Section 1031 Exchange Terminology Pros and Cons of 1031 Exchanges The Perfect Storm Capital Gain Taxes and other Tax Issues IRC Section 1031 and

Transcription

1

2 Section 1031 Exchange Terminology Pros and Cons of 1031 Exchanges The Perfect Storm Capital Gain Taxes and other Tax Issues IRC Section 1031 and Exceptions Partnership/LLC Issues and Related Party Rules The Exchange Equation Split Treatment Transactions: Section 121/1031 Delayed Exchanges and Identification Rules 1031 Exchange Documentation Parking Arrangements (Reverse & Improvement Exchanges) What is a Qualified Intermediary? Qualified Intermediary Due Diligence

3 Boot Cash Boot Constructive Receipt Direct Deeding Exchange Agreement Exchange Period Identification Period Like-Kind Property Mortgage Boot (Debt Relief) Qualified Intermediary Relinquished Property Replacement Property Sequential Deeding

4 Analysis of Crandall v. Commissioner (2011) Taxpayer sold land in Arizona and intended to exchange into property in California. Sale Proceeds were held in an escrow account by the Title Company handling the sale of Arizona. Proceeds transferred to Title Company in Calif. Lessons learned from Crandall v. Commissioner

5 The taxpayer s intention to take advantage of tax laws does not determine the tax consequences of their actual transactions. [See Bezdjian v. Commissioner (1988) and Carlton v. United States (1960).] The reinvestment of proceeds from a cash sale of one investment property into a second property will not qualify for the tax deferral benefits under Section Since the escrow account did not limit the taxpayer s right to receive, pledge, borrow or otherwise obtain the benefits of the proceeds nor anything else to properly reflect the transaction as a 1031 exchange, the account was not deemed a qualified escrow account.

6 Tax deferral (federal taxes, state taxes, depreciation recapture, net investment income tax if applicable under Section 1411) Wealth accumulation (preservation of equity) Leverage (more cash for reinvestment) Diversification (by asset class and/or geographically) Potential to obtain cash by refinancing replacement property postexchange (but well after the purchase is old and cold ) Management relief Estate planning Step up in basis to FMV available to heirs

7 Must follow specific IRS rules and time restrictions Replacement property basis is lower (replacement property basis = purchase price minus deferred gain) Lack of liquidity (must purchase like-kind property) Cannot recognize losses Possible risk of higher tax rates in the future Tax deferred (only non-recognition, not tax-free)

8

9 Much higher capital gain taxes 3.8% net investment income tax (NIIT) Price appreciation and rising rents Investors seeking out ways to reduce their tax burden

10 20% capital gain tax rate for high earners 3.8% net investment income tax (NIIT) pursuant to IRC Section 1411 Capital gain taxation now includes 4 components: 1) Taxation on depreciation recapture at 25% - plus 2) Federal capital gain taxes at 20% (or 15%) - plus 3) 3.8% net investment income tax - plus 4) The applicable state tax rate (0% %)

11 Investors owe Federal capital gain taxes on their economic gain depending upon their taxable income. A 20% capital gain tax rate for investors exceeding the $400,000 taxable income threshold for single filers and married couples filing jointly with taxable income over $450,000. The capital gain tax rate of 15% applies to investors below these threshold income amounts.

12 The Health Care and Education Reconciliation Act of 2010 added a 3.8% surtax on net investment income. This 3.8% tax applies to taxpayers with net investment income who exceed threshold income amounts of $200,000 for single filers and $250,000 for married couples filing jointly. Pursuant to IRC Section 1411, net investment income includes interest, dividends, capital gains, retirement income and income from partnerships (as well as other forms of unearned income ).

13 to the extent gain from a like-kind exchange is not recognized for income tax purposes under Section 1031, it is not recognized for purposes of determining net investment income under Section [ (C)(i)(2)(ii)].

14 As tax rates increase, investors look for strategies to reduce or defer taxes leading to more 1031 exchanges. One aspect of the tax code provides real estate investors with a huge tax advantage an IRC Section 1031 exchange. Section 1031 allows taxpayers holding property for investment purposes to potentially defer all taxes that would otherwise be incurred upon the sale of investment property.

