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Investment Property Exchange Services, Inc.

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IRC §1031 Tax Deferred Exchange

1031 Exchanges

Whitney BrennanVice President

Southeast Region, IPX1031®

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Today’s program is designed to help you better understand:

What is I.R.S. Code Section 1031An explanation of the basic applicability and benefits of 1031 Exchanges.

1031 Exchange Process RevealedA review of the qualifications, requirements, and restrictions pertaining to 1031 Exchanges, including time for identification, time for replacement, investment intent and holding periods, property value requirements, cash out and boot, “like‐kind” property, rules of identification, taxpayers, and selecting a Qualified Intermediary.

Tax StrategiesA review of the benefits of 1031 Exchanges including tax deferral for the taxpayer, and client development and retention for the Real Estate Professional.

Course Objectives

Objective 1

Objective 2

Objective 3


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Internal Revenue Code 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.”

If the sale of investment property would have a capital gains tax consequence, the investor can defer the capital gains tax by reinvesting the proceeds in another investment

property; in this event, the sales contract should include exchange cooperation language.

§1031 DEFERS taxes X

§1031 isNOT a tax‐free transaction

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• Higher Capital Gains Tax

• 3.8% Healthcare Tax

• Depreciation Recapture Tax

• State Taxes

Tax Update


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Single investors exceeding the $400,000 income threshold and married couples exceeding the $450,000 income threshold now pay the new 20% capital gains tax rate.

Higher Capital Gains Tax

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The Healthcare and Education Reconciliation Act added a 3.8% Medicare surtax on “net investment income.”

• Applies to individual earning over $200,000 and married couples earning over $250,000

• Net investment income includes: dividends, capital gains, retirement income and income from partnerships

3.8% Healthcare Tax


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Depreciation is a way to obtain a tax deduction by spreading the cost of the real estate over period of time.

As a result, depreciation reduces the property’s adjusted cost basis.

Upon sale, the part of the gain that is related to depreciation will be taxed at the rate of 25%.

Depreciation Recapture Tax

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Certain states, such as California, have a 13.3% top tax rate

• North Carolina – 5.8%• South Carolina – 7.0%• Georgia – 6.0%

State Taxes


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1st CALCULATE NET ADJUSTED BASIS

Original Purchase Price (Basis) $500,000

plus Capital Improvements + $50,000

minus Depreciation ‐ $150,000

equals NET ADJUSTED BASIS $400,000

2nd CALCULATE CAPITAL GAIN*

Sales Price $1,200,000

minus Net Adjusted Basis ‐ $400,000

minus Cost of Sale ‐ $80,000

equals CAPITAL GAIN $720,000

Sale vs. Exchange

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3rd CALCULATE CAPITAL GAIN TAX DUE

Recaptured Depreciation (25%) $150,000 x 25% =

$37,500

plus Federal Capital Gain (20)% $720,000 – $150,000 X 20 =

+ $114,000

plus Medicare Surtax (3.8%) $720,000 x 3.8%=

+ $27,360

plus State Tax (NC 5.8%) $720,000 x 5.8% =

+ $41,760

TOTAL TAX DUE $220,620

Sale vs. Exchange (cont.)


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In an IRC §1031 real property exchange, you can exchange real property for any other real property in the United States or its possessions, if said property is held for productive use in a trade or business or for investment purposes.

What is Like‐Kind Property?

Retail% Interest as a TIC

Commercial

Industrial Property

Single Family

Apartments

Raw Land

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With the proper intent, the following are examples of like‐kind real property exchanges:

• Residential for commercial• Commercial for industrial• Single family for multi‐family• Non‐income vacant land for income producing• Swamp land for Bank building

Like‐Kind Property (cont.)


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• Stock in trade or other property held primarily for sale (i.e. property held by a developer, “flipper” or other dealer)

• Securities or other evidences of indebtedness or interest • Stocks, bonds, or notes • Certificates of trust or beneficial interests • Interests in a partnership • Choses in action (rights to receive money or other property by judicial

proceeding) • Foreign property (real or personal) for U.S. based property • Goodwill of one business for goodwill of another business

IRC §1031 does not apply to any exchange of:

Like‐Kind Property (cont.)

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In order to obtain a deferral of the entire capital gain tax the

Exchanger must:

1. Purchase property of EQUAL OR GREATER value.

2. Reinvest ALL of the net proceeds from the relinquished property.

3. Obtain EQUAL OR GREATER financing on the replacement property

than was paid off on the relinquished property. Replacement

property debt can be offset with cash put into the exchange.

