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Like-kind exchange relief for those snared by QIs in bankruptcy or receivership

Wednesday, March 10th, 2010 by Moore McLaughlin

The IRS has at long last granted relief for taxpayers who were unable to timely complete a like-kind exchange because their qualified intermediary (QI) entered into bankruptcy or receivership. IRS will not treat taxpayers as being in actual or constructive receipt of exchange proceeds if they cannot complete an exchange because of a default of a QI in bankruptcy or receivership. Affected taxpayers may use a special safe harbor method to report gain or loss.

The IRS received many comments on this issue and has been promising action on it for a long time.  As far back as 2007, when the real estate market started heading south in many areas, the IRS wrote Rep. Barney Frank (D-MA) to say that IRS was considering whether it was appropriate for it to extend relief where QIs went bankrupt.  In substantially similar letters written to a number of Washington legislators in mid-2009, the IRS again said it was considering relief measures.

Background.  In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is held either for productive use in a trade or business or for investment. (Code Sec. 1031)  Under Code Sec. 1031(a)(3), for a deferred exchange to be treated as tax-free, a taxpayer must identify the replacement property within 45 days of the transfer of the relinquished property and must acquire the replacement property by the earlier of 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or the due date (determined with regard to extensions) of the taxpayer’s federal income tax return for the year in which the transfer of the relinquished property occurs.  Absent relief, if the statutory timing requirements are met, a taxpayer would have to treat the relinquished property as having been disposed of in a taxable sale or exchange.

The regulations allow a taxpayer to use a QI to facilitate a like-kind exchange. (Reg. §1.1031(k)-1(g)(4))  When a taxpayer uses a QI, generally he will transfer the relinquished property to the QI, who sells the property to a buyer.  The QI then takes the proceeds of the sale of the relinquished property, buys the replacement property, and transfers the replacement property to the taxpayer. If the taxpayer receives the replacement property within the period in Code Sec. 1031(a)(3) and meets the other Code Sec. 1031 requirements, he is treated as having engaged in a like-kind exchange of property with the QI and he will not recognize gain on the exchange.

Victims of the recession and the troubled real estate markets. In Rev Proc 2010-14, IRS says it is aware of situations in which taxpayers initiated like-kind exchanges by transferring relinquished property to a QI but were unable to complete the exchanges within the statutory time period solely due to the failure of the QI to acquire and transfer replacement property to the taxpayer (a “QI default”). In many of these cases, the QI enters bankruptcy or receivership, thus preventing the taxpayer from obtaining immediate access to the relinquished property’s sale proceeds.

The IRS says it’s generally of the view that in such situations, a taxpayer should not have to recognize gain from the failed exchange until the tax year in which he receives a payment attributable to the relinquished property.

Who is entitled to relief. A taxpayer is entitled to relief under Rev Proc 2010-14 if he:

(1) Transferred relinquished property to a QI in accordance with Reg. §1.1031(k)-1(g)(4).

(2) Properly identified replacement property within the identification period (unless the QI default occurs during that period).

(3) Did not complete the like-kind exchange solely because of a QI default involving a QI that becomes subject to a bankruptcy proceeding or a receivership proceeding under federal or state law.

(4) Did not, without regard to any actual or constructive receipt by the QI, have actual or constructive receipt of the proceeds from the disposition of the relinquished property or any property of the QI before the QI entered bankruptcy or receivership. For purposes of this condition, relief of a liability under the exchange agreement before the QI default, either through the assumption or satisfaction of the liability in connection with the transfer of the relinquished property or through the transfer of the relinquished property subject to the liability, is disregarded.

Relief provisions. Rev Proc 2010-14, Sec. 4, provides that a taxpayer meeting the above conditions recognizes gain on the disposition of the relinquished property only as required under the safe harbor gross profit ratio method, and only as he receives payments attributable to that property.

Under the safe harbor gross profit ratio method, the portion of any payment attributable to the relinquished property that is recognized as gain is found by multiplying the payment by a fraction, having the taxpayer’s gross profit as the numerator, and having the taxpayer’s contract price as the denominator. For this purpose:

  • A payment attributable to the relinquished property means a payment of proceeds, damages, or other amounts attributable to the disposition of the relinquished property (other than selling expenses), whether paid by the QI, the bankruptcy or receivership estate of the QI, the QI’s insurer or bonding company, or any other person. Unless it exceeds adjusted basis, satisfied indebtedness is not a payment attributable to the relinquished property.
  • Gross profit means the selling price of the relinquished property, minus the taxpayer’s adjusted basis in it (increased by any selling expenses not paid by the QI using proceeds from the sale of the relinquished property).
  • The selling price of the relinquished property is generally the amount realized on its sale, without reduction for selling expenses. But if a court order, confirmed bankruptcy plan, or written notice from the trustee or receiver specifies, by the end of the first tax year in which the taxpayer receives a payment attributable to the relinquished property, an amount to be received by the taxpayer in full satisfaction of his claim, the selling price of the relinquished property is the sum of the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) received or to be received and the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.
  • The contract price is the selling price of the relinquished property minus the amount of any satisfied indebtedness not in excess of the property’s adjusted basis. Satisfied indebtedness means any mortgage or encumbrance on the relinquished property that was assumed or taken subject to by the buyer or satisfied in connection with the transfer of the relinquished property.

Rev Proc 2010-14, Sec. 4, has detailed rules covering situations involving satisfied indebtedness exceeding adjusted basis, recapture income, and imputed interest.

A Code Sec. 165 loss deduction may be claimed for the amount, if any, by which the adjusted basis of the relinquished property exceeds the sum of (1) the payments attributable to that property (including satisfied indebtedness in excess of basis), plus (2) the amount of any satisfied indebtedness not in excess of basis. Those claiming a loss deduction may also claim a Code Sec. 165 loss deduction for the amount of any gain recognized in accordance with Rev Proc 2010-14, Sec. 4, in a prior tax year.

