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MINIMIZE TAXES, MAXIMIZE WEALTH: UNDERSTANDING TAX DEFERRAL

STRATEGIES WHEN SELLING REAL ESTATE

COPYRIGHT © 2019 BY LEGAL 1031 EXCHANGE SERVICES, LLC, ALL RIGHTS RESERVED.

LEGAL 1031 EXCHANGE SERVICES, LLC 445 BROAD HOLLOW ROAD, SUITE 25 MELVILLE, NY 11747 NYC OFFICE: 805 THIRD AVENUE, 10TH FLOOR NEW YORK, NY 10022

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TABLE OF CONTENTS

CHAPTER 1 - HOW TO CALCULATE BASIS, DEPRECIATION

AND TAXABLE GAIN

CHAPTER 2 - PRIMARY RESIDENCE CAPITAL GAINS TAX

EXCLUSION – IRC §121

CHAPTER 3 - IRC §1031 TAX DEFERRED EXCHANGE

CHAPTER 4 - IRC §1033 EXCHANGES CHAPTER 5 - INSTALLMENT SALES – IRC §453 CHAPTER 6 - DEFERRED SALES TRUST (DST)

CHAPTER 7 - REPLACEMENT PROPERTY STRATEGIES

Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Copyright © 2019 Legal1031 Exchange Services, LLC. All rights reserved.

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INTRODUCTION

Many investors focus on the returns achieved from their real estate investments while paying little attention to how taxes can affect their profitability when investments are sold.

This course is designed to provide an overview of several important real estate tax strategies, as well as the methods used to compute capital gain tax and depreciation recapture. Understanding taxes is one of the key methods to maximizing the profitability of real estate transactions.

As with any overview course the information provided is solely for educational purposes only and does not constitute tax or legal advice.

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BASIS, DEPRECIATION, CAPITAL IMPROVEMENTS AND CALCULATING CAPITAL GAIN TAX OR LOSS Any discussion regarding the amount of gain or loss which might be recognized upon the sale or disposition of real property must naturally begin with an understanding of the components that go into computing the amount. In order to figure out a gain or loss a real estate investor must first determine the adjusted basis in a property. Unfortunately, many investors use the term “basis” interchangeably with the term “adjusted basis”, even though they each mean something different. The basis of a property, or more properly, its “cost basis”, is generally the amount an investor pays for a property, plus closing costs. Closing costs do not include prorated items such as taxes, insurance, rent; finance charges paid by the buyer; or expenses that physically affect the property, such as repairs. If the owner received property by gift or inheritance, there are different considerations for calculating basis, which can be found in IRS Publication 551. https://www.irs.gov/publications/p551 If the property is acquired in an exchange the new basis is normally the basis in the property which was sold (relinquished or condemned property), plus any funds (debt or equity) which are used to purchase the replacement property over and above the amount the relinquished property was sold for. The basis in a property may also be affected if it was acquired in a non-arm’s length transaction.

The adjusted basis of a property is the cost basis of the property, plus capital

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improvements, minus depreciation. The adjusted basis needs to be calculated in order to properly determine the amount of gain or loss upon the sale or disposition of a property. A capital improvement is an improvement which materially adds to the property’s value and prolongs the property’s useful life. When an investor makes a capital improvement to their property the amount of the improvement is added to their basis and becomes part of the calculation of their adjusted basis. If improvements made to a property do not add value and prolong its life, then they are considered a repair and not a capital improvement. General repairs and maintenance are not considered capital improvements. Replacing the roof of a building is normally considered a capital improvement; however, fixing a roof leak is considered a repair. While capital improvements are added to an investors basis the amount of depreciation taken is a reduction. Depreciation, also known as “cost recovery”, is the periodic expending of an asset over the property’s theoretical economic life. IRC §1250 Depreciation is intended to recognize the decrease in value caused by, among other things, wear and tear, and outdated interior improvements. Land is generally not depreciable, and an investor must allocate the purchase price (“cost basis”) between the land and improvements. Many times, investors will claim that their property has a “zero basis” but this is rarely true as there is generally some residual basis in the land. Depreciation is somewhat of a double-edged sword for investors in that its benefits investors while they own a property and becomes a liability when a property is sold. While a property is “in service” the annual amount of depreciation becomes an expense offset against income. This benefits the investor by lowering the amount of income they have to recognize from their property. For example, if an investor receives $75,000 in annual income from a property, and receives a $24,000 depreciation allowance, the investor will only be taxed on $51,000. Currently, the amount of depreciation allowed for real property is determined by several factors: cost basis, the type of property (residential or commercial), and the amount to be depreciated which is an allocation of the cost basis between the land and improvements. The benefit of depreciation comes at a price - the investor’s cost basis is reduced by the amount of depreciation they have taken. And not only is it reduced, but the reduction in basis is taxed at the Federal level at 25%, instead of a 15% or 20% capital gain tax rate, when the property is sold. This is known as depreciation recapture. For Federal tax purposes the adjusted basis must be divided into gain

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from appreciation and depreciation upon a sale or disposition so that the different rates for each component of gain can be applies. Most states do not have a separate rate specific to depreciation recapture but instead tax depreciation at a capital gain tax rate, or sometimes, as ordinary income. Property that has not appreciated can still have a gain due to depreciation recapture if it was considered in service. Investors must use the depreciation method in place at the time the real property was acquired. There have been several different depreciation methods in place through the years.

