§1031 exchanges and tax planning in an …cpaacademy.s3.amazonaws.com/ppt/1031exchanges.pdf ·...
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§1031 EXCHANGES AND TAX
PLANNING IN AN ENVIRONMENT OF
INCREASING TAXATION
Scott SaundersAsset Preservation Inc.
Senior Vice President
• Sr. Vice President of Asset Preservation, Inc. (API)
• API has facilitated over 150,000 exchanges
• 26 years of experience with 1031 exchanges
• Over 150+ articles on 1031 exchanges
• Quoted in the Wall Street Journal July 2013
• CE Instructor for many trade organizations
Instructor: Scott R. Saunders
• Capital Gain Taxation & The Perfect Storm
• The Investment Real Estate Market
• 1031 Exchange and Tax Issues
• IRC Section 1031 and Exceptions
• Partnership Issues and Related Party Rules
• Delayed Exchanges and Identification Rules
• 1.1031(k)-(G)(6) Restrictions in a Delayed Exchange
• Parking Arrangements (Reverse & Improvement)
• Recent Developments, PLRs, etc.
• Qualified Intermediary (QI) Due Diligence
Outline
Capital Gain Taxation
• 20% capital gain tax rate for high earners
• “Net investment income” 3.8% Medicare surtax
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% Medicare surtax on net investment income - plus
4) The applicable state tax rate (0% - 13.3%)
Capital Gain Taxes
• Investors owe Federal capital gain taxes on their economic gain depending upon their taxable income.
• A 20% has been added to the tax code for investors exceeding the $400,000 taxable income threshold for single filers and married couples filing jointly with over $450,000.
• The capital gain tax rate of 15% remains for investors below these threshold income amounts.
3.8% Medicare Surtax (IRC §1411)
• The Health Care and Education Reconciliation Act of 2010 added a new 3.8% surtax on “net investment income.”
• This 3.8% surtax 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”).
The Perfect Storm
The Perfect Storm (for 1031s)
• Much higher capital gain taxes
• 3.8% net investment income tax
• Rebounding commercial and residential real estate markets nationwide
• Price appreciation and rising rents
• Investors seeking out ways to reduce their tax burden
Two Investment Markets: Commercial & Residential
COMMERCIAL:
• In 2014, nationwide CRE prices are actually 11% above the previous market peak
• Strong returns at many REITs
• Institutions have solid borrowing/buying capacity
• Increase in CRE financing rates generally won’t affect demand much
• Core and grade A buildings have strong demand
• CRE activity in secondary/tiersary markets increasing
• International demand for U.S. CRE assets
Investment Real Estate Market
Two Investment Markets: Commercial & Residential
RESIDENTIAL:
• Home prices plunged about 40% from the previous market
peak but have recovered about 29-30% in value
• Nationally, home prices are 11.3% below 2007 peak
• Assuming steady appreciation at forecasted levels, it will take
2.7 years for national home prices to reachieve pre-recession
levels.
• Year over year, home prices up 6.3%
• SFR rents up 2.5% year-over-year
• Lack of inventory contributing to price increases
• Home buyers are more sensitive to rising interest rates
Investment Real Estate Market
The tax code taketh, the tax code deferreth: The increasing value of 1031 exchanges…
• One aspect of the tax code provides real estate investors with a huge tax advantage – an IRC Section 1031 exchange.
• Allows taxpayers holding property for investment purposes to potentially defer all taxes that would otherwise be incurred upon the sale of investment property.
IRC §1031 Exchanges
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 in 2014 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.
Hold, Sell or Exchange?
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.
The Code
• 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
Exceptions
• 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 held at the time of sale
• The extent to which improvements 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
Property Held for Sale
• 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
§1031 - Partnership Issues
• 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 non-recognition treatment under §1031.
• It appears the IRS will be scrutinizing “drop and swap” or “swap and drop” partnership transactions more closely. See e.g., 2009 Marks TC 4797
§1031 - Partnership Issues
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 2002-83, PLR 9748006)
4. Delayed – Purchasing from a Related Party who is Exchanging (See PLR 2004-40002)
Related Party Issues
• What is Excluded?
• Qualifying Real Property
• Qualifying Personal Property
Like-Kind Property Issues
Revenue Procedure 2008-16
• 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.
Vacation Home Exchanges
Barry E. Moore v. Comm., T.C. Memo. 2007-134
• 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
Vacation Homes
• What is a typical fractional ownership investment?
• Advantages of fractional ownership
• Risks involved in fractional ownership
• Tenant-In-Common (TIC): Rev. Proc. 2002-22
• Delaware Statutory Trust (DST): Rev. Rul. 2004-86
• For more information, visit: www.adisa.org
(Alternative & Direct Investment Securities Association)
Fractional Ownership
• Only for an “accredited investor” (a high net worth investor as defined in Regulation D of the Securities Act of 1933)
• A Delaware Statutory Trust (DST) is a separate legal entity created as a trust under the laws of Delaware in which each owner has a “beneficial interest” in the DST and is treated as owning an undivided fractional ownership in the property.
• Chief advantage of a DST is the lender views the trust as only one borrower.
• Investors only right to the property is receiving distributions and they have no voting authority regarding the operation of the property.
• “Bad boy carve outs” are eliminated and the lender looks to the sponsor for these carve outs from the non-recourse provisions of the loan.
Fractional Ownership: DST
• “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)
Intent to Hold for Investment
• Case where facts did not support investment intent
• Taxpayer moved into 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
Goolsby v. Commissioner
• 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 tenants.
• 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.