Illustration: Mr. Able, a calendar year taxpayer owned investment property (Property 1) with a fair market value of $1.5 million and an adjusted basis of $500,000.  He entered into an agreement with QI to facilitate a deferred like-kind exchange. On May 6, Year 1, Able transferred Property 1 to QI and QI transferred the property to a third party in exchange for $1.5 million. Able intended that the QI use the money held by it to acquire Able’s replacement property. On June 1, Year 1, Able identified Property 2 as replacement property. On June 15, Year 1, QI notified Able that it filed for bankruptcy protection and could not acquire replacement property. As a result, Able failed to acquire Property 2 or any other replacement property within the exchange period. As of December Year 1, QI’s bankruptcy proceedings are on-going and Able has received none of the $1.5 million proceeds from QI or any other source.

On July 1, Year 2, QI exits from bankruptcy and the bankruptcy court approves the trustee’s final report, which shows that Able will be paid $1.3 million in full satisfaction of QI’s obligation under the exchange agreement. Able receives the $1.3 million on August 4, Year 2 and does not receive any other payment attributable to the relinquished property.

Under Rev Proc 2010-14, Able is not required to recognize gain in Year 1 because he did not receive any payments attributable to the relinquished property in that year. He recognizes gain in Year 2, as follows:

… His selling price is $1.3 million, i.e., the payments attributable to the relinquished property (the amount specified by the trustee before the end of the first tax year in which he receives a payment attributable to the relinquished property).

… His contract price also is $1.3 million because there is no satisfied or assumed indebtedness.

… His gross profit is $800,000 (the selling price of $1.3 million less his $500,000 adjusted basis).

… His gross profit ratio is 80/130 (gross profit over the contract price).

… Able’s recognized gain in Year 2 is $800,000 (the $1.3 million payment attributable to the relinquished property multiplied by the gross profit ratio (80/130)).

Even though the payment attributable to the relinquished property ($1.3 million) is less than the $1.5 million that the QI received, Able is not entitled to a Code Sec. 165 loss deduction because the payment attributable to the relinquished property exceeds his adjusted basis in the relinquished property ($500,000). (Rev Proc 2010-14, Sec. 4.10, Ex. 1)

Rev Proc 2010-14 carries four other detailed examples illustrating nuances of the new safe-harbor relief.

Effective date of relief. Rev Proc 2020-14 is effective for taxpayers whose like-kind exchanges fail due to a QI default occurring on or after January 1, 2009.  A taxpayer who is within the scope of Rev Proc 2020-14 may, subject to the Code Sec. 6511 limitations on credit or refund, file an original or amended return to report a deferred like-kind exchange that failed due to a QI default in a tax year ending before January 1, 2009, in accordance with Rev Proc 2010-14.

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Posted in 1031 Exchange Basics, 1031 News, Choosing a Qualified Intermediary, FAQs, Other

Supreme Court lets stand decision that using qualified intermediary cannot avoid §1031 related party rule

Wednesday, February 24th, 2010 by Moore McLaughlin
Supreme Court of the United States of America

Supreme Court of the United States of America

The Supreme Court has declined to review a Ninth Circuit holding that a taxpayer could not avoid the Code §1031 like-kind-exchange related-party rule by using a qualified intermediary (QI). Teruya Brothers, Ltd. & Subsidiaries , (CA 9 2/11/2009) 104 AFTR 2d ¶ 2009-5345 , cert denied 2/22/2010.

Background. If statutory identification and replacement period requirements are met, gain or loss is not recognized currently on the exchange of property held for productive use in a trade or business or for investment for property of like kind that will be held for productive use in a trade or business or for investment. (Code §1031) QIs may be used to structure like-kind exchanges. However, under Code §1031(f), gain or loss on an exchange between related persons (under Code §267(b) or Code §707(b)(1)) must generally be recognized if either the property transferred or the property received is disposed of within two years after the exchange. Nonrecognition treatment under the like-kind exchange rules does not apply to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related party exchange rule. (Code §1031(f)(4)) However, under Code §1031(f)(2)(C), a disposition will not trigger the related party bar if it is established to IRS’s satisfaction that neither the original transaction nor the later disposition had as one of its principal purposes the avoidance of federal tax.

Facts. Teruya Brothers Ltd. (Teruya) owned 62.5% of the common shares of Times Super Market Ltd (Times), so the two entities were related.  In 1995, in one series of planned transactions, Teruya transferred Real Property 1 to TGE, a QI, which then sold it to an unrelated third party. TGE used the sale proceeds, as well as additional funds from Teruya, to buy like-kind Replacement Property 2 for Teruya from Times, and then transferred Replacement Property 2 to Teruya. In another series of planned transactions, Teruya transferred Real Property 3 to TGE, which sold it to an unrelated party. TGE used the sale proceeds from Real Property 3, plus some cash from Teruya, to buy like kind Replacement Properties 4 and 5 from Times.

Teruya realized a $1.3 million gain on Property 1 and a $10.7 million gain on Property 3. Times realized and recognized a $1.3 million gain on Property 2 and a $2.2 million gain on Property 5, but these gains were offset by a large net operating loss. Times realized a $6.4 million loss on Property 4, but did not recognize it because of the Code §267 related-party restriction on loss recognition.

Teruya treated its transactions as tax-deferred like-kind exchanges under Code §1031, but IRS said the transactions ran afoul of the Code §1031(f)(4) related-party rule and hit Teruya with a $4 million deficiency.

Tax Court. In 2005, the Tax Court held that the transactions were economically equivalent to direct exchanges of properties between Teruya and Times (with boot from Teruya to Times), followed by the sales of the properties by Times to unrelated third parties. The interposition of a QI couldn’t obscure the end result.

Observation: In 2009, the Tax Court applied its Teruya reasoning and decision to rule against another taxpayer on the QI- Code §1031(f) issue (see Ocmulgee Fields, Inc., (2009) 132 TC No. 6).

