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Realtors® Land Institute

presents

Tax Deferred 1031 Real Property Exchanges

A Land University Course

© Copyright 2004 by the REALTORS® Land Institute, an affiliate of the National Association of REALTORS®. All rights reserved. Revised March 2006.

About the REALTORS® Land Institute The REALTORS® Land Institute, an affiliate of the National Association of REALTORS®, was founded in 1944 and is dedicated to improving the professional competence of its members in land brokerage. The Institute focuses on land brokerage transactions of five specialized types: farms and ranches; undeveloped tracts of land; transitional and development land; subdivision and wholesaling of lots; and site selection and assemblage of land parcels. Institute members also engage in other land specialties such as agribusiness, appraisal, consulting, and management.

RLI also offers the Accredited Land Consultant (ALC) designation, which is awarded to those who meet educational and experience requirements. RLI's chapter marketing sessions provide a forum for members to represent client's interests, whether buying, selling, or exchanging. The Institute: • Identifies its members as land consultants within the real estate profession. • Develops and maintains professional standards of practice. • Fosters professional expertise through educational activities • Awards the professional designation of Accredited Land Consultant (ALC) to members

who have meet educational and experience requirements • Formulates recommendations for public policy affecting land use • Advocates the wise use of land and the reasonable rights and privileges of private

ownership. • Endeavors, through its marketing programs, to enhance members' business activities.

The REALTORS® Land Institute thanks the following individuals for their contributions of expertise and experience and their assistance in development of this course. Dan Page, CCIM Sarasota, Florida David Baker, ABR Spokane, Washington Richard Halderman, ALC Wabash, Indiana

© Copyright 2004 by the REALTORS® Land Institute, an affiliate of the National Association of REALTORS®. All rights reserved. Revised March 2006.

Tax Deferred 1031 Real Property Exchanges Table of Contents 1. Introduction ...................................................................................................1

Course Goal....................................................................................................1 Course Organization and Objectives..............................................................2

2. The Fundamentals ........................................................................................3 1031 Exchanges–a Tax Deferral, Equity Preservation Opportunity...............3 Eligibility for a 1031 Exchange .......................................................................5 Business and Investment Objectives for a 1031 Exchange ...........................5 Advantages and Disadvantages of a 1031 Exchange....................................6 Four Basic Rules ............................................................................................8 Boot in 1031 Exchanges...............................................................................15 Basis .............................................................................................................19 Identifying Properties ....................................................................................23 Documenting Intent to Exchange .................................................................29 Reporting the Transaction ............................................................................30 Types of Exchanges .....................................................................................31 Tenants-in-Common Exchanges ..................................................................41

3. Safe Harbors and Intermediaries...............................................................45 Four Safe Harbors ........................................................................................45 Security or Guarantee Arrangements...........................................................45 Qualified Escrow Accounts and Trusts.........................................................46 Interest and Growth Factors .........................................................................47 Qualified Intermediaries................................................................................47 Disqualification as an Intermediary...............................................................50 How Are Real Estate Agents Paid?..............................................................52

4. Practicum: Concepts in Action Case Studies..........................................55 Case Study 4.1: Asking the Right Questions ..............................................56 Case Study 4.2: A Deferred Exchange.........................................................58 Case Study 4.3: Tenants-in Common ..........................................................60 Case Study 4.4: The Family Farm................................................................62

5. Putting it all Together .................................................................................65 Recognizing and Evaluating Potential Exchange Situations........................65 Finding an Accommodator/Intermediary.......................................................66 Pitfalls ...........................................................................................................68

6. Tool Kit and Resources ..............................................................................71 TITLE 26--INTERNAL REVENUE CODE.................................................................72 Exchange Basis Adjustment Form ...............................................................76 Glossary........................................................................................................77 Summary of Key Documents and Court Cases............................................79 Sample Exchange Addendum ......................................................................83 Resources.....................................................................................................84 Capital Gain Tax Rates.................................................................................86 Sale of Personal Residence Tax Summary..................................................88 Case Study Answers ....................................................................................90 Sample IRS Forms .......................................................................................94

Chapter 1 Introduction

REALTORS® Land Institute March 2006

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1. INTRODUCTION Taxes are an integral part of all real estate transactions, particularly for commercial and investment property. As a cost of doing business, taxes are an important factor in calculating cash flow and return on investment while property is held in ownership, and yield when the property is sold. This course focuses on 1031 tax-deferred exchanges in real estate transactions. When property is sold outright, the realized gain is taxable, although the Internal Revenue Code (IRC) exempts limited gains from sales of a personal residence. When property held for investment or productive use in trade or business changes hands through an exchange, taxes on the gain can be deferred. Tax-deferred 1031 exchanges, referred to by its section of the IRC, enable owners of real property held for investment or productive use in trade or business to defer, not avoid, taxes that would be due upon disposition by exchanging it for other real property. The underlying philosophy of the 1031 exchange is to allow the property owner to continue an investment and defer the taxes that would ordinarily be due on the gain from a sale. Real estate exchanging is a powerful sales tool that can save clients valuable tax dollars. A real estate professional whose business includes commercial and investment property and agricultural land can provide a valuable service for clients by recognizing situations in which a tax-deferred exchange could save tax dollars and by helping them formulate the transaction. In the case of “tax-locked” properties, or properties that have greatly appreciated in value, the 1031 exchange offers a tax-deferred method for disposing of a property and acquiring another.

Course Goal The goal of this course is to teach real estate practitioners to recognize and evaluate situations in which a 1031 tax-deferred exchange would be advantageous for a client, explain the tax saving benefits of the 1031 exchange as an alternative to selling and buying replacement real estate, and work with the client and a team of experts to structure the transaction. It is assumed that the student is experienced in handling real estate transactions, is familiar with basic tax terminology, and has a working knowledge of how real estate income and transactions are taxed.



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Course Organization and Objectives

Objectives

• Gain an understanding of how the rules governing 1031 tax-deferred real property exchanges are applied and how transactions are put together.

• Explain the tax deferral benefits of a 1031 exchange. • Recognize and evaluate situations in which a 1031 tax-deferred

exchange could be to the client’s advantage. • Involve and work with intermediaries and other experts to structure

the transaction. Course Organization The course material is organized as follows: Day One The Fundamentals: The first portion of the course covers the principles of 1031 tax-deferred real property exchanges. Safe Harbors and Intermediaries: Most exchanges necessitate use of a safe harbor and an accommodator or intermediary to structure the transaction. Intermediaries are experienced in handling the complexities of exchanges and assuring that the goal of tax deferral is met. Day Two Practicum: The workshop portion of the course helps participants put concepts into action by working through case study examples. Putting the Deal Together: In the final portion of the course, the focus is on recognizing and evaluating potential exchange situations, counseling the client, finding a qualified intermediary, and avoiding pitfalls in exchange transactions. Completion Exam: Successful completion of this open-book exam is required for credit toward the Accredited Land Consultant designation, which is awarded by the REALTORS® Land Institute.

Chapter 2 The Fundamentals


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2. THE FUNDAMENTALS “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.” -Internal Revenue Code, 26USC 1031

1031 Exchanges–a Tax Deferral, Equity Preservation Opportunity One of the most powerful tools for helping clients sell appreciated business, farm, and investment real estate is the Section 1031 exchange. It is a powerful tool because it accomplishes two positive economic outcomes for the property owner: • Deferral of capital gain taxes that would ordinarily be due upon sale. • Preservation of equity. In structuring a real estate deal, business reasons should always be the driving factor for deciding to sell a real property and acquire another one. If the deal makes sense from a business perspective, then structuring the transaction as a 1031 exchange can produce significant tax dollar savings for the seller. Exchanging properties involves complexities and costs and, as such, probably makes most sense when the potential tax liability outweighs both. There will be instances when the outright sale of a property and recognition of the resulting gain makes the best business and economic sense, and helping the client evaluate these situations is one of the objectives of this course. When a tax-deferred exchange of properties makes business sense, you, as a real estate professional, can provide a valuable service. From a tax standpoint, real property 1031 exchanges require careful compliance with IRC regulations on time limits, property qualifications, exchanged values, reporting, and documentation. From a business standpoint, exchanges require identification of exchangeable properties and negotiation with replacement property owners to structure the deal. The complexities of the exchange–and most exchanges are more complex than a simultaneous swap of equally valued properties–require a team of professional advisors, such as a CPA, attorney, tax accountant, financial planner, lender, escrow holder, professional accommodator, and intermediary. The costs of a failed exchange in



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unanticipated tax dollars owed, lost time, and lost investment opportunity, make the involvement of experts essential. As a real estate professional, you can perform a valuable service by helping your client think through the pros and cons of a property exchange, identify exchangeable properties, and interface with the other professional advisors involved in the transaction. The role of professional advisors is to assure compliance with the regulations that make 1031 tax-deferred real property exchanges possible. Your role as a real estate professional is to help the client make the best business decisions with regard to property exchanges, assemble the team of experts, and see the transaction through to a successful outcome. The basic concept of the 1031 exchange is to enable the investor to continue an investment without adverse tax consequences. The underlying philosophy of the exchange is that income tax should not apply as long as the investment remains intact in the form of real estate. Many real estate investors are locked into ownership of property with large, unrealized capital gains; this may be particularly true for owners of agricultural land in the path of urban and resort development. If sold, the federal capital gains tax liability of five to fifteen percent (25 percent for cost recovery [depreciation] recapture) for transactions after May 5, 2003 would reduce the dollars available for reinvestment in other real estate. For many, Internal Revenue Code Section 1031 and the related regulations are a solution to the “tax-locked property” dilemma. It permits the investor to exchange real estate for other real estate with little or no recognition of gain. The result is that all of the investor’s equity is available as consideration toward the "purchase" of the replacement property.



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Eligibility for a 1031 Exchange Eligibility for a tax-deferred exchange of real property is determined by the nature of the properties involved, not the status of the taxpayer. The property must be held for investment or productive use in trade or business, and exchanged for like-kind property. Individuals and corporations both can take advantage of the tax deferral opportunity if the property meets this qualification. The distinction between property held for investment or productive use in trade or business and a personal residence may seem like a straightforward delineation. The distinction can become complicated when, for example, an owner occupies a unit in a multi-family building, or a tract of agriculture land includes a farmhouse, or a resort property is rented for part of the year. Situations like these examples will be covered later in the course presentation.

Business and Investment Objectives for a 1031 Exchange If real estate professionals are familiar with the business and investment objectives that can be accomplished through 1031 exchange, they can spot the tax-saving opportunities for their clients and play a valuable role in business and financial planning. Business and investment objectives include: • Diversify or consolidate

Diversify one large investment into several properties or consolidate multiple investments. Farm operators may want to consolidate scattered acreages.

• Financial strategy Replacement property can be sought to increase cash flow or for appreciation potential based on the owner’s business and financial goals.

• Change of lifestyle Particularly in the case of retirement, a property owner may wish to reduce day-to-day management responsibilities.

• Relocation If owners move or retire to other locales, they may prefer to relocate property holdings, especially resort properties.



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• Estate planning Upon death of the property owner, deferred tax on capital gains is forgiven and heirs receive a stepped-up basis equivalent to fair market value (except for the year 2010). 1

• Business needs A growing or changing business may require a different amount or type of space, such as a larger warehouse facility, or more acreage.

• Avoid cost recovery (depreciation)) recapture Some property sales can trigger cost recovery (depreciation) recapture with negative results for the taxpayer; this is avoided in an exchange transaction because the basis is carried over to the replacement property from the relinquished one.

Advantages and Disadvantages of a 1031 Exchange Along with a familiarity of the business and investment objectives that can be accomplished, knowing the advantages and disadvantages of a 1031 exchange helps the real estate professional counsel the client about the suitability of the transaction. Advantages • Capital gains tax is deferred on the sale of property. • Heirs receive a stepped-up basis equivalent to the fair market value

and tax on accumulated capital gains is forgiven. • Tax-locked property is freed up, particularly properties that have

been held for a long period of time and greatly appreciated in value. • Money that would have gone to pay taxes can be available for

reinvestment. Disadvantages • Future capital gains tax rates could be higher or the taxpayer could

be in a higher bracket when the gain is ultimately recognized. • Basis in the replacement property is lower than if purchased outright,

due to transfer of basis from the relinquished property. • Exchange transactions can be complex and expensive. The

transaction costs and lowered basis may outweigh the tax benefits of selling a property and buying another outright.

1 In 2010, for one year, the estate tax will be entirely repealed and the taxpayer’s basis will be carried over to heirs. The current estate tax law will expire on December 31, 2010 and revert to the prior (pre-2001) law.



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• Losses cannot be recognized at the time of the transaction. Recognition of losses is also deferred.

• There are tax consequences if the net proceeds are not reinvested in real estate.

• Time limits must be strictly adhered to or the exchange will fail and be subject to taxation.

Advantages Disadvantages

• Capital gains tax is deferred • Heirs can receive a stepped up

basis and tax on accumulated gains forgiven

• Taxed-locked property freed up • Money available for

reinvestment instead of taxes

• Future tax rates could be higher

• Transfer of basis from relinquished property

• Transactions can be costly and complex

• Losses cannot be recognized • Time limits must be strictly

adhered to • Net proceeds must be invested

in real estate



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Four Basic Rules There are four basic rules that must be followed in a 1031 exchange. Real estate professionals need to know, and should probably memorize, these four fundamental principles of 1031 exchanges. All four conditions must be met, because if they are not the exchange will fail and all tax benefits will be lost. If neither of the first two conditions is met at the outset, there is no basis for pursuing a 1031 exchange.

Four Basic Rules of 1031 Exchanges

1. Property must be held for investment or productive use in trade or business.

2. Property must be exchanged for like-kind property.

3. Replacement properties must be identified within 45 days after the relinquished property is transferred.

4. The exchange must be completed (replacement property received) by the earlier of 180 days or the tax return due date.

Rule #1 Property must be held for investment or productive use in trade or business Qualified Property Both the exchanged (relinquished) property and the received (replacement) property must be held for productive use in trade or business (1231 property), or for investment (1221 property). Rental properties and farms are good examples of property held for use in business. A personal residence and property held primarily for sale, known as dealer property are not qualified property types. The classification of the relinquished property at the time of exchange and classification of the replacement property when received determines if the properties qualify for 1031 treatment. Therefore, for the relinquished property, classification is determined by how the taxpayer treated the property–trade, business use, or investment. For property received, it is what the taxpayer will do with the property–trade, business use, or investment. Since personal residences cannot be exchanged under the 1031 provisions, it is not possible to exchange business property for a personal residence. Some properties have more than one classification at the time of sale. For example, if a farmer sells or exchanges a farm including a personal



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residence, the sale is allocated for tax purposes between the real estate held for personal use (for example, a personal residence that is part of a farmstead) and that held for use in a trade or business–the productive acreage. Another example is the sale of a duplex where the seller lives in one unit and rents out the other unit. In a mixed-use property, such as a multi-family rental property in which the owner occupies a unit as a personal residence, the rental portion of the building could be disposed of as an exchange and the personal-use portion would receive capital gains tax treatment. (See tax treatment of personal residence in Toolkit and Resources section). Vacation Properties Can be a Problem Area – the 14 Day Rule Exchanges of a vacation property can be problematic if there is any personal use of it. The IRC stipulates that a dwelling unit is considered a personal residence if during the tax year the owner occupied it more than the greater of fourteen days or ten percent of the total days it was rented to others at a fair rental price. An allowance is made for any day that is spent working substantially full-time on repairs and maintenance. This occupancy rule also applies to a family member, a person who has an interest in the property, a below-market rental, or an arrangement that lets the owner use some other dwelling. If the vacation property is deemed to be a personal residence, then it is ineligible for a 1031 exchange. If a vacation property is held as an investment and never occupied by the owner, it is clearly eligible for a 1031 exchange. If a property is occupied for personal use at any time during a year, the period of personal use must be carefully documented in order to meet the fourteen-day rental rule requirements. The difficulty for vacation properties lies in credibly documenting occupancy. Dealer Property Does Not Qualify for 1031 Exchange Dealer property is held primarily for stock in trade as part of a sales inventory. It is specifically excluded from 1031 treatment. If dealer property is sold or exchanged at a gain, the gain is taxed as ordinary income. If dealer property is sold or exchanged at a loss, the loss is deductible as an ordinary loss. To be classified as dealer property, the property must be held at the time of sale or exchange primarily for sale in the ordinary course of business. Typical examples of dealer property are subdivision lots held by the developer and condominium units held by the condo converter. These properties, in the hands of the developer and the converter, do not qualify for section 1031 treatment. The same property may qualify in the hands of another taxpayer who holds, or intends to hold, the property for business or investment use. Also, a dealer in one property may not be a dealer in another property, and if



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the second property is held by the same party without dealer status then that property may qualify for exchange treatment. “Primarily for sale” is the most important factor. It does not have to constitute more than fifty percent of the purpose, it need only be the most important. However, the courts have ruled that, if an owner acquires a property for rental or investment use, but also plans to sell the property and realize a gain if the original plan becomes unfeasible, then the property is not held primarily for sale. The activity "in the ordinary course of business" must be directly related to the sale of that property and there must be a substantive business activity directly related to the property. Two substantive activities are sales activities related to the property and physical improvements to it. If a parcel of land is bought, subdivided, and houses for sale are built on it, it is clearly dealer property. But if a parcel of land is bought and subdivided, then sold in the form of an unsolicited offer it qualifies for capital gains tax treatment, because there was no business activity related to the property. Real Estate Agents Are Not Automatically Dealers Licensed real estate brokers and salespersons are not by this definition dealers, because they do not own the properties that are sold. The practice of listing and selling real property does not qualify the real estate professional as a dealer. In Scheuber v. Com. 371 F2nd 996, it was held that properties, purchased by a licensed real estate broker (who intended ultimately to sell) and held for realization of appreciation in value over a substantial period of time, were capital assets. If the property is listed with a licensed real estate broker, the sales activities of the real estate broker are not considered to be the sales activities of the owner. The Court has held that the real estate activities of corporations owned or controlled by an individual cannot be attributed to him even though he may be engaged full-time as an officer of the corporation.



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Unqualified Property In addition to a personal residence and dealer property, the following assets are specifically disqualified for 1031 exchanges: • Stocks, bonds, notes • Choses in action2 (accounts receivable) • Certificates of trust or beneficial interests • Securities or evidences of indebtedness or interest • Interest in a partnership

1031 Qualified Property

Dealer property; Stock in

trade or other property held primarily for sale in the ordinary course of business

Stocks, bonds, notes

Choses in action Certificates of trust or

beneficial interests Securities or evidences of

indebtedness or interest Interest in a partnership Personal residence

Property held for investment or productive use in trade or business

2 “Chose” is a French word meaning “thing”. In law, it applies to personal property. Choses in possession are personal things of which one has possession; choses in action are things one does not have in possession, but has a right of action for their possession. Choses in action are rights to recover a debt or receive money, or damages for breach of contract, or for a tort connected with a contract. These rights cannot be enforced without action and therefore are termed choses (things) in action.

Yes No



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Rule #2 Property must be exchanged for like-kind property The properties exchanged must be of a like kind. For purposes of section 1031, all real estate that is held for investment or productive use in trade or business is like kind. Property that is not like kind or cash included in an exchange is taxable boot. Like kind refers to the nature or the character of the property, not to its grade or quality. Exchanges of improved property for unimproved property and city property for country property are considered like kind. Real property within the United States (i.e., the fifty states and District of Columbia) is not treated as property of like kind if exchanged for property outside of the U.S.; foreign property is disqualified as either a replacement or relinquished property. Under a special treaty, property located in the U.S. Virgin Islands is treated as property located in the fifty states.

