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Commercial Real Estate - 1031 Exchanges
Deferring Capital Gains Tax on Investment Properties & Income Properties
What is a 1031 Exchange ?
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Article 1031, of the Internal Revenue Code of 1986, as amended,
offers real estate investors
one of the last great investment opportunities to build wealth and save taxes.
By completing an exchange, the investor (Exchanger) can dispose of their investment
property, use all of the equity to acquire replacement investment property, defer
the capital gain tax that would ordinarily be paid, and leverage all of their
equity into the replacement property. Two requirements must be met to defer the
capital gain tax: (a) the Exchanger must acquire like-kind replacement property
and (b) the Exchanger cannot receive cash or other benefits (unless the Exchanger
pays capital gain taxes on this money). The tax code states: "No gain or loss
shall be recognized on the exchange of property held for productive use in a trade
or business or for investment purposes if such property is exchanged solely for
property of a like-kind which is to be held for either productive use in trade
or business or for investment purposes." Investors can accomplish virtually
any investment objective with exchanges including greater leverage, diversification,
freedom from joint ownership, improved cash flow, geographic relocation and/or
property consolidation.
Benefits of a 1031 Exchange:
There are several benefits to consider with a 1031 Exchange. For example, you could use the proceeds to buy bare land and construct a building on it,
consolidate several properties into one to ease management and put all funds into a more valuable property, take one property and diversify into several
properties, and purchase commercial property from residential proceeds.
What Property Qualifies for a 1031 Exchange?:
To qualify you need to sell property that was held for business or real estate purposes for the purchase of other business or investment property. However,
YOU CANNOT sell investment property for the purchase of personal property, as this would not qualify for a tax deferral under section 1031.
Five Things You Should Remember About 1031 Exchanges:
1) To avoid any taxable gain you must reinvest all the Capital gains and purchase property of equal or greater value.
2) From the date that your old/former property CLOSES, you have 45 days to declare one or more properties you will purchase.
3) From the date of CLOSING of your old/former property you have 180 days to CLOSE one or more properties on your 45-day list.
4) The entity that is on the title of the old/former property must remain on the new property title.
5) A qualified intermediary, sometimes known as an Accommodator, can only handle the proceeds from the sale of the old/former property.
You cannot personally touch the money nor can a friend, broker, employee, CPA, or attorney to hold the money for you.
Who Is A Qualified Intermediary?:
Selecting the right QI (Qualified Intermediary) is very important to the exchange process. There are no Federal or State laws that control who can be a QI.
However, there are laws that state who cannot be a QI. That includes your lawyer, CPA, bank, or family members, etc. We would be delighted to provide you with
contact information for consulting with a qualified QI. Because we help investors every week to purchase property with 1031 exchanges, we will make it a positive
experience for you.
Reverse 1031 Exchanges:
The reverse exchange was established to defer the capital gains taxes in the same manner as the 1031 exchange. The reverse exchange in more complex and
more costly to set up than the standard 1031. You should consult a tax advisor and exchange professional to assist you. The major difference in the Reverse vs.
Standard 1031 Exchange is that you can purchase property for the exchange before you sell your old/former investment property. You must take title to the
new property in what is called an EAT (Exchange Accommodations Titleholder) which is set up by the Exchange company. The EAT takes title to the new
property, holds or parks it until the old closes. Then the EAT transfers the new property to you. The reverse exchange must be completed within 180 days from
the date the EAT purchases the new property for you.
Save Tax Dollars With a Section 1031 Exchange
By Max Hansen, Attorney & 1031 Intermediary
The use of tax-deferred exchanges of taxpayers property continues to increase as realtors, attorneys and accountants become more aware of the benefits of Internal Revenue Code (I.R.C.) Section 1031 Exchanges.
Even those people regularly involved in 1031 exchanges are confused regarding the proper methodology for structuring exchanges. It is also important to keep informed on some of the new developments in the exchange business. The purpose of this article is to outline some of the basic exchange concepts and update you on some new ideas in the exchange business.
The Ground Rules
To qualify for tax deferment under I.R.C. Section 1031, the taxpayer must exchange real property held for productive use in a business or trade, or held for investment for a “like kind” property also to be held for productive use in business or trade or held for investment purposes. An exchange can be a simple swap of property, a simultaneous exchange or a delayed exchange. With court cases and the IRS regulations now in place, it really does not make much sense to structure an exchange using multiple parties as was done before the changes in the law.
The Starker decision in 1979 was the landmark case which established the basis for delayed exchanges (T.J. Starker vs.U.S., 432 F. Supp 864 (D. OR. 1977) aff’d, rev’d & rem’d 602 F. 2d 1341 (9thCir.,1979).) The taxpayer, Starker, exchanged title to his property for a contractual promise by the buyer, Crown-Zellerbach, to acquire like-kind property to be selected and designated by Starker at a later date. No cash was paid at the time of Starker’s conveyance to Crown-Zellerbach. Starker’s net sale proceeds were held by the buyer as a “net exchange value” credit on its books. Starker later selected properties using his credit toward the acquisition price. Crown-Zellerbach acquired the properties and immediately transferred the title to Starker. This delayed exchange transaction set the precedent for completing 1031 exchanges on a delayed basis.