4. Receive nothing in the exchange but like‐kind property.

To the extent the Exchanger fails to observe these rules they will be

subject to capital gain tax.

Basic 1031 Rules


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For 100% deferral

Thumbnail Test

in value

debt

Spend ALL net proceeds

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Any non like‐kind property received in an exchange• Cash, installment note, debt relief or personal property

Partially tax deferred exchange is valid• Where exchanger receives like‐kind property and boot

What is Boot?


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Relinquished

Value $1,000,000

‐ Debt $300,000

‐ Cost of Sale $60,000

Net Proceeds $640,000

For full tax deferral, a Taxpayer must meet two requirements:

1. Reinvest all net exchange proceeds2. Acquire property with the same or greater debt.

Boot: Run The Numbers

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Relinquished Replacement Boot

Value $1,000,000 $1,300,000

‐ Debt $300,000 $660,000 $ 0


Net Proceeds $640,000 $640,000 $ 0


The Taxpayer acquired property of greater value, reinvesting all net proceeds and increasing the debt on the replacement property.

Analysis: There is no boot.


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Relinquished Replacement Boot

Value $1,000,000 $800,000

‐ Debt $300,000 $260,000 $ 40,000


Net Proceeds $640,000 $540,000 $ 100,000

Total Boot $ 140,000


The Taxpayer acquired property of a lower value, keeps $100,000 of the net proceeds 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)

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The Exchange Process


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1. 45‐Day RuleThe Exchanger must identify the potential replacement property or properties

within the first 45 days of the 180 day Exchange period.

2. 180‐Day RuleThe Exchanger must acquire the replacement property or properties within 180

days, or the date the Exchanger must file a tax return (including extensions) for

the year of the transfer of the relinquished property, whichever occurs first.

3. There are no extensions for Saturdays, Sundays, or holidays.

4. The time limits begin to run on the date the Exchanger transfers the

relinquished property to the buyer.

5. The “date of transfer” will be the date of recording or transfer of the benefits

and burdens of ownership, whichever occurs first.

Delayed Exchange Time Limits

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1. Three Property RuleThe Exchanger may identify up to three properties of any value.

2. 200% RuleThe Exchanger may identify more than three properties if the total fair market value of what is identified does not exceed 200% of the fair market value of the relinquished property.

3. 95% ExceptionIf the Exchanger identifies properties in excess of both Rule 1 and Rule 2, then the Exchanger must acquire 95% of the value of all properties identified.

Exchange Identification Rules


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1. The property identification must be delivered to a party to the exchange that is not a disqualified party (e.g., the Qualified Intermediary).

2. It must be in writing and signed by the Exchanger.

3. It must be “unambiguous” (site specific).

4. It must be delivered, mailed, faxed, or “otherwise sent” within the 45 days.

5. An identification can be revoked within the 45 days, but the revocation must also follow steps 1 through 4.

Procedures for Property Identification

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To qualify as a Safe Harbor against actual or constructive receipt of the exchange funds, the Exchange Agreement must limit the Exchanger’s right to receive, pledge, borrow, or otherwise receive the benefit of money or other property except:

1. After the end of the 45‐day Identification Period, if Exchanger has not identified any replacement property;

OR

2. If Exchanger has identified replacement property; then upon or after receipt by Exchanger of all replacement property to which Exchanger is entitled under the Exchange Agreement;

OR

3. If Exchanger has identified replacement property; then upon or after the occurrence, after the end of the Identification Period, of a material and substantial contingency that: (a) relates to the exchange, (b) is provided for in writing and (c) is beyond the control of Exchanger and of any disqualified party, other than the party obligated to transfer replacement property to Exchanger;

OR

4. After the end of the 180‐day Exchange Period.

Safe Harbor Restrictions


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• A Taxpayer needs to close on the acquisition of the replacement property before the relinquished property can close.

• Because IRC §1031 requires an “exchange” the taxpayer cannot own both the relinquished and the replacement properties at the same time.

• Typically, the reverse exchange involves a third‐party “parking” title until the taxpayer can complete the exchange.

What is a Reverse Exchange?

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• Revenue Procedure 2000‐37 provides a safe harbor for reverse exchanges. IRS will not challenge the tax deferred status of a reverse exchange structure in accordance with the Revenue Procedure.

• Reverse exchanges allow the Exchanger to purchase replacement property prior to transferring the relinquished property. The Revenue Procedure states a new entity known as Exchange Accommodation Titleholder (EAT) must be used by the Exchanger to hold title to either the replacement property or the relinquished property.

• The EAT will generally form a disregarded special purpose entity (the “Holding Entity”) to take title to the parked property.

