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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Presented by: Sara A. SmithDirector – Exchange ServicesATG Trust Company
Christopher J. PrincisSenior Vice PresidentBrook-Hollow Financial, LLC
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other StrategiesDecember 18, 2013
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Wealth Management Tools
Using § 1031 Tax-Deferred “Starker” Exchanges and Structured Sales
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Agenda
What is a § 1031 exchange?
Key Concepts
Like-Kind Property
Holding Requirement
Same Taxpayer Requirement
Delayed Exchanges
45-Day Rule
180-Day Rule
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Agenda
Constructive Receipt – Qualified Intermediary
Related Parties
Exchange Steps
Updates and New Rulings
Using Structured Sales as a Tool for Failed Exchanges
Summary and Questions
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
What is a Tax-Deferred Exchange?
No Exchange:– Taxpayer sells investment property.
– Taxpayer pays tax on any gain.
– Remaining funds are used to buy new investment property.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
What is a Tax-Deferred Exchange?
With a Tax-Deferred Exchange:– Taxpayer transfers “like-kind” investment property.
– Tax on gain is deferred.
– More funds are available to acquire new “like-kind” investment property.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
What is a Tax-Deferred Exchange?
A Tax Planning Tool for All Income Levels– Courts have said that there is nothing sinister in
arranging one’s affairs to keep taxes as low as possible.
– Everybody does so, rich or poor, and all do right, for nobody owes any public duty to pay more than the law demands.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
What is a Tax-Deferred Exchange?
Seven Key Concepts– Exchange, not Sale.
– What is like-kind property?
– Was the property held for a proper purpose?
– 45 days to properly identify Replacement Property.
– 180 days to complete the Exchange.
– Same Taxpayer
– Form over substance? i.e., no constructive/actual receipt – Qualified Intermediary
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
What is a Tax-Deferred Exchange?
Remember:– You do not have to be a tax expert to guide your client
through a tax-deferred exchange.
– Any sale of property that is not your client’s primary residence is a possible exchange.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Evolution of Tax-Deferred Exchanges
Simultaneous Two-Party Exchanges:– “A” has property “B” wants.
– “B” has property “A” wants.
– Properties are like-kind and of comparable value. How likely is this?
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Evolution of Tax-Deferred Exchanges
3-Party Exchanges:– “A” has property “B” wants.
– “B” has no property “A” wants.
– “C” has property “A” wants.
– “B” buys from “C”; transfers to “A.”
– “A” transfers to “B.”
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Benefits of an Exchange
Asset value is maintained.
Full equity is reinvested.
Taxes are deferred.
Recapture gain is postponed.
Management burdens are reduced .
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Effect of Not Doing an Exchange
Payment of tax.
Less equity to reinvest.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Section 1031
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.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Like-Kind Property
§ 1031 makes no distinction in qualities of real estate.– Farmland is like-kind to Willis Tower.
– A three-flat apartment building is like-kind to a single family home.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Like-Kind Property
All Real Estate in the United States is like-kind.
Interests in a Partnership are not like-kind, nor are stocks, bonds, or inventory.
Beneficial Interest in an Illinois land trust can be like-kind.
Leasehold Interests > 30 years are like-kind to a Fee Interest.
Perpetual Water Rights are like-kind to a Fee Interest. PLR 200404044
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Like-Kind Property
Foreign Real Estate– Not like-kind to U.S. real estate.
An apartment in New York City is not like-kind to an apartment in Paris, France.
– What is like-kind to U.S. real estate? Property in Puerto Rico is not like-kind to property in U.S., but
property in Virgin Islands is like-kind.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Like-Kind Property
Growing Timber or Crops– Exchange of all timber cut and removed from 60 acres
during two-year period for Fee Interest in three parcels of real estate.
– After two years, Taxpayer still has land, less timber, plus three parcels.
– Sale of timber for land was not like-kind. TAM9525002
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Like-Kind Property
Co-Op to Condo: Like-Kind PropertyLTR200137032
– Taxpayer owns stock in corporation and holds long-term lease (30+ years) for unit.
– Taxpayer wants to exchange Stock and Leasehold Interest for Fee Interest in the same underlying property.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Like-Kind Property
Co-Op to Condo: Like-Kind PropertyLTR200137032
– New York law is unclear whether co-op interest is realty or personalty.
