5/4/2016. Common Terms. Disadvantages of Exchanging. Advantages of Exchanging. Impact of Recent Tax Legislation Like-Kind Exchanges

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1 Advanced 1031 Like-Kind Exchange Issues Presented by: Michael A. Fritton, CPA Somerset CPAs, P.C. Common Terms 1031 Exchange Like-Kind Exchange Property Swap Starker Transaction Advantages of Exchanging Disadvantages of Exchanging Preservation of capital Convert non-income producing assets to income producing assets Leverage existing equity into larger properties Lack of liquidity Timeline restrictions Gain deferral not exclusion Impact of Recent Tax Legislation 1031 Like-Kind Exchanges Higher income tax rates Ordinary income: 39.6% LT capital gains: 20% Net Investment Income: 3.8% Accelerated depreciation Pros and cons to deferral Like-Kind Exchanges ( 1031) No gain or loss will be recognized by a taxpayer exchanging certain qualifying property for like-kind property. 1

2 Qualifying Property Qualifying Property Held for productive use in a trade or business or for investment Business operating assets Owner-operated manufacturing facility Machinery/equipment Rental real estate Investment property Excluded property: Inventory Stocks, bonds and other securities Partnership interests Certificates of trusts or beneficial interests Chooses in action Property outside U.S. Like-Kind Property Like-Kind Property Examples of like-kind real property Single-family rental houses Rental condominiums Apartment buildings Retail shopping centers Warehouses Office buildings Unimproved land All domestic real estate is like-kind Other property must be similar in use and function Specific exclusion for livestock of different sexes Exchange Requirement Qualified Intermediary Exchange versus sale and purchase Simultaneous vs. deferred exchanges Actual and constructive receipt Constructive receipt safe harbors Qualified intermediaries Independent, unrelated, disinterested party Serves as middleman or clearinghouse Must not be the agent of the exchanger Employee, partner, attorney, accountant, broker, real estate agent, family member, etc., are disqualified Holds and disburses proceeds 2

3 Structural Overview Example Deferred exchange Qualified intermediary Direct deeding versus multiple title transfers Taxpayer Property A Property B Property A Qualified Intermediary Buyer Property B Seller Deferred Exchanges Deferred Exchanges Timelines 45 day identification period 180 day replacement period No exceptions! Valid Property Identification 3 property rule - Identify any 3 properties / close on at least 1 200% rule - Identify more than 3 / aggregate value less than 2x sales price / close on at least 1 95% rule - Any number / any value / close on 95% Recognition of Gain Gain Recognition General rule for deferral: Exchange up in value Exchange up in equity Exchange up in debt Gain recognized to the extent cash or debt relief is received Netting of cash received and paid Netting of debt assumed and relieved Assumption of debt does not offset cash received 3

4 Calculation of Gain and Basis and Liquidity Trade up + + Debt = No Gain Trade up + Debt = No Gain Trade down Debt = Taxable Gain received in exchange is taxable Pre-exchange refinancing may be deemed part of exchange Pre-arranged post-exchange refinancing may be deemed part of exchange No safe-harbor timeline (1 year?) and Liquidity Reverse Exchanges Pre-exchange refinancing Refinance prior to listing or marketing property Document business purpose Post-exchange refinancing Begin process after exchange 1 year / separate tax years /??? Replacement property acquired before sale of relinquished property Unable to find buyer Property is parked with accommodator until relinquished property is sold Permitted by Rev. Proc Guidance provided because reverse exchanges were already being done Reverse Exchanges Reverse Exchanges Qualified Exchange Accommodation Arrangement (QEAA) Exchange Accommodation Titleholder (EAT) Must acquire qualified indicia of ownership generally, legal title Must be a taxable entity Treated as owner during holding period EAT and QI can be the same party Properties are essentially parked with the EAT until relinquished property is sold Option 1: Park Relinquished Property Option 2: Park Replacement Property 4

