1031 Exchange Principles

Transcription

1 1031 Exchange Principles 250 W Old Wilson Bridge Road Suite 320 Worthington OH (614) Securities Offered ThroughCambridge Investment Research, Inc. A Broker-Dealer, Member FINRA/SIPCAdvisory Services Offered Through Cambridge Investment Research Advisors, Inc. A Registered Investment Advisor Cambridge & The Bishoff Financial Group Are Not Affiliated

2 Index What Is It/How Does It Work? Page Characteristics Page 2 Qualified Intermediaries Page Rules Pages 4-5 Delaware Statutory Trusts Page 6 Example 1031 Transaction Page 7 Appendix A Like Kind Exchanges Appendix B Classification of A Delaware Statutory Trust Frequently Asked Questions Page A1 - A4 Page B1 - B7 Pages C1 - C3

3 The information presented in this communication should not be construed as legal or tax advice. Please consult independent counsel, accountant or business advisor as to legal, tax and related matters concerning investments in Interests. We make no representation or warranty of any kind with respect to the acceptance by the IRS or any state taxing authority of your treatment of any item on your tax return or the tax consequences if you are investing in Interest as part of a Section 1031 Exchange. This communication is intended only for the person to whom it was presented. You may not reproduce or distribute this communication, in whole or in part, or disclose any of its contents without the prior written consent of the preparer. This communication has been prepared solely for the benefit of persons interested in learning about 1031 exchange principles. The information presented was not prepared in connection with any specific offering or based on the individual needs of any one investor but rather for general educational purposes. This communication shall not constitute an offer to sell or the solicitation of an offer to buy securities. Furthermore, the delivery of this communication does not constitute an offer, or solicitation of an offer, to purchase an interest to anyone in any jurisdiction in which such an offer or solicitation is not authorized. This content is presented for informational purposes and is not an exhaustive list of all considerations related to 1031 exchange investments. You are encouraged to ask the trust or the sponsor questions concerning the terms and conditions of an offering and the property. This communication contains references to certain agreements and other documents. While we believe these references are accurate, you should refer to the actual agreements and documents for more complete information about the rights, obligations and other matters in the agreements and documents. Your Advisor will make the agreements and documents relating to the investment available to you and/or your advisors upon request, if such requested agreements and documents are readily available to the Advisor Exchange investments are intended only for persons who are accredited investors as that term is defined in Rule 501 promulgated under the Securities Act of 1933, as amended (the Securities Act ) and applicable state securities laws. Most interests in 1031 exchange investments will not be registered under the Securities Act or the securities laws of any state. The Sponsor typically will offer and sell the interests in reliance on exemptions from the registration requirements of these laws. Generally, the interests will be subject to restrictions on transferability and resale and you will not be able to transfer or resell interests or any beneficial interest therein unless the interests are registered pursuant to or exempted from such registration requirements. You must be prepared to bear the economic risk of an investment in the interest for an indefinite period of time and be able to withstand a total loss of your investment. The securities laws of certain jurisdictions grant purchasers of securities sold in violation of the registration or qualification provisions of such laws the right to rescind their purchase of such securities and to receive back the consideration paid. Many of these laws granting the right of rescission also provide that suits for such violations must be brought within a specified time, usually one year from discovery of facts constituting such violation. Should any purchaser institute an action claiming that the offering conducted as described herein was required to be registered or qualified; the contents of this communication will be deemed to constitute notice of the facts of the alleged violation.

4 As required by the IRS, you are advised that any discussion of tax issues in this material is not intended or written to be used, and cannot be used, (a) to avoid penalties imposed under the Internal Revenue Code or (b) to promote, market or recommend to another party any transaction or matter addressed herein. Prospective purchasers should seek advice based on their particular circumstances from an independent tax advisor. Beneficial owners possess limited control and rights. Most trusts will be operated and managed by the trustee and manager. Purchasers, as beneficial owners, may have no right to participate in any aspect of the operation or management of the trust. The trustee can often seek to sell the property in accordance with the provisions of the trust agreement, which could provide that the manager has sole power to determine when it is appropriate to sell the property. Beneficial owners generally do not have legal title to the property. The beneficial owners may not have the right to sell or cause the sale of the property. The trustee and manager have limited duties to beneficial owners. The trust agreement may restrict the beneficial owners access to information. Furthermore, depending on the structure of the entity, the beneficial owners rights could be restricted further. Please refer to the offering documents for the specific rights and limitations of owners. There is no guarantee that any real estate strategy, including those described herein, will be successful. An investment in a 1031 Exchange offering is speculative and involves significant risks including but not limited to: no secondary market for the securities; limited liquidity for the securities, limitations on the transfer and redemption of shares; distributions made may not come from income, could be subject to Board discretion, not guaranteed and can be deemed a return of capital there can be no limits on the amounts paid from these other sources; the investment may lack property diversification; the Sponsor and Trustee are generally dependent upon the advisor to select investments and conduct operations; and the advisor will face conflicts of interest. Investments are not bank guaranteed, not FDIC insured and may lose value.