Ninth Circuit. In 2009, the Ninth Circuit concluded that the Tax Court did not err in determining that the transactions were structured to avoid the purposes of Code §1031(f)(4). It rejected Teruya’s contention that the economic consequences of the transactions to Times were irrelevant, and that Teruya’s continued investment in real property was dispositive. Code §1031(f)(1)(C)(i) disallows nonrecognition treatment if a related party disposes of exchanged property within two years, regardless of whether the taxpayer does as well. Thus, examining the taxpayer and related party’s economic position in the aggregate is often the only way to tell if Code §1031(f) applies.

The legislative history indicating Congress’s desire to bar like-kind exchange treatment where related parties have, in effect, cashed out of the investment, confirmed that a taxpayer and a related party should be treated as an economic unit to see if Code §1031(f) applies. The Ninth Circuit pointed out that the changing economic positions of Teruya and Times readily showed that the related parties used the exchanges to cash out of an investment in low-basis real property. Before the exchanges, Teruya owned Property 1 and Property 3, and Times owned Properties 2, 4, and 5. After the exchanges, Properties 1 and 3 had been sold, Teruya owned Properties 2, 4, and 5, and Times had the cash from the sale of Properties 1 and 3 (along with boot from Teruya). All in all, Teruya and Times decreased their investment in real property by approximately $13.4 million, and increased their cash position by the same amount. By allowing Teruya and Times to cash out of a significant investment in real property under the guise of a nontaxable like-kind exchange, the Ninth Circuit concluded that the transactions were undoubtedly structured to contravene Congress’s desire that nonrecognition treatment only apply to transactions where a taxpayer can be viewed as merely continuing his investment.

The Ninth Circuit said Teruya could have exchanged its properties directly with Times, followed by Times’s selling Property 1 and Property 3 to the third-party purchasers, but this would not have had a tax-free result, since direct exchanges between related parties are ineligible for nonrecognition treatment when the exchanged property is sold within two years. Instead, Teruya employed TGE; the latter’s involvement as a QI served no purpose besides rendering simple, but tax disadvantageous, transactions more complex in order to avoid Code §1031(f)’s restrictions.

The Ninth Circuit also affirmed the Tax Court’s conclusion that Code Sec. 1031(f)(4) applied because improper avoidance of federal income tax was one of the principal purposes of the transactions.

Late in 2009, Teruya appealed the Ninth Circuit’s decision to the Supreme Court. However, on February 22, 2010, the Supreme Court declined to review the decision.

For more information on 1031 exchanges, or to ask specific questions regarding the related party rule of §1031, please contact Alexandra L. Hart, CES® at All States 1031 Exchange Facilitator, LLC by e-mail at AHart@AllStates1031.com or Moore McLaughlin, Esq., CPA, CES® by e-mail at FMM@AllStates1031.com or either of them by phone toll-free at 877-395-1031 extension 217.

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Posted in 1031 News, Choosing a Qualified Intermediary, FAQs, Qualifying Properties

What do I do if my TIC is in trouble?

Saturday, February 20th, 2010 by Moore McLaughlin

Alexandra L. Hart, CES® and I have been asked this question almost every other day for the past several months.  With the national commercial real estate and financial markets in turmoil, many investments that seemed solid only a year or two or three ago are now floundering.  Lenders are beginning foreclosure proceedings or are negotiating with the owners to take back a deed in lieu of foreclosure.  Buildings are being sold in so-called short sales.  And, lenders are selling off the promissory notes at deep discounts.  In other instances, the banks are not taking any immediate action, but the sponsors are offering to buy out investors for the amount of their investment.  Sometimes, individual investors are concerned and want to sell their interests, thus giving the other co-tenants an opportunity to buy a larger percentage for a small amount.tic-foreclosure

The question that we are continually asked is “What is my tax exposure?”  As a tax lawyer, I have been trained to answer “Well, it depends.”

In every TIC I know of, the property is encumbered by non-recourse debt.  Non-recourse debt is a loan made by a lender (could be a bank, an insurance company, a pension plan or some other type of lender) which debt is secured only by the property.  The key feature of non-recourse debt is that no one is personally liable for the debt and the lender can look only to the property for repayment.  As long as the rents are able to cover the expenses of the property and make the mortgage payments, then the lender typically feels comfortable.  However, if the cash flow only covers the expenses and the investors do not receive any distributions, then the investors are not comfortable.  Once the cash flow fails to cover the expenses, then the trouble really begins. 

Sometimes the sponsor or property manager will make a cash call.  If one or more of the owners is not willing or able to contribute enough cash, then the tenant-in-common agreement generally provides that the non-contributing owner either has to sell his or her interest, or the property has to be sold.  In any event, if there is insufficient cash to cover the expenses, the lender will eventually take action.

In most of these cases, the TIC investors do not contribute additional cash.  Thus, the lender starts the process of taking back or selling the property.  Because the debt is non-recourse, the lender cannot go after the TIC owners, and cannot force the TIC owners to pay any money.  So, the TIC owners generally lose the property, and their investment, but that is the extent of their losses.

These investors are convinced that they have sustained a loss for tax purposes.  In almost every instance, that is not the case.  For tax purposes, if a property that is encumbered by non-recourse debt is foreclosed upon or transferred back to the lender by a deed in lieu of foreclosure, the investor is treated for tax purposes as if he or she sold their interest in the property for their share of the non-recourse debt.  For tax purposes, this is known as the amount realized.  Taxable gain is calculated as the amount realized minus the adjusted tax basis of the property.

So, the next issue is to determine the investors’ adjusted tax basis in the property.  Most of the TIC owners acquired the TIC interest as a replacement property in a 1031 exchange.  If so, then their adjusted tax basis in the TIC interest is determined, in whole or in part, based on their adjusted tax basis in the property or properties that they sold in the 1031 exchange(s).  If the investor traded up in value on the 1031 exchange, then the investor may have added to his or her adjusted tax basis.  Any investor facing this dilemma should consult a qualified CPA or tax attorney who can make these complicated calculations.

