1031 tax-deferred exchanges: building wealth through real estate all audio is streamed through your...
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1031 Tax-Deferred Exchanges: Building Wealth through Real Estate
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§1031 Tax-Deferred Exchanges: Building Wealth through Real Estate
Qualifications for a “Like-Kind” Exchange
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Learning ObjectivesUpon completion of this webinar you will be able to:•Define the "Like-Kind" exchange & requirements for tax-deferred exchange.•List the steps involved in properly executing a Sec 1031 tax-deferred "like-kind" exchange. •Identify types of real estate properties such as principal residence, investment properties, vacation homes, and which qualify for a tax-deferred exchange. •Define the rules for identifying replacement property.•Identify special circumstances of exchanges.•Identify who can serve as a qualified intermediary.•Determine what is a related party exchange and who is a related party.•Identify problems with related party exchanges.•Determine qualifications of vacation home properties.•Recognize disaster area extensions.
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§1031 Tax-Deferred Exchanges
Tax-deferred exchange allows you to preserve your wealth through reinvestment in “like-kind” assets.
A tax-deferred exchange allows for deferral of capital gains taxes if structured correctly.
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The Concept of “Like-Kind”
Any real or personal property can be exchanged, provided it is held for
“Productive use in a trade or business” or
For investment, and
Is exchanged for “like-kind” property that will be held for the same purpose
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What is “Like-Kind”?
Like-kind does not mean exactly the same
Single family rental unit may be exchanged for other real property such as
Warehouse, retail center, office building, farm property, leasehold interest in real estate
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What is “Like-Kind”?
Most real property is “like-kind” to other real property.
Real property is not “like-kind” to personal property.
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“Like-Kind” Exchange Example
You acquired an improved property for $800,000 four years ago.
Current mortgage balance is $600,000
Property has appreciated to $1,800,000
Depreciation deductions of $100,000
$175,000 Capital Gains taxes if sold
No Capital Gains taxes if deferred-exchange
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“Like-Kind” Exchange Example
SALE EXCHANGE
Current Value $1,800,000 $1,800,000
Mortgage Payoff $(600,000) $(600,000)
Tax on $1,000,000 Appreciation @ 15%
$(150,000) Deferred
Tax on $100,000 Depreciation Recapture @ 25%
$(25,000) Deferred
Available for Reinvestment $1,025,000 $1,200,000
Value of Replacement Property 30% Down
$3,416,667 $4,000,000
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Requirements for Tax-Deferred Exchange
Identification period
Exchange period
Fully deferred exchanges
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Identification Period
Replacement property must be identified within 45 days of the transfer of the relinquished property.
Deadline can not be extended for weekends or holidays.
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Exchange Period
Acquisition of replacement property must be completed by the earlier of
180 days of the transfer of the relinquished property, or
The due date of filing your federal tax return for the year in which property was relinquished (includes extensions).
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Fully Deferred Exchanges
Exchange will be fully tax-deferred only if
Replacement property is equal to or greater in value and equity than your relinquished property
Debt of your replacement property must also be equal to or greater than debt on relinquished property unless cash is added to offset debt
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Rules for Identifying Replacement Property
3-Property Rule (Three properties regardless of value), or
200 Percent Rule (Any number of properties, as long as combined FMV doesn’t exceed twice the value of relinquished property), or
95 Percent Rule (Any number of properties, regardless of combined FMV, as long as you acquire 95% or more of the total value of properties)
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1031 Exchange Process
Use a “Qualified Intermediary” to ensure a successful and smooth transaction
Use a reputable and knowledgeable realtor
Use a “real estate” attorney experienced with 1031 exchanges
Allow sufficient time to complete entire real estate transaction
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1031 Exchange Process - Step 1
Purchase Contract –Relinquished Property
The contract between you and your buyer should contain a “cooperation clause”
Cooperation clause should state that buyer agrees to an assignment of the contract by the seller to the QI
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1031 Exchange Process – Step 2
Exchange Documentation
Contact the Qualified Intermediary (QI) to start tax-deferred exchange process
QI will prepare exchange agreement,
Assignment of the relinquished property purchase contract,
Notice of the assignment, and
Instructions to the settlement agent
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1031 Exchange Process – Step 3
Closing the relinquished property Property will be conveyed to buyer
Cash proceeds from sale must be delivered to the QI.
