IRC §1031 Tax Deferred Exchange
Strategies
Claudia Kiernan, Esq.
Certified Exchange Specialist®
Course Objectives
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IRC §1031 Rules-Review
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Tax Updates
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Recent changes to IRC §1031
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Advanced Issues in IRC §1031
Internal Revenue Code Section 1031
“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.”
Tax Update
Higher Capital Gains Tax
New 3.8% Healthcare Tax
Depreciation Recapture Tax
State Taxes
Higher Capital Gains Tax
Single investors exceeding the $400,000 income threshold and
married couples exceeding the $450,000 income threshold now
pay the new 20% capital gains tax rate.
3.8% Healthcare Tax
The Healthcare and Education Reconciliation Act added a new
3.8% Medicare surtax on “net investment income.”
Applies to individual earning over $200,000 and married couples
earning over $250,000
Net investment income includes: dividends, capital gains,
retirement income and income from partnerships.
Depreciation Recapture Tax
Depreciation is a way to obtain a tax deduction by spreading the
cost of the real estate over period of time.
As a result, depreciation reduces the properties adjusted cost
basis.
Upon sale, the part of the gain that is related to depreciation will
be taxed at the rate of 25%.
State Taxes
Certain states, such as California,
have a 13.3% top tax rate
Run The Numbers
§1031 permits deferral of:
•
•
•
Capital Gains Taxes of (15%/20% Federal and __% State)
Depreciation Recapture (25% Federal)
Medicare Surtax (3.8%)
Example: Selling $1,000,000 property that has no debt and has been fully depreciated.
Using an assumption of a 30% combined taxes between capital gains and depreciation
recapture. Purchasing replacement properties with a 75% LTV ratio.
SALE
NET EQUITY
CAPITAL GAIN TAX
EQUITY TO REINVEST
PROPOSED ACQUISITION
1,000,000
300,000
700,000
2,800,000
VS
EXCHANGE
1,000,000
0
1,000,000
4,000,000
Tax Deferred Exchange Terminology
Tax Deferred Exchange terminology may be confusing to those who are
unfamiliar with these transactions. The following are some of the typical
exchange terms and phrases, with their interpretation.
Exchanger: The property owner(s) seeking to defer capital gain tax by utilizing a
Section 1031 exchange.
(The Internal Revenue Code uses the term “Taxpayer.”)
Basis: Original cost plus improvements, minus depreciation taken.
Taxable Gain: Selling price minus Basis.
Boot: Fair Market Value of non-qualified property (i.e., property that is not of “likekind”) received in an exchange. (Examples: cash, notes, seller financing,
furniture, supplies, reduction in debt obligations)
Constructive Receipt: Control of proceeds by an Exchanger (even though funds
may not directly be in the Exchanger’s possession).
Tax Deferred Exchange Terminology
Like Kind Property: This term refers to the nature or character of the property,
and not its grade or quality. Generally, real property is “like kind” as to all other
real property, as long as the Exchanger’s intent is to hold the properties as an
investment or for productive use in a trade or business. The “like kind” rules for
personal property, however, are more restrictive.
Qualified Intermediary: The entity that facilitates the exchange for the
Exchanger. The term “facilitator” or “accommodator” is also commonly used,
although the Treasury Regulations specify the term “Qualified Intermediary.”
Relinquished Property: The property “sold” by the Exchanger. This is also
sometimes referred to as the “exchange” property or the “downleg” property.
Replacement Property: The property acquired by the Exchanger. This is
sometimes referred to as the “acquisition” property or the “upleg” property.
Exchange Myths
Exchangers have to find someone with property who
will swap property with them.
Exchangers have to complete the exchange in one
simultaneous transaction.
Exchanges are expensive, difficult, and only for large
property owners.
Exchange Myths
Exchangers will be audited if they exchange property
instead of selling it.
Exchangers who live on part of their property cannot do
an exchange.
Exchangers do not need to hire an intermediary; they
can simply have their attorney hold the exchange
funds until the replacement property is purchased.
Exchange Motives
Cashflow: Sell vacant land; acquire improved property to generate cash flow.
