1031 Tax Deferred Real Estate Transactions & Reverse 1031 Transactions

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1 1031 Tax Deferred Real Estate Transactions & Reverse 1031 Transactions Continuing Real Estate Education Seminar Pierre E. Debbas, Esq. Romer Debbas, LLP 183 Madison Avenue Suite 904 New York, NY I. INTRODUCTION I.R.C. 1031(a)-1: Section 1031(a)(1) provides an exception from the general rule requiring the recognition of gain or loss upon the sale or exchange of property. Under section 1031(a)(1), no gain or loss is recognized if property held for productive use in trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in trade or business or for investment. Under this section, property held for productive use in trade or business may be exchanged for property held for investment. Similarly, under this section, property held for investment may be exchanged for property held for productive use in trade or business. Basic Definition: A 1031 tax exchange is a mechanism used for deferring taxes in the sale of real estate; it is not a tax evasion tool. It is used by real estate investors who sell an investment (primary or secondary residences are not part of a 1031) property or properties and exchange the proceeds they received from the sale for other like-kind properties without recognition of capital gains.

2 II PROCEDURES 3 Basic Steps to Conduct a 1031 Exchange: 1. Contact an Intermediary and sign an exchange agreement (before the sale), 2. Chose the replacement property within 45 days of the sale of the relinquished property, and 3. Close on the replacement property within 180 days of the sale of the relinquished property. Step 1: Exchange Agreement Intermediary Qualified Intermediary is an independent and professional facilitator who receives the funds from the original sale and holds the funds until they are needed to purchase the new exchange property. The Qualified Intermediary ( QI ) then directly delivers the money to the closing agent who delivers the deed directly to the real estate investor. The QI is a third-party that facilitates the transaction; the IRS does not permit your accountant, attorney or escrow company to act as a QI. a. All proceeds from the sale must be made payable to the QI as escrow agent and only the QI. b. Adjustments for real estate taxes, common charges, etc. can be given to the seller, because they are not considered proceeds rather they are a reimbursement for carrying costs of the property. 2. Exchange Agreement: When an investor is going to sell an investment property and desires to use the proceeds in 1031 exchange, they sign the contract for the sale; this property then becomes referred to as the relinquished property. The investor sends the contract for the sale to the QI and then executes an Exchange Agreement. The Exchange Agreement states the investors desire to use the proceeds from the sale to purchase a like-kind property. The procedure for the 1031 exchange is outlined in this agreement. Step 2: Identification of the Replacement Property 1. Closing: At the closing for the relinquished property, all of the proceeds from the closing are sent to the QI. All of the checks must be made out to the QI. It is a violation of 1031 rules and regulations to have any of the checks made out to any other party other than the QI and if any checks are deposited by anyone other than the QI, the 1031 is deemed void. The QI holds all of the proceeds from the sale in an escrow account and when the closing for the replacement property takes place, the QI will cut the checks for the purchase from the proceeds of the sale of the relinquished property Days: The investor has 45 days from the sale of the relinquished property to notify the QI of a replacement property. The notification of the replacement property must be done within this 45 day period. 2

3 a. Down payment: When the replacement property is named, the investor will send the QI a copy of the contract of sale and request that the QI cut a check in the amount of the 10% down payment for the replacement property, out of the proceeds from the relinquished property. b. Like-Kind Property: the replacement property must be a like-kind property. Like-Kind is a federal tax term relating to the nature or character of the real estate in the hands of the owner rather than to its grade or quality. The fact that the real estate is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Qualified real estate located in the 50 United Sates is of like-kind when exchanged for other qualified real estate located in the 50 United States and the U.S. Virgin Islands. Foreign real estate does not qualify as like-kind property. Step 3: Closing of the Replacement Property Q&A: 1. The closing of the replacement property must take place within 180 days from the sale of the relinquished property. 2. All of the proceeds from the sale must be used on the purchase of the replacement property. The proceeds from the sale can be used to pay a portion of the purchase price of multiple replacement properties with the rest of the purchase price being financed or paid by the investor themselves (see below on multiple replacement properties), as long as all of the proceeds from the sale are used to purchase like-kind property within the 180 day period. Q: Can you use only a portion of the net sales proceeds in a 1031 transaction and pay capital gains tax on the portion you did not use to purchase a replacement property or do 100% of the net sales proceeds must be used in the 1031 transaction? A: Under I.R.C. 1031, a partial exchange is permissible. The taxpayer will pay capital gains on whatever money they pull out for themselves and the money that they intend on using for the 1031 exchange must be held by the QI. 3

