1

SECTION 1031 “LIKE-KIND” EXCHANGES A CLOSER LOOK FOR REAL ESTATE AGENTS

Introduction

One might ask, why go to the trouble of qualifying a transaction as a §1031 like-kind exchange? The Internal Revenue Code (hereinafter the “Code”) is tough enough to understand without digging into a complex section that could result in more tax complications. There are many answers: 1. The most obvious reason is for tax savings. Using this and other sections of the

code wisely, you can defer taxes, sometimes for the rest of your life. This means the money that would otherwise have gone to pay taxes is now available for investment, and it is, by the way, interest-free money. Because the taxes have been deferred under §1031, you are, in effect, using the money interest-free until a point far into the future.

2. You can increase the depreciable basis of the property you acquire by encumbering it with a larger debt.

3. You can add sheltered income to your investment portfolio by exchanging your unimproved land for income-producing improved land.

4. You can acquire a new property without cash, and can dispose of property via an exchange when an outright sale may not be possible in the economic climate at that time.

5. You can pick up some nontaxable cash by exchanging property, and then refinancing after the exchange.

6. You can diversify your holdings without paying the taxes associated with a sale and purchase of new holdings.

7. Because the tax savings to your client (or you, as an investor) are not only substantial, but can, with the benefits of leveraged purchasing, make a tremendous difference in the ultimate value of a real estate investment portfolio.

8. Because of the tax savings, the availability of a §1031 exchange may even make the difference between no sale at all and multiple sales (with multiple commissions). Just making the client aware of some of the possibilities of a §1031 exchange may open up all sorts of future transactions that would not otherwise have occurred to him or her.

9. Because of the flexibility built into the rules, it is not necessary to immediately find the property you wish to acquire and then arrange a simultaneous exchange for the property you are selling. In fact, there are ways to exchange your fully developed property for vacant land, build a custom building on that land, and have the entire transaction qualify under §1031.

In addition, we all know that the bar is always on the rise when it comes to the obligation of a professional real estate person to be competent and well-versed with respect to the latest tax, zoning, interest rates and all other matters that may impact a client’s plans. While we are all obviously liable for inaccurate or erroneous advice,

2

we also know we can be accountable for not offering information that a client might find valuable. Again, just the mention of what can possibly be accomplished under §1031 might be the difference between a disgruntled or even litigation-minded client and one who participates in numerous transactions that are more lucrative for you than typical sales and purchases of property. As we proceed through the course there will be numerous examples of how a particular transaction might work from a tax standpoint. While we will explain how many of the calculations are done, we will not go through every detail of the various tax calculations. Not only is it too time consuming, but those sorts of details are better left to an accountant or other professional that is accustomed to this area of taxation. Therefore, you need not be concerned with whether or not the tax result is exact to the penny. Your primary interest is in understanding how an exchange can make a substantial difference in the tax result in order that you can recognize the opportunities and explain them to your client. Finally, unless you are very familiar with some the terms used in discussing tax law, this would be a good time to review the Glossary at the end of the text. A thorough understanding of common income tax related terminology will make the discussion that follows much more understandable and much easier to follow. Of particular importance are the concepts of cost, basis, depreciation, realized gain, and recognized gain.

NOTE 1: The terms "he", "she", "his", "hers", etc., are used interchangeably throughout the course, and have no meaning beyond a gender-neutral indication of the person being described. Also, whenever the term "Code" is used, the reference is to the Internal Revenue Code, unless the context or the language specifically indicates otherwise. If the student desires more detailed language or deeper research into provisions of the Code, please refer to the Web Sites portion of the course.

(NOTE 2: In many segments of this course you will see a familiar pattern. First, the basic concepts or rules of the issue under discussion are outlined. Exceptions, things to look out for, or other relevant matters are mentioned. Finally, the student will be cautioned that the issue is more complex than it might appear from the discussion, and is encouraged to seek counsel with expertise in real estate tax law, including competent accountants and real estate/tax law attorneys, as well as to recommend such counsel to his/her client. While a certain amount of such advice is to be expected in any course dealing with legal issues presented to non-lawyers, it is particularly appropriate in the tax law setting. The purpose of the course is to provide the real estate professional with a better understanding of how a §1031 exchange works, and the variations of such a transaction that might be of interest to the real estate professional and his/her client. It is not intended to replace competent legal and accounting advice and direction, but neither is it intended as a "feeder" to push new clients to hire accounts and lawyers. Many professionals (especially lawyers and real estate agents) have found themselves in trouble by thinking they have the knowledge or expertise to handle an issue, only to find that a little knowledge is a dangerous thing. The most astute and successful agents/brokers are those with a broad range of knowledge of their profession and the various things that impact a

3

transaction (price, location, competition, financing, zoning, water, etc.), who use that knowledge to recognize areas in which a specialist is necessary, and are not reluctant to suggest or bring in the specialist(s).

I. The Basics

A. The Code

Before breaking the subject into manageable bites, let’s look at the Code section itself:

The full text of §1031 can be found in the Exhibits section at the end of the text, and we will look at various portions of the full text as we proceed through the course. In fact, it will be helpful in your study of this subject if you either print or remove the full text of §1031 to have handy For starters, however, the relevant portion of §1031 says:

4

“No gain or loss shall be recognized in 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.” (emphasis added)

Why such a provision in the first place? The answer most commentators and experts provide is that §1031 is an effort to recognize what is really occurring. A taxpayer (hereinafter sometimes referred to as “TP”) is changing the form of an investment, but it is still an investment. Selling a large tract of vacant land and then purchasing a new apartment building is much different than selling $100,000 worth of stock and purchasing that apartment building. In addition, we must remember that although the purpose of the Code is to raise money to fund the federal government’s programs, the Code is now and always has been a tool for social engineering and the encouragement of business. When the government determined that home ownership was a desirable matter, real estate taxes and interest paid on home loans became deductible. When the powers-that-be wanted to encourage the use of solar energy for domestic water and space heat, the Code sprouted rules allowing for a large same-year write off of the cost of purchasing and installing such equipment. Income tax rate cuts are viewed by many as stimulating to the national economy, and are enacted for that purpose.

So, understanding that a tax imposed on a theoretical gain where a TP was merely continuing the investment in an illiquid asset, §1031 was proposed and was enacted in 1939. A subsidiary reason was that discovering and pursuing the innumerable exchanges that took place each year was too great an administrative burden, so making this sort of transaction “legal” from a tax standpoint was beneficial to the IRS.

As with many portions of the Code, the simple language of the beginning of a section is then rendered extremely complex and confusing by several pages of definitions, exceptions, and “explanations” of what the section really means. In addition, there are, revenue rulings, private letter rulings, regulations, revenue procedures, and court cases to further muddy the water. While the course will at least mention and briefly discuss as many of the finer points as possible, remember that the purpose is to give you sufficient information to recognize possibilities and problems, not to make you an expert in §1031 exchanges.

What is a §1031 exchange? In its simplest form, your client, who will be the taxpayer or TP from this point forward, wants to sell his property and then invest the cash he gets out of it into a new, larger income property. (The Code refers to the property being sold as “relinquished” property, and the property being acquired as the “replacement” property. However, to make the discussion simpler and the properties easier to identify and remember, from this point forward, we will sometimes refer to the property being sold as the “old” property, and the property being purchased by TP as the “new” property.)

If the TP follows the initial plan, selling the old property, paying the tax on the profit, and then buying the new property, he will have less cash to invest, a chunk

5

of it obviously having gone to pay the federal, and perhaps state, income taxes on the profit. However, if he participates in a §1031 exchange, he can defer the tax and, in some instances, avoid paying it at all. Here’s how it works:

Example:

TP owns a building purchased 10 years ago at $30,000 TP’s basis is $20,000, and the property is worth $115,000, with a loan

of $50,000 TP wants to purchase a larger, more expensive property for investment

income.

If TP sells the property at $115,000, and paid $15,000 in closing costs and commissions, TP would have $50,000 cash to work with (115,000-$15,000 closing costs and $50,000 loan payoff). However, the tax on our imaginary transaction is $16,000, leaving only $34,000 to apply toward the next purchase.

However, if the TP does a like-kind exchange, the tax is deferred, which means our TP-client has $50,000 to apply to the next property. Obviously, this permits a higher down payment, lower purchase money loan, etc. In addition, it may earn you some additional commission money on the exchange, because you will also be involved in that transaction. In today’s market, $16,000 is probably not that significant. However, the same types of ratios can apply if you are dealing with larger numbers. If you were to merely add a couple of zeros to the foregoing numbers, and could therefore defer $1,600,000 in taxes rather than $16,000, the difference in your client’s bargaining position on the price of the new property and the terms of the acquisition loan is obviously significant. A purchaser with an additional $1,600,000 available as a down payment is in a much better position to deal with the seller and his, the client’s, banker.

NOTE: Like-kind exchanges are not limited to real estate. However, the rules are a little different for items of personal property, and, unless specifically pointed out or discussed, all comments and rules in the course deal with §1031 real estate exchanges.

6

B. Elements of a §1031 Exchange

For simplicity of discussion, we have broken these elements in to seven (7) requirements or rules that must be met to qualify the exchange under §1031. Many authorities consider qualified and like-kind as a single requirement, but we will consider them separately. These requirements are:

1. Both the old and new properties must qualify as investment or business use. If both properties qualify, almost any type of real estate can be exchanged.

2. The properties must be like-kind. 3. Unless it is a simultaneous exchange of properties, you have 45 days from

the closing of the sale of the old property to list or “identify” the new properties you may wish to acquire.

7

4. Again, if it is not a simultaneous exchange, you have 180 days to close the purchase of the new property or properties.

5. You must use a Qualified Intermediary (hereinafter “QI”) to prepare the paperwork and hold the proceeds of the sale of the old property. The QI must meet the definition of a QI in the Code.

6. Title to the new property must be taken exactly as you held title to the old property.

7. To defer all tax on the gain, you must pay a price for the new property at least equal to the selling price of the old property, and all cash from the sale must be reinvested in the new property.

We will look at each of these elements, and explore some of the interesting variations that can be of benefit to your client.