15 Provided the taxpayer is not financially distressed, real estate investors face several options: Hold: Wait as the market continues to come back. Sell: Sell the property and pay taxes owed. Invest funds in other investments outside of real estate. Exchange: Defer all capital gain taxes with a fully deferred exchange or receive some boot through a partially deferred exchange. Redeploy equity that would have been used to pay capital gain taxes into the purchase larger replacement property or properties.

16 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.

17 Stock in trade or other property held primarily for sale Stocks, bonds, or notes Other securities or evidences of indebtedness or interest Interests in a partnership Certificates of trust or beneficial interest Choses in action

18 The purpose for which the property was initially acquired The purpose for which the property was subsequently held The purpose for which the property was being held at the time of sale The extent to which improvements, if any, were made to the property The frequency, number and continuity of sales The extent and nature of the transaction involved The ordinary course of business of the taxpayer The extent of advertising, promotion of the other active efforts used in soliciting buyers for the sale of the property The listing of property with brokers

19 Swap and Drop: The partnership stays intact and acquires replacement property. Later, the partnership dissolves post-exchange. Drop and Swap: Election out of the partnership into separate undivided tenant-in-common (TIC) interests prior to closing. Timing Issues

20 The IRS and state tax authorities have often taken the position that if property relinquished or received in an exchange is either distributed out of a partnership to a former partner or contributed by a partner to a partnership near the time of the exchange, the transaction may not qualify for nonrecognition treatment under It appears the IRS will be scrutinizing drop and swap or swap and drop partnership transactions more closely.

21 Who is a Related Party? Four Different Scenarios: 1. Simultaneous Exchange (Swap) 2. Delayed Selling to a Related Party 3. Delayed Purchasing from a Related Party (See Rev. Ruling , PLR ) 4. Delayed Purchasing from a Related Party who is Exchanging (See PLR )

22

23 What is Excluded? Qualifying Real Property Qualifying Personal Property

24 Exchanges of vacation homes held for investment are possible, provided the primary reason is holding for investment and not for personal use. Conservative ( Safer ) Moore vs. Comm Revenue Procedure Safe Harbor Range of possible vacation home exchanges. Non-Safe Harbor Aggressive ( Riskier )

25 Revenue Procedure Creates safe harbor for vacation home exchanges. IRS will consider a dwelling unit held for investment if certain requirements are met. Requirements: The relinquished and replacement properties are owned by the taxpayer for at least 24 months (the qualifying use period); Within each of these two 12 month periods constituting the qualifying use period the taxpayer must. Rent the property to another person or persons at fair market rent for 14 or more days (family members qualify if they use the property as the primary residence); and The taxpayer s personal use of the dwelling unit cannot exceed the greater of 14 days or 10 percent of the time it is rented.

26 Barry E. Moore v. Comm., T.C. Memo The taxpayers never rented or attempted to rent the property The taxpayers deducted mortgage interest as home mortgage interest expense rather than investment interest expense. The taxpayers did not take (and probably did not qualify for) depreciation or other tax benefits associated with investment property, including deductions or maintenance expenses. Planning Strategies Substantiate investment intent Report rental income, attempts to rent property or conversion from a second home to a rental property held for investment. Treat property as held for investment on the tax return

27 What is a typical fractional ownership investment? Advantages of fractional ownership Risks involved in fractional ownership Tenant-In-Common (TIC): Rev. Proc Delaware Statutory Trust (DST): Rev. Rul For more information, visit: (Alternative and Direct Investment Securities Organization)

28 Intent is the taxpayer s subjective intent The IRS will look at objective factors that either support or negate the taxpayer s intent to hold for investment All facts and circumstances taken into account The holding period is just one (of many) factors Ideally the taxpayer has multiple factors to establish the intent to hold for investment Contrary facts may lead the IRS to conclude the property was not held for investment purposes Goolsby v. Commissioner (2010) Reesink v. Commissioner (2012) Allen v. United States (2014)

29 Case where facts did not support investment intent Taxpayer moved into the property after only 2 months Sold principal residence around the same time Replacement property could not be rented per HoA No attempts to rent the replacement property Finished basement shortly after acquiring Non-privileged conversations with QI taken into account

30 Recent case where facts did support investment intent Taxpayer placed many rental flyers throughout town advertising their house as available for rent Taxpayer showed house to two potential renters Taxpayer refrained from using the property for recreational use prior to moving into property Taxpayer sold their residence 6 months after purchasing replacement property in an exchange Taxpayer moved into property 8 months after acquiring Other supporting facts

31 Taxpayer was not able to prove their intent changed from holding for development to holding for investment Allen purchased property in 1987, and from 1987 to 1995 Allen attempted to develop the property on his own. From 1995 to 1999, Allen brought in partners who contributed capital for development In 1999, Allen sold the property to a developer Allen made significant and extensive efforts to develop the property over many years, and failed to substantiate when his actions changed with regard to the property Ultimately, Allen failed to provide any evidence to prove that his intent changed during the time of ownership of the property.

