new 1031 exchanges: identifying property, calculating depreciation,...
TRANSCRIPT
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1031 Exchanges: Identifying Property, Calculating
Depreciation, Completing Form 8824, Tax Reform Changes
TUESDAY, FEBRUARY 18, 2020, 1:00-2:50 pm Eastern
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February 18, 2020
1031 Exchanges: Identifying Property, Calculating Depreciation, Completing Form 8824, Tax Reform Changes
Professor Bradley T. Borden, Professor of Law
Brooklyn Law School
Craig Brown, Vice President and Regional Manager
Investment Property Exchange Services
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
1031 Exchanges: Identifying Property, Calculating Depreciation, Tax
Reform Changes, Addressing Partnership Issues
Craig Brown | Senior Vice President
(817) 271-1031
Bradley T. Borden | Professor of Law
(718) 780-7550
An explanation of the basic applicability
and benefits of 1031 Exchanges. Looking
at some of its history and recent changes.
6
A review of the qualifications,
requirements, and restrictions pertaining
to 1031 Exchanges, including time for
identification, time for replacement,
investment intent and holding periods,
property value requirements, cash out and
boot, “like-kind” property, rules of
identification, taxpayers and disregarded
entities, and selecting a Qualified
Intermediary.
A look at some of the business details
that can creep into transactions and
interfere with the initial goals of the
parties. Specifically at look at Related
Parties, Seller Carry, Partnership Issues
and other common issues to spot in
advance of the 1031.
COURSE OBJECTIVES
I.R.C. SECTION
1031
1031 EXCHANGE
PROCESS1031 Heads Up1 2 3
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INTERNAL REVENUE CODE SECTION 1031
“No gain or loss shall be recognized on the
exchange of real property held for productive use in
a trade or business or for investment if such real
property is exchanged solely for real property of
like-kind which is to be held either for productive
use in a trade or business or for investment.”
If the sale of investment property would have a
capital gains tax consequence, the investor can
defer the capital gains tax by reinvesting the
proceeds in another investment property; in this
event, the sales contract should include exchange
cooperation language to facilitate the
assignment of the contract to the Qualified
Intermediary.
§1031
DEFERS
taxes
§1031 is
NOTa tax-free
transaction
7
X
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TAX DEFERRED EXCHANGE TERMINOLOGY
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.”)
Original cost plus improvements,
minus depreciation taken.
BASIS
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).
Control of proceeds by an Exchanger
(even though funds may not directly
in the Exchanger’s possession).
BOOTCONSTRUCTIVE
RECEIPT
Selling price minus Basis.
TAXABLE GAIN
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.
LIKE KIND PROPERTY
8
Tax Deferred Exchange terminology may be confusing to those who are unfamiliar with 1031 transactions. The following are some of
the typical exchange terms and phrases along with their interpretation.
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TAX DEFERRED EXCHANGE TERMINOLOGY
QUALIFIED INTERMEDIARY
The person or entity that facilitates
the exchange for the Exchanger. The
term “facilitator” or “accommodator”
is also commonly used, although the
Treasury Regulations use the term
“Qualified Intermediary.”
The property “sold” by the
Exchanger. This is also sometimes
referred to as the “exchange”
property or the “downleg” property.
RELINQUISHED
PROPERTY
The property “acquired” by the
Exchanger. This is sometimes
referred to as the “acquisition”
property or the “upleg” property.
REPLACEMENT
PROPERTY
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Tax Deferred Exchange terminology may be confusing to those who are unfamiliar with 1031 transactions. The following are some of
the typical exchange terms and phrases along with their interpretation.
Investment Property Exchange Services, Inc. | www.ipx1031.com
TAX REFORM MAJOR POINTS OF INTEREST
2018 Income Tax Brackets: 10%,
12%, 22%, 24%, 32%, 35%, 37%
Corporate Tax Lowered to 21% (lowest since 1938)
Estate Tax Doubled (now $11M per
parent)
Personal Property Exchanges
Eliminated
Previously: 10%, 15%, 25%, 28%,
33%, 35%, 39.6%
Corporations will take more to the bottom line (more spending, hiring, buying, etc.)
If estate has less than $11M of assets, there is no “death tax”. Leaves more money for heirs to spend.
No more 1031 exchanges of businesses, franchises, FF&E, collectibles, heavy equipment, airplanes, etc.
