1031 exchanges

1031 EXCHANGES REAL ESTATE TAXATION, UNIVERSITY OF HOUSTON LAW CENTEROCTOBER 23, 2014

AUSTIN C. CARLSON, GRAY REED & MCGRAW, [email protected]

1031 Basics Mandatory: Application of 1031 deferral rules required (but easy to bust).

Gain/Loss: Gain recognized to the extent of boot; Loss not recognized.

Basis: Carryover basis in old property, adjusted by:subtracting (i) cash received, and (ii) liabilities assigned to other party and;adding (i) cash paid, (ii) liabilities assumed, and (iii) gain recognized.

Holding Period: Tacking for qualifying property. Begins on exchange date for non- qualifying property.

21031 Exchanges, Real Estate Taxation, October 23, 2014

I.R.C. 1031(a)(1) - The Basic RuleNo gain or loss shall be recognized on the exchange of

a) property… b) held for productive use in a trade or business or for investment

if such property is… c) exchanged solely for… d) property of like kind…e) which is to be held either for productive use in a trade or

business or for investment.

1031 Exchanges, Real Estate Taxation, October 23, 2014 3

(a) property

I.R.C. 1031(a)(2) – Non-Qualifying Property

1. Stock in trade or other property held primarily for sale;

2. Stocks, bonds, or notes;

3. Other securities or evidences of indebtedness or interest;

4. Interests in a partnership;

5. Certificates of trust or beneficial interests; and

6. Choses in action.


Other Non-Qualifying Property

1. Personal Use Property (but vacation homes can sometimes qualify see Rev. Proc. 2008-16)

2. Dealer Property (inventory) – Last Week’s Lecture

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(a) property


Qualifying Property

Generally real estate, but includes personal property (e.g. work trucks, airplanes).

Can be used in trade or business.

TIC interests can be exchanged.

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(a) property


(b) Held for productive use in a trade or business OR for investment

1. Minimal amount of personal use is allowed.

2. “Held for” is different from “used for” depreciation test.

3. Held for investment test is applied at the time of the exchange – intent can change (Rev Rule 57-244).

4. No clear holding period, however properly acquired for an exchange does not satisfy test (Rev Rule 84-121).


Can an exchange by former partner of property from a partnership qualify? Maybe: TCM case.

Better way to structure:Facts: A, B, and C own partnership ABC in equal shares. ABC owns a single asset, raw land acquired for investment. A and B want to sell the land, C wants to exchange.

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(b) Held for productive use in a trade or business OR for investment


(c) exchanged solely for

1. Exchange – can be between 3 and even 4 parties.

2. Solely – Gain deferral is limited to value received in like kind property. Gain recognized on boot.


(d) property of like kind

Real property for real property; personal for personal (state law controls).

U.S. situs property for U.S. situs property.


(e) which is to be held either for productive use in a trade or business or for investment.

Investment and business use can be exchanged.

Must continue to be used for investment or business use (no personal use conversion).


Calculation of Gain – Cash Received

Example:

Taxpayer exchanges land (Basis: $50,000, FMV: $80,000)for land with FMV of $60,000 and $20,000 cash.

Gain RealizedFMV of Property Received $60,000

+ Cash Received $20,000– Basis ($50,000)

$30,000

Gain Recognized $20,000(Limited to Boot)


Calculation of Gain – Mortgage Assumed

Example:

Taxpayer exchanges land (Basis: $50,000, FMV: $80,000, $20,000 mortgage)for land with FMV of $60,000.

Gain RealizedFMV of Property Received $60,000 + Mortgage on Old Prop. $20,000 – Basis ($50,000)

$30,000

Gain Recognized $20,000(Limited to Boot)


Calculation of Gain – Netting Mortgages

Example:

Taxpayer exchanges land (Basis: $50,000, FMV: $80,000, $40,000 mortgage)for land with FMV of $60,000, $20,000 mortgage.

Gain RealizedFMV of Property Received $60,000 + Mortgage on Old Property $40,000 - Mortgage on New Property ($20,000) - Basis ($50,000)

$30,000

Gain Recognized $20,000(Limited to Netted Mortgages)


Calculation of Basis After Exchange

Example:

Taxpayer exchanges land (Basis: $50,000, FMV: $80,000, $40,000 mortgage)for land with FMV of $60,000, $20,000 mortgage.