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Sample Depreciation Schedule

Real Property Placed in Service Date Between: The Depreciable Life Is:

Feb. 12, 1913 – Dec. 31, 1980 Economic Life

Jan. 1, 1981 – March 14, 1984 15 Years – ACRS

March 15, 1985 – May 8, 1985 18 Years – ACRS

May 9, 1985 – Dec. 31, 1986 19 Years – ACRS

Jan. 1, 1987 – May 12, 1993 27.5/31.5 Years* – MACRS

May 13, 1993 – Present 27.5/39 Years* – MACRS Under MACRS (Modified Accelerated Cost Recovery System) the first depreciable life is for residential real estate and the second depreciable life is for commercial real estate. A property must have at least 80% of its gross rental income derive from its residential rental income in order to be considered residential property. IRC §168(b)(3), (C) Investors may only choose one depreciable life for a property. When real property is placed into service the depreciation amount is computed

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from the mid-point of the month, regardless of when it is actually placed into service. This is known as the MACRS mid-month depreciation convention. As previously stated, the depreciation method is determined when the property is acquired. However, when a property is acquired pursuant to an IRC §1031 or IRC §1033 exchange determining the depreciation method can become complicated and requires complex rules.

EXAMPLE: FIGURING OUT A CAPITAL GAIN

The example below uses the highest federal bracket for long-term capital gains tax rates for individual taxpayers 20% and applies the Net Investment Income Tax of 3.8%. It also assumes that the taxpayer took straight-line depreciation and is subject to a 25% recapture rate.

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COMMON MISCONCEPTIONS

Many investors wrongly believe that gain is the amount of equity left in the property. The truth is that the amount of equity left in the property has nothing to do with gain. Gain is the sale price, minus the adjusted basis and closing costs. When investors refinance at the top of the market, and later see the value of their property retreat, there may not be enough equity remaining to pay a gain tax due upon sale. Another common misconception is that if a property is foreclosed, or sold through a short sale, the investor will not realize a gain. A foreclosure is considered a disposition. Both a foreclosure and a short sale can yield a gain if the adjusted basis is lower than the foreclosed mortgage amount or agreed upon short sale price. If an investor buys a property for $3M, and it rises to $5M, before retreating to $4M, at which point it is sold, the investor has a $1M loss. Since a gain or loss is not recognized until a property is sold this investor is still in line to recognize a $1M gain. If an investor did not take depreciation that they were entitled to they do not have to worry about depreciation recapture when they sell. Unfortunately, if an investment property is entitled to depreciation, and is in service, the investor must take depreciation and recognize recapture upon sale.

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IRC §121 AND PRIMARY RESIDENCES IRC §121 provides for an exclusion from capital gains tax upon the sale of a primary residence. An IRC §121 exclusion is available if the taxpayer has lived in the property as their primary residence two out of the preceding five years. The exclusion is $250,000 if the taxpayer is single and $500,000 if the taxpayers are married. A taxpayer can only have one primary residence. Spouses having separate primary residences can only each claim $250,000.

PARTIAL EXCLUSION

A reduced exclusion may apply for taxpayers who sell their principal residence but (1) fail to qualify for the 2 out of 5 year rule; or (2) previously sold another primary residence within the 2 year period ending on the sale date of the current home in a transaction in which the exclusion applies.

● Taxpayers may qualify for a reduced exclusion for some of the following reasons:

● Must sell home due to change of place of employment (50 miles);

● Health related issues of taxpayer or family pursuant to IRC §152(a);

● Sale is caused by “unforeseen circumstances” that taxpayer could not have anticipated before purchasing the residence.

IRC §121 AND IRC §1031

Primary residences are normally not a consideration when talking about IRC §1031 tax deferred exchanges, but some IRS rulings have clarified what the results are when these two areas intersect. Revenue Procedure 2005-14 (1/27/2005, corrected February 3, 2005) provides for clarification and additional benefits for those taxpayers converting property between a primary residence use and a business and investment. In addition, it also provides guidance for properties used partially as a primary residence and partially as a business or investment property.

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Unlike an IRC §1031 tax deferred exchange, which defers a gain upon the sale of business or investment property, IRC §121 provides for an exclusion of the capital gain tax upon the sale of a principal residence. The maximum exclusion under §121 is $250,000 for those filing as single and $500,000 for those filing a joint return. Effective October 22, 2004 the primary residence exclusion contained in IRC §121 was amended to provide for a five-year waiting period for property which was acquired using an IRC §1031 exchange. In other words, if a business or investment property acquired using an IRC §1031 tax deferred exchange is later converted to a primary residence the capital gains tax exclusion of IRC §121 cannot be applied until the taxpayer has lived in the property as its primary residence for at least two years out of a total of five years of ownership. It is important to note that a taxpayer’s initial intent must be to acquire the replacement property as business or investment property and not as their primary residence. Prior to Rev. Proc. 2005-14 when taxpayers converted a property from a primary residence to a business or investment use, or vice versa, taxpayers had to choose between IRC §121 and IRC §1031 treatment if both were available to them upon a sale. For example, if a taxpayer used a property as a primary residence for three years and thereafter rented the property for two years the taxpayer will have satisfied the requirements of §121, which provides that a taxpayer must use the property as a primary residence in two out of the preceding five years; as well as satisfying §1031 by renting out the property for over a year. It is important to keep in mind that in order to qualify for a §1031 tax deferral the taxpayer must have the intent to hold the property for business or investment purposes and no specific holding period is defined as sufficient by the Internal Revenue Service. With this ruling, taxpayers may now combine the benefits of these two code sections. Where a taxpayer satisfies the requirements of both IRC §121 and IRC §1031 the taxpayer must apply §121 to the realized gain before applying §1031. The forgiveness of gain available through §121 “does not apply to the gain attributable to depreciation deductions for periods after May 6, 1997, claimed with respect to the business or investment portion of a residence.” This amount, however, may be deferred through the use of §1031. In addition, for purposes of §1031 the amount of cash or non-like kind property (also known as boot) which would traditionally yield a taxable event, taxpayers are able to exclude the amount under §121 with respect to the relinquished business property. Lastly, taxpayers who utilize the benefits of Rev. Proc. 2005-14 to get the combined treatments of §121 and §1031 also obtain a benefit when computing their basis. Normally a taxpayer would carry over its basis from the relinquished