Non-recourse debt that is forgiven does not result in cancellation of indebtedness income (”COD income”).  COD income can be generated only from recourse debt.  COD income is subject to a completely different set of tax rules.  So, investors should not become confused with how the COD income rules operate.

The character of the gain on the foreclosure or deed in lieu of foreclosure of a TIC interest is likely to be capital.  The holding period of the TIC interest is determined, to some extent, based upon the holding period the investor had in his or her relinquished property or properties from the 1031 exchange.  However, if the investor traded up in value, he or she could have a split holding period.  In order to enjoy the lower long-term capital gains tax rates, the property has to have been held for more than twelve months.  In calculating the 12-month holding period, the investor may be able to tack on the holding period from his or her relinquished property.  Again, any investor in this situation needs to consult a qualified CPA or tax attorney.

Remember also that there is no bright-line test for how long a property has to be held to qualify as “held for investment” for purposes of section 1031.  There is no 2-year rule, 1-year rule or any other hard and fast rule.

In summary, the investor is treated as having sold the TIC interest in an amount equal to his or her share of the non-recourse debt.  The investor will recognize gain or loss on this deemed sale based on his or her adjusted tax basis.  In addition, the investor must determine his or her holding period.

The good news is that for investors facing a large tax bill, they may be able to defer the tax by effectuating another 1031 exchange.  Click here for more information about “coffin or “no equity” exchanges.

For more information about these issues, or to ask questions about a specific scenario, please contact Alexandra L. Hart, CES® by e-mail at AHart@AllStates1031.com or by phone toll-free at 877-395-1031 ext. 217.

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Posted in 1031 Exchange Basics, 1031 News, FAQs, Other, Qualifying Properties, Tenants-in-Common

Non-Resident Tax Withholding and 1031 Exchanges

Monday, November 23rd, 2009 by Moore McLaughlin

Because we handle 1031 exchanges in every state, we are frequently asked about the tax laws of individual states.  Alexandra L. Hart, CES® and I always encourage exchangers to seek tax and legal advice from their own professionals, who are generally more knowledgeable about local laws and the exchangers’ particular circumstances.  One of the most frequently asked questions involves non-resident tax withholding.Non-Resident Withholding

In many states, when an individual or entity that is not a resident of the state is selling real property, the state may impose a capital gains tax or other income tax.  Because the seller is not a resident of the state, the state assumes that the seller will not file a tax return for that state.  Once the property has been sold, the seller may have no further contacts within the state.  If the seller does not voluntarily file a tax return and pay the tax, the state may never collect the tax. 

As a measure to make sure all taxes are collected, most states have implemented a mechanism whereby the closing attorney or escrow company is required to withhold a portion of the sales proceeds and remit them to the state.  In most cases, the amount required to be withheld is based on the gross selling price, not the actual amount of the gain.  The reason for this technique is to make sure the taxes are collected, but without requiring an inquiry into the tax basis and other tax attributes of the seller.  If too much is withheld, the seller can file a non-resident income tax return and claim a refund, if one is due.

Many states recognize 1031 exchanges and adopt the federal tax rules.  As a result, exchangers who complete a valid 1031 exchange, with no boot, will owe no taxes to the state.  If taxes are withheld and then later returned to the exchanger, then such amounts could be treated as boot, and subject the exchanger to tax; which is quite a bad outcome.

To ameliorate this Catch-22 scenario, states typically allow an exchanger to provide a statement or certificate at the closing which relieves the closing agent from the requirement to withhold any amounts for taxes.  In Rhode Island, the form is known as Form 71.3.  Other states have similar forms or processes.  Some states require the seller to request the certificate days or weeks in advance of the closing.

So, if you are selling real estate located in a state in which you or the selling entity is not a resident, call us or check with your tax professional to determine whether non-resident withholding is required and, if it is, whether an exception exists for 1031 exchanges. Please click here to find some of the state non-resident withholding forms. Or click here for links to the various state websites.

Please contact us with any questions you may have.  You can reach Alexandra L. Hart CES® at 877-395-1031 or by e-mail at AHart@AllStates1031.com.

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Posted in 1031 Exchange Basics, Choosing a Qualified Intermediary, FAQs

Exchanging Real Estate Intangibles

Tuesday, October 27th, 2009 by Moore McLaughlin

When exchanging real estate, the exchanger must acquire property that is like-kind to the property that was sold.  Like-kind in connection with real estate is defined as “all other real estate.”  The types of property that qualify are very broad.  For example, raw land will be like-kind with improved real estate.  An office building is like-kind with an apartment building.  Real estate in Massachusetts or Rhode Island is like-kind with real estate in Florida, Texas or Arizona.conservation-easement

Further, a partial or fractional interest in real estate is like-kind to a full or fee simple interest in real estate.  So, an exchanger could sell a fee simple interest in real estate and purchase a tenant-in-common interest in real estate.

Recently, a series of rulings have been issued by the IRS which confirms that certain intangible interests in real estate are like-kind to fee simple interests in real estate.

Conservation Easements

In Private Letter Ruling (PLR) 9621012, the IRS ruled that the exchange of a “perpetual scenic conservation easement” (PSCE) for a fee simple interest in land that was either timberland, a ranch, or a farm qualifies for tax-free treatment under section 1031.  A PSCE means any limitation in a deed in the form of an easement, restriction, covenant, or condition, the purpose of which is to retain land predominantly in its natural, scenic, historical, agricultural, forested, or open-space condition.  Under a PSCE, the subject property remains as scenic open space in perpetuity, and its owner is not able to develop the property.  The ruling is based on a state’s civil code, which provides that a conservation easement is an interest in real property voluntarily created and freely transferable in whole or in part.  Assuming the PSCE is, by virtue of state law, an interest in real property, the exchange of the PSCE for the proposed replacement property qualifies as an exchange of like-kind property for purposes of Section 1031.

