understanding 1031 exchanges · 2017-03-28 · replacement property . exchange agreement &...

Understanding 1031 Exchanges

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Founded in 1945, Cantor Fitzgerald is a global financial services firm with approximately 10,000 employees located in more than 150 offices across the U.S. and around the world.

Over the last decade, Cantor has established a vertically-integrated portfolio of real estate companies with capabilities spanning the investment cycle including acquisitions, financing, property management, leasing and investment sales.

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An Introduction to Cantor Fitzgerald

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An Introduction to Cantor Fitzgerald


$15.7 Billion in 2015 Sales

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Fannie Mae, Freddie Mac, & FHA/Ginnie Mae

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Servicing Portfolio of Over $34 Billion

Representing in Excess of 2,000 Loans in 46

States

I. An Introduction to IRC Section 1031

II. Exchange Requirements

III. Step-by-Step Process

IV. The Benefits of a 1031 Exchange

V. DST Structure vs. Direct Real Estate

VI. Overview of the 1031 Environment Today

Summary

UNDERSTANDING 1031 EXCHANGES


An Introduction to IRC Section 1031

01

IRC Section 1031 states “that 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.” IRC Section 1031 is one of the most important and oldest tax planning vehicles available for investment real estate owners—continuously in income tax law since 1921.

What is IRC Section 1031?

AN INTRODUCTION TO THE IRC SECTION 1031


Relinquished property and replacement property must be like-kind, which the IRS defines as being a property that is similar in nature or character, regardless of differences in grade, property type, or quality. This broad definition allows most types of investment or business-use real estate to be exchanged for most any other type of investment or business-use real estate.

Examples of acceptable like-kind exchanges would be:

• Raw land for an apartment building • Duplex for a single tenant NNN asset • Farmland for an office property • Industrial for raw land • Shopping center for an investment

condo

What Constitutes “Like-kind”?



• Fee interest • Fractional (tenancy-in-common)

interest • Leasehold interest, 30-year plus lease • Water rights • Mineral rights • Oil & Gas interests • Certain Transferrable Development

rights • Vacation Homes

Interests that Qualify

• A personal residence • Land under development for resale • Construction or fix/flips for resale • Property purchased for resale • Inventory property • Corporation common stock • Partnership interests • Bonds • Notes

Interests that Do Not Qualify

Which Real Estate Interests Qualify for an Exchange?



Exchange Requirements

02

To successfully complete an exchange and defer all capital gains taxes, investors need to adhere to the following requirements (failure to satisfy these rules will create a tax liability, often referred to as “boot”):

• Purchase a property of Equal or Greater Value.

• Reinvest all of the Equity in Replacement Property. Note: Any equity not reinvested will be subject to tax.

• Obtain equal or greater debt on the replacement property. Exception: A reduction in debt can be offset with additional cash from the exchanger.

1031 Exchange Rules

EXCHANGE REQUIREMENTS


60 60

40 40

10

RelinquishedProperty

ReplacementProperty

Incremental Value

Equity

Debt

100

Equal or

more

Equity

100 Incremental value

can be funded by

assuming more

debt or additional

cash investment.

CLIENT 1

Relinquished Property (Multifamily Asset) Sale Price = $1 million Leverage = 50% Equity = $500,000 & Debt = $500,000 Replacement Property Leverage = 65% Equity = $500,000 & Debt = $769,230 Purchase Price = $1,269,230 Client 1 exchanged into a new property with 15% more leverage, he replaced all of his equity ($500K) and debt ($500K) from his relinquished asset in the new purchase. Client 1 takes on additional leverage which is acceptable per the “equal to or more rule.”

CLIENT 2

Relinquished Property (Duplex) Sale Price = $1 million Leverage = 50% Equity = $500,000 & Debt = $500,000 Replacement Property Leverage = 40% Equity = $500,000 & Debt = $333,333 Purchase Price = $833,333 Client 2 exchanged into new property with 10% less leverage and although the full $500K was deployed, the investor only acquires $333,333 in debt which is $166,667 short of the $500K needed to avoid boot. Client 2 will now be responsible for paying taxes on the $166,667 shortfall.

