The Power of Strategy™:
Mastering Advanced §1031 Exchange Concepts
A Leading National IRC §1031 “Qualified Intermediary”
TABLE OF CONTENTS
§1031 Exchange Terminology................................................................................................................ 2
IRC §1031.............................................................................................................................................. 3
Dealer Properties ................................................................................................................................... 4
Holding Period Issues ............................................................................................................................ 5
Exchange Entities................................................................................................................................... 6
Partnerships ........................................................................................................................................... 7
Definition of “Like-Kind” Property ....................................................................................................... 8
The Exchange Equation........................................................................................................................ 12
Closing Costs ...................................................................................................................................... 13
Investor Motives.................................................................................................................................. 14
Improving Investment Returns with a Cost Segregation Study ............................................................ 15
Related Party Rules.............................................................................................................................. 16
Overview of the Taxpayer Relief Act of 1997/Jobs & Growth Reconciliation Act of 2003 .................. 17
Treasury Decision 9152: Reduced Maximum Exclusion of Gain from Sale of Principal Residence ..... 18
American Jobs Creation Act of 2004 ................................................................................................... 19
Revenue Procedure 2005-14: Applying §1031 and §121 to a Sale ...................................................... 20
Split Treatment Transactions ............................................................................................................... 21
§1031 Exchange Formats & Variations ................................................................................................ 22
Delayed Exchange with a “Qualified Intermediary” ............................................................................ 23
Identification Rules.............................................................................................................................. 24
Restrictions on Exchange Proceeds...................................................................................................... 25
Highlights of a Valid Delayed Exchange.............................................................................................. 26
What Not to do in a Delayed Exchange ............................................................................................... 27
§1031 Exchange Documentation ......................................................................................................... 28
Multiple Property Exchanges ............................................................................................................... 29
Parking Arrangements ......................................................................................................................... 31
Revenue Procedure 2000-37................................................................................................................ 32
The Reverse Exchange – Replacement Property Parked ....................................................................... 34
The Reverse Exchange – Relinquished Property Parked ....................................................................... 36
The Improvement Exchange................................................................................................................. 38
Revenue Procedure 2004-51................................................................................................................ 40
“Non-Safe Harbor” Parking Arrangements.......................................................................................... 41
Sale vs. Exchange................................................................................................................................. 42
Choosing a “Qualified Intermediary” ................................................................................................. 43
APPENDIX:--“A” Seller Financing ....................................................................................................... 44
---------------“B” Replacement Property Basis .................................................................................... 45
---------------“C” IRS Form #8824....................................................................................................... 46
COURSE OBJECTIVES
The objective of this "open-forum" style is to enlighten the participant in the many
important aspects of Internal Revenue Code Section 1031. The course is
comprehensive, covering all pertinent regulations, major cases and developments.
The course includes a discussion of the most advanced exchanges such as Revenue
Procedure 2000-37 and various “parking arrangement” structures.
NOTICES
This course is for educational purposes only and is intended to provide a broad
overview of all the major issues relating to IRC Section 1031 tax deferred exchanges.
Participants are urged to seek independent legal/tax guidance on each transaction as
circumstances often change and can affect the validity of an IRC §1031 exchange. No
part of this material may be reproduced in any manner without the prior written
consent of Asset Preservation, Inc. ©2006 by Asset Preservation, Inc. All rights
reserved.
ASSET PRESERVATION, INC.
AND STEWART TITLE COMPANY
Asset Preservation, Inc (API) is a subsidiary of Stewart Title Company and dedicated
solely to facilitating 1031 tax deferred exchanges. Established in 1990, API has
successfully facilitated all types of IRC Section 1031 exchanges nationwide. In
addition, API provides unparalleled security of funds through a “Letter of Assurance”
from Stewart Title Company and additional security measures.
National Headquarters
4160 Douglas Blvd. Granite Bay, CA 95746
Phone: 800-282-1031
Fax: 916-791-6003
Web: www.apiexchange.com
Revised 2/28/2006
The Power of Strategy™ (Three-Hour Class)
§1031 EXCHANGE TERMINOLOGY
BOOT: “Non like-kind” property received; Taxable to the extent there is gain.
CASH BOOT: Any proceeds actually or constructively received by the Exchanger.
CONSTRUCTIVE RECEIPT: Although an investor does not have actual possession
of the proceeds, they are legally entitled to the proceeds in some manner such as
having the money held by an entity considered as their agent or by someone
having a fiduciary relationship with them. This creates a taxable event.
DIRECT DEEDING: Transfer of title directly from the Exchanger to Buyer and from
the Seller to Exchanger after all exchange documents have been executed.
EXCHANGER: Entity or taxpayer performing an exchange.
EXCHANGE AGREEMENT: The written agreement defining the transfer of the
relinquished property, the subsequent receipt of the replacement property, and
the restrictions on the exchange proceeds during the exchange period.
EXCHANGE PERIOD: The period of time in which replacement property must be
received by the Exchanger; ends on the earlier of 180 calendar days after the
relinquished property closing or the due date for the Exchanger’s tax return (If the
180th day falls after the due date of the Exchanger’s tax return, an extension may
be filed to receive the full 180 day exchange period.)
IDENTIFICATION PERIOD: A maximum of 45 calendar days from the relinquished
property closing to properly identify potential replacement property(ies).
LIKE-KIND PROPERTY: Any property held for productive use in trade or business
or held for investment; both the relinquished and replacement properties must be
considered “like-kind” to qualify for tax deferral.
MORTGAGE BOOT: This occurs when the Exchanger does not acquire debt that
is equal to or greater than the debt that was paid off on the relinquished property
sale; referred to as “debt relief.” This creates a taxable event.
QUALIFIED INTERMEDIARY: The entity who facilitates the exchange; defined as
follows: (1) Not a related party (i.e. agent, attorney, broker, etc.) (2) Receives a
fee (3) Receives the relinquished property from the Exchanger and sells to the
buyer (4) Purchases the replacement property from the seller and transfers it to
the Exchanger.
RELINQUISHED PROPERTY: Property given up by the Exchanger; also referred to
as the sale, exchange, ‘downleg’ or ‘Phase I’ property.
REPLACEMENT PROPERTY: Property received by the Exchanger; also referred to
as the purchase, target, ‘upleg’ or ‘Phase II’ property.
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The Power of Strategy™ (Three-Hour Class)
INTERNAL REVENUE CODE SECTION 1031
EXCHANGE OF PROPERTY HELD FOR PRODUCTIVE USE IN A TRADE OR
BUSINESS OR FOR INVESTMENT
(a) Nonrecognition of Gain or Loss from Exchange 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 likekind 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 interest,
or
(f)
choses in action.
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The Power of Strategy™ (Three-Hour Class)
INTERNAL REVENUE CODE SECTION 1031
Real estate held as “stock in trade or other property primarily for sale” is
excluded from the tax benefits of IRC §1031. Stock in trade describes property
which is included in the inventory of a dealer and is held for resale to customers in
the ordinary course of business. The gain on the sale of this property is taxed as
ordinary income.
SUBSTANTIATING THE INVESTMENT INTENT
To qualify for a §1031 exchange, a taxpayer must be able to support that their
intent at the time of the purchase was to hold the property for investment. Listed
below are some factors the IRS may review to determine whether or not the
intent was to hold the property for investment. The burden of substantiating the
investment intent is the responsibility of the taxpayer and the items below are not
an exhaustive list but provide useful indicators in determining the taxpayer's
intent.
•
The nature and purpose of the acquisition of the property and the
duration of ownership;
•
The extent and nature of the taxpayer's efforts to sell the property;
•
The number, extent, continuity and substantiality of the sales;
•
The use of a business office for the sale of the property;
•
The character and degree of supervision or control exercised by the
taxpayer over any representative selling the property;
•
The time and effort the taxpayer habitually devoted to the sales.
CAN A “DEALER” PERFORM AN EXCHANGE?
The fact that a taxpayer is considered a dealer does not automatically disqualify
them from performing an exchange. A dealer may segregate assets that they
intend “to hold for productive use in a trade or business or for investment” from
their dealer property. Some dealers have been advised by their attorneys to form
a separate entity, such as an LLC, specifically to hold title to property that may be
able to qualify for an exchange sometime in the future.
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The Power of Strategy™ (Three-Hour Class)
DEFINITION OF “LIKE-KIND” PROPERTY
“HOLDING PERIOD” ISSUES
IRC §1031 states that property “held for productive use in a trade or business or
for investment” must be exchanged for like-kind property. A frequently asked
question is, “Exactly how long does a property need to be held to be considered
an investment property by the IRS?” There is much confusion and misinformation
among real estate agents and investors on the issue of what is viewed as “held for
investment.”
A MORE COMPLETE PERSPECTIVE
There is no safe holding period for property to automatically qualify as being
“held for investment.” Time is only one factor at which the IRS looks in
determining the Exchanger’s intent for both the relinquished and replacement
properties. The IRS may look at all the facts and circumstances of an investor’s
situation to determine the Exchanger’s true intent for both properties involved in
an exchange.
ADDITIONAL PERSPECTIVES
• In one private letter ruling (PLR 8429039), the IRS stated that a minimum
holding period of two years would be sufficient. Many advisors believe two
years is a conservative holding period, provided no other significant factors
contradict the investment intent.
• Other advisors recommend that Exchangers hold property for a minimum
of at least twelve months. The reason for this is that a holding period of 12
or more months means the investor will usually reflect it as an investment
property in two tax filing years.
