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Under IRC section 1031, a taxpayer is allowed to postpone the
recognition of gain on the disposition of qualifying realty by the acquisition
of replacement real property that will be later identified and purchased
within a specific period of time. Structured properly, this deferred or
nonsimultaneous exchange is essentially a subsequent tax-free rollover of
the equity on the property being relinquished. By reinvesting the equity
(as long as there is as much debt on the new property as the mortgage
payoff on the disposed realty), capital gains tax and any IRC section 1250
unrecaptured gain taxable at the 25% rate can be completely avoided. This
will occur even when there is a liability-over-basis problem (i.e., when
the outstanding principal balance of the mortgage on the property exceeds
the realty's adjusted tax basis). In evaluating a deferred realty exchange,
the existence of certain tax attributes such as any carryovers (NOL,
capital loss, or passive activity losses) needs to be reviewed because
their availability may preclude the necessity of using section 1031 for all
or part of the transaction.
Tax deferral under IRC section 1031 does not include any recapture of tax
credits (e.g., low-income housing or rehabilitation credits) that may be
applicable if the property being exchanged has not been held for the
requisite holding period (15 years for the low-income housing credit).
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Qualifying property is broadly defined, for both the property
being transferred and that received, as realty used for investment or
business purposes.
Consequently, investment realty (held for either appreciation or rental)
can be exchanged for real property used in a trade or business. Partial
realty interests such as conservation easements and perpetual mineral or
oil rights are exchangeable with other types of realty (including a land
contract in which equitable title has been transferred) even a lease with
at least 30 years remaining (including renewal options) can be exchanged
for a fee-simple interest in realty.
If non-like-kind property is received (including any debt relief at the end
of the exchange), there will be partial gain recognition; there is no
all-or-nothing requirement of rolling over all of the equity and existing
debt to the replacement realty.
In contrast, the standard for replacement property from an involuntary
conversion under IRC section 1033 is a much narrower one: like-use. This
means that if a restaurant is destroyed by fire, the insurance proceeds
must be used to purchase or build another one. An involuntary conversion as
a result of an eminent domain proceeding under IRC 1033(g), however, is an
exception to this section's like-use requirement and uses a like-kind
standard similar to section 1031.
This postponement of tax can be continued with successive exchanges
(stemming from the original property that was relinquished). This
postponement will become a cancellation of the gain to the extent of the
step-up in basis received by the heirs at death for property held in the
decedent's name.
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Personal use realty is not eligible. The personal usage may be
considered nominal or substantial pursuant to the 10% of days rented or
14-day test under Section 280A. When a mixed-use exchange involving realty
with both qualifying and personal usages (such as an operating farm with a
personal residence eligible for IRC section 121) exists, these different
usages should be addressed through contractual allocations of the price.
Real estate should be held for the long-term capital gain period of one
year before disposition in order to satisfy section 1031's requirement of
being held for investment or business purposes. Any replacement property
received in an exchange should also be held for more than a year.
Foreign realty is also not eligible for section 1031 treatment.
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If an exchangor actually or constructively receives
non-like-kind property known as boot (e.g., money or personal property) for
the relinquished realty anytime before receiving the like-kind replacement
property, the transaction is a sale and not a deferred exchange. As a
result, the structuring of a deferred real property exchange requires
documentation to support an interdependent and integrated transaction with
the sale proceeds not being paid to the exchangor at the settlement date
(or held in escrow).
The paper trail for this documentation should begin with the original
purchase and sale agreement, which could contain a clause such as:
The seller reserves the option to convert the subject transaction to
qualify under IRC section 1031 with the purchaser agreeing to cooperate in
the execution of any of the required documentation (including but not
limited to a four-party deferred exchange agreement and a qualified
intermediary agreement), provided the purchaser shall incur no additional
cost or liability.
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The qualified intermediary (QI) is an entity or individual
independent of the exchangor and not deemed to be its agent, either
objectively or subjectively. Under the objective test, the QI cannot be the
taxpayer's closing attorney or anyone else who has had a business
relationship with the exchangor during the last two years.
The QI is the recipient of the net proceeds from the closing of the
relinquished property, with the money impounded for subsequent reinvestment
into other realty. Any earnings on these monies may not be paid to the
exchangor until the end of the exchange.