1. Qualified Property Both the old and new properties must be qualified and must be like kind. What does this mean? The Code divides real estate in to property held for business use (§1231), property held for investment (§1221), property held for personal use, and property held primarily for sale (also referred to as dealer property. Only property described under §§ 1221 and 1231 qualify for like-kind exchange treatment under §1031. Before we cover what property qualifies, note that there are six (6) specific types of property that do not qualify for §1031 treatment:

Stock in trade or other property held primarily for sale Stocks, bonds or notes Other securities or evidences of indebtedness or interest

8

Interests in a partnership (we will discuss later a big exception to this one)

Certificates of trust or beneficial interests Choses in action (a right to something such as payment of a

debt or damages for injury, that can be recovered in a lawsuit

With those exclusions in mind, let’s look at what does constitute qualified property for a §1031 exchange. Real estate used in business is §1232 property. The two types of business real estate are:

1. Property occupied by the TP and used in the TP’s business, such as the factory used to produce the TP’s products, and perhaps a storage warehouse to the TP uses to hold unsold inventory.

2. Rental income property. For example, a factory property owned by the TP and leased to a third party qualifies the property as being used in a trade or business. Likewise, an apartment building rented to third party tenants would also qualify as property used in a trade or business.

While both the new and the old property must be qualified under the rules, it is important to remember that they need not both be under the same definition. That is, if the old property is real estate used in business, such as the factory described in paragraph 1, above, and the new property is an apartment building as described in paragraph 2, both properties qualify and meet the “qualify” requirement of the Code.

Real Estate held for investment is §1221 property. It means property held primarily for appreciation in value due to location, the passage of time, and other factors outside the activities of the owner. Raw land, for example, is presumed to be held for appreciation. However, if your primary business is purchasing raw land, having it subdivided, and then building and selling homes, that land would almost certainly not be deemed investment real estate for purposes of §1031. On the other hand, even if the raw land had been purchased with future development in mind, if you did not develop it but at a later time offered it for sale, still as raw land, it most likely could be considered §1221 investment property and could be used in a §1031 exchange.

9

2. Like-kind Property

The next requirement is that the property be “like-kind”. This is sometimes considered the most confusing aspect of a §1031 discussion. “Like-kind” does not mean “the same as” or “identical to”. “Like-kind” is a term defined by the Code strictly for purposes of defining the rules under which the income tax on an exchange of this type of property can be deferred. Bearing this in mind, the test for like-kind is whether the real estate in question falls under the definition of either real estate used in a business (§1231) or real estate held for investment (§1221). In addition, both the old and the new property must be located in the same country to be deemed like-kind. Qualified property that is in any of the 50 United States

10

is like-kind if exchanged for other qualified property in any of the 50 United States. By process of elimination then, if either the old or new property is outside the U.S., it would not be qualified and would be treated as boot. (Glossary) However, both the old and the new properties are located in the same foreign country, are otherwise qualified properties, and would be subject to an income tax upon sale, they would most likely qualify for §1031 exchange treatment also.

3. Identification of New or Replacement Property (45-day rule)

Unless the exchange of properties is simultaneous, the next requirement is that the TP “identify” the property or properties that the TP may wish to acquire in exchange for the old property. One of the developments in the §1031 area has been the delayed or deferred exchange. It is unusual and very fortunate if a TP can locate just the new property she wants together with an owner that is willing to accept the TP’s property in an exchange. Even if that unusual circumstance should occur, the current owner of the new property will usually want to sell it, not just exchange it. That brings about the need to find a third party to purchase the old property once the exchange has been completed.

11

Faced with this type of problem, in the 1970’s a taxpayer named Starker sold some timberland using a Fortune 500 company as a qualified intermediary (don’t worry about the QI at this point, it will be covered a couple of sections on). Starker directed the QI to use the proceeds of the timberland sale to acquire several pieces of new property over a period of two years. He claimed this was a like-kind exchange under §1031. The IRS disagreed and the issue was fought through the courts and the 9th Circuit found the transactions qualified as §1031 like-kind exchanges under the Code as then written. The Congress was unhappy with what appeared to be an unlimited timeframe within which a taxpayer could use §1031. It therefore amended §1031 to add two time limits, the first being the 45-day identification rule in §1031(a)(3):

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 after the date on which the taxpayer transfers the property relinquished in the exchange, or

Although it states the requirement in a backward approach (the new property doesn’t qualify as like-kind if it is not identified on or before 45 days after the old property is sold), the net effect is once the old property is sold, the TP must “identify” the new property on or before 45 days have expired. These are calendar days, not business days, and no extensions are allowed. The next section will teach you what “identify” means, including the rules that can limit the TP’s choices. Identify does not just mean the TP lists a bunch of properties that she might wish to have in place of the old property. To properly identify the new property, the TP must:

Provide a specific description, such as name of building, address, legal description, etc.

Identify EITHER o Any three (3) properties, regardless of value, or o More than 3 properties so long as the total value of

those properties is not more than twice the value of the old property (the 200% rule).

If there is more than one old property transferred, and those transfers take place on different dates, the 45-day period begins on the date of the earliest transfer.

12

The list must be a written document, signed by the TP and hand delivered, mailed, telecopied, faxed or otherwise delivered to the QI or any other person involved in the exchange other than the TP.

If the TP wishes to do so, the list of identified properties can be amended by replacing one or more new identified properties IF, AND ONLY IF, the substitution is completed before the 45-day deadline expires.

Note that if the new property consists of more than one property, any property actually received before the 45 days expires is considered identified without further action by the TP.

4. The 180-day rule

Once again, if the transaction was not a simultaneous exchange, the TP must close the purchase of the new property no later than the earlier of: midnight of the180th day from the initial transfer of the old

property, or the due date (including extensions) for the TP’s return of the tax

imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.

For many taxpayers that wish to participate in a §1031 delayed exchange, this time limit is not a great concern. They are typically able to locate the new property and complete the transaction within the 180-day limit.

13

However, think about the problem of exchanging a developed property, such as a factory, for an undeveloped tract upon which the TP wishes to build a larger factory. You will see later that the rules allow for this type of exchange, and for the cost of the new factory to be included in the calculations of the cost of the new property. But, the only portion of the new factory that can be included in the calculation is the portion that is completed within the 180 days. Given that most large construction projects cannot be completed within such a short period, the TP runs the risk of incurring a substantial tax despite his or her best efforts to comply. Another area to watch out for in the construction area is that the property that has been identified is substantially the same as the property that the TP receives at the time of the actual exchange. We know that there are often numerous changes from the original plans for any construction project, let alone a large one. The risk is that the changes are so substantial that the IRS takes the position that the property delivered is not the same property that was identified at the time of the 45-day notice. There is no easy answer to this issue; however, one can see the importance of being as certain as possible about the description and details of the construction project that is identified as the new property.

5. The Qualified Intermediary

The next requirement to qualify for a §1031 exchange is the use of a qualified intermediary, or QI. One of the philosophical theories behind the tax-free exchange policy is that the transactions necessary to convert one investment into another of like-kind is that these transactions are truly just exchanges of properties rather than a sale of one property and subsequent purchase of a new or replacement property. In a simultaneous exchange, there is not, in tax terms, a sale, merely an exchange. To maintain that legal fiction in the case of a non-simultaneous exchange, the Code creates the QI concept.

14

§1031 does not define QI, it merely lists those who cannot be a QI, and are therefore disqualified:

TP’s attorney TP’s CPA TP’s real estate agent Any relative of the TP Any employee of the TP Any business associate of the TP

The goal is that the QI must be a completely independent party. You may recall that the QI is the party that holds the proceeds from the sale of the old property, using those proceeds to purchase the new property that is ultimately deeded to the TP. The theory here is that the TP has no control over or access to the funds, and so has never actually “received” the funds from the sale. You will see later this is another fiction created by the Code to support the theory that a delayed exchange is actually the same as a simultaneous exchange. That is not to say there is anything wrong with this method of reasoning, but it is sufficiently tortuous that it requires substantial and carefully drafted paperwork to satisfy the Code requirements. The existence of the QI concept created a substantial new business. There are literally thousands of businesses around the U.S. that hold themselves out as QI’s. Most promote themselves as sufficiently experienced and knowledgeable in §1031 exchanges that they can handle all the paperwork, the disbursement of funds, and the recording of documents involved in the transactions. Because they are truly independent of the TP, they meet the Code test and can be of tremendous assistance in seeing that the transactions proceed as required. A few of these QI’s are included on the Web Sites page. CAVEAT: While many companies are in the QI business, this area is not regulated by state or federal laws. Therefore, a TP is well-advised to do some serious homework before retaining a QI. A §1031 exchange will involve hundreds of thousands, if not millions, of dollars in terms of the value of the property to be exchanged and the cash involved. Much of that cash may be held by the QI for a period of time until a delayed exchange is completed. It is not only prudent but essential that the QI be checked out the way any potential professional would be. This means asking for and contacting references, perhaps having the TP’s attorney and/or CPA interview the QI, and even determining if the QI is bonded. This is not to suggest that QI’s are dishonest, but merely to suggest that in the absence of any sort of regulatory oversight, the consumer that proposes to use a QI should be every bit as careful as they would be in selecting an accountant, lawyer or CPA. In that regard, your client’s attorney and/or CPA may have worked with a local QI and provide adequate assurance of its competence and integrity.

15

6. Title to the New Property

The Code also requires that title to the new property be taken exactly as it was held in the old property. This does not limit the person or entity that can use §1031. Any individual or business entity (corporation, partnership, trust, limited liability company, etc.) can do a like-kind exchange. However, the entity or person that takes title to the new property must be the same entity or person that held the title to the old property. The test is whether, when filing an income tax return involving the new property, exactly the same name appears as the TP.

16

Therefore, if your TP client is a corporation, the title holder of the new property must be the same corporation. If John and Mary are married, the title to the new property must also be in John and Mary. However, if John and Mary are brother and sister, and file separate individual returns, Mary could, under the rules, exchange for any new property in her name alone. (but see Related Parties, below.) The problem this creates most frequently involves partnerships or limited liability companies. Often one or more members or partners in the entity want to receive cash, while the remaining members or partners wish to use §1031 to acquire a larger property. There are ways to solve the problem, and they will be discussed in the Variations unit.