Successful Exchange: All Taxes Deferred Unsuccessful Exchange: Tax Liability or “Boot”

Hypothetical Examples

EXCHANGE REQUIREMENTS


Step-by-Step Process

03

1031 Exchange structuring begins before the investment property is sold. Taking constructive receipt of any sales proceeds will immediately terminate the exchange. It’s very important that the exchanger seeks help from a Qualified Intermediary (“QI”), also known as an Accommodator, prior to closing on the sale of the investment property.

1031 Language and Constructive Receipt

STEP-BY-STEP PROCESS


A Qualified Intermediary (“QI”) is an agent that is in the business of facilitating Internal Revenue Code Section 1031 tax-deferred exchanges. The QI plays a pivotal role throughout the exchange process from beginning to end; customary services include:

• Replacement property identification - Three Identification Rules

• Final transfer of 1031 proceeds from

escrow/trust account to fund replacement properties

• Established QI firms may also have in-house legal and tax teams to provide additional support to the client’s professional advisors

• Incorporating 1031 exchange language in the investment sale contract prior to closing

• Escrow/Trust account setup so that proceeds from the sale of the relinquished property are sent directly to escrow/trust account

• Timeline management — 45-day and 180-day rules

What is a Qualified Intermediary?



Starting on the date of sale of the relinquished property, the exchanger has 45 days to identify potential replacement properties. Within the 45 day window, exchangers have the ability to change (add or remove) replacement property identifications, but once the 45 day period expires, the replacement property that has been identified is the only property qualified to complete the 1031 exchange. • Identifications are completed with the Qualified

Intermediary through written identification of the address or legal description of the replacement property.

The replacement property must be received and the exchange completed no later than the earlier of: • 180 days after the transfer of the exchanged

property; or

• The due date of the income tax return, including extensions, for the tax year in which the relinquished property was transferred.

THE 45-DAY RULE FOR IDENTIFICATION

THE 180-DAY RULE FOR RECEIPT OF REPLACEMENT PROPERTY

The 1031 Timeline



THE 95% RULE

Any three properties regardless of their market values (most common).

THE THREE- PROPERTY RULE

Any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate FMV of all of the exchanged properties as of the initial transfer date.

THE 200% RULE

Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified.

Identification Rules



1) Exchanger completes Exchange Agreement and escrow account with QI

2) Sales proceeds from the relinquished property are escrowed directly with the QI

Understanding the 1031 Process


PAGE 18

3) QI releases funds to purchase replacement property

4) Exchanger closes on replacement property and completes the exchange


Day 0 Sale of relinquished property

Day 45 Identification period ends

Day 180 Last day to purchase replacement property

1

2

3

4

Replacement

Property Seller

Exchanger

Qualified

Intermediary

Relinquished

Property Buyer

Cash

Relinquished Property

Cash

Replacement Property

Exchange Agreement & Assignments $

The Benefits of a 1031 Exchange

04

For clients who own investment property, IRC Section 1031 may be the single most important tax strategy that can help clients preserve and grow their investment portfolio.

The Impact of a 1031 Exchange

THE BENEFITS OF A 1031 EXCHANGE

PAGE 20

Past performance is not indicative of future results


To fully appreciate the benefits of doing a 1031 exchange, it’s important to understand the tax components:

Long-Term Capital Gains Tax (0%-20%) • 0% (Income less than $37,650/single or $72,500/joint) • 15% (Income between $37,650 and $415,050/single or $72,500 and

$466,950/joint) • 20% (Taxable income above $415,050/single or above $466,950/joint)

Net Investment Income Tax (3.8%) • Up to 3.8% on capital gains (Applied if adjusted gross income is above

$200,000/single or $250,000/joint)

Depreciation Recapture (25%) • All deferred income resulting from depreciation will be recaptured at 25%

2016 Federal Taxes

State Taxes (Up to 13.3%) • 41 states also impose state

capital gains taxes up to 13.3%

State Taxes

Understanding the Tax Components


PAGE 21

All tax rates are for your information only and subject to change


Initial Purchase Price = $500,000 Offer Price = $1,500,000 Improvements (Non Expensed) = $50,000

Steve Johnson, a Southern California native, has been investing in real estate for many years. Steve just received an attractive offer on an investment property he has owned for 20 years. He decides to take the offer but is deciding on whether he should pursue a 1031 exchange or just pay the taxes and cash out. Let’s review each scenario based on the following information. Depreciation = $400,000

Steve’s Income = $500,000 (Annual) CA State Tax = 13.3%

EXAMPLE 1 – STEVE JOHNSON

Defer or Pay Tax?