• The investor’s “intent” in holding both the relinquished and replacement
properties is the central issue. Each Exchanger and their advisors should be
able to substantiate that properties relinquished and acquired in a tax
deferred exchange were “held for investment.”
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EXCHANGE ENTITIES
Generally in a §1031 tax deferred exchange, an Exchanger should take title to the
replacement property in the same manner they held title on the relinquished
property. In most cases, the entity initiating the exchange must be the same entity
concluding the exchange. Some examples are reflected below:
•
If a wife relinquishes, then the wife acquires;
•
Smith LLC relinquishes, Smith LLC acquires;
•
Gemco Corp. relinquishes, Gemco Corp. acquires;
•
Durst Partnership relinquishes, Durst Partnership acquires.
SOME EXCEPTIONS TO THE GENERAL RULE
•
Partnerships and Limited Liability Companies (LLC’s): An Exchanger who
elects taxation as a sole proprietorship can hold the relinquished property as
an individual but acquire the replacement property as a single-member,
single-asset LLC. This provides the benefit of liability protection and also can
help to satisfy the ‘single asset entity’ requirements that many lenders impose
on replacement property purchases. The IRS has also ruled that a limited
liability company with two members will be considered a single member
limited liability company if the sole role of one of the members is to prevent
the other member from placing the LLC into bankruptcy and that the limited
role member had no interest in LLC profits or losses nor any management
rights other than the limited right regarding bankruptcy.
•
Grantor Trusts: An Exchanger can acquire a replacement property in a
revocable living trust or “grantor” trust for estate planning purposes.
•
Death of an Exchanger: If the Exchanger dies during the exchange, the
Exchanger’s estate may complete the exchange.
BUSINESS CONSIDERATION/LENDER REQUIREMENTS
Sometimes a business consideration, lender requirement or the Exchanger’s
liability issues can make it difficult to keep the vesting entity the same throughout
the exchange. For this reason, it is important that Exchangers review the entire
exchange transaction with their legal and/or tax advisors before closing on the
sale of the relinquished property.
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The Power of Strategy™ (Three-Hour Class)
INTERNAL REVENUE CODE SECTION 1031
A partnership may exchange property for other property of "like-kind." However,
IRC Section 1031(a)(2)(D) specifically prohibits exchanges of partnership interests.
This means that an Exchanger cannot buy into or sell interests in a partnership
and qualify for a §1031 exchange. The rationale is that a partnership interest
[along with a real estate investment trust (REIT) share] itself is personal property
and thus is not "like-kind" with real property.
IS IT A 'TRUE' PARTNERSHIP?
First, investors owning a property together must determine if they really own the
property in a true "partnership."
POTENTIAL ALTERNATIVES
One option is that the entire partnership stays intact and exchanges the
relinquished property for a replacement property. After the partnership closes on
the replacement property, the property can be refinanced and the proceeds are
distributed to the partner who wants to cash out.
Another alternative is that the partnership has a valid election out of subchapter K
under IRC §761(a). The partner seeking to cash out sells their undivided interest
and the other partner exchanges their tenancy-in-common interest for a
replacement property. Issues to consider:
•
•
•
Advance planning is important, as the greater the period of time between the
election out of the partnership and the exchange, the better. The election out
of the partnership to the individuals as an undivided interest shortly before
closing on the relinquished property leaves open the possibility that the
exchange would be invalidated because the property was not held as an
undivided interest long enough to be considered "held for investment."
[Note: In several instances, however, the Tax Court has extended §1031 tax
deferral to former partners who changed their ownership structure prior to
closing on a relinquished property.]
If the entire partnership will be exchanging, it is preferable that the
Partnership Agreement mention that they are holding the property "for
investment or use in a trade or business."
Every Exchanger should always consult with their legal and/or tax advisors to
review the many issues and risks involved with partnership situations.
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The Power of Strategy™ (Three-Hour Class)
DEFINITION OF “LIKE-KIND” PROPERTY
“As used in IRC 1031(a), the words like-kind have reference to the nature or
character of the property and not to its grade or quality. One kind or class of
property may not, under that section, be exchanged for property of a different
kind or class. The fact that any real estate involved is improved or unimproved is
not material, for that fact relates only to the grade or quality of the property and
not to its kind or class. 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.”
PROPERTY HELD FOR PRODUCTIVE USE IN A
TRADE OR BUSINESS OR FOR INVESTMENT
REAL PROPERTY = REAL PROPERTY
REAL PROPERTY. Real Estate which can be exchanged under IRC §1031 as "likekind" is extremely broad and is supported by numerous Revenue Rulings and
Private Letter Rulings that have addressed this subject.
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The Power of Strategy™ (Three-Hour Class)
DEFINITION OF “LIKE-KIND” PROPERTY
WHAT IS EXCLUDED?
An Exchanger’s primary residence and property held “primarily for sale” (dealer
property) are excluded from tax deferral under IRC §1031. [Note: Primary
residences qualify for tax exclusion, with certain restrictions, under IRC §121.]
QUALIFYING REAL PROPERTY
Any real estate held for productive use in a trade or business or for investment –
whether improved or unimproved – is considered “like-kind.” Improvements to
real estate refer to the grade or quality, not the nature or character of the real
property. Like-kind examples:
•
Unimproved for improved property
•
Fee for a leasehold with 30+ years to run
•
Vacant land for a commercial building
•
Duplex for commercial property
•
Single family rentals for an apartment
•
Industrial property for rental resort property
•
An easement for a rental property
QUALIFYING PERSONAL PROPERTY
Personal property that qualifies for a §1031 exchange must be “held for
productive use in a trade or business or for investment.” In general, qualifying
properties must both be in the same Asset Class or within the same Product Class.
The Standard Industrial Classification Manual provides categories for General
Asset Classes of depreciable tangible personal property. It is critical to review any
personal property transactions with tax advisors because the rules are far more
restrictive than for real property.
•
Business turboprop aircraft for business jet aircraft
•
Mexican gold coins for Austrian gold coins
•
Restaurant equipment for restaurant equipment
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The Power of Strategy™ (Three-Hour Class)
DEFINITION OF “LIKE-KIND” PROPERTY
VACATION HOMES
Property owners throughout the nation are obtaining the benefit of full
reinvestment of equity under Internal Revenue Code §1031. Some investors
exchange out of a single family rental, duplex, or any other type of investment
property and into a vacation/second home. Many tax/legal advisors believe it is
possible to perform an exchange on a vacation/second home which can be
considered “held for investment.”
SUPPORT FOR VACATION HOME EXCHANGES?
In Private Letter Ruling (PLR) 8103117, the IRS did allow for tax deferral when a
property owner intended to acquire property for personal enjoyment and as an
investment. As stated in this PLR, “...the house and lot you acquire in this trade
will be held for the same purposes as the properties exchanged: to provide for
personal enjoyment and to make a sound real estate investment.” Although a
PLR only applies to the facts and circumstances in a particular individual’s specific
situation, it appears, in this instance, that “personal enjoyment” of a property
does not prevent a property owner from benefiting from a tax deferred exchange.
EACH INDIVIDUAL CASE MUST BE REVIEWED
Note: There are no regulations, statutes, or court cases which give a definitive
answer on the exchange of vacation/second homes. Each exchange must be
reviewed on a case-by-case basis. To qualify for an exchange, the property owner
should be able to support that the property was “held for investment.”
A BRIEF ANALYSIS
Reg. 1.1031(a)-1(b) states in the definition of “like-kind” that “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.” It appears
that even property owners who have never rented their vacation property but can
substantiate that they acquired and held the property because they expected it to
increase in value (a wise investment decision) may qualify for a §1031 tax
deferred exchange. IRC §165 and IRC §280, which address when losses may be
deducted on vacation homes, may provide additional guidance to investors.
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The Power of Strategy™ (Three-Hour Class)
DEFINITION OF “LIKE-KIND” PROPERTY
TENANT-IN-COMMON (“TIC”) PROGRAMS
Acquiring a tenant-in-common (TIC) property ownership interest in a large
property with multiple owners is an option that can provide Exchangers with
creditworthy tenants, secure monthly income, stability and growth. A TIC interest
represents co-ownership between two or more investors. Rather than owning
100% of a smaller property, the investor receives a separate deed to an undivided
interest, thus owning a fractional interest in a much larger property. Great care
should be taken so that the TIC arrangement is not considered a joint venture or
partnership which could invalidate the tax deferred exchange.
REVENUE PROCEDURE 2002-22
Revenue Procedure 2002-22 addresses a couple of issues:
1) Guidelines for requesting advance rulings to assist taxpayers in preparing a
ruling request on a specific “co-ownership” structure and proposed
transactions.
2) Conditions present in the proposed TIC structure under which the IRS
normally will consider a ruling request.
REQUIRED GENERAL INFORMATION
• Name, taxpayer ID number, and percentage fractional interest;
• Name, taxpayer ID number, ownership of all persons involved in the
acquisition, sale, lease (including the sponsor, lessee, manager and lender);
• Full description of the property;
• Representation that each co-owner holds title to the property as a tenant-incommon under local law;
• All promotional documents relating to the sale;
• All lending agreements;
• All agreements among the co-owners;
• Any lease agreeements;
• Any purchase and sale agreements;
• Any property management or brokerage agreement;
• Any other agreement relating to the property including debt agreeements, and
any call and put options relating to the property.