In PLR 9232030, the IRS ruled that an agricultural conservation easement on a farm is of like kind to a fee simple interest in real estate.

In PLR 200201007, the IRS ruled that a taxpayer’s exchange of a perpetual conservation easement (PCE) on a ranch for other ranch property that would be subject to a PCE upon receipt by the taxpayer qualifies for like-kind exchange treatment under Section 1031.

In PLR 200651018, the IRS ruled that a perpetual stewardship easement as described in the ruling is of like-kind to fee interest in other real property, and use of proceeds from relinquished perpetual stewardship to purchase one or more fee interests in real property to be held by taxpayer for productive use in trade or business or for investment will not disqualify transaction from tax deferred exchange treatment.

Development Rights

The IRS ruled in PLR 200901020 that residential density development rights to be transferred by taxpayer as relinquished property were for Section 1031 purposes of a like-kind to a fee interest in real estate, leasehold interest in real estate with 30 years or more remaining at time of the exchange, and land use rights for hotel units. The land use rights that were a part of the put option addressed in this PLR and the restrictive covenant (collectively referred to as Development Rights) constituted interests in real estate under state law. Taxpayer intended to exercise the put option and use the sales proceeds from the Development Rights (the relinquished property) to acquire like kind replacement property. Taxpayer’s replacement property included a fee interest in real estate, a leasehold interest in real estate with 30 years or more remaining, and land use rights for hotel units.  The IRS ruled that the Development Rights to be transferred by Taxpayer as relinquished property were of like kind, for purposes of Code Sec. 1031, to a fee interest in real estate, a leasehold interest in real estate with 30 years or more remaining at the time of the exchange and land use rights for hotel units (which Taxpayer would receive if the Development Rights it transferred were for more than a certain number of residential units). The new rights for hotel units were to be applied to property Taxpayer already owned. The Development Rights were in perpetuity and were directly related and requisite to Taxpayer’s interest, use and enjoyment of the underlying land. The Development Rights were also interests in real property under state law. In effect, Taxpayer exchanged one set of Development Rights (pertaining to residential density) for other development rights (pertaining to hotel development). Some of the Development Rights were also to be exchanged for another fee interest in land, and another long-term leasehold interest in additional real property.

IRS has also ruled recently that development rights were like kind to the fee interest in property that a taxpayer relinquished in the exchange. The swap involved a complex exchange set up through a qualified intermediary (QI). In the PLR, Taxpayer was a C corporation that owned Property 1 and Property 2 located in City, State Z. It intended to transfer its fee interest in Property 1 (”Relinquished Property”) to a QI under an exchange agreement. QI wwould sell the Relinquished Property to a third-party purchaser in an arm’s-length transaction. QI would use part of the cash proceeds from this sale to buy Development Rights (”Replacement Property”) from a third-party seller. QI would transfer Development Rights to Taxpayer, who would cause Development Rights to be recorded with respect to Property 2. They would permit Taxpayer (or its lessee) to develop Property 2 with greater floor space than would otherwise have been allowed if Property 2 did not have Development Rights. Sections of State Z Tax Statute (and the corresponding sections of State Z regulations), defined “real property” to include “every estate or right, legal or equitable, present or future, vested or contingent, in lands, tenements or hereditaments, including buildings, structures and other improvements thereon, which are located in whole or in part within [State Z].” Sections of State Z Tax Statute further defined an “interest in real property” to include “title in fee, a leasehold interest, a beneficial interest, an encumbrance, development rights, air space and air rights, or any other interest with the right to use or occupancy of real property or the right to receive rents, profits, or other income derived from real property.” Whether property constitutes real or personal property generally is determined under state or local law.  In this case, Taxpayer proposed to acquire Development Rights as its replacement property and to transfer such rights to Property 2, which Taxpayer already owns. The IRS has previously noted that for purposes of Code Sec. 1031(a), it is not material that the property acquired by the taxpayer as the replacement property is on property already owned by that taxpayer so long as it is acquired in an arm’s-length transaction. For purposes of determining if Taxpayer’s proposed transaction qualifies as a like-kind exchange, IRS said it is thus immaterial that Development Rights to be acquired by Taxpayer will be used merely to enhance the real property already owned by it. More important is whether Development Rights constitute interests in real property under the state and local laws of State Z.  Although it is unclear whether Development Rights were treated as interests in real property for all purposes of State Z law, it is clear that Sections of State Z Tax Statute and the regulations thereunder did treat Development Rights as an interest in real property. Moreover, the various sections of the local Ordinances provided that Development Rights are as-of-right and not discretionary, meaning that they exist permanently rather than at the discretion of a city agency or other decision-making authority. As such, these rights appear to be analogous to perpetual rights. In addition, a deed transfer is similar to the perfecting of Development Rights, which involves an actual transfer of rights from one property to another. Thus, while the Tax Statutes of State Z do not explicitly state that Development Rights are granted in perpetuity, IRS concluded that such rights do arise out of an interest in the underlying real estate. Moreover, City Ordinances did not set an expiration date for Development Rights, and thus they were effectively perpetual in nature. Thus, IRS concluded that Development Rights that Taxpayer intended to acquire as replacement property were like kind to the fee interest in Relinquished Property.

The point of this discussion is to alert all potential exchangers to the borad definition of real estate and what will qualify under Section 1031.  For more information or questions about specific scenarios, please contact Moore McLaughlin, Esq., CPA, CES, owner of All States 1031 Exchange Facilitator, LLC at fmm@AllStates1031.com or Alexandra L. Hart, CES at AHart@AllStates1031.com.