5 What Is a 1031 Exchange and How Does It Work? What is a 1031 Exchange? Section 1031 of the Internal Revenue Code provides an alternative strategy for deferring the capital gains tax that may arise from an investor s business/investment property sale. By exchanging the property for like-kind real estate, property owners may defer their federal taxes and use all of the proceeds for the purchase of replacement business/investment property (see page 4). Whether any particular transaction will qualify under Section 1031 depends on the specific facts involved including, without limitation: -The nature and use of the relinquished property and the method of its disposition -The use of all qualified intermediary, and a qualified exchange escrow -The lapse of time between the sale of relinquished property and the identification and acquisition of the replacement property How Does It Work? Seller cannot receive or control the net sale proceeds; the proceeds must be deposited with a qualified intermediary (see page 3). Replacement property must be like-kind to the relinquished property. The replacement property must be identified within 45 days from the sale of the original property. Property identification is the responsibility of the real estate company operating the Delaware Statutory Trust (please see page 6 for more information). Typically, these real estate firms have numerous types of properties (multi-family, commercial, high rise, strip center) available simultaneously. The replacement property must be acquired within 180 days from the sale of the original property. The cash invested in the replacement property must be equal to or greater than the cash received from the sale of the relinquished property. The debt placed or assumed on the replacement property must be equal to or greater than the debt received from the relinquished property. 1

6 1031 Characteristics 1 There are a number of characteristics to draw to the attention of a taxpayer considering a 1031 exchange transaction. The list includes, but is not limited to: Tax Deferral (Immediate and Indefinite) In a properly executed 1031 exchange, the capital gain taxes are deferred and transferred to the replacement property. Tax is not due until the taxpayer sells the replacement property without utilizing a 1031 exchange. Since there is no limit to the number of exchanges a taxpayer can complete, it is possible to defer the payment of tax indefinitely. Improvement of Returns on Investment A taxpayer may wish to sell an underperforming asset and acquire an asset that offers a more attractive cash flow or appreciation potential. Additionally, a taxpayer may wish to trade a non-income producing asset, such as raw land, for an asset that produces positive cash-flow, such as a retail shopping center. A properly executed 1031 exchange will allow the taxpayer to achieve such an objective. Consolidation or Diversification Taxpayers may accumulate multiple property holdings and eventually determine the need to consolidate these holdings into a few larger assets. Conversely, taxpayers may own only one substantial property, and desire to diversify their holdings across several different properties. A comprehensive exchange strategy can help taxpayers achieve these objectives. Elimination of Management Hassles Many taxpayers own investment property that is management-intensive. These taxpayers may want to defer tax when selling their relinquished property, but do not want to acquire replacement property that requires a substantial management commitment. Potential solutions for this dilemma include the purchase of a triple net lease (NNN) property or tenant-in-common (TIC) interests, in which the maintenance and repairs are not the responsibility of the taxpayer. Wealth Building Potentially, the greatest benefit that comes from utilizing 1031 exchanges is the ability of the taxpayer to preserve all of the equity in the relinquished property. The compounding effect of earning a continual return on all of the equity, instead of a portion of the equity, can result in a higher overall yield for the taxpayer. This preservation of equity via exchanging is a powerful wealth-building tool. -In addition to the tax savings and potential income stream, another benefit which may be recognized would be a step-up in basis, which is: The readjustment of the value of an appreciated asset for tax purposes upon inheritance. With a step-up in basis, the value of the asset is determined to be the higher market value of the asset at the time of inheritance, not the value at which the original party purchased the asset. 2 1 Please note that this information is presented for educational purposes only. The actual benefits available will be dependent on the structure of the investment and cannot be guaranteed. All investments carry an element of risk. When investing in 1031 Exchanges, the risks include but are not limited to possible total loss of principal, economic risk due to vacancy rates, risk of default if unable to make payments on leveraged properties, potential lack of geographic diversification, risk that the Manager will not diversify within the investment or the risk that the stated objectives will not be met and that the Investment will not qualify under Section 1031 among others. Diversification strategies do not assure profit or protect against loss. Furthermore, diversification will not protect against losses or assure profit when there is a general decline across the industry. Beneficial owners generally possess limited control and rights. Please refer to the offering documents for the specific rights and limitations of owners. 2 Investopedia 2

7 Qualified Intermediaries 1 What is a Qualified Intermediary? The qualified intermediary (QI) is a company that is a full-time business of facilitating Section 1031 tax-deferred exchanges. The structure and rules of a QI is provided in Treasury regulations. The QI enters into a written agreement with the taxpayer where the QI transfers the relinquished property to the buyer, and transfers the replacement property to the taxpayer pursuant to an exchange agreement. The QI holds the proceeds from the sale for the relinquished property in a trust or escrow account in order to ensure the taxpayer never has actual or constructive receipt of the sale proceeds. The identification and replacement timelines should be monitored by the QI and the identification is done through the QI. Who is not a Qualified Intermediary? Neither the taxpayer nor a disqualified person may serve as a QI. A disqualified person is someone who is the agent of the exchanger at the time of the exchange. A person who has acted as the taxpayer s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two-year period preceding the date of the transfer of the first relinquished property is treated as an agent of the exchanger, and thereby a disqualified person. If an attorney has provided tax or legal services to the exchanger within the prescribed two-year period, the attorney is a disqualified person. The exchanger should, however, consider retaining an attorney to provide assistance with complicated closing documents and other aspects of the exchange. 1 1 See Income Tax Regulations (26 CFR Part 1) Under 1031(k).1. 3