BasisCarryover Basis $50,000 -Mortgage on Old Property ($40,000) + Mortgage on New Property $20,000 + Gain Recognized $20,000

$50,000

Other party’s basis increases by $20,000


Types of Exchanges

1. Simultaneous a. Two Party

b. Three (plus) Parties : (i) Unilateral; (ii) Bilateral with Seller; or

(iii) Bilateral with Purchaser

2. Deferreda. Starker

b. Reverse Starker


Brief History of 1031 Exchanges1921: First introduced in the Revenue Act of 1921 – securities and non- like-kind property if property did not have a “readily realizable market value”

1925: Non-Like Kind eliminated in 1925

1935: Board of Tax Appeals approved a Qualified Intermediary Exchange

1954: Changed to Section 1031 from 112(b)(1) – present day definition adopted

1979: Starker vs. U.S. (602 F.2d 1341)

1984: In response to Starker, 180 day/45 day rules, also disallowance of exchange of Partnership Interest

1989: Domestic and Non-Domestic Restriction; Related Party 2 Year Holding period


Brief History of 1031 Exchanges (Cont’d)

1990/91: Present day regulations issued

2000: Revenue Procedure 2000-37 – Safe Harbor for Reverse Starker Exchanges

2002: Revenue Procedure 2002-22 – Tenant-In-Common (TIC) Property Guidelines

2005: Revenue Procedure 2005-14 – 1031 Exchanges Can be Combined with 121 Exclusion

2008: Revenue Procedure 2008-16 – Safe Harbor rules for 2nd Homes


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Three Party Exchanges : Unilateral Transfers

Purchaser

Taxpayer Seller

$

Seller’s Property

Taxpay

er’s P

roperty

NotesExplicitly approved by Rev. Rule 90-34, 1990-1 C.B. 154


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Three Party Exchanges : Bilateral Exchange with Seller

Purchaser

Taxpayer Seller

$

Seller’s Property

Taxpayer’s Property

NotesSeller must actually take legal and beneficial ownership of taxpayer’s property, either as the buyer or as buyer’s agent. Leslie Q. Coupe, 52 T.C. 394.

Taxpayer’s Property


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Three Party Exchanges: Bilateral Exchange with Purchaser

Purchaser

Taxpayer Seller

$

Seller

’s Pro

perty

Taxpay

er’s P

ropert

y

NotesMust show (i) taxpayer intended and was only obligated to make an exchange rather than a sale; (ii) an exchange actually occurred between taxpayer and purchaser, and (iii) purchaser used its own funds to acquire ownership of the property temporarily for itself. Alderson v. Comm’r, 317 F.2d 790.

Seller’s Property


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Deferred Exchanges


Identification and Receipt Requirements

The 45 Day Identification Period

a) Unambiguously described in a written document

b) Two rules for identifying properties:i. Three property rule; and

ii. 200% percent rule

c) Two exceptions to the rules:i. Property received before the end of ID period

ii. Property received by end of EXCHANGE period equals at least 95% of FMV of properties identified

d) Can revoke a property before end of period by written document

The 180 Day Exchange Period

Earlier of 180 days after relinquished property or the due date (with extensions) of the taxpayer’s income tax return


Escrows, Trusts, and Qualified Intermediaries

Gain or loss is recognized if Taxpayer actually or constructively receives money or other property before receiving the replacement property. Reg. Section 1.1031(k)-(1)(f)(1).

Issue: Relying on promise to receive replacement property (vs. simultaneous exchange).

What type of arrangements will cause constructive receipt?

Example: Reg. Section 1.103(k)-1(f)(3) – Unrestricted right to demand payment before end of exchange period


Regulation Safe Harbors1. Qualified Escrow Accounts and Trusts

2. Security or Guaranty Arrangements

3. Qualified Intermediaries

4. Interest and Growth Factors


Safe Harbor: Qualified Escrow Accounts and Trusts

1. Qualified Escrow: a) Escrow holder is neither the taxpayer nor a disqualified person

b) Agreement expressly subjects right to receive, or otherwise obtain cash to the withdrawal limits (discussed in the next slide)

2. Qualified Trust:a) Trustee is neither the taxpayer nor a disqualified person

b) Trust terminates at the time the taxpayer has the unrestricted right to the cash

3. Taxpayer may receive money or other property directly from a party without affecting the rules


Withdrawal Limitations

No right to receive before:

a) End of identification period if taxpayer has not identified land;

b) Receipt of all replacement property;

c) End of the exchange period;

d) A material and substantial contingency after the identification period that:

i. Relates to the deferred exchange

ii. Is provided for in writing

iii. Is beyond the control of the taxpayer



Examples of Allowed Language

1. Taxpayer may demand funds in escrow at any time after the later of [end of exchange period].

2. Taxpayer may demand funds in escrow if the replacement property is destroyed, seized, requisitioned, or condemned.

Note: Items that can be received (Reg. Sec. 1.1031(k)-1(g)(7)

3. Items not included in the disposition of property (e.g. prorated rents)

4. Items related to disposition of property and appear under local standards in the closing statements (e.g. commissions, prorated taxes)



Safe Harbor: Security or Guaranty Arrangements

Constructive receipt does not occur merely because the taxpayer’s right to receive payment is secured or guaranteed. Reg. Section 1.1031-(k)-1(g)(2).

