new 1031 exchanges: identifying property, calculating depreciation,...

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1031 Exchanges: Identifying Property, Calculating

Depreciation, Completing Form 8824, Tax Reform Changes

TUESDAY, FEBRUARY 18, 2020, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

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February 18, 2020

1031 Exchanges: Identifying Property, Calculating Depreciation, Completing Form 8824, Tax Reform Changes

Professor Bradley T. Borden, Professor of Law

Brooklyn Law School

[email protected]

Craig Brown, Vice President and Regional Manager

Investment Property Exchange Services

[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

1031 Exchanges: Identifying Property, Calculating Depreciation, Tax

Reform Changes, Addressing Partnership Issues

Craig Brown | Senior Vice President

[email protected]

(817) 271-1031

Bradley T. Borden | Professor of Law

[email protected]

(718) 780-7550

An explanation of the basic applicability

and benefits of 1031 Exchanges. Looking

at some of its history and recent changes.

6

A 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 disregarded

entities, and selecting a Qualified

Intermediary.

A look at some of the business details

that can creep into transactions and

interfere with the initial goals of the

parties. Specifically at look at Related

Parties, Seller Carry, Partnership Issues

and other common issues to spot in

advance of the 1031.

COURSE OBJECTIVES

I.R.C. SECTION

1031

1031 EXCHANGE

PROCESS1031 Heads Up1 2 3

Investment Property Exchange Services, Inc. | www.ipx1031.com

INTERNAL REVENUE CODE SECTION 1031

“No gain or loss shall be recognized on the

exchange of real property held for productive use in

a trade or business or for investment if such real

property is exchanged solely for real 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 to facilitate the

assignment of the contract to the Qualified

Intermediary.

§1031

DEFERS

taxes

§1031 is

NOTa tax-free

transaction

7

X


TAX DEFERRED EXCHANGE TERMINOLOGY

EXCHANGER

The property owner(s) seeking to

defer capital gain tax by utilizing a

Section 1031 exchange. (The

Internal Revenue Code uses the

term “Taxpayer.”)

Original cost plus improvements,

minus depreciation taken.

BASIS

Fair Market Value of non-qualified

property (i.e., property that is not of

“like-kind”) received in an exchange.

(Examples: cash, notes, seller

financing, furniture, supplies,

reduction in debt obligations).

Control of proceeds by an Exchanger

(even though funds may not directly

in the Exchanger’s possession).

BOOTCONSTRUCTIVE

RECEIPT

Selling price minus Basis.

TAXABLE GAIN

This term refers to the nature or

character of the property, and not its

grade or quality. Generally, real

property is “like kind” as to all other

real property, as long as the

Exchanger’s intent is to hold the

properties as an investment or for

productive use in a trade or

business.

LIKE KIND PROPERTY

8

Tax Deferred Exchange terminology may be confusing to those who are unfamiliar with 1031 transactions. The following are some of

the typical exchange terms and phrases along with their interpretation.


TAX DEFERRED EXCHANGE TERMINOLOGY

QUALIFIED INTERMEDIARY

The person or entity that facilitates

the exchange for the Exchanger. The

term “facilitator” or “accommodator”

is also commonly used, although the

Treasury Regulations use the term

“Qualified Intermediary.”

The property “sold” by the

Exchanger. This is also sometimes

referred to as the “exchange”

property or the “downleg” property.

RELINQUISHED

PROPERTY

The property “acquired” by the

Exchanger. This is sometimes

referred to as the “acquisition”

property or the “upleg” property.

REPLACEMENT

PROPERTY

9

Tax Deferred Exchange terminology may be confusing to those who are unfamiliar with 1031 transactions. The following are some of

the typical exchange terms and phrases along with their interpretation.


TAX REFORM MAJOR POINTS OF INTEREST

2018 Income Tax Brackets: 10%,

12%, 22%, 24%, 32%, 35%, 37%

Corporate Tax Lowered to 21% (lowest since 1938)

Estate Tax Doubled (now $11M per

parent)

Personal Property Exchanges

Eliminated

Previously: 10%, 15%, 25%, 28%,

33%, 35%, 39.6%

Corporations will take more to the bottom line (more spending, hiring, buying, etc.)

If estate has less than $11M of assets, there is no “death tax”. Leaves more money for heirs to spend.

No more 1031 exchanges of businesses, franchises, FF&E, collectibles, heavy equipment, airplanes, etc.