A. A sort of subsidiary issue is the related party rule. This rule states that “there shall be no nonrecognition of gain or loss under this section (1031). . . “ if:

• The TP exchanges property with a related person, and, • The TP uses §1031 to not realize a taxable gain, and, • Less than two (2) years after the last transfer in the

exchange either the TP or the related party disposes of the property that person received.

For purposes of this rule, “related person” means any person having a relationship to the TP described in §§267 (b) and 707

17

(B)(1) of the Code. These are long lists, but the essence of them is that family members (brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants), corporations that are 50% or more owned by the TP, directly or indirectly, trusts, 50% or more owned partnerships, etc., are all deemed related. The result is that attempts at transfers between family members or entities that the TP controls, directly or indirectly, will be disallowed under §1031.

7. Price and Cash Reinvestment Rule

Finally, in order to defer all tax on the gain, the TP must pay at least as much for the new property as the selling price of the old property, and all cash from the sale of the old property must be reinvested in the new property. An example of how this rule works: Sale price of Old Property $100,000 Debt Payoff at closing -40,000

18

Cash to QI: $ 60,000 Now, if the TP directs the QI to purchase new property that costs $90,000, this does not defeat the exchange; however, the difference between the sales price of the old and new properties ($10,000) is taxable. That difference is called “boot”, and will be discussed in a later section. However, the point here is that because the purchase price of the new property was less than the sale price of the old property, some of the gain is taxable. Let’s change the facts a little. This time, TP buys a new property for $150,000, with a loan of $100,000 and $50,000 cash down. This means the TP used only $50,000 of the $60,000 received from the sale of the old property. Again, that $10,000 will be taxable as boot, even though the purchase price of the new property was greater than the sales price of the old property. Notice that in both situations, the transaction still qualifies as a §1031 exchange; the flaw in the transactions is that by not observing the purchase price and the cash reinvestment rule, the additional cash is treated as boot, and is taxable. This boot is taxable up to but not exceeding the profit on the transaction. In other words, if the boot is $10,000, but the profit on the deal is $5,000, the tax would be based on the $5,000 figure. According to the experts, there is a common misconception that the debt on the new property has to be equal to or greater than the debt that was paid off on the old property. This is not true. So long as the purchase price of the new property is equal to or greater than the sales price of the old property and all of the cash received in the sale of the old property is reinvested in the new property, there should be complete deferral of income tax on the transaction.

II. Boot: “Extra” Cash in the Deal

Now that we know the basic elements of a §1031 exchange, we will examine more closely an area that can cause unintended and unpleasant tax consequences. You recall that the last element necessary to qualify the transaction for deferral of all capital gains tax was the purchase price/cash reinvestment rule. If this rule was not followed, we learned that the shortfall in either the purchase price of the new property or in the amount of cash reinvested would be treated as boot, and would be taxable, at least up to the total profit on the transaction. In its typical backward fashion, the Code states:

19

“(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. “ §1031 (b), IRC

In simpler language, if the TP receives some new property that does not qualify as like-kind, the fair market value of that property, as well as any cash received, then the gain on the transaction becomes immediately taxable. The limit on the amount that is taxable is the cash and fair market value of the non like-kind property that is received. Any such non like-kind property and cash is referred to as “boot”. However, remember that there is a limit on the amount that can be taxed in this situation. That limit is the lesser of the capital gain or the value of the money and non like-kind property received. If the boot has a total value of $25,000, but the gain is $50,000, the tax would be based on $25,000. If the boot has a total value of $50,000, but the gain on the transaction was $25,000, the tax would once again be based on $25,000. Before we look at how boot is calculated, it is important that you understand the difference between realized gain and recognized. For purposes of a §1031 transaction: Realized gain is the amount received in the transaction (both like-kind

and non like-kind property, including cash) minus the basis in the old property. The formula would be:

Value of all property received – basis in old property = realized

gain. Another way to think of it would be that realized gain is the profit on the

transaction, ignoring the effects of §1031. Recognized gain is the amount or portion of the realized gain that is

taxable. It could be referred to as the amount that will be taxable in the current tax period after application of the deferral rules under §1031. Presuming §1031 applies to the transaction, recognized gain will always be less than realized gain.

Yet another way to think of these concepts is that realized gain is the

amount of profit your client actually “made” on the transaction, while recognized gain is the amount the client will owe taxes on.

20

Here are some examples of how boot is calculated. Remember, the transaction qualifies as a §1031 exchange, which means that at least a portion of the tax on the profit will be deferred. Example 1: TP owns investment property with a basis of $10,000 and fair market

value of $50,000. The second party also owns investment property with a basis of $25,000

and fair market value of $50,000. They exchange their properties in a §1031 exchange. TP has a realized gain of $40,000 ($50,000 value of property received

minus $10,000 basis = $40,000. However, TP does not recognize gain at the time of the exchange because the all property received is qualified and like-kind. Therefore, the tax on the gain is deferred.

The second party has a realized gain of $25,000 ($50,000 value of property received minus $25,000 basis).

And, because the property received was all qualified, like-kind property, the second party likewise has no recognized gain, with all tax being deferred.

Example 2: TP owns investment property with a basis of $50,000 and fair market

value of $80,000. TP exchanges the old property for qualified investment property with a

fair market value of $60,000 plus cash of $20,000. TP has a realized gain of $30,000 ($80,000 value of property received

minus $50,000 basis = $30,000. Because cash if not qualified property, the TP has a realized gain of

$20,000, the value of the cash or boot received. As you can see, even though this transaction did not achieve complete tax

deferral, there was still benefit to the TP because while there was a “real” gain of $30,000, the tax due will be calculated only on $20,000.

Example 3: You recall that boot includes not only cash, but also any other property received by the TP that does not qualify as §1031 exchange property. §1031(a)(2) lists such non-qualifying property as including stocks, bonds, notes, partnership interests, beneficial interests in choses in action, and any other property that fails the like-kind test. Here is how boot would be calculated in a transaction that includes both qualifying and non-qualifying property: TP exchanges a large, unimproved parcel with a fair market value of

$500,000, and TP receives a shopping center with fair market value of $250,000, maintenance equipment worth $50,000 and a promissory note of $200,000.

The unimproved parcel and the shopping center are clearly qualifying, like-kind property.

The maintenance equipment is qualifying property that can be exchanged under §1031; HOWEVER, it is not like-kind as compared to the unimproved parcel.

21

The promissory note is non-qualifying property. The result is our TP client has received boot in the amount of $250,000,

consisting of the $50,000 in maintenance equipment and the $200,000 promissory note.

Example 4: Another area of “boot” that can create problems involves exchanges in which the properties are not of approximately equal value. The IRS may look at this type of transaction as an attempt to hide boot, and therefore attach the transaction as being only a partial qualification under §1031. For example: TP and her business associate own equal tenant-in-common interests in

two separate parcels of investment property. They have a falling out, and TP sues her associate for breach of contract,

breach of fiduciary duty, and anything else the lawyer can think of. TP and her associate arrive at a settlement. TP deeds her interest in Parcel A to her associate, and the associate deeds

his interest in Parcel B to TP. The result is that TP owns 100% of Parcel B and the associate owns 100% of Parcel A.

If Parcels A and B are “approximately the same value, the transaction should qualify for complete deferral of tax under §1031.

HOWEVER, if Parcel B is substantially more valuable than Parcel A, the IRS would take the position that TP had received boot. It would claim that TP ended up with a more valuable parcel than her associate because what the transaction really involved was a transfer of Parcel B to TP in exchange for her interest in Parcel A plus a release of TP’s claims against the associate.

As we learned before, choses in action are not qualifying property; therefore, the IRS would argue that the associate received both qualifying property (the TP’s interest in Parcel A) and boot in the form of a release of TP’s claim against the associate.

So, while the associate has eliminated the TP’s claim against the associate, he has created a claim against the TP in favor of the IRS!!

In analyzing these types of transaction, remember that, depending on the structure of the transaction, both parties to an exchange can be considered to either be giving or receiving boot. It is important to look at the property going both directions and analyze each side of the transaction for anything that might be boot. A. Treatment of Liabilities

Another trap for the unwary in the area of boot is the debt that is associated with the properties being transferred. Treasury Regulation 1.1031(d)-2 states in part: “. . . the amount of any liabilities of the taxpayer assumed by the other party to the exchange (or of any liabilities to which the property exchanged by the taxpayer is subject) is to be treated as money received by the taxpayer upon the exchange.”

22

In other words, in calculating boot, and therefore what amount, if any, may be taxable now as opposed to deferred, you must consider the debt that is attached to each property. If both properties involved in the exchange have debt, the Code allows you to “net” them for purposes of calculating boot. That is, the amount of the debt on the old property, whether paid off by the closing of the transaction or remaining on the old property, is “netted” against the debt that is conveyed with the new property. Example: TP owns the Tan Apartments with a basis of $100,000, a loan of

$80,000, and fair market value of $200,000. Trader 2 owns the Blue Apartments with a basis of $175,000, a

mortgage of $150,000, and fair market value of $250,000. In the exchange, TP transfers the Tan Apartments to Trader 2, and

receives $40,000 cash plus the Blue Apartments, while Trader 2 receives the Tan Apartments.

Both apartment complexes are transferred with their existing loans in place.

With those basic facts, the analysis of the tax impact is for both parties: Taxpayer:

o Receives $250,000 in real estate plus $40,000 cash plus relief from $80,000 in debt on apartments transferred, for total consideration of $370,00.

o From the $370,000 we subtract $100,000, the basis of the Tan Apartments, and the debt that remains on the Blue Apartments, $150,000, for a remaining total of $120,000.

o Those two calculations have the effect of netting the liabilities-we added the $80,000 debt for the Tan Apartments that were transferred and subtracted the $150,000 for the Blue Apartments that were received.

o The remaining $120,000 is the gain realized by TP on this transaction. o The next step is to determine the gain that must be recognized.

Remember, realized is the actual “profit” on the deal, recognized is the amount that cannot be deferred and must bear a tax now as a result of the transaction.

o Recall that TP received $40,000 cash as part of the deal. We know that cash is non-qualifying property, or boot.

o We also know that the liabilities are netted; so, having been relieved of the $80,000 debt on the Tan Apartments, but having received the $150,000 debt on the Blue Apartments, our TP has no net boot received other than the $40,000 cash. (Note: the excess debt our TP received is not offset against the cash.)

o Therefore, the $40,000 is treated as boot and our TP must, on the next tax return, “recognize” $40,000 of the $120,000 gain we calculated before.