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NEW CHANGES EFFECT/IMPORTANCE
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TAX REFORM MAJOR POINTS OF INTEREST
Immediate expensing on capital
assets is 100% through 2022 and then
drops 20% per year thereafter
Deductibility of State Income Tax, Property Tax and Sales Tax limited to $10,000 on Federal Tax Returns (previously unlimited)
Mortgage Interest Deduction on Primary Residence lowered to $750K (previously $1M)
The Tax Reform Act repeals the technical termination rules under Section 708(b)(1)(B) for tax years beginning after 2017
2027 it completely goes away
As an offset to that the Standard Deduction was nearly Doubled.
May slightly affect home buying in
high-end areas
If a majority partner wants out (50%+), but minority partners want to remain in place, the exiting majority partner no longer causes a technical termination of the partnership as long as the remaining members stay in the partnership
• ABC, LP• Partner A owns 60% and wants to cash out• Partners B & C each own 20% and want to
exchange
11
NEW CHANGES EFFECT/IMPORTANCE
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TAX UPDATE
Higher Capital
Gains Tax
3.8% Healthcare
Tax
Depreciation
Recapture Tax
State Taxes
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TAX UPDATE
Higher Capital
Gains Tax
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Single investors exceeding the $441,451 taxable income
threshold and married couples exceeding the $496,601
taxable income threshold now pay the 20% Capital
Gains tax rate.
TAX UPDATE
3.8% Healthcare
Tax
14
The Affordable Healthcare Act added a 3.8%
tax on certain “net investment income.”
The surtax is imposed on the amount in
excess of $200,000 for single filers and
$250,000 for married couples filing jointly.
Net investment income includes: dividends,
capital gains, retirement income and income
from partnerships.
Investment Property Exchange Services, Inc. | www.ipx1031.com
TAX UPDATE
Depreciation
Recapture Tax
15
Depreciation is a method of allocating the cost
of a tangible asset over its useful life.
Depreciation deductions reduce a property’s
adjusted tax basis.
Upon sale, the part of the gain that is related
to “straight-line” depreciation will be taxed at
the rate of 25%.
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TAX UPDATE
State Taxes
16
Source: www.tax-rates.org/taxtables/income-tax-by-stateInvestment Property Exchange Services, Inc. | www.ipx1031.com
BASIC 1031 RULES
3REPLACE THE VALUE OF THE DEBT
Replace the value of the debt that was on the
relinquished property. This can be achieved by
placing a loan on the replacement property of an
equal amount, injecting equity from outside of
the exchange into the replacement property or a
combination of these.
4RECEIVE NO $
Receive nothing in the exchange but like-
kind property.
1EQUAL OR GREATER
Purchase property of EQUAL OR GREATER
value. 2REINVEST
Reinvest ALL of the net proceeds from the
relinquished property.
17
In order to obtain a deferral of the entire capital gain tax the Exchanger must:
To the extent the Exchanger fails to observe these rules they will be subject to capital gain tax on what is not reinvested.
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BASIC 1031 RULES
1BUY ABOVE THE BASIS
Purchase property of EQUAL OR GREATER value than the
adjusted basis of the Relinquished Property.
2TAKE CASH THAT IS LESS THAN REALIZED GAIN
The amount of cash taken out of the exchange (cash boot) must be less than the
Realized Gain from the sale of the Relinquished Property. (Gross sales price less
ordinary closing costs less adjusted basis).
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In order to obtain a partial deferral of the capital gain tax the Exchanger must:
To the extent the Exchanger fails to observe these rules they will be subject to capital gain tax on what is not reinvested.
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SALE VS. EXCHANGE
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Tax Rates IF SOLD• Federal Capital Gain: 15 - 20% (Maximum)
• Depreciation recapture: 25%
• 3.8% tax on certain investment income imposed by Affordable Healthcare Act
• State rates vary from 0% to 13.3%
EXAMPLE:George Grapegrower (married, filing jointly with no other taxable income) has owned a vineyard for almost 10 years and wants to sell the property for $3,000,000. Exchanger originally paid $1,500,000 for the property, put about $200,000 of capital improvements into the property and took approximately $600,000 in depreciation deductions. George owes $2,000,000 to the Lender.