You should never be in either actual or constructive receipt of the cash proceeds
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1031 Exchange Process – Step 4
Investment of cash proceeds & identification forms
After closing of relinquished property the QI will hold the proceeds, and
Provide you with forms to identify replacement properties within the 45 day identification period
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1031 Exchange Process – Step 5
Purchase Contract–Replacement Property
Enter into purchase contract with seller
Replacement property purchase contract should have “cooperation clause”
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1031 Exchange Process – Step 6
Exchange Documentation Qualified Intermediary will prepare
Assignment of the replacement property purchase contract (assign rights to QI)
Notice of the assignment (deliver to seller)
Instructions to the settlement agent
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1031 Exchange Process – Step 7
Closing the Replacement Property Qualified Intermediary delivers exchange proceeds to purchase replacement property
Seller will convey replacement property
Closing must occur by 180 days from date of closing of relinquished property, or due date of filing federal tax return
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1031 Exchange Process – Step 8
Completion of Your ExchangeQualified Intermediary provides you all the exchange documents including proof of
Receipt and disbursement of all exchange funds
Complete Form 8824 to file with tax return
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Why Do I Need a Qualified Intermediary?
A QI is necessary to create the exchange correctly
It requires experience, special knowledge, and extreme care to preserve the tax-deferred character
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Can Anyone Serve As a QI?
Absolutely Not!
Relatives, or anyone who within a two year period prior to the exchange has acted as your
Attorney, accountant, real estate broker, or agent
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What Characteristics Should A QI Have?
Experience
Financial Stability
Customer Satisfaction
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If I Have a QI Do I Need A Legal or Tax Advisor?
Yes, Absolutely!
Your QI will carry out the exchange and prepare necessary documentation for tax deferral
Your QI does not offer tax advice
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How Do I Identify Replacement Property?
Identification of replacement property must be submitted in writing
Unambiguously described,
Signed by you,
Delivered or sent before midnight of the 45th day
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What If I Want To Cancel My Exchange?
If you cancel after the QI receives your cash proceeds, certain restrictions apply that limit access to your cash until certain time periods elapse
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What If I Sell A Property & Decide To Do A Tax-Deferred Exchange?
You might be Out of Luck!
If you actually or constructively receive proceeds from the sale, you can’t participate in a tax-deferred exchange
If you have not closed on the sale you may be able to do a tax-deferred exchange
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What Is Boot?
“Boot” can be cash received from the sale of the relinquished property, or
Other non-cash consideration, including property that is not “like-kind”, or
Promissory notes, or
Debt relief (mortgage boot)
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Do I Need To Do A Tax-Deferred Exchange For My Personal Residence?
NO, Principal residence is not considered property held “for productive use in a trade or business”, or “for investment”
Principal residence gains can be excluded under Code Section 121
$250,000 exclusion for single taxpayer $500,000 exclusion for married couple filing joint
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Review Questions for Self-Study CPE
Now’s the time to answer the review questions.
Follow this link:http://www.proprofs.com/quiz-school/story.php?title=NTc1NzMz
Please leave quiz window open and wait to submit until prompted to complete questions 4 through 6. Once completed, press Submit and close quiz window.
Same Taxpayer Requirement
Replacement property must be held in same manner as the relinquished property
A single-member LLC that elects taxation as a sole proprietorship as the single member are treated as one and the same taxpayer
A grantor trust (revocable living trust) and the grantor are treated as one and the same
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Like-Kind Requirement
Only “like-kind” property qualifies for replacement property
All real property is considered like-kind to all other real property
Regardless if property is improved or not
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Fully Deferred Exchange
Replacement property must be equal to or greater in value than relinquished property
Must reinvest all equity from the relinquished property
Acquire only like-kind property
Any cash pulled out (including initial down payment) will be treated as taxable boot
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Receipt of Boot
Cash and other non like-kind property received in an exchange, or
Debt that is paid off on the relinquished property and not replaced with equal or greater amount of debt on new property is
Considered “boot” and taxable up to amount of gain
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Reverse and Improvement Exchanges
Reverse exchanges are available for taxpayers who need to acquire replacement property before transferring the relinquished property, or
If exchanged proceeds are to be used to make improvements to targeted replacement property
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What Is A Related Party Exchange?
A 1031 exchange where either buyer of the relinquished property, or
Seller of the replacement property (or both) is “related” to the investor doing the exchange
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Related Parties
Property may be transferred to a related party as long as related party holds the property for two years
May not acquire a replacement property from a related party if the related party receives cash from the transaction
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Who Is A Related Party?
Related party includes family members such as:SpousesBrothersSistersAncestors (parents & grandparents)Lineal descendants (children & grandchildren)Corporation or partnership and a person who owns more than
50% interest in the entity
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What’s The Problem With Related Party Exchange?
Related party exchanges can encourage abusive basis shifting
IRS gives related party exchanges special scrutiny
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Swapping With A Related Party
Each related party must hold their replacement property for at least two years after the last transfer occurs in the exchange
If either party transfers their property before the two year holding period, both parties exchanges will be disqualified, and
Gain must be recognized on each of the original transfers, as of the date of disposition of property
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Selling To A Related Party
IRS has issued private letter rulings holding that two year requirement does not apply when
The investor uses a QI and sells to a related party, but acquires new property from unrelated party
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Buying From A Related Party
If investor acquires replacement property from a related party and sells relinquished property to unrelated third party,
IRS will likely scrutinize and disqualify exchange because of potential basis shifting
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Exchanging Fractional Interest In Multiple Parcels
Related parties may exchange fractional interests in multiple parcels
IRS has ruled these types of exchanges to be valid
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Can I Exchange My Vacation Home?