In a four-party deferred exchange, the QI is the fourth party, with the
other three being the exchangor, the buyer and the replacement property
owner. These relationships are defined in the required documentation,
executed with the buyer's cooperation because of contractual requirements,
using sample language described in question 4. These documents would
include notice to the parties of the use of direct deeding, in which the
exchangor would deed the realty being disposed directly to the buyer, while
the replacement property owner's deed would name the exchanging taxpayer as
the grantee. The QI would not need to take legal title to the realty being
relinquished or exchanged.
IRS Revenue Ruling 2002-83 prohibits a QI from using the impounded funds to
acquire the property of a party related to the exchangor to be used as the
replacement realty. Such a disposition by the related party would be deemed
a sale under IRC 1031(f), precluding any party from cashing out during the
two-year period following the exchange.
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The key date begins with the Initial Transfer Date (ITD),
which is the date of closing for the property being relinquished. Forty-five
days from that date, there must be a formal identification of the choices
for the replacement property.
The closing for the replacement property must occur no later than 180 days
from the ITD (unless the due date of the individual's tax return is earlier
because the exchange occurs after October 17). While these time
restrictions provide no extra days if this deadline falls on a weekend or
holiday, practitioners should advise clients that the ITD can be postponed.
This can be accomplished through a contractual provision for the buyer to
have preclosing occupancy with a triple net lease feature; the closing date
would be at the option of the exchanging taxpayer.
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Replacement property is “identified” under the regulations if
it is
- identified in a written
agreement (preferably executed by the QI subsequent to the ITD) using
a portion of the impounded funds for the earnest money deposit; or
- designated as
replacement property in a written document signed by the exchangor and
hand-delivered, mailed, faxed, or otherwise received by the QI before
the end of the identification period. The property ultimately acquired
must be substantially the same as that identified. For example, if two
acres are identified, at least 75% of the acreage must be purchased as
replacement property.
The regulations permit more than one property to be identified
as replacement property. As reflected in the Exhibit, the maximum
number of replacement properties which the exchangor may identify under the
regulations is:
- three properties of any
fair market value (FMV); or
- any number of
properties, as long as the aggregate FMV of all properties identified
as of the end of the identification period does not exceed 200% of the
aggregate FMV of all relinquished properties as of the date of
transfer; or
- under the 95% rule, an
exchangor is permitted to identify any number of properties of any
total value, provided that 95% of what has been identified is actually
acquired within the 180-day replacement period.
Replacement property acquired during the 45-day period reduces
the number of properties that can be identified under the rules above.
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The exchangor's right to receive money or other property must
be limited. These limitations provide that the exchangor may not, pursuant to
the documentation, have a right to receive money or non-like-kind property
until the earlier of:
- the end of the
identification period (if the exchangor has not identified any
replacement property within 45 days);
- the receipt by the
exchangor of all of the identified replacement property (or that for
which identification has subsequently failed due to an unfulfilled
material and substantial written contingency, such as zoning
approval); or
- the expiration of the
180-day reinvestment period for a calendar-year exchangor. This could
result in a one-year tax deferral of recognizing the boot received for
any exchange by an individual after July 4 because the receipt of the
non-like-kind property occurs in the following taxable year. This
deferral also applies to a failed exchange begun after this midyear
date if the property was properly identified but never acquired for
bona fide reasons during the 180 days that followed.
Regardless of whether the exchangor subsequently receives
money or boot from the QI at the end of an exchange, IRS Form 1099-S, box
2 should be 0, and box 4 should be checked
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The exchangor is not deemed to be in receipt of the funds to
the extent that these are used to pay closing costs. The regulations
indicate that the use of money held by a QI to pay transactional items will
not result in the actual or constructive receipt by the exchangor of the
remaining funds. This rule applies to costs that relate to the disposition
of the relinquished property or acquisition of the replacement property, as
well as expenses listed as the responsibility of a buyer or seller in the
typical closing statement under local standards.
Examples of these expenditures include, commissions, recording or transfer
taxes and the title company fees. In addition, an exchangor's right to
receive items (such as prorated rents) that a taxpayer may receive as a
consequence of the disposition of property and that are not included in the
amount realized from the property transfer does not affect the exchange.
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No. The property of a taxpayer can be excluded from section
1031 even though used in a business or for investment purposes, under the
following circumstances:
- Since property must be
held for business or investment purposes in order to qualify,
inventory is never deemed eligible property under section 1031. Realty
can be constructively deemed to be inventory if, in the determination
of the IRS, a "dealer taint" exists.
