1 A GUIDE TO IRC 1031 TAX DEFERRED EXCHANGES
2 IRC 1031 TAX DEFERRED EXCHANGES No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment. Deferral of tax, NOT a tax free transaction.
3 IRC 1031 STEPS 1 SELL the Relinquished Property in coordination with a Qualified Intermediary 2 IDENTIFY the Replacement Property within 45 days of the sale of the Relinquished Property 3 ACQUIRE the Replacement Property within 180 days from the sale of the Relinquished (caveat- the tax filing date)
4 HISTORY OF IRC 1031 Income tax first imposed in 1918 and required the recognition of a gain or loss on all dispositions of property. In 1921 provisions were made for non-recognition of a gain or loss in certain circumstances. This is the precursor to the current IRC In 1923 the Tax Reform Act of 1921 was limited in scope by excluding stocks, bonds, notes, choses in action, trust certificates, and other securities from non-recognition treatment. Starker v. U.S. (9th Circuit Ct. of Appeals 1979) created ability to do an exchange on a delayed basis. Tax Reform Act of 1984 codifies Starker into statute, but establishes 45 and 180 day limitations.
5 CURRENT USES FOR & INVESTOR MOTIVES Consolidation / Management Relief Diversification Restart / Increase Depreciation Cash Flow Retirement Planning Estate Planning
6 OVERVIEW AND MYTHS OF AN IRC 1031 TAX DEFERRED EXCHANGES An exchange is no longer an actual swap. It is a sale and purchase with very little difference from a non-1031 transaction. Exchange documents create the transaction. The gain from the relinquished property is deferred into the replacement property.
7 LIKE KIND REAL PROPERTY INTENT Intent: actions over a period of time. LIKE KIND Held for productive use in a trade or business. or Held for investment purposes.
8 LIKE KIND REAL PROPERTY LIKE KIND PROPERTY
9 LIKE KIND PERSONAL PROPERTY LIKE KIND NOT LIKE KIND
10 EXCEPTIONS TO IRC 1031 Stock in trade or other property held primarily for sale Stocks, bonds, or notes Other securities or evidence of indebtedness or interest Interests in a partnership Certificates of trust or beneficial interest Choses in action
11 EXCHANGES OF LESS THAN FEE INTEREST Leases with at least 30 years remaining including renewal options. Vendee s interest in a land sale contract, but not a vendor s interest. An undivided interest in one property for an undivided or 100% interest in another property. Air rights, easements, development rights, conservation easements.* * Real property interest determined by state law.
12 LIKE KIND TICS What is a Tenant-in-Common Interest? Undivided fractional ownership of real estate Co-ownership between two or more people Separate deeds for each undivided interest Generally, most tenant-in-common ( TIC ) programs are treated as real estate for exchange purposes and securities for sales purposes.
13 LIKE KIND TICs / DSTs Benefits of a TIC/ DST Program: May help taxpayer meet the 45-day Identification Period deadline Potential to exactly match taxpayer s equity and debt requirements in the replacement property Predictable cash flow with minimal management Higher quality buildings and tenant credit Diversity by market and product type
14 REVENUE PROCEDURE Vacation Homes A dwelling unit qualifies for IRC 1031 treatment under the safe harbor if it is owned for 24 months and during such period: 1) The property is rented at fair rental for 14 days or more each year; and 2) The taxpayer s personal use does not exceed the greater of 14 days or 10% of the days rented. If a taxpayer reports a transaction as an exchange expecting to meet the standards, but ultimately does not, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange. It is just a safe harbor. An exchange may still fall outside the parameters and meet the statutory requirements, but you should expect heightened scrutiny in such a case.
15 Tax Court Memorandum Goolsby v. Commissioner (April 1, 2010) The Tax Court denied the exchange when the taxpayer moved into the replacement property two months after acquiring it. Minimal efforts to rent (merely placed an ad for a couple of months with no further effort to gain rental exposure). Taxpayer began preparations to finish the basement within two weeks of purchase. The court also found the taxpayer liable for accuracy related penalty due to a substantial understatement of tax, as they failed to provide any evidence they acted with reasonable cause and in good faith.