Depreciation: Exchange from fully depreciated property to a higher value
property – the additional value can be depreciated.
Appreciation: Dispose of property in a slow market area and acquire property in
a hot market area.
Conversion: Acquire property suitable for future conversion to primary
residence or vacation home.
Joint Ownership Problems: Acquire separate properties so that co-owners can
separate interests.
Reduce Management Burdens: Acquire management-free property.
Estate Planning: Dispose of one property and acquire several properties
(example: distribute one replacement property to each family member).
Use in Profession: For example, a doctor sells a rental house and acquires a
medical building to support the practice.
Why do a 1031?
No. 1 Diversification
SELL
1031
BUY
Sell One
Buy Multiple
No. 2 Consolidation
SELL
Multiple
properties
1031
BUY
One larger property that
is easier to manage or
no management
Apartment complex,
commercial strip center, DST
T.I.C., DST, etc..
No. 3 Move Markets
SELL
Sell in California
1031
BUY
Buy in FL
No. 4 Estate Planning
Heir #1
SELL
1031
BUY
Heir #2
Heir #3
Delayed Exchange Time Limits
1. 45-Day Rule: The Exchanger must identify the potential replacement
property or properties within the first 45 days of the 180 day Exchange
period.
2. 180-Day Rule: The Exchanger must acquire the replacement property or
properties within 180 days, or the date the Exchanger must file a tax
return (including extensions) for the year of the transfer of the relinquished
property, whichever occurs first.
3. There are no extensions for Saturdays, Sundays, or holidays.
4. The time limits begin to run on the date the Exchanger transfers the
relinquished property to the buyer.
5. The “date of transfer” will be the date of recording or transfer of the
benefits and burdens of ownership, whichever occurs first.
Disaster Extensions
Since September 11, 2001, Congress has permitted 120
day extensions for taxpayers affected within federal
disaster areas by presidential order. The rules are
complicated, but generally the Exchanger receives the
extension if one of the following is within the affected area:
• Exchange Properties
• Exchanger’s Principle Residence
• Exchanger’s Tax Preparer
• Qualified Intermediary
Exchange Identification Rules
1.
Three Property Rule: The Exchanger may identify up to three properties of any
value.
2.
200% Rule: The Exchanger may identify more than three properties if the total fair
market value of what is identified does not exceed 200% of the fair market value of
the relinquished property.
3.
95% Exception: If the Exchanger identifies properties in excess of both Rule 1 and
Rule 2, then the Exchanger must acquire 95% of the value of all properties
identified.
Procedures for Property Identification
1. The property identification must be delivered to a party to the exchange that
is not a disqualified party (e.g., the Qualified Intermediary).
2. It must be in writing and signed by the Exchanger.
3. It must be “unambiguous” (site specific).
4. It must be delivered, mailed, faxed, or “otherwise sent” within the 45
days.
5. An identification can be revoked within the 45 days, but the
revocation must also follow steps 1 through 4.
What is Like-Kind Property?
In an I.R.C. §1031 real property exchange, you can exchange real property
for any other real property in the United States or its possessions, if said
property is held for productive use in a trade or business or for
investment purposes.
Condos
1031
Property
Retail
Raw Land
% Interest
as a TIC
Apartments
Commercial
Single
Family
Industrial
Property
Like-Kind Property (cont’d)
1. “Like-kind” refers to the nature or character of the property,
and not its grade or quality.
2. Generally, all real property is “like-kind” to all other real
property.
3. Real property can be improved or unimproved, because this
only relates to the grade or quality – not to its kind or class.
4. The Exchanger’s intent must be to hold the replacement
property as an investment, or for productive use in a trade or
business.
Personal Property Exchanges
•
The “like kind” requirement for personal property exchanges is more
restrictive than real property exchanges.
•
The relinquished and replacement assets must be either “like-kind” or “like
class”.
•
“Like-kind” refers to assets that are the same, such as an airplane for an
airplane or a backhoe exchanged for a backhoe.