5 Reverse Exchanges Relinquished Property Parked Lender may not allow EAT to acquire replacement property Taxpayer must take direct title Relinquished property is identified when parked Taxpayer Replacement Property Relinquished Property Seller Intermediary EAT EAT Reverse Exchanges Relinquished Property Buyer Replacement Property Parked More common method Relinquished property can be identified later Must be used if replacement property is to be improved Seller Replacement Property EAT Replacement Property Taxpayer Intermediary EAT Relinquished Property Buyer 5

6 Reverse Exchanges 45 / 180 day timelines apply 5 day period for entering into QEAA Parking transactions outside the safe-harbor are not expressly prohibited, but are not expressly allowed Improvements may be needed to fully utilize proceeds and defer gain Improvements made after replacement property is acquired by taxpayer do not defer gains Improvements must be made by seller or intermediary Property is identified by description of improvements to be made If not completed within 180 days, CIP must be transferred to taxpayer Cannot pre-pay construction costs Transferred CIP must be substantially the same as property that was identified when completed Replacement property can be build-to-suit Construction cannot be performed by taxpayer Construction by affiliate is vulnerable to anti-abuse rule of 1031(f)(4) unless direct exchange Construction must be performed by seller-developer, QI or EAT Use of an EAT is generally preferred if unrelated party is not used Building on land owned by taxpayer or affiliate Land and building cannot be exchanged for new building built on land already owned by taxpayer (Rev. Rul ) Transfer of taxpayer s land to another party for construction period followed by transfer back to taxpayer may be disregarded (DeCleene) Taxpayer generally cannot acquire land from affiliate as replacement property through QI ( 1031(f)(4); Teruya Brothers; Rev. Rul ) Building on land owned by taxpayer or affiliate Preferred approach is to use a ground lease to the EAT during construction, which is later transferred to taxpayer in the exchange The law is undeveloped on this approach; still may be vulnerable to disregard of lease grant and transfer 6

7 Building on land owned by taxpayer or affiliate IRS has approved exchanges into build-to-suit property on land leased from an affiliate of exchanging taxpayer PLR PLR Facts Taxpayer enters into QEAA with EAT EAT enters into (acquires) >30 ½ year lease in land owned (or leased) by affiliate and pays no consideration for leasehold interest EAT constructs improvements Within 180 days of EAT s acquisition of the leasehold interest: Taxpayer sells relinquished property through a QI Taxpayer acquires leasehold interest and partially/fully constructed building from EAT through the QI IRS Rulings Taxpayer satisfies QI and Rev. Proc safe harbors Exchange involves a related party, but no gain recognized under ( 1031(f)unless taxpayer or affiliate disposes of interest in the property within 2 years Implications Road map for build-to-suit exchange on land owned by related person Holding does not extend to build-to-suit exchanges on land owned by taxpayer IRS will not rule favorably if land is owned by the exchanging taxpayer within 180 days before transfer to EAT See Rev. Proc Partnership Issues Partnership Issues Split-up of existing partnership ing-out one or more partners Multiple entity exchanges Exchanging into and out of a partnership interest Meeting the held for test Step transaction issues Split-up of existing partnership Drop and Swap technique Use of non-safe harbor TICs Holding period for individuals Exchange and distribute Holding period for partnership Risks of step transaction 7

8 Partnership Issues Partnership Issues ing-out one or more partners Pre-exchange or post-exchange issues Source of funds Risk of partner wanting to remain Technical termination of partnership Multiple entity exchanges Combining exchanges of multiple properties in multiple entities into a single replacement property Drop and swap technique Safe harbor TIC structure Post-exchange combination of interests Balancing different ownership Partnership Issues Partnership Issues Exchanging into a partnership interest Partnership is not qualifying property Acquisition of TIC interest Acquisition and subsequent contribution of property to a partnership Contribute property to partnership and have partnership exchange properties Holding period and held for issues Exchanging out of a partnership interest Distribution and sale of non-safe harbor TIC interest to other partners Holding period and held for issues Have partnership acquire property to be distributed to partner in liquidation Related Party Exchanges Anti-Abuse Rule Two year holding period Definition of related party Section 1031(f)(2) Permits Exceptions for: Death of either taxpayer or related party Compulsory or involuntary conversion What if T enters into exchange with QI, who sells relinquished property to third party X and uses cash to purchase replacement property from related party B? Exchange is taxable under standard application of anti-abuse rule. No different than exchange with B followed by sale by B. X s cash stays in the related party group. Teruya Brothers Rev. Rul

