1031 Exchanges. Seminar Topic: This material provides an in-depth examination. The Basics and Pitfalls

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2 1031 Exchanges The Basics and Pitfalls Seminar Topic: This material provides an in-depth examination of the process and procedure in a 1031 Exchange including structuring the transaction as an exchange of one property for another of "like kind". Since 1921, tax-deferred or 1031 exchanges have evolved from a simple but restrictive two-party swap to today s highly strategic and sophisticated exchanges. Now possible for taxpayers large or small, 1031 exchanges can only be facilitated with the guidance and specialized services of a Qualified Intermediary, like LandAmerica 1031 Exchange Services. This material is intended to be a guide for insurance issues in general. As always, if you have any specific question regarding the state of the law in any particular jurisdiction, we recommend that you seek legal guidance relating to your particular fact situation. The course materials will provide the attendee with the knowledge and tools necessary to identify the current legal trends with respect to these issues. The course materials are designed to provide the attendee with current law, impending issues and future trends that can be applied in practical situations. Copyright 2008, All Rights Reserved. Page i

3 Copyright 2008 Printed in the United States of America. All rights reserved. No part of this monograph may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, except for citation within legal documents filed with a tribunal, without permission in writing from the publisher. Disclaimer: The views expressed herein are not a legal opinion. Every fact situation is different and the reader is encouraged to seek legal advice for their particular situation. The Apex Jurist, is Published by ApexCLE, Inc North Michigan Avenue, Suite 300 Chicago, Illinois Toll Free South Spring Street Springfield, Illinois Toll Free Ordering Information: Copies of this monograph may be ordered direct from the publisher for $24.95 plus $4.25 shipping and handling. Please enclose your check or money order and shipping information. For educational, government or multiple copy pricing, please contact the publisher. Library of Congress Cataloging-in-Publication Data ApexCLE, Inc. Professionalism in Illinois 1. ApexCLE, Inc. 2. Law-United States Guide-books. 3. Real Estate. 4. Investment. Copyright 2008, All Rights Reserved. Page ii

4 About The Author Noel Hara is Vice President and Manager of LandAmerica 1031 Exchange Services. His current responsibilities include management of the sales and production of 1031 Tax-Deferred Exchange qualified intermediary services within the Midwest states. Noel was hired by LandAmerica s Houston, TX office in May of 2004 to open the Southwest regional offices of LandAmerica 1031 and then relocated to Chicago in March of 2006 to do the same in the Midwest. Noel has been a featured speaker and MCE/MCLE/CPE educator for DePaul University, multiple real estate associations, The Illinois CPA Society and the CCIM. Additionally, he regularly teaches these courses in-house to law firms. His accomplishments have been published in The Houston Business Journal, Houston Realtor and Houston InTown. Noel has written articles published in UrbanLand Magazine, The Illinois Real Estate Journal, Midwest Real Estate News, Texas Real Estate Business and RedNews. Additionally, Noel is an active member of The Urban Land Institute where he sits on the National Membership Committee. Noel began his real estate career with a Chicago-based condominium developer in Upon being promoted to sales manager, he moved to Houston, TX and resided there from 2000 to Noel currently holds active real estate brokers licenses in Illinois and Texas and is a graduate of Illinois State University Author s Address: Author s Website: NHara@Landam.com Author s Mailing Address: 10 S. LaSalle St. Chicago, IL Author s Phone Number: (312) Copyright 2008, All Rights Reserved. Page iii

5 1031 Exhanges: The Basics and Pitfalls By Noel Hara Table of Contents Introduction... 1 The Basic Process... 1 For Your Reference... 2 From the IRS Website:... 2 Appendix Title 26, Subtitle A, Chapter 1, Subchapter, O, Part III, Section Copyright 2008, All Rights Reserved. Page iv

6 Introduction The Internal Revenue Code imposes taxes when property is sold or transferred and a gain is realized. According to Section 1031 of the tax code, if a taxpayer adheres to strict code guidelines, then all or a portion of the gains from the disposition of business or investment property can be deferred or reinvested into a new replacement property. These deferred gains, as well as the gains from the new property, are not taxed until the new property is transferred and fails to qualify for tax deferral. To qualify for tax deferment, the taxpayer must structure the transaction as an exchange of one property for another of "like kind". Since 1921, tax-deferred or 1031 exchanges have evolved from a simple but restrictive two-party swap to today s highly strategic and sophisticated exchanges. Now possible for taxpayers large or small, 1031 exchanges can only be facilitated with the guidance and specialized services of a Qualified Intermediary, like LandAmerica 1031 Exchange Services. LandAmerica established its 1031 Exchange Services Division in 1990 solely to facilitate tax-deferred exchanges. To ensure our best possible service to the taxpayer, LandAmerica offices that specialize in 1031 Exchange Services have passed a LandAmerica certification standard. To find a LandAmerica 1031 Exchange Services office, please use this Locate a 1031 Exchange Office link, or the link at the right. The Basic Process A 1031 exchange, also known as a tax deferred exchange is a strategy and method for selling one property, and buying another property within a specific time frame. The process of selling one property and then buying another property are the same as a typical real estate transaction. The 1031 exchange is the key to the tax savings by deferring income. Copyright 2008, All Rights Reserved. Page 1