•
“Like-class” refers to tangible, depreciable personal property that falls
within the same General Asset Class or within the same Product Class
(sharing North American Industry Classification System (NAICS) codes)
IRC §1031 shall not apply to any exchange of:
•
•
•
•
•
•
•
•
Stock in trade or other property held primarily for sale (i.e. property
held by a developer, “flipper” or other dealer)
Securities or other evidences of indebtedness or interest
Stocks, bonds, or notes
Certificates of trust or beneficial interests
Interests in a partnership
Choses in action (rights to receive money or other property by
judicial proceeding)
Foreign property (real or personal) for U.S. based property
Goodwill of one business for goodwill of another business
Qualified Purpose Test
“Held for use in Trade or Business or for Investment”
1. Not Held for Sale
•
•
Inventory
Other instances of “Held for Sale”
2. Not Held for Personal Use
•
•
Residences
Second Homes
3. Test is at time of Exchange
4. Holding period
How long do I need to own something before I
can do a 1031 Exchange?
•
•
•
1989-U.S. House of Representatives passed a one-year holding
requirement before and after exchanging a property. This did not reach the
final version of the Revenue Reconciliation Act of 1989.
Nonetheless, prudent to hold a property in use for at least one year (long
term gain). A taxpayer might note that Congress did include in the Act a
two-year holding period of any property received in a “related party”
exchange.
The more conservative professionals and commentators speculate that this
two-year hold might be a more appropriate holding period.
Vacation and Second Homes
•
•
In Moore v. Commissioner, T.C. memo 2007-134, the Tax
Court held that properties held for personal use with the mere
hope or expectation of gain did not establish investment intent.
Effective for all exchanges on or after March 10, 2008,
Revenue Procedure 2008-16 creates a safe harbor (meaning
the IRS will not challenge the exchange) for “dwelling units”
that meet the following criteria:
Vacation and Second Homes
•
•
•
•
The relinquished property: 1) was owned by the taxpayer for 24
months prior to the exchange and 2) was rented for 14 days or more
in each of the two 12 month periods preceding the exchange and 3)
the Taxpayer’s personal use in each of those years did not exceed
the greater of 14 days or 10 percent of the number of days the
property was rented at fair rental rates.
The replacement property must meet the same criteria.
The exchange must meet all the other Section 1031 requirements.
It is unknown how the IRS will view properties that do not fall within
this safe harbor.
Combining IRC Sections 1031 and 121
•
•
IRC §121 permits an exclusion from capital gain realized of
$250,000 for a single person and $500,000 for a married
couple on the sale of a home used as a primary residence for
any two of the past five years.
If, however, the residence was acquired as a replacement
property in a §1031 exchange, the Exchanger must have held
the property for a total of FIVE years before it qualifies for the
§121 exclusion when it is sold. (HR 4520 October 22,2004)
Combining IRC Sections 1031 and 121
•
•
Effective January 1, 2009, the §121 exclusion will not apply to
gain from the sale of a residence that is allocable to periods of
“nonqualified use”. (Housing Assistance Act of 2008)
If a primary residence is converted for use as rental, it may
qualify for both a §1031 exchange as property used in a trade
or business and also for the §121 exclusion when it is sold
(Revenue Procedure 2005-14)
Housing Assistance Tax Act of 2008
•
Amends §121 to further restrict its exclusion benefits
•
$250,000/$500,000 no longer applies to periods of “Non-qualified” use.
•
Non-qualified use: “Any use other than primary residential” by the taxpayer.
Thus no exclusion allowed for portion of ownership that was either:
– Rental (Investment) or Personal Use (Second or Vacation Home).
•
Effective January 1, 2009 the exclusion will not apply to gain from the sale of the
residence that is allocable to periods of “nonqualified use.”
•
§121 Exclusion is now allocated based on ratio of qualified use period to
ownership period.
•
Non-qualified use prior to January 1, 2009 is not taken into account for the nonqualified use period (but is considered for the ownership period).
Exchange Contract Cooperation Clauses
To provide the other party to the transaction with notice of the exchange the
Exchanger should have an exchange cooperation clause in the purchase and
sale agreement for both the relinquished and replacement properties:
Relinquished Property
Buyer hereby acknowledges that it is the intent of the Seller to complete a tax
deferred exchange under IRC Section 1031 which will not delay the close of
the purchase transaction or cause additional expense to the Buyer. The
Seller’s rights under the purchase and sale agreement may be assigned to a
Qualified Intermediary of the Seller’s choice for the purpose of completing such
an exchange. Buyer agrees to cooperate with the Seller and the Qualified
Intermediary in a manner necessary to complete the exchange.