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property into the replacement property when structuring the transaction as an IRC §1031 tax deferred exchange. By combining the benefits of §121 and §1031 the basis of the replacement property is increased by the amount of gain recognized by §121. Accordingly, the basis of the replacement property is higher due to the application of §121 which means that the taxpayer will recognize less of a gain if it chooses to sell, instead of exchange, the property in the future.

REDUCTION IN IRC §121 EXCLUSION FOR NON-QUALIFIED USE The Housing Assistance Tax Act of 2008 (H.R. 3221) may affect any taxpayer selling their primary residence, as defined in IRC §121, if the taxpayer did not use the property solely as their primary residence during their period of ownership. Previously, so long as a taxpayer resided in their primary residence for two of the previous five years from the date of sale they would be entitled to 100% of the benefit of the capital gain tax exclusion of $250,000 if single, or $500,000 if married and filing a joint return. What that means is that if a taxpayer rented a property for three years and thereafter lived in the property as a primary residence for two years that taxpayer would only get a 2/5 benefit of the exclusion, versus receiving the entire exclusion under the previous rules. Adding further complication, the amendment addresses how the gain is allocated to periods of nonqualified use. In the past, IRC §121 only concerned itself with a five-year period of ownership and specifically required a two-year occupancy requirement to receive the full exclusion benefits. However, in 2004, IRC §121 was modified to consider properties acquired in IRC §1031 tax deferred exchanges and later converted to primary residences. IRC §121 was amended to provide for a five-year waiting period for property which was acquired using an IRC §1031 exchange. In other words, if a business or investment property acquired using an IRC §1031 tax deferred exchange is later converted to a primary residence, the capital gains tax exclusion of IRC §121 cannot be applied until the taxpayer has lived in the property as its primary residence for at least two years out of a total of five years and also requiring five years of ownership to become eligible for the exclusion. This modification is still in effect. The modification made by H.R. 3221 concerns itself with a much greater period of time inasmuch as the gain is computed based on the ratio which “(i) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to (ii) the period such property was owned by the taxpayer.” What this means is that the ratio will not always be governed by the five-year period in which a taxpayer must use the property as a primary residence, but rather by the

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total period of ownership of the property versus its period of non-qualified use. For example, if the taxpayer rented a property for four years and thereafter utilized the property as a primary residence for two years, totaling six years of ownership, the taxpayer would receive a two-sixths benefit of the §121 exclusion. It is important to note that the allocation rules apply only to a property which has a nonqualified use period followed by a use as a primary residence. For example, if a taxpayer lives in a property for three years and thereafter rents it for one year before selling it, they would still receive 100% of the benefit under IRC §121. However, if the non-qualified use comes before the use of the property as a primary residence the allocation rules will apply. Furthermore, although this amendment to IRC §121 applies to sales and exchanges after December 31, 2008 for purposes of computing the nonqualified use period, the ownership prior to January 1, 2009 is still taken into consideration when computing the ownership period for purposes of allocation. For example, if a taxpayer rented their property for a year, five years ago, this period would be discarded from the computation involving the nonqualified use period, however, the ownership period prior to January 1, 2009 is still used when computing the ratio. HR 3221 modifies IRC §121 to provide that the exclusion will not apply to gain from the sale of the primary residence that is allocable to periods of “non-qualified use” which includes periods of use as a second home as well as a rental. A period of nonqualified use does not include “any other period of temporary absence (not to exceed an aggregate period of 2 years) due to change of employment, health conditions, or such unforeseen circumstances as may be specified by the Secretary”; as well as any period (not to exceed an aggregate period of 10 years) during which the taxpayer of taxpayer’s spouse is serving on ‘qualified official extended duty’” A person who “qualified official extended duty” must be a member of the armed forces, Foreign Service of the United States, or an intelligence officer working more the 50 miles from their primary residence or residing under government orders in government housing. This exception might prove especially important for members of the armed forces currently serving extended tours of duty overseas. In conclusion, these two changes affecting IRC §121 will not only alter the ability to exchange any property fitting the definition of a dwelling unit, but also change the benefits afforded by IRC §121 for many properties that have been used both as a primary residence and an investment property.