– Taxpayer now owns directly what he previously owned indirectly (as shareholder). See also, PLR 200631012 – TIC Interest
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Like-Kind Property
TAM 200424001– Taxpayer was a Railroad.
– Taxpayer exchanged two types of assets: intact rail line segments, including affixed rails and ties; and
rails and ties that were not affixed to the rail line.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Like-Kind Property
TAM 200424001– State law determines nature of property:
Loose rails and ties were not of a like-kind to affixed rails and ties, even though the property is otherwise identical.
State law controls in determining whether the subject property is realty or personalty for federal income tax purposes.
Law of the state where the property is located controls, even if this would result in the identical property being treated as not of a like-kind merely because it was located in a different state.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Holding Requirement
Was the Property Held for a Proper Purpose?– Productive use in a trade or business or for investment.
– Stock in trade and inventory are excluded.
– Taxpayer’s residence is excluded.
– Look to Taxpayer’s intended use at the time of the exchange.
– Mixed-use property can qualify.
– “Investment” does not always mean “income producing.”
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Holding Requirement
How long must the Taxpayer hold the property?– IRS says two years.
– One year should be okay. Applies to both Relinquished and Replacement Property.
– Was property acquired just to exchange?
– Was property disposed of immediately after the exchange?
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Holding Requirement
Intent– What was the Taxpayer’s state of mind?
Why was property held:– Sale?
– Investment?
– Flip?
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Holding Requirement
Intent– Factors to Consider; No IRS Safe Harbor
Why was the property acquired?
Why was it held?
Was there a pre-arranged plan to sell?
How many/frequent sales?
Taxpayer’s business/occupation?
What was the extent of efforts to sell property, e.g., listed with a broker?
Purpose of property at time of sale?
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Holding Requirement
Intent– Paullus v. Commissioner
T.C. Memo 1996-419 September 1996
Corporation owned golf course and vacant land.– Land zoned residential.
– Sales office with 100 “Buyers.”
– Corporation sold land to concentrate on golf course business.
IRS: Land held for sale.
Taxpayer: Sale of land was an ancillary business.
Corporation held property for four years with few sales.
Judge found this “troubling” but held for Taxpayer.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Holding Requirement
Intent– Baker v. Commissioner
Tax Ct. Dkt. No. 20372-95 April 1997
Developer:– Subdivided land into 48 lots.
– Built 14 homes; transferred remaining lots for $600,000 exchange credit.
– Reported lots as “work in progress” on tax returns and business records.
Holding: Lots were inventory, not property “held for Investment.”
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Title to Replacement Property
Same Taxpayer Requirement– General Rule:
The Taxpayer who receives Replacement Property must be the same Taxpayer who relinquished property.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Delayed Exchanges
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Delayed Exchanges
Starker v. United States 602 F.2d 1341 (9th Cir. 1979)
– Thurman James (T.J.) Starker, Professor of Forestry – Oregon State University Two-year exchange period;
6% growth factor;
Continuity of ownership?
Proper purpose?
Collateral estoppel;
Spurred IRS to create time limits.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Delayed Exchanges
Time Limit to Identify– Identification Rules
Prior to midnight on the 45th day after the Relinquished Property closing date, Taxpayer must unambiguously identify the Replacement Property:
– in writing, signed by the Taxpayer; and
– delivered to at least one party to the exchange who is not a disqualified person.
This deadline cannot be extended for any reason.
No identification may be made after 45 days, even if the desired transaction fails.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Delayed Exchanges
Time Limit to Identify– Identification Rules
Start counting on the day after the closing date.
Each Taxpayer should sign the Identification.
Identification may be revoked during 45 days and replaced with other property.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Delayed Exchanges
Federal Disaster Area– This is the only exception.
“Affected Taxpayers”:– Individuals and businesses located in the disaster area;
– Those whose tax records are located in the disaster area;
– Relief workers, regardless of their state of residence or the location of their tax records. IR 2004-108
Notice 2005-3
Rev. Proc. 2007-56 gives guidance
www.irs.gov/uac/Tax-Relief-in-Disaster-Situations
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Identification Rules
Three Property Rule– This is the most commonly used identification rule.