Scenario 1 – 1031 Exchange Scenario 2 – Pay Tax & Cash Out Initial Purchase $500,000

+ Improvements $50,000

- Depreciation $400,000

Adjusted Cost Basis $150,000

Offer Price $1,500,000

Total Taxable Gain $1,350,000

Capital Gains Tax (20%) $0

State Tax (13.3%) $0

Net Investment Income Tax (3.8%)

$0

Dep. Recapture Tax (25%)

$0

Total Taxes Due $0

Net Proceeds to Reinvest $1,500,000

Initial Purchase $500,000

+ Improvements $50,000

- Depreciation $400,000


Offer Price $1,500,000

Total Taxable Gain $1,350,000

Capital Gains Tax (20%) $190,000

State Tax (13.3%) $126,350


$36,100

Dep. Recapture Tax (25%)

$100,000

Total Taxes Due $452,450

Net Proceeds $1,047,550

Defer or Pay Tax?


PAGE 23

Whether a like-kind exchange is beneficial to a holder of real estate is factually specific and each investor should consult their own tax

advisor and financial advisor.


Initial Purchase Price = $50,000 Offer price = $550,000 Improvements (Non-Expensed) = $0

Grant Singer, a resident of North Carolina, purchased raw land in the Raleigh area many years ago. Lucky for Grant, the Raleigh market has grown significantly and a multifamily developer has offered to purchase his land. Using the information provided below, let’s review the numbers to help Grant make a decision whether to pay taxes or participate in a 1031 exchange. Depreciation = $0

Grant’s Income = $125,000 (Annual) NC State Tax = 5.75%

EXAMPLE 2 – GRANT SINGER

Defer or Pay Tax?


PAGE 24

Whether a like-kind exchange is beneficial to a holder of real estate is factually specific and each investor should consult their own tax advisor and financial

advisor.


Defer or Pay Tax?


Scenario 1 – 1031 Exchange Scenario 2 – Pay Tax & Cash Out Initial Purchase $50,000

+ Improvements $0

- Depreciation $0


Offer Price $550,000

Total Taxable Gain $500,000

Capital Gains Tax (20%) $0

State Tax (5.75%) $0


$0

Dep. Recapture Tax (25%) $0

Total Taxes Due $0

Net Proceeds to Reinvest $550,000

Initial Purchase $50,000

+ Improvements 0

- Depreciation $0


Offer Price $550,000

Total Taxable Gain $500,000

Capital Gains Tax (15%) $75,000

State Tax (5.75%) $28,750


$0

Dep. Recapture Tax (25%) $0

Total Taxes Due $103,750

Net Proceeds $446,250


Delaware Statutory Trust (“DST”) Vs. Direct Real Estate

05

A Delaware Statutory Trust (“DST”) is a business trust that can be used for real estate ownership where a trustee holds title to assets for the benefit of the trust interest owners. Investors in a DST own an undivided interest in the assets held by the trust.

What is a DST?

DST vs DIRECT REAL ESTATE

PAGE 27

There is no guarantee of success. Investors could incur a loss of all or a portion of their investment.


Although the DST structure has become more popular in recent years, the vast majority of 1031 exchanges are completed directly by the client, typically, with the help of a real estate agent and/or broker.

Equity Raised (2002 – 2015) DST vs DIRECT REAL ESTATE


Securitized Fundraising (TIC and DST)

DST’s may provide a solution for exchangers who may not have the time, energy, or real estate expertise to find and/or manage replacement property.

• Access to institutional quality real estate

• Institutional management • Passive ownership • Institutional financing • Non recourse debt • Tax reporting (Grantor letter) • Lower minimum investment

DST Advantages & Disadvantages


PAGE 29

There is no guarantee of success. Investors could incur a loss of all or a portion of their investment.