Reesink v. Commissioner
• Taxpayer was not able to prove their intent changedfrom 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.
Allen v. United States
Relinquished
Value $900,000
- Debt $300,000
- Cost of Sale $60,000
Net Equity $540,000
The Exchange Equation
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
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.
The Exchange Equation
The Taxpayer acquired property of greater value, reinvesting all net
equity and increasing the debt on the replacement property.
Analysis: There is no boot.
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
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.
The Exchange Equation
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)
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 Exchange Equation
The Delayed Exchange
SALE PURCHASE
$ $
45-Day 180-DayIdentification Period Total Exchange Period
Taxpayer
Qualified
Intermediary SellerBuyer
Time Requirements
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.
• 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.
Identification Rules
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
Identification Rules
(a) The receipt by the Taxpayer of all replacement property to which the taxpayer is entitled under the exchange agreement
(b) The occurrence after the end of the identification period of a material and substantial contingency that —
(1) Relates to the deferred exchange,
(2) Is provided for in writing, and
(3) Is beyond the control of the Taxpayer and of any disqualified person (as defined in paragraph (K) of this section), other than the person obligated to transfer the replacement property to the taxpayer.”
Restrictions on Exchange Proceeds
• Section 1.1031(k)-1(g)(6)
• Scenario #1: Multiple properties within the 45 day Identification Period.
• Scenario #2: Multiple properties outside the 45 day Identification Period.
Restrictions on Exchange Proceeds
• 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)
What Not To Do In An Exchange
WHAT NOT
TO DO
What is a Reverse Exchange?
• Purchasing the replacement property before closing on 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.
Parking Arrangements
Why Perform a Reverse Exchange?
• Seize the moment
• Protect your exchange
• Improve replacement property
The Reverse Exchange
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.
The Improvement Exchange
Improvement Exchange
“…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.”
• An exchange of real estate owned by a
Taxpayer for improvements on land owned by
the same Taxpayer does not meet the
requirements of §1031.
• 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. 67-225. 1967 2 C. B. 270, holds that
a building constructed on land owned by a
Taxpayer is not of a like-kind to Taxpayer.
Revenue Procedure 2004-51
Exchanges Face Uncertain Future
• Former Senator Max Baucus (D-MT) released a proposal when he was Chairman of the Senate Finance Committee to eliminate 1031 exchanges.
• Representative Dave Camp (R-MI) has released a proposal to eliminate exchanges on Jan. 1, 2015.
• President Obama in his budget proposal wants to limit capital gains in an exchange to $1 million (indexed for inflation) beginning Jan. 1. 2015.
Recent Developments
Tell Congress Not to Repeal 1031 Exchanges
• 1031 exchanges benefit millions of American investors and businesses every year. 1031 exchanges encourage businesses to expand and help keep dollars moving in the U.S. economy.
• Tell Congress 1031 exchanges have powerful value to the U.S. Economy. Get involved.
• Go to www.1031taxreform.com and bring your voice to the discussion in Washington D.C.
Recent Developments
• PLR 201216007 – Related Party Ruling: The non-tax exception to 1031 (f)(4) applies when related parties are also exchanging and receive a limited amount of boot. Each party must hold the replacement property for 2 years and permitted cash boot up to 5%.
• PLR 2012120012 – Related Party Ruling: Involves successive exchanges and each taxpayer receives its own 45/180 day time period.
Recent Developments
• Adams v. Commissioner, T. C. Memo 2013-7: Involves a taxpayer exchanging into a replacement rented by the taxpayer’s son and family. Although the rent paid to the taxpayer was considered below market, the court found that when the rent was combined with the value of improvements made to the house by the son, there was no bargain rent. Consequently, the exchange treatment was allowed and this case highlights the importance of receiving fair market rent when renting an exchange property to a family member.
Recent Developments
• Yates v. Commissioner, T. C. Memo 2013-28: The 1031 exchange was determined to be invalid
when the taxpayer moved into the replacement
property and made it their residence 4 days after
acquisition in the exchange. The court nonoted
that using the property as a residence created a
clear presumption of non-business intent.
Recent Developments
• Johnson vs. C.I.R., 2014 WL 2965410 (MN Tax Court, 6/20/2014) – The Minnesota state tax court determined the taxpayer did not hold the replacement property for a qualified use when their son lived in the property with no payment of rent.
• Allen v. USA (USDC ND CA 6/28/14) – The court determined the taxpayer was a dealer with respect to land purchased for development. The taxpayer purchased land for development and held for 12 years. The taxpayer argued their intent changed from development to being held for investment. The court found no evidence to support the taxpayer’s claimed change in intent and did not allow the gain to be characterized as long-term gain on the tax return.
Recent Developments
• Blangiardo v. Commissioner, TC Memo 2014-110:
• Taxpayer used an attorney, who was also his son, as his Intermediary. Taxpayer argued because A) his son was an attorney; B) funds were held in an attorney trust account; and C) documents referred to this as a Section 1031 exchange, that this transaction should qualify.
• The Court rejected these arguments. A lineal descendant is a disqualified person and the Regulations make no exception based on the disqualified person’s profession
Recent Developments
• California Franchise Tax Board Audit Targets
• Drop/Swap and Swap/Drop involving partnership/LLC’s shortly before or after the 1031 exchange
• Pulling cash boot out of the relinquished property closing without authorization in the exchange documents
• Exchanging a contract into real property
• Pre-arranged refinancing after closing of the replacement property
Recent Developments
• 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).
QI Due Diligence
• 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?
QI Due Diligence
• 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?
QI Due Diligence