An Interesting Note:

In an exchange of livestock gender matters; animals of different genders are not considered like kind. A trade of a bull for a cow is not like kind. Tangible depreciable personal property held for investment or productive use in trade or business can be exchanged; some examples are office furniture and fixtures, trucks, tractors, airplanes, and computer equipment. These assets can be traded as like kind if traded for an asset in the same asset class set forth in the North American Industry Classification System (NAICS). Prior to 2004, the classification system in use was the Standard Industrial Classification (SIC) System. Copies of the NAICS Manual are available from the National Technical Information Service of the Department of Commerce, or online at www.census.gov/NAICS.



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Rule #3 Replacement property must be identified within 45 days Replacement property must be identified no later than 45 days after the date of transfer of the relinquished property. The identification period starts on the day that the title to the relinquished property is transferred and ends 45 days later. If more than one property is relinquished, the 45-day identification period begins when the first property is transferred. Rule #4 Exchange must be completed within 180 days or by tax due date The replacement property must be transferred to the taxpayer before the earlier of 180 days after the date of transfer of the relinquished property, or the due date, including extensions, of the tax return for the tax year of the exchange. If the exchange transaction is not completed within these time requirements, the property received will not qualify as like kind; it will be treated as taxable boot received. For this reason, exchanges initiated after October 15th of a year require particular vigilance of this deadline for calendar-year taxpayers. The 180-day rule essentially forces an exchange to be completed within the same tax year that it is initiated. And, while the tax return due date may be extended, the 180-day limit cannot.



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Time Clock—1031 Tax-deferred Exchange

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Complete Exchange August 27 180 days

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* May file for an extension but exchange must be completed within 180 days. Actual Exchange Must Occur Finally, section 1031 provisions require that an actual exchange, a reciprocal transfer of property, takes place. An intention to exchange is not sufficient. A transfer of property for money consideration only is not an exchange; it would be considered a sale of a property and a purchase of another. Exchanges Involving Foreign Taxpayers Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) regulations apply to transactions in which the transferor (seller) is a non-U.S. taxpayer (individual or organization) and the property is a U.S. real property interest (USRPI). Generally, FIRPTA requires that the transferee (buyer), or the withholding agent (often the real estate agent) withhold ten percent of the amount realized by the transferor at closing and remit the withheld amount to the IRS by the 20th day after the transaction. A foreign taxpayer may avoid the withholding requirement by providing a certification that the property is not a U.S. real property interest or the transferor is not a foreign person. If a real estate agent involved in the transaction has actual knowledge that these certifications are false and conceals this information, the agent is held liable for the tax, up to the amount of compensation received from the transaction. These regulations apply to both property sales and exchanges.

Remember: If property is located outside of the 50 U.S. States, District of Columbia, or U.S. Virgin Islands, it is not eligible for a 1031 exchange.

30 days

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Since November 8, 2003, the IRS has required that all non-U.S. persons provide a Taxpayer Identification Number (TIN) when they buy or sell U.S. real property. The TIN is for an individual who cannot or does not qualify to receive a Social Security number. The exchanger/transferor must provide a tax identification number (TIN) on any tax withholding documents. The amount of time required (6-8 weeks or more) to obtain a TIN is an issue for exchanges. However, if a TIN is not available at the time of settlement, the IRS will accept an application for a TIN along with a tax withholding certificate. The September 2003 rulings also provided that the expedited non-recognition notice procedure [Reg Section 1.1445-2(d)(2)] cannot be used in a deferred exchange in order for a foreign seller to avoid withholding. The rationale is that transferee cannot be sure at the time of closing that the transaction will eventually qualify for a 1031 exchange, such as meeting time requirements, or that it will be entirely tax-free with no boot received by the foreign transferor.

Boot in 1031 Exchanges Boot is any cash and unlike property received in the exchange and is taxable. If boot is received in an exchange, its fair market value is recognized as a taxable gain. The amount is determined by the amount of cash received plus the fair market value of unlike property received.

and or =

Boot Cash

Unlike Property



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Examples of boot include cash, debt relief, and any other unlike property. Unlike property may be property that falls into the asset classes defined by the IRC as exchangeable, but is not real property. For example, an airplane cannot be exchanged for real estate. Other examples of unlike property include gold, silver, foreign currency, motor homes, precious stones, and real estate to be used as a personal residence. The section 1031 tax-deferred provisions do not apply to unlike property transferred as boot in an exchange. A gain or loss will be recognized if boot is given in unlike property, other than cash. The transaction is treated as a sale of the unlike property and the regular gain and loss tax rules apply. The gain or loss is the difference between the adjusted basis in the unlike property and the fair market value at the time of the exchange. Receiving boot in a like-kind exchange does not defeat the exchange; it introduces a taxable gain into the transaction. Only the gain that results from cash and unlike property is taxable and it cannot exceed the amount of gain that would be recognized if the property was sold in a taxable transaction. The taxable gain is determined by comparing the fair market value of boot with the gain that would result from selling the property. The taxable gain is the smaller of these two amounts. Example 2.1

Real estate with an adjusted basis of $30,000 is exchanged for other real estate with a fair market value of $100,000, plus $35,000 boot. Total consideration received ........................ $135,000 Less adjusted basis ..................................... $30,000 Total realized gain ....................................... $105,000 GAIN Total boot received ...................................... $35,000 Taxable gain is the smaller of the two.......... $35,000

(ONLY TO THE EXTENT OF BOOT RECEIVED)

The character of taxable gain is determined by the property sold, not by the character of the consideration received. If the real estate traded is capital gain real estate, any gain recognized from boot received will be capital gain. If the property is subject to cost recovery (depreciation) recapture, the ordinary income from recapture will be recognized before the capital gain.



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Debt Assumption and Mortgage Relief as Boot If either party assumes any of debts or liabilities of the other as part of the exchange, the amount of liability is treated as cash boot. An illustration follows, although in practice most financing arrangements include a “due on sale” provision that bars assumption of the mortgage by another party. Example 2.2

Allen exchanged real estate with an adjusted basis of $30,000 for other real estate with a fair market value of $100,000. In addition, he received $35,000 cash and the other party assumed a mortgage of $25,000. Step 1 - Total gain realized FMV of like-kind property Allen received.......................... $100,000 Cash boot received .......................................................... $35,000 Mortgage assumed by other party.................................... $25,000 Total consideration Allen received ................................... $160,000 Less basis of property given up ....................................... $30,000 Total gain realized ........................................................... $130,000* Step 2 - Total boot received by Allen Mortgage assumed by other party.................................... $25,000 Cash received.................................................................. $35,000 Total boot received .......................................................... $60,000* * lesser of two Step 3 - Taxable gain Lesser amount is taxable gain ......................................... $60,000 Figuring Net Mortgage Relief Exchange transactions become more complicated when both properties are mortgaged. If both parties assume the liabilities of the other, the liabilities of one are offset against the liabilities of the other. Only the excess is treated as net boot given or received. The mortgages are netted—the mortgage assumed is subtracted from the mortgage on the relinquished property. If the assumed mortgage is less than the mortgage on the relinquished property, the net liability—called mortgage relief—is treated as boot received. If the assumed mortgage is more than the mortgage on the relinquished property, the excess is counted as boot paid in. While a mortgage on relinquished property is counted as boot received, a mortgage assumed may be offset against this boot. This is called "netting the liabilities.” When the mortgage assumed is more than the



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mortgage given up, the excess is treated as boot paid, but is subject to the following offset rule: mortgage boot paid offsets mortgage boot received, but does not offset cash or unlike property boot received. Example 2.3

Christine exchanged land with a mortgage of $10,000 for land with a mortgage of $15,000. In addition, she received cash boot of $6,000. After offsetting the mortgages, she has paid $5,000 mortgage boot, but is not allowed to deduct this boot paid from the cash boot received. Her taxable boot received is $6,000. Treatment of Selling Expenses Transaction costs reduce both recognized and realized gain on the sale side and increase basis on the purchase side. Selling expenses include brokerage commissions and other closing costs such as title policy, escrow, and recording fees. Depending on the party that is obligated to pay, the value of the asset is adjusted accordingly. Expenses paid by the seller (exchanger) reduces the recognized and realized gain; expenses paid by the buyer are added to basis. Example 2.4

Dave owned property with an adjusted basis of $30,000 and exchanged it for like-kind property with a fair market value of $100,000 plus $35,000 cash. He paid a $9,000 commission to his real estate broker. Dave’s taxable gain is limited to the net boot he received—$26,000. If no cash or property boot is received in the exchange, but there is net mortgage relief, sales expenses may be offset against net mortgage relief. However, if the offset creates a "loss", it cannot be deducted.



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Offset Rules

• Cash boot paid offsets boot received. • Mortgage boot paid offsets mortgage boot received • Mortgage paid, if more than mortgage assumed, may not offset cash

or unlike property • Other boot paid may be treated as the purchase price for non-like

kind property received • Selling expenses offset boot received • Selling expenses may offset net mortgage relief if no cash or unlike

property boot is received • Recognized gain may be offset by suspended losses

Basis The term “basis” is the cost of a property for tax purposes. When a property is purchased outright, the purchaser’s basis is the price paid for the property plus acquisition costs. Over the term of ownership, the basis of the property may change, resulting in an adjusted basis. Capital improvements to the property increase the owner’s basis. Items for which the owner receives a tax benefit, such as cost recovery (depreciation), decrease basis. Anything that increases basis decreases the amount of gain, and vice versa. When the property is sold or exchanged the difference, negative or positive, between the sales price and the seller’s basis in the property will determine the amount of capital gain and capital gain tax. Adjusted basis is a very important factor in real property exchanges because the basis in the relinquished property is carried over to the replacement property, regardless of the fair market value of either of the properties. This carryover of basis can be one of the disadvantages of an exchange transaction. The real estate professional should help the client carefully evaluate if it would be more advantageous to sell the current property, pay the resulting capital gains tax and purchase a property outright, resulting in a new basis, or opt for the tax-deferred benefit of an exchange with a carried-over basis, below the cost of the replacement property.



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Adjustments to Basis in an Exchange Increases in Basis • Cash paid in to balance equities, when the relinquished property is

of lesser value than the replacement • Liabilities/debts assumed on the replacement property • Improvements to the property • Acquisition costs (closing costs) Decreases in Basis • Cost recovery (depreciation) • Cash or nonqualified property received in the exchange • Debt relief on the relinquished property • Reimbursement from an insurance policy for casualty or theft loss



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Exchange Basis Adjustment Form

Realized Gain(Loss) Computation

1. Market value of property conveyed ................. $ 2. Less disposition costs ..................................... $ 3. Less basis at time of disposition ..................... $ 4. Equals: realized gain (loss) * $*

* If a (loss) – skip to line 9

Recognized Gain Computation

Sum of unlike property received A. Cash .......................................................... $ B. Boot ........................................................... $ C. Net loan relief ............................................ $

Sum of A, B & C above ............................................... $

$ __________ $ (Realized gain–line 4) (Sum of A, B, & C above)

5. Recognized Gain............................................. $*

* recognized gain is lesser of line 4 or sum of A, B, C.

Computation of Unrecognized Gain

6. Realized gain (line 4) ...................................... $ 7. Less recognized gain (line 5) .......................... $ 8. Equals: unrecognized gain.............................. $

Computation of Substitute Basis in Replacement Property

9. Market value of acquired property................... $ 10. Less unrecognized gain (line 8) or Plus

realized gain (line 4) if loss.............................. $

11. Plus acquisition costs...................................... $ 12. Equals: substitute basis .................................. $

Allocation of Substitute Basis

13. Land allocation ........................... %_____ $ 14. Improvement allocation .............. %_____ $ 15. Personal property allocation....... %_____ $

Form reprinted with permission of the CCIM Institute.



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Exchange with Installment In the preceding examples, the fair market value of net boot received is added up and treated as recognized gain in the year of the exchange. However, there is an exception if an installment note is part of an exchange. Although the fair market value of the installment note received is boot and recognized as gain under exchange rules, this gain can be reported using the installment method of tax reporting. When an exchange includes an installment note, both exchange and installment rules apply. Section 1031 provisions limit the recognized gain to the fair market value of the net boot received. After the recognized gain is figured, the installment rules (which are elective) apply. The installment sale contract price does not include the fair market value of the like-kind property received in the exchange. Therefore, like-kind property received in the exchange is not treated as payment received. The installment sale gross profit (recognized gain) is reduced by gain not recognized in the exchange. Following is an example of a deferred exchange with installment note. Notice that the installment sale gross profit is limited by application of Section 1031 provisions since no gain is recognized from the like-kind property received. Example 2.5

Frank owned, free and clear, an investment property with a fair market value of $100,000 and a basis of $30,000. If he made a cash sale, he would be taxed on $70,000. Frank decided to make a like-kind exchange for an investment property owned by George. The fair market value of George’s property is $75,000. Frank receives George’s property in the exchange and agrees to accept an installment note for $25,000 to balance the equities. Frank receives no payments of principal in the year of sale. Section 1031 rules apply first and limit Frank’s gross profit to $25,000—the amount of boot taken back in the exchange. The installment contract price is $25,000; the $75,000 parcel of like-kind property he received is not treated as part of the contract price. Frank’s gross profit percentage is 100%—the gross profit of $25,000 divided by contract price of $25,000. Since he did not collect any



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payments in the year of sale, he has no recognized gain in the year of the exchange. Each year following, 100% of the principal collected that year will be recognized as taxable capital gain and no interest or penalties will be assessed because the gain was postponed.

Identifying Properties There is no limit on the number or value of properties that may be relinquished in an exchange. Regardless of the number of relinquished properties that will be transferred as part of the same exchange, there are limitations on how many replacement properties may be identified. One of the following identification rules must be followed. Three Property Rule The maximum number of replacement properties that may be identified is three without regard to the fair market value of the properties. 200 Percent Rule Any number of properties may be identified as long as the aggregate fair market value is not more than 200 percent of the aggregate fair market value of all the relinquished properties. The fair market value of the replacement properties is figured as of the end of the identification period. The fair market value of the relinquished properties is figured as of the date they are transferred. For purposes of applying the three-property rule and the 200 percent rule, all identifications of property as replacement property are taken into account, but revoked property identifications do no have to be included. If, as of the end of the 45-day identification period, more than the permitted number or value of properties has been identified, the transaction will be regarded as if no replacement property has been identified. 95 Percent Rule If the exchange has failed to comply with the three-property rule and the 200 percent rule, there is still a possibility that the transaction will be treated as an exchange if it meets the test of the 95 percent rule. Any number of properties may be identified if by the end of the exchange period (180 days or tax due date), the aggregate fair market value of property acquired is at least 95 percent of the aggregate fair market value of all property identified. Any replacement property received during the identification period will be treated as identified.



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3 property rule Maximum of 3 properties without regard to FMV.

200% rule Any number of properties if aggregate value does not exceed 200% of relinquished property.

95% rule Any number of properties if aggregate FMV value of property acquired in exchange period (180 days or tax due date) is 95% of aggregate FMV of all identified property.

Rules for Identifying Properties

Exchanges must meet one of these property identification rules.



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Incidental Property Property incidental to a larger item of property is not treated as property that is separate from the larger item of property. An example of incidental property could be the refrigerators in the units of an apartment building. Property is incidental to a larger item of property if in standard commercial transactions it is typically transferred together with the larger item of property and the aggregate fair market value of all incidental property is not more than fifteen percent of the aggregate fair market value of the real property and incidental property combined. How to Identify Properties In Writing Replacement property must be designated as such in a written document signed by the taxpayer. This document must be hand delivered, mailed, or telecopied (faxed), on or before the end of the 45-day identification period, to the other person involved in the exchange. Or, the identification can be part of a written agreement signed by all of the parties involved in the agreement. The term “all parties to the agreement” does not specify particular persons, but it could be assumed that the term covers the taxpayer, the owner of the replacement property, the real estate agent, the qualified intermediary, closing and title agents. Use of an exchange agreement eliminates the need to deliver or send an additional identification notice. Described Clearly The document or agreement should clearly describe the replacement property, using the legal description or street address.



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Revoking Identification of a Property An identification of a replacement property may be revoked at any time before the end of the 45-day identification period. The revocation must be made in a written document signed by the taxpayer. Unlike an exchange agreement, only the taxpayer and the person to whom the notice is being sent are involved in a revocation of an identification. This document must be sent–hand delivered, mailed, or telecopied (faxed)–before the end of the identification period to the person to whom the identification of the replacement property was sent. Regulations state that the notice must be sent, not received, by the end of the 45-day identification period. Fax machines, for example, can prove when a revocation notice was sent and received. Identification and Receipt of Replacement Property to be Produced If a property is not in existence or is in production at the time it is identified, it can still qualify as a replacement property. For example, if an identified replacement property consists of improved real property with the improvements to be constructed, the description of the replacement property will satisfy the requirements if a legal description is provided for the underlying land and as much detail as practicable, at the time the identification is made, is provided for construction of the improvements. The fair market value of the replacement property to be produced is its estimated fair market value as of the date expected to be received, an important factor for purposes of the 200 percent and incidental property rules. In determining whether the replacement property received is substantially the same property as identified to be produced, variations due to usual or typical production changes are not taken into account. However, if substantial changes are made in the property to be produced, the replacement property received will not be considered to be substantially the same property as identified. If construction is not completed on or before the date the property is received, the property received will be considered to be the same as identified, provided it would be substantially the same had construction been completed on the date it was received. Caution: Be careful not to get caught in an exchange for services trap. Additional production on replacement property after it is received does not qualify for like-kind exchange. The transaction will be treated as a taxable exchange of property for services.



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Holding periods The regulations set forth in Section 1031 of the Code do not specifically state how long a property must be held to qualify for a tax-deferred exchange. Should a question arise about the eligibility for 1031 treatment, the IRS will most likely examine the taxpayer’s intent. Just as the adjusted basis in the relinquished property is carried over to the replacement property, so is the holding period of the relinquished property for capital gains tax treatment. A capital asset must be held for more than one year to qualify for capital gains tax treatment, which is usually more favorable than ordinary income tax treatment. Long-term capital gains on real property are taxed at five to fifteen percent (for sales and dispositions after May 5, 2003 and before December 31, 2008, depending on the regular tax rate that would apply), while short-term gains (under one year) are taxed at the same rates as ordinary income. Cost recovery (depreciation) recapture is taxed at a rate of twenty-five percent. If net capital gain is from Maximum capital gain rate3 Collectibles gain 28% Gain or qualified small business stock equal to the section 1202 exclusion

28%

Unrecaptured section 1250 gain 25% 20% for sales and other dispositions before May 6, 2003

Other gain(A) and the regular tax rate that would apply is 25% or higher

15% for sales and other dispositions after May 5, 2003 (and installment payments received after that date). Expires December 31, 2008. 8%(B) or 10% for sales or other dispositions before May 6, 2003

Other gain (A) and the regular tax rate that would apply is lower than 25%

5% for sales and other dispositions after May 5, 2003 (and installment payments received after that date). Expires December 31, 2008.