4 III. CALCULATION OF CAPITAL GAINS The following example is based upon a purchase price of $100, and a sales price of $150, Calculate Net Adjusted Basis: a. Original Purchase Price: $100, b. Plus Improvements (+) $ 10, c. Minus Depreciation (-) $ 20, i. NET ADJUSTED BASIS $ 90, Calculate Capital Gain Sales Price of Property a. Sales Price $150, b. Minus New Adjusted Basis (-) $ 90, c. Minus Closing Costs of Sale (-) $ 15, (commission, fees, etc.) i. CAPITAL GAIN $ 45, Calculate Capital Gain Tax Due a. Recaptured Depreciation (Note 1) $ 5, b. Plus Federal Capital Gains (Note 2) $ 5, Rate (20%) c. Plus NYS Non-Resident Gains Tax (Note 3) $ 3, Rate (8.82%) i. TOTAL TAXES DUE $ 13, Calculate After-Tax Equity a. Sales Price $150, b. Minus Cost of Sale (-) ($ 15,000.00) c. Minus Loan Balances (-) ($ 50,000.00) d. GROSS EQUITY $ 85, e. Minus Capital Gain Taxes Due (-) ($ 13,969.00) i. AFTER-TAX LIQUIDITY $ 71, Comparison* a. Loan to Value % - 80% Loan b Exchange Investment Value $425, (with equity of $85,000.00) c. Non-1031 Exchange Investment $355, (with equity of $71,031.00) Value i. GAIN IN VALUE FROM 1031 $ 69,

5 *Comparison: This comparison is based upon the investor purchasing a new property and using the proceeds for the sale to pay for 20% of the purchase price and financing 80%. If the investor did not use a 1031 they would have $72, to purchase a property and based upon an 80% loan the maximum the investor could afford would be a property worth $361, If the investor utilizes a 1031 transaction, the investor will have $85, to purchase a replacement property and with 80% financing the investor can afford a purchase price up to $425, If the investor did not desire to purchase another investment property, then the total taxes owed would be $12, Note 1: Recaptured Depreciation: This is a flat 25% tax on the sum that has been depreciated during the taxpayer s ownership of the property. In our example, the taxpayer took depreciation of $20, and thus owes a recapture tax of $5, upon the sale of the property. This tax in addition to capital gains and NYS non-resident gains tax is deferred in a 1031 transaction. Note 2: Federal Capital Gains Tax: This is a flat 20% tax on the capital gain. However, the sum taxed at 20% is the net gain minus the sum depreciated which is taxed at the recaptured depreciation rate described in Note 1. In our example, there is a net gain of $45, and depreciation of $20, The sum that was depreciated ($20,000.00) was taxed at 25% under recaptured depreciation. The sum of the gain outstanding that has not been taxed is $25, which is taxed at the rate of 20% and thus the sum owed of $5, Note 3: NYS Non-Resident Gains Tax: This is a flat 8.82% tax on the total gain without reducing the sum of the recaptured depreciation in calculating the tax owed. NYS residents do not have to pay this tax nor do entities which have filed for and obtained a certificate of authority to do business in NY. IV. REPLACEMENT PROPERTY QUALIFICATIONS A. Property Types: a. Vacation Homes: a vacation home or second home not held as a rental is classified as real estate held for personal use and does not qualify for 1031 treatment. However, a dwelling unit held for both personal use and rental purposes must take a use test each tax year to determine its tax classification for that tax year. i. The property is treated as real estate held primarily for personal use and treated as an asset not held for profit if the owner s personal use is more than 14 days or 10% of the total rental days and the unit is rented for one day or more during the tax year. This does not qualify for 1031 treatment. ii. The property is treated as rental property if the owner s personal use is no more than 14 days or 10% of the rental days during the tax year and the property is rented more than 14 days during the tax year. May qualify for 1031 treatment. 5

6 b. Primary Residence: Only real estate property held for business or investment purposes can be used in a Primary residences or second homes do not qualify for a 1031 exchange. B. Identification Rules: a. The 3-Property Rule (most common): i. The maximum number of replacement properties you may identify is three properties without regard to the fair market values of the properties. b. The 200 Percent Rule (fairly utilized): i. You may identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all Relinquished Properties. ii. Example: if you sold relinquished property(ies) in the amount of $1,000,000 you would be able to identify as many like-kind replacement properties as you want as long as the total (aggregate) value of the identified like-kind replacement properties does not exceed $2,000,000 (200% of $1,000,000). c. The 95 Percent Rule (least common and most complex): i. You may need to identify significantly more like-kind replacement properties than the first two identification rules permit. There is no limit as to the total (aggregate) number or value of identified like-kind replacement properties permitted under the 95% exception as long as you actually acquire and close on 95% of the value identified. ii. If you do not acquire and close on at least 95% of the value of the identified like-kind replacement properties the entire 1031 Exchange transaction will be disallowed. Note: You only have to satisfy one of the above three rules. C. Value of the Property a. The Replacement Property you wish to acquire needs to have a value equal to, or greater than, the adjusted sales price of the Relinquished Property. b. The exception to this rule is if you wish to only use a portion of the proceeds from the sale of the relinquished property in the acquisition of the replacement property and pay the gains tax owed on the remaining sum. D. New Construction As Replacement Property a. A transfer will still qualify for 1031 treatment if the new construction is identified within the 45-day grace period, and received within the 180-day exchange period. This property must be carefully identified within the 45-day period, and received 6