7 For Your Reference IRS: Cornell: From the IRS Website: Like-Kind Exchanges - Real Estate Tax Tips Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized. Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets. Like-Kind Property Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties. Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties. Copyright 2008, All Rights Reserved. Page 2

8 Appendix 1 Title 26, Subtitle A, Chapter 1, Subchapter, O, Part III, Section 1031 (a) Nonrecognition of gain or loss from exchanges solely in kind (1) In general No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. (2) Exception This subsection shall not apply to any exchange of (A) stock in trade or other property held primarily for sale, (B) stocks, bonds, or notes, (C) other securities or evidences of indebtedness or interest, (D) interests in a partnership, (E) certificates of trust or beneficial interests, or (F) choses in action. For purposes of this section, an interest in a partnership which has in effect a valid election under section 761 (a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership. (3) Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if (A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (B) such property is received after the earlier of Copyright 2008, All Rights Reserved. Page 3

9 (i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date (determined with regard to extension) for the transferor s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs. (b) Gain from exchanges not solely in kind If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property. (c) Loss from exchanges not solely in kind If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized. (d) Basis If property was acquired on an exchange described in this section, section 1035 (a), section 1036(a), or section 1037 (a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035 (a), section 1036(a), or section 1037 (a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035 (a), and section 1036 (a), where as part of the consideration to the taxpayer another party to the exchange assumed (as determined under section 357 (d)) a liability of the taxpayer, such assumption shall be considered as money received by the taxpayer on the exchange. Copyright 2008, All Rights Reserved. Page 4

10 (e) Exchanges of livestock of different sexes For purposes of this section, livestock of different sexes are not property of a like kind. (f) Special rules for exchanges between related persons (1) In general If (A) a taxpayer exchanges property with a related person, (B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and (C) before the date 2 years after the date of the last transfer which was part of such exchange (i) the related person disposes of such property, or (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs. (2) Certain dispositions not taken into account For purposes of paragraph (1)(C), there shall not be taken into account any disposition (A) after the earlier of the death of the taxpayer or the death of the related person, (B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or (C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax. (3) Related person Copyright 2008, All Rights Reserved. Page 5

11 For purposes of this subsection, the term related person means any person bearing a relationship to the taxpayer described in section 267 (b) or 707 (b)(1). (4) Treatment of certain transactions This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. (g) Special rule where substantial diminution of risk (1) In general If paragraph (2) applies to any property for any period, the running of the period set forth in subsection (f)(1)(c) with respect to such property shall be suspended during such period. (2) Property to which subsection applies This paragraph shall apply to any property for any period during which the holder s risk of loss with respect to the property is substantially diminished by (A) the holding of a put with respect to such property, (B) the holding by another person of a right to acquire such property, or (C) a short sale or any other transaction. (h) Special rules for foreign real and personal property For purposes of this section (1) Real property Real property located in the United States and real property located outside the United States are not property of a like kind. (2) Personal property (A) In general Personal property used predominantly within the United States and personal property used predominantly outside the United States are not property of a like kind. (B) Predominant use Except as provided in subparagraphs (C) and (D), the predominant use of any property shall be determined based on (i) in the case of the property relinquished in the exchange, the 2-year period ending on the date of such relinquishment, and Copyright 2008, All Rights Reserved. Page 6

12 (ii) in the case of the property acquired in the exchange, the 2-year period beginning on the date of such acquisition. (C) Property held for less than 2 years Except in the case of an exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection (i) only the periods the property was held by the person relinquishing the property (or any related person) shall be taken into account under subparagraph (B)(i), and (ii) only the periods the property was held by the person acquiring the property (or any related person) shall be taken into account under subparagraph (B)(ii). (D) Special rule for certain property Property described in any subparagraph of section 168 (g)(4) shall be treated as used predominantly in the United States. Copyright 2008, All Rights Reserved. Page 7

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14 1031 Exchanges The Basics The Pitfalls

15 The Basics: What? Since 1921, there has been an exception in the tax Code that Capital Gain Tax is deferred when investment property is exchanged as opposed to sold. The policy behind Section 1031 is that Taxpayers should be able to dispose of investment or income property and acquire replacement investment or income property without incurring a large cost of sale the Capital Gain Tax. This exception has changed very little since 1921.