- The nature of the
property is determined to be in the hands of the person seeking the
benefit of the exchange. In other words, even if property is acquired
from a dealer, the recipient can hold the property for business or
investment purposes for a sufficient period of time in order to
qualify for exchange treatment.
- Various subjective
factors are involved in the dealer issue which label can either be
applied to the taxpayer or a particular parcel of property. The
factors include the holding period of the property, the number of
realty sales, the percentage of the taxpayer's income that the sales
comprise, whether or not a sales agent is used in the marketing of the
properties and to what extent is the gain attributable to the
taxpayer=s efforts such as subdividing and adding improvements (e.g.,
streets/sewers).
- One way of avoiding the
dealer taint is to separate the taxpayer's investment realty from
potential dealer real property. For example, if an individual is
involved in the rental of apartment buildings and is also subdividing
a parcel of property into lots, it may want to consider having the
land development activity conducted within a wholly owned Subchapter S
corporation (with the potential benefit for FICA savings through the
use of subchapter S corporation dividends).
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Both the diversification exchange and the consolidation
exchange refer to the fact that an exchange need not be a one-for-one
transaction. In a diversification exchange, a taxpayer may be interested in
diversifying his real estate portfolio either to reduce the risk associated
with having property in one location or to provide smaller units of real
estate for subsequent liquidation of a portion of the original investment.
This is accomplished by exchanging one parcel for several.
In a consolidation exchange, the taxpayer has several properties but
desires to simplify a portfolio, reducing the number of realty interests
through section 1031.
Under both types, there must be strict adherence to the time limitations
outlined in question 6.
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Even in situations where the exchangor has not added money to
the acquisition of the replacement property, its basis can be increased. If
the total liabilities on the replacement property exceed the debt that had
existed on the relinquished property (assuming the taxpayer does not
receive any cash or other non-like-kind property), the basis of the new
property will increase.
The depreciation deductions can be increased when a nondepreciable asset is
exchanged for a depreciable asset, such as vacant land exchanged for an
apartment building. In addition, an exchangor could receive property which
has a higher building-to-land ratio than the one transferred.
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The "build to suit" or construction exchange
involves the acquisition by the QI of vacant land on which a structure will
be built (i.e., not merely improving already-owned property owned by the
exchangor). This results in pretax dollars from the QI's impounded funds
being used (which can be supplemented by proceeds from new debt financing).
Upon the earlier of the completion of the project or the expiration of 180
days from the ITD, the portion constructed and considered as realty
qualifies as replacement property, provided that the "as built"
structure is substantially the same (in terms of completion) as what had
specifically been timely identified under the 45-day rule.
The "rehab to suit" exchange is similar because the QI acquires
realty which needs rehabilitation with pretax dollars being held by the QI.
In either case, the applicable documentation should utilize "time is
of the essence" language, as well as address the issue of liquidated
damages for purposes of ensuring the completion of the contractor's work
before the end of the exchange in order to avoid the receipt of boot.
Documentation should also require sequential deeding (as opposed to the
direct deeding referred to in question 5), in which the QI takes legal
title as an interim grantee during the construction and rehabilitation
period, eventually deeding the title to the exchangor before the expiration
of the 180-day exchange replacement period.
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The bona fide conversion of usage can benefit the only type of
realty for which there is no favorable tax treatment under the IRC:
vacation homes. This type of property (along with a personal residence in
the rare case when the section 121 gain exclusion is inadequate) should be
eligible for an IRC section 1031 exchange after a year of bona fide rental
activity is reported on Schedule E of the taxpayer's Form 1040.
The question that arises is: How long after an exchange can the replacement
property received under section 1031 be converted to personal use without
jeopardizing the individual's original exchange? While there is no
statutory, judicial, or administrative authority on this point, most
advisers would recommend a substantial period of time (e.g., three years)
before considering the conversion of business or investment realty to
personal use. After this time, the taxpayer may then be able to qualify
this property as a personal residence in order to take advantage of the IRC
section 121 gain exclusion after subsequently satisfying the two-year
holding period requirement.