DST Advantages DST Disadvantages

• Loss of control • Long-term holding periods • Higher fees • No control or involvement in

property management • No public market exists for the

DST Interests, and it is highly unlikely that any such market will develop

Under IRS ruling 2004-86, for beneficial interests to qualify as direct interests in real estate for Section 1031 purposes, the DST must be limited in its actions and may NOT:

1) Exchange DST property for other property

2) Invest cash between distribution dates in anything other than short-term securities

3) Accept additional capital to the DST 4) Renegotiate terms of debt or enter into

new financing 5) Renegotiate existing leases* 6) Enter into new leases* 7) Make repairs or improvements other

than minor, non-structural repairs

To deal with these limitations, DST’s contain provisions for “springing” into a limited liability company taxed as a partnership if action prohibited in the DST format is needed. • This is normally not taxable, but may

limit future 1031 exchange options.

DST Limitations: Seven Deadly Sins


PAGE 30

* Except in the event of an original tenant bankruptcy or insolvency.


06

Overview of the 1031 Environment Today

• Real estate values in most markets across the U.S. have recovered since the recession. This recovery, combined with the continued low interest rate environment, has led to an active market with sellers looking to lock in gains and buyers eager to secure new investment properties with attractive financing.

• This unique environment has created an opportunity for accredited investors who are selling investment properties and looking to defer capital gains via 1031 exchange to access turn-key DST replacement property solutions.

• Real estate is an important part of a portfolio, sometimes the largest component of one’s net worth, so it’s important to understand all the investment options available.

• Work with your financial advisor and tax professional to determine if 1031 DST solutions may be the right solution for you.

Today’s Real Estate Environment

OVERVIEW OF THE 1031 ENVIRONMENT TODAY


EXHIBIT B – DISCLAIMER The information contained herein is for informational purposes only and is not an offer or a solicitation related to the sale of any securities. Such an offer or solicitation can be made only through an Offering Memorandum, which is always the controlling document and supersedes the information contained herein. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. We recommend that you obtain financial and/or tax advice as to the implications of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness. All information and opinions as well as any prices indicated are current only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of Cantor Fitzgerald, L.P. (“Cantor Fitzgerald”) or its affiliates as a result of using different assumptions and/or criteria. The contents of this document have not been and will not be approved by any securities or investment authority in the United States or elsewhere. Cantor Fitzgerald and its affiliates disclaim any and all liability for any loss that may arise from use of the information contained herein. References herein to past returns of any fund, investment product or market sector are no indication of future performance. Cantor Fitzgerald and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting professionals before engaging in any transaction

• There is no guarantee of success. Investors could incur a loss of all or a portion of their investment

• No public market exists for the DST Interests, and it is highly unlikely that any such market will develop.

• There are substantial restrictions on the transfer of DST Interests.

• There is no specified time that the properties will be liquidated and the DST may not be able to sell any or all of the properties at a price equal to or greater than the purchase price paid for the DST Interests.

• Delaware Statutory Trusts are a relatively new vehicle for real estate investment and are inflexible vehicles to own real property.

• If a property is transferred (or the DST is converted) to the Springing LLC, investors will likely lose their ability to participate in a future. Code Section 1031 exchange with respect to the transferred property or properties.

• Investors will have no voting rights and will have no control over management of the DST or the properties.

• There is no guarantee that investors will receive any return.

• The performance of the DST will depend on tenants’ ability to pay rent.

• The properties will be subject to the risks generally associated with the acquisition, ownership and operation of real estate including, without limitation, environmental concerns, competition, occupancy, easements and restrictions and other real estate related risks.

• The DST will only own buildings leased to the tenant and will not be diversified with respect to the assets it owns.

• The properties will be leveraged. • The manager and its affiliates will receive substantial

compensation in connection with the offering and in connection with the ongoing management and operation of the properties.

• The manager and its affiliates are newly formed entities with limited history of operations, limited experience managing or operating Delaware Statutory Trusts and have limited capital.

• An investment in the DST Interests involves certain tax risks.

Consider Additional Risk Factors EXHIBIT A


RIA and/or Broker Dealer inquiries: ______________________________ Cantor Fitzgerald & Co. 110 E 59th St New York, NY 10022 Sales Desk # (855) 9-CANTOR (22-6867) www.cantor.com

understanding 1031 exchanges · 2017-03-28 · replacement property . exchange agreement &...

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