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THE EXCHANGE EQUATION
In order for an exchange to qualify for 100% tax deferral, the Exchanger must
meet two requirements:
1. Reinvest all net proceeds exchange proceeds.
Example 1
2. Acquire property with the same or greater debt. (The IRS considers a
reduction in debt a benefit to the Exchanger unless it is offset by adding
equivalent cash to the replacement property purchase.)
Value
-Debt
-Cost of Sale
Net Equity
Total Boot
Relinquished
$ 900,000
$ 300,000
$
60,000
$ 540,000
Replacement
$ 1,200,000
$
660,000
Boot
$
$0
$0
$0
540,000
The Exchanger acquired property of greater value, reinvesting all net equity and
increasing the debt on the replacement property.
Example 2
Analysis: This results in no boot.
Value
-Debt
-Cost of Sale
Net Equity
Total Boot
Relinquished
$ 900,000
$ 300,000
$
60,000
$ 540,000
Replacement
$ 700,000
$ 260,000
$
440,000
Boot
$ 40,000
$ 100,000
$ 140,000
The Exchanger acquired property of a lower value, keeps $100,000 of the net
equity and acquired a replacement property with $40,000 less debt.
Example 3
Analysis: This results in a total of $140,000 in boot.
($40,000 (mortgage boot) + $100,000 (cash boot) = $140,000)
Value
-Debt
-Cost of Sale
Net Equity
Total Boot
Relinquished
$ 900,000
$ 300,000
$
60,000
$ 540,000
Replacement
$ 800,000
$ 260,000
$
540,000
Boot
$ 40,000
$0
$ 40,000
The Exchanger acquired property of a lower value, reinvesting all net equity, but
has less debt in the replacement property.
Analysis: This results in $40,000 in mortgage boot.
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The Power of Strategy™ (Three-Hour Class)
CLOSING COSTS
Although the IRS has not published a complete list of qualifying expenses, there
are some rulings that provide general parameters. Brokerage commissions can be
deducted from the exchange proceeds (Revenue Ruling 72-456). Other
transactional costs may also be able to be deducted if they are paid in connection
with the exchange. (Letter Ruling 8328011).
WHAT ARE “EXCHANGE EXPENSES?”
Transactional costs that are referred to as “exchange expenses” on Form 8824
are not specifically listed but should generally include costs that are:
A. A direct cost of selling real property, which typically include:
•
•
•
•
•
•
Real estate commissions
Title insurance premiums
Closing or escrow fees
Legal fees
Transfer taxes and Notary fees
Recording fees - or -
B. Costs specifically related to the fact the transaction is an exchange such as the
Qualified Intermediary fees.
ITEMS THAT ARE NOT “EXCHANGE EXPENSES”
Although not a complete list, the costs related to obtaining the loan should not be
deducted from the proceeds. These and other “non-exchange expenses” include:
•
•
•
•
•
•
•
•
•
•
Mortage points and assumption fees
Credit reports
Lender’s title insurance
Prorated mortgage insurance
Loan fees and loan application fees
Property taxes
Utility charges
Association fees
Hazard insurance
Credits for lease deposits
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The Power of Strategy™ (Three-Hour Class)
INVESTOR MOTIVES
Investors have the ability to go from one type of property to
another allowing an investor to utilize the following concepts:
• LEVERAGE
High equity property for……………...Highly leveraged property
• DIVERSIFICATION
Commercial property for……………..Industrial and apartments
• CONSOLIDATION
Multiple property types for…………..Single property type
• CASH FLOW
Non-income producing land………….Triple-net leased property
• MANAGEMENT RELIEF
Multiple rental properties for…………Single-user commercial
• INCREASE DEPRECIATION
Fully depreciated building for………..Property with a new depreciation
• ESTATE PLANNING
One large building for………………..Properties designated for each heir
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The Power of Strategy™ (Three-Hour Class)
IMPROVING RETURNS WITH COST SEGREGATION
A cost segregation study is a strategic tax saving tool that allows property owners
who have constructed, purchased, remodeled, or expanded virtually any kind of
real property, to increase current cash flows by accelerating depreciation
deductions and deferring federal and state income taxes. A cost segregation study
identifies, separates, and reclassifies property inaccurately depreciated as real
property, as personal property with a shorter depreciable tax life. By increasing
current income through the deferral of income taxes to a later tax period,
property owners benefit financially because of the time value of money related to
the deferral of taxes. Put simply, a tax deduction today is worth more than a tax
deduction spread over decades.
WHAT IS INVOLVED IN A COST SEGREGATION STUDY?
Although the Internal Revenue Service requires property owners to depreciate real
property and most leasehold improvements over a 27.5 or 39-year period, a cost
segregation study helps property owners improve their immediate cash flow and
save money. This tax savings occurs by accelerating deductions which provides an
immediate deferral of income taxes.
Real property is assigned a 27.5-year or 39-year straight depreciation period
under the Modified Accelerated Cost Recovery System (MACRS). However,
certain land improvements and personal property can have significantly more
advantageous tax recovery periods. Without a cost segregation study, the cost
basis of the shorter-life assets are typically undifferentiated from the construction
costs or purchase price. The real property recovery period for these assets is often
much longer than necessary. A cost segregation study analysis can produce a
substantial classification into shorter-life property, which means current tax
deferral. [Note: This information was provided by Asset Segregation, LLC;
www.assetsegregation.com]
BENEFITS OF A COST SEGREGATION STUDY
•
Reduced income taxes
•
Reduced property taxes
•
Reduced sales taxes
•
Increased cash flow
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RELATED PARTY RULES
The related party rules were enacted to prevent related parties from “basis
shifting” and cashing out of an investment and avoiding tax if either party’s
property is disposed of within two years of the exchange. In addition, §1031(f)
states that the Internal Revenue Service reserves the right to invalidate any
exchange in which the taxpayer can’t prove that the “exchange” did not have a
principal purpose of avoiding taxes that would otherwise be due or avoiding the
purposes of the related party rules.
WHO IS A RELATED PARTY?
A related party is any person or entity bearing a relationship with the taxpayer.
Although not an exhaustive definition, this includes:
1. Family members such as brothers, sisters, spouses, ancestors and
lineal descendents. (Stepparents, uncles in-laws, cousins, nephews
and ex-spouses are not considered related.)
2. A corporation or partnership in which more than 50% of the stock or
more than 50% of the capital interest is owned by the taxpayer.
SIMULTANEOUS EXCHANGE
When related parties directly swap with each other, both parties must hold the
property acquired for two years following the exchange, or else the capital gain
tax will need to be recognized.
DELAYED – SELLING TO A RELATED PARTY
A taxpayer can sell to a related party, but the related party must hold the property
for a minimum of two years or the exchange will be invalidated. (Note: The twoyear period begins as of the last transfer performed.)
DELAYED – PURCHASING FROM A RELATED PARTY
A taxpayer should not purchase a replacement property from a related party. In
Private Revenue Ruling 9748006, the IRS disallowed tax deferral to a taxpayer
who purchased his mother’s property. Rev. Ruling 2002-83 also indicates
purchasing property from a related party is not desirable.
DELAYED – PURCHASING FROM A RELATED PARTY WHO IS EXCHANGING
In PLR 2004-40002, a related party exchanged into a property owned by a
related party who also performed a 1031 exchange. In this situation, an
exchange was allowed because neither related party was cashing out of their
investment and it was determined that tax avoidance was not the primary
objective.A reasonable guideline to observe is: “If the buyer and seller are related,
and one of the parties ends up with the property and the other ends up with
thecash, the exchange may be disallowed.”
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TAXPAYER RELIEF ACT OF 1997 – IRC §121
PRIMARY RESIDENCE: IRC §121
• Couples filing a joint tax return can exclude up to $500,000 of gain on the sale
of their principal residence, and single filers can exclude up to $250,000
• Gains in excess of $500,000 were taxed at the capital gain rate of 20% (as
opposed to 28%) (Note: This was lowered to 15% or 5% on May 6, 2003)
• New rates and rules effective for dispositions on or after May 7, 1997
• Home must have been the primary residence of both spouses 2 of the last 5
years
• $500,000 exclusion available once every 2 years
• Vacation homes and second homes do not qualify
• If the home was used as a rental and a primary residence during ownership,
any depreciation taken after May 7, 1997 must be recognized on the sale.
JOBS AND GROWTH RECONCILIATION ACT
MAY 6, 2003
• Rate reduced to 15% (from 20%) for taxpayers in the top tax bracket
• Rate reduced to 5% for taxpayers in the 10% and 15% tax brackets
• Retroactive to May 6, 2003
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T.D. 9152 – REDUCED MAXIMUM EXCLUSION OF GAIN
FROM SALE OR EXCHANGE OF PRINCIPAL RESIDENCE
The final regulations apply to a taxpayer who has not owned and used the
property as the taxpayer’s principal residence for two of the preceding five years.
Section 121(b)(3) allows the taxpayer to apply the maximum exclusion to only
one sale or exchange during the two-year period ending on the date of the sale or
exchange. Section 121(c) provides that a taxpayer who fails to meet any of the
conditions by reason of a change in place of employment, health, or, to the
extent provided in regulations, unforeseen circumstances,
Employment: Exception permitted if the new job site is at least 50 miles farther
from the old home than the old workplace was from that home.
Health: Exception permitted if the primary reason is related to a disease, illness or
injury or if a physician recommends a change in residence for health reasons. In
addition, a qualified person for health reasons includes close relatives, so that sales
related to caring for sick family members will qualify.