(A) Other gain means any gain that is not collectibles gain, gain on qualified small business stock or unrecaptured section 1250 gain. (B) The rate is 8% only for qualified 5-year gain. Two Year Holding Period for Exchanges Between Related Parties If related parties are involved in an exchange of property, either in

relinquishing a property or providing the replacement, a minimum two-year holding period

3 IRS Publication 544, Sales and Dispositions of Assets.



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applies. If either of the related parties disposes of an exchanged property within the two-year holding period, then recognition of the gain is triggered and tax-deferred benefits are lost. Furthermore, the two-year holding period will be suspended for any period of time in which there is a contract or option to sell the property–an action that would lessen the property owner’s risk of loss. This holding requirement is also applicable in instances in which a taxpayer exchanges a property with an unrelated person who then reconveys the property to a person related to the taxpayer. The IRC definition of a related person encompasses family members (siblings, spouse, ancestors, and lineal descendants) as well as a range of corporate, partnership, trust, estate, and organizational relationships. Exchanges between related parties also involve additional reporting. Form 8824, which is completed by a taxpayer for the year in which the exchange is initiated, must be submitted for two more years when related parties are involved. The purpose of this additional documentation is to inform the IRS if the property has been disposed of within the two years; it conversely attests to continued holding of the property for the required two-year period. An IRS 2004 Private Letter Ruling, indicated that taxpayers should not receive replacement property from a related party in a three-party exchange if the related party is “cashing out” of the investment. If related parties are involved in an exchange transaction even with an unrelated third party, the related parties (includes family members, related corporations, and partnerships) cannot receive the deed to a relinquished property or a replacement property from a related party if one of the related parties “cashes out” the property within the two-year holding period. The Private Letter Ruling applied to a case in which two related corporations engaged in an exchange with an unrelated third party, and used a qualified intermediary. Five Year Holding Period for Residential Property Received in an Exchange A provision of the American Jobs Creation Act of 2004 imposes a five-year ownership requirement for a “tax-free” sale of a property received in an exchange transaction and converted to a personal residence. Prior to enactment of this regulation, a taxpayer might exchange an investment property for a property eventually intended for a personal residence, e.g., a retirement residence. After completion of the exchange and required investment period, the taxpayers moved into the residence and lived there for two years in order to make the sale of the property eligible for exclusion of gain (see “Sale of a Personal Residence Tax Summary” in Toolkit and Resources section). This

Private Letter Rulings do not set precedent and apply only to specific cases, but the do indicate how the IRS might determine similar cases.



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exclusion (up to $250,000, $500,000 for joint returns) may be claimed repeatedly every two years. Depreciation, if taken during the time the property was held for business or investment, must be recaptured at the time of sale. Under the 2004 law, the exclusion of gain does not apply if the sale occurs within five years of acquiring the residence if it was received as a replacement property in a tax-deferred 1031 exchange. State Laws This course focuses entirely on the federal tax regulations governing property exchanges. State laws are an issue that must be explored in deciding if an exchange transaction is the best course of action. State taxes on capital gains could be a factor in property exchange. Some states’ tax laws view exchangers as having the immediate right to receive money or other property held in an escrow or trust, or by a qualified intermediary. Some states also require both the relinquished and replacement properties to be located within the state for non recognition of gain in an exchange. Laws must be examined for both the state in which the relinquished property and the replacement property are located.

Documenting Intent to Exchange Listing Agreement The listing agreement should include a 1031 exchange contingency if the offer to sell the relinquished property is dependent on the ability to complete a tax-deferred exchange. This goes to establish the taxpayer’s intent to engage in an exchange transaction. Exchange Agreement The relationship between the taxpayer and the chosen safe harbor should be documented in an exchange agreement before title is transferred on the relinquished property. Sales Contract The sales contract should include a notice of assignment of rights if a qualified intermediary will be involved in the transaction. Purchase Agreement The purchase agreement should contain a 1031 exchange provision to clearly establish the intent of the transaction. Escrow Instructions Specific instructions should be provided for the chosen safe harbor or qualified intermediary directing how the proceeds should be received and disbursed.



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Documenting Intent to Exchange

Listing Agreement 1031 exchange provision clause

Exchange Agreement Document relationship

Sales Contract Notice of assignment of rights

Purchase Agreement 1031 exchange provision clause

Escrow Instructions Instructions on how proceeds should be received and disbursed

Use of the safe harbors, discussed later in the course, also requires various documents and agreements to be in place. Although these documents are not required to be included with the tax forms filed with the IRS, they should be in place to prove the intent of the taxpayer in the event that questions arise about the transaction. Obviously, it is best to plan ahead for the exchange transaction to assure that all necessary documents and notifications are in place before the transaction’s elements are put into play. If at any point before completion of the transaction the taxpayer receives actual or constructive receipt of any of the cash proceeds from the relinquished property, all bets are off and no amount of documentary backtracking can prove intent to exchange.

Reporting the Transaction The IRC specifies a number of documents and agreements that must be in place for a qualified tax-deferred exchange of properties (documents necessary for safe harbors will be covered in the next section). The basic forms for reporting a real property exchange transaction are: • Form 1099-S Proceeds From Real Estate Transactions

This form reports the sale or exchange of a property, except a personal residence. It is usually completed and filed by the settlement agent conducting the closing.

• Form 8824 Like Kind Exchanges

The purpose of this form is to report the exchange transaction to the IRS. It is filed in the year in which an exchange begins—the year in which property is transferred. Note that this form calls for completion of additional forms in the case of multi-asset exchanges of like-kind properties or receipt of cash or non like-kind property (boot). The taxpayer includes a statement to show calculation of the recognized and realized gain. Recognized gain is reported on Schedule D,



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Form 4797, Sales of Business Property or Form 6252, Installment Sale Income, if applicable.

• Form 4797 Sales of Business Property This form is used to report a gain or loss from the sale, exchange, or involuntary conversion of a depreciable property.

Types of Exchanges Simultaneous Exchanges The simplest exchange is the simultaneous swap of one real property for another. The taxpayer finds another party who owns a property that meets specification, and the other party is willing to accept the taxpayer’s relinquished property. An exchange agreement outlining the details, including boot that will be involved, is drawn up between the two property owners. Escrow instructions are provided for the person responsible for handling the exchange. On the agreed day, the parties meet at the closing table to swap deeds for the properties. However, in practice, it is a rare instance when the parties to an exchange each desire the other’s property and can synchronize time lines so that a simultaneous swap can occur. A more likely scenario involves time intervals between relinquishing a property, and identifying and securing its replacement. Simultaneous does not necessarily mean reciprocal exchanges. It may take place within a complex structure of exchanges involving multiple parties and properties. Deferred and Reverse Exchanges, “Starker” Exchanges In a deferred exchange, property is transferred before the seller is able to acquire, and possibly even identify, the replacement property. The closing for transfer of the relinquished property takes place before the replacement property has been located or acquired. What happens when a taxpayer has already found and acquired a replacement property before giving up the relinquished property? Enter the reverse exchange, also known as a reverse Starker exchange. Prior to 1979, simultaneous exchanges were the rule. The landmark 1979 Federal District Court Case, T.J. Starker v. United States4, established that exchanges do not have to be simultaneous in order to

4 In 1967, Mr. T.J. Starker and his family agreed to an immediate transfer of timberland, located in Columbia County, Oregon, in return for the transferees’ unsecured promise to purchase replacement property to be named later. The transferees were two companies, Crown Zellerbach and Longview Fibre. In 1979, after several decisions and appeals, the Federal District Court found that the IRS Code Section 1031 did not



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qualify for a tax-deferred exchange. Today, the more likely scenario is a delayed or deferred exchange, which is sometimes referred to as a “Starker” exchange after the 1979 court ruling. Rev. Proc. 2000-37, issued in September 2000, facilitated the use of reverse exchanges by setting forth conditions under which properties will not be challenged as relinquished or replacement properties under Section 1031 and third party accommodators will not be challenged as beneficial owners of the property. The key to a successful deferred exchange is avoiding actual or constructive receipt of cash proceeds or other property before actually receiving the replacement property. • Actual receipt means that the cash proceeds or property are in the

taxpayer’s possession.

• Constructive receipt means that the cash proceeds or property are available to be drawn on at any time, or the taxpayer is in substantial control of the proceeds or property. In addition, actual or constructive receipt of money or property by an agent is actual or constructive receipt by the taxpayer.

Rev. Proc. 2000-37 sets forth conditions for creation of a Qualified Exchange Accommodation Arrangement (QEAA) through which the taxpayer retains a Qualified Exchange Accommodation Titleholder (QEAT) to actually take and hold title to the replacement property. This “parks” the title to the property with the QEAT until the replacement property can be identified and transferred, and the exchange completed. Thus, for the taxpayer, the deferred and reverse exchange maintains the same sequence of events and time guidelines as a regular exchange transaction.

contain any requirement for simultaneous transactions and ruled in favor of the Starkers. The Deficit Reduction Act of 1984 amended Section 1031 to allow deferred exchanges only if all of the exchanged property is identified (45 days) and acquired (180 days) within specified time periods.



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In 2004, the IRS issued Safe Harbor Guidelines for reverse exchanges. Safe Harbors are covered in the next section, however in the context of reverse exchanges, the provisions are: • The reverse exchange must be completed within 180 days or the

property held by the QEAT is deeded to the taxpayer. • The relinquished property must be identified within 45 days. • The Intermediary can hold title to either the replacement or

relinquished property. • A Qualified Exchange Accommodation Agreement (QEAA) must be

entered into within 5 days after the property title is taken by the Exchange Accommodation Titleholder (EAT).

In 2004, the IRS modified Rev. Proc. 2000-37 provisions regarding “parking” transactions. Rev. Proc. 2004-51 states that in a reverse exchange, replacement property held in a QEAA is not eligible for a tax-deferred exchange if the property was owned by the taxpayer within the 180-day period preceding the date of transfer of the property to the Exchange Accommodation Titleholder. This prevents a taxpayer from transferring a property to a QEAT and receiving that same property back as replacement property in exchange for other property owned by the taxpayer. A parking arrangement cannot be used to reinvest the sale proceeds of one property into improvements for another property the taxpayer already owns. Five-day QEAT Agreement Deadline The reverse exchange involves another time deadline, in addition to the 45-day identification and 180-day exchange periods which still apply. The taxpayer must complete an agreement with the QEAT no later than five days after the Accommodator has acquired the replacement property. A delayed closing should not be confused with a deferred exchange. In a delayed closing, the relinquished property "sale" does not close until an agreed date, or until the replacement property is located and closed concurrently. Two and Three Party Exchanges So far, exchanges have been examined based on the sequence of events for relinquishing a property, identifying and acquiring a replacement property. The next examples of exchanges are based on the number of parties involved and the configuration of the transaction. The examples are based on the scenario that follows.



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Scenario 2.1

Edward wants to relocate to Scottsdale, Arizona from Albany, New York. He is fed up with winter cold and snow, and the desert beckons. He currently owns an income property, Center Court Apartments, in Albany. He would like to maintain an investment in rental property and wants to acquire a similar property in Arizona. When he bought Center Court Apartments ten years ago the surrounding neighborhood was stable, but far from trendy. A few years ago the area started to gentrify and now the property has skyrocketed in value. If he sold the property for cash at today’s value, he would face a hefty tax bill. On a recent trip to Scottsdale, he saw the Silver City Apartment building, which looked like just the right property and is close in value to the building he currently owns. A tax-deferred exchange of real property seems like a good option, but would anyone who lives in Arizona want to relocate to Albany? Susan lives in Scottsdale, Arizona and owns Silver City Apartments. She recently inherited the apartment building from her father’s estate and has no interest in being a landlord. If she sells the property soon, there will not be any appreciation in value and she will not owe any tax on the sale proceeds. She would prefer to sell the property and use the cash proceeds to build up a stock portfolio. Bob, who lives in upstate New York, recently received a cash-windfall from stock options, but has become discouraged about investing in the stock market and would like to put his money into real estate. The Center Court Apartment building, which Edward owns, looks just right and Bob would like to live in the trendy neighborhood where it is located. In summary: Edward (exchanger) wants to dispose of Center Court Apartments in

Albany, acquire Silver City Apartments in Scottsdale, and defer the taxes that would be due on a sale.

Susan (seller) wants to sell Silver City Apartments for cash.

Bob (buyer) wants to buy Center Court Apartments and has cash.



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Example: Two Party Exchange Trading properties directly with the other party is called a two party exchange. Based on the scenario, the simplest exchange would be between Edward and Susan.

Three Party Exchange As previous noted, it is rare that two property owners each want the other's property. In usual practice, the other owner seldom wants the offered property, but would accept another one, or prefers to sell the property and take the cash proceeds. A three-way exchange solves the dilemma of a two-way swap. The following examples are based on court cases as noted. These examples are for the purpose of illustrating the transactions’ configurations. The provisions for a deferred exchange, including safe harbors and accommodators are usually incorporated into “real-life” transactions. Example: Three Individual Transfers Edward transfers his property to Bob, Bob gives cash to Susan, and Susan transfers her property to Edward.5 Example: Exchange With Purchaser

Edward (exchanger)

Susan(seller)

Central Court

Silver City

Example 2.6 Two Way Exchange

Edward (exchanger)

Susan (seller)

Example 2.7 Three Individual Transfers

Bob (buyer)



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Bob acquires Susan's property for cash, and then exchanges it for Edward's property. This arrangement qualifies for 1031 treatment if, in fact, an actual exchange between the Edward and Bob takes place. Furthermore, under the agreement, Edward must be obligated only to make an exchange, and not a sale, and Bob must use his own funds to acquire the property from Susan. It is not necessary for Bob to take title to the property. The exchange will not fail because all negotiations are carried out by Edward.6

5 In W.D. Hayden Co. vs. Commissioner, 165 F.2nd 588, the court held the taxpayer (Client) had exchanged one property for another although the Buyer made cash payment to the Seller. See also Rev. Rul. 57-244. 6 Alderson v. Com., 1963 CA9

Edward (exchanger)

Susan (seller)

Example 2.8 Exchange with Purchaser

Bob (buyer)

1.

2.



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Example: Exchange With Seller Edward exchanges properties with Susan. Then, Bob purchases the property from Susan. To qualify, Susan must take title to the property. 7

7 In Leslie Q. Coupe, 52 TC 394, the court said, “The statute only requires that as the end result of an agreement, property be received as consideration for property transferred by the taxpayer, without his receipt of, or control over, cash.”

Edward (exchanger)

Susan (seller)

Example 2.9 Exchange with Seller

Bob (buyer)

2. 1.



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Example: Escrow Holder As Accommodator, Sequential Deeding The Barker case8 is a good example and road map to follow in structuring a three-party exchange through an escrow holder. Using a series of interrelated contracts, the accommodator takes title and receives payments for all properties, then transfers title and cash among parties to carry out the exchange. Under escrow agreements, successful closing of each transaction depends on successful closing of all others. This integrated agreement, and the fact that the exchanger (Edward in the illustration) has no option or right to take cash, guarantees nonrecognition of gain under 1031 provisions.

8 Earlene T. Barker, 1980 74 TC 555

Edward (exchanger)

Susan (seller)

Example 2.10 Escrow Holder as Accommodator

Bob (buyer)

Escrow



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Example: Exchange with an Intermediary, Direct Deeding In an exchange with an intermediary, properties are deeded between the parties and the intermediary distributes the cash proceeds. Unlike the previous example, the intermediary has the right to assign the deed and does not actually take title to the property. The previous example involves sequential deeding of the properties between escrow holder and the parties. In sequential deeding, each transfer must be separately recorded. The escrow holder is also at risk for liabilities even during the brief time interval between title transfers. In the following example the intermediary, who must be a qualified intermediary, has the right to assign the titles to the properties, which are deeded directly between parties, a less time-intensive and expensive process.

Edward (exchanger)

Susan (seller)

Example 2.11 Exchange with an Intermediary

Bob (buyer)

Intermediary



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Multiple Asset Exchanges Exchanges that involve multiple assets in different classes of property are beyond the scope of this course. Exchange transactions involving multiple assets should be conducted through an expert exchange accommodation firm. Successful completion of the transaction involves grouping of assets into exchange groups of relinquished and replacement properties, residual groups of unlike, unqualified property, and offsets of liabilities. These groupings and offsets are the basis for calculating gain on the transaction.



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Tenants-in-Common Exchanges Tenants-in-common ownership allows several investors to own an undivided, deeded interest in a single property. This form of ownership is a recent innovation9 that enables the smaller investor to participate in the ownership of large, premium commercial and investment property that would normally be beyond the individual’s means. Tenants-in-common ownership of an interest in a real property qualifies as like-kind property for a 1031 exchange. The form of ownership is not a joint venture, partnership or limited partnership; rather each investor owns an undivided, or fractional, interest in the property. The owners are bound together under a management or operating agreement. The maximum number of co-owners of a property is thirty-five. A co-owner retains the right to transfer the undivided interest in the property, although the ownership agreement may require that the interest be offered to the other owners. Each co-owner has a proportionate share in the revenues and costs associated with the property, as well as any indebtedness.

The tenants-in-common 1031 exchange for investors who want to:

• Avoid involvement in day-to-management of property and take advantage of professional management of investment properties

• Invest in high quality properties • Comply quickly with 45-day identification time limits (properties are

usually already packaged) • Exchange a specific amount of value • Upgrade and diversify a portfolio through investment in premium-

quality properties

The provisions of Rev. Proc. 2002-22 do not state any minimum or maximum investment amount for a tenants-in-common investment; however, practitioners report that in practice $250,000 is usually the minimum investment. Investments in the range of $500,000 are common.

The transaction to acquire or dispose of the ownership must comply with all exchange provisions, such as the 45-day identification and 180-day exchange periods, maximum value of replacement properties, and avoidance of actual or constructive receipt of cash proceeds.

9 IRS Rev. Proc. 2002-22.



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One of the major advantages of tenants-in-common real property exchanges is that specialized firms, known as sponsors, research properties and package investments, and monitor performance. This facilitates compliance with the 45-day identification deadline. A tenants-in-common property can be identified as a backup—a second or third choice property—to ensure the investor does not lose the benefit of a 1031 exchange if the first-choice property cannot be successfully acquired and makes it possible to buy “just the right amount” thus avoiding the need for taxable boot to balance equities in the transaction. Another distinguishing characteristic of tenants-in-common real property ownership is access to investment in large, institutional-grade properties. The ownership interest is a percentage of the property not the whole property. An investor may not have the financial means to acquire the property outright, but could afford a percentage ownership. For example, if ownership of a $9 million commercial building is offered in twenty equal tenants-in-common co-ownership shares, a share’s acquisition cost would be $450,000–a five percent interest in the property. For investors who want to maintain an investment in real estate, but do not want the responsibility of day-to-day property management, a tenants-in-common Section 1031 exchange may be the right choice. This strategy can prove particularly attractive for a retiree who wants a steady income stream from a real property investment, but does not want to be involved in operations. Because tenants-in-common ownerships are handled by professional sponsors, 1031 exchange opportunities can be well researched and planned before the transaction is set in motion, and compliance with time deadlines and professional management of the transaction can be assured. A sponsor can monitor ongoing performance of an investment and provide regular reports to investors and their advisors. The sponsor of the investment may also be the provider of day-to-day management services.



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Although the IRS regards the tenants-in-common ownership as like-kind property for real property exchanges, the Securities and Exchange Commission (SEC) views the ownership interest as a security and therefore subject to SEC regulations. This is important for real estate agents because it impacts how they can counsel clients about the properties and be compensated. When counseling clients about TIC properties, real estate agents should be careful that their advice is focused on the merits of the TIC investment as real estate and does not stray into the area of giving investment advice, such as the future performance of an investment. When a tenants-in-common ownership interest is involved in the exchange, real estate professionals should be cautious about how their compensation is characterized. SEC regulations bar payment of a commission or referral fee unless the real estate professional is a licensed security dealer. However, the real estate agent may be compensated for counseling services; the agent should negotiate this consulting fee as part of the representation agreement. As a selling expense, the agent’s consulting fee may be paid on behalf of the taxpayer from the funds held by the intermediary.



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Type Description Regulation

Simple TIC Simple TIC transactions involve several investors who are familiar to one another; they purchase a property and make group decisions on the management of the property.

Simple TIC transactions are regulated by state real estate regulators and should not be a source of concern.

Securitized TIC In securitized TIC transactions, a seller may act as a sponsor, and use a securities broker dealer to attract investors who are unfamiliar to one another. The sponsor retains an interest in the property and may also manage the property, subject to the approval of the co-owners.

Securitized TICs are subject to both securities and real estate laws and thus regulated by each area’s enforcement body:

Caution: Although, real estate laws make clear that a real estate licensee must be involved to affect a transfer of title, securities rules have strict limitations on how privately placed securities are sold, and prohibit broker-dealers from providing compensation to non-broker dealers (e.g. real estate agents).