10

NEW CHANGES EFFECT/IMPORTANCE


TAX REFORM MAJOR POINTS OF INTEREST

Immediate expensing on capital

assets is 100% through 2022 and then

drops 20% per year thereafter

Deductibility of State Income Tax, Property Tax and Sales Tax limited to $10,000 on Federal Tax Returns (previously unlimited)

Mortgage Interest Deduction on Primary Residence lowered to $750K (previously $1M)

The Tax Reform Act repeals the technical termination rules under Section 708(b)(1)(B) for tax years beginning after 2017

2027 it completely goes away

As an offset to that the Standard Deduction was nearly Doubled.

May slightly affect home buying in

high-end areas

If a majority partner wants out (50%+), but minority partners want to remain in place, the exiting majority partner no longer causes a technical termination of the partnership as long as the remaining members stay in the partnership

• ABC, LP• Partner A owns 60% and wants to cash out• Partners B & C each own 20% and want to

exchange

11

NEW CHANGES EFFECT/IMPORTANCE


TAX UPDATE

Higher Capital

Gains Tax

3.8% Healthcare

Tax

Depreciation

Recapture Tax

State Taxes


12


TAX UPDATE

Higher Capital

Gains Tax


13

Single investors exceeding the $441,451 taxable income

threshold and married couples exceeding the $496,601

taxable income threshold now pay the 20% Capital

Gains tax rate.

TAX UPDATE

3.8% Healthcare

Tax

14

The Affordable Healthcare Act added a 3.8%

tax on certain “net investment income.”

The surtax is imposed on the amount in

excess of $200,000 for single filers and

$250,000 for married couples filing jointly.

Net investment income includes: dividends,

capital gains, retirement income and income

from partnerships.


TAX UPDATE

Depreciation

Recapture Tax

15

Depreciation is a method of allocating the cost

of a tangible asset over its useful life.

Depreciation deductions reduce a property’s

adjusted tax basis.

Upon sale, the part of the gain that is related

to “straight-line” depreciation will be taxed at

the rate of 25%.


TAX UPDATE

State Taxes

16

Source: www.tax-rates.org/taxtables/income-tax-by-stateInvestment Property Exchange Services, Inc. | www.ipx1031.com

BASIC 1031 RULES

3REPLACE THE VALUE OF THE DEBT

Replace the value of the debt that was on the

relinquished property. This can be achieved by

placing a loan on the replacement property of an

equal amount, injecting equity from outside of

the exchange into the replacement property or a

combination of these.

4RECEIVE NO $

Receive nothing in the exchange but like-

kind property.

1EQUAL OR GREATER

Purchase property of EQUAL OR GREATER

value. 2REINVEST

Reinvest ALL of the net proceeds from the

relinquished property.

17

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

To the extent the Exchanger fails to observe these rules they will be subject to capital gain tax on what is not reinvested.


BASIC 1031 RULES

1BUY ABOVE THE BASIS

Purchase property of EQUAL OR GREATER value than the

adjusted basis of the Relinquished Property.

2TAKE CASH THAT IS LESS THAN REALIZED GAIN

The amount of cash taken out of the exchange (cash boot) must be less than the

Realized Gain from the sale of the Relinquished Property. (Gross sales price less

ordinary closing costs less adjusted basis).

18

In order to obtain a partial deferral of the capital gain tax the Exchanger must:

To the extent the Exchanger fails to observe these rules they will be subject to capital gain tax on what is not reinvested.


SALE VS. EXCHANGE

20

Tax Rates IF SOLD• Federal Capital Gain: 15 - 20% (Maximum)

• Depreciation recapture: 25%

• 3.8% tax on certain investment income imposed by Affordable Healthcare Act

• State rates vary from 0% to 13.3%

EXAMPLE:George Grapegrower (married, filing jointly with no other taxable income) has owned a vineyard for almost 10 years and wants to sell the property for $3,000,000. Exchanger originally paid $1,500,000 for the property, put about $200,000 of capital improvements into the property and took approximately $600,000 in depreciation deductions. George owes $2,000,000 to the Lender.

Application of Tax Rates


SALE VS. EXCHANGE

2 Calculate Capital Gain

1 Calculate Net Adjusted Basis 3 Calculate Taxes Due

21

4 Run the Numbers


SALE VS. EXCHANGE

Calculate NET ADJUSTED BASIS

22

1Original Purchase Price (Basis) $1,500,000

PLUS Capital Improvements + $200,000

LESS Accumulated Depreciation - $600,000

equals NET ADJUSTED BASIS $1,100,000


SALE VS. EXCHANGE

Calculate CAPITAL GAIN


23

2Fair Market Value $3,000,000

LESS Estimated Closing Costs -$200,000

Net Sales Price $2,800,000

LESS Net Adjusted Basis - $1,100,000

equals CAPITAL GAIN $1,700,000


SALE VS. EXCHANGE

Calculate CAPITAL GAIN TAX DUE


24

3FEDERAL CAPITAL GAIN

Gain Due to Depreciation (25%)