Unforeseen Circumstances:
• Death
• Divorce or legal separation
• Becoming eligible for unemployment compensation
• Change in employment that leaves the taxpayer unable to pay the
mortgage or reasonable basic living expenses
• Multiple births resulting from the same pregnancy
• Damage to the residence resulting from a natural or man-made disaster, or
an act of war or terrorism
• Condemnation, seizure or other involuntary conversion.
WHICH HOUSE IS THE ‘PRINCIPAL RESIDENCE?’
Generally, the property the taxpayer uses a majority of the time will be
considered the taxpayer’s principal residence. A number of factors are relevant in
determining which home is the “principal residence” of taxpayers who own more
than one home:
•
•
•
•
•
•
Place of employment
Amount of time used
Where other family members live
Address used for tax returns
Driver’s license, car and voter registration
Bills and correspondence and location of taxpayer’s banks and clubs
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AMERICAN JOBS CREATION ACT OF 2004
5 YEAR COMBINED HOLDING PERIOD TO EXCLUDE GAIN UNDER IRC §121
On October 22, 2004, President Bush signed into law corporate and foreign tax
legislation that also contained a provision affecting IRC §1031. Under this
provision, an Exchanger who performs an IRC §1031 tax deferred exchange into
a rental house as replacement property and later the rental house is converted
into the Exchanger’s primary residence, is not allowed to exclude gain under the
principal residence exclusion rules of IRC §121 unless the sale occurs at least five
years after the closing date of the replacement property purchase. The
Conference Agreement on H.R. 4520 includes the following provision to amend
§121(d):
Sec. 840. Recognition of gain from the sale of a principle residence acquired in a
like-kind exchange within 5 years of sale. (10) PROPERTY ACQUIRED IN LIKEKIND EXCHANGE -- If a taxpayer acquired property in an exchange to which
section 1031 applied, subsection (a) shall not apply to the sale or exchange of
such property if it occurs during the 5-year period beginning with the date of the
acquisition of such property.
The change to IRC §121 is effective for principal residence sales occurring on or
after October 22, 2004. All investors who previously acquired their current
residence through a §1031 exchange within the past three years will now have to
wait at least two more years before selling their residence to exclude the gain.
This assumes they meet the two out of five year occupancy test.
The result of this additional requirement to IRC §121 is that an investor
exchanging into a rental house, which they convert to a primary residence at a
later date, will have to wait a minimum of five years to exclude capital gain under
IRC §121 (subject to the maximum exclusion restrictions of $500,000, married
filed jointly; $250,000 filing as a single). Also, note that the Exchanger must
initially intend to hold the replacement property for investment.
AN EXAMPLE
An Exchanger completes an exchange for a rental home that is held for
investment and rents the property out for two years. The exchanger decides to
move into their former rental house and live it in as their primary residence. Under
the new law, they will have to wait for at least three years before selling their
primary residence and excluding gain under IRC §121.
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REVENUE PROCEDURE 2005-14:
APPLYING §1031 & §121 TO A SALE
The IRS recently gave guidance in Revenue Procedure 2005-14 on how to report
exchanges of property used as a principal residence and for business/investment use in
the last five years. A property owner can convert a principal residence to a rental
property and later sell it and benefit from both IRC §121 (principal residence tax
exclusion rules) and IRC §1031 (investment property tax deferred exchange rules).
Property owners must comply with all the rules in both sections to qualify.
APPLICATION OF §121 AND §1031
If a property owner has owned and lived in a principal residence for at least 2 out of the
last 5 years preceding the sale of the principal residence, the following capital gain tax
exclusions may apply to the sale of the property (with the exception of any depreciation
taken on the property since May 6, 1997): 1) $250,000 if filing as a single taxpayer; or,
2) $500,000 if married and filing a joint return. IRC §121 does not require the owner to
live in the property at the time of closing to qualify for gain exclusion. A principal
residence does not qualify if it was purchased in a §1031 exchange within the previous 5
years.
In essence, the Treasury has declared that if an owner lives in the residence long enough
to meet the principal residence requirements, they may then convert the house into a
property “held for investment” which can qualify for a §1031 exchange. (Note:
Although there is no defined “holding period” to be considered “held for investment,”
many tax/legal advisors believe 1-2 years is sufficient barring any factors which
contradict an investment intent.) The property owner can perform an IRC §1031
exchange and still be eligible for gain exclusion under IRC §121.
When the owner sells the home as an investment property, they must still meet all the
necessary requirements for tax deferral. This includes hiring a Qualified Intermediary
prior to closing on the relinquished property and adhering to all the time requirements of
an exchange, such as identifying the replacement property within 45 calendar days from
the sale date and purchasing all replacement properties within 180 days, or the owner’s
tax filing date, whichever is earlier.
DEPRECIATION
The property owner can exclude gain up to $250,000 (filing single) or $500,000 (filing
jointly) under IRC §121 except for any depreciation taken on the property after May 6,
1997. Realized gain is first excluded under IRC §121 and then is eligible for deferred tax
treatment under IRC §1031.
The revenue procedure provides six illustrations of depreciation and boot treatment
when both the benefit of §121 exclusion and §1031 deferral are applied. Please visit the
“Tax Code/Legal References” section at apiexchange.com to read the full text of
Revenue Procedure 2005-14.
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SPLIT TREATMENT EXCHANGES
USE TWO TAX CODE SECTIONS TO YOUR ADVANTAGE
A property owner selling a duplex, triplex or fourplex, where the owner lives in
one unit and rents out the remaining units, can use two tax code sections and
receive excellent tax advantages! The unit where the owner lives is considered
their primary residence and can qualify for exclusion of capital gain taxes as
described in IRC §121. The capital gain taxes associated with the remainder of the
multi-family property can qualify for tax deferral by performing a §1031 tax
deferred exchange on the rental units.
§121– BENEFITS OF SELLING A RESIDENCE
Tremendous tax benefits are available on the portion of the property considered
the primary residence by the owners. §121 of the tax code allows a homeowner
to exclude capital gain taxes if they meet the following requirements:
• Couples filing a joint tax return can exclude up to $500,000 of the capital
gain on the sale of their primary residence, and single filers can exclude up
to $250,000.
• The home must have been the primary residence of both spouses two of the
last five years.
• (Note: The two years may consist of 24 full months or 730 days.)
ALLOCATION ISSUES
A good tax professional is generally needed to determine the value allocated to
the residence portion and to the remaining units held for investment. A few of the
ways the allocation can be determined include:
• Percentage devoted to residence vs. investment portion
• Value of the improvements in the residence vs. investment portion
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The Power of Strategy™ (Three-Hour Class)
§1031 EXCHANGE FORMATS & VARIATIONS
The following section contains the main types of exchanges used regularly. The
Delayed Exchange is certainly the most predominant §1031 exchange format, as
it utilizes the Safe Harbors provided in the 1991 Rules & Regulations. It cannot be
overemphasized that each §1031 transaction contains a unique set of facts and
circumstances and, therefore, each transaction should be reviewed individually.
•
•
•
•
•
•
The Two-Party Trade (“swap”)
The Three-Party Format
The Delayed Exchange
Multiple Sales and Acquisitions
The Reverse Exchange
The Improvement Exchange
REGULATION SECTION 1.1031 (k)-1
TREATMENT OF DEFERRED EXCHANGES
“A deferred exchange is defined as an exchange in which, pursuant to an
agreement, the taxpayer transfers property held for productive use in a trade or
business or for investment (the "relinquished property") and subsequently
receives property to be held either for productive use in a trade or business or for
investment (the "replacement property".)
In order to constitute a deferred exchange, the transaction must be an exchange
(i.e., a transfer of property for property, as distinguished from a transfer of
property for money).
The transfer of relinquished property in a deferred exchange is not within the
provisions of Section 1031 (a) if, as part of the consideration, the taxpayer
receives money or property which does not meet the requirements of Section
1031 (a).
In addition, in the case of a transfer of relinquished property in a deferred
exchange, gain or loss may be recognized if the taxpayer "actually or
constructively receives money. "
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The Power of Strategy™ (Three-Hour Class)
FORMAT: THE DELAYED EXCHANGE WITH A “QI”
EXCHANGER
SALE
PURCHASE
A.P.I.
BUYER
STEWART TITLE
CLOSING AGENT
$
$
SELLER
45
DAYS
0
Identification Period
Total Exchange Period
180
DAYS
IDENTIFICATION PERIOD
• Ends on midnight of the 45th calendar day after closing on the sale property
TOTAL EXCHANGE PERIOD:
• 180 calendar days or day tax return is due, whichever is earlier
IDENTIFICATION RULES:
(1) THREE PROPERTY RULE: The Exchanger may identify a maximum of
three (3) replacement properties without regard to the fair market value
of the properties.
(2) TWO HUNDRED PERCENT RULE: The Exchanger may identify any
number of properties, so long as the aggregate fair market value of the
identified properties does not exceed 200% of the aggregate fair market
value of the relinquished properties.
(2) NINETY FIVE PERCENT RULE: The Exchanger may identify any number
of properties without regard to the aggregate fair market value so long
as exchanger receives 95% of the aggregate fair market value of all
identified replacement properties, prior to the end of the one hundred
and eighty day period.