23

Trader 2 o Receives $220,000 in real estate plus relief from $150,000 in debt on

apartments transferred, for total consideration of $370,000. o From the $370,000 we subtract $175,000, the basis of the Blue

Apartments, plus the $40,000 cash given plus the debt that remains on the Tan Apartments, $80,000, for a remaining total of $75,000.

o As before, the effect of the calculations is to net out the liabilities. o The remaining $75,000 is the gain realized by Trader 2 on this

transaction. o The next step is to determine the gain that must be recognized.

Remember, realized gain is the actual “profit” on the deal, recognized gain is the amount that cannot be deferred and must bear a tax now as a result of the transaction not being fully tax-deferred.

o Under Treasury Reg. 1.1031(d)(2), consideration received in the form of cash is not offset against consideration given in the form of property subject to a liability. That is, the $40,000 received by Trader 2 cannot be offset by the $150,000 debt to which the received property is subject (the $150,000 mortgage).

o This means that there are no offsets to the gain, and Trader 2 must also recognize the full $75,000 capital gain on the next tax return.

This is a somewhat confusing concept. Boot given in the form of cash or other property may be netted against boot received in the form of an assumption or receipt of liability of the property transferred. Those same regulations do not permit the offset of consideration received in the form of cash against consideration given in the form of property subject to a liability. On the face of it, this seems contradictory. However, the Tax Court provides this “explanation”: “. . . a taxpayer who receives cash . . . to compensate for a difference in net values must recognize a gain . . . to the extent of the sum of the cash received and the net difference in favor of himself between the mortgage of the property transferred and the mortgage on the property received. Furthermore, he cannot offset the cash boot received by the net of the mortgages eve if the property he receives has a larger mortgage.“ Barker v Commissioner, 74 T.C. 555 (1980) In all candor, it isn’t much of an explanation. It merely restates the rule without providing an explanation or the rationale for the rule. That being said, the important thing to remember is that this is how the rule works.

24

III. Title Issues We know from an earlier section that one of the requirements to qualifying for §1031 exchange treatment is that the title to the new property must be held in exactly the same manner as title to the old property. In many transactions, probably the majority, this is not a serious issue. If the investor held title to a group of apartments as a sole proprietor, limited liability company (LLC), corporation, etc., the investor merely takes title to the new property in the same way, and the requirement is satisfied. However, as business dealings grow more complex, and particularly as member of a partnership, joint venture or LLC grow older or need to liquidate their investments for such things as medical expenses, education of children, or even retirement, the transactions can become much

25

more complex. For any number of reasons, one or more members of the group may wish to be cashed out. The remaining members may wish to go on to a larger investment. Whatever the reason, if it is clear that the composition of the new entity will be different from the original group, it appears §1031 will not apply because title to the new property will, by definition, be held differently than was the old. Prior to the 1984 Tax Reform Act, investors utilized some rather convoluted methods to permit their transactions to qualify for §1031 treatment. Some of these efforts resulted in prolonged litigation with the IRS, but the courts tended to be somewhat lenient, reasoning that the underlying theory of §1031 nonrecognition is the continuity of investment by the taxpayer(s). The Tax Court generally would permit §1031 qualification if the underlying assets of the old and new general partnerships were qualifying assets under the Code. That is, the court examined the economic reality of the transaction rather than relying solely on the issue of how title was held. This IRS’ approach to denying the benefits of §1031 treatment to partnerships led to a variety of different schemes to avoid characterization as partnerships. In Chase v. Commissioner, 92T.C. 874 (1989) the partnership issued a deed conveying an undivided percentage interest in the partnership property to the taxpayer. The taxpayer never received any rental income directly for the tenants, never paid any operating expenses, and the deed was not recorded until; immediately before the closing of the sale. The court held that “in substance, (the partnership) disposed of the apartments, not the individual, and therefore there was no §1031 exchange. There are several variations created by innovative tax planners, including the “drop and swap” (distribution of partnership property followed by the exchange”, the preplanned contribution of property into a partnership, and the “swap and drop” (a partnership level exchange followed by disposition of the property). These are all complex transactions, and should be undertaken only after careful disclosure of all facts to the client’s tax advisors, and careful planning. However, the point is that there are ways for partnerships to benefit from a §1031 exchange. IV. Variations and Creative Use of §1031

A. Reverse Exchanges and Revenue Procedure 2000-37 The foundation of the reverse or deferred exchange (reverse and deferred will be used interchangeably in this discussion) is the case of Starker v. U.S., 602 F.2d 1341 (9th Cir. 1979). You may recall we discussed this case in the Identification of New or Replacement Property unit. In the Starker case, the taxpayer had, over a 2-year period, exchanged timberland for multiple purchases of replacement real property identified by the taxpayer after the sale of the timberland, using a Fortune 500 company as the intermediary. The IRS

26

challenged the nonrecognition of gain, and the battle was fought through the courts for a number of years. The Ninth Circuit Court of Appeals, often characterized in recent years as the Ninth Circus Court due to the extraordinarily high rate of reversals of its opinions by the U.S. Supreme Court, adopted the taxpayer’s argument, and permitted nonrecognition of the gain under §1031. In response, the Congress adopted §1031(a)(3), which crated the 45-day identification period and the 180-day replacement period we have previously discussed. However, in its preamble, IRS Regulation 1.1031 (k)-1 states that the deferred exchange rules did not apply to a reverse Starker exchange, that is, an exchange in which the replacement property is acquired before the relinquished or old property is transferred. This situation created an obvious predicament for the taxpayer. If the taxpayer was obligated to close on the sale of the replacement property, but there has been a delay in the closing of the sale of the relinquished property, the regulation would seem to preclude nonrecognition of the gain. Prior to Rev. Proc. 2000-37, the most commonly used method of avoiding this nonrecognition risks was to “park” the replacement property with an accommodation party, with that party holding the replacement property until the taxpayer identified the property he intended to relinquish. A variation on the parking approach was for the accommodation party to acquire the replacement or new property on behalf of the taxpayer, and then immediately exchange it for the old or relinquished property. The accommodation party then held the old property until the taxpayer could arrange for a sale to a third party. While these parking approaches often worked, they were still considered risky in that they were subject to challenge by the IRS. To remedy this situation, and, according to the language of the document, Rev. Proc 2000-37 was adopted “. . . in the best interest of sound tax administration, to provide taxpayers with a workable means of qualifying their transactions under §1031 . . . “. The purpose is to provide a “safe harbor” under which the IRS will not dispute:

(1) the qualification of property as either replacement property or relinquished property for purposes of §1031 of the Code; or

(2) the treatment of the “exchange accommodation titleholder” (accommodation party) as the beneficial owner of such property if the property is held in compliance with a “qualified exchange accommodation agreement (QEAA).

Rev. Proc. 2000-37 details the requirements of a QEAA. As with most tax law, the language can be a little tedious. Therefore, the key words or phrases in the following requirements are in bold type to help you remember them. A QEAA must include: “Qualified indicia of ownership” of the property must be held by an

accommodation party that is not the taxpayer or a disqualified person. “Qualified indicia of ownership” is defined as legal title to the property, though there are other “indicia” that can be considered.

27

At the time the accommodation party obtains title to the replacement property, the taxpayer must have a good faith intent that the property will be replacement property in an exchange that is intended to qualify for nonrecognition under §1031.

Within five (5) business days after the accommodation party acquires the property, the taxpayer and accommodation party must enter into a written agreement that spells out that the accommodation party is holding the property for the benefit of the taxpayer to facilitate an exchange under §1031 and the Rev. Proc.

Within forty-five (45) days after the transfer to the accommodation party, the taxpayer must identify the property to be relinquished. Remember that the replacement property may include alternate and multiple properties. (The property is still subject to the rules under Regulation Section 1.1031 (k)-1), dealing with the 3-property rule, the 200% rule, the 95% rule, and revocation of identification.)

Within one hundred eighty (180) days after the transfer to the accommodation party, the replacement property must be transferred (either directly or through a qualified intermediary) to the taxpayer as the replacement or new property. The combined time period that the relinquished property and the replacement property may be held under a QEAA cannot exceed 180 days.

A number of questions and “murky” areas still remain unanswered by Rev. Proc. 2000-37, but this are best reserved for examination and deciphering by accountants and tax lawyers that specialize in this area of tax law. The thing to remember here is that if your taxpayer client has a situation in which a reverse like-kind exchange may avoid crippling income tax payments, there are some relatively straightforward guidelines under which such an exchange can be accomplished.

B. Construction Exchanges

Another area that can benefit from a §1031 exchange is the construction of a new facility for a client’s business. Your client has owned and used the property for many years. Like all “good” real estate it has appreciated tremendously over the years. However, it has been depreciated for tax purposes to the point that the tax basis is very low. Your client needs a new, much larger building to accommodate the growth in business, and the facility must be custom built to satisfy the requirements of the business. A simple exchange for an existing facility won’t work. If your client sells the existing

28

property and pays the resulting income taxes, he will be left with far too little money to build the new building. Bearing in mind the 45-day and 180-day rules we learned earlier, it appears a §1031 exchange will not work. If for no other reason, it will take far longer than 180 days to find a building site, build the new building, sell the old building, and complete the move. And, because the company is a manufacturing business, we haven’t even taken into account the cost of shutting down the plant while the new building is being constructed. However, there is a way to benefit from §1031, using a build-to-suit like kind exchange. The steps your would follow might be something like this:

1. The contractor that will build the new facility buys a site selected by the client, and proceeds to build the new plant with plans approved by your client, using loan funds arranged and guaranteed by the client.

2. Your client continues to operate the old plant until the new facility is completed, in the meanwhile placing the old plant on the market.

3. When the new facility is ready for occupancy, your client closes the sale of the old facility, moves into the new one, and begins operations.

4. Because the proceeds of the sale of the old facility are used to purchase the new one, the purchase price exceeds the sales price for the old facility, and the 45- and 80-day deadlines were met, the transactions comply with §1031 and the client therefore defers the income tax.