Gain Due to Appreciation

$479,000* X 15% =

$621,000* X 20% =*based on 2018 Breakpoints

Taxable Investment Income (Healthcare Tax)

$1,700,000

-$600,000 x 25% =

$1,100,000

$1,450,000 x 3.8% =

$150,000

$71,850

$124,200

$55,100

STATE State Tax (using 5%) state taxes vary from 0-13.3% $1,700,000 x 5% = $85,000

TOTAL FEDERAL & STATE TAXES $486,150

SALE VS. EXCHANGE

Run THE NUMBERS


25

4§1031 permits deferral of ALL:

• Capital Gains Taxes (Federal &

State)

• Depreciation Recapture (25%

Federal)

• Healthcare Tax (3.8%)

Sale Exchange

Net Equity $800,000 $800,000

Total Capital Gain Taxes $486,150 -0-

Equity to Reinvest $313,850 $800,000

Proposed Acquisition (using net equity as 25% down payment)

$1,255,400 $3,200,000

RESULT: The exchanger can buy approximately 2½ times the value of property

without adding cash

At 5% return, this will generate additional income of $97,230 per year

LIKE-KIND PROPERTY

26

Generally, all real

property is “like-kind” to

all other real property.

“Like-kind” refers to the

nature or character of the

property, and not its

grade or quality.

Real property can be

improved or unimproved,

because this only relates

to the grade or quality –

not to its kind or class.

The Exchanger’s intent

must be to hold the

replacement property as

an investment, or for

productive use in a trade

or business.


WHAT IS LIKE-KIND PROPERTY?

In an IRC §1031 real property exchange, as a general principle you can exchange real property for any other real

property in the United States, if said property is held for productive use in a trade or business or for investment

purposes.


27

RETAIL

APARTMENTS

SINGLE FAMILY

RAW LAND

INDUSTRIAL PROPERTY

COMMERCIAL

% INTEREST AS A TIC

REAL PROPERTY

1. Leases with

at least 30

years

remaining,

including

renewal

options.

2. Cell

phone

towers and

perpetual

easements

3. A undivided interest in

one property for an

undivided or 100%

interest in another

property. (i.e. Tenants in

Common, where each has

an equal right to possess

the whole.)

5. Timber

rights,

Riparian

rights,

Mineral

Rights, Air

Rights, &

Development

Rights*

REAL PROPERTY: Less than

fee interests that qualify for exchanges:

28

4. Remainder

interest in

real property

* Whether these rights are treated as real estate and qualify for a real property exchange or are considered personal property is

determined by the state law where the property is located.


NON LIKE-KIND PROPERTY

29


THE DELAWARE STATUTORY TRUST

The rights and obligations of

investors in a DST will be

governed by the DST’s trust

agreement.

30

Typically, investors have limited

voting rights over the operation

and ownership of any

properties owned by the DST.

Multiple Investors in each

property with the percentage of

beneficial ownership varying

from one investor to the next.

Internal Revenue Service’s Revenue Ruling 2004-86, a beneficial interest in the Delaware Statutory Trust (DST), which holds the replacement property, can be considered “like-kind”

replacement property in an exchange. A DST may own one or more properties.

21 3


PROPERTY HELD FOR SALE

Property Held for Sale DOES

NOT QUALIFY for an Exchange

There are a number of factors, including

the Exchanger’s intent at the time of the

exchange, that are considered in

determining whether a property is held for

sale and therefore does not qualify for an

exchange

31

21

3


IRC

§1031

shall

NOT

apply

DEALER PROPERTY

Such property does not meet

the test of property “held for

investment or used in a trade

or business”

Gain from the disposition of such property is generally taxed as ordinary income. IRC § §1221(a)(1)-(2); Margolis v. Commissioner (9th Cir 1964) 337 F2nd 1001

32

Dealer Property is defined as real

property held for sale in the

ordinary course of a trade or

business.


QUALIFIED PURPOSE TEST

3TEST IS AT TIME OF EXCHANGE

4HOLDING PERIOD

1NOT HELD FOR SALE

• Inventory

• Other instances of “Held for Sale” 2NOT HELD FOR PERSONAL USE

• Residences

• Second Homes

33

“Held for use in Trade or Business or for Investment”


FOREIGN PROPERTY

Prior to 1989 Exchangers could exchange US property for foreign

investment property.