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The Power of Strategy™ (Three-Hour Class)
IDENTIFICATION RULES
The identification period in a delayed exchange begins on the date the Exchanger
transfers the relinquished property and ends at midnight on the 45th calendar day
thereafter. To qualify for a §1031 tax deferred exchange, the tax code requires
the Exchanger to identify replacement property:
•
In a written document signed by the Exchanger;
•
Must be unambigously described (street address, legal description);
•
Hand delivered, mailed, telecopied, or otherwise sent;
•
Before the end of the identification period (within 45 calendar days);
•
To either the person obligated to transfer the replacement property to the
Exchanger [generally the “QI”] or any other person involved in the
exchange other than the taxpayer or a disqualified person.
The type of property should be described in a personal property exchange.
ADDITIONAL ISSUES
• Exchangers acquiring a property which is being constructed must identify
this property and the improvements in as much detail as is practicable at
the time the identification is made. Exchangers who intend to acquire less
than a 100% ownership interest in the replacement property should specify
the specific percentage interest. Exchangers should always consult with
their tax and/or legal advisors about the specific identification rules and
restrictions.
• Any properties acquired within the 45-day identification period are
considered properly identified. An investor has the ability to substitute new
replacement properties by revoking a previous identification and correctly
identifying new replacement properties as long as this is done in writing
within the 45-day identification period and in accordance with all
identification rules.
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The Power of Strategy™ (Three-Hour Class)
RESTRICTIONS ON EXCHANGE PROCEEDS
SECTION 1.1031(k)-1(g)(6)
PLR 2000-27028 clarified an issue regarding the section of the Treasury
Regulations, which describe under what conditions an Exchanger can obtain
proceeds held by a Qualified Intermediary. In a deferred exchange, U.S. Treasury
Regulations, Section 1.1031 (k)-1(g)(6), require stipulations in the exchange
agreement which limit the Exchanger’s ability “to receive, pledge, borrow or
otherwise obtain the benefits of money or other property before the end of the
exchange period. The Exchanger may have rights to receive, pledge, borrow, or
otherwise obtain the benefits of money or other property upon or after:
(a) The receipt by the Taxpayer of all replacement property to which the
taxpayer is entitled under the exchange agreement
(b) The occurrence after the end of the identification period of a material
and substantial contingency that —
1) Relates to the deferred exchange,
2) Is provided for in writing, and
3) Is beyond the control of the Taxpayer and of any disqualified
person (as defined in paragraph (K) of this Section), other than the
person obligated to transfer the replacement property to the
taxpayer.”
WHAT IS THE IMPACT OF THESE RESTRICTIONS?
• SCENARIO #1: The Exchanger identifies multiple replacement properties within
the 45-day Identification Period, acquires one of these properties within the
Identification Period, and they would like to receive the remaining proceeds
(referred to as ‘cash boot’) in the exchange account.
A SOLUTION: Revoke the Identification of all other replacement properties, so
the remaining proceeds can be released on day 46 by the Qualified
Intermediary.
• SCENARIO #2: The Exchanger identifies multiple replacement properties and
acquires at least one, but not all of these properties. However, they are past
the 45-day Identification Period, and they would like to receive the
remaining proceeds.
A SOLUTION: The remaining exchange proceeds must be held by the Qualified
Intermediary until either the end of the exchange period (day 181) or one of
the occurrences specifically cited in the (g)(6) restrictions.
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HIGHLIGHTS OF A VALID DELAYED EXCHANGE
(1) If possible, establish the taxpayer's intent to perform an
exchange in the purchase and sale contract.
(2) Consult with an experienced "Qualified Intermediary," (Q.I.),
and their own tax/legal advisor prior to closing the sale of the
relinquished property.
(3) Ensure that the purchase and sale contract is "assignable" and
that the buyer is made aware of such assignment in writing. It
is common to show the seller as "John Doe and/or assignee."
(4) The following verbiage is to establish three things: 1) Intent to
effect a §1031 tax deferred exchange; 2) Release the Buyer
from any liabilities or costs resulting in the Exchange; 3) Notify
the buyer in writing of assignment.
SALE OF RELINQUISHED PROPERTY: COOPERATION CLAUSE:
“Buyer is aware that Seller is to perform an IRC §1031 tax
deferred exchange. Seller requests buyer’s cooperation in such
an exchange, and agrees to hold buyer harmless from any and
all claims, liabilities, costs, or delays in time resulting from such
an exchange. Buyer agrees to an assignment of this contract by
the Seller.”
(5) The Qualified Intermediary’s Exchange Agreement must be
executed prior to closing the sale.
(6) The Qualified Intermediary should oversee the closing to ensure
that the closing properly reflects the §1031 exchange.
(7) The Exchanger must identify the property(ies) to be acquired in
accordance with the "Rules of Identification.”
(8) The Exchanger must close on the new property by the 180th
calendar day (or their tax filing date – whichever is earlier) from
the close of the relinquished property sale.
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WHAT NOT TO DO IN A DELAYED EXCHANGE
Listed below are three recent examples of what not to do in a deferred exchange:
CHRISTENSEN VS. COMM. (April 10, 1998)
What Happened: The Christensen’s filed their tax return on April 15 and acquired
replacement property within 180 days, but this purchase closed after they had
already filed their tax return. The Tax Court cited failure to comply with the
deadlines, specifically the requirement to complete the exchange within 180 days
OR the tax filing date, whichever is earlier, as the reason tax deferral was not
allowed.
What Should Have Happened: They should have filed an extension prior to their
closing to obtain benefit of the entire 180 day exchange period.
KNIGHT VS. COMM. (March 16,1998)
What Happened: On day 179, the Knight’s purchase of their replacement
property fell apart. The Knight’s acquired another property after the 180th day
and argued they made a “good faith” attempt to meet the time requirements.
The Tax Court denied the exchange because the tax code clearly allows only a
maximum of 180 days to complete the exchange.
What Should Have Happened: The Knights should not have postponed their
acquisition to last moment, if at all possible. Had more time been available, they
may have been able to acquire another properly identified property before their
180th day.
DOBRICH VS. COMM. (October 20, 1997)
What Happened: The Dobrich’s intentionally “back-dated” an Identification
Notice. This was discovered by the IRS and they were liable for $2.2 Million in
capital gain taxes -- plus a $1.6 Million fraud penalty!
What Should Have Happened: The Dobrich’s should have acquired only property
identified within the 45 day Identification Period. Under no circumstances,should
investors ever backdate Identification Notices!
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The Power of Strategy™ (Three-Hour Class)
§1031 EXCHANGE DOCUMENTATION
Proper documentation is critical to a valid exchange. The documents prepared by
the Qualified Intermediary are paramount to the exchange, and must be executed
prior to closing on the relinquished property. Backseat to the Qualified
Intermediary documents, but very important, are the documents prepared by the
closing entity. The standard closing documents used in any given area of the
country are still used in a §1031 tax deferred exchange. However, there are
minor changes to reflect the exchange transaction as compared to a sale
transaction.
QUALIFIED INTERMEDIARY
(1)
Exchange Agreement
(2)
Assignment Agreement
(3)
Notice of Assignment
(4)
Account Set-Up Forms
(5)
Security of Funds Instrument
CLOSING ENTITY
(1)
Settlement Forms which should properly reflect an IRC Section
1031 tax deferred exchange (by showing the Qualified
Intermediary as the Seller)
(2)
FRPTA (and state withholding forms where applicable)
(3)
1099 Form
(4)
Other documents common to the area
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The Power of Strategy™ (Three-Hour Class)
THE MULTIPLE PROPERTY EXCHANGE
Exchanger
Sold 3 Properties
SALE
DEED
PURCHASE
DEED
DEED
DEED
Buyer #1
$
Buyer #2
$
Buyer #3
A.P.I.
Closing Agent
$
0
Seller
$
45
180
Identification Period
Total Exchange Period
EXAMPLE – SELLING THREE RELINQUISHED PROPERTIES AND
CONSOLIDATING INTO ONE REPLACEMENT PROPERTY
FACTS: In this example, the Exchanger is selling three smaller relinquished
properties and anticipates exchanging into one larger replacement property.
ANALYSIS: The time period for selling the two remaining relinquished properties –
and also closing on the purchase of the replacement property is the earlier of 180
calendar days, or the Exchanger’s tax filing date, whichever is earlier, from the
closing date of the first relinquished property sale
PRACTICAL APPLICATION: Exchanger’s may want to postpone the actual closing
date on the first relinquished property under contract for more than the
customary time in the marketplace because the exchange period begins when the
first property closes, not when it is under contract. In addition, the Exchanger
should have the 2nd and 3rd relinquished properties priced where they anticipate
closing on these two remaining relinquished property sales within the exchange
period.
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The Power of Strategy™ (Three-Hour Class)
THE MULTIPLE PROPERTY EXCHANGE
Exchanger
Purchases 3 Properties
DEED
DEED
DEED
Seller #1
DEED
$
Buyer
$
A.P.I.
Closing Agent
Seller #2
$
$
0
Seller #3
45
180
Identification Period
Total Exchange Period
EXAMPLE – SELLING ONE RELINQUISHED PROPERTY AND
DIVERSIFYING INTO THREE SMALLER REPLACEMENT PROPERTIES
FACTS: In this example, the Exchanger is selling one larger relinquished property
and anticipates exchanging into three smaller replacement properties.
ANALYSIS: The Exchanger has a maximum of 180 calendar days, or the
Exchanger’s tax filing date, whichever is earlier, to close on all three replacement
properties.