The foregoing is obviously a simplified outline of a complex series of transactions. There are many legal and practical consequences that attend this type of planning. The point, however, is that what at first appeared to be a transaction or series of transactions that might not qualify for §1031 treatment can, in fact, be made to work very well for the client.

C. Oil and Gas Rights

Suppose your or your client has a working or royalty interest in an oil and/or gas property, and you wish to exchange the asset for other working or royalty interests. Can it work? Yes, it can. Recall that §1031 like kind exchanges are meant to allow the sale of an old property and the purchase of a new, like kind property for the purpose of deferring taxes. Included in the definition of property qualifying for this exchange are bare land, rental property, and mineral interests.

29

However, it is important that the proposed transaction be reviewed in advance by a tax professional, as there are some traps in this area that could prove costly. For example, if you sell a working interest in a well, but retain the royalty interests and/or the surface rights in the property, the transaction may not qualify for §1031 treatment. Also, production payments do not qualify for §1031 application. The rationale is that these are for services performed in the extraction of the minerals from the ground, not property interests under §1031. On the other hand, remember the discussion in the Qualified Property and Like Kind sections of this course. Recall that like kind doesn’t mean identical, and qualified property means property that meets the definitions indicated by the Code. Therefore, a mineral interest can be sold and the proceeds used to purchase rental property, perhaps an office building. While this offers an opportunity for changing the nature of your investment and deferring some taxes, again, beware of tax traps. In the case of an office building, IRS rules would require you to recapture the intangible drilling costs previously deducted when you owned your working interest in the well.

D. Water Rights

Perhaps your rancher-client has owned the family farm for a long time. The water rights are extremely valuable now, given the high demand for additional water to serve the growing Front Range population. Your client would like to sell the water rights but retain the land. However, the rights have such a low tax basis that income taxes would cut deeply into the profit, leaving too little cash to reinvest in a profitable manner. Once again, the answer may be a §1031 exchange.

30

There is little question that a water right may, depending on state law, qualify as property held for productive use in the trade or business, or for investment. Therefore, it is important to determine whether, under state law, the water rights owned by your client can qualify for §1031 treatment.

In Colorado, water has something of a dual nature. In fact, it has been treated as both personal and real property. The right to divert water under a specific priority date has been called a real property interest, and can in many instances be conveyed by a deed. However, after the water is diverted into a ditch or storage vessel of some sort, it has been called personal property. In West End Irrigation Co. v Garvey, the Court said: ". . . water in possession is personal property; the right to divert water from a stream is an interest in real estate." (117 Colo. 109, 184 P2nd 476 (1947) (emphasis added). Therefore, a water right classed as real property should qualify for a §1031 exchange. Of course, this should be confirmed with the client’s professional tax adviser.

E. Second, Vacation and Retirement Homes

As your clients mature, either by via age or financially, or both, they may have some interest in acquiring a vacation or second home, or even a home intended as a retirement home in the future. The sale of assets to raise the money to purchase the secondary home means income taxes must be paid, leaving too little for the next purchase. §1031 may be of some help.

31

If a vacation home is used by the owners less than 14 days or ten percent of the time that it is rented (whichever is less), it qualifies as property held for investment, and can therefore be used in a §1031 exchange. However, if the secondary home is never rented, and used only by the owners, does it still qualify? The experts argue both sides of the question. Those that support a secondary home as §1031 property rely on the definition of “like-kind”: “Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale.” This would seem to include a vacation home that is not rented to third parties. In addition, a Private Letter Ruling* in 1981, the IRS said: “The house and lot you acquire in this trade will be held for the same purposes as the properties exchanged therefore: to provide for personal enjoyment of the community and to make a sound real estate investment.” Again, this seems to support the use of §1031 in a vacation or secondary home exchange. Despite these arguments supporting §1031 treatment, a safer approach may be to be certain to not use the property for more than 14 days in the year of the exchange, or perhaps be certain to rent the property during the year of the exchange. As always, the guidance and advice of qualified tax professionals is essential in planning the transaction. *A Private Letter Ruling letter sent by the IRS in response to a request for clarification or interpretation of a tax law as it applies to a specific question or situation. It is applicable only to the specific facts and circumstances and the specific taxpayer that sought the ruling. While not binding on the IRS, private letter rulings can provide valuable guidance in trying to determine what position the IRS may take if the facts and circumstances of another taxpayer’s situation are identical or quite similar.

F. Tenant-in-Common Twist

As §1031 exchanges grew in popularity, a new form of investment was developed. Companies acquired investment properties, typically leased office or similar investments. The company then sells tenant in common (hereinafter TIC) interests, usually on a percentage basis. The benefits of such an arrangement are:

32

1. The management company, and not the investor, is obligated for all property management.

2. Investors with neither the time, the money nor the expertise to operate a large, national investment company benefit from participating in a professional real estate investment operation dealing with hundreds of thousands or millions of dollars of real estate.

3. Investors should benefit from the economies of scale by pooling their money with other investors.

4. Investors may diversify by acquiring TIC interests in a number of properties.

The concern in this area is that a TIC interest appears similar to partnership interest. We know that interests in a partnership do not qualify as replacement property in a §1031 exchange. (Code §1031 (a)(2)(D). After changing positions a couple of times, the IRS finally stuck with Rev. Proc. 2002-22. The net effect of this Procedure is to provide requirements for an advance ruling on whether or not the TIC interests of a particular program will qualify for §1031 treatment. This procedure is long, detailed, and, in some respects, very difficult for the manager or promoter of a TIC program to comply with. Some of the information may not even be available prior to the end of the offering. That concern, coupled with the rather voluminous requirements, means advance rulings may not occur very often. However, Section 4 of Rev. Proc. 2000-22 gives some conditions under which a request for an advance ruling may be provided. They are:

1. Tenants In Common Ownership. Each of the co-owners must hold title to the property (either directly or through a disregarded entity) as a tenant in common under local law. 2. Number of Co-Owners. The number of co-owners must be limited to no more than 35 persons (and husband and wife are treated as a single person for this purpose). 3. No Treatment of Co-Owners as an Entity. The co-owners may not file a partnership tax return or otherwise hold themselves out as a partnership or other form of entity. 4. Co-Ownership Agreement. The co-owners may enter into a limited co-ownership agreement that may run with the land. This agreement may provide that a co- owner must offer the interest for sale to the other co-owners or the sponsor at fair market value before exercising any right of partition. In addition, the agreement may provide for majority voting on certain issues. 5. Voting. The co-owners must retain their voting rights as described below. Unanimous approval is required for any sale, lease or re-lease of a portion or all of the property, any negotiations or re-negotiations of indebtedness secured by the property, the hiring of any manager, or the

33

negotiation of any management contract (or any extension or renewal of such contract). However, for all other actions, the co-owners may agree to be bound by a vote of more than 50% of the co-owners. A co-owner who has consented to an action in this matter may provide the manager with a power of attorney to execute specific documents with respect to that action. 6. Restrictions on Alienation. In general, each co-owner must have the right to transfer, partition, and encumber their interest in the property without the agreement or approval of any person. However, restrictions that are required by a lender and that are consistent with customary commercial lending practice are not prohibited. Moreover, the co-owners or the sponsor may have a right of first refusal and a co-owner may agree to offer an interest for sale to the other co-owners or the sponsor at fair market value before exercising any right to partition. 7. Sharing Proceeds and Liabilities Upon Sale of Property. If the property is sold, any debt secured by the property must be satisfied and the remaining proceeds distributed to the co-owners. 8. Proportionate Sharing of Profits and Losses. Each co-owner must share in all revenue generated by the property and all costs associated with the property in proportion to their interests in the property. Neither the other co-owners, the sponsor, nor the manager may advance funds to a co-owner to meet expenses associated with the property, unless the advance is recourse and is not for a period exceeding 31 days. 9. Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by the property in proportion to their undivided interests in the property. 10. Options. A co-owner may issue an option to purchase his interest, provided the exercised price reflects fair market value of the property determined as of the time the option is exercised. A co-owner may not acquire an option to sell the interest (put option) to the sponsor, the lessee, another co-owner or the lender or any person related to such parties. 11. No Business Activities. The activities of the co-owners must be limited to those customarily performed in connection with the maintenance and repair of rental real estate. See Rev. Rul. 75-374, 1975-2 CB 261. 12. Management and Brokerage Agreements. The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually. The manager or broker may be a sponsor or co-owner (or a related party), but may not be a lessee. The management agreement may authorize the manager to maintain common bank accounts for the collection and deposit of rents and to offset expenses associated with the property against any revenues before dispersing each co-owner’s share of net revenues. In addition, the management agreement may authorize the manager to take certain actions on behalf of the owners (subject to the voting regime described above in Paragraph 5). The manager may not be paid a fee based in whole or in part on the income or profits derived from the property and the fees may not exceed the fair

34

market value of the manager's service based upon comparable fees paid to unrelated parties for similar services. 13. Leasing Agreements. All leasing agreements must be bona fide leases for federal tax purposes. 14. Loan Agreements. The lender may not be a related person to any co-owner, the sponsor, the manager, or any lessee of the property. 15. Payments to Sponsor. The amount of any payment to the sponsor for the acquisition of the co-ownership interest and services must reflect the fair market value of the interest acquired and the services rendered. This means that such payments and fees may not depend, in whole or in part, on the income or profits derived from the property (i.e., no back-end or carried interest is permitted).

These requirements are not included to provide you with a long list of boring and confusing items to memorize. They are not known as substantive law that binds the IRS. However, they do provide some insight into what a qualifying TIC investment will probably be required to have to qualify for §1031 treatment.

It should also be borne in mind that this type of transaction is not automatically a good deal. Bear in mind:

1. The guidelines are just that, guidelines that do not give automatic approval by the IRS.

2. There is no established secondary market for selling a TIC interest, making it less liquid than some other investments.

3. TIC investment groups often involve large commissions for the promoters, plus management fees for the promoters, and perhaps even a §1031 QI division that takes yet another bite of the deals.

As with any investment, have it checked carefully by tax and legal advisors.