8 1031 Rules 2 What is Like Kind? In order to qualify for safe harbor tax deferral, the relinquished property must be like-kind to the replacement property. It is this like-kind definition that often confuses many taxpayers and their tax advisors. In exchange transactions involving real property, all real property is deemed to be like-kind with other real property. Thus, as an example, a retail shopping center is like-kind to an office building. Also qualifying as like-kind real property: Raw land Office buildings Retail property Multi-family property Residential rental property Leases and lease options of 30+ years Options and contracts Oil, gas and mineral rights Tenants-in-common ( TIC ) interests Boat slips/docks *Note that state law will control whether these are treated as personal property or real property* In personal property exchanges, the like-kind requirement is much more restrictive and therefore more onerous for the taxpayer. As an example, an aircraft is not like-kind to a bulldozer, and a car is not like-kind to a truck. 2 Both the relinquished and the replacement properties must have been held for investment purposes or for productive use in a trade or business. 2 2 See Appendix A for more information on Like-Kind Exchanges. 4

9 Property Identification Rules 1031 Rules Continued According to Section 1031 of the Internal Revenue Code, there are three different rules that an exchanger can utilize when identifying property in a 1031 exchange: 1. The Three Property Rule: The exchanger may identify up to three potential replacement properties without regard to their value. Or 2. The 200% Rule: The exchanger may identify more than three properties, provided that the aggregate fair market value of these properties does not exceed 200% of the value of the relinquished property. Or 3. The 95% Rule: The exchanger may identify more than three properties, without regard to their aggregate value, provided that the exchanger acquires 95% of the fair market value of the identified properties. Bits and Pieces Vacation and second homes may qualify for exchange, if certain conditions are met. Investors may take some case proceeds from the sale before the funds are sent to the qualifying intermediary. The investor will pay capital gains tax on the cash, but not the proceeds that were reinvested. Capital gains on the un-invested portion will be paid at prevailing federal and state capital gain rates. Upon the death of the owner of the property, under current tax laws, the heirs would get a step up in basis, thereby avoiding all capital gains taxes on the original and subsequent properties. This may be an estate planning strategy for an investor. These offerings may also be appropriate for replacement properties in a 1031 exchange, which uses proceeds derived from an eminent domain condemnation or an insurance settlement as a result of a catastrophe. 5

10 Deleware Statutory Trusts 3 What is a Delaware Statutory Trust? Delaware Statutory Trust (DST): In accordance with the Internal Revenue Service s Revenue Ruling , a beneficial interest in a Delaware Statutory Trust (DST), which holds the replacement property, can be considered like-kind replacement property in an exchange. A DST may own one or more properties. The rights and obligations of investors in a DST will be governed by a DST s trust agreement. Typically, investors have limited voting rights over the operation and ownership of any properties owned by a DST. In addition, the trustees of a DST will be entitled to certain fees and reimbursements, as set forth in the applicable trust agreement. 3 3 See Appendix B for more information on Delaware Statutory Trusts. 6

11 Example 1031 Exchange Transaction *This calculator determines the tax deferment realized by performing a 1031 tax exchange rather than a taxable sale. Original Purchase Price ($) 1,000,000 Capital Improvements ($) 250,000 Accumulated Depreciation ($) 500,000 Sales Price ($) 2,000,000 Selling Expenses ($) 120,000 Federal Capital Gains Rate ($) 20 State Capital Gains Rate (%) 5 Mortgage Loan Balances at Sale ($) 300,000 Results Net Adjusted Basis 750,000 Capital Gain 1,130,000 Depreciation Recapture (25%) 125,000 Federal Capital Gains Tax 226,000 State Capital Gains Tax 56,500 Total Taxes Due 407,500 Gross Equity 1,580,000 After-Tax Equity 1,172,500 7

12 Appendices

13 Appendix A Like-Kind Exchanges Under IRC Code Section FS200818, February 2008 WASHINGTON Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax deferred, but it is not tax-free. The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value. This fact sheet, the 21st in the Tax Gap series, provides additional guidance to taxpayers regarding the rules and regulations governing deferred like-kind exchanges. Who qualifies for the Section 1031 exchange? Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section What are the different structures of a Section 1031 Exchange? To accomplish a Section 1031 exchange, there must be an exchange of properties. The simplest type of Section 1031 exchange is a simultaneous swap of one property for another. Deferred exchanges are more complex but allow flexibility. They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties. To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. Taxpayers engaging in deferred exchanges general use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations. A1

14 A reverse exchange is somewhat more complex than a deferred exchange. It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange. What property qualifies for a Like-Kind Exchange? Both the relinquished property you sell and the replacement property you buy must meet certain requirements. Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. Both properties must be similar enough to qualify as like-kind. Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land. Real property and personal property can both qualify as exchange properties under Section 1031 but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks. Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of: Inventory or stock in trade Stocks, bonds, or notes Other securities or debt Partnership interests Certificates of trust What are the time limits to complete a Section 1031 Deferred Like-Kind Exchange? While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters. The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient. Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified. A2