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IRC §121 BENEFITS FOR PROPERTY ACQUIRED WITH AN IRC §1031

A property acquired through an IRC §1031 tax deferred exchange does not have to remain an investment property forever. Once a taxpayer complies with the requirements to hold the replacement property for investment purposes the property can be used personally, including as a primary residence. However, effective October 22, 2004 IRC §121 was modified to provide for a five-year waiting period before a taxpayer can claim a primary residence exemption for property acquired using an IRC §1031 tax deferred exchange. Normally a taxpayer may claim a primary residence so long as they use a property as a primary residence for two years out of a five-year period. If property acquired through an IRC §1031 is later converted to a primary residence the taxpayer must own it for five years, in addition to the requirement of living in the property as their primary residence for two years, before they may obtain the benefits of IRC §121. The earliest date a taxpayer can claim an IRC §121 exclusion is five years.

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IRC §1031 TAX DEFFERRED EXCHANGE Although exchanges have been in the Internal Revenue Code in one form or another since 1921, many people are not aware of this powerful and easy to use tax benefit. The first questions that need to be answered are “what is an exchange” and “what does it accomplish”? Simply put, an exchange allows owners of business or investment property to sell their property and not recognize a capital gains tax, so long as they buy a property of equal or greater value. Unlike the sale of a primary residence structuring a sale as a 1031 exchange does not yield a tax forgiveness. Instead, the tax that would have been recognized upon the sale is deferred into the property that is subsequently purchased in the exchange. Should that property later be sold the tax becomes due. However, the benefit lies in continuing to exchange property, thus continuing to defer the tax. During the deferral period the investor has the benefit and use of the money interest free. If a taxpayer has a basis of $100,000 and sells that property for $300,000, that taxpayer will recognize a $200,000 gain. Assuming an estimated blended Federal, state, and city capital gains tax rate of 20%, this taxpayer would recognize a tax of $40,000. In this example the taxpayer would have only $260,000 to purchase a new property after paying their capital gains tax. If this same transaction were structured as an exchange the $40,000 would be deferred as long as they purchase a like kind property of equal or greater value.

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Myths and Misconceptions The most common question upon hearing about Exchanges for the first time is “If this is so beneficial then why isn’t everyone doing it?” The simple answer: a lot of misconceptions and a lack of planning. Some of the major misconceptions are as follows:

If you want to complete an Exchange, you have to find someone who you can “swap” property with. While this is originally how Exchanges were structured, Exchangers are now free to sell their property to anyone they wish, and to buy from anyone they wish. Although there are a few issues regarding sales and purchases between related parties, most Exchanges are structured not unlike any other typical sale and subsequent purchase. Exchangers have to complete the Exchange in one simultaneous transaction. By virtue of a favorable ruling to the taxpayer in the now famous case of Starker v. United States in 1979, Exchangers have the ability to complete an Exchange on a delayed basis so long as they purchase replacement property within 180 days of selling their first relinquished property. This means that a typical exchange transaction is not very different from a normal sale or purchase. I don’t need a Qualified Intermediary; I can simply have the Client’s attorney or accountant hold the sale proceeds until the replacement property is purchased. A Qualified Intermediary who prepares the Exchange Agreement, and other ancillary exchange documents, is essential to completing a valid delayed Exchange. Using a well-established Qualified Intermediary allows an Exchanger to take advantage of the “Safe Harbors” provided for in the Treasury Regulations, protecting the Exchanger against “constructive receipt” of the Exchange funds. It is also a good practice to research the nature of the guaranties offered by the Qualified Intermediary. Unlike the primary residence capital gains tax exclusion available to homeowners under IRC §121, which is a forgiveness of tax, an IRC §1031 tax deferred exchange is a deferral of tax. This means that the capital gain tax and depreciation recapture which would have been recognized upon the sale of the relinquished property is deferred with the purchase of the replacement property. Should the exchanging taxpayer choose to sell, instead of again exchanging the replacement property, the tax which was deferred will normally become due.

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Like Kind Rules One of the most misunderstood concepts of tax deferred exchanges is the concept of like kind. Many people wrongly believe that like kind means the same type of property must be purchased when completing an exchange. Nothing can be further from the truth. Exchangers can sell one type of property and buy a completely different type of real estate as is explained below.

Real property must be held for productive use in a trade or business, or for investment purposes, and be exchanged for real property that is to be held for productive use in a trade or business, or for investment purposes. IRC 1031(a)(1). Keep in mind that for tax years beginning after December 31, 2017, Section 1031 was limited to real property by the Tax Cuts and Jobs Act. Prior to this, exchanges of like-kind personal property were possible. Although tax deferred exchanges are a creature of federal statute, it is state law that determines if a property interest qualifies as real property. See Treas. Reg. 1.1031(a)-1(b), (c), Aquilino v. United States, 363 U.S. 509 (1960). Furthermore, like-kind only refers to the nature or character of the property, not to its grade or quality. Treas. Reg. 1.1031(a)-1(b). Accordingly, it does not matter if you exchange a property zoned for residential use for another property zoned for commercial use. So long as both properties are held for business or investment purposes the exchange will be valid. It is a broad standard.

Nowhere is this concept better illustrated than the typical scenario where an exchange client sells a six-unit apartment building and thereafter seeks to purchase a five-unit apartment building. We have witnessed numerous exchangers with misconceptions explain how he or she has already lined up a contractor to subdivide one of the apartments to make six "like-kind" apartments. Similarly, it is no different where exchangers try to buy the same acreage of vacant land, the same square footage office building, or the same type of two-family house. In each of these examples the exchanger is far too strictly construing the requirement to purchase like-kind property as a much more restrictive requirement than it actually is. For purposes of an IRC §1031 tax deferred exchange real property will be considered like- kind if it is held for productive use in a trade or business or for investment purposes. Treas. Reg. §1.1031(a)-1. Any real property fitting this definition will be considered like-kind to all other real property fitting this description, regardless of whether the properties are industrial, commercial or residential. Accordingly, an exchange of vacant land for an office building is valid, for example, if said properties were held for productive use in a trade or business or for investment purposes.