16 Reesink v. Commissioner, T.C. Memo (April 23, 2012) Tax Court recently ruled in favor of the taxpayer in which they moved into the replacement property as their primary residence seven months after acquiring the 1031 property. Taxpayer unsuccessfully attempted to rent the property. Facing financial hardship (carrying multiple properties, coupled with the husband s loss of income due to disability), their financial situation led to the decision to sell their home and move into the replacement property. Note, they did not pursue the sale of the replacement property because they felt the value had dropped significantly and that they had more equity in their primary residence. The brother testified that the Reesinks told him on several occasions that they planned to sell their personal residence and move once their children were out of high school (Taxpayer s eldest son was only 15 years old).
17 PRIMARY RESIDENCE AND 1031 Mixed Use Property Vacation home, second home, retirement home as replacement property. Conversion of replacement property to a primary residence Primary Residence
18 RULES TO OBTAIN A COMPLETE DEFERRAL Napkin Test To be a fully tax deferred exchange, the replacement property must be: Equal or greater in value AND Equal or greater in equity
19 BOOT DEFINED The term BOOT does not appear anywhere in the Internal Revenue Code or Regulations. If the Exchanger does not use all of its net cash or have equal or greater liability on the replacement property, there is boot. If the Exchanger receives non-like kind property or uses exchange funds to pay for non-exchange transactional costs, there is boot.
20 BALANCING THE EXCHANGE Relinquished Replacement Boot Contract Price $750,000 $600,000 Debt $400,000 $325,000 $75,000 Costs $50,000 Net Equity $300,000 $275,000 $25, ,000 Of Boot Is Recognized
21 EXCHANGE COOPERATION CLAUSE Buyer hereby acknowledges that it is the intent of the Seller to structure its sale as a tax deferred exchange under IRC Seller covenants that this will not delay the close of the subject transaction nor cause the Buyer any additional expenses. The Seller s rights under the purchase and sale agreement may be assigned to Legal 1031 Exchange Services, Inc., a Qualified Intermediary for IRC 1031 Tax Deferred Exchanges. Buyer agrees to cooperate with the Seller and the Qualified Intermediary to complete the exchange.
22 DELAYED EXCHANGE STRUCTURE EXCHANGER Sale Purchase BUYER $ $ SELLER IDENTIFICATION PERIOD TIME PERIOD TO ACQUIRE REPLACEMENT PROPERTY 0 45 DAYS 180 DAYS
23 DELAYED EXCHANGE TIME LIMITS 45 DAY IDENTIFICATION RULE Exchanger has 45 days from the date of the sale of the first property to identify potential replacement property. 180 DAY EXCHANGE PERIOD Exchanger has 180 days from the date of the sale of the first property, or the date upon which Exchanger has to file its Federal tax return for the year in which the relinquished property was sold, to complete the acquisition of all replacement properties.
24 DELAYED EXCHANGE TIME LIMITS There are no individual extensions. 45 and 180 days are calendar days, not business days. Time limits begin to run on the earlier of the date the taxpayer transfers the benefits or burdens of ownership of the first relinquished property to a buyer, or recording a deed evidencing a transfer, whichever occurs first.
25 IDENTIFICATION RULES THREE PROPERTY RULE Exchanger may identify up to three properties regardless of value. 200% RULE 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. 95% EXCEPTION If Exchanger identifies more than three properties which are worth more than 200% of the value of all relinquished properties than Exchanger must acquire 95% of the value of all properties identified.
26 PROCEDURE FOR PROPER IDENTIFICATION Identification must be made in writing. Unambiguously describe the property. Signed and dated by the taxpayer. Received by midnight of the 45 th day or postmarked by the 45 th day. Delivered to Exchanger s Qualified Intermediary or to a party related to the exchange who is not a disqualified person.