16 What Tax is Deferred by 1031? Two Components: 1. Tax due on the profit earned on the sale of investment or income property; generally, the rate is 15%. The profit earned is the appreciation in value of the property and is determined by gross sales price minus the adjusted basis and the cost of sale Tax due on the recapture of depreciation previously taken by Taxpayer during the time Taxpayer owned the property; generally the rate is 25%.

17 Calculating Capital Gain Step One: Calculate Adjusted Basis Fair Market Value Original Purchase Price $300,000 Add Capital Improvements 50,000 Minus Depreciation 150,000 Equals Adjusted Basis 200,000 Step Two: Calculate Capital Gain FMV or Sales Price $450,000 Capital Improvements Original Purchase Price Depreciation Recapture Capital Gain Minus Adjusted Basis 200,000 Minus Cost of Sale 10,000 Equals Capital Gain 240,000 Adjusted Basis

18 Federal Tax Treatment Step Three: Calculating Capital Gain Taxes Total Capital Gain $240,000 with Depreciation Recapture of $150,000. Recaptured Depreciation Tax Rate = 25% $150,000 x 25% $37,500 + Appreciation Gain Tax Rate = 15% $13,500 $90,000 x 15% 15% 25% TAXES Total Taxes Due $51,000 Under Section 1031 treatment, Capital Gain Taxes are deferred and are not due when property is exchanged.

19 Who Can Take Advantage of 1031 s? Any tax paying entity is entitled to the benefits of Section 1031: Corporations Partnerships Individuals Limited Liability Companies Trusts Foreigners who own property in the U.S.

20 Why an Exchange is done is as important as How to do one...

21 Exchanging is a tool to help Taxpayers achieve their goals and/or solve problems.

22 Why Exchange? Improve investment performance Change property types Consolidate (many properties into few) Diversify (few properties into many) Life transition Relocate Change tenants Change management Defer maintenance

23 There Are Four (4) Basic Requirements Under Section 1031

24 First Requirement: 1. A 1031 Transaction must involve a transfer of Real or Personal Property

25 Qualifying Real Property Apartments Shopping centers Medical facilities Warehouses Terminal properties Factories Hotels Casinos Vacant land Oil, gas, mineral, water rights Leases Farm Land

26 Qualifying Personal Property Airplanes Boats Tractors Trailers Licenses Copyrights Equipment

27 Property Excluded from 1031 Treatment Stocks, bonds or notes Other securities or evidences of indebtedness or interest Interests in a Partnership Certificates of trust or beneficial interest Primary residences Good Will Inventory / Property held primarily for resale

28 Second Requirement: 1. A 1031 Transaction must involve a transfer of Real or Personal Property; and 2. That property must be held for a Qualified Purpose, either as an investment, or used in a trade or business

29 The Property Must be Held for a Qualified Purpose The Code specifically states that property must be held by the Taxpayer, for either 1) Productive use in a trade or business; or, 2) Investment to qualify for Exchange consideration. Purpose for holding is: Fact Sensitive Determined at the time of exchange Applies to Both Properties Purpose For Holding Is NOT Based on Length of Time.

30 Third Requirement: 1. A 1031 Transaction must involve a transfer of Real or Personal Property; and 2. That property must be held for a Qualified Purpose, either as an investment, or used in a trade or business 3. The Relinquished Property must be Like-Kind with the Replacement Property OK

31 Real property exchanges SFR Rental Multi-family Office Retail Industrial Hospitality Medical Care Land SFR Rental Multi-family Office Retail Industrial Hospitality Medical Care Land

32 Real property exchanges SFR Rental Multi-family Office Retail Industrial Hospitality Medical Care Land SFR Rental Multi-family Office Retail Industrial Hospitality Medical Care Land

33 Non Like-Kind Money, cash or cash equivalents Personal Property for Real Property Inventory: Property held primarily for sale

34 Fourth Requirement: 1. A 1031 Transaction must involve a transfer of Real or Personal Property; and 2. That property must be held for a Qualified Purpose, either as an investment, or used in a trade or business 3. The Relinquished Property must be Like-Kind with the Replacement Property 4. The transaction must be an Exchange as distinguished from a sale with a new purchase

35 Compare a Sale and Purchase vs. an Exchange The essence of a Sale and Purchase of real estate is the receipt of cash for property. The essence of an Exchange is the transfer of property for property. The Exchange is what distinguishes a Section 1031 tax-deferred transaction from a Sale and Purchase.