G. FCC Licenses

Because §1031 is so often associated with real estate transactions, it is easy to forget that this section can be utilized to defer taxes on many other types of property. Remember that the section applies to “. . . property held for

35

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”. (Code §1031 (a)(1). Therefore, in Technical Advice Memorandum 200035005, the IRS stated that a Federal Communication Commission television license and an FCC radio license qualified as like-kind property under §1031. The differences in assigned frequencies are differences in grade, not differences in nature or character. Therefore, with the burgeoning cable television industry and growth of radio stations across the country, there are many opportunities to defer taxes as assets change hands. Remember also that under Rev. Proc. 2000-37, one can utilize reverse exchanges and forward exchanges, thus making it a little easier to deal with the timing of transactions.

H. Bankruptcy Remote Entities

What is a bankruptcy remote entity? For purposes of this discussion, it is a single-asset entity that at least arguably would not be impacted if other

36

investments owned by the taxpayer suffered cash flow problems, or perhaps were forced into bankruptcy. For example, if your client proposes to purchase a large new investment property, but is already the holder of several other large and heavily indebted projects, the lender may require that the property be held by a bankruptcy remote entity to protect the new property from claims of creditors on other projects, should they go “south”. How does this apply to §1031? Presume these facts: 1. The client owns, in her own name, a large apartment complex valued at

$750,000. 2. The client wants to sell the apartment complex and purchase a new, much

larger rental project valued at $2,500,000. 3. Being an astute and proactive broker, you suggest a like-kind exchange to

defer some $150,000 in taxes. 4. All elements of the exchange are met, including the preparation of the

required exchange agreements, the use of an intermediary, the loan commitment, etc. However, at the last minute the bank tells your client that title to the new property must be taken by a bankruptcy remote entity, such as a new corporation or partnership.

As you recall, one of the requirements of a 1031 exchange is that the taxpayer must take title to the new property in the same manner as the old property was held. Unfortunately, the bank is not sympathetic and tells your client that if the bankruptcy remote entity is not used, the loan will not be made. At this point, it looks like the whole deal will die, and there go a couple of nice commissions! Fortunately, you recently completed a continuing education class that dealt with this problem, and here is what you tell your client, of course reminding the client to clear this all with the appropriate tax professionals: 1. The client has the attorney form a limited liability company (LLC) to take

title to the new/replacement property. 2. When the client’s accountant files the client’s tax return, there is a box that

can be “checked” to indicate the client has elected to ignore the LLC and have all income and expense for the property reported on the client’s individual return.

3. This will cause the IRS to disregard the LLC and treat the client as the buyer of the new property, thus fulfilling the §1031 requirement.

Not only have you pointed your client in a direction that defers thousands of dollars in taxes, but you have helped “save” transactions that mean some healthy commissions for you.

37

I. Rehab Sales

As a general rule, investors/entrepreneurs that purchase, rehab and sell fixer-upper properties cannot utilize the benefits of §1031. The Code and the position taken by the IRS have been consistent: if a taxpayer makes his/her living buying property to rehab, or building spec homes, and always sells the property after completion of construction, the taxpayer is a “dealer” and the income is treated as ordinary income for tax purposes.

38

However, if you buy a rehab project only on occasion, and typically hold the property for at least a year, you may qualify for §1031 treatment. In determining the taxpayer’s intent, the IRS may consider:

1. The stated purpose for purchase of the property. (purchase, rehab and rent, or purchase, rehab and sell ASAP.)

2. When the sale was actually closed. (1 year or more after purchase is a good indicator of investment property {and therefore §1031 qualification} as opposed to immediate sale upon completion of rehab.)

3. The nature and extent of the improvements to the property. 4. The number and frequency of similar transactions. (Obviously, if your

primary source of income is purchasing, rehabbing and selling houses once very few months, it will be hard to convince the IRS these were investments.)

5. When the property was listed with a broker. (Listing the property for sale less than 1 year from the acquisition date provides the IRS a strong argument for §1031 disqualification.)

Some steps to consider in structuring a transaction to qualify for §1031 treatment:

1. If you are a dealer in rehabbed properties, create a separate legal entity, perhaps an LLC, to handle the properties you wish to treat as investments rather than as “inventory” that turns over as quickly as you can rehab and sell it.

2. Indicate in your records the intent to hold the property. For example, if the property is available for rent on a minimum 1-year lease, this indicates an investment intent. If the tenant would prefer to purchase, give the tenant an option to lease (a separate agreement from the lease) that cannot be exercised until at least 1 year in the future.

3. Do not list the property with a broker, at least not until after the expiration of 1 year from the purchase.

J. The Like-kind Exchange and Your Home As you know, the general rule is that §1031 applies to investment property and

not to one’s personal home. However, when used judiciously with §121 of the Code, §1031 can provide an interesting way to avoid some income taxes.

39

§121 provides that all or a portion of the gain from the sale of a residence the taxpayer has occupied for at least 2 of the last 5 years can be tax free. The rule is that if the taxpayer has lived in the residence for any 24 months out of the last 60, the first $250,000 (500,000 if married) is tax-free. It is not necessary that the 24 months be consecutive, and the use of the property during the other 36 months is not relevant. It is not necessary to have owned the home for 60 months so long as the 24-month occupancy test is met as of the date of sale.

Here is how these two sections can work together:

A. Sell the “old” investment property, working with a Qualified Intermediary just as you would with any other §1031 exchange.

B. Purchase as the replacement property a single-family residence you either wish to live in, or would be willing to live in for 2 years.

C. Rent, or attempt to rent the single-family residence during the year plus one day from the date you purchase it. If you are not able to rent the property, be certain to keep copies of the for rent ads as proof of your attempts.

D. At the expiration of the one-year plus one day period, move into the property as your principal residence.

E. After you meet the 2-year occupancy requirement, you can sell the property using the §131 $250,000/500,000 exclusion, which will presumably help cover any §1031 rollover gain.

There is currently no limit on the number of times you can utilize these tax provisions, other, of course, than the 2-year residency requirement.

K. Sale/Leaseback Transactions

Taxpayer owns a commercial building in which it manufactures widgets. The building has a basis of $500,000. Taxpayer sells the building to an unrelated third party for $300,000 and then leases the building back for a term of thirty-five years. If the sale/leaseback is characterized as a Section 1031 exchange, Taxpayer will not be entitled

40

to immediately recognize the $200,000 loss, but instead may amortize the $200,000 over the 35-year leaseback term. Assume instead that Taxpayer sells the building for $750,000, with a corresponding leaseback of 35 years. Taxpayer will recognize a gain of $250,000 even if the sale/leaseback qualifies as a Section 1031 exchange, being the value of money or other property received in the exchange.

As is frequently the case with respect to the analysis of many aspects of 1031 exchanges, the IRS and the courts differ in their analysis of relevant issues. The IRS appears to focus on the term of the leaseback. If the term of the lease is 30 years or more, the IRS will likely characterize the transaction as a 1031 exchange. Conversely, if the term of the lease is for less than 30 years, the IRS will likely view the transaction as the sale and leaseback of non-like-kind property and therefore a true sale of the property. Courts, however, use a different analysis in determining whether an exchange has occurred in a sale/leaseback transaction. Instead of focusing primarily on the term of the leasehold received upon transfer of the fee interest of the property, courts examine whether the property was sold at its fair market value and whether the rentals under the lease are fair market rental payments (i.e. does the lease have "value" to the taxpayer, in form of below market rental payments). A leasehold is deemed to have value in a sale/leaseback transaction if the rental payments due under the lease are less than the fair market rental value of the property. If the rental payments equal or exceed the fair market rental value of the property, the taxpayer will not have received "boot" in the sale/leaseback (at least not in the form of a leasehold with value). For examples of the courts'' analyses, see Leslie Co. v. Comm''r, 64 T.C. 247 (1975), wherein the Tax Court found that the leaseback had no separate value and therefore a bona fide sale occurred allowing a claimed loss to be recognized; and Century Electric Co. v. Comm''r, 192 F.2d 155 (1951), wherein the U.S. Court of Appeals characterized a sale/leaseback transaction as an exchange, and denied the petitioner’s claimed loss, finding that the petitioner had exchanged a fee interest in property for a leasehold interest and cash. Additionally, courts may re-characterize a sale/leaseback as a 1031 exchange in cases where the seller/lessee has an option to repurchase the property, particularly if the purchase price is (or will be) below market value at the time the option is exercised. Because of the different treatments by the IRS and the courts, careful consideration must be made in applying (or not applying) Section 1031 to sale/leaseback transactions. However, it appears that the application of Section 1031 can be avoided (and losses may be recognized) in circumstances where the taxpayer has legitimate business purposes, transfers the property and receives the leasehold on market terms, and the transaction is conducted at arm’s length with an unrelated party. One or more parties may desire to reinvest the proceeds from the sale of the relinquished property into other investment property and take advantage of 1031, but other investors want to liquidate their interests in the property (notwithstanding potential gain from the liquidation), they may do so easily if the investors hold title to the investment property as tenants-in-common.

41

V. Colorado

1. Income tax and §1031 Exchanges

According to the Colorado Department of Revenue, the starting point for determining whether income is taxable in Colorado is the federal taxable income. That is, if income is properly excludable from federal

42

income for tax purposes, it is also excludable from Colorado income. Therefore, a properly structured and executed §1031 exchange would also defer income taxes in Colorado.

b. CREC Contract Form The Colorado Real Estate Commission provides a commission-approved

form for use in simultaneous exchanges. The form is rather long, at 17 pages, and can be found at http://www.dora.state.co.us/real-estate/contracts/0604/EX30-05-04.pdf. It may be beneficial to print contract from the site in order to follow along with the discussion.\

Some things to note about the approved form:

A great many of the provisions are the same ones you are accustomed to in a typical contract to buy and sell; that is, deadlines, attachments to the contract, inclusions with the property, title and survey matters and deadlines, financing requirements, how title is to be assured, etc.

However, you will note that most of the “standard” provisions appear twice, once for what is called property one, once for property two. Because the parties are exchanging properties, it is clearly necessary to deal with all the expected issues for each property.