Tax Court Decision Confirms Need for
Qualified Intermediary
Crandall vs. Commissioner of Internal Revenue
No QI
No Exchange Agreement
Court held that the taxpayers had constructive receipt of the proceeds
and were required to pay not only capital gains taxes on the sale of
the property but also a hefty accuracy-related penalty.
“it is well established that a taxpayer’s intention to take advantage of tax
laws does not determine the tax consequences of his
transactions…Congress enacted strict provisions under section 1031
with which taxpayers must comply.”
Qualified Intermediary
The use of a Qualified Intermediary is essential to completing a valid delayed
exchange. The Qualified Intermediary performs several vital functions in an
exchange.
Acts as a Principal
The IRS stipulates that a reciprocal trade or actual exchange must take
place in each IRC §1031 transaction. This means the Exchangers must
assign to a Qualified Intermediary (1) their interest as seller of the
relinquished property and (2) their interest as buyer of the replacement
property. The Qualified Intermediary should be an Independent Party (not
DISQUALIFIED) to the transaction.
The use of a Qualified Intermediary allows for “DIRECT DEEDING” of
the properties involved in the exchange. This is only allowed with
the use of a Qualified Intermediary.
Qualified Intermediary (cont’d)
Holds Exchange Proceeds
If the Exchanger actually or constructively receives any of the
proceeds from the sale of the relinquished property, those
proceeds will be taxable as boot.
Prepares Legal Documentation
Several legal documents are necessary in order to properly
complete an exchange. The Qualified Intermediary will prepare
an Exchange Agreement, two Assignment Agreements, and
Exchange closing instructions for each closer.
Provides Quality Service
Although the process is relatively simple, the rules are
complicated and filled with potential pitfalls.
Balancing Act
How to
Measure the
Exchange
Balancing the Exchange
In order to obtain a deferral of the entire capital gain tax the Exchanger must:
1.Purchase property of equal or greater value.
2.Reinvest all of the net proceeds from the relinquished property.
3.Obtain equal or greater financing on the replacement property than was paid
off on the relinquished property. Replacement property debt can be offset
with cash put into the exchange.
4.Receive nothing in the exchange but like-kind property.
To the extent the Exchanger fails to observe these rules they will be subject to
capital gain tax
Balancing the Exchange
Example I.
Exchanger goes up in value, across in
equity and up in mortgage:
No Tax is due.
Value
Relinquished
$150,000
Replacement
$225,000
Mortgage
$100,000
$175,000
Equity
$ 50,000
$50,000
Balancing the Exchange
Example II. Exchanger goes up in value, up in mortgage and
keeps $10,000 of net proceeds:
Tax is due on $10,000 of Cash Boot.
Relinquished
Replacement
Value
$150,000
$225,000
Mortgage
$100,000
$185,000
Equity
$ 50,000
$ 40,000
Balancing the Exchange
Exchanger goes down in value, across in equity
and down in mortgage:
Example III.
Tax is due on the $25,000 of Mortgage Boot.
Value
Relinquished
$150,000
Replacement
$125,000
Mortgage
$100,000
$ 75,000
Equity
$ 50,000
$ 50,000
Refinancing Issues
Refinancing prior to the relinquished property sale
Refinancing after the purchase of replacement property – Better but
should have a time break/separate transaction.
To avoid the pitfalls of the “step transaction doctrine”: The refinance
should not appear to be solely for the purpose of “pulling out equity”,
refinance prior to listing relinquished for sale, document as separate
transactions.
Exchange Vesting Issues
With few exceptions in an exchange, title to the Replacement
property must be held in the same manner as title was held on the
Relinquished property.