Structuring a Reverse Exchange


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Why 1031

#1 Diversification

SELLone

BUY multiple

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Why 1031

#2 Consolidation

SELLmultiple

BUY one

Property that is easier to manage – i.e. apartment complex, commercial strip center, DST, TIC, etc.


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Why 1031

#3 Move Markets

SELL BUY

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Why 1031

#4 Estate Planning

SELLone

Upon death, each heir inherits one


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Rev. Proc. 2008‐16: Safe Harbor for Exchanges of Vacation Homes And Conversions to/from Personal Residences.

Safe harbor is effective for exchanges occurring on or after March 10, 2008.

Vacation Homes & Conversions

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How does the Taxpayer meet Safe Harbor for a Vacation Home And Principal Residence?

1. Taxpayer most own the property for 24 months prior to the exchange, and

2. Taxpayer must rent for 14 days or more in each of the 12 month periods.

3. Taxpayer’s personal use in each of those years must not exceed the greater of 14 days or 10% of the numbers of days the property was rented at fair rental rates.

4. Replacement property must meet the same criteria as outlined above.

Meet Safe Harbor?


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Using IRC §1031 to Buy a Primary Residence

•Sell your rental property and use §1031 to buy your dream home

•Buy the dream home as a rental (property must be held for productive use in a trade or business or for investment)

•Rent it out for 2 years (Taxpayer must consult with tax advisor to determine how long they should hold before moving into as a principal residence)

1031 & Primary Residences

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Exclude up to $250K ($500K for certain joint returns) gain realized on the sale or exchange of property if:

• The property was owned and used as the taxpayer's principal residence for at least 2 years during the 5‐year period ending on the date of the sale or exchange.

• A pro‐ration of the exclusion can be received by the taxpayer in less than 2 years if they can prove hardship or unforeseen circumstances (must consult with their tax advisor).

IRC §121 Primary Residence Exclusion


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IRC §121 permits an exclusion from capital gain realized of $250,000 for a single person and $500,000 for a married couple on the sale of a home used as a primary residence for any two of the past five years.

If, however, the residence was acquired as a replacement property in a §1031 Exchange, the Exchanger must have held the property for a total of FIVE years before it qualifies for the §121 exclusion when it is sold. (HR 4520 October 22, 2004).

Combining IRC Sections 1031 and 121

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• Amends §121 to further restrict its exclusion benefits.

• $250,000/$500,000 no longer applies to periods of “Non‐qualified” use.

• Non‐qualified use: “Any use other than primary residential” by the taxpayer. Thus no exclusion allowed for portion of ownership that was either:– Rental (Investment) or Personal Use (Second or Vacation Home).

• Effective January 1, 2009 the exclusion will not apply to gain from the sale of the residence that is allocable to periods of “nonqualified use.”

• §121 Exclusion is now allocated based on ratio of qualified use period to ownership period.

• Non‐qualified use prior to January 1, 2009 is not taken into account for the non‐qualified use period (but is considered for the ownership period).

Housing Assistance Tax Act of 2008


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• Now possible under Rev. Proc. 2005‐14 to both exclude capital gains under §121 and defer capital gains in an exchange under §1031

• Property’s last use must have been as investment to qualify §1031

• Must have been occupied for 2 out of last 5 years as principal residence

• Can take up to $250K or $500K tax free under §121

• Exchange the rest into a like‐kind business or investment property for equal or greater value under §1031, tax deferred

Combining §1031 & §121 in a Single Exchange

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• Bought as residence in 2000 for $200,000• Converted to investment property in 2011• Sells in 2013 for $860,000• If sold under §121 exclusively the taxable

gain would be approximately $100K

Sale price $860,000Closing Costs ‐$ 60,000§121 Exclusion ‐$500,000Basis ‐$200,000Taxable gain $100,000

• Since the property was used as investment for the last 2 years, it qualifies §1031

• Since the property was occupied for 2 out of the last 5 years, it qualifies §121

Combining §1031 & §121 Example


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By combining a §1031 and §121:

Sale price $860,000Closing Costs ‐$ 60,000§121 Exclusion ‐$500,000Left to §1031 $300,000

• Taxpayers put $500,000 tax free cash in their pocket at closing and purchase $300,000 of like‐kind replacement propertieswithin 180 days using IPX1031® as their Qualified Intermediary.

• Taxpayers eliminate $500,000 of taxable gain under §121 and defer the depreciation recapture and excess gain under §1031.