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Yes, when an exchange involves an operating business, section
1031 applies separately to both the realty and personalty (a "mixed
property exchange"). Personal property is more difficult to configure
under section 1031 because the definition of like-kind involves the concept
of "like-class" under the Treasury Regulations. The resulting
complexities in the tangible personal property area mean that office
equipment and a business auto are not like-class and thus not like-kind.
With respect to the business' intangible property, goodwill of one
operating business cannot be exchanged for that in another. As addressed in
question 4, it is important to attempt to match allocations (based on fair
market value) between the relinquished property and the acquired property.
Consequently, there is a need to establish exchange categories that can
qualify (e.g., realty and like-class personal property) and those that are
never eligible (e.g., good-will and inventory).
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A "Reverse Starker" exchange occurs when a taxpayer
needs to either contract or acquire the replacement property before the
title closing for the property being relinquished. Revenue Procedure
2000-37 provides a set of safe harbor guidelines:
- An exchange
accommodation title-holder (EAT) can also be the QI. The EAT acquires
and reports the beneficial ownership or title of the replacement
property before there has been a disposition of the property
relinquished by the exchangor.
- The exchanging taxpayer
or a related party may advance money or guarantee loans to be used
toward the acquisition of the replacement property by the EAT. In
addition, the exchangor may use or lease the property being held by
the EAT as well as provide management and construction services such
as would be required for the build-to-suit or rehab-to-suit exchanges
discussed in question 13. Any of these arrangements between the
exchangor and the EAT can be for less than full and adequate
consideration.
- Five days after the EAT
acquires the title, a qualified exchange accommodation agreement
(QEAA) must be executed between the parties; 45 days from the date of
the EAT's realty acquisition, the exchangor must identify the property
to be disposed of within 180 days (whose closing proceeds will be used
to acquire the replacement realty from the EAT).
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The following are the implications when a purchase money
mortgage is received in an exchange:
- The debt instrument
should name the QI as the initial mortgagee and be executed by the
buyer-mortgagor of the property being relinquished.
- Upon receipt of the
mortgage receivable a the end of the exchange period, the exchangor
must still recognize gain under the installment sale rules, pursuant
to IRC section 453.
- When the QI receives a
purchase money mortgage in an exchange, there are two alternatives to
recognizing gain:
- the mortgage could be
discounted to cash by the QI, with the net proceeds put toward the
replacement property, or
- the mortgage could be
assigned by the QI and put toward the acquisition of the replacement
property, whose seller would accept the face value of the mortgage as
consideration. In this case, the mortgage is secured by both the
relinquished and the replacement properties as an inducement for the
replacement property owner to accept this mortgage as consideration.
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Even when the sole asset of a partnership or LLC is realty,
the interest in the entity is considered to be a form of intangible
personal property in the hands of the partner or member. Accordingly, an
exchange of an interest in an entity-holding realty for real estate is not
considered the exchange of like-kind assets. In addition, the holding
period (for purposes of calculating the time frame discussed in question 3)
for any realty distributed from an entity to its owners will begin upon
receipt of the property.
When a partnership wishes to dispose of realty, there may be a difference
of opinion between partners who wish to reinvest under section 1031 and
those who wish to cash out. One solution is to have those partners who
desire to remain in the partnership make a liquidating distribution to the
others. Provided there is no technical termination of the partnership, the
partners cashing out can receive consideration for their partial interests,
while remaining partners take advantage of section 1031, with the
partnership as the exchanging taxpayer.
Revenue Procedure 2002-22 has recently provided insight in the area of
partial realty interests or undivided fractional interests (UFI), which are
being considered either as the replacement realty or as the property to be
relinquished in an exchange. Revenue Procedure 2002-22 addresses the
prerequisites for submitting a Private Letter Ruling request to the IRS
regarding a nonpartnership tenant in common (TIC) arrangement by noting:
- There must be pro-rate
sharing (in proportion to the TIC co-owner's percentage interest in the
underlying title) of profits, expenses, cash distributions and
indebtedness.
- Up to 35 TIC co-owners
are permitted to own a single parcel (or multiple parcels that are
contiguous or related in use).
- Customary investment
real estate activity may be undertaken by the TIC co-owners (e.g.,
repair and maintenance); business involvement may not.
- The use of a common bank
account for the benefit of the TIC co-owners is acceptable as long as
separate reporting is provided to the co-owners.