15 The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above. Are there restrictions for deferred and reverse exchanges? It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable. If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property. One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete. You cannot act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator. Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections. How do you compute the basis in the new property? It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations. Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange. The basis of property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. A3

16 How do you report Section 1031 Like-Kind Exchanges to the IRS? It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations. Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange. The basis of property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. How do you report Section 1031 Like-Kind Exchanges to the IRS? You must report an exchange to the IRS on Form 8824, like-kind exchanges and file it with your tax return for the year in which the exchange occurred. Form 8824 asks for: Descriptions of the properties exchanged Dates that properties were identified and transferred Any relationship between the parties to the exchange Value of the like-kind and other property received Gain or loss on sale of other (non-like kind property given up) Cash received or paid liabilities relieved or assumed Adjusted basis of like-kind property given up realized gain If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions. Beware of schemes Taxpayers should be wary of individuals promoting improper use of like-kind exchanges. Typically they are not tax professionals. Sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes. Many promoters of like-kind exchanges refer to them as tax-free exchanges not tax-deferred exchanges. Taxpayers may also be advised to claim an exchange despite the fact that they have taken possession of cash proceeds from the sale. Consult a tax professional or refer to IRS publications listed below for additional assistance with IRC Section 1031 Like-Kind Exchanges. Please see: A4

17 Appendix B 2 Internal Revenue Bulletin - August 16, Rev. Rul Internal Revenue Bulletin: Classification of A Delaware Statutory Trust This ruling explains how a Delaware statutory trust described in the ruling will be classified for federal tax purposes and whether a taxpayer may acquire an interest in the Delaware statutory trust without recognition of gain or loss under section 1031 of the Code. Rev. Ruls and distinguished. Issue(s) (1) In the situation described below, how is a Delaware statutory trust, described in Del. Code Ann. title 12, , classified for federal tax purposes? (2) In the situation described below, may a taxpayer exchange real property for an interest in a Delaware statutory trust without recognition of gain or loss under 1031 of the Internal Revenue Code? Fact(s) On January 1, 2005, A, an individual, borrows money from BK, a bank, and signs a 10-year note bearing adequate stated interest, within the meaning of 483. On January 1, 2005, A uses the proceeds of the loan to purchase Blackacre, rental real property. The note is secured by Blackacre and is nonrecourse to A. Immediately following A s purchase of Blackacre, A enters into a net lease with Z for a term of 10 years. Under the terms of the lease, Z is to pay all taxes, assessments, fees, or other charges imposed on Blackacre by federal, state, or local authorities. In addition, Z is to pay all insurance, maintenance, ordinary repairs, and utilities relating to Blackacre. Z may sublease Blackacre. Z s rent is a fixed amount that may be adjusted by a formula described in the lease agreement that is based upon a fixed rate or an objective index, such as an escalator clause based upon the Consumer Price Index, but adjustments to the rate or index are not within the control of any of the parties to the lease. Z s rent is not contingent on Z s ability to lease the property or on Z s gross sales or net profits derived from the property. Also on January 1, 2005, A forms DST, a Delaware statutory trust described in the Delaware Statutory Trust Act, Del. Code Ann. title 12, , to hold property for investment. A contributes Blackacre to DST. Upon contribution, DST assumes A s rights and obligations under the note with BK and the lease with Z. In accordance with the terms of the note, neither DST nor any of its beneficial owners are personally liable to BK on the note, which continues to be secured by Blackacre. The trust agreement provides that interests in DST are freely transferable. However, DST interests are not publicly traded on an established securities market. DST will terminate on the earlier of 10 years from the date of its creation or the disposition of Blackacre, but will not terminate on the bankruptcy, death, or incapacity of any owner or on the transfer of any right, title, or interest of the owners. The trust agreement further provides that interests in DST will be of a single class, representing undivided beneficial interests in the assets of DST. B1

18 Under the trust agreement, the trustee is authorized to establish a reasonable reserve for expenses associated with holding Blackacre that may be payable out of trust funds. The trustee is required to distribute all available cash less reserves quarterly to each beneficial owner in proportion to their respective interests in DST. The trustee is required to invest cash received from Blackacre between each quarterly distribution and all cash held in reserve in short-term obligations of (or guaranteed by) the United States, or any agency or instrumentality thereof, and in certificates of deposit of any bank or trust company having a minimum stated surplus and capital. The trustee is permitted to invest only in obligations maturing prior to the next distribution date and is required to hold such obligations until maturity. In addition to the right to a quarterly distribution of cash, each beneficial owner has the right to an in-kind distribution of its proportionate share of trust property. The trust agreement provides that the trustee s activities are limited to the collection and distribution of income. The trustee may not exchange Blackacre for other property, purchase assets other than the short-term investments described above, or accept additional contributions of assets (including money) to DST. The trustee may not renegotiate the terms of the debt used to acquire Blackacre and may not renegotiate the lease with Z or enter into leases with tenants other than Z, except in the case of Z s bankruptcy or insolvency. In addition, the trustee may make only minor non-structural modifications to Blackacre, unless otherwise required by law. The trust agreement further provides that the trustee may engage in ministerial activities to the extent required to maintain and operate DST under local law. On January 3, 2005, B and C exchange Whiteacre and Greenacre, respectively, for all of A s interests in DST through a qualified intermediary, within the meaning of (k)-1(g). A does not engage in a 1031 exchange. Whiteacre and Greenacre were held for investment and are of like kind to Blackacre, within the meaning of Neither DST nor its trustee enters into a written agreement with A, B, or C, creating an agency relationship. In dealings with third parties, neither DST nor its trustee is represented as an agent of A, B, or C. BK is not related to A, B, C, DST s trustee or Z within the meaning of 267(b) or 707(b). Z is not related to B, C, or DST s trustee within the meaning of 267(b) or 707(b). Law Delaware law provides that a Delaware statutory trust is an unincorporated association recognized as an entity separate from its owners. A Delaware statutory trust is created by executing a governing instrument and filing an executed certificate of trust. Creditors of the beneficial owners of a Delaware statutory trust may not assert claims directly against the property in the trust. A Delaware statutory trust may sue or be sued, and property held in a Delaware statutory trust is subject to attachment or execution as if the trust were a corporation. Beneficial owners of a Delaware statutory trust are entitled to the same limitation on personal liability because of actions of the Delaware statutory trust that is extended to stockholders of Delaware corporations. A Delaware statutory trust may merge or consolidate with or into one or more statutory entities or other business entities. Section 671 provides that, where the grantor or another person is treated as the owner of any B2