Application of Tax Rates
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SALE VS. EXCHANGE
2 Calculate Capital Gain
1 Calculate Net Adjusted Basis 3 Calculate Taxes Due
21
4 Run the Numbers
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SALE VS. EXCHANGE
Calculate NET ADJUSTED BASIS
22
1Original Purchase Price (Basis) $1,500,000
PLUS Capital Improvements + $200,000
LESS Accumulated Depreciation - $600,000
equals NET ADJUSTED BASIS $1,100,000
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SALE VS. EXCHANGE
Calculate CAPITAL GAIN
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2Fair Market Value $3,000,000
LESS Estimated Closing Costs -$200,000
Net Sales Price $2,800,000
LESS Net Adjusted Basis - $1,100,000
equals CAPITAL GAIN $1,700,000
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SALE VS. EXCHANGE
Calculate CAPITAL GAIN TAX DUE
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3FEDERAL CAPITAL GAIN
Gain Due to Depreciation (25%)
Gain Due to Appreciation
$479,000* X 15% =
$621,000* X 20% =*based on 2018 Breakpoints
Taxable Investment Income (Healthcare Tax)
$1,700,000
-$600,000 x 25% =
$1,100,000
$1,450,000 x 3.8% =
$150,000
$71,850
$124,200
$55,100
STATE State Tax (using 5%) state taxes vary from 0-13.3% $1,700,000 x 5% = $85,000
TOTAL FEDERAL & STATE TAXES $486,150
SALE VS. EXCHANGE
Run THE NUMBERS
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4§1031 permits deferral of ALL:
• Capital Gains Taxes (Federal &
State)
• Depreciation Recapture (25%
Federal)
• Healthcare Tax (3.8%)
Sale Exchange
Net Equity $800,000 $800,000
Total Capital Gain Taxes $486,150 -0-
Equity to Reinvest $313,850 $800,000
Proposed Acquisition (using net equity as 25% down payment)
$1,255,400 $3,200,000
RESULT: The exchanger can buy approximately 2½ times the value of property
without adding cash
At 5% return, this will generate additional income of $97,230 per year
LIKE-KIND PROPERTY
26
Generally, all real
property is “like-kind” to
all other real property.
“Like-kind” refers to the
nature or character of the
property, and not its
grade or quality.
Real property can be
improved or unimproved,
because this only relates
to the grade or quality –
not to its kind or class.
The Exchanger’s intent
must be to hold the
replacement property as
an investment, or for
productive use in a trade
or business.
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WHAT IS LIKE-KIND PROPERTY?
In an IRC §1031 real property exchange, as a general principle you can exchange real property for any other real
property in the United States, if said property is held for productive use in a trade or business or for investment
purposes.
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RETAIL
APARTMENTS
SINGLE FAMILY
RAW LAND
INDUSTRIAL PROPERTY
COMMERCIAL
% INTEREST AS A TIC
REAL PROPERTY
1. Leases with
at least 30
years
remaining,
including
renewal
options.
2. Cell
phone
towers and
perpetual
easements
3. A undivided interest in
one property for an
undivided or 100%
interest in another
property. (i.e. Tenants in
Common, where each has
an equal right to possess
the whole.)
5. Timber
rights,
Riparian
rights,
Mineral
Rights, Air
Rights, &
Development
Rights*
REAL PROPERTY: Less than
fee interests that qualify for exchanges:
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4. Remainder
interest in
real property
* Whether these rights are treated as real estate and qualify for a real property exchange or are considered personal property is
determined by the state law where the property is located.
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NON LIKE-KIND PROPERTY
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THE DELAWARE STATUTORY TRUST
The rights and obligations of
investors in a DST will be
governed by the DST’s trust
agreement.
30
Typically, investors have limited
voting rights over the operation
and ownership of any
properties owned by the DST.
Multiple Investors in each
property with the percentage of
beneficial ownership varying
from one investor to the next.
Internal Revenue Service’s Revenue Ruling 2004-86, a beneficial interest in the Delaware Statutory Trust (DST), which holds the replacement property, can be considered “like-kind”
replacement property in an exchange. A DST may own one or more properties.
21 3
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PROPERTY HELD FOR SALE
Property Held for Sale DOES
NOT QUALIFY for an Exchange
There are a number of factors, including
the Exchanger’s intent at the time of the
exchange, that are considered in
determining whether a property is held for
sale and therefore does not qualify for an
exchange
31
21
3
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IRC
§1031
shall
NOT
apply
DEALER PROPERTY
Such property does not meet
the test of property “held for
investment or used in a trade
or business”
Gain from the disposition of such property is generally taxed as ordinary income. IRC § §1221(a)(1)-(2); Margolis v. Commissioner (9th Cir 1964) 337 F2nd 1001
32
Dealer Property is defined as real
property held for sale in the
ordinary course of a trade or
business.