32 For full tax deferral, a Taxpayer must meet two requirements: 1. Reinvest all net exchange proceeds 2. Acquire property with the same or greater debt. Relinquished Value $900,000 - Debt $300,000 - Cost of Sale $60,000 Net Equity $540,000

33 For full tax deferral, a Taxpayer must meet two requirements: 1. Reinvest all net exchange proceeds 2. Acquire property with the same or greater debt. Relinquished Replacement Value $900,000 $1,200,000 - Debt $300,000 $660,000 - Cost of Sale $60,000 Net Equity $540,000 $540,000

34 For full tax deferral, a Taxpayer must meet two requirements: 1. Reinvest all net exchange proceeds 2. Acquire property with the same or greater debt. Relinquished Replacement Boot Value $900,000 $1,200,000 - Debt $300,000 $660,000 $ 0 - Cost of Sale $60,000 Net Equity $540,000 $540,000 $ 0 The Taxpayer acquired property of greater value, reinvesting all net equity and increasing the debt on the replacement property. Analysis: There is no boot.

35 Relinquished Replacement Boot Value $900,000 $700,000 - Debt $300,000 $260,000 $ 40,000 - Cost of Sale $60,000 Net Equity $540,000 $440,000 $ 100,000 Total Boot $ 140,000 The Taxpayer acquired property of a lower value, keeps $100,000 of the net equity and acquired a replacement property with $40,000 less debt. Analysis: This results in a total of $140,000 in boot. ($40,000 mortgage boot and $100,000 in cash boot = $140,000)

36 Relinquished Replacement Boot Value $900,000 $800,000 - Debt $300,000 $260,000 $ 40,000 - Cost of Sale $60,000 Net Equity $540,000 $540,000 $ 0 Total Boot $ 40,000 The Taxpayer acquired property of a lower value, reinvesting all net equity, but has less debt on the replacement property. Analysis: This results in $40,000 in mortgage boot.

37 Married taxpayers, filing a joint return, can exclude up to $500,000. Single filers can exclude up to $250,000 Gains in excess of $500k are taxed at 20% Home must be primary residence of both spouses for 2 of the last 5 years 121 exclusion available once every two years Vacation/second homes do not qualify

38 Sale of a fourplex 3 units rented 1 unit primary residence / / Primary Residence

39 REVENUE PROCEDURE : This addresses how to report exchanges of property used as a principal residence and most recent held for business/investment use. A property owner can convert a principal residence into a rental property and later sell it and benefit from both IRC 121 (principal residence tax exclusion rules) and IRC 1031 (investment property tax deferred exchange rules). Gain is excluded under 121 and then is eligible for deferral under If a property owner has owned and lived in a principal residence for at least 2 out of the last 5 years preceding the sale of the principal residence, $250,000 if filing as a single ($500,000 if married and filing jointly) of the gain from the sale, except for any depreciation taken on the property since May 6, 1997, can be excluded. IRC 121 does not require the owner to live in the property at the time of the closing to qualify for the gain exclusion. When the owner sells the home as an investment property, they must still meet all the necessary requirements for a valid 1031 exchange.

40 Two-Party Trade (swap) Three-Party Format ( Alderson ) The Delayed Exchange with a QI The Reverse Exchange The Improvement Exchange The Reverse/Improvement Exchange

41 SALE Taxpayer PURCHASE Buyer Qualified Intermediary $ $ Seller 45-Day Identification Period 180-Day Total Exchange Period

42 45 Day Identification Period: The Taxpayer must identify potential replacement property(s) by midnight of the 45th day from the date of sale. 180 Day Exchange Period: The Taxpayer must acquire the replacement property by midnight of the 180th day, or the date the Taxpayer must file its tax return (including extensions) for the year of the transfer of the relinquished property, whichever is earlier.