Paragraph 7 is where the equities are adjusted. You will recall that in calculating whether or not a taxpayer has received boot, the equities are “netted”. In this paragraph, the equities are netted for purposes of determining how much, if anything, is due either party as a result of any difference in the equity of the two properties. Here is how it would be done in a simple transaction:

“DIFFERENCE BETWEEN EQUITIES. The difference in equities of the respective properties, after having considered and deducted existing loans not to be released at Closing, shall for purposes of this contract be as calculated below in this section:

Property One and Inclusions One

Property Two and Inclusions Two

Value $ 100,000 Value $ 250,000 Less Debt - $ 75,000 Less Debt - $ 125,000 Equity $ 25,000 Equity $ 125,000

The difference is $ (Equity Difference)__100,000________________

43

The Equity Difference shall be paid at Closing in U.S. dollars by the Party having the smaller Equity (determined above) as set forth in sections 8 and 11 below, or as follows: .”

In this case, the owner of property one would be paying the owner of property two $100,000 to equalize the equities. Depending on the tax basis of property two, this may mean that owner 2 is receiving boot in the sum of $100,000.

Finally, be sure to remember this form is for use in a

simultaneous exchange only. If a deferred or delayed exchange is being utilized, it is necessary to use a qualified intermediary, and comply with the detailed and specific steps required by §1031.

44

Frequently Asked Questions

1. What is IRS Code §1031?

Section 1031 of the Internal Revenue Code relates to the disposition of property that is held for use in productive trade or business or held for investment. It provides an exception to the rule requiring recognition of gain upon the sale or exchange of property. In other words, if the requirements of a valid 1031 exchange are met, capital gain recognition can be deferred until the taxpayer chooses to recognize it. For an exchange to be 100% tax deferred, the Exchanger must acquire replacement property that is of equal or greater value and spend all of the net proceeds from the relinquished property. Many specific requirements must be satisfied in order to complete the exchange properly. With the recent IRS Regulations in place, an experienced qualified Broker, Intermediary and Escrow/title Officer, can accomplish an exchange with ease.

2. Why do I, as a broker or agent, care about §1031 exchanges?

In today’s real estate climate, it is imperative that Real Estate Brokers and Agents understand the options a 1031 Exchange can offer their clients. Without such knowledge brokers and their agents are open to potential liabilities, due to lack of knowledge. Unfortunately, you can be as liable for what you don’t say as for what you do say. Simply offering the option of a Tax-deferred Exchange can eliminate potential liability on the Broker’s part. The "Exchange Agent" can have more satisfied clients by offering them the option to save substantial tax dollars, through exchanging. The Exchange Agent can also increase his or her income with the additional knowledge of exchanging.

3. What is “like-kind” property?

Section 1031 states that property held for use in productive trade or business or property held for investment, is potentially exchangeable. One can therefore qualify for non-recognition of gain upon the disposition of such property, assuming all other requirements are met. This means that business property or property held for investment, may be disposed of to a buyer (sold), set up with a "Qualified Intermediary", put into escrow, which will document the transaction as an exchange, and within the required time frame, repurchase replacement property of "like kind" thereby completing the exchange. It is not required that exactly the same type of property is acquired. In 1989 the IRS attempted to change the meaning of "like kind" to "similar use", and unfortunately many people still believe that is the rule. The attempt was defeated.

45

"Like kind" property that can be exchanged can include:

A. Property that is held for productive use in a trade or business, or,

B. Property that is held for investment. C. Commercial, single family rental property, condos, raw land,

apartments, vacations home, second home, duplexes, industrial properties and a Leasehold Interest of 30 years or more.

A person’s primary residence does NOT come under the rules of Section 1031, and is specifically EXCLUDED, as is property held "primarily for resale" or dealer property.

A common misconception to "like kind" is that the properties being exchanged be of "similar use". This is simply not true. A commercial property can be exchanged for an apartment complex or bare land exchanged for a single-family rental.

4. What is Section 1034 Property?

Code Section 1034 encompasses a primary residence only. A taxpayer is only allowed one primary residence, therefore, by reason of default, any other real property could be considered possible 1031 property. The only condition is that it meets the guidelines of Section 1031.

5. Why exchange property instead of selling it?

The most important reason is to defer taxable gain one may realize from a sale of the property. This may allow the taxpayer to use all of the equity in the property to purchase new property rather than use only what was left over after paying federal and state income taxes. By definition, this will typically enable the taxpayer to acquire a more expensive property, increasing portfolio value, cash flow, etc. It is obviously a method by which an investor can create a larger net worth much faster than if the investor were required to pay income taxes after each profitable sale.

6. What is the current identification period/closing time to accomplish a delayed §1031 like-kind exchange?

After an exchange has been set up, by contacting a Qualified Intermediary prior to closing a sale, the Seller (Exchanger), must identify within 45 days of the close of the "sale" escrow up to three (3) potential properties the seller MAY intend to acquire. The value of potential properties is immaterial.

If the seller wishes, he/she may identify, four (4) or more, properties; however, these properties cannot have an aggregate value of 200% or more of the sale property. If more than three (3) properties are identified, and the value exceeds 200% of the sale price, then you must close escrow on 95% of the list. Escrow must close, on at least one of the identified properties, within 180 calendar days from the date of the close of the sale escrow. These can be tricky rules, so always consult with appropriate tax professionals.

46

7. What happens when the taxpayer obtains a new loan from an institutional lender?

The Intermediary does not need to see or sign any of the lender’s documents. This is the taxpayer’s loan and only the taxpayer should be signing. Most lenders do not have a problem with the Qualified Intermediary inserted as the Exchanger’s Name on Instructions or Settlement Statements. However, if the lender does not want to see the Intermediary’s name on your statements or instructions, you can eliminate their name on items sent to the lender.

8. What is a “qualified intermediary?

Paramount to any exchange is a competent Qualified Intermediary. The Intermediary is the entity which structures, consults, guides and documents the exchange transaction from beginning to end. A sound Intermediary will provide safety and security for the funds held, and will provide the technical experience needed to maintain the integrity of the exchange. The qualified intermediary does not replace competent tax or legal advise. In fact, the QI should not give tax or legal advise, as this could disqualify them as an Intermediary.

9. Where do I find, and what do I pay, a Qualified Intermediary?

As the popularity of §1031 exchanges has grown, many QI firms have been formed. They range from real estate businesses that create separate QI entities to help market their products, to law and accounting firms that have a “side” business as QI’s, to title insurance and escrow companies that have a separate QI unit.

While many companies are in the QI business, this area is not regulated by state or federal laws. Therefore, a TP is well advised to do some serious homework before retaining a QI. A §1031 exchange will involve hundreds of thousands, if not millions, of dollars in terms of the value of the property to be exchanged and the cash involved. Much of that cash may be held by the QI for a period of time until a delayed exchange is completed. It is not only prudent but essential that the QI be checked out the way any potential professional would be. This means asking for and contacting references, perhaps having the TP’s attorney and/or CPA interview the QI, and even determining if the QI is bonded. This is not to suggest that QI’s are dishonest, but merely to suggest that in the absence of any sort of regulatory oversight, the consumer that proposes to use a QI should be every bit as careful as they would be in selecting an accountant or a CPA. In that regard, your client’s attorney and/or CPA may have worked with a local QI and provide adequate assurance of its competence and integrity.

Fees are usually competitive, and are usually a very minor part of the cost of a typical like-kind exchange. However, as with any other service, you are wise to obtain quotes from several QI’s as well as consult with attorneys and/or CPAs familiar with like-kind exchanges to get a feel for costs in your area.

10. Why bother with a QI?

47

In the regulations of 1991, and subsequent code, regulation and revenue procedure amendments, many of the gray areas of §1031 requirements were clarified, including the establishment of certain safe harbor provisions. You probably already know that a safe harbor is a provision or set of rules that give a taxpayer and his tax advisors some dependable guidelines to follow in attempting to qualify under certain tax rules. In this instance, one of the safe harbors indicated for certain types of §1031 exchanges was the use of a QI. Hence, the growth of QI businesses over the years.

11. What is needed if the taxpayer is a partnership, corporation or trust?

There is nothing different in how the exchange is handled, but the Intermediary will need to see a copy of the Trust Agreement, the Partnership Agreement, or a Corporate Resolution.

12. How should the taxpayer’s name appear on the deed?

To have a valid exchange, the taxpayer’s name should be exactly the same as it appeared in the deed by which the taxpayer sold the old property. However, there are exceptions to this rule. See “Bankruptcy Remote Entities” page of the Course.

13. Is a §1031 exchange always completely free of income taxes?

No. First, it is important to remember that a §1031 exchange does not avoid or preclude income taxes, it merely defers them until another time, thus making the money that would otherwise have gone for taxes available for additional investment. Also, for an exchange to be 100% tax deferred, the taxpayer must acquire a replacement property that is of equal or greater value and spend all of the net proceeds from the relinquished property.

14. What is boot?

Boot is defined as any "NON LIKE KIND" property received by the Exchanger in the exchange and it is taxable. Some different types of boot are:

A. Cash Boot:

Cash Boot consists of any funds received by the Exchanger, either actually or constructively. If an Exchanger does not spend all of the proceeds from the sale of the relinquished property, he/she will have actual receipt of the balance not spent and pay taxes on that amount.

Constructive receipt of funds may occur in a case where the Exchanger carries back a note from his/her Buyer of the relinquished property, then sells that note at a discount. The Exchanger never actually receives funds for the discounted amount, however, he/she has constructively received that discount and pays tax on that amount.

48

B. Mortgage boot or debt relief:

Mortgage Boot occurs when the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, therefore, they were "RELIEVED" of debt, which is perceived as taking a monetary benefit out of the exchange. Therefore, the debt relief portion is taxable, unless offset by adding equivalent cash to the transaction.

So a taxpayer must buy property of equal or greater value while spending the NET (after costs) equity. Note that it is absolutely acceptable to take cash out of the exchange and pay taxes on that amount only.

15. §1031 and second homes.

One of the fundamental requirements of Section 1031 is that the exchanged properties must be "held for productive use in a trade or business or for investment." As a result, residences used for personal use cannot qualify under Section 1031. However, owners of second homes that are patient and that are willing to make a bona fide conversion of the second home or the primary residence into rental property may be handsomely rewarded under Section 1031. See “Second, Vacation and Retirement Homes” page of this Course for a detailed discussion of this process.

49

Glossary

Accommodation Party: A third party that helps to facilitate the exchange. Sometimes refers to as "facilitator," or "accommodator."