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QUALIFIED PURPOSE TEST
3TEST IS AT TIME OF EXCHANGE
4HOLDING PERIOD
1NOT HELD FOR SALE
• Inventory
• Other instances of “Held for Sale” 2NOT HELD FOR PERSONAL USE
• Residences
• Second Homes
33
“Held for use in Trade or Business or for Investment”
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FOREIGN PROPERTY
Prior to 1989 Exchangers could exchange US property for foreign
investment property.
After the Revenue Reconciliation Act of 1989, IRC §1031 was
amended such that US property was not like-kind to foreign
property. Treas. Reg. §1.1031(h)
Foreign Property, however, is like-kind to foreign property.
34
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EXCHANGE STRUCTURES WITH A QI
DELAYED /
SIMULTANEOUS
REVERSE BUILD-TO-SUIT REVERSE
BUILD-TO-SUIT
35
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WHAT IS A DELAYED EXCHANGE?
A Taxpayer will close on the Relinquished Property before needing to close
on the Replacement.
This requires the use of Qualified Intermediary, even if both close on the same
day.
Generally, these employ Direct Deeding, so the title need not pass through
the Qualified Intermediary.
36
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DELAYED EXCHANGE TIME LIMITS
45 DAY RULE 180 DAY RULE
The Exchanger must identify the
potential replacement property or
properties within the first 45 days of
the 180-day Exchange Period.
The Exchanger must acquire the
replacement property or properties within
the earlier of (a) 180 days, or (b) the date
the Exchanger must file the tax return
(including extensions) for the year of the
transfer of the relinquished property.
• There are no extensions for the
deadlines. The days are calendar
days (including Saturdays, Sundays
and holidays).
• The time limits begin to run on the
date the Exchanger transfers the
relinquished property (or the first
relinquished property) to the buyer.
• The “date of transfer” will be the
transfer of the benefits and burdens
of ownership.
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DISASTER EXTENSIONS
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Exchanger’s Principal Residence
Exchanger’s Place of Business
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:
Investment Property Exchange Services, Inc. | www.ipx1031.com
DELAYED EXCHANGE ID RULES
THREE PROPERTY RULE
The Exchanger may identify up
to three properties of any value.
39
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(ies).
95% EXCEPTION
If the Exchanger identifies properties
in excess of both Rule 1 and Rule 2,
then the Exchanger must acquire at
least 95% of the value of all
properties identified.
3 95%200%
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PROCEDURES FOR PROPERTY IDENTIFICATION
The property identification must be
delivered to a party to the exchange
that is not a disqualified party (i.e.
the Qualified Intermediary).
It must be in writing and
signed by the Exchanger.
It must be “unambiguous”
(site specific).
It must be delivered, mailed,
faxed, or “otherwise sent”
within the 45 days.
An identification can be
revoked within the 45 days,
but the revocation must also
follow steps 1 through 4.
40
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WHAT IS A 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.
42
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WHAT IS A BUILD-TO-SUIT EXCHANGE?
A Taxpayer desires to add value to the Replacement property using tax
deferred dollars.
The Taxpayer cannot own the Replacement property while it is being improved, so it
must be “parked” with an Exchange Accommodation Titleholder.
This can be a Delayed or Reverse. It cannot be on property already owned
by the Exchanger. It can be a 30+yr leasehold and improvements.
43
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RELATED PARTY EXCHANGES
Who are Related Parties?
BROTHERS & SISTERS
Whether by whole or half blood
SPOUSE ANCESTORS LINEAL DESCENDANTS
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RELATED PARTY EXCHANGES
A fiduciary of a trust and a beneficiary of such trust
45
A grantor and a fiduciary
of any trust
Two corporations which
are members of the same
controlled group
A fiduciary of a trust and
a fiduciary of another
trust, if the same person is
a grantor of both trusts
A corporation and a
partnership if the same
persons own:> 50% in value of the outstanding
stock of the corporation, and
> 50% of the capital interest, or the
profits interest, in the partnership
An individual and a
corporation where > 50% percent in value of the
outstanding stock is owned,
directly or indirectly, by or for
such individual
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• Some Subtitle Goes Here
PARTNERSHIP ISSUES
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PARTNERSHIP ISSUES COMMON SCENARIOS
SCENARIO ONE
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.