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All the properties pictured above are like kind to each other if held for productive use in a trade or business or for investment purposes.

Rules to Obtain a Complete Deferral

In order to have a fully tax deferred exchange the exchanger must:

1. Buy replacement property that is of equal or greater value to the relinquished property;

2. Reinvest all of the net proceeds from the relinquished property into the

replacement property; 3. Obtain equal or greater financing for the replacement property as was satisfied on

the relinquished property (Note: a decrease in the financing amount can be offset with additional cash added to the transaction.); and

4. Purchase only like-kind property.

To the extent that some of these rules are not followed, the exchanger may be able to obtain the benefits of a partial tax deferred exchange.

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Exchange Structure, Timeline, and Documenting the Exchange

Tax deferred exchanges are normally structured as one of four variants: simultaneous, delayed [Treas. Reg. 1.1031(k)-1(a)], reverse [Revenue Procedure 2000-37], and build-to- suit. In the case of a simultaneous or delayed exchange, the exchanger first enters into a contract to sell the relinquished property or properties. Contrary to popular belief there is no “exchange contract” for a delayed exchange. The exchanger enters into a contract that they would normally use if they were not structuring the transaction as an exchange. However, the addition of an exchange cooperation clause is recommended to secure the cooperation of the buyer or seller of the relinquished property or replacement property, respectively. A person or entity that is not a disqualified party [Treas. Reg. 1.1031(k)-1(g)(4)(iii)], usually a Qualified Intermediary, thereafter, assigns into the rights, but not the obligations of the contract. This assignment creates the legal fiction that the Qualified Intermediary is actually swapping one property for another. In reality, the exchanger sells the relinquished property and purchases the replacement property from whomever he or she wishes in an arms-length transaction. There is absolutely no requirement that an exchanger actually "swap" properties with another party. In addition to the assignment of contract, there must be an exchange agreement entered into prior to the closing of the first property to be exchanged. The exchange agreement sets forth the rights and responsibilities of the exchanger and the entity acting as a qualified intermediary, and classifies the transactions as an exchange, rather than a sale and subsequent purchase. In addition, the exchange agreement must limit the exchanger's rights "to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period." Treas. Reg. 1.1031(k)-1(g)(6). That is, the exchanger may only use the exchange funds to purchase new property, and to pay most expenses related to the sale and purchase of the properties.

Once the exchange agreement and assignment of contract are executed, the exchanger sells the property; however instead of collecting the proceeds at the closing, they are sent directly to the Qualified Intermediary. The exchanger thereafter has 45-days in which to identify potential replacement properties and 180 days, or the date upon which the exchanger has to file his or her tax return for the year in which the exchange was initiated, to complete the purchase of the replacement properties. When the replacement property or properties are located, the exchanger enters into a contract to purchase same, and thereafter uses the exchange funds to complete the purchase. This, in very basic form, is the structure of a delayed tax deferred exchange.

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Identification Rules

The Exchanger has 45-days from the date of the sale of the relinquished property to identify the potential replacement properties. The identification is a written (signed and dated by the taxpayer), unambiguous description of the property and does not require that such properties be under contract or in escrow to qualify. Exchangers acquiring an undivided percentage interest (“fractional interest”) in a property should identify the specific percentage that will be acquired. The Exchanger may change the properties identified as often as he wants during the 45-day identification period by revoking the previously identified properties and then identifying new potential replacement properties. It is essential that the identification is delivered by midnight of the 45th day, or postmarked by the 45th day, to the Exchanger’s Qualified Intermediary or to a party related to the exchange who is not a disqualified person. Typically, delivering the identification to the Qualified Intermediary is the safest course of action to prevent disqualification of the transaction for an invalid and/or untimely identification. If the Exchanger fails to deliver the identification on a timely basis or does not comply with one of the three identification options, the exchange will be disallowed. To qualify for a 1031 exchange, the exchanger must comply with one of the following identification options:

1. The Three Property Rule: the “three property” identification rule allows an Exchanger to identify up to three replacement properties. There is no value limitation placed upon the prospective replacement properties and the exchanger can acquire one or more of the three properties as part of the exchange transaction. The “three property” rule is the most commonly used identification option, allowing an exchanger to identify fall back properties in the event their preferred replacement

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property cannot be acquired.

2. The 200% Rule: The Exchanger can identify an unlimited number of properties, provided that the total value of the properties identified does not exceed 200% of the value of all relinquished properties. There is no limitation on the total number of potential replacement properties identified under this rule, only a limitation on the total fair market value of the identified properties.

• For example, if an Exchanger sold relinquished property for $1,000,000 under the 200% rule, the Exchanger would be able to identify as many replacement properties as desired, provided the aggregate fair market value of all of the identified properties does not exceed $2,000,000 (200% of the $1,000,000 sales price of the relinquished property).

3. The 95% Exception Rule: The Exchanger may identify an unlimited number of replacement properties exceeding the 200% of fair market value rule, however the Exchanger must acquire at least 95% of the fair market value of the properties identified. This rule is utilized in limited circumstances as there is a much higher risk of the transaction failing.

• For example, assume an Exchanger identifies ten properties of equal value.