43 Three Property Rule: The Taxpayer may identify up to three properties of any fair market value. 200% Rule: The Taxpayer may identify an unlimited number of properties provided the total fair market value of all properties identified does not exceed 200% of the fair market value of the relinquished property. 95% Rule: If the Taxpayer identifies properties in excess of both of the above rules, then the Taxpayer must acquire 95% of the value of all properties identified.

44 Identification must be: Made in writing Unambiguously describe the property Hand delivered, mailed, telecopied or otherwise sent Sent by midnight of the 45th day Delivered to the Qualified Intermediary or a party related to the exchange who is not a disqualified person

45 Qualified Intermediary: 1. Exchange Agreement 2. Assignment Agreement 3. Notice of Assignment 4. Account Set-Up Forms 5. Security of Funds Instrument Closing Entity: 1. Settlement Forms 2. FRPTA (state withholding, where applicable) Form 4. Other documents common to the area Accountant/CPA/Tax Advisor: 1. IRS Form 8824: Like-Kind Exchanges

46 WHAT NOT TO DO Christensen v. Commissioner (Didn t file extension to obtain full 180 days) Knight v. Commissioner (Closed after the 180th day) Dobrich v. Commissioner (Backdated the Identification Notice)

47 SALE Taxpayer PURCHASE Sold 3 properties Buyer 1 Buyer 3 Buyer 2 $ $ Qualified Intermediary $ $ Seller 45-Day Identification Period 180-Day Total Exchange Period

48 SALE Taxpayer PURCHASE Purchased 3 properties Seller 1 Buyer Qualified Intermediary $ $ $ $ Seller 1 Seller 1 45-Day Identification Period 180-Day Total Exchange Period

49 What is a Reverse Exchange? Purchasing the replacement property before the sale of the relinquished property. What is an Improvement Exchange? Building a new replacement property from the ground-up or making improvements to an existing replacement property.

50 Effective September 15, 2000 Provides a safe harbor for reverse and improvement exchange transactions that stay within the parameters of the Revenue Procedure. Reverse and improvement exchanges may be structured outside the safe harbor.

51 Why Perform a Reverse Exchange? Seize the moment Protect the exchange Improve the replacement property

52 Why Perform an Improvement Exchange? The property to be acquired in the exchange is not of equal or greater value to property being sold. Build a new investment from ground-up. The new investment is of equal or greater value, but it needs refurbishments.

53 ID of Replacement Property to be Produced if a legal description is provided for the underlying land and as much detail is provided regarding construction of the improvements as is practicable at the time identification is made.

54 if not within the provisions of Section 1031(a) if the relinquished property is transferred in exchange for services (including production services). Thus, any additional production occurring with respect to the replacement property after the property is received by the taxpayer will not be treated as the receipt of property of like-kind.

55 An exchange of real estate owned by a Taxpayer for improvements on land owned by the same Taxpayer does not meet the requirements of See Decleene v. Commissioner, 115 T.C. 457 (2000); Bloomington Coco-Cola Bottling Co. v. Commissioner, 89 F.2d 14 (7th Cir. 1951). Rev. Rul C. B. 270, holds that a building constructed on land owned by a Taxpayer is not of a like-kind to Taxpayer.

56 Not the taxpayer or a disqualified person Enters into a written agreement to: A) Acquire the relinquished property from taxpayer B) Transfer relinquished property to buyer C) Holds the exchange proceeds in a manner consistent with Treas. Reg. Section 1031(k) D) Acquire the replacement property E) Transfer the replacement property to the taxpayer

57 This is the most important choice a taxpayer will make in a Section 1031 exchange. Paramount to every 1031 exchange is the safety of funds held by the Qualified Intermediary (QI).

58 Does the QI offer customers the written backing of a large creditworthy entity? What is the financial rating and balance sheet of this entity? Does the QI conduct due diligence on the depositories holding the funds and monitor them?

59 Does the QI offer segregated accounts? Does the QI offer a qualified escrow account? Does the QI offer a qualified trust account? Does the QI have sufficient fidelity bond coverage?

60 COLORADO Scott Saunders HQ WEBSITE National Headquarters Eastern Regional Office apiexchange.com