Drop & Swap
Partial Drop & Swap
Buy out Cash Out Partners
PIN
Partnership Division
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 want to purchase different properties.
Drop & Swap
Partial Drop & Swap
Tracking Allocations
SCENARIO TWO
47
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PARTNERSHIP ISSUES POSSIBLE SOLUTIONS
What if the partners do not wish to purchase the new property together?
◼ 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.”
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The partnership can be liquidated and terminated and the relinquished property
distributed to the partners as tenants in common.
PARTNERSHIP ISSUES FORM 1065
2Distributed to any partner a tenancy-in-common or other undivided interest in
partnership property?
1Distributed any property received in a like-kind exchange, or contributed
such property to another entity?
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49
Partnership Tax Return (Form 1065) asks the taxpayer two new questions related to
exchanges. Has the partnership:
It appears the IRS will be scrutinizing “drop and swap” partnership transactions more
closely in the future (as the States of California and New York already do).
• Some Subtitle Goes Here
COMBINE SELLER CARRY WITH 1031
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COMBINE SELLER CARRY AND 1031
50Investment Property Exchange Services, Inc. | www.ipx1031.com
COMBINING SELLER FINANCING WITH AN EXCHANGE
If the Exchanger carries back financing for the buyer, the Exchanger can:
Treat the seller financing as an
installment sale under IRC Section 453.
The capital gain taxes are due when
Exchanger receives principal payments
on the note.
Exchanger can act as a “third-party lender”
and loan the buyer the equivalent amount
of Exchanger’s own funds at the close of the
relinquished property. The note and security
instrument is in Exchanger’s name. All
exchange funds are transferred to Qualified
Intermediary for use in the exchange. When
buyer pays off note the proceeds are not
taxable to Exchanger.
Note and security instrument are made
payable to Qualified Intermediary who
sells the note and combines note
proceeds with exchange proceeds to
acquire replacement property totally tax
deferred.
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• Some Subtitle Goes Here
COMBINE SELLER CARRY WITH 1031
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COMBINE SELLERY CARRY AND 1031REPORTING THE 1031 EXCHANGE
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FORM 8824
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◼ Form requests dates of the exchange transaction, the date the properties were “identified”
and financial information obtained from the closing/settlement statement.
◼ Have to check the box if related parties.
◼ The IRS revised the form in 2003 to require 45 day identification information. STRICTER!
An exchange is reported on Form 8824, “Like-Kind Exchanges”.
AUDIT ISSUES
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February 14, 2020
◼ 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 from a related party?
AUDIT ISSUES
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February 14, 2020
◼ 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 from a related party?
• Some Subtitle Goes Here
SECURITY OF 1031 FUNDS
Millions of dollars of Taxpayers’ 1031 funds
have been lost in the past.
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Investment Property Exchange Services, Inc. | www.ipx1031.com
Investment Property Exchange Services, Inc. | www.ipx1031.com
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QUESTIONS TO ASK QI
Who owns the Qualified
Intermediary? How
financially stable are its
owners?
Is Qualified Intermediary
a publicly traded
corporation?
Will the Qualified
Intermediary provide you
with its financial
statements?
Does the Qualified
Intermediary have
trained professionals
(Attorneys, CPAs, CES®)
on staff?
What is the package of
security that the
Qualified Intermediary
offers?
• Fidelity Bond
• Corporate Guarantee
• Errors and Omissions
Insurance
Investment Property Exchange Services, Inc. | www.ipx1031.com
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BANK QUESTIONS TO ASK QI
Are the banks stable?What criteria does QI use
to pick its bank or will it
use any bank?
Investment Property Exchange Services, Inc. | www.ipx1031.com
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ACCOUNT STRUCTURE QUESTIONS TO ASK QI
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?
Are policies are in place
to battle cyber fraud?
Does the 1031
Intermediary deposit
1031 funds in
segregated accounts
under the exchanger’s
name and Taxpayer
Identification Number?
Investment Property Exchange Services, Inc. | www.ipx1031.com
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SECURITY QUESTIONS TO ASK QI
Transparency about
entire organization?
Exchange funds
deposited into
segregated, interest
bearing bank accounts
that are separately
identified to each
Exchanger?
Disbursement of
exchange funds
requiring written
authorization of the
Exchanger?
Exchange funds
deposited into highly
rated financial
institutions?
Performance Guaranty
issued on each
exchange? Fidelity Bond?
Errors and Omissions
Insurance?