36 How do you restructure a sale into an exchange?

37 Qualified Intermediary s Role To structure your exchange with proper documentation

38 Escrow versus Qualified Intermediary Different Roles in Real Estate Transactions What is a QI? No certification or licensing requirement. Defined in the Regulations as Safe Harbor number 3. No requirement that accommodator be Qualified Intermediary. Elements to achieve QI status: 1. Written agreement that contains (g)(6) language, 2. QI must acquire relinquished property from Taxpayer and transfer to Buyer, 3. Control sales proceeds from Relinquished Property, 4. Acquire like-kind replacement property from Seller and transfer to Taxpayer. Safe Harbor eliminates agency designation and constructive receipt issues.

39 Qualified Intermediary QI

40 Escrow versus Qualified Intermediary A Qualified Intermediary is not Escrow Agent QI should not hold funds before an exchange begins. Investment Banker Attorney CPA / Tax Advisor

41 1. Written Escrow Agreement 2. Prepares Closing Statement 3. Collects Documents Escrow Agent Roles a.k.a., Closing Agent 4. Responsible for Certificate of Non-Foreign Status Affidavit (FIRPTA) 5. Responsible for 1099-S Reporting 6. Disburses Funds and Documents According to Written Instructions or Escrow Agreement

42 Most Common Exchange Straight-Deferred or Forward Exchange Q I C Buyer of your property You the Taxpayer B Seller of replacement property A

43 C Q I B A A

44 C Q I B A B A

45 What do you need for a valid exchange? Proper exchange documents! Proves INTENT Prevents CONSTRUCTIVE RECEIPT Provides ACCOMMODATING PARTY

46 Types of Exchanges Deferred (aka Delayed) Simultaneous Construction (aka To-Be-Built) Reverse Reverse Construction Non-Safe Harbor Reverse Personal Property

47 The Basics, and now The Pitfalls

48 Pitfall: Control of Proceeds C Q I B A B Not Like Kind A

49 Pitfall: Settlement Statements Improperly Done Cash due Seller

50 Potential Pitfall: Time Frame 1 The 45-Day Property Identification Period C Q I 45 days to identify A A

51 Identification Rules before midnight of the 45 th day 1. In writing 2. Unambiguous 3. Signed by taxpayer 4. Sent

52 Identification Rules alternate and multiple properties 1. 3 property rule % rule 3. 95% exception

53 Potential Pitfall: Time Frame 2 The 180-Day Exchange Completion Deadline C Q I B A B A 180 days to complete exchange

54 Pitfall: Related Parties two-party swap 24 month holding period A B B A

55 Pitfall: Related Party Exchanges If less than 24 months A B B A New Buyer New Buyer B A

56 Major Pitfall: Acquiring Replacement Property From A Related Party Third Party Buyer C Q I B A B A What does B hold?

57 New Revenue Ruling General Rule: Taxpayer cannot acquire replacement property from a related party. Many Exchange Agreement reflects this prohibition. [ Taxpayer s Representations. Taxpayer hereby represents to QI as follows (b) Taxpayer will not purchase any Replacement Property from a related person as such term is defined in Section 1031(f)(3) of the Code.] Revised Form 8824 requires more than check-the-box.

58 Potential Pitfall: Change of Entity Entity must not change B A Old property as ABC Partnership B New property as ABC Partnership

59 Same Taxpayer Rule 1. Husband & Wife are TWO Taxpayers 2. Disregarded or Pass-through entity 3. Single member LLC means ONE member* *except in a community property state if LLC members are Husband and Wife who reside in the community property state, and the 1031 property is located in a community property state( Rev. Ruling )

60 Examples of Disregarded Entities: Grantor Trust (which is not a Testamentary Trust) Single member limited liability company -However, Sub S Corp is not a disregarded entity & -A general or limited partnership is not a disregarded entity.

61 Pitfall: Failure to Trade Up or Trade Even Two (2) Rules: 1. Equal or Increased Sales Price. 2. All Cash or Equity Applied to Acquisition.

62 Pitfalls: Failure to Trade Up or Trade Even Or A Reason Not to Add a Party to the Deed A Taxpayer (Husband) desires to take advantage of the 1031 Exchange process. The gross sales price of the Relinquished Property is $200, The acquired Replacement Property must have a gross sales price equal to or greater than $200,000.00, and all the cash or equity from the sale of the Relinquished Property must be applied toward the acquisition of the Replacement Property.

63 Potential Pitfall: Taxpayer has scheduled back-to-back closings for the relinquished property and the replacement property, but the relinquished property buyer is backing out.

64 Noel M. Hara Vice President (312)