PRACTICAL APPLICATION: The Exchanger should probably begin the process of
narrowing the spectrum of desired replacement properties prior to closing on their
relinquished property sale. The Exchanger may also want to begin making offers
on potential replacement properties before closing on their sale in an effort to line
up the exact replacement properties. There are no extensions of the 45/180 day
periods, so it is preferable to begin locating the replacement property as soon as
possible.
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The Power of Strategy™ (Three-Hour Class)
“PARKING ARRANGEMENTS”: AN INTRODUCTION
In the past, “title parking” exchanges were completed with some frequency even
though there was no formal IRS guidance in the reverse exchange variation. Due
to a lack of guidance, “title parking” arrangements involving reverse exchanges
were considered a gray area and taxpayers either proceeded with much caution or
ultimately chose to avoid this format.
There were two basic approaches to reverse exchanges:
1) The exchange FIRST (“relinquished property parked”) approach;
2) The exchange LAST (“replacement property parked”) approach.
The general consensus was to create an arms length transaction whereby the
Qualified Intermediary (or an entity created by the Qualified Intermediary)
acquired either the relinquished property or the replacement property for the
taxpayer and created an exchange which should otherwise fall within the 1991
IRS Rules and Regulations relating to deferred exchanges.
The primary issue to contend with was the problem of “constructive ownership.”
Practitioners had to be concerned with burdens and benefits of ownership versus
bare legal title. The fear was that if the taxpayer were to retain all the burdens
and benefits of ownership, while mere legal title was “parked”, the structure
would be collapsed because the taxpayer would be treated as actually owning
both the relinquished property and the replacement property at the same time.
Prior to the release of Revenue Procedure 2002-37, problems always existed such
as management of the “parked” property, loan arrangements, taxpayer advances
to fund the acquisition, puts and calls, exit strategy, fixed price versus fair market
value and who was to receive the tax benefits of ownership while the property
was “parked.”
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REVENUE PROCEDURE 2000-37
Revenue Procedure 2000-37 provides the framework to safely perform an
exchange involving a “title parking” arrangement.
Basic Points of Concern:
•
Issued on September 15, 2000 and also referred to as a “Rev. Proc.”
•
Effective September 15, 2000
•
Provides a “safe harbor” if transaction is within it’s parameters
•
IRS may amend the Rev. Proc. If necessary
•
“Reverse” exchanges may still be structured outside the Rev. Proc.
•
Transactions already completed or in progress are not affected
Rev. Proc. 2000-37 Key Terms:
1. Qualified Exchange Accommodation Arrangements = QEAA
2. Exchange Accommodation Titleholder = EAT
QEAA Summary:
1. Qualified indicia of ownership. The EAT must not be the taxpayer or a
disqualified person and must be subject to federal income tax. Indicia of
ownership must be maintained at all times until the property is transferred
as described in section 4.02(5) of the Rev. Proc. Qualified indicia of
ownership means legal title or other applicable principals of ownership
under commercial law such as contract for deed.
2. The taxpayer must have bonafide intent that the property held by the EAT
must represent either the replacement or the relinquished property in an
exchange that is intended to qualify for non-recognition of gain (whole or
in part) under section 1031.
3. The taxpayer and the EAT must enter into an agreement (the qualified
exchange accommodation agreement) no later than 5 days after the
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The Power of Strategy™ (Three-Hour Class)
transfer of qualified indicia of ownership to the EAT. The agreement must
state that the EAT is holding title for the benefit of the taxpayer in order to
complete an IRC section 1031 and this Rev. Proc. and that the taxpayer
and EAT agree to report the acquisition, holding and disposition of the
property. In addition, the agreement must state that both parties will be
treated as the beneficial owner for tax purposes and report it as such on it’s
tax returns.
4. In the event that the replacement property is held by the EAT, the taxpayer
must identify within 45 days, the relinquished property. This must be done
in accordance with the multiple property identification rules in section
1.1031(k)-1(c)(4).
5. The EAT must transfer the property held within 180 days from the date of
acquisition to either the taxpayer (in the event EAT held the replacement
property) or the buyer (in the event the EAT held the relinquished
property).
6. The combined time period that the relinquished property and the
replacement property cannot exceed 180 days.
Permissible Agreements:
1. The EAT may act as both the qualified intermediary and the EAT provided
that they satisfy the qualified intermediary safe harbor provisions in section
1.1031(k)-1(g)(4).
2. The taxpayer may guarantee all or part of the obligations of the EAT
including debt and incurred expenses.
3. Taxpayer may loan or advance funds to the EAT.
4. The EAT may lease the property to the taxpayer.
5. The EAT may enter into a management agreement with the taxpayer.
6. The taxpayer may act as contractor or supervisor with respect to the
property.
7. EAT and taxpayer may enter into agreements using puts and calls at fixed
or formula prices for subsequent dispositions.
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The Power of Strategy™ (Three-Hour Class)
THE REVERSE EXCHANGE
“REPLACEMENT PROPERTY PARKED”
STEP 1 – “EAT” Purchase of Replacement Property
A.
B.
C.
D.
Exchanger advances/loans funds to the EAT.
EAT purchases the replacement property.
Seller deeds the replacement property to the EAT.
EAT leases the replacement property to the Exchanger.
EXCHANGER
LEASE
$
DEED
EAT
SELLER
$
STEP 2 – Sale of Relinquished Property and
Exchange of the Replacement Property to the Exchanger
A. Relinquished property is deeded to the EAT in exchange for the replacement
property to the Exchanger.
B. Payoff of the original advance/loan from the Exchanger from sale proceeds.
EXCHANGER
DEED
$
BUYER
© 2006 Asset Preservation, Inc.
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DEED
EAT
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The Power of Strategy™ (Three-Hour Class)
“REPLACEMENT PROPERTY PARKED” - EXAMPLE
STEP #1- Replacement Property Purchase
SALE PRICE
Value
Debt
Equity
$400,000
$200,000
$200,000
PURCHASE PRICE
$800,000
$700,000
$100,000
EXCHANGER
$100,000 - Exchanger
$700,000 - Loan
LEASE
DEED
EAT
SELLER
$800,000
A. Exchanger advances/loans $100,000 funds to the EAT.
B. EAT purchases the replacement property for $800,000 consisting of the
Exchanger’s $100,000 loan plus $700,000 in financing.
LENDER ISSUES:
• Will the lender want to loan to the Exchanger when EAT is on title?
• Loan is non-recourse
• Lender can ask for a personal guarantee from the Exchanger
DEBT/EQUITY ISSUES:
• Equity and debt don’t need to be equal at the time of purchase
• At the later relinquished property sale, $100,000 can be repaid to the
Exchanger and the remaining $100,000 can be used to pay down the note,
thus matching the equities
© 2006 Asset Preservation, Inc.
35
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The Power of Strategy™ (Three-Hour Class)
“REPLACEMENT PROPERTY PARKED” - EXAMPLE
STEP #2 – Relinquished Property Sale/Transfer of Replacement Property
EXCHANGER
DEED
LENDER
DEED
$100,000
$100,000
BUYER
EAT
$200,000
A. Relinquished property is sold to the Buyer for $400,000. The EAT receives
$200,000 net proceeds from the sale.
B. $100,000 is forwarded to the Exchanger (to pay off the loan for the
original $100,000 used by the EAT to purchase the replacement property.)
C. The remaining $100,000 in net equity is used to pay down the $700,000
loan used to purchase the replacement property.
D. The replacement property is transferred back to the Exchanger. The
replacement property value is $800,000, consisting of $600,000 debt and
$200,000 equity.
© 2006 Asset Preservation, Inc.
36
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The Power of Strategy™ (Three-Hour Class)
“RELINQUISHED PROPERTY PARKED” - EXAMPLE
STEP #1 – EAT Purchase of Replacement Property/Exchange for Relinquished
EXCHANGER
DEED
$200,000
LEASE
DEED
$200,000
SELLER
EAT
A. Exchanger loans $200,000 to the EAT.
B. EAT purchases the replacement property for $800,000 with terms of
$200,000 equity and $600,000 debt.
C. The replacement property is deeded to the Exchanger and the relinquished
property is deeded to the EAT.
D. EAT leases the relinquished property to the Exchanger.
LENDER ISSUES:
• Lender provides loan if the Exchanger is on title to the replacement property.
DEBT/EQUITY ISSUES:
• For a fully deferred exchange, the equity and debt must be the same or greater
at the time of the replacement property purchase by the EAT.
EXCHANGER
DEED
BUYER
$200,000
EAT
$200,000
STEP #2 – EAT Sale of Relinquished Property
A. EAT sells the relinquished property to Buyer.
B. EAT forwards $200,000 net equity to Exchanger to pay off loan.
© 2006 Asset Preservation, Inc.
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The Power of Strategy™ (Three-Hour Class)
THE IMPROVEMENT EXCHANGE
The improvement (also called a construction or build-to-suit) exchange allows an
Exchanger, through the use of a Qualified Intermediary and Exchange
Accommodation Titleholder (EAT), to make improvements on a replacement
property using exchange equity.
BENEFITS OF THE IMPROVEMENT EXCHANGE
Improvement exchanges offer an Exchanger a wide array of benefits which often
result in a better investment than properties readily available on the open market.
The ability to refurbish, add capital improvements, or build from the ground up,
while using tax deferred dollars, can create tremendous investment opportunities.
IMPROVEMENT EXCHANGES - THREE REQUIREMENTS
An Exchanger must meet three basic requirements in order to defer all of their
capital gain in the improvement exchange format:
1)
2)
3)
Reinvest the entire net exchange equity on completed improvements or
down payment by the 180th day.