- An annually renewable
contact with a leasing management company, and arrangements such as
voting agreements, call options and rights of first offer or refusal
among the TIC co-owners, are permissible with certain restrictions.
As a result of the limitations contained within Revenue
Procedure 2002-32, advisers may want to consider a master lease for
multitenant property that provides for a sublessor (such as the sponsor
packaging the TIC interests) to pay a net lease amount to the co-owners.
Several recent private letter rulings have permitted taxpayers disposing of
individually owned realty to receive the membership interest in a
single-member LLC that owns the replacement real property. This arrangement
may be beneficial to taxpayers concerned about liability exposure. The use
of LLCs as the preferred entity for realty holdings is discussed in two of
the author's previous articles, "Twenty Questions on Selection of a
Legal Entity" (The CPA Journal, August 1999) and "Twenty
Questions on Protecting Business and Family Assets" (The CPA Journal,
February 2000).
Though the subject article emphasizes deferred section 1031 exchanges
undertaken by individual taxpayers, all of the various types of business
organizations, including trusts, are able to utilize section 1031 by
disposing of entity-owned realty and later acquiring replacement real
property.
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An alternative to section 1031 exchanges is the use of an
umbrella partnership real estate investment trust (UPREIT), which involves
a tiered ownership structure encompassing a realty operating partnership
(OP) and a REIT that is a partner in the OP.
Property owners wishing to divest their realty can contribute their
property to the OP and, pursuant to IRC section 721, receive a tax-free
partnership interest in the OP. This interest is convertible after a period
of time into cash or shares of the REIT. When there is a
liability-over-basis problem with respect to realty contributed to the OP,
consideration should be given to the transferors guaranteeing a portion of
the underlying property debt held by the OP. (For more information, see
"Planning for UPREIT Transactions When Selling Partners Want to Go
Their Separate Ways," Journal of Taxation, April 1999.)
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If a taxpayer wishes to avoid taxes on the disposition of real
property and does not wish to take advantage of section 1031 (or has not
utilized a self-directed IRA for the holding and tax-free dispositions of
realty), there is another option. Prior to the execution of a contract to
sell highly appreciated realty held for investment or business purposes, a
taxpayer may consider donating this property to a newly created charitable
remainder trust (CRT). This CRT will then sell the property and avoid
capital gains tax. The CRT would pay an income for the life of the original
owner based upon the pretax value of the donated property. This income
stream is usually higher than that which would be obtained by reinvesting
the after-tax sale proceeds in a certificate of deposit from a taxable
transaction. Not only are the sale proceeds removed from the taxpayer's
estate, there is also the benefit of a charitable income tax deduction for
income tax purposes (subject to the AGI limitations, with a five-year
carryover period for any excess) based on the actuarial value of the
remainder interest received by the charity.
A wealth replacement trust (WRT) may be used in conjunction with a CRT,
since the latter does not provide any benefit of the trust principal to
family members (i.e., the remainder is directed to charity). As a result,
the life insurance industry developed the concept of having a portion of
the tax savings/cash flow obtained from the CRT applied toward the purchase
of life insurance (such as a second-to-die policy) that is held by the WRT
as applicant, owner and beneficiary of a policy insuring the husband and
wife as grantors. The WRT is similar to a life insurance trust with a
"Crummey" feature (see "Answers to 20 Questions on the Use
of Trusts," The CPA Journal, September 1998). Upon the death of the
insured, the insurance proceeds held by the trust are used to replace the
wealth that has been "lost" to charity.
IRC section 1031 offers a number of opportunities because of its
flexibility. Nevertheless, tax cases have consistently indicated that the
required documentation (along with the procedures for implementing a
deferred realty exchange) must be, in the words of the courts,
"bullet-proof" in order to avoid problems at an IRS audit.
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Peter A. Karl, III, JD, CPA, is a partner
with the law firm of Paravati, Karl, Green & DeBella in Utica, N.Y. and
a professor of law and taxation at the State University of New
York-Institute of Technology (Utica-Rome). He is also the author of
www.1031exchangetax.com.
Exhibit I
Alternatives for Identification of
Replacement Property Under Section 1031
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3 Property Rule
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200% Rule
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95% Rule
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Total # of
Properties
that can be identified
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3
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No Limit
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No Limit
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Total FMV of
Properties identified
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No Limit
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2 times the disposition price of the property being
relinquished
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No Limit
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