Property held for personal use does not qualify
Must be able to prove investment use
Appreciation is not sufficient to prove investment intent
Barry E. Moore vs. Commissioner T.C Memo 2007-134
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IRS Safe Harbor – Rev. Proc 2008-16
In 2007 the Treasury Inspector General for Tax Administration issue a report recommending additional oversight of like-kind exchange
In response IRS issued Rev. Proc 2008-16 providing a safe harbor
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Qualifying Under Rev. Proc 2008-16
Properties must be owned for at least 24 months before and after the exchange
During each 12 month period both properties must be rented at FMV for 14 days or more
Personal use cannot exceed the greater of 14 days or 10% of the days during each 12 month period the property was rented at FMV
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Qualifying Under Rev. Proc 2008-16
“Personal Use” is not limited to use by the taxpayer. Includes use by:Taxpayer’s family members,Any other person with an interest in the unit, or their families,Anyone using the unit under an arrangement allowing taxpayer to use some other dwelling, orAnyone, if property is rented for less than FMV
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Qualifying Under Rev. Proc 2008-16
Keep personal use limited to greater of 14 days or 10% of rental period
Rent property to unrelated party for at least 14 days per year. No need to rent for more than 14 days
Treat property as investment by deducting expenses for maintenance, insurance, utilities, and depreciation.
Structure mortgage loan as investment loan and not for primary residence
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Real Estate Outside the U.S.
Real estate outside the U.S. is not like-kind to real estate in the 50 states
You can exchange foreign for foreign real estate
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1031 Treatment for Conservation Easements
Sale of an entire fee interest in land held for investment would qualify for 1031 exchange
IRS has issued private letter rulings finding that certain conservation and agricultural easements are like-kind to real estate
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Extensions for Disaster Areas
Rev. Proc 2007-56 allows the 45 and 180 day deadlines to be extended to 120 days from such deadline for Covered Disaster Areas
1) Taxpayer must be located in Covered Disaster Area (relinquished or replacement properties don’t need to be in disaster area)
2) Relinquished property should be transferred on or before the listed disaster date
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Extensions for Disaster Areas
As of March 12, 2012 Covered Disaster Areas include Massachusetts and Rhode Island
As of March 23, 2012 includes Mississippi
As of April 24, 2012 includes Alabama
As of April 30, 2012 includes Tennessee
As of May 12, 2012 includes Kentucky
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Extensions for Disaster Areas
As of February 10, 2013 includes Mississippi
As of April 16, 2013 includes Illinois
As of May 2013 includes Oklahoma
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Dodd-Frank Wall Street Reform Act
On July 21, 2010 President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act
Title X of the Act created a new agency “Bureau of Consumer Financial Protection” which will regulate Qualified Intermediaries
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Revenue Procedures
March 2010 – Rev. Proc 2010-14 (Insolvency issues of a QI)
Nov 2008 – Rev. Proc 2008-16 (Safe harbor for vacations and second homes)
Jan 2009 – Rev. Proc 2007-56 (Clarifies who is eligible for an extension of 45 and 180 days)
Nov 2008 – Rev. Proc 2000-37 (Provides guidance on structuring reverse 1031 exchanges)
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Private Letter Ruling 201048025
Issued December 3, 2010
Ruling made Section 1031 available to taxpayer, related party, and affiliates providing each party holds their replacement property for two years
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Revenue Ruling 90-34
Ruling allows direct transfers of like-kind property
Seller who sells like-kind property to investor does not have to receive or hold title to property being transferred to investor
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The Rich’s 1031 Exchange
Don and Susan Rich own 3 beachfront condos in Destin, FL (Unit 7, 8, 9)
All 3 units were purchased in 2002
Unit 7 (1 bed/1 bath) and Unit 8 (2 bed/2 bath) are actively rented
Unit 9 (2 bed/2 bath) is the Rich’s second home. It was has never been rented
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The Rich’s 1031 Exchange
Basis in Unit 7 is $90,000
Basis in Unit 8 is $235,000
Basis in Unit 9 is $235,000
Unit 7 has suspended losses of $110,000
Unit 8 has suspended losses of $105,000
All 3 units are under contract to sell for $658,000
Replacement property a single family home is under contract for $580,000
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The Rich’s 1031 Exchange
Do the 3 units qualify for 1031 exchange?
What would you recommend to the Rich’s? Why?
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Review Questions for Self-Study CPE
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Follow this link:http://www.proprofs.com/quiz-school/story.php?title=NTc1NzMz
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