Receive substantially the same property identified by the 45th day.
The replacement property must be of equal or greater value at time of
transfer to the Exchanger.
The final value of the replacement property is the combination of the original
purchase price plus the capital improvements made to the property. The
improvements needed to meet the requirements for full deferral must be in place
prior to the Exchanger taking title to the replacement property.
IMPORTANT ISSUES IN IMPROVEMENT EXCHANGES
• Identification of Replacement Property to be Produced: “…if a legal
description is provided for the underlying land and as much detail is
provided regarding construction of the improvements as is practicable at
the time identification is made.”
• Receipt of Replacement Property to be Produced: Exchanger must actually
receive real property, not “goods and services to be produced.”
© 2006 Asset Preservation, Inc.
38
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The Power of Strategy™ (Three-Hour Class)
THE IMPROVEMENT EXCHANGE
STEP I – Sale of Relinquished Property/Purchase of Replacement Property
DEED
EXCHANGER
DEED
BUYER
EAT/QI
$
SELLER
$
STEP 2 - Improvements to Replacement Property
EXCHANGER
DEED
EAT/QI
0
45
180
Identification Period
Total Exchange Period
SCENARIO: Exchanger is selling a $1,000,000 (free and clear) automobile
dealership and wants to build a new and larger automotive dealership in a growing
part of the town. The new dealership, both land and improvements, will be worth
$2,000,000 at completion and will consist of $930,000 equity and $1,030,000
financing with a local lender. The $930,000 net equity must be reinvested in “likekind” real property within the 180-day exchange period. The Exchanger will
complete the remainder of the improvements after the exchange is completed and
they are back on title to the land and a partially completed building.
RELINQUISHED PROPERTY SALE
Sales Price
Debt
Cost of Sale
Net Equity
REPLACEMENT PROPERTY PURCHASE
$1,000,000
$0
$70,000
$930,000
© 2006 Asset Preservation, Inc.
Lot Purchase (Cash)
$600,000
Draw #1 (site work)
Draw #2 (foundation)
Exchange Value =
$100,000
$230,000
$930,000
)
39
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The Power of Strategy™ (Three-Hour Class)
REVENUE PROCEDURE 2004-51
Key Portions of Rev. Proc. 2004-51 are Reflected Below: Taxpayers are not
required to establish that the exchange accommodation titleholder bears the
economic benefits and burdens of ownership and is the “owner” of the property.
The Service and Treasury Department are aware that some taxpayers have
interpreted this language to permit a taxpayer to treat as a like-kind exchange a
transaction in which the taxpayer transfers property to an exchange
accommodation titleholder and receives that same property as replacement
property in a purported exchange for other property of the taxpayer.
An exchange of real estate owned by a taxpayer for improvements on land
owned by the same taxpayer does not meet the requirements of § 1031. See
DeCleene v. Commissioner, 115 T.C. 457 (2000); Bloomington Coca-Cola
Bottling Co. v. Commissioner, 189 F.2d 14 (7th Cir. 1951). Rev. Rul. 67-255,
1967-2 C.B. 270, holds that a building constructed on land owned by a taxpayer
is not of a like kind to involuntarily converted land of the same taxpayer. Rev.
Proc. 2000-37 does not abrogate the statutory requirement of § 1031 that the
transaction be an exchange of like-kind properties. The Service and Treasury
Department are continuing to study parking transactions, including transactions in
which a person related to the taxpayer transfers a leasehold in land to an
accommodation party and the accommodation party makes improvements to the
land and transfers the leasehold with the improvements to the taxpayer in
exchange for other real estate.
Section 1 of Rev. Proc. 2000-37 is modified to read: This revenue procedure
provides a safe harbor under which the Service will treat an exchange
accommodation titleholder as the beneficial owner of property for federal income
tax purposes if the property is held in a “qualified exchange accommodation
arrangement” (QEAA), as defined in section 4.02 of this revenue procedure.
Section 4.01 of Rev. Proc. 2000-37 is modified to read: The Service will treat an
exchange accommodation titleholder as the beneficial owner of property for
federal income tax purposes if the property is held in a QEAA. Property held in a
QEAA may, therefore, qualify as either “replacement property” or “relinquished
property” (as defined in § 1.1031(k)-1(a)) in a tax deferred like-kind exchange if
the exchange otherwise meets the requirements for deferral of gain or loss under
§ 1031 and the regulations thereunder.
Section 4.05 is added to Rev. Proc. 2000-37 to read: This revenue procedure
does not apply to replacement property held in a QEAA if the property is owned
by the taxpayer within the 180-day period ending on the date of transfer of
qualified indicia of ownership of the property to an EAT.
© 2006 Asset Preservation, Inc.
40
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The Power of Strategy™ (Three-Hour Class)
“NON-SAFE HARBOR” PARKING ARRANGEMENTS
Revenue Procedure 2000-37 specifically states that parking arrangements can be
accomplished outside the parameters of the the Rev. Proc. The main reason an
Exchanger might desire to perform a “non-safe harbor” parking arrangement is
that they would like more than 180 days to complete the exchange transactions.
However, to date there has been very little direct guidance in this area. Most tax
and legal advisors agree that a “non-safe harbor” parking arrangement is
considerably more risky than one staying within all the parameters of the Rev.
Proc. A couple of cites are listed below which may provide additional guidance
DECLEENE V. COMMISSIONER
•
The Tax Court issued its first decision on built-to-suit exchanges.
•
The party constructing the property in DeCleene did not possess the
benefits and burdens of ownership of the property while it was being
constructed.
TAM 200039005
•
Without any safe harbor applying, the issue of QI’s agency status was
relevant.
•
The IRS concluded the QI had no independent role in the transaction and
was considered the Taxpayer’s agent.
•
As a result, the Taxpayer was deemed to have acquired the replacement
property on the QI’s acquisition of title.
© 2006 Asset Preservation, Inc.
41
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The Power of Strategy™ (Three-Hour Class)
A SALE VS. AN EXCHANGE
1. CALCULATE NET ADJUSTED BASIS
Original Purchase Price (Basis)
plus Capital Improvement
minus Depreciation
equals Net Adjusted Basis
$500,000
+ $50,000
- $150,000
$400,000
2. CALCULATE CAPITAL GAIN*
Sales Price
minus Net Adjusted Basis
minus Cost of Sale
equals CAPITAL GAIN
$1,200,000
- $400,000
- $80,000
$720,000
3. CALCULATE CAPITAL GAIN TAX DUE
Recaptured Depreciation (25%)
plus Federal Capital Gain (15%)
plus State Tax (CA 9.3%)
TOTAL TAX DUE
$37,500
+ $85,500
+ $66,960
$189,960
4. CALCULATE AFTER-TAX EQUITY
Sales Price
less Cost of Sale
less Loan Balances
equals GROSS EQUITY
$1,200,000
- $80,000
- $300,000
$820,000
minus Capital Gain Taxes Due
equals AFTER-TAX EQUITY
$189,960
$630,040
5. ANALYZE REINVESTMENT - SALE
After-Tax Equity x 4
= $2,520,160
6. ANALYZE REINVESTMENT – EXCHANGE
Gross Equity = Net Equity
Gross Equity x 4
*Note: 25% x $150,000 = $37,500
© 2006 Asset Preservation, Inc.
$820,000
= $3,280,000
15% x $570,000 = $85,500
42
9.3% x 720,000 = $66,960
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The Power of Strategy™ (Three-Hour Class)
CHOOSING A “QUALIFIED INTERMEDIARY”
1. This is probably the most critical choice you’ll make in a §1031 tax deferred
exchange transaction!
2. Paramount to every exchange is the safety of the funds held by the
Qualified Intermediary.
3. Interview several and take special note of the "fund management
program"
•
In whose name are funds held?
•
What are the requirements for deposit and withdrawal?
•
Where are the exchange funds held?
•
Is the Qualified Intermediary insured by a much larger parent
company, (i.e., title company?)
4. Remember, Qualified Intermediaries are not regulated (except in Nevada)
and your careful scrutiny is required!
© 2006 Asset Preservation, Inc.
43
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The Power of Strategy™ (Three-Hour Class)
APPENDIX “A”: SELLER FINANCING
When an Exchanger elects to carry-back a Note on the relinquished property,
there are basically two options for treatment of the Note:
(1) Do not include the Note in the exchange and pay taxes that may be due. The
Exchanger would receive the Note as the Beneficiary at the closing and pay
taxes on this portion of the capital gain under the Installment method (§453).
(2) Include the Note in the exchange by initially showing the “Qualified
Intermediary” (QI) as the Beneficiary and possibly defer the capital gain taxes.
•
Use the Note Towards the Down Payment on the Replacement Property
The Seller of the replacement property accepts the Note as partial payment
towards the purchase price. In this scenario, the Note is assigned to the
Seller by the QI and delivered to the Seller at closing.
•
Exchanger Purchases Note From the Qualified Intermediary
The Exchanger purchases the note from the QI. The purchase may include
discounting the note to represent its fair market value at the time of
purchase. The sale of the note to the Exchanger takes place during the
exchange period, thus allowing the QI to use the note proceeds towards
the replacement property.
•
Note Payer Pays Off the Note Prior to Closing on Replacement Property
The Note is actually paid off during the exchange. This works only on
short-term Notes due within the 180 day exchange period. The Payer pays
off the Note directly to the QI, the holder of the Note. The QI adds the
payoff proceeds to the existing proceeds in the Qualified Exchange
Account.