Examples:
•
•
Individual Relinquishes
Partnership ABE
Relinquishes
• ACME, Inc. Relinquishes
•
Individual Acquires
•
Partnership ABE Acquires
•
ACME, Inc. Acquires
Except in limited circumstances, the same tax identification number
should be used on both the relinquished and replacement phases of the
transaction.
Exchange Vesting Issues
Grantor Trust (e.g. revocable living trust): Trustee takes title to replacement property
as an individual and then transfers it later to trust. Trust is disregarded for tax
purposes.
Death of Exchanger If Exchanger dies, Exchanger’s estate can complete exchange.
Single Asset Entities: Exchanger who relinquished as an individual can acquire
replacement property in a single-member LLC. This entity is disregarded for tax
purposes under “check the box” rules. (Rev. Proc. 2002-69 Husband and Wife in
community property state – can choose disregarded treatment.)
A corporation merges out of existence in a tax-free reorganization after disposition of
relinquished property, may complete the exchange and acquire the replacement
property as the new corporate entity.
Exchange Structures with
A Qualified Intermediary
• Delayed/Simultaneous
• Reverse
• Build-to Suit
• Reverse Build-to-Suit
What is Reverse Exchange?
A Taxpayer needs to close on the acquisition of the replacement property
before the relinquished can close.
Because IRC 1031 requires an “exchange” the taxpayer cannot own both
the relinquished and the replacement properties at the same time.
Typically, the reverse exchange involves a third-party “parking” title until
the taxpayer can complete the exchange.
Parking Title to the Replacement Property
Seller
Phase One
Loan from Exchanger
for Downpayment or
Entire Purchase Price
Cash
Cash
EXCHANGER
Exchange Agreement
& Assignment
Replacement
Property
Qualified
Intermediary
Intermediary holds title to Exchanger’s
Replacement Property until the Relinquished is sold
Parking Title to the Replacement Property
Phase Two
Exchanger
Exchange Agreement
& Assignment
Replacement
Property
Cash
Qualified
Intermediary
Used to Repay Exchanger’s
Loan for Replacement
Property
Buyer
Build-to-Suit Exchange
Step 1
Buyer
Cash
Exchanger
Exchange Agreement
& Assignment
Qualified
Intermediary
Step 2
Qualified
Intermediary
Replacement Property
to be Improved
Cash from
Exchange Account
Seller
Intermediary holds title to the Replacement Property
while it is being improved with Exchange Funds
Step 3
Qualified
Intermediary
Completed
Replacement Property
Exchanger
There can be no more than 180 days between steps 1 and 3
in order to remain within the safe harbor
Build to Suit on Tax Payer Owned Property
(Rev Proc 2004-51)
Related Party Issues
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•
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IRC §1031(f) is designed to prevent basis-shifting & avoidance of payment of
federal income tax.
Through exchange of high basis property for low basis property, in anticipation of
the sale of the low basis property.
If a related party exchange is followed shortly thereafter by a disposition of the
property, the related parties have, in effect ‘cashed out’ of the investment, and the
original exchange should not be accorded non-recognition treatment.” H.R. Rep.
No. 247, 101st Congress 1st Sess. 1340 (1989)
Related Party Buyer
•
•
•
Related Party Buyer must hold the Relinquished Property received from Exchanger
for 2 years. IRC §1031(f)(C)(i)
Unless Related Party Buyer is not actually “trading” any Related Party Buyer owned
property with Exchanger.
If Related Party Buyer starts out with cash, not property, and it simply a purchaser
of Exchanger’s property, ending up with 100% basis in the purchased property,
then the Related Party Buyer may dispose at will.
PLRs 200709036 & 200712013-There is some dispute as to whether this will hold
up for others.
Related Party Seller
•
•
•
•
Exchanger must hold Replacement Property received from Related Party for 2
years. IRC §1031(f)(C)(ii)
Related Party Seller of Replacement Property must also do an exchange.
Related Party Seller may not receive cash or non like-kind property.
If Related Party Seller does not do an exchange, IRS views this as “cashing out”
and transaction will be taxable (Revenue Ruling 2002-83).
Partnership Issues
COMMON SCENARIOS:
1. A partnership owns property and wishes to sell it. Some of the partners
want to engage in a 1031 tax deferred exchange upon the sale and some
do not.