– Taxpayer may identify up to three replacement properties without regard to market value.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Identification Rules
200% Rule– Taxpayer may identify more than three properties as
Replacement Property if: at the end of the Identification Period, the Aggregate Fair
Market Value of the properties does not exceed 200% of the fair market value of the Relinquished Property.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Identification Rules
95% Rule– Taxpayer may identify more than three properties as
Replacement Property if: prior to the end of the exchange period, the Taxpayer acquires
identified Replacement Property with fair market value equal to at least 95% of the Aggregate Fair Market Value of all the Identified Replacement Properties.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Identification Rules
Dobrich v. Commissioner T.C. Memo 1997-477 October 20, 1997
– Taxpayers are sophisticated real estate investors.
– Relinquished Property closed August 22, 1989.
– 45 days expired October 6, 1989.
– Exchange Period ended February 18, 1990.
– Exchange Agreement outlined time limits.
– Taxpayers timely identified 10 properties.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Identification Rules
Dobrich v. Commissioner T.C. Memo 1997-477 October 20, 1997
– Offers were made and earnest money deposited, but none were acquired.
– January 1990 Taxpayers tried to identify five additional properties.
Qualified Intermediary advised Taxpayer of expired time limits.
Taxpayers backdated ID letters and contracts for two properties.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Identification Rules
Dobrich v. Commissioner T.C. Memo 1997-477 October 20, 1997
– IRS disallowed both exchanges.
– Taxpayers never expressed interest in Replacement Properties during 45 days.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Identification Rules
Dobrich v. Commissioner T.C. Memo 1997-477 October 20, 1997
– Taxpayers claimed to have orally identified properties to each other.
– Regulations did not require written identification until June 10, 1991, but … identification between Exchangors would render identification
requirements meaningless.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Identification Rules
Dobrich v. CommissionerT.C. Memo 1997-477 October 20, 1997aff’d T.C. Memo 1999-28804 August 25, 1999
– Installment treatment denied;
– Assessed tax of $2,222,612;
– Assessed penalties of $1,666,959;
– Guilty of filing false documents with IRS;
– Previously pled guilty to two criminal counts.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Deadline for Completion
Closing on the Replacement Property mustTake Place by the earlier of :– the day that is 180 days after the closing on the
Relinquished Property; or
– the due date of the Taxpayer’s tax return for the tax year in which the Relinquished Property was transferred.
This deadline cannot be extended for anyreason except Federal Disaster Area exceptions issued by the IRS.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Deadline for Completion
180 Days is not 6 Months.– If the Relinquished Property is transferred after October
17, the tax return will be due before the expiration of 180 days.
– Extending the filing date will give the Taxpayer the full benefit of the 180-day exchange period.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Deadline for Completion
Knight v. Commissioner T.C. Memo 1998-107 March 16, 1998
– Taxpayers identified three replacement properties.
– Seller of second property cancelled sale on Day 179.
– Third property acquired on Day 309.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Deadline for Completion
Knight v. Commissioner T.C. Memo 1998-107 March 16, 1998
– Taxpayers argued that “good faith effort” was sufficient, since the circumstances were beyond their control (IRS should be “citizen friendly”).
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Deadline for Completion
Knight v. Commissioner T.C. Memo 1998-107 March 16, 1998
– Analogized to § 1033 Involuntary conversion and two-year time limit.
– Tax law is contained in statutes, regulations, and judicial decisions, not in informal IRS publications.
– Internal Revenue Code controls, not equitable principles.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Deadline for Completion
Receivership of QI Does Not Extend Exchange Period LTR200211016 December 10, 2001
– Taxpayer argued that the Exchange Deadline was suspended. Filing deadlines ... necessarily operate harshly and arbitrarily
with respect to those who fall just on the other side of them, but if the concept of a filing deadline is to have any content, the deadline must be enforced.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Death of Taxpayer
Effect of Taxpayer’s Death During Exchange– Prior to Husband’s death:
Two Relinquished Properties transferred;
One Replacement Property identified.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Death of Taxpayer
Effect of Taxpayer’s Death During Exchange– After Husband’s death:
One Replacement Property identified;
Two Replacement Properties acquired;
IRS approved exchange.– Therefore, Husband’s share of proceeds is not income in respect
of a decedent. LTR 9829025 April 17, 1998
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Receipt of Proceeds
Constructive Receipt– Gain or Loss may be recognized, if:
Taxpayer actually or constructively receives money or other property before the Taxpayer actually receives like-kind property, even if the Taxpayer ultimately receives the like-kind property.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Safe Harbor
Use of Safe Harbor will result in determination that Taxpayer is not in actual or constructive receipt of money or other property.