The IRS amended the regulations for exchanges generally in 1991. The changes clarified the case law for exchanges including the issues of identification and receipt of replacement property and “safe Harbors” for avoiding actual and constructive receipt of cash or other non-qualifying property. Under the most recent regulations, it is easier to structure an exchange acceptable to the IRS while providing the taxpayer some security for the exchange funds held during the course of the transaction. The regulations also helped resolve some taxpayer uncertainty about exchanges in general.
To qualify for tax deferral, the taxpayer must trade or exchange his or her Section 1031 property for like-kind Section 1031 property following the terms of an integrated plan (exchange agreement) structured to effect the exchange of like-kind properties. An agreement to sell and a subsequent purchase do not qualify as an exchange. The taxpayer may enter into an agreement to exchange with either (a) the Seller of the replacement property, (b) the Buyer of the replacement property, or (c) a qualified exchange intermediary. Since individuals are subject to liens, judgments, incapacity or vacations, the taxpayer is well advised to seek the assistance of a professional exchange intermediary to facilitate the exchange. Most professional intermediary companies will provide the exchange agreement and documentation, and will oversee the closing, reviewing closing instructions and settlement statements.
The Exchange Agreement
The exchange agreement should set forth clearly and concisely the intentions of the parties. The agreement should clearly provide for retention of exchange funds by the qualified intermediary. It should also describe the limited circumstances under which the taxpayer may terminate the exchange and receive the exchange proceeds. If the taxpayer has the right to demand cash in lieu of property during the exchange period, after the closing on the relinquished property, the agreement appears more like a taxable sale transaction than an exchange of property, and may create problems for the taxpayer. A well-drafted exchange agreement can eliminate or at least reduce potential problems with an exchange.
Replacement Property
The taxpayer must identify the replacement property within 45 days of the date of closing on the relinquished property. The taxpayer may identify up to three replacement properties or may identify any number of replacement properties if their aggregate value does not exceed 200% of the aggregate value of all relinquished property. A party to the exchange (i.e., the intermediary or the qualified escrow holder) must receive the written identification form, or “designation form,” not later than the 45th day of the exchange. There is absolutely no grace period.
In addition to properly identifying the replacement property, and staying within the limited number of properties, the taxpayer must acquire the title to the replacement property the sooner of (1) his or her tax filing date, or (2) 180 calendar days from the date in which the relinquished property was transferred (tax filing extensions not with-standing).
Danger Zones
The problem areas in exchanges have always been “constructive receipt” or “actual receipt” of cash or other non-qualifying property, and the “agency” or “related party” issues.
Simply put, the taxpayer cannot receive cash form the exchange, have the right to receive cash (including the interest or “growth factor”), or have control over the exchange funds, directly or indirectly, during the course of the exchange without creating a tax liability or disqualifying the exchange. The actions taken during the course of the exchange must coincide with the taxpayer’s intent. The taxpayer is in constructive receipt of the exchange funds if they even indirectly “enjoy the benefit of” the funds. These issues are more specifically addressed in the “safe harbors” discussion contained in the current regulations.
“Safe harbors” include a “quality intermediary,” “qualified escrow accounts or trusts,” or “qualified security or guarantee arrangements.” The taxpayer will not be considered to be in constructive receipt of cash or replacement property if the transaction utilizes these safe harbors. You should refer to the regulations or an expert for further clarification.
The qualified intermediary must acquire both the relinquished property and the replacement property. This requirement can be satisfied by the intermediary acquiring title to the property or accepting an assignment of contractual rights, notifying all of the parties prior to the transfer date, and causing the direct delivery of the property.
Final regulations also address who can act as the exchange intermediary. A “disqualified person” or “related party” is anyone who acted as the taxpayer’s attorney, employee, accountant, investment banker or broker, or real estate agent or broker within two years of the disposition of the relinquished property. Persons with a relationship to the taxpayer within the definitions of I.R.C. ÔÔ267(b) and 707(b) are also disqualified. If a disqualified person acts as the intermediary, the entire exchange may be jeopardized. To find a good qualified intermediary, check with real estate professionals for someone they have used and recommend. You can also check the Yellow Pages in larger cities.
Getting the Boot
Another important issue covered in the regulations is the taxpayer’s receipt of cash or other non-qualifying property, or “boot.” “Boot” is cash or other property the taxpayer receives which does not qualify for non-recognition of gain. Mortgages or other liabilities attached to property transferred in an exchange can also be “boot.” The taxpayer can receive cash boot ¾ although caution should be exercised when making it available ¾ and the regulations provide examples of how to treat a boot.
New Developments
There have been a number of recent developments, which are of some interest to taxpayers. Those involve exchanges of conservation easements, water rights, timber rights and wetland mitigation credits.