19 portion of a trust (commonly referred to as a grantor trust ), there shall be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that the items would be taken into account under chapter 1 in computing taxable income or credits against the tax of an individual. Section (e)(1) of the Income Tax Regulations provides that, for purposes of subchapter J, a grantor includes any person to the extent such person either creates a trust or directly or indirectly makes a gratuitous transfer of property to a trust. Under (e)(3), the term grantor includes any person who acquires an interest in a trust from a grantor of the trust if the interest acquired is an interest in certain investment trusts described in (c). Under 677(a), the grantor is treated as the owner of any portion of a trust whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be distributed, or held or accumulated for future distribution, to the grantor or the grantor s spouse. A person that is treated as the owner of an undivided fractional interest of a trust under subpart E of part I, subchapter J of the Code ( 671 and following), is considered to own the trust assets attributable to that undivided fractional interest of the trust for federal income tax purposes. See Rev. Rul , C.B. 304; Rev. Rul , C.B. 183; and Rev. Rul , C.B See also (c), Example 5. Section 761(a) provides that the term partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and that is not a corporation or a trust or estate. Under regulations the Secretary may, at the election of all the members of the unincorporated organization, exclude such organization from the application of all or part of subchapter K, if the income of the members of the organization may be adequately determined without the computation of partnership taxable income and the organization is availed of (1) for investment purposes only and not for the active conduct of a business, (2) for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted, or (3) by dealers in securities for a short period for the purpose of underwriting, selling, or distributing a particular issue of securities. Section (a)(2) provides the requirements that must be satisfied for participants in the joint purchase, retention, sale, or exchange of investment property to elect to be excluded from the application of the provisions ofsubchapter K. One of these requirements is that the participants own the property as coowners. Section 1031(a)(1) provides that no gain or loss is 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 that is to be held either for productive use in a trade or business or for investment. Section 1031(a)(2) provides that 1031(a) does not apply to any exchange of stocks, bonds or notes, other securities or evidences of indebtedness or interest, interests in a partnership, or certificates of trust or beneficial interests. It further provides that an interest in a partnership that has in effect B3

20 a valid election under 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 the partnership and not as an interest in a partnership. Under (a)(1) of the Procedure and Administration Regulations, whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law. Generally, when participants in a venture form a state law entity and avail themselves of the benefits of that entity for a valid business purpose, such as investment or profit, and not for tax avoidance, the entity will be recognized for federal tax purposes. See Moline Properties, Inc. v. Comm r, 319 U.S. 436 (1943); Zmuda v. Comm r, 731 F.2d 1417 (9th Cir. 1984); Boca Investerings P ship v. United States, 314 F.3d 625 (D.C. Cir. 2003); Saba P ship v. Comm r, 273 F.3d 1135 (D.C. Cir. 2001); ASA Investerings P ship v. Comm r, 201 F.3d 505 (D.C. Cir. 2000); Markosian v. Comm r, 73 T.C (1980). Section (a) defines the term business entity as any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under ) that is not properly classified as a trust under or otherwise subject to special treatment under the Code. A business entity with two or more owners is classified for federal tax purposes as either a corporation or a partnership. A business entity with only one owner is classified as a corporation or is disregarded. Section (a) provides that an eligible entity can elect its classification for federal tax purposes. Under (b)(1), unless the entity elects otherwise, a domestic eligible entity is a partnership if it has two or more owners or is disregarded as an entity separate from its owner if it has a single owner. Section (a) provides that the term trust refers to an arrangement created either by will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting and conserving it for the beneficiaries. Usually the beneficiaries of a trust do no more than accept the benefits thereof and are not voluntary planners or creators of the trust arrangement. However, the beneficiaries of a trust may be the persons who create it, and it will be recognized as a trust if it was created for the purpose of protecting and conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Section (b) provides that there are other arrangements known as trusts because the legal title to property is conveyed to trustees for the benefit of beneficiaries, but that are not classified as trusts for federal tax purposes because they are not simply arrangements to protect or conserve the property for the beneficiaries. These trusts, which are often known as business or commercial trusts, generally are created by the beneficiaries simply as a device to carry on a profit-making business that normally would have been carried on through business organizations that are classified as corporations or partnerships. Section (c)(1) provides that an investment trust will not be classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders. See Comm r v. North American Bond Trust, 122 F.2d 545 (2d Cir. 1941), cert. denied, 314 U.S. 701 (1942). An investment trust with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust, will be classified as a trust if there is no power to vary the investment of the certificate holders. B4