Adjusted Basis - The original basis plus improvement costs minus the depreciation of the property.

Boot - Any assets received from an exchange that is not "like-kind." The most common types are "Cash Boot" and "Mortgage Boot." All Boot is taxable.

Capital Gain — Generally speaking, this is the difference between the sales price of the Relinquished Property less selling expenses and the adjusted basis of the property.

Cash Boot - Any cash an exchangor receives upon the closing of the relinquished property is taxed.

Delayed Exchange — Also called non-simultaneous, deferred, and Starker. A delayed exchange is when the Replacement Property is received after the transfer of the Relinquished Property. All potential Replacement Properties must be identified within 45 days from the transfer of the Relinquished Property and the Exchanger must receive all Replacement Properties within 180 days or the due date of the Exchanger’s tax return, whichever occurs first.

Direct Deeding — At the direction of the accommodator, title passes directly to the ultimate owners without the accommodator being in the chain of title.

Constructive Receipt — The critical question in a delayed exchange is whether the Exchanger has control over the proceeds during the exchange period. Any type of account to maintain exchange proceeds must substantially limit and restrict the Exchanger’s control to avoid having the exchange disallowed.

EAT or Exchange Accommodation Titleholder: A third party that helps to facilitate the exchange. Sometimes refers to as "facilitator," or "accommodator

Equity - The proceeds from the sale of a property.

Exchange Period - The 180-day window in which the Exchangor has to complete an exchange.

50

Exchangor - The owner of the investment property looking to make an exchange.

Fair Market Value - The likely selling price as defined by the market at a specific point in time.

Identification Period - The time period that begins upon the close-of-escrow of the relinquished property. During this 45-day period, the exchangor must identify the replacement property.

Like-Kind Property - The type of properties involved in an exchange that must meet the definition of like-kind in the Internal Revenue Code. Like-kind relates to the nature or character of the property in the hands of the tax payer, and how it fits into the Code definitions. It does not mean identical. For example, undeveloped real estate held for investment and a fully-developed apartment complex would most likely qualify as like-kind for purposes of a §1031 exchange.

Original Basis - The purchase price of a property. It is used to calculate capital gains or losses for tax purposes.

Personal Property - Any property belonging to the Exchangor that is non-real estate related.

Phase I - The process in which the relinquished property is sold and all respective paper work for that process are done. This process is also known as the "down-leg" of the exchange process.

Phase II - The process in which the replacement property is bought and all the respective paperwork for that process are done. This process is also known as the "up-leg" of the exchange process.

QEAA or Qualified Exchange Accommodation Arrangement: The document required by the IRS Code and Regulations that sets out the agreement between a taxpayer and an independent third party as to the terms and conditions of an exchange. There are specific guidelines for what terms the QEAA must contain.

Qualified Intermediary - A third party that helps to facilitate the exchange. Sometimes refers to as "facilitator," or "accommodator."

Realized Gain: the amount received in the transaction (both like-kind and non like-kind property, including cash) minus the basis in the old property.

Recognized Gain: the amount or portion of the realized gain that is taxable.

Relinquished Property - The property that you sell when making an exchange.

Replacement Property - The property that you acquire when making an exchange.

51

Simultaneous Exchange: Also referred to as a concurrent exchange when the Exchanger transfers out of the Relinquished Property and receives the Replacement Property at the same time.

Step Transactions: Transactions that are sometimes disregarded by the IRS in determining that actual nature of a transaction as opposed to what it may appear to be.

Relinquished Property (Property Sold): The property given up by the Exchanger to start the 1031 exchange transaction. This is Phase One of the transaction.

52

Web Sites

The following web sites are but a few of literally hundreds of sites the author found dealing with §1031 like-kind exchanges. Since the initial research, it is likely that even more sites have come into existence. For those with curiosity for more in-depth research, there are innumerable resources, limited only by the student’s time and interest. The provider of the course makes no representations as to the accuracy or completeness of the information contained on these sites, and this listing is not intended, and may not be construed, as an endorsement of either the content or the provider of the information on the site. http://www.findlaw.com/ http://www.expert1031.com/index.html http://www.diversifiedllc.com/1031p/1031P.pdf http://fourmilab.ch/uscode/26usc/www/t26-A-1-O-III-1031.html http://www.rodrawlings.com/exchanges.htm http://www.oldrepnatl.com/exchangefacilitator/1031exchange/irsregs99.pdf http://www.iag1031.com/exchangebasics.asp

53

VI. Exhibits (Note: Documents that are deemed too voluminous for reprinting are shown as websites from which the student can print as much or little of the document as desired.)

Section 121 of the Code: http://fourmilab.ch/uscode/26usc/www/t26-A-1-B-III-121.html

Section 1031 of the Code:

(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 after 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

54

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 a liability of the taxpayer or acquired from the taxpayer property subject to a liability, such assumption or acquisition (in the amount of the liability) shall be 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,

55

(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 rule for foreign real property 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.

Section 1031 IRS Regulations:

http://www.oldrepnatl.com/exchangefacilitator/1031exchange/irsregs99.pdf

Rev. Procedure 2000-37 http://www.unclefed.com/Tax-Bulls/2000/rp00-37.pdf Rev. Procedure 2002-22 http://www.unclefed.com/Tax-Bulls/2002/rp02-22.pdf

Section 267 (b) of the Code: b) Relationships The persons referred to in subsection (a) are: (1) Members of a family, as defined in subsection (c)(4);

(2) An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual;

56

(3) Two corporations which are members of the same controlled group (as defined in subsection (f));

(4) A grantor and a fiduciary of any trust; (5) A fiduciary of a trust and a fiduciary of another trust, if the same person is a

grantor of both trusts;

(6) A fiduciary of a trust and a beneficiary of such trust;

(7) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;

(8) A fiduciary of a trust and a corporation more than 50 percent in value of the

outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;

(9) A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;

(10) A corporation and a partnership if the same persons own -

(A) more than 50 percent in value of the outstanding stock of the corporation, and (B) more than 50 percent of the capital interest, or the profits interest, in the partnership;

(11) An S corporation and another S corporation if the same persons own more than

50 percent in value of the outstanding stock of each corporation; (12) An S corporation and a C corporation, if the same persons own more than 50

percent in value of the outstanding stock of each corporation; or (13) Except in the case of a sale or exchange in satisfaction of a pecuniary bequest,

an executor of an estate and a beneficiary of such estate. Section 1221 of the Code

57

http://uscode.house.gov/uscode-cgi/fastweb.exe?getdoc+uscview+t26t28+859+1++%28%29%20%20AND%20%28%2826%29%20ADJ%20USC%29%3ACITE%20AND%20%28USC%20w%2F10%20%281221%29%29%3ACITE%20%20%20%20%20%20%20%20%20

Section 1231 of the Code http://fourmilab.ch/uscode/26usc/www/t26-A-1-P-IV-1231.html IRS Form 8824 (Like-Kind Exchanges) http://www.irs.gov/pub/irs-pdf/f8824.pdf

58

Contract Language: This following is language you may wish to include in purchase agreements for the sale or relinquished (old) property, and for the acquisition of replacement (new) property. It is not intended as legal or tax advice, and one should always consult with legal and tax professionals before using any form language.

For Sale of relinquished (old) property:

Buyer hereby acknowledges that Seller has the option to qualify this transaction as part of a tax deferred exchange under section 1031 of the Internal Revenue Code. Buyer agrees that Seller may assign its rights and obligations under this agreement to (Insert name of QI) as necessary to facilitate the exchange. Buyer agrees to cooperate with the Seller and (QI) in order to complete the exchange, which will neither delay the closing nor cause additional expense or liability to the Buyer.

For Acquisition of replacement (new) property:

Seller hereby acknowledges that it Buyer has the option to qualify this transaction as part of a tax deferred exchange under Section 1031 of the Internal Revenue Code. Seller agrees that Buyer may assign its rights under this agreement to (Insert name of QI) as necessary to facilitate the exchange. Seller agrees to cooperate with the Buyer and (QI) in order to enable the Buyer to complete the exchange, which will neither delay the closing nor cause additional expense or liability to Seller.

59

Tax Reporting Form 45-day Identification notice: This following a form you may wish to use when dealing with a deferred exchange. It is not intended as legal or tax advice, and one should always consult with legal and tax professionals before using any form language.

TO BE SENT TO (Name of Qualified Intermediary) VIA FACSIMILE OR CERTIFIED MAIL WITHIN 45 DAYS OF TODAY’S CLOSING (insert name of QI, address, and fax number) RE: Designation of Acquisition Property within 45 Days of Closing Exchanger: _________________________________ Sale Property Address: ______________________________________________ Pursuant to the Real Property Exchange Agreement between you and (QI) the following property(s) has been identified as Acquisition Property, as defined in the Exchange Agreement, and is hereby designated as such: Acquisition Property #1 Street Address City, County and State Legal Description, if applicable Estimated Purchase Price Check here if constructing or improving replacement property. Check here if purchasing less than 100% interest. Percentage % Acquisition Property #2 Street Address City, County and State Legal Description, if applicable Estimated Purchase Price Check here if constructing or improving replacement property Check here if purchasing less than 100% interest. Percentage % Acquisition Property #3 Street Address City, County and State Legal Description, if applicable Estimated Purchase Price Check here if constructing or improving replacement property. Check here if purchasing less than 100% interest. Percentage % I intend to purchase: _____Only one of these properties, ______More than one, ______All that I’ve listed (check one) Exchanger Exchanger

60

_______________________________________ Received by Accommodator this Date Signed ______ day of _______________, 200_. ________________________________

Acknowledgments: The material in this course came from a variety of sources, almost all of which are available to the researcher via the Internet, the public libraries of the State of Colorado, and numerous State and Federal websites. The writer acknowledges the contributions of: FindLaw for Legal Professionals Arter & Hadden, LLP The 1031 Exchange Experts, LLC. CBIZ Accounting, Tax and Advisory Services. APEX Property Exchange, Inc. Chicago Deferred Exchange Corporation The Diversified Investment Companies Numerous IRS publications and rulings C. Richard Loftin, Attorney at Law The CPA Journal Petroleum Strategies, Inc. Real Estate eXchange/ors Network Realty Times VestaStrategies, LLC Realty Exchangers, Inc.