Written by admin on May 18th, 2011

Overview – An IRC §1031 tax deferred exchange allows owners of real estate to defer the recognition of a capital gains tax they would have recognized when they sold their property so long as they reinvest in other “like-kind” real property.

Tax deferred exchanges are not new – they have been available in one form or another since 1921, and in its current format since 1986.

Exchanging allows taxpayers to reinvest money into new property held for business or investment purposes without having to pay a capital gain tax.

Both the property you sell and the new property you buy must meet certain requirements.

Property Types – In order to have a valid IRC §1031 tax deferred exchange the relinquished property (sale property) and the replacement property (purchase property) must be like-kind to each other and held for business or investment purposes and not primarily for resale purposes or personal use.

For real estate exchanges, the properties to be exchanged do not have to be the same type or use. As long as they are both held for productive use in a trade or business (ex. restaurant or warehouse used by the owner of the property) or investment purposes (ex. rental property such as an apartment building or strip mall) they are considered like kind.

While both properties must be held either for business or investment use their uses can be interchangeable for purposes of like-kind.  For instance, a piece of raw land can be exchanged for a rental property.  Industrial real estate can even be exchanged for office buildings, apartments, or storage facilities. The like-kind rules are fairly flexible when it comes to exchanges of real estate.

Deferral and Timing – To obtain a complete deferral of the income taxes a taxpayer must:

•    Purchase a replacement property of equal or greater value as to his relinquished property.  (If a taxpayer sells for 0k they must by for 0k – less closing costs.)

•    Use all net cash proceeds received from the relinquished property toward the purchase of the replacement property.

•    Obtain equal or greater financing on the replacement property as was paid off on the relinquished property.

•    Purchase nothing except like-kind property.  (Beware of transactions that have property other than real property mixed in with the purchase price – such as the sale of real property with a business.)

Once the original property is sold:

•   The investor has 180 days to close on the replacement property

•   During the 180 days, a qualified intermediary must handle all of the assets involved and carefully organize the exchange.

•    The investor has 45 days from the sale date of the original produce a written list of up to 3 potential replacement properties

Advantages – One advantage of an exchange is that a taxpayer can continue to exchange properties and build wealth while deferring their capital gain tax.  A taxpayer is able to obtain the use of additional equity by using the money that otherwise would have been paid to the government.

Although changes to the estate tax laws in 2010 may change the benefit, currently taxpayer’s heirs inherit exchanged real estate without the deferred capital gain tax.  Heirs obtain the property with a “stepped up basis” upon the date of the exchanger’s death, meaning that the heir’s basis “steps up” to market value upon the date of the exchanger’s death.

Financial Professional Support – Because of the complexity of 1031 exchanges, it is important to engage a financial professional familiar with real estate and 1031 exchanges. A good qualified intermediary can walk a potential client through a potential transaction and thereafter work with their attorney and CPA.

Effects of Credit Market on 1031 Exchanges – If a taxpayer sells a highly leveraged relinquished property a new lender may not be willing to give as much debt as need on the replacement property.  For example, if a taxpayer sells a property for M with 0k of debt, and is buying a new property for M, but is only able to obtain 0k in debt, he will have to inject 0k in cash in order to have a fully tax deferred exchange.  With the debt to equity ratio requirements in place now taxpayers may need to look for lower priced replacement property and structure their transaction as a “partial deferred exchange” meaning that they recognize a portion of their capital gains tax (also known as “boot”).

Primary Residences, Second Homes and 1031 Exchanges – The recently passed Housing Assistance Tax Act of 2008 (H.R. 3221) may affect any taxpayer selling their primary residence, as defined in IRC §121, if the taxpayer did not use the property solely as their primary residence during their period of ownership.  Previously, so long as a taxpayer resided in their primary residence for two of the previous five years from the date of sale they would be entitled to 100% of the benefit of the capital gain tax exclusion of 0,000 if single, or 0,000 if married and filing a joint return.  What that means is that if a taxpayer rented a property for three years and thereafter lived in the property as a primary residence for two years that taxpayer would only get a 2/5 benefit of the exclusion, versus receiving the entire exclusion under the previous rules.

Prior to Revenue Procedure 2005-14 when taxpayers converted a property from a primary residence to a business or investment use, or vice versa, taxpayers had to choose between IRC §121 and IRC §1031 treatment if both were available to them upon a sale. For example, if a taxpayer used a property as a primary residence for three years and thereafter rented the property for two years the taxpayer will have satisfied the requirements of §121, which provides that a taxpayer must use the property as a primary residence in two out of the preceding five years; as well as satisfying §1031 by renting out the property for over a year. It is important to keep in mind that in order to qualify for a §1031 tax deferral the taxpayer must have the intent to hold the property for business or investment purposes and no specific holding period is defined as sufficient by the Internal Revenue Service. Rev. Proc. 2005-14 allows taxpayers to combine the benefits of these two code sections.

In March 2008 the Internal Revenue Service issued Revenue Procedure 2008-16 which helped to clarify whether vacation homes or second homes would qualify as an investment property for purposes of structuring IRC §1031 tax deferred exchange.  The central issue, which was first addressed in Moore v. Commissioner (T.C. Memo 2007-134), was whether a vacation home or second home could be considered investment property if the taxpayer utilized the property for personal use.  Both the Moore ruling, and later, Rev. Proc. 2008-16, clarify the investment intent expectations held by the Tax Courts and the Service, with the revenue procedure going further and mandating actual rental history for two years in order for a “dwelling unit”, as these properties are now defined, to be considered an investment property.

Tenant in Common (TIC) Properties and the NAR Exemption – The drive to satisfy both the statutory deadlines and reinvest all of the net proceeds in qualifying replacement property has spawned a boutique industry of companies that sell undivided tenant in common (TIC) interests in real property, most often triple net leased properties. Typically, a sponsor identifies and purchases a desirable property. The sponsor then determines the offering price and how many TIC interests (typically computed on a percentage basis, for example, a 5.5 percent interest) they will sell. The TIC sponsor may earn a commission or acquisition fee and typically manages the property for the TIC owners for a customary management fee. The TIC owners receive a distribution check monthly or quarterly, without having any management responsibilities.

Although a TIC interest is considered real property for purposes of an IRC §1031 exchange, pursuant to Rev. Prov. 2002-22, they are considered a security for sales purposes.  Accordingly, in order to sell an interest in a TIC you need a securities license.  The Nation Association of Realtors (NAR) has proposed an exemption for realtors to be able to sell, or at the very least, collect a referral commission on these sales with obtaining a securities license.  NAR has proposed making its members exempt under the following conditions:

•   The client must sign a buyer agreement that would allow the Realtor to advise on tenant in common investments that are sold as securities.

•   The real estate broker must not advertise TIC investments in any way.

•   Suitability will be determined by the securities broker dealer.

•   The sponsor (seller) will be responsible for paying the buyer’s agent a real estate referral fee (It is the responsibility of the sponsor to disclose this fee).

Also, the real estate broker may not be disallowed from selling any security previously, must show the client traditional real estate investments, and should have some knowledge commercial real estate investments

Legal 1031 Exchange Services, Inc.877/701-1031

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Leave a Reply