Combining §1031 & §121 Example

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Sale of a Fourplex

• 3 units rented• 1 unit primary residence

§1031 & §121 Split Treatment

§1031§1031 §1031§1031

§1031§1031 §121§121primary residence

§1031 = 3/4§121 = 1/4


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Examples:

Exchange Vesting Issues

With few exceptions in an exchange, title to the Replacement property must be held in the same manner as title was held on the Relinquished property.

• Partnership ABE Acquires

• ACME, Inc. Acquires

• Individual Acquires• Individual Relinquishes

• Partnership ABE Relinquishes

• ACME, Inc. Relinquishes

Except in limited circumstances, the same tax identification number should be used on both the relinquished and replacement phases of the transaction.

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Grantor Trust (e.g. revocable living trust)Trustee takes title to replacement property as an individual and then transfers it later to trust. Trust is disregarded for tax purposes.

Death of ExchangerIf Exchanger dies, Exchanger’s estate can complete exchange.

Single Asset EntitiesExchanger who relinquished as an individual can acquire replacement property in a single‐member LLC. This entity is disregarded for tax purposes under “check the box” rules. (Rev. Proc. 2002‐69 Husband and Wife in community property state – can choose disregarded treatment.)

A corporation merges out of existence in a tax‐free reorganization after disposition of relinquished property, may complete the exchange and acquire the replacement property as the new corporate entity.

Exchange Vesting Issues


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• IRC §1031(f) is designed to prevent basis‐shifting & avoidance of payment of federal income tax.

• Through exchange of high basis property for low basis property, in anticipation of the sale of the low basis property.

• If a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect ‘cashed out’ of the investment, and the original exchange should not be accorded non‐recognition treatment.” H.R. Rep. No. 247, 101st

Congress 1st Sess. 1340 (1989)

Related Party Issues

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• Related Party Buyer must hold the Relinquished Property received from Exchanger for 2 years. IRC §1031(f)(C)(i)

• Unless Related Party Buyer is not actually “trading” any Related Party Buyer owned property with Exchanger.

• If Related Party Buyer starts out with cash, not property, and it simply a purchaser of Exchanger’s property, ending up with 100% basis in the purchased property, then the Related Party Buyer may dispose at will.

• PLRs 200709036 & 200712013‐There is some dispute as to whether this will hold up for others.

Related Party Seller (selling to)


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• Exchanger must hold Replacement Property received from Related Party for 2 years. IRC §1031(f)(C)(ii)

• Related Party Seller of Replacement Property must also do an exchange.

• Related Party Seller may not receive cash or non like‐kind property.• If Related Party Seller does not do an exchange, IRS views this as

“cashing out” and transaction will be taxable (Revenue Ruling 2002‐83).

Related Party Seller (buying from)

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Common Scenarios

1. A partnership owns property and wishes to sell it. Some of the partners want to engage in a 1031 tax deferred exchange upon the sale and some do not.

2. A partnership owns property and wishes to sell it. All of the partners would like to participate in a 1031 tax deferred exchange, but the partners do not want to purchase the new property together

Partnership Issues


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If most of the partners in the partnership wish to complete the 1031 Exchange together:

Distributing an undivided interest.

Purchase of the interest of the retiring partner.

The partnership could sell the relinquished property, distribute a portion of the proceeds to the partners who wish to cash out and use the remaining proceeds to purchase the new property.

ISSUE: The partners that are cashing out would receive a special allocation of the gain from the sale of the property. This gain maybe greater for the partners that cashed out.

Partnership Issues: Possible Solutions

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What if the partners do not wish to purchase the new property together?

The partnership can be liquidated and terminated and the relinquished property distributed to the partners as “Tenants In Common”

This should be done as far in advance of the sale as possible.

If a distribution or dissolution occurs shortly prior to the sale, the key issue is whether the relinquished property was “held for productive use in a trade or business or for investment purposes.”

Partnership Issues: Possible Solutions


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• Who owns the Qualified Intermediary? How financially stable are its owners?

• Is the QI a publicly traded corporation?• Will the QI provide you with its financial statements?• What is the package of security that the QI is offering your client?− Fidelity Bond

− Corporate Guarantee− Errors and Omissions Insurance

• Does the QI have trained professionals (Attorney or CPA) on staff?

Questions to Ask About QI

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IRC §1031 Tax Deferred Exchange

Whitney BrennanVice President

Southeast Region, IPX1031®[email protected]

916‐806‐1468www.ipx1031.com

Download - 4 - 1031 Exchanges.ppt - CTIC - 1031 Exchanges...•Because IRC 1031 requires an “exchange” the taxpayer cannot own both the relinquished and the replacement properties at the

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