With regard to conservation easements, some conservation groups and state agencies are now offering to purchase conservation easements on ranch, farm and other land. These offerings are especially attractive to landowners who can grant the easement on unproductive land, generating cash to acquire more productive property to enhance their ranching or farming operations. The Internal Revenue Service (IRS) issued letter ruling No. 9621012 on February 16, 1996. The IRS determined that a perpetual scenic conservation easement on ranch land was “like kind” with timberland, farmland and ranch land. In that instance, the state in which the property was located recognized the scenic conservation easement as a real property right and, therefore it was “like kind” with other real property interest.
Keep in mind that letter rulings are specific to the situation addressed in the request for letter ruling and are not binding in other situations. Even though the letter ruling is not controlling with regard to other transactions, but may be a good indication of how the IRS may look at a similar situation involving the exchange of a conservation easement for other land held for investment purposes or productive use in the trade or business.
In Letter Ruling No. 9612009, which was issued December 18, 1995, the IRS determined that mitigation credits for restoring wetland property could be exchanged utilizing Section 1031 for other mitigation credits.
Water rights are another potential basis for exchange. In many states, water rights are treated as real property interests. Increasingly, ranchers and farmers have conveyed or leased water rights and that trend will probably increase. In those states where water rights are classified as real property interests, the conveyance or long term leasing of water rights could be utilized for the purposes of effecting a 1031 exchange into other “like kind” investment or income producing property.
With regard to timber rights, there have been an increasing number of farmers and ranchers who own timber property and entered into timber sale contracts with various logging companies. They have attempted to use those sale proceeds to acquire properties in a Section 1031 exchange. Unfortunately, the Internal Revenue Service has relied upon a 1953 tax court case, known as the Oregon Lumber Company Case, in disallowing those transactions as exchanges. In TAM No. 9525002, the IRS disallowed the sale of timber as part of a Section 1031 exchange.
However, timber rights, much like water rights or mineral rights, are classified as real property interests in many states. Properly structured, the conveyance of timber rights should be the basis for an exchange into other “like kind” property. Use of real estate professionals who know how to structure these exchanges can result in an exchange acceptable to the IRS or at least the Tax Court.
Gray Areas
“Parking arrangements” and “construction to suit exchanges” have increased in the past few years as more and more real estate professionals become acquainted with the benefits of utilizing those transactions to effect exchanges for their clients. “Reverse exchanges” have never been approved by the Internal Revenue Service and are not included in Section 1031. A “reverse exchange” is simply a situation when the taxpayer acquires the replacement before they divest themselves of the relinquished property. However, taxpayers have been successful in entering into an exchange agreement with a qualified intermediary who acquires a replacement property and holds that replacement property for a period of time until the taxpayer is successful in entering into an agreement to exchange out of the relinquished property. Once the relinquished property transaction is closed, the taxpayer can then proceed to close the transaction for the acquisition of the replacement property with the qualified intermediary. These “parking arrangements” can be tricky, but as long as the real estate professionals involved know some of the pitfalls, those pitfalls can hopefully be avoided, and the transaction successfully concluded.
“Construction to suit exchanges” are increasingly utilized where the taxpayer has been able to exchange out of the relinquished property but is unable to find a replacement property which is suitable for their purposes. The taxpayer can find the raw land, but requires certain improvements to be constructed on the replacement property as part of the exchange. In those situations, it is possible to enter into an agreement with the seller of the replacement property, a developer or the exchange accommodator to construct the improvements on the property prior to the closing on the replacement property. When the improvements are complete, the taxpayer then closes on the replacement property to complete the exchange. Great care must be taken in structuring these construction to suit exchanges to avoid the agency or related party issues discussed above. Special care must also be taken to insure that the construction process can be completed within the 180-day exchange period. That can be tricky, especially in the Rocky Mountain region where the building season is shortened by adverse weather conditions and problems in obtaining materials. Again, the help of qualified real estate professionals, including professional exchange Accommodators, can be very helpful in making sure that a construction to suit exchange is successfully completed.
Summary
Tax deferred exchanges under Section 1031 continue to be a sensible and cost effective way of deferring tax on capital
gains. Because the tax code is amended form time to time and new regulations adopted, you may want to discuss your
impending exchanges with a professional, qualified exchange intermediary. Intermediary’s fees vary, but do not be
afraid to ask about them up front. If the taxpayer desires to make a real estate investment without paying taxes,
he or she will certainly value the advice from a knowledgeable exchange intermediary about how exchange transactions
are structured.
For additional information please refer to the following websites for 1031 Exchange
intermediaries. An intermediary can guide you through the IRS's regulations, making a 1031 exchange easy,
inexpensive, and safe. You should also consider having your accountant and/or attorney review any real
estate transaction.
For additional information, please contact the following 1031 Exchange Intermediaries:
Fidelity National 1031 Exchange Services, Inc.
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