In order to satisfy the rule, the Exchanger would be required to acquire all ten identified properties within the exchange period to complete a successful exchange. If one of the properties fell through, the entire 1031 exchange will be disqualified because the exchanger did not acquire 95% of the fair market value identified. This rule should only be utilized in situations where there is a high level of certainty pertaining to the acquisition of the identified properties and the other two rules do not meet the Exchanger’s objectives.

Exchange Vesting Rules

With limited exception, IRC §1031 requires that taxpayers disposing of relinquished property must be the same taxpayer to acquire the replacement property. IRC defines like- kind property as “property held for productive use in a trade or business, or for investment purposes.”

Most tax advisers will argue that when a taxpayer has received an interest in real property as part of a distribution or dissolution from an entity in which he/it had an interest, such

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as a partnership or corporation, immediately prior to selling the property, the taxpayer will not satisfy the “held for” requirement of IRC § 1031. Instead, the taxpayer will be deemed to have held that property for resale, since it was the prior entity that truly held it for business or investment purposes.

At odds with the requirement of keeping the same taxpayer on both sides of the transaction is a lender’s requirement, in many cases, for taxpayers to acquire real property in bankrupt remote entities. The question then arises: What form of bankrupt remote entity will allow a taxpayer to complete a tax-deferred exchange?

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IRC §1033 INVOLUNTARY CONVERSION EXCHANGES

An IRC §1033 exchange operates very similar to IRC §1031 in that it defers a capital gain tax. However, unlike an IRC §1031 tax deferred exchange, a tax deferral pursuant to IRC §1033 does not generally involve a sale of property, nor does it require the use of a qualified intermediary. An involuntary conversion occurs when an investor’s property is destroyed by casualty or taken in condemnation, or threat of condemnation, and the owner uses the insurance or condemnation proceeds to acquire replacement property. The IRS requires that the involuntary conversation must be by reason of destruction, theft, seizure, requisition, or condemnation. A threat or imminence of condemnation can justify a voluntary conveyance of property to the condemning authority. The cost of the replacement property must be equal or greater than the net proceeds received (including payoff of any mortgages) from the converted property. The taxpayer does not have to use the actual funds received from the condemnation award to acquire the replacement property. Unlike a §1031 exchange the taxpayer may obtain a larger mortgage on the replacement property and doesn’t have to replace all the equity that was in the relinquished property. Like a §1031 exchange, a §1033 exchange will defer both capital gains tax and depreciation recapture. Property acquired must be similar or related in service or use; or If the subject property being condemned was held for productive use in a trade or business, the more liberal “like kind” requirements of IRC §1031 can be used. The replacement property must be acquired within two years after the close of the first tax year in which any part of the gain is realized, unless the property was held for productive use in a trade or business or for investment purposes, in which case the investor has three years to acquire replacement property. The IRS has ruled

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that under certain circumstances the acquisition of an entity which owns qualifying replacement property will be deemed a valid 1033 replacement property. The property acquired through the acquisition of an entity must be of similar use to the condemned property.

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IRC §453 INSTALLMENT SALES

IRC §453 provides that to the extent a taxpayer does not receive consideration from a sale they are not taxed on the amount outstanding. An installment sale occurs when the taxpayer receives at least one payment after the close of the taxable year in which the sale or exchange occurs. IRC §453(b)(1)

Installment sales may not be used to defer the recognition of a loss. A loss must be reported in the year of the sale. Rev. Rul. 70-430. Installment sale treatment may not be used by dealers of real or personal property. IRC §453(b)(2) In order to figure out what portion of an installment note payment is taxable the taxpayer must determine the gross profit percentage. GROSS PROFIT PERCENTAGE – the ratio of the gross profit realized to the contract price. IRC §453(c) If part of the gain recognized is from unrecaptured IRC §1250 depreciation the taxable portion of the gain received is paid first at the higher depreciation recapture rate. (For sales after August 23, 1999) Reg. §1.453-12

Certain depreciation methods can cause the recapture to be reclassified as ordinary income and not treated as an installment sale. (e.g. – ACRS commercial real property depreciated using accelerated depreciation instead of straight line.)

If a buyer assumes a mortgage liability in excess of the basis of the sale property, the difference is considered a payment in the first year. IRC §453(f)(3).

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CALCULATING GROSS PROFIT PERCENTAGE

CALCULATING CAPITAL GAINS TAX ON INSTALLMENTS ASSUMPTIONS: Sale Price: $800,000, 1st Year Down Payment: $200,000, $60,000 per year for 10 years. Basis $150,000 - $50,000 depreciation = $100,000 Adjusted Basis

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Structured Installment Sales are considered an alternative to an IRC §1031 tax deferred exchange. If a seller takes back a note from a buyer to obtain installment note treatment, they must be concerned with the buyer’s ability to pay. With a structured installment sale, the seller assigns the sale contract to a third-party company in return for an installment note. IRC §453. The third-party company receives the net proceeds from the sale. The net proceeds are used to purchase an annuity (normally from a life insurance company). In return the third-party company structures an installment note in favor of seller. Payments consist of return of basis (which is not taxed), gross profit (taxed at 25% depreciation recapture and 15% or 20% capital gain tax rate ), and ordinary income derived from the annuity investment. The seller benefits by receiving income on the deferred taxes as opposed to only receiving income from after tax dollars in a straight sale. Most structured installment sales limit the investment of proceeds to annuities. Limits on ability to control payments (income only versus principle and income.) Limited access to tax-free proceeds through a refinance of the investment. No ability to continue deferring the tax at completion of structured installment sale.