More than one Safe Harbor may be used.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Safe Harbor
Terms of each Safe Harbor must be satisfied independently.
Exchange may qualify without using Safe Harbor.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Safe Harbor
Secured Obligation– Obligation of the Taxpayer’s transferee to transfer the
Replacement Property to the Taxpayer may be secured by: mortgage;
letter of credit; or
third party guarantee.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Safe Harbor
Secured Obligation– “A” has Property “B” wants;
“B” has no property “A” wants.
– “A” transfers to “B,” subject to mortgage.
– “B” buys from “C,” transfers to “A.”
– “A” releases mortgage.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Safe Harbor
Qualified Escrow or Trust– Obligation of the Taxpayer’s transferee to transfer the
Replacement Property to the Taxpayer may be secured by cash or cash equivalent, held in a qualified escrow.
– Taxpayer can perfect a Security Interest.
– Can be used with the Qualified Intermediary Safe Harbor, as protection against a dishonest QI.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Safe Harbor
Qualified Intermediary– The Most Commonly Used Safe Harbor
Cannot be the Taxpayer or a disqualified person.
Under a written agreement with the Taxpayer, the QI acquires the Relinquished Property and transfers it to the Buyer.
QI holds the exchange proceeds to prevent actual or constructive receipt by the Taxpayer.
QI acquires the Replacement Property and transfers it to the Taxpayer.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Safe Harbor
Interest on Proceeds– Taxpayer can receive interest or other growth factor on
the proceeds.
– This is a taxable event.
– 1099 statement will be issued to the Taxpayer.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Safe Harbor
Limits on Safe HarborsReg 1.1031(k)-1(g)(6)
– Safe harbors cease to apply at the time the Taxpayer has the immediate ability to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the exchange period ends.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Safe Harbor
Limits on Safe HarborsReg 1.1031(k)-1(g)(6)
– If there is money in the escrow and identified Replacement Property that has not been acquired, money cannot be disbursed to the Taxpayer until the exchange period expires.
– Can only disburse for a (g)(6) event or Taxpayer risks premature receipt of boot.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Receipt of Proceeds
Constructive Receipt Voids Exchange Ab InitioFlorida Industries Investment Corporation and Subsidiaries v. Commissioner, T.C. Memo 1999-346 October 19, 1999
Florida Industries
Orlando Industrial(Exchangor)
Alpha Trust
Joint Venture
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Receipt of Proceeds
Constructive Receipt Voids Exchange Ab InitioFlorida Industries Investment Corporation and Subsidiaries v. Commissioner, T.C. Memo 1999-346 October 19, 1999
– June 25, 1990
Orlando Industrial(Exchangor)
Alpha Trust
Joint Venture
Vacant Lots
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Receipt of Proceeds
Constructive Receipt Voids Exchange Ab InitioFlorida Industries Investment Corporation and Subsidiaries v. Commissioner, T.C. Memo 1999-346 October 19, 1999
– Exchange escrow opened: July 26, 1990
– 45th day: September 9, 1990
– 180th day: January 22, 1991
Bank(Escrowee)
Orlando Industrial(Exchangor)
Vacant Lots
Alpha Trust Cash
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Receipt of Proceeds
Constructive Receipt Voids Exchange Ab InitioFlorida Industries Investment Corporation and Subsidiaries v. Commissioner, T.C. Memo 1999-346 October 19, 1999
– Escrow Disbursements July 27, 1990: First Replacement Property; excess funds to Exchangor,
not Escrowee.
November 20, 1990: Second Replacement Property (residence of Exchangor’s president).
November 26, 1990: $50,000 “draw” to Exchangor.
December 11, 1990: $50,000 “draw” to company owned by Exchangor’s president.
December 11, 1990: Third Replacement Property;
December 20, 1990: Fourth Replacement Property; excess funds to Exchangor, not Escrowee;
January 8, 1991: Balance of funds to Exchangor.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Receipt of Proceeds
Constructive Receipt Voids Exchange Ab InitioFlorida Industries Investment Corporation and Subsidiaries v. Commissioner, T.C. Memo 1999-346 October 19, 1999
– The Court held:
Taxpayer’s control of proceeds made exchange void ab initio.
Residence did not meet “Purpose” test.
No valid identification for last three properties.