21 A power to vary the investment of the certificate holders exists where there is a managerial power, under the trust instrument, that enables a trust to take advantage of variations in the market to improve the investment of the investors. See Comm r v. North American Bond Trust, 122 F.2d at 546. Rev. Rul , C.B. 384, discusses the situation where a provision in the trust agreement requires the trustee to invest cash on hand between the quarterly distribution dates. The trustee is required to invest the money in short-term obligations of (or guaranteed by) the United States, or any agency or instrumentality thereof, and in certificates of deposit of any bank or trust company having a minimum stated surplus and capital. The trustee is permitted to invest only in obligations maturing prior to the next distribution date and is required to hold such obligations until maturity. Rev. Rul concludes that, because the restrictions on the types of permitted investments limit the trustee to a fixed return similar to that earned on a bank account and eliminate any opportunity to profit from market fluctuations, the power to invest in the specified kinds of short-term investments is not a power to vary the trust s investment. Rev. Rul , C.B. 344, concludes that a trust established by the heirs of a number of contiguous parcels of real estate is an association taxable as a corporation for federal tax purposes where the trustees have the power to purchase and sell contiguous or adjacent real estate, accept or retain contributions of contiguous or adjacent real estate, raze or erect any building or structure, make any improvements to the land originally contributed, borrow money, and mortgage or lease the property. Compare Rev. Rul , C.B. 448 (concluding that a trust formed by three parties to hold a single parcel of real estate is classified as a trust for federal income tax purposes when the trustee has limited powers that do not evidence an intent to carry on a profit making business). Rev. Rul , C.B. 204, addresses the transfer of a taxpayer s interest in an Illinois land trust under Under the facts of the ruling, a single taxpayer created an Illinois land trust and named a domestic corporation as trustee. Under the deed of trust, the taxpayer transferred legal and equitable title to real property to the trust, subject to the provisions of an accompanying land trust agreement. The land trust agreement provided that the taxpayer retained exclusive control of the management, operation, renting, and selling of the real property, together with an exclusive right to the earnings and proceeds from the real property. Under the agreement, the taxpayer was required to file all tax returns, pay all taxes, and satisfy any other liabilities with respect to the real property. Rev. Rul concludes that, because the trustee s only responsibility was to hold and transfer title at the direction of the taxpayer, a trust, as defined in (a), was not established. Moreover, there were no other arrangements between the taxpayer and the trustee (or between the taxpayer and any other person) that would cause the overall arrangement to be classified as a partnership (or any other type of entity). Instead, the trustee was a mere agent for the holding and transfer of title to real property, and the taxpayer retained direct ownership of the real property for federal income tax purposes. Analysis Under Delaware law, DST is an entity that is recognized as separate from its owners. Creditors of the beneficial owners of DST may not assert claims directly against Blackacre. DST may sue or be sued, and the property of DST is subject to attachment and execution as if it were a corporation. The beneficial owners of DST are entitled to the same limitation on personal liability because of actions of DST that is extended to stockholders of Delaware corporations. DST may merge or consolidate with or into one or more statutory entities or other business entities. B5

22 DST is formed for investment purposes. Thus, DST is an entity for federal tax purpose. Whether DST or its trustee is an agent of DST s beneficial owners depends upon the arrangement between the parties. The beneficiaries of DST do not enter into an agency agreement with DST or its trustee. Further, neither DST nor its trustee acts as an agent for A, B, or C in dealings with third parties. Thus, neither DST nor its trustee is the agent of DST s beneficial owners. Cf. Comm r v. Bollinger, 485 U.S. 340 (1988). This situation is distinguishable from Rev. Rul First, in Rev. Rul , the beneficiary retained the direct obligation to pay liabilities and taxes relating to the property. DST, in contrast, assumed A s obligations on the lease with Z and on the loan with BK, and Delaware law provides the beneficial owners of DST with the same limitation on personal liability extended to shareholders of Delaware corporations. Second, unlike A, the beneficiary in Rev. Rul retained the right to manage and control the trust property. Issue 1. Classification of Delaware Statutory Trust Because DST is an entity separate from its owner, DST is either a trust or a business entity for federal tax purposes. To determine whether DST is a trust or a business entity for federal tax purposes, it is necessary, under (c)(1), to determine whether there is a power under the trust agreement to vary the investment of the certificate holders. Prior to, but on the same date as, the transfer of Blackacre to DST, A entered into a 10-year nonrecourse loan secured by Blackacre. A also entered into the 10-year net lease agreement with Z. A s rights and obligations under the loan and lease were assumed by DST. Because the duration of DST is 10 years (unless Blackacre is disposed of prior to that time), the financing and leasing arrangements related to Blackacre that were made prior to the inception of DST are fixed for the entire life of DST. Further, the trustee may only invest in short-term obligations that mature prior to the next distribution date and is required to hold these obligations until maturity. Because the trust agreement requires that any cash from Blackacre, and any cash earned on short-term obligations held by DST between distribution dates, be distributed quarterly, and because the disposition of Blackacre results in the termination of DST, no reinvestment of such monies is possible. The trust agreement provides that the trustee s activities are limited to the collection and distribution of income. The trustee may not exchange Blackacre for other property, purchase assets other than the short-term investments described above, or accept additional contributions of assets (including money) to DST. The trustee may not renegotiate the terms of the debt used to acquire Blackacre and may not renegotiate the lease with Z or enter into leases with tenants other than Z,except in the case of Z s bankruptcy or insolvency. In addition, the trustee may make only minor non-structural modifications to Blackacre, unless otherwise required by law. This situation is distinguishable from Rev. Rul , because DST s trustee has none of the powers described in Rev. Rul , which evidence an intent to carry on a profit making business. Because all of the interests in DST are of a single class representing undivided beneficial interests in the assets of DST and DST s trustee has no power to vary the investment of the certificate holders to benefit from variations in the market, DST is an investment trust that will be classified as a trust under (c)(1). B6