2. A partnership owns property and wishes to sell it. All of the partners
would like to participate in a 1031 tax deferred exchange, but the partners
do not want to purchase the new property together
Possible Solutions
IF MOST OF THE PARTNERS IN THE PARTNERSHIP WISH
TO COMPLETE THE 1031 EXCHANGE TOGETHER:
Distributing an undivided interest.
Purchase of the interest of the retiring partner.
The partnership could sell the relinquished property, distribute a portion of the
proceeds to the partners who wish to cash out and use the remaining
proceeds to purchase the new property.

ISSUE: The partners that are cashing out would receive a special
allocation of the gain from the sale of the property. This gain maybe
greater for the partners that cashed out.
Possible Solutions
What if the partners do not wish to purchase the new
property together?
The partnership can be liquidated and terminated and the relinquished
property distributed to the partners as tenants in common.
This should be done as far in advance of the sale as possible.
If a distribution or dissolution occurs shortly prior to the sale, the key issue is
whether the relinquished property was “held for productive use in a trade or
business or for investment purposes.”
Exchange Strategies
A foreclosure or short sale may result in taxes on gain that must
be recognized.
Taxpayers can take advantage of creative exchange strategies
to use the funds that would otherwise be needed to pay capital
gain taxes for the purchase of a better performing replacement
property.
Why is Tax Basis Important?
Pay taxes on the difference between the sales price and the tax
basis not the difference between sale price and the equity
Can owe taxes even if there is no (or even negative) equity!
The 1031 Exchange Solution
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•
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Structure the short sale as an exchange
Acquire replacement property
By doing so, you can avoid recognizing capital gains taxes
Unfortunately, COD income cannot be avoided
Audit Issues
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Verify the Exchange Agreement was executed prior to the closing of the
relinquished property. IRS looks for “as of” dates.
Exchange Agreement must contain the “(g)(6)” restrictions from the
Treasury Regulations regarding the limitations on the Taxpayer’s
access to exchange funds.
Qualified Intermediary cannot be a disqualified party.
Was the 45 day identification timely done…lot of issues here…
Did the Exchanger buy or sell to a related party?
Security of 1031 Funds
Millions of Taxpayer 1031 Funds have been lost over the last
five years
HOW DID THIS HAPPEN?
1.
Qualified Intermediaries are not regulated or monitored by the Federal
Government, but a few states have recently enacted legislation.
2.
Treasury Reg §1.1031(k)-1(f) Taxpayers must not have actual or
constructive receipt of the sale proceeds from their relinquished property
until the replacement property has been purchased and the exchange
has terminated.
Questions To Ask Regarding The QI
Who owns the Qualified Intermediary? How financially stable are its owners?
Is it a publicly traded corporation?
Will the Qualified Intermediary provide you with its financial statements?
What is the package of security that the Qualified Intermediary is offering your
client?
• Fidelity Bond
• Corporate Guarantee
• Errors and Omissions Insurance
Does the Qualified Intermediary have trained professionals (Attorney or CPA)
on staff?
Questions To Regarding
The Banks The QI Uses
What criteria does QI use to pick its bank or will
it use any bank?
Does the bank send bank statements to
taxpayer?
Questions To Ask Regarding The
Account Structure The QI Uses
Does the 1031 Intermediary deposit 1031 funds in segregated
accounts under the exchanger’s name and Taxpayer
Identification Number?
Are funds commingled?
Does the 1031 documentation state exactly what type of an
account structure is being used?
Does the QI require written authorization to disburse funds?
Security Features You Should
Look For In A QI
Performance Guaranty issued on each exchange
Fidelity Bond
Errors and Omissions Insurance
Transparency about entire organization
Exchange funds deposited into segregated, interest bearing bank
accounts that are separately identified to each Exchanger.
Disbursement of exchange funds requiring written authorization of the
Exchanger
Exchange funds deposited into highly rated financial institutions.
Investment Property Exchange Services, Inc.
Contact Information: CLAUDIA KIERNAN, ESQ., CES
Vice President
877-494-1031
904-826-7140
claudia.kiernan@ipx1031.com