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DEFERRED SALES TRUSTS A Deferred Sales Trust (DST) is a trade name for a type of structured installment sale pursuant to IRC §453. Unlike a standard structured installment sale, a DST can provide more flexibility and investment choices. A Deferred Sales Trust should not be confused with a Delaware Statutory Trust, which shares the same acronym, “DST” and will be discussed in the next chapter. An interest in a Delaware Statutory Trust, a securitized beneficial interest in a trust holding real estate, can qualify as 1031 exchange replacement property where a Deferred Sales Trust is a different tax deferral option outside of Section 1031. A Deferred Sales Trust can save investors hundreds of thousands of dollars in taxes, and at the same time, give them the opportunity to potentially make a profit on the money they would have paid to the Internal Revenue Service in the year of the sale. This strategy is gaining popularity as an alternative to a 1031 exchange among those who have highly appreciated assets that they wish to sell. The process starts when an investor assigns its contract to sell its property to a trust owned by a third-party company, similar in some respects to the way a 1031 exchange is structured. The trust next sells the property to the buyer. Next, the trust "pays" the investor. The payment isn't in cash, but with a payment contract called an "installment contract." The contract promises to make payments to the investor over an agreed period. There are no taxes to the trust on the sale since the trust "purchased" the property from the investor for what it was sold for. The options on when and how payments can be made are flexible. The investor may have other income and doesn't need the payments right away. The tax code doesn't require payment of the capital gains tax unless and until the investor starts receiving installment payments. The capital gains tax is paid to the IRS as an "installment plan" since only that portion of capital gains tax is due in proportion to the number of years established in the term of the installment agreement. Similar to a standard structured installment sale the proceeds from the sale property are used to purchase an investment to fund the installment note. However, instead of

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purchasing an annuity with the proceeds, the funds are placed in a trust account and invested pursuant to risk tolerances dictated by seller during the formation of the trust. Proceeds can be invested in stocks, bonds, mutual funds, real estate (e.g. REITs),annuities, and many other types of financial products. In order to provide security to the investor the DST installment note payments are typically secured by the Trustee of the DST and directly against the DST assets. The Deferred Sales Trust has the potential to generate more money over the long run than a direct and taxed sale. There is also the opportunity to borrow against the investment and have access to the funds tax free.

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REPLACEMENT PROPERTY STRATEGIES

Maximizing a 1031 Identification

A common mistake for many investors structuring their transaction as an IRC §1031 tax deferred exchange is when they only identify one property within the 45-day identification period. This creates a risk if the exchanger is unable to close on the only property they identified after the expiration of the 45-days identification period. Since the identification may not be changed after the expiration of the identification period the exchange will fail. The solution is to utilize either the three-property rule or the 200% rule to allow for backup properties in case the primary property cannot be purchased. An additional strategy is to purchase multiple properties which in the aggregate will complete the equity and financing requirements. One or more properties can be purchased primarily to absorb the residual equity or financing needed to avoid a tax liability. (i.e. - Zero-Coupon strategy)

Triple Net Lease Properties

A Triple Net Lease property is a deeded interest in a property where the tenant is responsible for most or all the costs (insurance, taxes, maintenance). For this reason, net lease properties make ideal replacement properties for exchangers looking to relieve themselves of the management responsibilities associated with owning real estate. Since the tenant has almost all the responsibility for the maintenance and upkeep of the property the investor simply collects its rent check every month – a “mailbox” landlord. The term “triple net lease” property is not a legal term and what it means can vary somewhat according to the purchase contract or the rights of the parties under the lease itself.

For example, in a “triple-net ground lease” the owner generally retains a fee interest in the ground, which is leased to a tenant, who in turn owns the improvements pursuant to terms in the lease. In a ground lease, during the lease term, the tenant is generally entitled to take depreciation deductions on the structures while the owner/landlord owns the ground only, which does not depreciate. The improvements may revert to the owner/landlord at the completion/termination of the lease and any options, if the lease provides so.

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Typically, a national or regional company develops a location, sells it to an investor, and takes back a long-term lease. Examples of some companies who take advantage of the net lease market are: CVS, Advance Auto, Home Depot, 7-11. Selling properties to investors allow companies to expand without using capital which could otherwise be deployed. In addition, many companies sell their properties for more than their development costs giving them a profit on the sale of the real estate. The credit of the tenant and time left on a lease can have an effect on the investment’s return and subsequent sale price. Net lease properties are sometimes known as “credit tenant properties” because the cap rate is determined in part on the credit of the tenant. A company with good credit can dictate more favorable terms because they are considered a less risky investment. Net lease properties are also attractive to investors because there is a large secondary market making them somewhat of a “liquid” real estate investment. The opportunity to obtain attractive financing at the time of the purchase, or to refinance the property in order to obtain access to funds, are another attractive feature. Most net lease properties are priced at $1M+ placing them somewhat out of reach of small investors.