•
Selling the Note on the Secondary Market
The Exchanger finds an investor willing to purchase the Note, thereby
replacing the Note with cash. The cash proceeds are added to the existing
cash in a Qualified Exchange Account for purchasing the replacement
property. If the Note is discounted, the discounted amount may be
considered a selling expense.
© 2006 Asset Preservation, Inc.
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The Power of Strategy™ (Three-Hour Class)
APPENDIX “B”: REPLACEMENT PROPERTY BASIS
In a §1031 exchange, the tax basis in the replacement property is reduced using a
formula that takes into account the adjusted basis of the relinquished property
sold in the exchange. Treas. Reg. §1.1031(d)-1(e) says that the basis of the
replacement property acquired must be increased (or decreased) by the amount
of the gain (or loss) recognized on the transfer of the relinquished property.
REPLACEMENT PROPERTY BASIS FORMULA
1. Relinquished Property Adjusted Basis
2. Plus: Any other Property Transferred
3. Plus: Liabilities Assumed by Taxpayer
4. Plus: Amount of Cash Paid by Taxpayer
5. Plus: Gain Recognized on other Property
6. Less: Money or Property Received
7. Less: Liabilities assumed by other Party
8. Less: Loss recognized on other Property
9. Equals: Basis in Replacement Property
____________
+ ____________
+ ____________
+ ____________
+ ____________
- ____________
- ____________
- ____________
= ____________
AN EXAMPLE
Taxpayer exchanges a relinquished property with a value of $1,000,000,
mortgage of $500,000 and a basis of $500,000 for a replacement property with a
value of $1,500,000, a mortgage of $900,000 and the taxpayer adds cash of
$100,000.
Basis of Relinquished Property
Plus: Liabilities Assumed
Plus: Amount of Cash Paid
Less: Liabilities Assumed
Equals: Basis in Replacement Property
+
+
=
$500,000
$900,000
$100,000
$500,000
$1,000,000
A SIMPLE RULE
An easy rule to remember is that the taxpayer’s basis in the replacement property
is the value of the replacement property less the amount of gain deferred in the
exchange (or plus the amount of unrecognized loss.) Asset Preservation, Inc.
expressly disclaims any responsibility for any tax calculations and urges all
investors to seek the advice of tax professionals regarding their specific gain
and/or tax calculations.
© 2006 Asset Preservation, Inc.
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The Power of Strategy™ (Three-Hour Class)
APPENDIX “C”: IRS FORM #8824
© 2006 Asset Preservation, Inc.
46
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5
TLS, have you
transmitted all R
text files for this
cycle update?
Date
I.R.S. SPECIFICATIONS
TO BE REMOVED BEFORE PRINTING
INSTRUCTIONS TO PRINTERS
FORM 8824, PAGE 1 of 6.
MARGINS: TOP 13mm (1⁄2 "), CENTER SIDES.
PAPER: WHITE WRITING, SUB. 20.
FLAT SIZE: 216 mm (81⁄2 ") 279 mm (11")
PERFORATE: (NONE)
8824
OMB No. 1545-1190
2005
(and section 1043 conflict-of-interest sales)
䊳
Signature
Revised proofs
requested
Like-Kind Exchanges
Department of the Treasury
Internal Revenue Service
Attachment
Sequence No.
Attach to your tax return.
Name(s) shown on tax return
Part I
Date
O.K. to print
PRINTS: HEAD TO HEAD
INK: BLACK
DO NOT PRINT — DO NOT PRINT — DO NOT PRINT — DO NOT PRINT
Form
Action
109
Identifying number
Information on the Like-Kind Exchange
1
Note: If the property described on line 1 or line 2 is real or personal property located outside the United States, indicate the country.
Description of like-kind property given up 䊳
2
Description of like-kind property received
3
Date like-kind property given up was originally acquired (month, day, year)
3
/
/
4
Date you actually transferred your property to other party (month, day, year)
4
/
/
5
Date like-kind property you received was identified by written notice to another party (month,
day, year). See instructions for 45-day written notice requirement
5
/
/
6
Date you actually received the like-kind property from other party (month, day, year). See instructions
6
/
/
7
Was the exchange of the property given up or received made with a related party, either directly or indirectly
(such as through an intermediary)? See instructions. If “Yes,” complete Part II. If “No,” go to Part III
Part II
8
䊳
Yes
No
Related Party Exchange Information
Name of related party
Relationship to you
Related party’s identifying number
Address (no., street, and apt., room, or suite no., city or town, state, and ZIP code)
9
10
During this tax year (and before the date that is 2 years after the last transfer of property that was part of the
exchange), did the related party directly or indirectly (such as through an intermediary) sell or dispose of any
part of the like-kind property received from you in the exchange?
Yes
No
During this tax year (and before the date that is 2 years after the last transfer of property that was part of the
exchange), did you sell or dispose of any part of the like-kind property you received?
Yes
No
If both lines 9 and 10 are “No” and this is the year of the exchange, go to Part III. If both lines 9 and 10 are “No” and this is not the
year of the exchange, stop here. If either line 9 or line 10 is “Yes,” complete Part III and report on this year’s tax return the deferred
gain or (loss) from line 24 unless one of the exceptions on line 11 applies.
11
If one of the exceptions below applies to the disposition, check the applicable box:
a
The disposition was after the death of either of the related parties.
b
The disposition was an involuntary conversion, and the threat of conversion occurred after the exchange.
c
You can establish to the satisfaction of the IRS that neither the exchange nor the disposition had tax avoidance as its
principal purpose. If this box is checked, attach an explanation (see instructions).
For Paperwork Reduction Act Notice, see page 5.
Cat. No. 12311A
Form
8824
(2005)
5
I.R.S. SPECIFICATIONS
TO BE REMOVED BEFORE PRINTING
INSTRUCTIONS TO PRINTER
FORM 8824, PAGE 2 of 6
MARGINS: TOP 13 mm (1⁄2 "), CENTER SIDES.
PRINTS: HEAD TO HEAD
PAPER: WHITE WRITING, SUB. 20.
INK: BLACK
FLAT SIZE: 216 mm (81⁄2 ") 279 mm (11")
PERFORATE: (NONE)
DO NOT PRINT — DO NOT PRINT — DO NOT PRINT — DO NOT PRINT
Form 8824 (2005)
Page
Name(s) shown on tax return. Do not enter name and social security number if shown on other side.
Part III
2
Your social security number
Realized Gain or (Loss), Recognized Gain, and Basis of Like-Kind Property Received
Caution: If you transferred and received (a) more than one group of like-kind properties or (b) cash or other (not like-kind) property,
see Reporting of multi-asset exchanges in the instructions.
12
13
14
15
16
17
18
19
20
21
22
23
24
25
Note: Complete lines 12 through 14 only if you gave up property that was not like-kind. Otherwise, go to line 15.
12
Fair market value (FMV) of other property given up
13
Adjusted basis of other property given up
Gain or (loss) recognized on other property given up. Subtract line 13 from line 12. Report the
14
gain or (loss) in the same manner as if the exchange had been a sale
Caution: If the property given up was used previously or partly as a home, see Property used
as home in the instructions.
Cash received, FMV of other property received, plus net liabilities assumed by other party, reduced
(but not below zero) by any exchange expenses you incurred (see instructions)
FMV of like-kind property you received
Add lines 15 and 16
Adjusted basis of like-kind property you gave up, net amounts paid to other party, plus any
exchange expenses not used on line 15 (see instructions)
Realized gain or (loss). Subtract line 18 from line 17
Enter the smaller of line 15 or line 19, but not less than zero
Ordinary income under recapture rules. Enter here and on Form 4797, line 16 (see instructions)
Subtract line 21 from line 20. If zero or less, enter -0-. If more than zero, enter here and on Schedule
D or Form 4797, unless the installment method applies (see instructions)
Recognized gain. Add lines 21 and 22
Deferred gain or (loss). Subtract line 23 from line 19. If a related party exchange, see instructions
Basis of like-kind property received. Subtract line 15 from the sum of lines 18 and 23
Part IV
15
16
17
18
19
20
21
22
23
24
25
Deferral of Gain From Section 1043 Conflict-of-Interest Sales
Note: This part is to be used only by officers or employees of the executive branch of the Federal Government for reporting
nonrecognition of gain under section 1043 on the sale of property to comply with the conflict-of-interest requirements. This part
can be used only if the cost of the replacement property is more than the basis of the divested property.
26
Enter the number from the upper right corner of your certificate of divestiture. (Do not attach a
䊳
copy of your certificate. Keep the certificate with your records.)
–
䊳
27
Description of divested property
28
Description of replacement property
29
Date divested property was sold (month, day, year)
30
Sales price of divested property (see instructions)
30
31
Basis of divested property
31
32
Realized gain. Subtract line 31 from line 30
33
Cost of replacement property purchased within 60 days after date
of sale
34
Subtract line 33 from line 30. If zero or less, enter -0-
34
35
36
Ordinary income under recapture rules. Enter here and on Form 4797, line 10 (see instructions)
Subtract line 35 from line 34. If zero or less, enter -0-. If more than zero, enter here and on
Schedule D or Form 4797 (see instructions)
35
36
37
Deferred gain. Subtract the sum of lines 35 and 36 from line 32
37
38
Basis of replacement property. Subtract line 37 from line 33
38
䊳
29
/
/
32
33
Form
8824
(2005)