Note: NAR is working with the SEC to resolve this issue by developing a framework whereby real estate professionals may serve as a buyer’s agent without running afoul of securities laws.

Complex “Real Estate’ TIC

In complex TIC transactions, a seller may act as a sponsor, attract investors who are unfamiliar to one another, put in place a property management structure, and then exit operational responsibilities for the property.

Complex TICs are regulated by real estate regulators but may be subject to close scrutiny by state securities enforcement agencies. Some of these transactions may rely on narrow exceptions to securities definitions and should be approached with caution.

Chapter 3 Safe Harbors and Intermediaries


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3. SAFE HARBORS AND INTERMEDIARIES The provisions for Section 1031 exchanges define four safe harbors, and more than one safe harbor may be used in a transaction. The purpose of these safe harbors is to avoid actual or constructive receipt of the proceeds before the exchange is completed. Use of a safe harbor itself does not guarantee successful completion of the exchange transaction if other factors disqualify the deal. Because the safe harbors exist to avoid actual or constructive receipt of proceeds, it stands to reason that the parties’ rights to the cash proceeds and property are restricted. The right to receive money or other property is restricted until after the exchange is completed or if the parties fail to meet the identification or exchange period requirements. The exchanger’s right, under state agency law to dismiss an escrow holder, trustee, or intermediary, is disregarded in determining whether the exchanger has the ability to receive or otherwise obtain the benefits of money or other property held. Caution: although state law may grant this right, in actuality exercising it can jeopardize the exchange. Actual or constructive receipt occurs at the time the exchanger exercises these rights.

Four Safe Harbors

1. Security or guarantee arrangements 2. Qualified escrow accounts and trusts 3. Interest and growth factors 4. Qualified intermediaries

Security or Guarantee Arrangements The obligation to transfer the replacement property may be secured or guaranteed by one or more of the following: • mortgage, deed of trust, or other security interest in property (other

than cash or a cash equivalent) • standby letter of credit that does not allow the exchanger to draw on

it except upon a default of the transferee's obligation to transfer the like-kind replacement property. The letter must satisfy all IRS requirements10 for a letter of credit

10 § 15a.453-1(b)(3)(iii) A non-negotiable, non-transferable (except together with the evidence of indebtedness which it secures) letter of credit issued by a bank or other



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• guarantees of a third party

Qualified Escrow Accounts and Trusts Cash or a cash equivalent may be held in a qualified escrow account or in a qualified trust. The escrow or trust may not be held by the exchanger or a related party. The exchanger’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the account’s contents must be limited. The exchanger may receive money or other property directly from another party to the transaction, but not from a qualified escrow account, trust, or a qualified intermediary, without disqualifying the safe harbor. The exchanger may not access the funds or cash equivalent held in the account until successful completion of the exchange or if the identification or exchange period requirements are not met. However, the exchanger may need some of the funds held in a qualified account, or by a qualified intermediary, to pay closing costs. Even though the exchanger would be in constructive receipt of funds used to pay these costs, the use of this money to pay specified transactional items, such as commissions, prorated taxes, recording or transfer taxes, and title company fees, will not disqualify use of the safe harbor. These specified transactional items: • must relate to the disposition of the relinquished property or to the

acquisition of the replacement property, and • are listed as the responsibility of a buyer or seller on the typical

closing statement under local standards.

The exchanger may receive items, such as prorated rents, as a result of the disposition of property; these items are generally not included in the amount realized from the exchange, although they may be paid from the funds held by the intermediary.

financial institution, which serves as a guarantee of the evidence of the indebtedness which is secured by the letter of credit.



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Interest and Growth Factors Interest may be earned while the sale proceeds are held in escrow. In large transactions, a sizeable amount of cash can be held by the accommodator and over the 180-day exchange period can yield a significant amount of interest. The IRS allows this interest to be paid into the escrow without disqualifying the exchange transaction. Exchange practitioners commonly refer to this as a “growth factor.” The term also encompasses increases in property values that would require the buyer to purchase a high-priced replacement property. Interest held in escrow is paid to the exchanger upon completion of the exchange and reported as earned income.

Qualified Intermediaries A qualified intermediary is a person (or company) who for a fee facilitates the exchange by entering into an agreement for the exchange of properties. The intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. An intermediary is treated as acquiring and transferring property if: • The intermediary acquires and transfers the rights to legal title of

that property. • The intermediary (either on its own behalf or as the agent of any

party to the transaction) enters into an agreement with a person, other than the exchanger, for the transfer of the relinquished property to that person. Under the agreement, the intermediary transfers the relinquished property to that person.

• The intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with the owner of the replacement property for the transfer of that property. Under the agreement, the intermediary transfers the replacement property to the exchanger.

The intermediary acquires the rights to transfer deeds to the properties involved, but not the deed itself. This is termed direct deeding. If the intermediary actually acquires the deed to the relinquished property for transfer to the transferee, and acquires the deed to the replacement property for transfer to the exchanger, it is termed sequential deeding. Sequential deeding adds cost and time to the exchange transaction, as each title transfer must be closed and recorded. For most transactions that involve a qualified intermediary, property is transferred through



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direct deeding, rather than sequential. Following is an example of direct deeding, based on the scenario of Edward, Bob, and Susan.

Scenario 3.1

On May 1st Edward agrees to sell Central Court Apartments to Bob for $1,000,000 on May 17th. Bob does not have a property to exchange. Edward engages the services of a qualified intermediary (QI). In the exchange agreement Edward assigns all rights in his agreement with Bob to the QI. The agreement expressly limits the rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property held by the QI. On May 17th, Edward notifies Bob in writing of the assignment of rights and the QI deeds Central Court Apartments to Bob. Bob pays $100,000 to Edward and $900,000 to the QI.

On June 1st, Edward identifies Silver City Apartments as a replacement property. On July 5th, he agrees to purchase Silver City Apartments from Susan for $900,000, assigns his rights in that agreement to the QI, and notifies Susan in writing of the assignment. On August 9th the QI pays $900,000 to Susan and deeds Silver City Apartments to Edward.

Because Edward’s rights in his agreements with Bob and Susan were assigned to the QI, and they were notified in writing of the assignment on or before the transfers of the properties, the QI is viewed as acquiring and transferring both Central Court Apartments and Silver City Apartments. Because Edward did not have the immediate ability or unrestricted right to receive money or other property held by the QI before he received Silver City, he was not in actual or constructive receipt of the $900,000 held by the QI before receipt of the replacement property.

Before . . . . After . . . . Edward owns Central Court Apartments valued at $1,000,000

Edward owns Silver City Apartments valued at $900,000 plus has $100,000 cash

Bob has $1,000,000 Cash Bob owns Central Court Apartments valued at $1,000,000

Susan owns Silver City Apartments valued at $900,000

Susan has $900,000 cash



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Edward (Exchanger)

Susan (Seller)

Example 3.1A Direct deeding by a Qualified Intermediary

Bob (Buyer)

Qualified Intermediary

Edward (exchanger)

Susan (seller)

Example 3.1B Direct deeding by Exchanger & Seller

Bob (buyer)

Qualified Intermediary

$1 million$1 million property

$1 million cash

$900,000 property

$100,000 $1,000,000

$900,000



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Disqualification as an Intermediary The Code specifies that a qualified intermediary may not be the taxpayer, a related person, an agent of the taxpayer, or a person related to the agent of the taxpayer. The term “person” also applies to corporate entities. Specifically, a qualified intermediary may not be: A person who is an agent of the exchanger at the time of the

transaction. An agent is defined as a person who has been an employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two-year period ending on the date of the transfer of the first of the relinquished properties. Exceptions are allowed for performance of services that are solely with respect to exchanges of real estate, and performance of routine financial, title insurance, escrow, trust services by a financial institution, title insurance company, or escrow company.

A person who is related to the exchanger. The definition of a related

person encompasses familial relationships and business, corporate, and fiduciary relationships.

The definition of related person includes: • Family members–siblings, spouse, ancestors, and lineal

descendants • A corporation in which the person owns, directly or indirectly, more

than ten percent of the outstanding stock • Two corporations that are part of the same controlled group. • A grantor and a fiduciary of any trust • A fiduciary of a trust and a fiduciary of another trust if the same

person is a grantor of both trusts • A fiduciary and the beneficiary of the trust • A fiduciary of a trust and a beneficiary of another trust if the same

person is a grantor of both trusts • A fiduciary of a trust and a corporation in which the trust or grantor of

the trust owns, directly or indirectly, more than ten percent of the outstanding stock

• A person and a Section 501 tax-exempt organization that is controlled, directly or indirectly, by that person or family member.

• A corporation and a partnership if the same persons own more than ten percent of the outstanding stock of the corporation and more than ten percent of the capital interest or the profit interest in the partnership



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• An S corporation and another S corporation if the same persons own more than ten percent of the outstanding stock of each corporation

• An S corporation and a C corporation, if the same persons own more than ten percent of the outstanding stock of each corporation

• An executor of an estate and the estate’s beneficiary, except in a case of a sale or exchange in satisfaction of a pecuniary bequest

• A partnership and a person owning, directly or indirectly, more than ten percent of the capital interest, or the profit interest in the partnership

• Two partnerships in which the same person owns, directly or indirectly, more than 10 percent of the capital or profit interest

The exchanger, or a disqualified person, cannot qualify as a qualified intermediary for his or her own exchange. Referring back to the previous scenario, following are two examples of the disqualified person definition. Example 3.2

Edward’s accountant, Henry Olson, has rendered his accounting services during the two-year period ending on May 17th, the date the deed to Central Court Apartments was relinquished. Because Mr. Olson’s accounting services have been other than with respect to 1031 exchanges of property, he is disqualified to serve as an intermediary. If Mr. Olson had not acted as Edward’s accountant within the two-year period ending May 17th, or if he had acted as Edward’s accountant within that period only with respect to 1031 exchanges, he would not be a “disqualified person.“ Example 3.3

1031-Made-Easy, Inc. is engaged in the business of acting as an intermediary to facilitate deferred exchanges. It is a wholly owned subsidiary of an escrow company that has performed routine escrow services for Edward in the past. 1031-Made-Easy, Inc. had been previously retained by Edward to act as an intermediary in a prior Section 1031 exchange. 1031-Made-Easy, Inc. is not disqualified; neither due to the intermediary services previously provided nor the combination of the relationship to the escrow company and the escrow services previously provided to Edward. It should be clear by now that 1031 exchanges, particularly deferred, reverse, and multiple asset exchanges, require specialized expertise in finance, tax compliance, and property selection. An expert, experienced



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qualified intermediary/accommodator can structure the transaction, possibly using the other safe harbor arrangements, to assure compliance with tax code provisions, as well as handle the details involved in transferring deeds, holding an escrow, and disbursing proceeds. Your attorney or accountant may be able to refer you and your client to an expert accommodator who can serve as a qualified intermediary. Lenders and title companies may also be sources of information.

How Are Real Estate Agents Paid? Each of the safe harbor arrangements described above allow the real estate professional’s commission to be paid on behalf of the taxpayer. This payment is considered a transactional item–an item related to the disposition of relinquished or acquisition of replacement property that, by local standards, typically appears on the closing statement as the responsibility of the buyer or seller. Payment of the commission on behalf of the taxpayer is not considered to be constructive receipt and therefore does not disqualify the safe harbor arrangement. Remember, when a tenants-in-common ownership interest is involved in the exchange, real estate professionals should be cautious about how their compensation is characterized. SEC regulations bar payment by the TIC sponsor of a commission or referral fee unless the real estate professional is a licensed security dealer. However, the real estate agent may be compensated for counseling services; the agent should negotiate this consulting fee as part of the representation agreement. As a selling expense, the agent’s consulting fee may be paid on behalf of the taxpayer from the funds held by the intermediary.



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Review Notes



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Notes:

Chapter 4 Practicum: Concepts in Action


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4. PRACTICUM: CONCEPTS IN ACTION CASE STUDIES The following pages contain scenarios that describe various types of real estate exchange transactions. Answer the questions posed for each scenario. Your instructor may add activities or pose additional questions.



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Case Study 4.1: Asking the Right Questions You receive a phone call from Dave Jergensen, a broker in Columbus, Ohio. Dave tells you he has a contract on a duplex that his client has owned for fifteen years. When Dave asked the client what he planned to do, the client said, “I want to buy something in Sarasota or Bradenton, Florida.” Both of these locations are within your market area. Dave’s client told him he had heard there was a possibility he could postpone the capital gains tax if the properties were exchanged. Activities: Develop a set of questions you would ask Dave about the property. Your questions should elicit enough information to answer the following:

- Is the transaction worth pursuing? - What type of property, size, and equity should you search for? - What is the time frame in which you must produce?

After you have developed the set of questions, assign each question an answer that you think would lead to the settlement of a tax-deferred exchange.

Case study reprinted with permission of the CCIM Institute.



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Case Study Notes



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Case Study 4.2: A Deferred Exchange You get a call on February 17th from a broker who has concluded a transaction for a client in Michigan. The client desires to move his equity to California and defer as much capital gain tax as possible. The proceeds from the sale are on deposit with a qualified intermediary who has entered into an agreement with the client. In the conversation with the broker, you learn the following:

- The sale closed on February 15th (not a leap year) - Type of property: apartment building - Sale price: $1,200,000 - Mortgage balance: $430,000 - Transaction costs: $84,000 - Cash placed with qualified intermediary: $626,000 - Adjusted basis at sale: $555,000 (before transaction costs) - Terms of sale:

Down payment: $240,000 First Mortgage: $900,000 Seller carry back second mortgage: $60,000 Total: $1,200,000

- Additional cash available: none You have several properties that could be identified as possible replacements. However, your first choice is an eight-unit apartment building currently available at $2,000,000. Present mortgage balance is $1,100,000, and it has a new loan available for $1,400,000. Questions: • What is the realized gain? • What is the recognized gain? • When do the 45-day identification and 180-day completion periods

expire? • What is the client’s substitute basis in the replacement property? • How would it change the deal if the client wants to live in one of the

apartments in the replacement property?

Case study reprinted with permission of the CCIM Institute.



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Sum of A, B & C above ............................................... $

$ or $ (Realized gain–line 4) (Sum of A, B, & C above)

5. Recognized Gain............................................. $*



6. Realized gain (line 4) ...................................... $

7. Less recognized gain (line 5) .......................... $ 8. Equals: unrecognized gain.............................. $


9. Market value of acquired property................... $

10. Less unrecognized gain (line 8) or Plus realized gain (line 4) if loss ...........................................

$







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Case Study 4.3: Tenants-in Common For the past thirty years, Matt Sommers worked hard to put together and manage a portfolio of premium real estate investments in the Northwest. Most of the properties are in the area of Boise, Idaho, Matt’s hometown, and the value of his holdings was now close to $10 million. Having reached that financial milestone, as well as his 65th birthday, Matt decided to sell some properties that required a lot of day-to-day management. He wanted to have more free time for travel and to spend with his grandchildren in Tacoma, WA. Matt was a very savvy investor, but he also relied heavily on the opinion of his son, Ray, a CPA with a thriving practice in Tacoma, WA. Matt, with Ray’s input, selected two properties with a combined value of $1,650,000. One of the properties, a duplex, was valued at $350,000. It was one of his first acquisitions, and fully depreciated, but because of recent refinancing its equity was $125,000. The other property, a commercial building, was valued at $1,300,000 with a basis equal to half of its FMV, and equity of $575,000. After several sleepless nights thinking about the potential tax bill, Matt phoned his son and said, “I’ve worked for thirty years to build something that would provide a comfortable life for your Mother and myself. I want you and your kids to have the benefit from it when I’m gone–not the IRS!” Ray suggested that they investigate a tenants-in-common property investment and structure the transaction as an exchange, and Matt agreed. Independently, they both started researching available properties and receiving proposals from competing brokers. In the meantime, the sale of the first property closed on November 17th and proceeds were placed with a QI. At about the same time, Matt received and accepted an offer on the second property. By the time they selected a Tacoma-based real estate broker to work with, 44 days had elapsed from the time of the first sale. With the prospect of a sizeable tax bill looming even larger, Matt hopped on a flight to Tacoma to meet with the real estate broker who Ray felt could offer the best service. The broker quickly guided them in identifying three properties, only one of which was really a “first choice.” The broker warned that it could be difficult to close on the properties because so much money was currently flowing out of the stock market and the proceeds from second property would be needed to acquire the TIC investment. Things got complicated when they tried to close on one of the identified properties. The “first choice” was bought out of from under them. Two of the identified properties remained; after further research, Matt rejected one and settled on the other. The TIC sponsor accepted Matt’s investment contingent on the closing of the commercial building.



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Questions: Why is a tenants-in-common exchange a good idea for Matt? Based on the value of Matt’s properties, what would be the maximum value for identified properties? What steps would you advise Matt and Ray to take in the future to assure a less stressful transaction? What are the advantages and disadvantages of “shopping the market” with competing real estate brokers? Why would money flowing from the stock market complicate closing on identified properties? Why did Matt need the proceeds from both properties to make the TIC investment? How would the real estate broker be compensated?



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Case Study 4.4: The Family Farm The Howard farm has been in the family for three generations and the white frame farmhouse and round barn are community landmarks. The farm used to be three miles from the county seat, but new housing development has pushed the town limits outward and now the century-old farmhouse sits across the road from new ranch homes and town houses. Dwayne and Francine Howard have two high-school age sons who are looking forward to studying agribusiness in college and then continuing the tradition of operating the family farm enterprise. The income from the farm will not be enough to pay for the sons’ college. Dwayne can foresee that the economics of the farm will make it very difficult to continue supporting Dwayne and Francine plus the sons’ families in the future. The situation seemed bleak until a couple of weeks ago when a developer approached the Howards about selling their land. The offered deal could make the Howard family millionaires, but it will mean a hefty tax payment and the Howards want to continue farming–it’s the only way of life they know and consider it their sons’ heritage. News travels fast in a small town, and the local landmark preservation committee is already mobilizing to prevent new construction by stalling the necessary rezoning. The committee’s position is that the Howard farmhouse and round barn are historic landmarks and tearing them down will destroy a vital part of the community heritage. Over the years you have helped the Howards buy and sell acreages; a lot depends on this deal and they would like you to help them work it out. In your conversation with Dwayne, you learn:

- The farm holdings consist of 500 tillable acres, plus about 50 wooded acres. Income per acre averages $125 annually - When Bill and Francine inherited the farm, FMV value was set at $1825 per acre - The developer is offering $4500 per acre and will do an exchange - FMV on offered replacement acreage is $1850 per acre with an annual income $150 Questions: • If an equivalent amount of land value is exchanged, what will be

the annual income on the replacement property? • What are the pros and cons of the deal for the Howard family? Do

you think the deal will accomplish the Howards’ goals? • How might you prepare the Howards for the process of the

transaction? for community reaction?