Safe Harbor Arrangements:

1. Mortgage, deed or trust, or other security interest in property.

2. Standby letter of credit as long as taxpayer can’t draw unless in case of default.

3. Guaranty of third party.


Safe Harbor: Interest and Growth Factors

Growth Factor - Compensation for time that the property is in the hands of the transferee.

a) Taxable as interest income. Reg. Section 1.1031(k)-1(h)(2).

b) Present if the amount of money the TP is entitled to depends on the length of time between property exchanges. Reg. Section 1.1031(k)-1(h)(1).

c) Right to receive the growth factor must be subject to the Withdrawal Limitations.


Safe Harbor: Qualified Intermediaries

QI – Person who is neither the taxpayer or a disqualified person with written agreement under which the QI acquires and transfers the relinquished property AND acquires and transfers the replacement property. Reg. Section 1.1031(k)-1(g)(4)(iii).

Direct Deeding is Permitted.

Rules must be followed “with precision”. TAM 2001300001.

Form over Substance


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Disqualified Persons

1. Taxpayer’s “Agent”Expanded definition of Agent: a person who has been the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker, within the two year period ending on the date of the transfer of the first of the relinquished properties.

Reg. Section 1.1031(k)-1(k)(2).

2. Related parties rules of I.R.C. Section 267(b) and 707(b)◦ Family Members, Entities (individual owns 10% directly or indirectly),

Commonly Controlled Entities, Trusts

3. Persons related to “Agents”


Mechanics of a Typical Transaction

1. Taxpayer and purchaser enter into an Earnest Money Contract.

2. Taxpayer and purchaser enter into Purchase and Sales Agreement.a. Need clause establishing intent to engage in a deferred like-kind exchange

through Q.I

b. Clause allowing assignment of Sales Agreement to QI.

3. Assign Earnest Money Contract and Purchase and Sales Agreement to QI (instructs direct deeding).

4. Give notice to purchaser for assignments.

5. Identify replacement property and give written notice to QI.


Mechanics of a Typical Transaction (Cont’d)6. Close on replacement property within 180 days.

7. Execute Purchase and Sale Agreement with respect to replacement property.

a. Need clause establishing intent to engage in a deferred like-kind exchange through QI.

b. Clause allowing assignment of Sales Agreement to QI.

8. Execute Assignment of Purchase and Sale Agreement in favor of QI (instructs direct deeding).

9. Deliver notice to seller.

10. File IRS Form 8824 for tax year in which property is relinquished.


Reverse Starker Transactions

Starker case allowed a reverse transaction within 5 years

Rev. Proc. 2000-37 provided response that adopts many of the same rules as a Starker transaction (45 day ID period, 180 day exchange period).

Parking Arrangements Issue – Is the accommodation party the owner of the property for federal income tax purposes?

Solution: QEAA


Qualified Exchange Accommodation Arrangements

1. Qualified indicia of ownership a) Can’t be a disqualified person, must be subject to federal income tax on

interest.

b) Legal title or interest in an entity that is disregarded entity (e.g. single-member LLC).

2. Bona fide intent of taxpayer at time of transfer for 1031 exchange to occur.

3. Within 5 days of transfer, enter into qualified exchange accommodation agreement.

4. 45 day/180 days rules --similar to Starker transaction.


Permissible Arrangements in a QEAA1. Exchange accommodation titleholder (EAT) can also be QI.

2. Taxpayer can indemnify or reimburse EAT for costs and loan or advance funds to EAT.

3. EAT can lease property to taxpayer or other party.

4. Taxpayer can manage the property or supervise improvements.

5. Taxpayer and EAT can enter into puts and calls during the exchange period.

6. Taxpayer and EAT can provide for arrangements to take into account variation of price of the property.

Can the taxpayer use his own property as replacement property? Maybe.


Issues with Related Parties

1. Related party definition less broad than disqualified person (only I.R.C. 267(b) rules).

2. Two year holding period for land with exceptions:a) Disposition occurs after the death of a taxpayer or related person;

b) Compulsory or involuntary conversion; and

c) Established to the satisfaction of the Secretary of non-avoidance purpose.

3. Catch-all anti-avoidance provision: applied to “any exchange which is part of a transaction… structured to avoid the purposes of this subsection.” I.R.C. Section 1031(f)(4).


Tax Compliance: Required 1031 Reporting1. Form 8824

a) Filed With tax return for the year including extensions (remember 180 day rule with extensions).

b) Asks for specific dates relating to the identification and replacement periods

c) Related Parties – Must also file 2 years following the year of a related party exchange.

2. Gains Reported on Form 4797 (Trade or Business/Non-Capital Assets) or Schedule D (Capital Assets).

3. Form 1099 Reporting Requirement.


1031 exchanges

Documents

exchanges real estate

real property personal

personal property

situs property

old property

partner of property

kind property

non qualifying property