First exchange also failed, even though “Bad Acts” occurred after it was acquired.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Disqualified Persons
Taxpayer’s:– employee;
– attorney;
– accountant;
– realtor;
– investment banker;
– broker; or
– other agent,
if they performed services for the Taxpayer in the two years prior to the exchange.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Disqualified Persons
Relatives of the Taxpayer; or
Those having relationships described in §267(b) or § 707(b) (using 10% instead of 50%).
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Disqualified Persons
Exceptions to the Rule:– Persons who rendered services for the Taxpayer solely
with respect to § 1031 exchanges.
– Persons who provided routine financial, title insurance, escrow, or trust services for the Taxpayer.
– Now includes “bank affiliates” (T.D. 8982).
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Don’t settle for a Qualified IntermediaryWho is Merely Not Disqualified– The Federation of Exchange Accommodators (FEA)
Upholds standards in the exchange services field: Administrative and technical support;
Safety of exchange balances;
Regulation of exchange fees.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Related Parties
Any person bearing a relationship to the Taxpayer as described in IRC § 267(b) or § 707(g)(1);
Family members;
Common ownership among entities (i.e., same person owns 50% or more of each);
Grantor or fiduciary of a trust.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Related Parties
What’s the Problem?– IRS fears that related party transactions will result in an
“abusive shift of basis.”
– Abuse occurs when high basis property is exchanged for low basis property.
– Reduces the recognition of gain on the subsequent sale of the low basis property.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Related Parties
Example of Abusive Basis Shift– “X” and “Y” are related parties.
– “X” wants to sell Blackacre to “Z” (unrelated).
– “X” will recognize a gain of $900,000 on sale.
“X” owns Blackacre.
FMV: $1,000,000Basis: $100,000
“Y” owns Whiteacre.
FMV: $1,000,000Basis: $800,000
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Related Parties
Example of Abusive Basis Shift– “X” and “Y” exchange properties.
– “Y” sells Blackacre to “Z.”
– “Y” will recognize a gain of $200,000 on sale.
“X” owns Blackacre.
FMV: $1,000,000Basis: $100,000
“Y” owns Whiteacre.
FMV: $1,000,000Basis: $800,000
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Related Parties
Two-Year Holding Period– Intended to prevent abusive basis shifting.
– Non-recognition treatment is denied if either related party disposes of the property they received in the exchange.
– Both parties must recognize gain.
– Period begins on the date of the last transfer required to complete the exchange.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Related Parties
Exceptions to Two-Year Holding Period– Involuntary conversion;
– Death of related party;
– Convincing the IRS that the avoidance of taxes is not a principal purpose of the transaction.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Related Parties
Do Related Parties Always Cause an Abusive Basis Shift?– A related party buying the Relinquished Property
creates a new tax basis: if the Replacement Property is acquired from an unrelated
party; and
if the related party never owned the Replacement Property there should be no abusive basis shift.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Related Parties
The Real Related Party Rule– If related parties each hold like-kind property at the start
of the exchange; and
– when the exchange is over, one has like-kind property and the other does not;
– no matter what you did to get to that point, you probably did something wrong!
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Related Parties
PLRs for Reference:– Related Seller:
201220012
201216007
201048025
200820025
– Related Buyer: 200709036
200712013
200728008
201027036
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Example of a Deferred Exchange Using the Qualified Intermediary Safe Harbor
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer enters into a contract for Relinquished Property.
Taxpayer BuyerContract
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer assigns contract to Qualified Intermediary.
Taxpayer Assignment
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer must give notice of the Assignment to all parties to the Exchange.
TaxpayerNotice of
Assignment
Co-Owners
Buyers
QualifiedIntermediary
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer gives notice of the Assignment to all parties to the Exchange. – Must have proof Notice was given.
TAM 200130001
Taxpayer could not prove Notice of Assignment was given.– Rules are specific and exact, and must be followed with precision
or the integrity of the transaction will be jeopardized.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer transfers Relinquished Property directly to Buyer.
Taxpayer BuyerRelinquished
Property
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Buyer pays proceeds to Qualified Intermediary.
QualifiedIntermediary
BuyerProceeds
of Sale
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer identifies the Replacement Property.– Within 45 days after the transfer of the Relinquished
Property Taxpayer must identify the property: Unambiguously in writing;
Signed by the Taxpayer;
Delivered to a party to the exchange who is not a disqualified person.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer enters into a contract for Replacement Property.
– NOTE: This may be done prior to identification.
Taxpayer SellerContract
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer assigns contract to Qualified Intermediary.