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Posted in 1031 Exchange Basics, 1031 News, FAQs, Qualifying Properties, Tenants-in-Common

Dispelling 1031 Myths, part 5

Monday, October 12th, 2009 by Moore McLaughlin

MermaidIn our continuing effort to help investors understand the rules of 1031 exchanges, we present two more common myths.  Avoiding these myths and misconceptions will allow investors to maxmimize the return on their investments by reducing the amount of taxes they pay.

Myth No. 9

I only have to reinvest my gain.  Or, I only have to reinvest my cash proceeds.

If Alexandra and I have heard this once, we have heard it a million times.  The general rule of 1031 exchanges is that the exchanger must buy a replacement property that is equal to or greater in value than the relinquished property.  The 1031 rules require the exchanger to reinvest their adjusted sales price, not just their gain or cash equity.  The reason is because Section 1031 requires an exchanger to receive like-kind property.  Luckily, all United States real estate is like-kind to all other United States real estate, regardless of the type or grade. Non-like kind property (called boot) typically consists of cash or debt relief.  To the extent that an exchanger trades down in value (i.e. buys a replacement property of less value than the relinquished property), than the exchanger receives boot, in the form of cash or debt relief equal to the amount of the trade down. Net boot received will always be taxed, to the extent of the taxpayer’s gain. However, often times, paying some tax is better than paying all the tax if no exchange is completed.

So, the easy rule to remember is for the exchanger to buy a replacement property or properties of equal or great value than their relinquished property or properties.  The good news, though, is that once these rules are understood, the exchanger realizes that he or she can trade down in value a little without blowing up the whole exchange.  Instead, a small amount of gain is recognized, while the balance of the gain is deferred.  Thus, the 1031 transaction is still worth doing. To learn more about partially tax-deferred exchanges or taking some cash at the closing, please click here.

Myth No. 10

I can exchange my primary residence tax-free under section 1031.

A primary residence does not qualify under section 1031.  In order for a property to qualify under section 1031, the property must be held for the productive use in a trade or business or held for investment.  Under these rules, a primary residence is held for personal use, therefore it is not deemed to be held for investment.  Thus, a primary residence generally does not qualify under Section 1031.

However, Section 121 provides for gain exclusion on the sale of a principal residence, if certain criteria are met.  If these criteria are satisfied, up to $250,000 of gain may be excluded (up to $500,000 for joint returns).  The basic rule of section 121 requires that the seller own and occupy the property as a primary residence for at least 2 out of the previous 5 years.  However, if the property was acquired as part of a previous 1031 exchange (and the taxpayer converted it from a rental property to their primary residence), than the taxpayer must own the property for 5 years and live there as a primary residence for at least 2 out of the 5 years before they may be eligible for the 121 exclusion. Furthermore, effective January 1, 2009, an amendment to the 121 exclusion will affect the amount of gain exclusion allowed for primary residences with a rental history (AKA “non-qualifying use”). In the event that the gain exceeds this exclusion amount, capital gain must be recognized and cannot be deferred even if a replacement primary residence is purchased.  If you are interested in learning more about the tax consequences of the sale of your home, you should consult an experienced tax attorney or CPA to learn more about section 121. It is especially important to consult with your tax advisor if your primary residence has or had an investment or business-use component (i.e. a home office or rental unit). Certain combination or consecutive use properties may allow for the combination of section 121 and section 1031, thereby maximizing the potential tax exclusion and deferral.

So, even for those lucky homeowners who say “…but my home is the best investment I ever made,” I say, “That may be true, but generally, it does not qualify under section 1031.” We continue dispelling as many 1031 myths as we can.  Stay tuned for more 1031 myths in the near future; or call us toll free at 877-395-1031 or contact Alexandra L. Hart by e-mail at ahart@allstates1031.com.

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Dispelling 1031 Myths, part 4

Monday, September 28th, 2009 by Moore McLaughlin

Loch Ness MonsterAlexandra Hart and I are still amazed that we hear so many of the same myths and misconceptions every week about 1031 exchanges, what properties qualify and how exchanges work.  Unfortunately, many of the myths result in someone not exchanging when a 1031 would have saved a significant amount of taxes.  Here are two more myths that we hear as reasons not to do an exchange.

Myth No. 7

In order for a 1031 exchange to work, I have to find someone who has property I want and who wants my property.

Not true.  The IRS has allowed so-called delayed or deferred exchanges for many years.  For a number of years, no guidance existed on how to handle deferred exchanges.  In the late 1970’s, the Starker case held that a 1031 exchange did not have to be simultaneous.  Subsequently, the tax law was changed which allowed deferred exchanges, subject to certain limitations.

Now deferred exchanges are the norm.  We very rarely see direct swaps of property, although they are certainly allowed.  Most exchanges are effected by exchangers who sell their relinquished property to an unrelated third-party buyer and then purchase the replacement property from someone who is unrelated to either the exchanger or the buyer of the relinquished property.  In fact, in many cases neither the buyer of the relinquished property nor the seller of the replacement property are doing 1031 exchanges.  Although, in many cases they are.

The deferred exchanges must meet several simple rules.  The exchanger must acquire the replacement property within the earlier of 180 days from the sale of the relinquished property or the due date of the tax return (including extensions).  The exchanger must identify the potential replacement properties within 45 days from the sale of the relinquished property.  And, lastly, the exchanger should use a qualified intermediary (QI) or other safe harbor to avoid receipt of the sales proceeds from the sale of the relinquished property.  Following these rules, and a few others, will ensure a valid 1031 exchange.

Myth No. 8

If I fail to identify property within 45 days or if I fail to acquire sufficient replacement property during the exchange period, I will lose my money or be hit with severe penalties by the IRS.

Failure of an exchange results in no penalties and you will not lose your money.  An exchanger who fails to identify any property during the 45-day identification period will have his or her exchange proceeds returned on Day 46.  Likewise, an exchanger who fails to acquire any property during the exchange period will receive the exchanges funds on Day 181.  Please click here to read more about at what points during the exchange period the exchanger is allowed to get their money back.  The only economic loss is the fee charged by the intermediary, which is typcially minimal compared to the potential tax savings.