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Case Study Notes



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Notes:

Chapter 5 Putting It All Together


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5. PUTTING IT ALL TOGETHER

Recognizing and Evaluating Potential Exchange Situations Assess the Overall Situation Experienced 1031 exchange practitioners state that the best starting point for recognizing a potential exchange opportunity is an assessment of the client’s overall financial and business situation. Within this context, the client’s business and investment objectives can be discussed, problems identified, and solutions formulated. (Refer back to the business and investment objectives mentioned at the beginning of the course.) For example, does the client want to diversify real estate holdings, relocate, expand or exit a business, consolidate scattered acreages, or other objectives? If accomplishing the objective involves a change in real estate holdings and taxes on the gain from a sale will be high, then a 1031 tax-deferred exchange may be the solution. Emphasis is on may because experienced exchange practitioners know that other factors, beyond the dollars and cents issues, influence the decision to exchange real estate or sell and buy. Experience and Comfort Level The client’s experience and comfort level with complex real estate transactions is definitely a factor. In contrast to a sell-and-buy transaction, the process of a 1031 exchange can, and usually does, involve multiple negotiations for replacement properties, interdependent transactions, creation of a paper trail, and participation of experts with specialized knowledge. The risks and ambiguities of identifying and negotiating for replacement properties and complying with time limits may be well beyond the client’s comfort level. Real estate professionals may need to spend a considerable amount of time educating their clients about the transaction and coaching them through it. Change of Mindset Involvement in an exchange may require a paradigm shift, a change in mindset, for the client. In an exchange, large values of real estate can change hands with little or no cash on the table. A client, who has only experienced the clear-cut boundaries of sale and purchase with cash and deeds changing hands, may find the exchange transaction to be disconcerting. Consider the case of agricultural land that lies in the path of development. The family farm may have been purchased for a few hundred dollars per acre or passed down from previous generations; when valued for development the farmland’s value may have appreciated to several hundred thousand or more. The experience of realizing this value gain on paper, but not in a bank account, can be quite astonishing for the landowners.



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Even Swap or Value Gain Some real estate exchange professionals counsel that the exchanger must gain more value from the transaction than an even swap of property. Tax deferral is certainly a major objective, but not the only one. Value must be gained, such as potential for future appreciation or improved cash flow from a new income stream, to make the transaction worthwhile. If the 1031 exchange makes business and tax sense, does it also have potential for value gain, or is it an even swap? Will the effect on the client’s overall investment or business holdings be positive or neutral? Some practitioners would say that if the impact is neutral, it is not worth the risks and costs of an exchange.

Finding an Accommodator/Intermediary An attorney who handles real property exchanges, a lender, or title company may be able to refer you to an experienced exchange accommodator. Another source of information is the professional organization for exchange accommodators. The Federation of Exchange Accommodators (FEA), formed in 1989, is a national trade organization that represents intermediaries, their primary legal/tax advisors, and affiliates who are directly involved in Section 1031 exchanges. FEA goals are to promote the discussion of ideas and innovations in the industry, provide and promote the establishment of ethical standards of conduct, offer education to both the industry and general public, and work toward the development of uniformity of practice and terminology within the exchange profession. The FEA also provides input and updates on pending state and federal legislation, Internal Revenue Service and Treasury Rulings, and Court Decisions. The FEA administers a certification and continuing education program leading to the designation of Certified Exchange Specialist™. Earning the designation requires exchange professionals to meet a specific work-experience criterion of at least three years and pass a 2 ½ hour test on exchange laws and procedures. Membership in FEA and earning the designation are voluntary. Although not all accommodators are members of the organization, many are. The organization’s web site (www.1031.org) offers a membership directory searchable by company name, special services, and location.



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Checklist: Finding an Accommodator

___ Is the accommodator a member of the Federation of Exchange Accommodators (FEA?

___ Does the accommodator hold a Certified Exchange Specialist tm designation?

___ Is the firm bonded by an insurance company? Will the firm provide a copy of the bond?

___ What is the accommodator’s professional background, e.g. attorney or CPA with 1031 experience?

___ Will the accommodator take responsibility for losses if a mistake is made or the transaction does not qualify with the IRS?

___ Who receives the interest on the escrow account? The accommodator may quote a low fee as a tradeoff for receiving the escrow interest.

___ Is the accommodator accessible to your client and you? Will you meet face-to-face?

___ Is the accommodator a team player? Will other experts be involved to assure due diligence? review documents? handle financing?

___ Will an adequate paper trail be created?

___ Is the accommodator accustomed to handling a type and size of transaction similar to your client’s?

___ Does the accommodator have a specialty? tenants-in-common? agricultural land?

___ If a tenants-in-common ownership will be involved, is the accommodator a licensed securities representative?



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Pitfalls Complying With Time Limits Although there are few statistics on the number of failed exchanges, some professionals report that thirty to forty percent of exchange transactions fail because of missed time deadlines. Exchangers can encounter difficulty in finding the right replacement properties and completing the negotiations with the property owner. The time needed for completion of due diligence may overtake the 180-day transaction completion deadline. For example, zoning hearings for land being repurposed can tie up a real estate deal well beyond 180 days. The transaction completion timeframe can be considerably shortened by an intervening tax return due date. Remember–transactions must be completed by the earlier of 180-days or the tax return due date. And, 180 days does not equal six months. Preparation Experienced practitioners know the importance of getting organized for an exchange before the components of the transactions are put into play. Preparation steps may involve obtaining all of the necessary tax forms and documents to create a paper trail, identifying experts to assist with the deal, and assuring that exchange contingency clauses are inserted in the appropriate documents. The preparation phase may also necessitate educating and coaching the client. If a client’s previous real estate transaction experience includes only sell and buy transactions, the elements of the exchange deal may seem “out of sync,” and overly drawn out. Some practitioners report that exchanges seem like “hurry up and wait” situations for clients, and they may be short on the patience needed to see the transaction through to the end. In the case of farmland being converted to development, coaching clients may also involve preparing them to face emotional issues from community backlash. Community residents may feel that the farm owners are “selling out” to developers and contributing to negative change. The farm owner may become the focal point for blame and ill-feelings toward speculative developers. Negotiating For Replacement Properties Exchange professionals report that a mistake often made by real estate salespersons involves negotiating seriously for only the most preferred property, the “Plan A.” The less-preferred properties are relegated, sometimes unconsciously, to a “Plan B” status. If negotiations for the first-choice property fall through close to the 45-day identification



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deadline, there may not be enough time left to negotiate successfully for a second-choice property. Or, while negotiations are concentrated on the first-choice property the second-choice property can be bought out from under the exchanger. The 45-day identification time limit can be used against an exchanger in negotiations. One of the basic principles of effective negotiation is to avoid revealing any time constraints for completing the deal. If the owner of a replacement property knows that the exchanger must meet a strict 45-day time limit, the property owner may use that leverage to raise the price. Other Obstacles May Intervene Completion of environmental reports, zoning hearings, disclosures, inspections, and due diligence steps may overtake the transaction completion deadline. As mentioned above, in areas where agricultural land is undergoing conversion to development, community resistance can stall the transaction. Unscrupulous Parties The Federation of Exchange Accommodators promulgates a voluntary code of ethics. However, the business of real estate exchanging is not regulated and it is a hard reality that unscrupulous parties may try to take advantage of the unsuspecting. The assignments of rights, title transfers, cash held in escrow accounts, and other elements of exchange transactions depend on the trust of the parties involved. The drawn out time lines, complexities, interdependent transactions, and involvement of others in holding cash and property titles can make the real estate exchange vulnerable to potential fraud. As with any business transaction, it is important to know whom you are dealing with in all of the stages of the transaction.



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1031 Exchange Decision Map

Is the property held for use in trade or business or for investment? (p. 8)

Property is not eligible for exchange.

Does the client want to continue an investment in real estate? (p. 12)

A sale may be the best course of action.

Will business objectives be met? (p. 5)

A sale and purchase may be a better course of action.

Will there be a large tax liability, greater than the transaction costs? (p. 6)

A sale and purchase may be a better course of action.

Is the client comfortable with an exchange transaction? (p. 65)

Be prepared to educate and coach the client.

Will boot be given or received? debt relief given or other value received? (p. 15)

An even swap of properties may or may not be advantageous.

Can replacement property be identified: 3 properties or 200%? (p. 23)

The 95% rule may apply.

Can time deadlines be easily met? (p. 13)

Consider a reverse or deferred exchange.

Will value be gained in the exchange? (p. 65)

If the exchange is an even swap, look for value-added replacement property.

Does the exchanger want to be involved in day-to-day management? (p. 41)

Consider a tenants-in-common exchange transaction.

Can a qualified intermediary/accommodator be identified? (p. 66)

Reconsider: exchanges require a team of experts to assure a successful transaction.

1031 Exchange

NO

YES

NO

YES

NO

YES

YES

NO

NO

YES

YES

NO

NO

YES

NO

YES

YES

YES

NO

NO

YES

NO

Chapter 6 Toolkit and Resources


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6. TOOL KIT AND RESOURCES



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From the U.S. Code Online via GPO Access [wais.access.gpo.gov] [Laws in effect as of January 7, 2003] [Document not affected by Public Laws enacted between January 7, 2003 and February 12, 2003] [CITE: 26USC1031]

TITLE 26--INTERNAL REVENUE CODE Subtitle A--Income Taxes

CHAPTER 1--NORMAL TAXES AND SURTAXES Subchapter O--Gain or Loss on Disposition of Property

PART III--COMMON NONTAXABLE EXCHANGES Sec. 1031. Exchange of property held for productive use or investment (a) Nonrecognition of gain or loss from exchanges solely in kind (1) In general 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. (2) Exception This subsection shall not apply to any exchange of-- (A) stock in trade or other property held primarily for sale, (B) stocks, bonds, or notes, (C) other securities or evidences of indebtedness or interest, (D) interests in a partnership, (E) certificates of trust or beneficial interests, or (F) choses in action. For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership. (3) Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if-- (A) such property is not identified as property to be received in the exchange on or before the day which is 45

days the date on which the taxpayer transfers the property relinquished in the exchange, or (B) such property is received after the earlier of-- (i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date (determined with regard to extension) for the transferor's return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs. (b) Gain from exchanges not solely in kind If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property. (c) Loss from exchanges not solely in kind If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized. (d) Basis If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035(a), section 1036(a), or section 1037(a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035(a), and section 1036(a), where as part of the consideration to the taxpayer another party to the exchange assumed (as determined under section 357(d)) a liability of the taxpayer, such assumption shall be



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considered as money received by the taxpayer on the exchange. (e) Exchanges of livestock of different sexes For purposes of this section, livestock of different sexes are not property of a like kind. (f) Special rules for exchanges between related persons (1) In general If-- (A) a taxpayer exchanges property with a related person, (B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and (C) before the date 2 years after the date of the last transfer which was part of such exchange-- (i) the related person disposes of such property, or (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs. (2) Certain dispositions not taken into account For purposes of paragraph (1)(C), there shall not be taken into account any disposition-- (A) after the earlier of the death of the taxpayer or the death of the related person, (B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or (C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax. (3) Related person For purposes of this subsection, the term ``related person'' means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1). (4) Treatment of certain transactions

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. (g) Special rule where substantial diminution of risk (1) In general If paragraph (2) applies to any property for any period, the running of the period set forth in subsection (f)(1)(C) with respect to such property shall be suspended during such period. (2) Property to which subsection applies This paragraph shall apply to any property for any period during which the holder's risk of loss with respect to the property is substantially diminished by-- (A) the holding of a put with respect to such property, (B) the holding by another person of a right to acquire such property, or (C) a short sale or any other transaction. (h) Special rules for foreign real and personal property For purposes of this section-- (1) Real property Real property located in the United States and real property located outside the United States are not property of a like kind. (2) Personal property (A) In general Personal property used predominantly within the United States and personal property used predominantly outside the United States are not property of a like kind. (B) Predominant use Except as provided in subparagraph \1\ (C) and (D), the predominant use of any property shall be determined based on-- --------------------------------------------------------------------------- \1\ So in original. Probably should be ``subparagraphs''. --------------------------------------------------------------------------- (i) in the case of the property relinquished in the exchange, the 2-year period ending on the date of such relinquishment, and (ii) in the case of the property acquired in the exchange, the 2-year period beginning on the date of such acquisition. (C) Property held for less than 2 years



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Except in the case of an exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection-- (i) only the periods the property was held by the person relinquishing the property (or any related person) shall be taken into account under subparagraph (B)(i), and (ii) only the periods the property was held by the person acquiring the property (or any related person) shall be taken into account under subparagraph (B)(ii). (D) Special rule for certain property Property described in any subparagraph of section 168(g)(4) shall be treated as used predominantly in the United States. (Aug. 16, 1954, ch. 736, 68A Stat. 302; Pub. L. 85-866, title I, Sec. 44, Sept. 2, 1958, 72 Stat. 1641; Pub. L. 86-346, title II, Sec. 201(c)-(e), Sept. 22, 1959, 73 Stat. 624; Pub. L. 91-172, title II, Sec. 212(c)(1), Dec. 30, 1969, 83 Stat. 571; Pub. L. 98-369, div. A, title I, Sec. 77(a), July 18, 1984, 98 Stat. 595; Pub. L. 99-514, title XVIII, Sec. 1805(d), Oct. 22, 1986, 100 Stat. 2810; Pub. L. 101-239, title VII, Sec. 7601(a), Dec. 19, 1989, 103 Stat. 2370; Pub. L. 101-508, title XI, Secs. 11701(h), 11703(d)(1), Nov. 5, 1990, 104 Stat. 1388-508, 1388-517; Pub. L. 105-34, title X, Sec. 1052(a), Aug. 5, 1997, 111 Stat. 940; Pub. L. 106-36, title III, Sec. 3001(c)(2), June 25, 1999, 113 Stat. 183.) Amendments 1999--Subsec. (d). Pub. L. 106-36, in last sentence, substituted `àssumed (as determined under section 357(d)) a liability of the taxpayer'' for `àssumed a liability of the taxpayer or acquired from the taxpayer property subject to a liability'' and struck out `òr acquisition (in the amount of the liability)'' after ``such assumption''. 1997--Subsec. (h). Pub. L. 105-34 amended heading and text of subsec. (h) generally. Prior to amendment, text read as follows: ``For purposes of this section, real property located in the United States and real property located outside the United States are not property of a like kind.'' 1990--Subsec. (a)(2). Pub. L. 101-508, Sec. 11703(d)(1), inserted at end ``For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.'' Subsec. (f)(3). Pub. L. 101-508, Sec. 11701(h), substituted ``section 267(b) or 707(b)(1)'' for ``section 267(b)''. 1989--Subsecs. (f) to (h). Pub. L. 101-239 added subsecs. (f) to (h).

1986--Subsec. (a)(3)(A). Pub. L. 99-514 substituted `òn or before the day'' for ``before the day''. 1984--Subsec. (a). Pub. L. 98-369, Sec. 77(a), in amending subsec. generally, designated existing provisions as par. (1), substituted ``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'' for ``No gain or loss shall be recognized if property held for productive use in trade or business or for investment (not including stock in trade or other property held primarily for sale, nor stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest) is exchanged solely for property of a like kind to be held either for productive use in trade or business or for investment'', and added pars. (2) and (3). 1969--Subsec. (e). Pub. L. 91-172 added subsec. (e). 1959--Subsecs. (b) to (d). Pub. L. 86-346 inserted references to section 1037(a) in subsecs. (b) and (c) and in first two sentences of subsec. (d). 1958--Subsec. (d). Pub. L. 85-866 inserted in first sentence a comma between `èxchanged'' and ``decreased'' and `òr decreased in the amount of loss'', and substituted in second sentence ``subsection'' for ``paragraph''. Effective Date of 1999 Amendment Amendment by Pub. L. 106-36 applicable to transfers after Oct. 18, 1998, see section 3001(e) of Pub. L. 106-36, set out as a note under section 351 of this title. Effective Date of 1997 Amendment Section 1052(b) of Pub. L. 105-34 provided that:`` (1) In general.--The amendment made by this section [amending this section] shall apply to transfers after June 8, 1997, in taxable years ending after such date. ``(2) Binding contracts.--The amendment made by this section shall not apply to any transfer pursuant to a written binding contract in effect on June 8, 1997, and at all times hereafter before the disposition of property. A contract shall not fail to meet the requirements of the preceding sentence solely because-- ``(A) it provides for a sale in lieu of an exchange, or ``(B) the property to be acquired as replacement property was not identified under such contract before June 9, 1997.'' Effective Date of 1990 Amendment Section 11701(h) of Pub. L. 101-508 provided that the amendment made by that section is effective with respect to transfers after Aug. 3, 1990. Section 11703(d)(2) of Pub. L. 101-508 provided that: ``The amendment made by paragraph (1) [amending this section] shall apply to transfers after July 18, 1984.''



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Effective Date of 1989 Amendment Section 7601(b) of Pub. L. 101-239 provided that: ``(1) In general.--Except as provided in paragraph (2), the amendments made by this section [amending this section] shall apply to transfers after July 10, 1989, in taxable years ending after such date. ``(2) Binding contract.--The amendments made by this section shall not apply to any transfer pursuant to a written binding contract in effect on July 10, 1989, and at all times thereafter before the transfer.'' Effective Date of 1986 Amendment Amendment by Pub. L. 99-514 effective, except as otherwise provided, as if included in the provisions of the Tax Reform Act of 1984, Pub. L. 98-369, div. A, to which such amendment relates, see section 1881 of Pub. L. 99-514, set out as a note under section 48 of this title. Effective Date of 1984 Amendment Section 77(b) of Pub. L. 98-369, as amended by Pub. L. 99-514, Sec. 2, Oct. 22, 1986, 100 Stat. 2095, provided that: ``(1) In general.--Except as otherwise provided in this subsection, the amendment made by subsection (a) [amending this section] shall apply to transfers made after the date of the enactment of this Act [July 18,1984] in taxable years ending after such date. ``(2) Binding contract exception for transfer of partnership interests.--Paragraph (2)(D) of section 1031(a) of the Internal Revenue Code of 1986 [formerly I.R.C. 1954] (as amended by subsection (a)) shall not apply in the case of any exchange pursuant to a binding contract in effect on March 1, 1984, and at all times thereafter before the exchange. ``(3) Requirement that property be identified within 45 days and that exchange be completed within 180 days.--Paragraph (3) of section 1031(a) of the Internal Revenue Code of 1986 (as amended by subsection (a)) shall apply-- ``(A) to transfers after the date of the enactment of this Act [July 18, 1984], and ``(B) to transfers on or before such date of enactment if the property to be received in the exchange is not received before January 1, 1987. In the case of any transfer on or before the date of the enactment of this Act which the taxpayer treated as part of a like-kind exchange, the period for assessing any deficiency of tax attributable to the amendment made by subsection (a) [amending this section] shall not expire before January 1, 1988. ``(4) Special rule where property identified in binding contract.--

If the property to be received in the exchange is identified in a binding contract in effect on June 13, 1984, and at all times thereafter before the transfer, paragraph (3) shall be applied-- ``(A) by substituting `January 1, 1989' for `January 1, 1987', and ``(B) by substituting `January 1, 1990' for `January 1, 1988'. ``(5) Special rule for like-kind exchange of partnership interests.--Paragraph (2)(D) of section 1031(a) of the Internal Revenue Code of 1986 (as amended by subsection (a)) shall not apply to any exchange of an interest as general partner pursuant to a plan of reorganization of ownership interest under a contract which took effect on March 29, 1984, and which was executed on or before March 31, 1984, but only if all the exchanges contemplated by the reorganization plan are completed on or before December 31, 1984.'' Effective Date of 1969 Amendment Section 212(c)(2) of Pub. L. 91-172, as amended by Pub. L. 99-514, Sec. 2, Oct. 22, 1986, 100 Stat. 2095, provided that: ``The amendment made by paragraph (1) [amending this section] shall apply to taxable years to which the Internal Revenue Code of 1986 [formerly I.R.C. 1954] applies.'' Effective Date of 1959 Amendment Amendment by Pub. L. 86-346 effective for taxable years ending after Sept. 22, 1959, see section 203 of Pub. L. 86-346, set out as an Effective Date note under section 1037 of this title. Effective Date of 1958 Amendment Amendment by Pub. L. 85-866 applicable to taxable years beginning after Dec. 31, 1953, and ending after Aug. 16, 1954, see section 1(c)(1) of Pub. L. 85-866, set out as a note under section 165 of this title. Plan Amendments Not Required Until January 1, 1989 For provisions directing that if any amendments made by subtitle A or subtitle C of title XI [Secs. 1101-1147 and 1171-1177] or title XVIII [Secs. 1800-1899A] of Pub. L. 99-514 require an amendment to any plan, such plan amendment shall not be required to be made before the first plan year beginning on or after Jan. 1, 1989, see section 1140 of Pub. L. 99-514, as amended, set out as a note under section 401 of this title. Section Referred to in Other Sections This section is referred to in sections 83, 197, 424, 453, 454, 704, 857, 1035, 1036, 1037, 1060, 1245, 1250, 2032A, 2057 of this title



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Sum of A, B & C above ............................................... $

$ __________ $ (Realized gain–line 4) (Sum of A, B, & C above)

5. Recognized Gain............................................. $*



6. Realized gain (line 4) ...................................... $ 7. Less recognized gain (line 5) .......................... $ 8. Equals: unrecognized gain.............................. $


9. Market value of acquired property................... $ 10. Less unrecognized gain (line 8) or Plus

realized gain (line 4) if loss.............................. $





Toolkit and Resources


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Glossary Accommodator A person (or company) who facilitates the exchange of properties. Actual receipt The taxpayer is in possession of cash proceeds or property. Adjusted basis The amount paid for a property for tax purposes taking into consideration added value for improvements and decreased value for cost recovery (depreciation). Basis The value of a property for tax purposes, usually the purchase price. Boot Cash, unlike property, or debt relief received in an exchange. Constructive receipt The taxpayer does not have possession of the cash proceeds or property, but has substantial control. Dealer property Property held primarily for sale or exchange in the ordinary course of business. Deferred exchange A non-simultaneous, time-delayed exchange. Cost recovery (depreciation) The allocation of the cost of an asset over a period of time for accounting and tax purposes; reduces basis. (Allowable as a deduction.)