After the Revenue Reconciliation Act of 1989, IRC §1031 was

amended such that US property was not like-kind to foreign

property. Treas. Reg. §1.1031(h)

Foreign Property, however, is like-kind to foreign property.

34


EXCHANGE STRUCTURES WITH A QI

DELAYED /

SIMULTANEOUS

REVERSE BUILD-TO-SUIT REVERSE

BUILD-TO-SUIT

35


WHAT IS A DELAYED EXCHANGE?

A Taxpayer will close on the Relinquished Property before needing to close

on the Replacement.

This requires the use of Qualified Intermediary, even if both close on the same

day.

Generally, these employ Direct Deeding, so the title need not pass through

the Qualified Intermediary.

36


DELAYED EXCHANGE TIME LIMITS

45 DAY RULE 180 DAY RULE

The Exchanger must identify the

potential replacement property or

properties within the first 45 days of

the 180-day Exchange Period.

The Exchanger must acquire the

replacement property or properties within

the earlier of (a) 180 days, or (b) the date

the Exchanger must file the tax return

(including extensions) for the year of the

transfer of the relinquished property.

• There are no extensions for the

deadlines. The days are calendar

days (including Saturdays, Sundays

and holidays).

• The time limits begin to run on the

date the Exchanger transfers the

relinquished property (or the first

relinquished property) to the buyer.

• The “date of transfer” will be the

transfer of the benefits and burdens

of ownership.

37


DISASTER EXTENSIONS

38

Exchanger’s Principal Residence

Exchanger’s Place of Business

Since September 11, 2001, Congress has permitted 120 day extensions for taxpayers affected within federal disaster areas by Presidential order. The rules are complicated, but generally the Exchanger receives the extension if one of the following is within the affected area:


DELAYED EXCHANGE ID RULES

THREE PROPERTY RULE

The Exchanger may identify up

to three properties of any value.

39

200% RULE

The 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(ies).

95% EXCEPTION

If the Exchanger identifies properties

in excess of both Rule 1 and Rule 2,

then the Exchanger must acquire at

least 95% of the value of all

properties identified.

3 95%200%


PROCEDURES FOR PROPERTY IDENTIFICATION

The property identification must be

delivered to a party to the exchange

that is not a disqualified party (i.e.

the Qualified Intermediary).

It must be in writing and

signed by the Exchanger.

It must be “unambiguous”

(site specific).

It must be delivered, mailed,

faxed, or “otherwise sent”

within the 45 days.

An identification can be

revoked within the 45 days,

but the revocation must also

follow steps 1 through 4.

40


WHAT IS A REVERSE EXCHANGE?

A Taxpayer needs to close on the acquisition of the Replacement property

before the Relinquished 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.

42


WHAT IS A BUILD-TO-SUIT EXCHANGE?

A Taxpayer desires to add value to the Replacement property using tax

deferred dollars.

The Taxpayer cannot own the Replacement property while it is being improved, so it

must be “parked” with an Exchange Accommodation Titleholder.

This can be a Delayed or Reverse. It cannot be on property already owned

by the Exchanger. It can be a 30+yr leasehold and improvements.

43


44

RELATED PARTY EXCHANGES

Who are Related Parties?

BROTHERS & SISTERS

Whether by whole or half blood

SPOUSE ANCESTORS LINEAL DESCENDANTS


RELATED PARTY EXCHANGES

A fiduciary of a trust and a beneficiary of such trust

45

A grantor and a fiduciary

of any trust

Two corporations which

are members of the same

controlled group

A fiduciary of a trust and

a fiduciary of another

trust, if the same person is

a grantor of both trusts

A corporation and a

partnership if the same

persons own:> 50% in value of the outstanding

stock of the corporation, and

> 50% of the capital interest, or the

profits interest, in the partnership

An individual and a

corporation where > 50% percent in value of the

outstanding stock is owned,

directly or indirectly, by or for

such individual


• Some Subtitle Goes Here

PARTNERSHIP ISSUES

46


PARTNERSHIP ISSUES COMMON SCENARIOS

SCENARIO ONE

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.

Drop & Swap

Partial Drop & Swap

Buy out Cash Out Partners

PIN

Partnership Division

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 want to purchase different properties.

Drop & Swap

Partial Drop & Swap

Tracking Allocations

SCENARIO TWO

47


PARTNERSHIP ISSUES POSSIBLE SOLUTIONS

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

◼ 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.”


48

The partnership can be liquidated and terminated and the relinquished property

distributed to the partners as tenants in common.

PARTNERSHIP ISSUES FORM 1065

2Distributed to any partner a tenancy-in-common or other undivided interest in

partnership property?