7 within the 180 day exchange period. This identification should include the legal description of the underlying ground and as much other description as possible for the property to be constructed. Also, the new construction must be completed and received in substantially the same form as described in the identification documents. Partially completed real property can be received in a like kind exchange if properly identified. V. REVERSE 1031 EXCHANGES A Reverse 1031 Exchange must be in done in compliance with Rev. Proc , which provides the Safe Harbor rules for a reverse exchange. A reverse exchange is a transaction in which the Replacement Property is acquired before the Relinquished Property is sold. This tax planning procedure permits you to acquire the Replacement Property before you are able to sell the Relinquished Property. This type of transaction is typically utilized in a bullish market or if the taxpayer finds an opportunity to acquire a property below market value. 3 Steps Required to Complete a Reverse 1031 Exchange: Step 1: Acquiring The Replacement Property Exchange Accommodation Titleholder: i) An Exchange Accommodation Titleholder (EAT) must take title to the replacement property. The EAT will park the property until you sell your property. ii) Within five days from when the EAT takes title to the property, you must enter into a Qualified Exchange Accommodation Agreement (QEAA) with the EAT. The QEAA must specify the intentions of both parties and the rules that must be followed to complete the exchange. iii) You must identify the property you wish to relinquish within 45 days of signing the QEAA and you must close on the sale of your property within 180 days of signing the QEAA. Step 2: Financing the EAT s Acquisition of the Replacement Property Negotiate a loan with your lender on behalf of the EAT. The loan is usually secured by the new property. The EAT signs the Note and the Deed of Trust. Your lender will require you to guarantee the loan. Sometimes the lender also takes a security interest in your old property. Be sure that there is an assumption clause in the Deed of Trust allowing you to assume the loan made to the EAT. A) Loan Structure: The EAT will purchase the relinquished property by borrowing 100 percent of the needed funds. EAT can borrow the funds from any source authorized by the exchanger. i) Lease: The EAT will enter into a triple net lease with the exchanger for the property and this will correspond with the amount of the mortgage/loan, real estate taxes, insurance and maintenance. The term of the lease will be for 6 months (180 days). 7

8 ii) Financing: financing for the purchase of the Replacement Property can be done through one of the following four methods: 1. The Exchanger can provide financing to the EAT, 2. The seller of the Replacement Property can provide the financing, 3. The EAT can assume the current loan on the property, and 4. The EAT can enter into a new loan with an institutional lender. Step 3: Closing of the Relinquished Property and Purchase of the Replacement Property from the EAT A) Sale of Relinquished Property: The sale of the relinquished property must take place within 180 days from the purchase of the replacement property. The net proceeds from the sale of the relinquished property will be used to buy replacement property, from the EAT. i) The QEAA will state that the EAT will be obligated to sell the Replacement Property to the QI when the QI holds the proceeds from the sale of the Exchanger s Relinquished Property that were obtained from a third-party (buyer of the Relinquished Property). ii) Once the Exchanger enters into a binding contract with the Buyer of the Relinquished Property, then the Exchanger will assign the contract for the sale of the Relinquished Property to the QI. iii) The QI will cause the Relinquished Property to be sold, with a deed directly from the Exchanger to the Buyer and with the net sales proceeds delivered to the QI. B) Purchasing the Replacement Property from the EAT: The QI will use the proceeds that it has obtained from the sale of the Relinquished Property to purchase the Replacement Property from the EAT. i) The deed for the Replacement Property will come from the EAT and go directly to the Exchanger. Once this is done, the Reverse Exchange will be completed. 8

9 Q&A: Q: What happens if for some reason the sale of the relinquished property does not take place? Is the exchanger on the hook to pay off the mortgage (given from either the QI or institutional lender) or just continue making the monthly payments until the replacement property is sold, then the debt is relieved, but the exchange is blown if not completed within the 180 days? A: On a reverse 1031, the QI takes title through the EAT, the intermediary holds legal title but the exchanger has operational control of the property and pays any expenses on the properties including any mortgages. If the exchange fails, the EAT transfers title to the replacement property to the exchanger on day 181, no tax is due but the exchanger has to carry both properties as owner and has to acquire another property in the future if it wishes to conduct a standard or reverse 1031 exchange involving the relinquished property that never closed Romer Debbas, LLP IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein; and is strictly to be used for informational purposes only and should not replace the advise of a tax attorney or an accountant. 9