Cost recovery (depreciation) recapture Inclusion of part or all of the cost recovery (depreciation) deducted in previous years in a year's taxable income when the property is sold. Direct deeding Transfer of an exchange property from one owner to another. Escrow account, qualified An account that restricts the exchanger’s access to the funds’ contents until exchange completion. Exchange accommodator titleholder (EAT) The person or entity who takes title to a property in a reverse or deferred exchange. Exchange period Period of time (180 days) within which an exchange transaction must be completed; Beginning on the date title is transferred for the relinquished property. Exchanger The property owner who initiates the exchange and relinquishes a property. Fair market value (FMV) The price at which a property would change hands between a willing seller and buyer. Federation of Exchange Accommodators (FEA) A national trade organization representing intermediaries and others directly involved in Section 1031 exchanges. Gross profit percentage In an installment sale, the percentage of each payment that is installment sale income, calculated by dividing gross profit from the sale by the contract price.



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Identification period Period of time (45 days) in which replacement property must be identified, beginning on the date title is transferred for the relinquished property. Incidental property Property typically transferred in standard commercial transactions together with a larger item of property. Improvement exchange An exchange involving a property on which construction (built to suit) will be completed before the exchanger takes title to it. Imputed interest Increments of value treated as interest even though interest is not paid or received. Involuntary exchange Forced disposition of a property due to condemnation, theft, or damage Like kind Property in the same asset class, as defined by the Internal Revenue Code. Mortgage relief Assumption of a mortgage by another party. Multiple asset exchange An exchange involving different classifications of assets. Parking An accommodator receives and holds title to a property that will be involved in an exchange. Qualified intermediary A person (or company) who for a fee facilitates an exchange of properties.

Related party A person associated through a familial, business, corporate, or fiduciary relationships, as defined by the IRC. Relinquished property The property that is given up in an exchange. Replacement property The property that is received in an exchange. Reverse exchange A transaction in which the replacement property is identified and acquired before the relinquished property is disposed of. Safe harbor An arrangement that enables avoidance of actual or constructive receipt of proceeds or property in an exchange. Sequential deeding An exchange transaction in which the relinquished property’s title is transferred from the exchanger to the accommodator and then to the transferee, and the replacement property’s title is transferred from the transferee to the accommodator and then to the exchanger. Simultaneous exchange An exchange in which titles to property are swapped at the same time. Starker exchange A deferred exchange. Tenants-in-common ownership An undivided, fractional ownership interest in a property. Trust account, qualified (See escrow account, qualified.)



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Summary of Key Documents and Court Cases Starker V. U.S., 1975-1 USTC 8443 (D. Ore. 1975) In 1967, Mr. T.J. Starker and his family agreed to an immediate transfer of timberland, located in Columbia County, Oregon, in return for the transferees’ unsecured promise to purchase replacement property to be named later. The transferees were two companies, Crown Zellerbach and Longview Fibre. In 1979, after several decisions and appeals from 1975 through 1979, the Court found that the IRS Code Section 1031 did not contain any requirement for simultaneous transactions and ruled in favor of the Starkers. The Deficit Reduction Act of 1984 amended Section 1031 to allow deferred exchanges only if all of the exchanged property is identified (45 days) and acquired (180 days) within specified time periods. (Page 2.25) Scheuber v. Com. 371 F.2d 996 The Court held that properties purchased by a licensed real estate broker (who intended ultimately to sell) and held for realization of appreciation in value over a substantial period of time were capital assets. If the property is listed with a licensed real estate broker, the sales activities of the real estate broker are not considered to be the sales activities of the owner. (Page 2.7) W.D. Haydn Co, v. Commission, 165 F.2d 588 The Court held the taxpayer (client) had exchanged one property for another although the buyer made a cash payment to the seller. See also Rev. Rul. 57-244. Leslie Q. Coupe, 52TC 394 (1960) Even though a contract to sell at a stipulated price had already been signed, Mr. Coupe arranged for a second party to deposit the money into an escrow account and instructed the escrow holder to pay the money to the titleholder of Mr. Coupe’s property. He exchanged his property for other real property owned by a third party. The third party sold the Coupe property to the second party for the cash held in escrow. The court ruled, “the statute only requires that as the end result of an agreement, property be received as consideration for property transferred by the taxpayer, without his receipt of, or control over, cash." (Page 2.28) Alderson V. Commissioner, 317 F.2d (9th Cir. 1963) After earnest money was deposited into an escrow account, the escrow agreement was changed so that, in place of the cash deal, the buyer would purchase land Mr. Alderson wanted and exchange that property for Alderson’s. The buyer would use the money originally intended for the cash deal to purchase the replacement property. The court held that the outcome of the transaction was an exchange, not a sale and a purchase. (Page. 2.29) Earlene T. Baker, 74 TC 555 (1960) The court held that a party may hold transitory ownership of an exchange property solely for the purposes of effecting the exchange. (Page 2.31)



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A Failed Exchange–Joyce M. Allen, TC Memo 1982-188 The taxpayer's attempted three-party exchange did not qualify under Section 1031. The transaction was held to be a sale and a purchase. The two transactions were only related by the fact that proceeds from sale of one property were used to buy the other property. The court held the transfers of properties were not steps in an integrated transaction and that nothing in the records indicated that the successful completion of either transaction was a condition of the other. If Allen's purchase escrow had failed, she would have ended up with the proceeds from the sale of her property. IRS Rev. Proc. 87-56 Sets forth the class lives of property necessary to compute the cost recovery (depreciation) allowance. This revenue procedure defines two broad categories of depreciable assets: assets used in all business activities; and assets used in specific business activities. (Page 2.17) Rev. Proc. 2000-37 Issued in September 2000, this procedure facilitated the use of reverse exchanges by setting forth conditions under which properties will not be challenged as relinquished or replacement properties under Section 1031 and third party accommodators will be not be challenged as beneficial owners of the property. (Page 2.28) SEC v. Howey, 328 U.S. 293 (1946) The Howey case established criteria for determining if an investment is a security: 1) there must be an investment; 2) the investment is in a common enterprise; 3) the investment was motivated by an expectation of profits and; 4) the profits are to be derived from the enterprise or managerial efforts of a third party. IRS Rev. Proc. 2002-22 Specifies the conditions under which the IRS may consider the purchase of a tenants-in-common interest an investment in real estate. (Page 2.37) SEC v. Edwards, 540 U.S.___(2004) The Supreme Court was asked to determine if an investment scheme can be excluded from the definition of a “security” if it promises a fixed (e.g. rents), instead of variable, rate of return, or the investor is entitled by contract to a fixed rate of return. The Court held that such a scheme can be an “investment contract” and therefore a security, subject to federal securities laws.



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Reg.1.168 (i)-6T In 2004, the IRS and Treasury issued new regulations for figuring cost recovery (depreciation) on replacement property received in an exchange (replaces Notice 2000-4). The new rulings continue the concepts of old basis and new basis.

Old (exchanged) basis: tax basis of the relinquished property. Carried over to the replacement property. New basis: additional basis received in the exchange.

According to the 2004 regulations, the new depreciation schedule for replacement property has a (depreciation) start-date for “old basis” consistent with the start date of the “new basis” depreciation schedule. Old basis will continue to be depreciated in the same manner as the relinquished property unless the replacement property has the same or shorter cost recovery schedule or method as the relinquished property. Rev. Proc. 2004-51 Rev. Proc 2004-51 modifies Rev. Proc. 2000-37 provisions regarding “parking” transactions in a reverse exchange with the taxpayer has owned the replacement property within the preceding 180 days. Rev. Proc. 2004-51 states that a in a reverse exchange, replacement property held in a QEAA is not eligible for a tax-deferred exchange if the property was owned by the taxpayer within the 180-day period preceding the date of transfer of the property to the Exchange Accommodation Titleholder. This prevents a taxpayer from transferring a property to a QEAT and receiving that same property back as replacement property in exchange for other property owned by the taxpayer. A parking arrangement cannot be used to reinvest the sale proceeds of one property into improvements for another property the taxpayer already owns. American Jobs Creation Act of 2004 Five Year Holding Period for Residential Property Received in an Exchange A provision of the American Jobs Creation Act of 2004 imposes a five-year ownership requirement for a “tax-free” sale of a property received in an exchange transaction and converted to a personal residence. Prior to enactment of this regulation, a taxpayer might exchange an investment property for a property eventually intended for a personal residence, e.g., a retirement residence. After completion of the exchange and required investment period, the taxpayers moved into the residence and lived there for two years in order to make the sale of the property eligible for exclusion of gain (see “Sale of a Personal Residence Tax Summary” in Toolkit and Resources section). This exclusion (up to $250,000, $500,000 for joint returns) may be claimed repeatedly every two years. Under the 2004 law, the exclusion of gain does not apply if the sale occurs within five years of the acquiring the residence if it was received as a replacement property in a tax-deferred 1031 exchange.



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North American Industry Classification System used to categorize Like-Kind Personal Property Tangible depreciable personal property held for investment or productive use in trade or business can be exchanged; some examples are office furniture and fixtures, trucks, tractors, airplanes, and computer equipment. These assets can be traded as like kind if traded for an asset in the same asset class set forth in the North American Industry Classification System (NAICS). Prior to 2004, the classification system in use was the Standard Industrial Classification (SIC) System. Copies of the NAICS Manual are available from the National Technical Information Service of the Department of Commerce, or online at www.census.gov/NAICS. Safe Harbor Guidelines for Reverse Exchanges In 2004, the IRS issued Safe-Harbor Guidelines for reverse exchanges. Safe Harbors are covered in the next section, however in the context of reverse exchanges, the provisions are: • The reverse exchange must be completed within 180-days or the property held by the

QEAT is deeded to the taxpayer. • The relinquished property must be identified with 45 days. • The Intermediary can hold title to either the replacement or relinquished property. • A Qualified Exchange Accommodations Agreement (QEAA) must be entered into within

5 days after the property title is taken by the Exchange Accommodation Titleholder (EAT).

Foreign Investment in Real Property Tax Act In transactions involving FIRPTA, the exchanger/seller must provide a tax identification number (TIN) on any tax withholding documents. The amount of time required (6-8 weeks or more) to obtain a TIN is an issue for exchanges. However, if a TIN is not available at the time of settlement, the IRS will accept both an application for a TIN along with a tax withholding certificate. The ruling also provides that the expedited non-recognition notice procedure [Reg Section 1.1445-2(d)(2)] cannot be used in a deferred exchange in order for a foreign seller to avoid withholding. The rationale is that transferee cannot be sure at the time of closing that the transaction will eventually qualify for a 1031 exchange, such as meeting time requirements, or that it will be entirely tax-free with no boot received by the foreign transferor.



83

Sample Exchange Addendum

Form reprinted with permission of Investment Property Exchange Services, Inc. www.ipx1031.com

S A M P L E



84

Resources The following articles and references are available online at www.realtor.org in the Virtual Library – Field Guides. 1031 Exchange Manual, 1031 Corporation, 2003 An overview of real estate like-kind exchanges, The Appraisal Journal, July 2003 20 questions about deferred realty exchanges under IRC Sec. 1031, The CPA Journal, May 2003 Review the fundamentals of Section 1031 like-kind exchanges, Commercial Investment Real Estate, Jan./Feb. 2003 Shelter gains with a swap; With real estate investing hot, a tax-cut strategy takes center stage, Money Magazine, Aug. 2002 Real Estate Exchange under Section 1031, Real Estate Center Report No. 932, 1995/2000 How to make tax time less costly, Realty Times, Feb. 4, 2002 Section 1031 - Tax-deferred exchanges: Real estate's best-kept secret for tax relief, Real Estate Issues, Winter 2000-2001 Leasehold interests offer alternative 1031 exchange options, Commercial Investment Real Estate, Nov./Dec. 2003 Building value: IRS approves more ways to use 1031 exchanges, The Wall Street Journal, Aug. 6, 2003 The 'state of the art' in like-kind exchanges, revisited, Journal of Taxation, June 2003 1031 exchanges do more than save taxes; These transactions can be used strategically to upgrade portfolios or even to liquidate partnerships, National Real Estate Investor, Jan. 2003 Leasehold interests offer alternative 1031 exchange options, Commercial Investment Real Estate, Nov./Dec. 2003

Building value: IRS approves more ways to use 1031 exchanges, The Wall Street Journal, Aug. 6, 2003 Constructing an exchange; After surveying their opportunities, exchangers should consider building their replacement properties, Commercial Investment Real Estate, Jan./Feb. 2002 1031 Tax-Deferred Exchanges: Evolving rules, greater opportunities, Tierra Grande, July 2002 Tax-Free Exchanges and Sales of Residences, Tierra Grande, Jan. 2002 Smooth moves: Successful exchanges follow these 12 rules of the road, Commercial Investment Real Estate, Mar./Apr. 2001 Exchanges add value in up markets, too; Like-kind exchanges offer complicated, but important option to clients interested in disposing of property, REALTOR® Magazine, Jan. 2001 Reverse Exchanges Using the reverse Starker, Realty Times, Sept. 29, 2003 Reverse exchanges offer investors tax-saving benefits, Commercial Investment Real Estate, Mar./Apr. 2003 New safe harbor for reverse exchanges, The CPA Journal, Jan. 2003 Tax trade-off; Section 1031 offers a safe harbor in like-kind exchanges, Journal of Property Management, Sept./Oct. 2002 Reverse exchanges come of age, Journal of Accountancy, Aug. 2001



85

Tenancy-In-Common (TIC) Exchanges IRS revenue procedure provide guidance for Section 1031 exchanges for property held in tenancy-in-common form, Real Estate Finance, Aug. 2003 An uncommon 1031 deal: How a group of 30-plus tenant-in-common investors out-hustled the competition to buy a regional mall, National Real Estate Investor, Aug. 2003 Trading places: Real estate investors who want to do a Section 1031 exchange and get out of property management can now do so carefully, Financial Planning, Mar. 1, 2003 A 1031 exchange vehicle for small investors; Tenant-In-Common ownership can put individual investors into big deals, and the structure is poised for growth, National Real Estate Investor, Mar. 2003 Exchanges involving tenancy-in-common interests can be tax-free, Practical Tax Strategies, Jan. 2003

Rules, Forms, & Guidelines from the IRS at www.irs.gov Publication 225: Farmer’s Tax Guide Publication 523: Selling Your Home Publication 544: Sales and Other Disposition of Assets Publication 550: Investment Income and Expenses (Including Capital Gains and Losses) Publication 551: Basis of Assets Form 1099-S: Proceeds from Real Estate Transactions Form 4797: Sales of Business Property Form 8824: Like-Kind Exchanges Like-Kind Exchanges: Frequently Asked Questions Like-Kind Exchanges: Real Estate Tax Tips Internal Revenue Code, Part 1: Income Taxes www.access.gpo.gov/nara/cfr/waisidx_02/26cfr1v11_02.html Scroll down to access section 1.1031 et seq.



86

Capital Gain Tax Rates

If net capital gain is from Maximum capital gain rate11

Collectibles Gain 28%

Gain on qualified small business stock equal to the section 1202 exclusion

28%

Unrecaptured section 1250 gain 25%

20% for sales and other dispositions before May 6, 2003

Other gain (A) and the regular tax rate that would apply is 25% or higher 15% for sales and other

dispositions after May 5, 2003 (and installment payments received after that date) Expires December 31, 2008.

8%(B) or 10% for sales or other dispositions before May 6, 2003

Other gain (A) and the regular tax rate that would apply is lower than 25% 5% for sales and other dispositions

after May 5, 2003 (and installment payments received after that date). Expires December 31, 2008.

(A) Other gain means any gain that is not collectibles gain, gain on qualified small business stock or unrecaptured section 1250 gain. (B) The rate is 8% only for qualified 5-year gain.

11 IRS Publication 544, Sales and Dispositions of Assets.



87

84.4 78 73 73 73.5 73.5 70 39.6 30 32.3 33 33 35 35 25 25 25 28 20 20 15 15 15 12 1916 15% 15%

1920 73% 73%

1930 12% 25%

1940 30% 78%

1950 25%

84.4%

1960 25%

73.5%

1970 32.3% 73.5%

1980 28% 70%

1990 33% 33%

2000 20%

39.6%

2005 15% 35%

2010 20% 35%

Top Capital Gains Tax Rate Top Individual Income Tax Rate

Capital Gains and Income Tax Top Rates, 1916 - 2010



88

Sale of Personal Residence Tax Summary Gain May Be Excluded from Taxable Income There may be little or no tax on the gain from the sale of a personal residence that is the taxpayer’s main home. A gain of up to $250,000 ($500,000 for joint returns) may be excluded from taxable income. Joint owners who are not married may each exclude up to $250,000 of gain. This exclusion may be claimed repeatedly (unlike previous regulations which allowed a one-in-a-lifetime exclusion), but only once every two years. Two Tests To qualify as a main home, two tests must be met. During the five-year period* ending on the date of sale, the taxpayer must meet the following tests:

Ownership test–owned the home for at least two years.

- and -

Use test–lived in the home as a main home for at least two years.

* Special Provision for Military and Foreign Service Personnel In December 2003, legislation was enacted to extend the qualification period to ten years for military and Foreign Service personnel who have foreign assignments and cannot meet the two-out-of-five year ownership and use tests. Use of the home as a main residence for two years is required, but up to ten years is allowed to qualify for the exclusion. Reporting the Sale Unless the taxpayer has a taxable gain, it is not necessary to report the sale. A taxable gain is reported on Schedule D (Form 1040). For more information about tax treatment of the sale of a personal residence and worksheets for calculating the gain, refer to IRS Publication 523, Selling Your Home.