9 Anti-Abuse Rule What if T enters into exchange with a QI, which sells relinquished property to related party B for cash which QI uses to buy replacement property from Third Party X? This should be OK. No different from exchange with B for property purchased by B. leaves the related party group. PLRs , and Does not matter whether related party B sells relinquished property within two years. Types: Single Owner LLC Illinois Land Trust Grantor Trust Qualified Sub S Subsidiary Qualified REIT Subsidiary Partnership between DRE and Taxpayer Reasons to Use DRE Liability protection Bankruptcy remote entity for financing Transfer tax minimization Replacement property may be acquired by DRE owned by taxpayer PLRs , , Taxpayer may acquire 100% of interests in DRE that owns replacement property PLRs , Taxpayer may transfer replacement property to DRE after exchange See, e.g., PLR Taxpayer may transfer relinquished property to DRE before exchange and then transfer DRE in exchange Rev. Rul Where A sells interest in single owner LLC to B, treated as sale of undivided interest in property followed by partnership formation 9

10 Rev. Rul Thus, partial interest in single member LLC should be usable as relinquished property or replacement property, subject to Qualified Use issue Rev. Rul Where A purchases B s entire interest in AB LLC, A is treated as receiving undivided interest in assets in liquidation and purchasing B s undivided interest in assets Rev. Rul But B is treated as selling partnership interest So A could treat acquisition of B s interest as replacement property Rev. Rul But B could not treat interest transferred as relinquished property Installment Sales Installment Sales Exchanges can be combined with installment sales Gain will be partially deferred via 1031 Remaining gain will be deferred until payment is received Basis will be allocated to replacement property first, then to installment note Exchanges straddling two taxable years can be treated as installment sale if proceeds are not fully reinvested Receipt of un-reinvested exchange proceeds will be treated as payment on an installment obligation 10

11 Installment Sales Tenants in Common Original intent must be to acquire replacement property If property is not acquired, QI can hold proceeds to defer gain into next year Earnings on exchange proceeds belong to the taxpayer Direct undivided interests in real estate Not considered a partnership Rev. Proc Allows sale of a fee interest and acquisition of an undivided interest Tenants in Common Tenants in Common Rev. Proc Provisions Title held as tenant in common Maximum of 35 co-owners Cannot file a partnership return Free transferability of interests Revenue and expense sharing according to ownership interest Debt shared in proportion to ownership interest Rev. Proc Call options permissible among co-owners Activities limited to customary property management Bona fide leases and management contracts No related party lenders Payments to sponsor must reflect FMV Creates market for private placements Tenants in Common Conversion to Personal Use Issues to consider Liquidity (or lack thereof) Secondary market / exit strategy Quality of third-party manager Fees and commissions Non-safe harbor TIC arrangements for existing partnerships Conversion to non-investment use Must originally qualify as replacement property No safe-harbor holding period Fact and circumstances 5 year holding period to qualify for personal residence exclusion 11

12 Keys to Successful Exchange Documentation Documentation Documentation Questions? Michael A. Fritton, CPA Mike is responsible for coordinating the financial services needs of our real estate clients, as a principal in Real Estate. Mike has extensive experience in complex tax issues related to real estate and construction, including tax-free exchanges, business valuations, estate and succession planning, cost segregation analysis and financial forecasting. He is a frequent speaker on tax issues related to the real estate industry and is committed to providing aggressive and proactive service to our clients. 12