Tenants in Common (TIC)

A “tenancy in common” is the co-ownership of property by two or more persons under an arrangement that is not deemed to be a partnership. A “tenancy in common interest” (commonly referred to as a “TIC”) is a fractional ownership interest in a piece of property, rather than purchasing the entire property. The TIC transactions have grown exponentially since 2002 when the IRS, through Revenue Procedure 2002-22, issued guidelines with respect to obtaining a favorable private letter ruling that a properly structured TIC transaction will qualify for 1031 treatment. Tenant in common properties share some of the traits of net lease properties, such as the lack of management responsibilities by the exchanger and the receipt of a net check each month for the rent by the exchanger. TIC properties are different from other traditional types of real estate ownership because by definition its owners are co-owners with other people in the property. The co-owners in the property have been grouped together by companies known as sponsors who structure these types of transactions. Sponsors will identify a property to be purchased, determine how many investors will take part in the purchase, arrange for financing on the property, and act as the property manager. For example, a TIC sponsor may purchase a $20M property with twenty investors

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each contributing $1M each. The benefit of a TIC property is that many times investors can purchase a small portion of credit worthy building, whereas they would not be able to buy anything credit worthy on their own. Another reason why exchangers like this type of investment is that the sponsors always have new properties coming on the market to buy. If an exchanger is running out of time and does not know what to buy, these properties can become an attractive alternative. In return for these benefits a TIC owner has very little control in the property, may not take cash out of the property in a refinance, and must generally wait until a predetermined date to sell the property. Most TIC investments are sold as securities by licensed securities brokers and are marketed through a private placement memorandum which includes comprehensive disclosure about the property, reporting things like the price a sponsor paid for it, its share of the profit, fees and commissions, along with potential risks. Although these transactions are packaged as securities, they are real estate deals at heart. The fundamentals of the investment are the same as in any other traditional real estate investment. The TIC investor should thoroughly evaluate the investments – the tenant roster, building quality, financing structure, etc. to gain the level of confidence they are making a sound investment.

Zero Coupon Strategy and Delaware Statutory Trusts

In economic climates where investment real estate values have deteriorated and financing for properties can be difficult to obtain, more and more investors find themselves in a predicament where they want or need to sell a property, but the net proceeds of the sale will not cover their tax obligations from the sale. This can happen because of a distressed sale, a short sale, a deed in lieu of foreclosure, or a foreclosure, which are also considered to be sales for purposes of Section 1031 of the Internal Revenue Code. This can also happen because the investor previously refinanced the property to a level where debt service exceeds current cash flow and they want to sell to eliminate the negative cash flow, but the net sales proceeds are less than the tax liability. A potential solution to this problem may be the use of highly leveraged (or ‘zero-coupon’) properties to allow investors to complete a 1031 exchange and, therefore, defer the taxes that would otherwise be due as a result of the sale.

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While the availability of mortgage financing for investment properties is extremely difficult, there is still capital available for financing single-tenant properties that are occupied on a long-term basis by tenants with very strong credit. The capital markets view these mortgages as more of a ‘corporate-financing’ vehicle than a ‘property-backed’ vehicle, which allows them to largely ignore traditional loan-sizing metrics such as loan-to-value ratios and debt service-coverage ratios. Instead, the focus is on using nearly all the cash flow from the property to service the debt. The amortization schedule for the mortgage is tied to the remaining length of the lease so that the principal balance is zero, or nearly zero, when the primary term of the lease expires. These mortgages are secured by the lease(s) and the property and are generally non-recourse to the borrowers. Even in the poor financing environment during the last recession, it was possible to obtain mortgage financing of 90% to 95% on properties with long-term leases (at least 20-years remaining on the lease) with tenants which have very strong credit. These zero-coupon programs typically combine several qualifying properties into a Delaware Statutory Trust (‘DST’ and not to be confused with a Deferred Sales Trust which also shares the same acronym) structure whereby investors can choose to invest either all of the equity from their relinquished property (if that is enough to cover their exchange), or exactly the amount of equity that they need to complete their 1031 exchange, thereby continuing to defer taxes in accordance with Section 1031. Such a DST offering can have up to 99 investors and may be available to investors with minimum individual equity investments under $50,000 (which might cover as much as $500,000 of debt). While the purpose of these zero-coupon DST offerings may be to provide investors with a way to complete a 1031 exchange with minimal equity, there are likely to be significant tax implications during the holding period of the properties. Generally speaking, all operating income is taxable unless it is offset by qualifying items such as interest payments on qualifying mortgages and depreciation. When the combination of interest payments and depreciation deductions is less than the operating income, the remaining income is typically taxable. However, since this type of DST structure uses all (or most) of the operating income to service the mortgage payments, there is typically little or no cash flow available for distributions to the investors. This leads to the creation of ‘phantom income’ where there is no cash flow to the investors, but the operating income is greater than the tax deductions, thus creating taxable income. The timing and amount of phantom income is based on each investor’s individual circumstances, but it is likely to occur at some point during the holding period. So why would one participate in such an investment? Well, remember that upon

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the sale of the relinquished property, many investors will owe more in taxes than they receive from the sale of their relinquished property. If they write a check for the difference, the money is gone forever, and the investor has nothing to show for it. For example, if an investor receives $100,000 cash from the sale of their property but has a tax obligation of $200,000 they will need to come up with the additional $100,000 and they will have no way of recovering their money. If, on the other hand, that same investor uses the $100,000 sales proceeds to invest in a zero-coupon investment, they will own real estate that pays off the mortgage automatically, leaving a building free and clear of debt when the lease expires. Even if the investor pays $100,000 in taxes on phantom income during the holding period (spread out over years) they will still have the free and clear value of the real estate (albeit, perhaps vacant) upon the expiration of the lease. Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. Copyright © 2019 Legal1031 Exchange Services, LLC. All rights reserved.