27 EXCHANGE VESTING ISSUES SAME TAXPAYER REQUIREMENT With very limited exception, the person or entity who relinquishes property must be the same person or entity to buy the replacement property. A good rule of thumb is that you must have the same tax identification number on both sides of the transaction.
28 EXCHANGE VESTING ISSUES EXCHANGES INVOLVING ENTITIES When a person or entity has an ownership interest in an entity (corporation, partnership, LLC, etc.) which owns real estate, that person or entity does not own real estate. They own an interest in an entity which owns real estate. This creates issues when less than 50% of the ownership interest wants to do an exchange. An existing entity will be deemed a new entity by the IRS if more than 50% of the ownership changes.
29 EXCHANGE VESTING ISSUES STRUCTURING DISSOLUTIONS FOR EXCHANGES INVOLVING ENTITIES If you dissolve an entity and make each former member a tenant in common they will be holding property for resale purposes unless done with property planning a year or more in advance of the contemplated sale (a/k/a drop and swap). If more than 50% of members/shareholders/partners wish to exchange the most expedient solution is to make a distribution at the closing and let the surviving members do the exchange in the name of the entity. Major issue when less than 50% of the ownership interest wants to do an exchange. An existing entity will be deemed a new entity by the IRS if more than 50% of the ownership changes.
30 Partnership Tax Returns Form 1065 (Revised) Form is an information return used to report the income, deductions, gains, losses, etc., from the operation of a partnership. The proposed form 1065 issued on July 24, 2008 (which would apply to returns filed after 12/2008), includes the following questions in Schedule B: Ø 13. Check this box, if during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (including a disregarded entity). Ø 14. At any time during the taxpayer year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in the partnership property?
31 SAFE HARBOR RESTRICTIONS A/K/A WHEN CAN MY CLIENT GET ITS MONEY BACK? Treasury Regulations provide that an Exchange Agreement must restrict the Exchanger s right to receive, pledge, borrow, or otherwise receive the benefits of the exchange funds, except: After the end of the 45 day Identification Period where the Exchanger does not have identified replacement property If the Exchanger has purchased all identified replacement property and is beyond the 45th day. If the Exchanger has identified replacement property then upon or after the occurrence, after the end of the identification period, of a material and substantial contingency that, 1. related to the exchange; 2. is provided for in writing; and 3. is beyond the control of the Exchanger and of any disqualified party, other than the party obligated to transfer the replacement property to the Exchanger. After the end of the 180 day Exchanger Period.
32 ALTERNATIVE STRUCTURES
33 PARKING ARRANGEMENTS Reverse Exchange Exchanger is acquiring Replacement Property before disposing of Relinquished Property. Improvement Exchange Exchanger wishes to use Exchange Funds to increase the value of the Replacement Property. Reverse/Improvement Exchange Exchanger wishes to acquire and improve Replacement Property before selling Relinquished Property.
34 REVENUE PROCEDURE Effective September 15, 2000 Provides a safe harbor for reverse exchange transactions that stay within the parameters of the Revenue Procedure. Reverse exchanges may be structured outside the safe harbor.
35 REVERSE EXCHANGE Acquire the Replacement Property first. The Qualified Intermediary sets up an EAT to take legal title. Exchanger identifies the Relinquished Property to be sold within 45 days of acquisition of the Replacement Property. Exchanger sells the Relinquished Property within 180 days. The Reverse Exchange can also be set up under an alternative structure whereby the Relinquished Property is deeded to the EAT and the Exchanger takes direct title to the Replacement Property. The same 180 day timeline applies.
36 IMPROVEMENT EXCHANGE Exchange starts out as a forward moving exchange with exchange funds deposited with Qualified Intermediary. EAT uses funds to acquire Replacement Property. Pursuant to Exchanger s instructions EAT enters into construction agreement and uses exchange funds to build improvements to property. All improvements must be made before the 180th day. There can be no prepayment of materials or to contractor.
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