1Distributed any property received in a like-kind exchange, or contributed

such property to another entity?


49

Partnership Tax Return (Form 1065) asks the taxpayer two new questions related to

exchanges. Has the partnership:

It appears the IRS will be scrutinizing “drop and swap” partnership transactions more

closely in the future (as the States of California and New York already do).


COMBINE SELLER CARRY WITH 1031

Investment Property Exchange Services, Inc. | www.ipx1031.com/brown

50

COMBINE SELLER CARRY AND 1031

50Investment Property Exchange Services, Inc. | www.ipx1031.com

COMBINING SELLER FINANCING WITH AN EXCHANGE

If the Exchanger carries back financing for the buyer, the Exchanger can:

Treat the seller financing as an

installment sale under IRC Section 453.

The capital gain taxes are due when

Exchanger receives principal payments

on the note.

Exchanger can act as a “third-party lender”

and loan the buyer the equivalent amount

of Exchanger’s own funds at the close of the

relinquished property. The note and security

instrument is in Exchanger’s name. All

exchange funds are transferred to Qualified

Intermediary for use in the exchange. When

buyer pays off note the proceeds are not

taxable to Exchanger.

Note and security instrument are made

payable to Qualified Intermediary who

sells the note and combines note

proceeds with exchange proceeds to

acquire replacement property totally tax

deferred.


51


COMBINE SELLER CARRY WITH 1031


52

COMBINE SELLERY CARRY AND 1031REPORTING THE 1031 EXCHANGE


FORM 8824


53

◼ Form requests dates of the exchange transaction, the date the properties were “identified”

and financial information obtained from the closing/settlement statement.

◼ Have to check the box if related parties.

◼ The IRS revised the form in 2003 to require 45 day identification information. STRICTER!

An exchange is reported on Form 8824, “Like-Kind Exchanges”.

AUDIT ISSUES


54

February 14, 2020

◼ Verify the Exchange Agreement was executed

prior to the closing of the relinquished property.

IRS looks for “as of” dates.

◼ Exchange Agreement must contain the “(g)(6)”

restrictions from the Treasury Regulations

regarding the limitations on the Taxpayer’s access

to exchange funds.

◼ Qualified Intermediary cannot be a disqualified

party.

◼ Was the 45 day identification timely done…lot of

issues here…

◼ Did the Exchanger buy from a related party?

AUDIT ISSUES


55

February 14, 2020

◼ Verify the Exchange Agreement was executed

prior to the closing of the relinquished property.

IRS looks for “as of” dates.

◼ Exchange Agreement must contain the “(g)(6)”

restrictions from the Treasury Regulations

regarding the limitations on the Taxpayer’s access

to exchange funds.

◼ Qualified Intermediary cannot be a disqualified

party.

◼ Was the 45 day identification timely done…lot of

issues here…

◼ Did the Exchanger buy from a related party?


SECURITY OF 1031 FUNDS

Millions of dollars of Taxpayers’ 1031 funds

have been lost in the past.

56



57

QUESTIONS TO ASK QI

Who owns the Qualified

Intermediary? How

financially stable are its

owners?

Is Qualified Intermediary

a publicly traded

corporation?

Will the Qualified

Intermediary provide you

with its financial

statements?

Does the Qualified

Intermediary have

trained professionals

(Attorneys, CPAs, CES®)

on staff?

What is the package of

security that the

Qualified Intermediary

offers?

• Fidelity Bond

• Corporate Guarantee

• Errors and Omissions

Insurance


58

BANK QUESTIONS TO ASK QI

Are the banks stable?What criteria does QI use

to pick its bank or will it

use any bank?


59

ACCOUNT STRUCTURE QUESTIONS TO ASK QI

Are funds commingled? Does the 1031

documentation state

exactly what type of an

account structure is

being used?

Does the QI require

written authorization to

disburse funds?

Are policies are in place

to battle cyber fraud?

Does the 1031

Intermediary deposit

1031 funds in

segregated accounts

under the exchanger’s

name and Taxpayer

Identification Number?


60

SECURITY QUESTIONS TO ASK QI

Transparency about

entire organization?

Exchange funds

deposited into

segregated, interest

bearing bank accounts

that are separately

identified to each

Exchanger?

Disbursement of

exchange funds

requiring written

authorization of the

Exchanger?

Exchange funds

deposited into highly

rated financial

institutions?

Performance Guaranty

issued on each

exchange? Fidelity Bond?

Errors and Omissions

Insurance?

new 1031 exchanges: identifying property, calculating depreciation,...

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