A failed 1031 exchange is treated merely as a sale of the relinquished property, subject to whatever taxes would have been imposed had a 1031 exchange not been attempted.  Even better, the exchange that begins in one tax year and fails in the subsequent tax year is treated as an installment sale with the possibility of significant tax deferral.  Click here for more information on the tax treatement of a failed exchange.

In any event, once sellers become aware of these realities, most realize that they have nothing to fear from a failed exchange and decide to enter into the exchange to preserve the right to defer taxes.

Stay tuned for more posts exposing the myths of 1031 exchanges that keep investors from saving taxes.

For more information on 1031 exchanges, contact Moore McLaughlin by e-mail at fmm@allstates1031.com or Alexandra L. Hart at ahart@allstates1031.com or by call toll-free at 877-395-1031.

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Dispelling 1031 Myths, part 3

Monday, August 31st, 2009 by Moore McLaughlin

UnicornThe following are two additional myths that trip up investors and cause them to pay more taxes than they should.  This post is a continuation of my previous posts where I am trying to help investors understand the power of 1031 exchanges and not fall into certain misunderstandings.

 Myth No. 5

 I can’t do a 1031 exchange because I am purchasing the Replacement Property and I haven’t sold my Relinquished property yet.

A reverse exchange is the “flip side” of a deferred exchange, where an investor directly or indirectly acquires a like kind replacement property before disposing of a relinquished property. Once the replacement property is acquired, the investor has 180 days from that date to close on the sale of their relinquished property (or until the due date of their tax return, including extensions). In the current real estate market, owners of real estate often face the prospect of losing the opportunity to acquire a desirable replacement property when the seller of such property is unwilling or unable to wait while the investor completes the disposition of a relinquished property. Sellers in today’s market may have a hard time estimating how many days their relinquished property will be listed on the market for sale before the deal will actually close. Furthermore, it is taking buyers more time than usual to secure financing and get to the closing table. However, in the meantime, perhaps the seller has found the perfect replacement property, or a property that has just been reduced and now the price is right and they need to act quickly. Or perhaps a business owner who is relocating may desire to purchase their new office space before selling their current office space to accommodate a smooth transition of employees and daily operations. A reverse exchange is perfect for these scenarios.

 On October 2, 2000 the Internal Revenue Service (”IRS”) issued Revenue Procedure 2000-37 providing guidance on structuring reverse exchanges to avoid IRS challenge.  The Revenue Procedure describes a safe harbor for reverse exchanges if certain requirements are met.  All States 1031 has been a leader in structuring and implementing reverse exchanges, and has formed an affiliated company, All States Reverse Exchange Facilitator, LLC, to handle the high volume of transactions. Taxpayers contemplating a reverse exchange also need to consider their financing options in advance. It is important to note that if a taxpayer wishes to defer taxes with a reverse exchange, they must contact a Qualified Intermediary like All States 1031 before they close on the purchase of their replacement property. Anyone considering the purchase or sale of investment property is encouraged to call Alexandra L. Hart at All States 1031 toll free at (877) 395-1031 for a complimentary consultation.  Planning ahead is the best way to ensure a seamless 1031 exchange, so call today!

 Myth No. 6

 My partners don’t want to exchange, so I’m going to exchange my partnership interest.

 Exchanges of partnership interests generally do not qualify for non-recognition treatment under IRC § 1031.  Therefore, when partners want to end their relationship, they cannot each exchange out of their partnership interests into another partnership interest or real property under IRC § 1031. Such transactions can be structured as 1031 exchanges, however, by converting the partnership interest into a real property interest. Once the partners dissolve their partnership and hold the property as tenants in common, they can each defer taxes with their own 1031 exchange(s), or some partners can take cash at closing and pay tax on their portion. The various structures include partnership split-ups, split-offs, buy-outs and formations. Such transactions are often referred to as “drop & swaps” or “swap & drops.” Structuring these transactions is not without tax risk, and requires the advice of an experienced tax professional. When partners are selling investment property and no longer want to stay in the partnership, the key to structuring a successful exchange is to plan ahead. Once the partnership has signed a legal contract to sell, it may be too late to structure a 1031 exchange, since the name on the contract should not be the partnership entity, unless the partnership is staying together to buy the replacement property. However, with proper planning, it is possible for each partner to get exactly what they want out of the sale. The owner of All States 1031, F. Moore McLaughlin, IV, Esq., CPA, CES®, is a licensed tax attorney and nationally recognized educational speaker on this subject. To start planning ahead for a partnership exchange, please call Attorney McLaughlin toll free at (877) 395-1031 for a complimentary consultation.

Educate yourself and don’t fall for these common myths. 

Check back for more posts dispelling other myths about 1031 exchanges.  In the meantime, click here for more 1031 myths or contact me or Alexandra L. Hart at 877-395-1031 or by e-mail fmm@allstates1031.com or ahart@allstates1031.com.

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Dispelling 1031 Myths, part 2

Thursday, August 20th, 2009 by Moore McLaughlin

The following is a continuation from a previous post regarding some common myths surrounding 1031 exchanges.  Taxpayers who understand the rules of section 1031 and do not fall for the many myths will save more taxes and see better returns from their investments.  Here are two more of the tops myths that Alexandra and I hear daily.Bigfoot

Myth No. 3

 I heard that 1031 exchanges are only for the big investors.