89

Excerpt from www.irs.gov Tax Topic 415 - Renting Residential and Vacation Property (formerly Renting Vacation Property and Renting to Relatives) If you receive rental income from renting to others a dwelling unit, such as a house or an apartment, to others, you may deduct certain expenses. These expenses, which may include interest, taxes, casualty losses, maintenance, utilities, insurance, and depreciation, will reduce the amount of rental income that is taxed. You will generally report such income and expenses on Schedule E, Form 1040. If you are renting to make a profit and do not use the dwelling unit as a home, your deductible rental expenses can be more than your gross rental income, subject to certain limits. For information on these limits, refer to Topic 425, Passive Activities – Losses and Credits. However, if you rent a dwelling unit that you also use as a home, your deductible rental expenses are subject to stricter limitations. You are considered to use a dwelling unit as a home if you use it for personal purposes during the tax year for more than the greater of: 14 days or 10% of the total days it is rented to others at a fair rental price. It is possible that you will use more than one dwelling unit as a home during the year. For example, if you live in your main home for 11 months, your home is a dwelling unit. If you live in your vacation home for the other 30 days of the year, your vacation home is also a dwelling unit, unless you rent your vacation home to others at a fair rental value for more than 300 days during the year. A day of personal use of a dwelling unit is any day that it is used by: You or any other person who has an interest in it, unless you rent your interest to

another owner as his or her main home under a shared equity financing agreement; A member of your family or of a family of any other person who has an interest in it,

unless the family member uses it as his or her main home and pays a fair rental price; Anyone under an agreement that lets you use some other dwelling unit; or Anyone at less than fair rental price.

If you use the dwelling unit for both rental and personal purposes, you generally must divide your total expenses between the rental use and the personal use based on the number of days used for each purpose. However, you will not be able to deduct all your expenses of rental use if your rental expenses exceed your gross rental income. If you itemize your deductions on Schedule A, Form 1040, you may still be able to deduct mortgage interest, property taxes, and casualty losses on that schedule. There is a special rule if you use a dwelling as a home and rent it for fewer than 15 days. In this case, do not report any of the rental income and do not deduct any expenses as rental expenses. Another special rule applies if you rent part of your home to your employer and provide services for your employer in that rented space. In this case, report the rental income, but do not deduct any expenses as rental expenses. Refer to Publication 527, Residential Rental Property (Including Rental of Vacation Homes).



90

Case Study Answers Case Study 4.1: Asking the Right Questions Suggested Answers: • What is the estimated amount of capital gains or capital gains tax to be reported if an

exchange does not take place? The tax benefits of an exchange should be greater than the costs of the transaction.

• Will the exchanger carry back any seller financing? A note received in an exchange is not property of like kind.

• Who will sign the purchase agreement for the replacement property? The intermediary may sign on behalf of the exchanger. Direct deeding is allowable (exchanger signs al agreements) if the intent to exchange is clearly indicated and documented with a proper paper trail.

• What type of property is being sold and how has the owner used it? • How will the owner use the replacement property? The property must be qualified

property, real estate used in trade or business, or held for investment. • What is the status of the sale and was the intent to exchange indicated in the contract to

sell? If the sale is pending and scheduled to close, a paper trail can be initiated in the contract or by addendum that establishes the seller’s intent to acquire a replacement property by exchange.

• When is/was the closing date? The closing date is important because the exchange time clock (45 days to identify/180 days or tax due date to close) starts from this date.

• Will/is an intermediary holding the sale proceeds? The seller cannot have actual or constructive receipt of the sale proceeds.

• What are the sale price, mortgage balance, transaction costs, and amount of cash collected by the intermediary? These amounts are important in calculating: gain the exchanger would report if the property were sold outright; the amount of equity to be exchanged; and possibility of retained cash, net mortgage relief, or boot in relation to a replacement property.



91

Case Study 4.2: A Deferred Exchange Exchange Basis Adjustment Form


1. Market value of property conveyed ................. $ 1,200,000 2. Less disposition costs ..................................... $ 84,000 3. Less basis at time of disposition ..................... $ 555,000 4. Equals: realized gain (loss) * $* 561,000



Sum of unlike property received A. Cash .......................................................... $ 26,000 B. Boot ........................................................... $ 60,000 C. Net loan relief ............................................ $ 0

Sum of A, B & C above ............................................... $

$ or $ 86,000 (Realized gain–line 4) (Sum of A, B, & C above)

5. Recognized Gain............................................. $* 86,000



6. Realized gain (line 4) ...................................... $ 561,000

7. Less recognized gain (line 5) .......................... $ 86,000 8. Equals: unrecognized gain.............................. $ 475,000


9. Market value of acquired property................... $ 2,000,000

10. Less unrecognized gain (line 8) or Plus realized gain (line 4) if loss ...........................................

$

475,000

11. Plus acquisition costs...................................... $ 12. Equals: substitute basis .................................. $ 1,525,000






92

Case Study 4.3: Tenants-in Common • Why is a tenants-in-common exchange a good idea for Matt?

A TIC property accomplishes his goal of reducing day-to-day management of properties while continuing to produce an income stream. Because TIC investments were already packaged the sponsors, replacement properties could be quickly identified. The exchange defers tax on the disposition of the property. Combined basis on the two properties was $1 million, which would result in a large tax bill. In the future, accumulated capital gains, and the resulting tax, will be forgiven when his son inherits the property.

• Based on the value of Matt’s properties, what would be the maximum value for identified properties? Because only one property has been identified there is no limit on the maximum value; a maximum of three replacement properties may be identified without regard to FMV. If more than three properties were identified the maximum value of identified properties would be $3,300,000.

• What steps would you advise Matt and Ray to take in the future to assure a less stressful transaction? Make an earlier selection of a real estate broker experienced in 1031 exchanges and TIC properties; the broker can provide valuable guidance in structuring the transaction. Identify replacement properties earlier, which will allow more time to structure the transaction and revoke an identification of an unwanted property. Initiate the transaction earlier in the year. Assuming Matt is a calendar year taxpayer, the exchange must be completed by April 15th, which is 150 days elapsed time.

• What are the advantages and disadvantages of “shopping the market” with competing real estate brokers? Advantage: investor can evaluate the services a broker will offer. Disadvantage: brokers generally have access to the same inventory of TIC investments, so “shopping the market” can be confusing.

• Why would money flowing from the stock market complicate closing on identified properties? Large amounts of cash flowing out of a volatile stock market can increase the demand for high-grade real estate investments as investors seek greater stability, return, and a steady revenue stream. The result is too many dollars chasing too few TIC investment opportunities.

• Why did Matt need the proceeds from both properties to make the TIC investment? Most TIC investments generally require a minimum investment of $250,000 or more. The equity from the first property to close, the duplex, was $125,000.

• How would the real estate broker be compensated? Assuming the real estate broker is not a licensed securities representative, the real estate broker can be paid a consulting fee from the proceeds held by the QI. The securities broker cannot reduce his commission to offset the real estate consulting fee.



93

Case Study 4.4: The Family Farm • If an equivalent amount of land is exchanged, what will be the annual income on the

replacement property? If an equivalent amount of land is exchanged, what will be the annual income on the replacement property? 500 relinquished acres @$4500 per acre = $2,250,000 $2,250,000 / $1850 = 1216.216 acres 1216 acres x $150 per acre = $182,400.

• What are the pros and cons of the deal for the Howard family? Do you think the deal will

accomplish the Howards’ goals? Pros: - Family can continue farming and increase both acreage and income. - Capital gains tax will be avoided on the sale of the family farm. - Income from replacement property can probably accomplish the Howard’s financial goals; the family’s annual income is currently $62,000. - The sons can eventually inherit the replacement property with a stepped up basis and tax on accumulated capital gains forgiven. Cons: - The family will have to relocate. - Community reaction may be difficult to experience. - The larger acreage will also likely increase operating expenses.



94

Sample IRS Forms

4I.R.S. SPECIFICATIONS TO BE REMOVED BEFORE PRINTING

DO NOT PRINT — DO NOT PRINT — DO NOT PRINT — DO NOT PRINT

TLS, have youtransmitted all Rtext files for thiscycle update?

Date

Action

Revised proofsrequested

Date Signature

O.K. to print

INSTRUCTIONS TO PRINTERSFORM 4797, PAGE 1 of 2MARGINS: TOP 13 mm (1⁄2 "), CENTER SIDES. PRINTS: HEAD TO HEADPAPER: WHITE WRITING, SUB. 20. INK: BLACKFLAT SIZE: 216 mm (8 1/2") � 279 mm (11")PERFORATE: (NONE)

Sales of Business Property(Also Involuntary Conversions and Recapture Amounts

Under Sections 179 and 280F(b)(2))Department of the Treasury Internal Revenue Service

Attachment Sequence No. 27�Attach to your tax return.

Identifying numberName(s) shown on return

Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions From OtherThan Casualty or Theft—Most Property Held More Than 1 Year (see instructions)

Enter the gross proceeds from sales or exchanges reported to you for 2005 on Form(s) 1099-B or 1099-S (or substitutestatement) that you are including on line 2, 10, or 20 (see instructions)

11

(f) Cost or otherbasis, plus

improvements andexpense of sale

(e) Depreciationallowed or

allowable sinceacquisition

(g) Gain or (loss)Subtract (f) from the

sum of (d) and (e)

(c) Date sold(mo., day, yr.)

(b) Date acquired(mo., day, yr.)

(a) Descriptionof property

(d) Grosssales price

2

Gain, if any, from Form 4684, line 423

Section 1231 gain from installment sales from Form 6252, line 26 or 374

Gain, if any, from line 32, from other than casualty or theft

5

Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows:

6

7

Partnerships (except electing large partnerships) and S corporations. Report the gain or (loss) following theinstructions for Form 1065, Schedule K, line 10, or Form 1120S, Schedule K, line 9. Skip lines 8, 9, 11, and 12 below.

Individuals, partners, S corporation shareholders, and all others. If line 7 is zero or a loss, enter the amountfrom line 7 on line 11 below and skip lines 8 and 9. If line 7 is a gain and you did not have any prior year section1231 losses, or they were recaptured in an earlier year, enter the gain from line 7 as a long-term capital gainon the Schedule D filed with your return and skip lines 8, 9, 11, and 12 below.

Nonrecaptured net section 1231 losses from prior years (see instructions)89 Subtract line 8 from line 7. If zero or less, enter -0-. If line 9 is zero, enter the gain from line 7 on line 12 below.

If line 9 is more than zero, enter the amount from line 8 on line 12 below and enter the gain from line 9 as along-term capital gain on the Schedule D filed with your return (see instructions)

Ordinary Gains and Losses (see instructions)Ordinary gains and losses not included on lines 11 through 16 (include property held 1 year or less):

Loss, if any, from line 7

10

Gain, if any, from line 7 or amount from line 8, if applicable

11

Gain, if any, from line 31

12

Net gain or (loss) from Form 4684, lines 34 and 41a

13

Ordinary gain from installment sales from Form 6252, line 25 or 36

14

15

Combine lines 10 through 16

16

b

If the loss on line 11 includes a loss from Form 4684, line 38, column (b)(ii), enter that part of the loss here. Enterthe part of the loss from income-producing property on Schedule A (Form 1040), line 27, and the part of theloss from property used as an employee on Schedule A (Form 1040), line 22. Identify as from “Form 4797, line18a.” See instructions

Redetermine the gain or (loss) on line 17 excluding the loss, if any, on line 18a. Enter here and on Form 1040,line 14

Form 4797 (2005)For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 13086I

Part I

Part II

OMB No. 1545-0184

Section 1231 gain or (loss) from like-kind exchanges from Form 8824

Ordinary gain or (loss) from like-kind exchanges from Form 8824

17

3

4

5

6

7

8

11

12

13

14

15

16

17

18a

18b

(99)

9

( )

4797Form

a

For all except individual returns, enter the amount from line 17 on the appropriate line of your return and skiplines a and b below. For individual returns, complete lines a and b below:

18

�See separate instructions.

2005



INSTRUCTIONS TO PRINTERSFORM 4797, PAGE 2 of 2MARGINS: TOP 13 mm (1⁄2 "), CENTER SIDES. PRINTS: HEAD TO HEADPAPER: WHITE WRITING, SUB. 20. INK: BLACKFLAT SIZE: 216 mm (81⁄2 ") � 279 mm (11")PERFORATE: (NONE)

Page 2Form 4797 (2005)

Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255(see instructions)

(c) Date sold(mo., day, yr.)

(b) Date acquired(mo., day, yr.)(a) Description of section 1245, 1250, 1252, 1254, or 1255 property:

A

BC

D

Property DProperty CProperty BProperty AThese columns relate to the properties on lines 19A through 19D. �

Gross sales price (Note: See line 1 before completing.)

Cost or other basis plus expense of sale

19

Depreciation (or depletion) allowed or allowable

20

Adjusted basis. Subtract line 22 from line 21

21

Total gain. Subtract line 23 from line 20

22

If section 1245 property:

23

a Depreciation allowed or allowable from line 22b Enter the smaller of line 24 or 25a

If section 1250 property: If straight line depreciation was used, enter-0- on line 26g, except for a corporation subject to section 291.

24

Additional depreciation after 1975 (see instructions)a

Applicable percentage multiplied by the smaller of line 24 orline 26a (see instructions)

b

Subtract line 26a from line 24. If residential rental property orline 24 is not more than line 26a, skip lines 26d and 26e

c

Additional depreciation after 1969 and before 1976d

Enter the smaller of line 26c or 26def Section 291 amount (corporations only)g Add lines 26b, 26e, and 26f

25

If section 1252 property: Skip this section if you did notdispose of farmland or if this form is being completed for apartnership (other than an electing large partnership).

Soil, water, and land clearing expensesaLine 27a multiplied by applicable percentage (see instructions)bEnter the smaller of line 24 or 27bc


26

Intangible drilling and development costs, expenditures fordevelopment of mines and other natural deposits, andmining exploration costs (see instructions)

a

Enter the smaller of line 24 or 28ab


27

Applicable percentage of payments excluded from incomeunder section 126 (see instructions)

a

Enter the smaller of line 24 or 29a (see instructions)b

Summary of Part III Gains. Complete property columns A through D through line 29b before going to line 30.

Total gains for all properties. Add property columns A through D, line 24

28

Add property columns A through D, lines 25b, 26g, 27c, 28b, and 29b. Enter here and on line 13

29

Subtract line 31 from line 30. Enter the portion from casualty or theft on Form 4684, line 36. Enter the portion fromother than casualty or theft on Form 4797, line 6

30

3132

33

Recapture Amounts Under Sections 179 and 280F(b)(2) When Business Use Drops to 50% or Less(see instructions)

(b) Section 280F(b)(2)

(a) Section179

Section 179 expense deduction or depreciation allowable in prior years34 Recomputed depreciation (see instructions)35 Recapture amount. Subtract line 34 from line 33. See the instructions for where to report

Part IV

Part III

20

21

22

23

24

25a

26a

27a

28a

29a

26b

26c

26d

26e

26f

26g

27b

27c

28b

29b

25b

30

31

32

33

34

35

Form 4797 (2005)



TLS, have youtransmitted all Rtext files for thiscycle update?

Date

Action

Revised proofsrequested

Date Signature

O.K. to print

INSTRUCTIONS TO PRINTERSFORM 8824, PAGE 1 of 6.MARGINS: TOP 13mm (1⁄2 "), CENTER SIDES. PRINTS: HEAD TO HEADPAPER: WHITE WRITING, SUB. 20. INK: BLACKFLAT SIZE: 216 mm (81⁄2 ") � 279 mm (11")PERFORATE: (NONE)

OMB No. 1545-1190Like-Kind Exchanges8824Form(and section 1043 conflict-of-interest sales)

Department of the TreasuryInternal Revenue Service

� Attach to your tax return.AttachmentSequence No. 109

Identifying numberName(s) shown on tax return

Information on the Like-Kind Exchange

Description of like-kind property given up �1

Description of like-kind property received �2

/ /3Date like-kind property given up was originally acquired (month, day, year)3

/ /4Date you actually transferred your property to other party (month, day, year)4

/ /5Date like-kind property you received was identified by written notice to another party (month,day, year). See instructions for 45-day written notice requirement

5

/ /6Date you actually received the like-kind property from other party (month, day, year). See instructions6

7 Was the exchange of the property given up or received made with a related party, either directly or indirectly(such as through an intermediary)? See instructions. If “Yes,” complete Part II. If “No,” go to Part III

8 Name of related party Related party’s identifying number

Address (no., street, and apt., room, or suite no., city or town, state, and ZIP code)

Relationship to you

During this tax year (and before the date that is 2 years after the last transfer of property that was part of theexchange), did the related party directly or indirectly (such as through an intermediary) sell or dispose of anypart of the like-kind property received from you in the exchange?

9

During this tax year (and before the date that is 2 years after the last transfer of property that was part of theexchange), did you sell or dispose of any part of the like-kind property you received?

10

If both lines 9 and 10 are “No” and this is the year of the exchange, go to Part III. If both lines 9 and 10 are “No” and this is not theyear of the exchange, stop here. If either line 9 or line 10 is “Yes,” complete Part III and report on this year’s tax return the deferredgain or (loss) from line 24 unless one of the exceptions on line 11 applies.

11 If one of the exceptions below applies to the disposition, check the applicable box:

The disposition was after the death of either of the related parties.

The disposition was an involuntary conversion, and the threat of conversion occurred after the exchange.

You can establish to the satisfaction of the IRS that neither the exchange nor the disposition had tax avoidance as itsprincipal purpose. If this box is checked, attach an explanation (see instructions).

Form 8824 (2005)For Paperwork Reduction Act Notice, see page 5. Cat. No. 12311A

Part I

NoYes

NoYes

Note: If the property described on line 1 or line 2 is real or personal property located outside the United States, indicate the country.

a

b

c

Part IINoYes

2005

Related Party Exchange Information



INSTRUCTIONS TO PRINTERFORM 8824, PAGE 2 of 6MARGINS: TOP 13 mm (1⁄2 "), CENTER SIDES. PRINTS: HEAD TO HEADPAPER: WHITE WRITING, SUB. 20. INK: BLACKFLAT SIZE: 216 mm (81⁄2 ") � 279 mm (11")PERFORATE: (NONE)

Page 2Form 8824 (2005)

Deferral of Gain From Section 1043 Conflict-of-Interest Sales

Description of divested property �

Description of replacement property �

/ /29Date divested property was sold (month, day, year)

30Sales price of divested property (see instructions)

26

31

27

Basis of divested property

Realized gain. Subtract line 31 from line 30

28

33

29

Cost of replacement property purchased within 60 days after dateof sale

30

34

31

Ordinary income under recapture rules. Enter here and on Form 4797, line 10 (see instructions)

Basis of replacement property. Subtract line 37 from line 33

32

35

Note: This part is to be used only by officers or employees of the executive branch of the Federal Government for reportingnonrecognition of gain under section 1043 on the sale of property to comply with the conflict-of-interest requirements. This partcan be used only if the cost of the replacement property is more than the basis of the divested property.

Name(s) shown on tax return. Do not enter name and social security number if shown on other side. Your social security number

33

34

3536

37

38

Subtract line 33 from line 30. If zero or less, enter -0-

Subtract line 35 from line 34. If zero or less, enter -0-. If more than zero, enter here and onSchedule D or Form 4797 (see instructions)

Deferred gain. Subtract the sum of lines 35 and 36 from line 32

36

Part IV

Form 8824 (2005)

Enter the number from the upper right corner of your certificate of divestiture. (Do not attach acopy of your certificate. Keep the certificate with your records.) �

37

38

32

–

Caution: If you transferred and received (a) more than one group of like-kind properties or (b) cash or other (not like-kind) property,see Reporting of multi-asset exchanges in the instructions.

Note: Complete lines 12 through 14 only if you gave up property that was not like-kind. Otherwise, go to line 15.12Fair market value (FMV) of other property given up121313 Adjusted basis of other property given up

Gain or (loss) recognized on other property given up. Subtract line 13 from line 12. Report thegain or (loss) in the same manner as if the exchange had been a sale

1414

15 Cash received, FMV of other property received, plus net liabilities assumed by other party, reduced(but not below zero) by any exchange expenses you incurred (see instructions) 15

16FMV of like-kind property you received1617Add lines 15 and 1617

Adjusted basis of like-kind property you gave up, net amounts paid to other party, plus anyexchange expenses not used on line 15 (see instructions)

181819Realized gain or (loss). Subtract line 18 from line 1719

Enter the smaller of line 15 or line 19, but not less than zero20 202121 Ordinary income under recapture rules. Enter here and on Form 4797, line 16 (see instructions)

Basis of like-kind property received. Subtract line 15 from the sum of lines 18 and 23

2222

Realized Gain or (Loss), Recognized Gain, and Basis of Like-Kind Property Received

2324 Deferred gain or (loss). Subtract line 23 from line 19. If a related party exchange, see instructions

Subtract line 21 from line 20. If zero or less, enter -0-. If more than zero, enter here and on ScheduleD or Form 4797, unless the installment method applies (see instructions)Recognized gain. Add lines 21 and 22

25

232425

Part III

Caution: If the property given up was used previously or partly as a home, see Property usedas home in the instructions.