Taxpayer Assignment
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer must give notice of the Assignment to all parties to the exchange.
TaxpayerNotice of
Assignment
Sellers
QualifiedIntermediary
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Taxpayer requests funds for closing.– In writing.
– How much?
– When?
– Where?
– How? One business day notice is required.
Fax request to 312.338.1594
Please use the Disbursement Request for Funds from Exchange Account (ATG Trust Form 8040).
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Qualified Intermediary makes payment to Seller from escrow.
QualifiedIntermediary
SellerPayment
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Example of Deferred Exchange
Seller transfers Replacement Property directly to Taxpayer.
Taxpayer SellerReplacement
Property
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Exchange Agreement (ATG Trust Form 8003)
Exchange Agreement should designate “ATG Trust Company” as the Qualified Intermediary.
To obtain forms:– Download at www.atgtrust.com; or
– Call 312.752.1031
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Updates
Capital Gains Tax Hike– Depending on income level, taxpayers can expect to
pay up to 23.8% in federal capital gains tax. Don’t forget that includes the new 3.8% Medicare surtax.
– Add in any state tax and depreciation recapture and there could be a blended tax rate of near 40%.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Updates
Choosing a Reputable Qualified Intermediary– Kreisers, Inc. v. First Dakota Title Limited Partnership
(Circuit Court, Second Judicial District, S. Dakota, 7/10/2013) Excellent example of how courts analyze and decide a case
assessing negligence on the part of the QI.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Summary
What is a 1031 exchange?
Key Concepts
Like Kind Property
Holding Requirement
Delayed Exchanges
45-Day Rule
180-Day Rule
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Summary
Exchange Requirement
Same Taxpayer Requirement
Constructive Receipt – Qualified Intermediary
Related Parties
Exchange Steps
Updates and Rulings
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Structured Sales and Fallback
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Tax Deferral Options
Exchange– What if Taxpayer can’t exchange?
Primary Residence
Vacation Property
Goodwill, etc.
– What if exchange fails? Boot
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Cap Rate is Only 15%-20%
But Not So Fast …– Actual rate probably will be greater than 15%.
Recapture Rate: 25% or Ordinary Income Rate
Alternative Minimum Tax
Phase-out of Personal Exemptions
Phase-out of Itemized Deductions
State Income Tax
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Real Rate Could Be Upwards of 40%
So when your client says:– “I’m not concerned about capital gains taxes because
the rate is only 15% or 20%,”
we work through the transaction with them.
Does deferral make sense?
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Installment Sale: § 453
Sale of Property where at Least One Payment Is Received in a Tax Year after the Year of Sale– Income is taxed under the “Installment Method.”
– Gain is recognized over the years in which the payments are received.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Installment Sale Example
First Scenario– Sold for Cash in 2013
Second Scenario– Sold in 2013 for a Series of Equal Payments to Be
Received Over 5 Years
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
First Scenario
Sale Price $500,000
Less: Tax Basis 0
Gross Profit $500,000
2013 2014 2015 2016 2017
Taxable Capital Gain $500,000
Tax @ 20% Rate $100,000 $0 $0 $0 $0
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Second Scenario
Sale Price $500,000
Less: Tax Basis 0
Gross Profit $500,000
2013 2014 2015 2016 2017
Taxable Capital Gain $100,000 $100,000 $100,000 $100,000 $100,000
Tax @ 15% Rate;Installment Method: Taxable Amount
$15,000 $15,000 $15,000 $15,000 $15,000
Total Taxes Paid: $75,000 vs. $100,000
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Installment Sales
Benefits– Defer payment of federal/state capital gains tax.
– Defer taxation on recapture of depreciation.
– Create a stream of income.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Installment Sales
Disadvantages/Risks– Property Deterioration
– Foreclosure Risk
– Early Payoff
Structured Sale can eliminate disadvantages of an installment sale.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Structured Sale
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Structured Sale Benefits
No ongoing relationship between buyer and seller, unlike a traditional “installment” sale.
Seller can choose investment risk and access a loan.