 Actually, anyone who owns investment property should consider a §1031 exchange before selling.  The property size and value do not matter when considering a 1031 exchange. All that matters is the gain and the tax consequences. It’s fair to assume that about a quarter of the gain will go to the IRS in taxes if no exchange is completed. If the property has a low basis or has appreciated in value, the owner should seriously consider a 1031 exchange before selling. IRS code section 1031 is the only legal way to defer taxes on the sale of investment or business-use property. Currently, real estate sales are taxed at the 15% federal long-term capital gains tax rate, plus the state tax rate, plus 25% tax on any depreciation deductions taken. Furthermore, with tax rates rising steeply, it gives investors an even greater reason to do a 1031 exchange and defer that tax. The more taxes that are deferred, the more money the investor can retain to work for them in their next investment. Whether they are selling a small rental unit or an office building, they can simply pay the gain and throw away their hard earned money, or effectuate a §1031 exchange, preserving their capital and building their wealth. Any investor should consult a tax adviser who is familiar with §1031 exchanges to determine the most beneficial strategy.

 Myth No. 4

 I’ll just have my attorney hold the sales proceeds in escrow while I look for Replacement Property.

IRS regulations specifically exclude the investor’s agent, broker, attorney, accountant, most family members and other related parties or agents who have acted on the investor’s behalf within the previous two years from acting as the exchange facilitator or Qualified Intermediary (QI) for a tax-deferred exchange. To ensure compliance with the latest IRS regulations and updates, the investor should choose a well established full-time Qualified Intermediary, not someone who merely “dabbles” in exchanges. Generally, companies who are exclusively devoted to structuring and facilitating 1031 exchanges have streamlined the process and offer the most competitive fees. Typically, the fee for a QI can range from $750 - $7,500, depending on the QI and the complexity of the exchange. Furthermore, the QI should have instituted financial safeguards such as a fidelity bond and insurance to protect the sales proceeds during the exchange. Ideally, the QI will set up a separately segregated dual signatory exchange account for each exchange client, not a co-mingled or sub-account. Furthermore, sale proceeds should be deposited in a liquid money market account at a stable financial institution or back to ensure preservation of principal and liquidity of funds. Click here to learn about how All States 1031 secures clients’ funds. Finally, be sure to ask the QI certain due diligence questions to make sure that the owners and operators of the company have a comprehensive understanding of the tax code, preferably with tax attorneys, CPAs, and Certified Exchange Specialists® on staff.

Don’t fall for these common myths.  You will save money in the long-run and be a smarter investor.

Check back for more posts dispelling other myths about 1031 exchanges.  In the meantime, click here for more 1031 myths or contact me or Alexandra Hart at 877-395-1031 or by e-mail fmm@allstates1031.com or ahart@allstates1031.com.

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Posted in 1031 Exchange Basics, 1031 myths, Choosing a Qualified Intermediary, FAQs, Qualifying Properties, Reverse Exchanges

Dispelling 1031 Myths, part 1

Monday, August 10th, 2009 by Moore McLaughlin

ufoOver the next few posts, I will be dispelling many of the common myths surrounding 1031 exchanges.  The confusion and misunderstandings caused by the myths has resulted in many taxpayers paying more taxes than they should.  By paying the excess taxes, the non-exchangers have reduced the amount that they can reinvest, thereby needlessly reducing their income.

Myth No. 1

I sold a single-family rental property, thus I must buy a single-family rental property.

Alexandra and I hear this all the time.  Similarly, we hear “I can only trade raw land for raw land” or “multi-family for multi-family” or “Massachusetts property for Massachusetts property.”  In actuality, Section 1031 requires an exchange of “like-kind” property.  When dealing with real estate, “like-kind” is defined as any interest in real property.  Therefore, an exchanger can trade a single-family rental property for a commercial building.  Raw land can be exchanged for developed land.  Massachusetts real estate can be exchanged for Florida real estate.

Fractional interests can be exchanged for fee simple (or undivided) interests.  Likewise, fee simple interests can be exchanged for tenants-in-common interests.  Often times we see exchangers selling fee simple interests in Rhode Island property and buying TICs in other states.

Conservation easements, development rights, air rights and other intangible real estate rights can qualify as real property and be exchanged for fee simple interests, TICs and other real estate investments.

In summary, real estate is broadly defined.  Tax courts look to local law in determining if an interest is “real property”.  If the interest is real property, then the exchanger has a very wide array of options

Myth No. 2

My property is not worth enough for the trouble of a 1031 exchange.

Nothing could be further from the truth.  First of all, 1031 exchanges are very easy, especially with All States 1031 Exchange Facilitator, LLC.  We handle all the paperwork to satisfy the stringent requirements of the IRS and hold your hand throughout the entire process.  Our experience and knowledge of the tax law and the 1031 exchange process allows us to simply everything for you.

Second, the key in determining the value of the 1031 exchange is to look at the amount of taxes that will be deferred, not the selling price of the relinquished property.  The amount of the tax that will be deferred is based on the amount of gain that will be recognized if you do not complete an exchange.  Your CPA or other tax return preparer can help you with the exact calculation or use our capital gains calculator to determine an estimate of your tax.  In any event, even for a low selling price, a taxpayer who has owned the property for many years or who otherwise has a low adjusted tax basis may be staring at a large tax bill.  the other component of determining your tax is the tax rate.  The federal long-term capital gains rate is currently 15%.  However, under several proposals, this rate could increase to 20%, 28% or higher.  Don’t forget that any depreciation you have taken gets taxed at 25% currently.  And, for some of you, various states will impose taxes.  For example, Rhode Island just increased its tax on long-term capital gains from 1.67% to 9.9%.  By exchanging real estate in a 1031 exchange, all of these taxes can be deferred, and the tax money reinvested in your new property.

So, even a relatively low selling price of $300,000 by a person with an adjusted tax basis of $100,000 could result in a tax of over $50,000.  Instead of sending that money to the government, why not reinvest it and reap the rewards of the larger investment?

In summary, understand the facts of 1031 exchanges and don’t fall for these common myths.  You will save money in the long-run and be a smarter investor.

Check back for more posts dispelling other myths about 1031 exchanges.  In the meantime, click here for more 1031 myths or contact me or Alexandra Hart at 877-395-1031 or by e-mail fmm@allstates1031.com or ahart@allstates1031.com.

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