23 Issue 2. Exchange of Real Property for Interests under 1031 B and C are treated as grantors of the trust under (e)(3) when they acquire their interests in the trust from A. Because they have the right to distributions of all trust income attributable to their undivided fractional interests in the trust, B and C are each treated, by reason of 677, as the owner of an aliquot portion of the trust and all income, deductions, and credits attributable to that portion are includible by B and C under 671 in computing their taxable income. Because the owner of an undivided fractional interest of a trust is considered to own the trust assets attributable to that interest for federal income tax purposes, B and C are each considered to own an undivided fractional interest in Blackacre for federal income tax purposes. See Rev. Rul Accordingly, the exchange of real property by B and C for an interest in DST through a qualified intermediary is the exchange of real property for an interest in Blackacre, and not the exchange of real property for a certificate of trust or beneficial interest under 1031(a)(2)(E). Because Whiteacre and Greenacre are of like kind to Blackacre, and provided the other requirements of 1031 are satisfied, the exchange of real property for an interest in DST by B and C will qualify for nonrecognition of gain or loss under Moreover, because DST is a grantor trust, the outcome to the parties will remain the same, even if A transfers interests in Blackacre directly to B and C, and B and C immediately form DST by contributing their interests in Blackacre. Under the facts of this case, if DST s trustee has additional powers under the trust agreement such as the power to do one or more of the following: (i) dispose of Blackacre and acquire new property; (ii) renegotiate the lease with Z or enter into leases with tenants other than Z; (iii) renegotiate or refinance the obligation used to purchase Blackacre; (iv) invest cash received to profit from market fluctuations; or (v) make more than minor non-structural modifications to Blackacre not required by law, DST will be a business entity which, if it has two or more owners, will be classified as a partnership for federal tax purposes, unless it is treated as a corporation under 7704 or elects to be classified as a corporation under In addition, because the assets of DST will not be owned by the beneficiaries as coowners under state law, DST will not be able to elect to be excluded from the application of subchapter K. See (a)(2)(i). Holdings (1) The Delaware statutory trust described above is an investment trust, under (c), that will be classified as a trust for federal tax purposes. (2) A taxpayer may exchange real property for an interest in the Delaware statutory trust described above without recognition of gain or loss under 1031, if the other requirements of 1031 are satisfied. Effect on other revenue rulings Rev. Rul and Rev. Rul are distinguished. Drafting information The principal author of this revenue ruling is Christopher L. Trump of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Christopher L. Trump at (202) (not a toll-free call). 2 B7

24 Frequently Asked Questions 1 1. Why would a taxpayer want to do a 1031 Exchange? Most commonly, taxpayers utilize 1031 exchanges to defer capital gains tax on the sale of commercial, business, or investment property that would otherwise be due. However, there are many other benefits to exchanging. 2. Is a 1031 Exchange a loophole in the Internal Revenue Code? No. Section 1031 has been a part of the Internal Revenue Code since its inception. With the addition of several beneficial amendments to the code in 1991, section 1031 may now be one of the most powerful tools available for investors in real estate. 3. What type of property is eligible for a 1031 Exchange? Any real property that is deemed to be like-kind is eligible for 1031 exchange treatment. Additionally, personal property can also be exchanged. Each state defines real property and personal property in its own way. 4. Is deferral under IRC 1031 only for capital gains? No. Section 1031 applies to capital gains taxes (15%), depreciation recapture (25%), and state income taxes. Long-term capital gains taxes apply to property held over 1 year. Gains from property held less than a year are typically taxed as ordinary income. 5. Does a 1031 Exchange permanently delete capital gains tax? No. A 1031 exchange defers taxes; it generally does not eliminate them. The replacement property will carry the tax basis of the relinquished property. Upon the sale of the replacement property, all tax will be due or the taxpayer can enter into another 1031 exchange to defer taxes again. There is no limit to how many 1031 exchanges can be performed, therefore, deferment can be indefinite. 6. Why can t my own attorney or CPA serve as my Qualified Intermediary? A qualified intermediary must remain completely independent from the taxpayer and cannot have been the taxpayer s agent in any other capacity for the past 2 years. 7. Do I have to know what property I will be purchasing when I start the exchange? No. The taxpayer has 45 days from the sale of the relinquished property to identify the potential replacement properties. 8. Can I back-date my identification form to be within the 45 day period? Absolutely not. The 45 calendar-day deadline is part of the Internal Revenue Code. It cannot be extended by the taxpayer or any party to the exchange under any circumstances. The act of back-dating, altering or changing the identification after the 45 day deadline has passed is criminal tax fraud and should never be considered under any circumstances. 9. How long do I have to purchase my replacement property? The taxpayer has 180 days from the sale of the relinquished property to purchase and take title to the replacement property/properties. C1