Enhanced Security– Receipt of payments is not dependent on the solvency
or the future financial performance of the buyer.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Cash Sale
Seller Buyer
Cash
Property
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Installment Sale
Seller Buyer
Cash Plus Promise of Future Periodic Payments
Property
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Structured Sale
Seller Buyer
Cash Plus Promise of Future Periodic Payments
Property
Substitute Obligor(Assignment Company)
Future Periodic
PaymentsCash
Liability to make future periodic
payments of fees
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
“Custom Tailored” Payment Stream
Payments can be made:– monthly;
– annually;
– in periodic lump sums; or
– any combination thereof)
No Restrictions on Payment Streams– Benefits Matched to Seller’s Needs and Risk Tolerance
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
“Custom Tailored” Payment Stream
Payments can be structured to keep taxpayer out of AMT trap and/or a higher tax bracket.
Funds lost to taxation (of lump sum payment) are instead put to work for tax-deferred growth.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
§ 1031 Fallback
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
What is a § 1031 Fallback?
The Exchangor currently has an exchange with Qualified Intermediary.
The Exchangor fails to identify any Replacement Property by Day 45 or does not close on a Replacement Property before Day 180 and, therefore, has a significant boot issue.
The Exchangor still wants to receive beneficial tax treatment for the transaction.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
What is a § 1031 Fallback?
Prior to termination of the exchange, the Exchangor gives Qualified Intermediary an Irrevocable Direction to pay the Exchange Funds to Note Guarantor and the Exchange Agreement is amended to provide for an agreed upon Payment Stream.
The Assignment Company Makes Future Periodic Payments directly to Exchangor, and all parties go on “their merry way.”
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
§ 1031 Fallback with Assignment Company
ExchangorQualified
Intermediary
Exchange Agreementamended to specify payment
schedule
Irrevocable Direction to Pay Exchange Funds to
Assignment Company
Substitute Obligor(Assignment Company)
Future Periodic
PaymentsCash
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
IRS Approval
Installment sales are authorized under Section 453 of the Internal Revenue Code (where at least one payment is received in a tax year after the year of sale).
IRS Permits the substitution of obligors under Revenue Ruling 75-457 and Revenue Ruling 82-122.
Tax Court has also approved the substitution of obligors in installment transactions.– Wynne v. Comm., and Cunningham v. Comm., 44 T.C.
103 (1965), acq., 1966-2 C.B. 4
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Opportunities for Structured Sale/Fallback
§ 1031 Exchange when the Exchangor:– fails to identify Replacement Property in 45 days;
– fails to purchase Replacement Property within 180 days;
– fails to use all exchange funds (boot). “Get ‘em and keep ‘em.”
Failed Reverse Exchange
Non-Exchangeable Assets, i.e.:– personal residence;
– vacation home;
– goodwill.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Opportunities for Structured Sale/Fallback
Exchangor wants to leave real estate.
Busted Installment Sale – Early Payoff
Large Commissions/Bonuses
Structured Settlements, Attorney Fees, Qualified Settlements
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Updates
Investment Options and Loans
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Your Investment Choices Are Endless
Cash Money Markets
Fixed Income– U.S.
– High Yield
– International
Equities– U.S. Large Cap
– U.S. Mid Cap
– U.S. Small Cap
– International
– Emerging Markets
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Your Investment Choices Are Endless
Commodities
Structured Notes and Managed Portfolios
Hedge Funds
Managed Futures
Private Placements
Private Equity
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Your Investment Choices Are Endless
Money Managers– Credit Suisse
A balanced portfolio
– Goldman Sachs The structured not specialist
– RBC Individualized portfolio construction
– Morgan Stanley International wealth management
– ATG Trust Trust and custodial firm with 30+ years of experience
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Analysis Example
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Access Up to 80% of Your Pre-Tax Sale
Pay Loan (with deferral)
$350,000 lost to taxes
$650,000 available
Access up to $800,000 now.
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Access Up to 80% of Your Pre-Tax Sale
Loan– You have $800,000 available now. This significantly
increases the amount of capital working for you.
– There are many benefits and uses for your available proceeds: Comfort of Liquidity
– Defer tax while having ready access to cash.
Parking Lot– Failed exchange; still purchase property.
Paying off an existing bank loan.
Achieve lifestyle goals, i.e., successful retirement planning.
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Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Christopher J. PrincisSenior Vice PresidentBrook-Hollow Financial, LLC– 312.550.4658 (Cell)
– 312.529.4017 (Office)
Deferring Capital Gains Using § 1031 Tax-Deferred Exchanges and Other Strategies
Thank you for attending today’s ATG Legal Education seminar.
Earn Your CLE with ATG Legal EducationFor a list of ATG Legal Education programs, visit www.atgf.com.