Page 3Form 8824 (2005)

Section references are to the InternalRevenue Code unless otherwise noted.

General Instructions

Purpose of FormUse Parts I, II, and III of Form 8824 toreport each exchange of business orinvestment property for property of a likekind. Certain members of the executivebranch of the Federal Government use PartIV to elect to defer gain onconflict-of-interest sales.

If during the current tax year youtransferred property to another party in alike-kind exchange, you must file Form8824 with your tax return for that year.Also file Form 8824 for the 2 yearsfollowing the year of a related partyexchange (see the instructions for line 7 onpage 4).

Like-Kind ExchangesGenerally, if you exchange business orinvestment property solely for business orinvestment property of a like kind, no gainor loss is recognized under section 1031.If, as part of the exchange, you alsoreceive other (not like-kind) property ormoney, gain is recognized to the extent ofthe other property and money received,but a loss is not recognized.

Section 1031 does not apply toexchanges of inventory, stocks, bonds,notes, other securities or evidence ofindebtedness, or certain other assets. Seesection 1031(a)(2). In addition, section 1031does not apply to certain exchangesinvolving tax-exempt use property subjectto a lease. See section 470(e)(4).

Multiple exchanges. If you made morethan one like-kind exchange, you may fileonly a summary Form 8824 and attachyour own statement showing all theinformation requested on Form 8824 foreach exchange. Include your name andidentifying number at the top of each pageof the statement. On the summary Form8824, enter only your name and identifyingnumber, “Summary” on line 1, the totalrecognized gain from all exchanges on line23, and the total basis of all like-kindproperty received on line 25.

Real properties generally are of like kind,regardless of whether they are improved orunimproved. However, real property in theUnited States and real property outside theUnited States are not like-kind properties.

When To File

Deferred exchanges. A deferred exchangeoccurs when the property received in theexchange is received after the transfer ofthe property given up. For a deferredexchange to qualify as like-kind, you mustcomply with the 45-day written notice andreceipt requirements explained in theinstructions for lines 5 and 6.

Like-kind property. Properties are of likekind if they are of the same nature orcharacter, even if they differ in grade orquality. Personal properties of a like classare like-kind properties. However, livestockof different sexes are not like-kindproperties. Also, personal property usedpredominantly in the United States andpersonal property used predominantlyoutside the United States are not like-kindproperties. See Pub. 544, Sales and OtherDispositions of Assets, for more details.

Multi-asset exchanges. A multi-assetexchange involves the transfer and receiptof more than one group of like-kindproperties. For example, an exchange ofland, vehicles, and cash for land andvehicles is a multi-asset exchange. Anexchange of land, vehicles, and cash forland only is not a multi-asset exchange.The transfer or receipt of multipleproperties within one like-kind group isalso a multi-asset exchange. Special rulesapply when figuring the amount of gainrecognized and your basis in propertiesreceived in a multi-asset exchange. Fordetails, see Regulations section 1.1031(j)-1.

Reporting of multi-asset exchanges. Ifyou transferred and received (a) more thanone group of like-kind properties or(b) cash or other (not like-kind) property,do not complete lines 12 through 18 ofForm 8824. Instead, attach your ownstatement showing how you figured therealized and recognized gain, and enter thecorrect amount on lines 19 through 25.Report any recognized gains on ScheduleD; Form 4797, Sales of Business Property;or Form 6252, Installment Sale Income,whichever applies.

Lines 1 and 2. For real property, enter theaddress and type of property. For personalproperty, enter a short description. Forproperty located outside the United States,include the country.

Specific Instructions

Additional information. For moreinformation on like-kind exchanges, seesection 1031 and its regulations and Pub.544.

Line 5. Enter on line 5 the date of thewritten notice that identifies the like-kindproperty you received in a deferredexchange. To comply with the 45-daywritten notice requirement, the followingconditions must be met.

1. The like-kind property you receive in adeferred exchange must be designated inwriting as replacement property either in adocument you signed or in a writtenagreement signed by all parties to theexchange.

2. The document or agreement mustdescribe the replacement property in aclear and recognizable manner. Realproperty should be described using a legaldescription, street address, ordistinguishable name (for example,“Mayfair Apartment Building”).

Exchanges using a qualified exchangeaccommodation arrangement (QEAA). Ifproperty is transferred to an exchangeaccommodation titleholder (EAT) and heldin a QEAA, the EAT may be treated as thebeneficial owner of the property, theproperty transferred from the EAT to youmay be treated as property you received inan exchange, and the property youtransferred to the EAT may be treated asproperty you gave up in an exchange. Thismay be true even if the property you are toreceive is transferred to the EAT beforeyou transfer the property you are giving up.However, the property transferred to youmay not be treated as property received inan exchange if you previously owned itwithin 180 days of its transfer to the EAT.For details, see Rev. Proc. 2000-37 asmodified by Rev. Proc. 2004-51. Rev.Proc. 2000-37 is on page 308 of InternalRevenue Bulletin 2000-40 atwww.irs.gov/pub/irs-irbs/irb00-40.pdf. Rev.Proc. 2004-51 is on page 294 of InternalRevenue Bulletin 2004-33 atwww.irs.gov/irb/2004-33_IRB/ar13.html.

Property used as home. If the propertygiven up was owned and used as yourhome during the 5-year period ending onthe date of the exchange, you may be ableto exclude part or all of any gain figured onForm 8824. For details on the exclusion(including how to figure the amount of theexclusion), see Pub. 523, Selling YourHome. Fill out Form 8824 according to itsinstructions, with these exceptions:

1. Subtract line 18 from line 17. Subtractthe amount of the exclusion from theresult. Enter that result on line 19. On thedotted line next to line 19, enter “Section121 exclusion” and the amount of theexclusion.

2. On line 20, enter the smaller of:

3. Subtract line 15 from the sum of lines18 and 23. Add the amount of yourexclusion to the result. Enter that sum online 25.

a. Line 15 minus the exclusion, orb. Line 19.Do not enter less than zero.

Property used partly as home. If theproperty given up was used partly as ahome, you will need to use two separateForms 8824 as worksheets—one for thepart of the property used as a home andone for the part used for business orinvestment. Fill out only lines 15 through25 of each worksheet Form 8824. On theworksheet Form 8824 for the part of theproperty used as a home, follow steps (1)through (3) above, except that instead offollowing step (2), enter the amount fromline 19 on line 20. On the worksheet Form8824 for the part of the property used forbusiness or investment, follow steps (1)through (3) above only if you can excludeat least part of any gain from the exchangeof that part of the property; otherwise,complete the form according to itsinstructions. Enter the combined amountsfrom lines 15 through 25 of both worksheetForms 8824 on the Form 8824 you file. Donot file either worksheet Form 8824.

More information. For details, see Rev.Proc. 2005-14 on page 528 of InternalRevenue Bulletin 2005-7 atwww.irs.gov/irb/2005-07_IRB/ar10.html.




Page 4Form 8824 (2005)

Line 7. Special rules apply to like-kindexchanges made with related parties,either directly or indirectly. A related partyincludes your spouse, child, grandchild,parent, grandparent, brother, sister, or arelated corporation, S corporation,partnership, trust, or estate. See section1031(f).

Line 11c. If you believe that you canestablish to the satisfaction of the IRS thattax avoidance was not a principal purposeof both the exchange and the disposition,attach an explanation. Generally, taxavoidance will not be seen as a principalpurpose in the case of:

Lines 12, 13, and 14. If you gave up otherproperty in addition to the like-kindproperty, enter the fair market value (FMV)and the adjusted basis of the otherproperty on lines 12 and 13, respectively.The gain or (loss) from this property isfigured on line 14 and must be reported onyour return. Report gain or (loss) as if theexchange were a sale.Line 15. Include on line 15 the sum of:● Any cash paid to you by the other party,● The FMV of other (not like-kind) propertyyou received, if any, and● Net liabilities assumed by the otherparty—the excess, if any, of liabilities(including mortgages) assumed by theother party over the total of (a) anyliabilities you assumed, (b) cash you paidto the other party, and (c) the FMV of theother (not like-kind) property you gave up.

● A nonrecourse liability generally istreated as assumed by the party receivingthe property subject to the liability.However, if an owner of other assetssubject to the same liability agrees with theparty receiving the property to, and isexpected to, satisfy part or all of theliability, the amount treated as assumed isreduced by the smaller of (a) the amount ofthe liability that the owner of the otherassets has agreed to and is expected tosatisfy or (b) the FMV of those otherassets.

Reduce the sum of the above amounts(but not below zero) by any exchangeexpenses you incurred. See the exampleon this page.

The following rules apply in determiningthe amount of liability treated as assumed.● A recourse liability (or portion thereof) istreated as assumed by the party receivingthe property if that party has agreed to andis expected to satisfy the liability (orportion thereof). It does not matter whetherthe party transferring the property hasbeen relieved of the liability.

● The 180th day after the date youtransferred the property given up in theexchange.

● The due date (including extensions) ofyour tax return for the year in which youtransferred the property given up.

If the related party (either directly orindirectly) or you dispose of the propertyreceived in an exchange before the datethat is 2 years after the last transfer ofproperty from the exchange, the deferredgain or (loss) from line 24 must be reportedon your return for the year of disposition(unless an exception on line 11 applies).

If you are filing this form for 1 of the 2years following the year of the exchange,complete Parts I and II. If both lines 9 and10 are “No,” stop.

Line 18. Include on line 18 the sum of:

● Net amount paid to the other party—theexcess, if any, of the total of (a) anyliabilities you assumed, (b) cash you paidto the other party, and (c) the FMV of theother (not like-kind) property you gave upover any liabilities assumed by the otherparty.

See Regulations section 1.1031(d)-2 andthe following example for figuring amountsto enter on lines 15 and 18.

● The adjusted basis of the like-kindproperty you gave up,● Exchange expenses, if any (except forexpenses used to reduce the amountreported on line 15), and

● An exchange made with a related partythrough an intermediary (such as aqualified intermediary or an exchangeaccommodation titleholder, as defined inPub. 544), or● An exchange made by a disregardedentity (such as a single member limitedliability company) if you or a related partyowned that entity.

An exchange made indirectly with arelated party includes:

If either line 9 or line 10 is “Yes,” and anexception on line 11 applies, check theapplicable box on line 11, attach anyrequired explanation, and stop. If no line11 exceptions apply, complete Part III.

An exchange structured to avoid therelated party rules is not a like-kindexchange. Do not report it on Form 8824.Instead, you should report the disposition ofthe property given up as if the exchangehad been a sale. See section 1031(f)(4).Such an exchange includes the transfer ofproperty you gave up to a qualifedintermediary in exchange for property youreceived that was formerly owned by arelated party if the related party receivedcash or other (not like-kind) property for theproperty you received, and you used thequalified intermediary to avoid theapplication of the related party rules. SeeRev. Rul. 2002-83 for more details. You canfind Rev. Rul. 2002-83 on page 927 ofInternal Revenue Bulletin 2002-49 atwww.irs.gov/pub/irs-irbs/irb02-49.pdf.

● A disposition of property in anonrecognition transaction,● An exchange in which the related partiesderive no tax advantage from the shiftingof basis between the exchangedproperties, or● An exchange of undivided interests indifferent properties that results in eachrelated party holding either the entireinterest in a single property or a largerundivided interest in any of the properties.

The property must be received by theearlier of the following dates.

B enters $30,000 on line 15—the excessof the $150,000 of liabilities assumed by Aover the total ($120,000) of the $80,000 ofliabilities B assumed and the $40,000 cashB paid. B enters on line 18 only theadjusted basis of $175,000 because thetotal of the $80,000 of liabilities B assumedand the $40,000 cash B paid does notexceed the $150,000 of liabilities assumedby A.Line 21. If you disposed of section 1245,1250, 1252, 1254, or 1255 property (seethe instructions for Part III of Form 4797),you may be required to recapture asordinary income part or all of the realizedgain (line 19). Figure the amount to enteron line 21 as follows:

A transfers his apartment house to Band receives in exchange B’s apartmenthouse plus $40,000 cash. A assumes themortgage on the apartment house receivedfrom B, and B assumes the mortgage onthe apartment house received from A.

A enters on line 15 only the $40,000cash received from B. The $80,000 ofliabilities assumed by B is not includedbecause it does not exceed the $150,000of liabilities A assumed. A enters $170,000on line 18—the $100,000 adjusted basis,plus the $70,000 excess of the liabilities Aassumed over the liabilities assumed by B($150,000 - $80,000).

Example. A owns an apartment housewith an FMV of $220,000, an adjustedbasis of $100,000, and subject to amortgage of $80,000. B owns anapartment house with an FMV of $250,000,an adjusted basis of $175,000, and subjectto a mortgage of $150,000.

Section 1245 property. Enter the smallerof:

1. The total adjustments for deductions(whether for the same or other property)allowed or allowable to you or any other

3. No later than 45 days after the dateyou transferred the property you gave up:

b. All parties to the exchange must signthe written agreement designating thereplacement property.

a. You must send, fax, or hand deliverthe document you signed to the personrequired to transfer the replacementproperty to you (including a disqualifiedperson) or to another person involved inthe exchange (other than a disqualifiedperson), or

Generally, a disqualified person is eitheryour agent at the time of the transaction ora person related to you. For more details,see Regulations section 1.1031(k)-1(k).Note. If you received the replacementproperty before the end of the 45-dayperiod, you automatically are treated ashaving met the 45-day written noticerequirement. In this case, enter on line 5the date you received the replacementproperty.

Line 6. Enter on line 6 the date youreceived the like-kind property from theother party.

Report the deferred gain or (loss) from line24 on this year’s tax return as if the exchangehad been a sale.



INSTRUCTIONS TO PRINTERFORM 8824, PAGE 5 of 6. PAGE 6 IS BLANK.MARGINS: TOP 13 mm (1⁄2 "), CENTER SIDES. PRINTS: HEAD TO HEADPAPER: WHITE WRITING, SUB. 20. INK: BLACKFLAT SIZE: 216 mm (81⁄2 ") � 279 mm (11")PERFORATE: (NONE)

Page 5Form 8824 (2005)

Line 24. If line 19 is a loss, enter it online 24. Otherwise, subtract the amount online 23 from the amount on line 19 andenter the result. For exchanges with relatedparties, see the instructions for line 7 onpage 4.

Line 25. The amount on line 25 is yourbasis in the like-kind property you receivedin the exchange. Your basis in otherproperty received in the exchange, if any, isits FMV.

If you sell property at a gain according to acertificate of divestiture issued by theOffice of Government Ethics (OGE) andpurchase replacement property (permittedproperty), you may elect to defer part or allof the realized gain. You must recognizegain on the sale only to the extent that theamount realized on the sale is more thanthe cost of replacement propertypurchased within 60 days after the sale.(You also must recognize any ordinaryincome recapture.) Permitted property isany obligation of the United States or anydiversified investment fund approved bythe OGE.

Complete Part IV of Form 8824 only if thecost of the replacement property is morethan the basis of the divested property andyou elect to defer the gain. Otherwise,report the sale on Schedule D or Form4797, whichever applies.

Line 30. Enter the amount you receivedfrom the sale of the divested property,minus any selling expenses.Line 35. Follow these steps to determinethe amount to enter.

2. Enter on Form 8824, line 35, theamount from Form 4797, line 31. Do notattach the Form 4797 used as a worksheetto your return.

Line 36. If you sold a capital asset, enterany capital gain from line 36 on ScheduleD. If you sold property used in a trade orbusiness (or any other asset for which thegain is treated as ordinary income), reportthe gain on Form 4797, line 2 or line 10,column (g). In column (a), write “From Form8824, line 36.” Do not complete columns(b) through (f).

Section 1043Conflict-of-Interest Sales(Part IV)

1. Use Part III of Form 4797 as aworksheet to figure ordinary income underthe recapture rules.

3. Report the amount from line 35 onForm 4797, line 10, column (g). In column(a), write “From Form 8824, line 35.” Donot complete columns (b) through (f).

Paperwork Reduction Act Notice. Weask for the information on this form tocarry out the Internal Revenue laws of theUnited States. You are required to give usthe information. We need it to ensure thatyou are complying with these laws and toallow us to figure and collect the rightamount of tax.

You are not required to provide theinformation requested on a form that issubject to the Paperwork Reduction Actunless the form displays a valid OMBcontrol number. Books or records relatingto a form or its instructions must beretained as long as their contents maybecome material in the administration ofany Internal Revenue law. Generally, taxreturns and return information areconfidential, as required by section 6103.

The time needed to complete and filethis form will vary depending on individualcircumstances. The estimated burden forindividual taxpayers filing this form isapproved under OMB control number1545-0074 and is included in the estimatesshown in the instructions for their individualincome tax return. The estimated burdenfor all other taxpayers who file this form isshown below.Recordkeeping 1 hr., 38 min.Learning about thelaw or the form 27 min.Preparing the form 59 min.

If you have comments concerning theaccuracy of these time estimates orsuggestions for making this form simpler,we would be happy to hear from you. Seethe instructions for the tax return withwhich this form is filed.

If the property you sold wasstock you acquired by exercisinga statutory stock option, you maybe treated as meeting the

holding periods that apply to such stock,regardless of how long you actually held thestock. This may benefit you if you do notdefer your entire gain, because it may allowyou to treat the gain as a capital gaininstead of ordinary income. For details, seesection 421(d) or Pub. 525.

TIP

Your basis in the replacement property isreduced by the amount of the deferred gain.If you made more than one purchase ofreplacement property, reduce your basis inthe replacement property in the order youacquired it.

1. See section 453(f)(6) to determine theinstallment sale income taxable for thisyear and report it on Form 6252.

4. If all the ordinary income is notrecaptured this year, report in future yearson Form 6252 the ordinary income up to thetaxable installment sale income, until it is allreported.Line 22. Report a gain from the exchangeof property used in a trade or business(and other noncapital assets) on Form4797, line 5 or line 16. Report a gain fromthe exchange of capital assets accordingto the Schedule D instructions for yourreturn. Be sure to use the date of theexchange as the date for reporting thegain. If the installment method applies tothis exchange, see section 453(f)(6) todetermine the installment sale incometaxable for this year and report it on Form6252.

3. Also enter this amount on Form 4797,line 15.

2. The gain shown on line 20, if any, plusthe FMV of non-section 1245 like-kindproperty received.Section 1250 property. Enter the smallerof:

1. The gain you would have had toreport as ordinary income because ofadditional depreciation if you had sold theproperty (see the Form 4797 instructionsfor line 26), or

2. The larger of:a. The gain shown on line 20, if any, orb. The excess, if any, of the gain in

item (1) above over the FMV of the section1250 property received.Section 1252, 1254, and 1255 property.The rules for these types of property aresimilar to those for section 1245 property.See Regulations section 1.1252-2(d) andTemporary Regulations section16A.1255-2(c) for details. If the installmentmethod applies to this exchange:

2. Enter on Form 6252, line 25 or 36, thesection 1252, 1254, or 1255 recaptureamount you figured on Form 8824, line 21.Do not enter more than the amount shownon Form 6252, line 24 or 35.

person for depreciation or amortization (upto the amount of gain shown on line 19), or

Copying, assembling, and sending the form to the IRS 33 min.