25 10. What happens if my 45th or 180th day falls on a Saturday, Sunday, or holiday? Are there any extensions to these dates? No. These deadlines are actually part of the Internal Revenue Code and cannot be extended for any reason except by a presidential disaster declaration. The deadline is not extended if it falls on a Saturday, Sunday or legal holiday. 11. Do I have to use all the cash proceeds from my sale on my purchase? In order to completely defer the applicable capital gains tax, all cash proceeds from the transaction must be used. To the extent the proceeds are not used on the purchase, the taxpayer will be responsible for any tax on the difference. 11. Do I have to use all the cash proceeds from my sale on my purchase? In order to completely defer the applicable capital gains tax, all cash proceeds from the transaction must be used. To the extent the proceeds are not used on the purchase, the taxpayer will be responsible for any tax on the difference. 12. I ve already sold my property and put it under contract. Can I still do an exchange? Yes, as long as the sale has not yet closed. An exchange can be set up as late as the day of closing. 13. Can I sell more than one relinquished property in the same 1031 exchange? Yes. There is no limit to the number of relinquished properties a taxpayer can have within the same 1031 tax-deferred exchange transaction. 14. What is a related party, and can I do an exchange with them? A related party is defined as lineal ancestors and descendants, brothers and sisters and business entities in which the exchanger owns greater than a 50% interest. Recent rulings have stated that while there is no issue with selling your relinquished property to a related a party, there are certain restrictions when buying your replacement property from a related party. Generally, there are two situations in which it would be acceptable to purchase property from a related party: (1) the related party is also participating in an exchange or (2) the exchanger acquires property from a related party and tax avoidance is not an issue. 15. May a corporation or partnership be involved in a 1031 exchange? Yes, absolutely. Taxpaying entities of any type are allowed to structure and complete tax-deferred exchange transactions. 16. Can I close on my replacement property before I have a buyer for my relinquished property? In a reverse exchange, the eventual replacement property is acquired before the sale of the relinquished property. Since the taxpayer has yet to sell relinquished property, the taxpayer may not hold the replacement property. Therefore, the eventual replacement property is parked by an unrelated third-party, referred to as an accommodating titleholder, until the relinquished property is sold. In order to qualify for tax-deferral under the safe-harbor regulations, the parked property must be acquired as replacement property within 180 days from the day the accommodating titleholder purchased it. The fees associated with these exchanges are higher due to the transactional complexity. C2

26 17. May I construct my eventual replacement property? In a construction exchange (also known as a Build-to-Suit Exchange), the exchange proceeds from the relinquished property sale are used to acquire the parked property, and to construct improvements on the property. The property must be held by the accommodating titleholder until either the improvements are complete or the 180-day exchange deadline occurs. On or before the 180th day, the improved property must be transferred to the exchanger as the replacement property, in completion of the exchange. These transactions may also be structured as reverse construction exchanges. The fees associated with both of these exchanges are higher due to the transactional complexity. 18. If I sell non-income producing property such as raw land with a very low cost basis can I 1031 exchange the proceeds into an income producing property? Yes, absolutely. As long as the property being sold was held for investment and the taxpayer is purchasing property for investment, then the like-kind requirement has been satisfied. In fact, this is a great investment strategy, because you are selling a non-productive asset (vacant land) and acquiring a productive asset (commercial office building) on a tax-deferred basis. 19. Can I change the use of my 1031 exchange property? For example, I want to eventually make my beach rental a second home. Yes, you can change the use of your property. You should always establish your property as investment for ideally 2 years before you change the use of your property. An ideal situation is to move into your 1031 exchange property and make it your primary residence. If you rent the home for 3 years and live in it for 2, you can then sell the property with the primary residence tax exclusion which is 250K exemption if single and 500K exemption if married. 20. How long must I own my property before it is eligible for a 1031 exchange? There is no statutorily defined holding period for 1031 exchanges. A taxpayer must own the property long enough to establish held-for-investment-intent. A generally accepted industry practice is 1 year and 1 day. 1 Like-Kind Exchanges Under IRC Code Section 1031, Internal Revenue Service: C3

27 Remember, all investments carry an element of risk offerings have the usual risks of most real estate transactions including but not limited to possible loss of principal, economic risk due to vacancy rates, risk of default if unable to make payments on leveraged properties, or potential lack of geographic diversification among others. This communication shall not constitute an offer to sell or the solicitation of an offer to buy securities. The information is presented for general educational purposes only. This information is provided for informational purposes and does not address the entire topic.