remain within the safe harbor


Exchanger

Build to Suit on Tax Payer Owned Property

(Rev Proc 2004-51)

Related Party Issues

• IRC §1031(f) is designed to prevent basis-shifting & avoidance of payment of federal income tax.

• Through exchange of high basis property for low basis property, in anticipation of the sale of the low basis property.

• If a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect ‘cashed out’ of the investment, and the original exchange should not be accorded non-recognition treatment.” H.R. Rep. No. 247, 101st Congress 1st Sess. 1340 (1989)

Related Party Buyer

• Related Party Buyer must hold the Relinquished Property received from Exchanger for 2 years. IRC §1031(f)(C)(i)

• Unless Related Party Buyer is not actually “trading” any Related Party Buyer owned property with Exchanger.

• If Related Party Buyer starts out with cash, not property, and it simply a purchaser of Exchanger’s property, ending up with 100% basis in the purchased property, then the Related Party Buyer may dispose at will. PLRs 200709036 & 200712013-There is some dispute as to whether this will hold up for others.

Related Party Seller

• Exchanger must hold Replacement Property received from Related Party for 2 years. IRC §1031(f)(C)(ii)

• Related Party Seller of Replacement Property must also do an exchange.• Related Party Seller may not receive cash or non like-kind property.• If Related Party Seller does not do an exchange, IRS views this as “cashing out”

and transaction will be taxable (Revenue Ruling 2002-83).

Partnership Issues

COMMON SCENARIOS:

1. A partnership owns property and wishes to sell it. Some of the partners want to engage in a 1031 tax deferred exchange upon the sale and some do not.

2. A partnership owns property and wishes to sell it. All of the partners would like to participate in a 1031 tax deferred exchange, but the partners do not want to purchase the new property together

Possible Solutions

IF MOST OF THE PARTNERS IN THE PARTNERSHIP WISH TO COMPLETE THE 1031 EXCHANGE TOGETHER:Distributing an undivided interest. Purchase of the interest of the retiring partner.The partnership could sell the relinquished property, distribute a portion of the proceeds to the partners who wish to cash out and use the remaining proceeds to purchase the new property.

ISSUE: The partners that are cashing out would receive a special allocation of the gain from the sale of the property. This gain maybe greater for the partners that cashed out.

What if the partners do not wish to purchase the new property together?

The partnership can be liquidated and terminated and the relinquished property distributed to the partners as tenants in common.

This should be done as far in advance of the sale as possible.If a distribution or dissolution occurs shortly prior to the sale, the key issue is whether the relinquished property was “held for productive use in a trade or business or for investment purposes.”

Possible Solutions

Exchange Strategies

A foreclosure or short sale may result in taxes on gain that must be recognized.

Taxpayers can take advantage of creative exchange strategies to use the funds that would otherwise be needed to pay capital gain taxes for the purchase of a better performing replacement property.

Why is Tax Basis Important?

Pay taxes on the difference between the sales price and the tax basis not the difference between sale price and the equity

Can owe taxes even if there is no (or even negative) equity!

The 1031 Exchange Solution

• Structure the short sale as an exchange• Acquire replacement property• By doing so, you can avoid recognizing capital gains taxes • Unfortunately, COD income cannot be avoided

Audit Issues

• Verify the Exchange Agreement was executed prior to the closing of the relinquished property. IRS looks for “as of” dates.

• Exchange Agreement must contain the “(g)(6)” restrictions from the Treasury Regulations regarding the limitations on the Taxpayer’s access to exchange funds.

• Qualified Intermediary cannot be a disqualified party.• Was the 45 day identification timely done…lot of issues here…• Did the Exchanger buy or sell to a related party?

Millions of Taxpayer 1031 Funds have been lost over the last five years

HOW DID THIS HAPPEN?

1. Qualified Intermediaries are not regulated or monitored by the Federal Government, but a few states have recently enacted legislation.

2. Treasury Reg §1.1031(k)-1(f) Taxpayers must not have actual or constructive receipt of the sale proceeds from their relinquished property until the replacement property has been purchased and the exchange has terminated.

Security of 1031 Funds

Who owns the Qualified Intermediary? How financially stable are its owners?Is it a publicly traded corporation?Will the Qualified Intermediary provide you with its financial statements?What is the package of security that the Qualified Intermediary is offering your client?

• Fidelity Bond• Corporate Guarantee• Errors and Omissions Insurance

Does the Qualified Intermediary have trained professionals (Attorney or CPA) on staff?

Questions To Ask Regarding The QI

What criteria does QI use to pick its bank or will it use any bank?

Does the bank send bank statements to taxpayer?

Questions To RegardingThe Banks The QI Uses

Questions To Ask Regarding The Account Structure The QI Uses

Does the 1031 Intermediary deposit 1031 funds in segregated accounts under the exchanger’s name and Taxpayer Identification Number?

Are funds commingled?

Does the 1031 documentation state exactly what type of an account structure is being used?

Does the QI require written authorization to disburse funds?

Security Features You ShouldLook For In A QI

Performance Guaranty issued on each exchange Fidelity BondErrors and Omissions InsuranceTransparency about entire organizationExchange funds deposited into segregated, interest bearing bank accounts that are separately identified to each Exchanger.Disbursement of exchange funds requiring written authorization of the ExchangerExchange funds deposited into highly rated financial institutions.

Investment Property Exchange Services, Inc.

Contact Information: CLAUDIA KIERNAN, ESQ., CES Vice President 877-494-1031

904-826-7140 [email protected]