Section 1031 Exchanges under the United States Internal Revenue Code (26 U.S.C. 1031)

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1 Section 1031 Exchanges under the United States Internal Revenue Code (26 U.S.C. 1031) Presented by: A. Jay Kenlan, Esq. Kenlan, Schwiebert, Facey & Goss, PC 1

2 Section 1031 Exchanges under United States Internal Revenue Code (26 U.S.C. 1031) 1031 of the Internal Revenue Code has been and will continue to be one of the most effective tax planning tools in the Code. It has been used over the years to enable taxpayers to defer gain and the payment of taxes on the sale of real and personal property that has been held for investment or in a trade or business. In the past, much of the structuring of exchange transactions was ad hoc, without much guidance from the IRS. In recent years, the Service has provided Revenue Procedures and other guidance that have made the 1031 exchange process more rational and predictable. The following is a brief overview of the more significant aspects of 1031 exchanges. INTRODUCTION: 1031 is a powerful tax DEFERRAL tool, not tax avoidance tool 1031 is a powerful tool within limits 2

3 Powers: Limits: Convey appreciated investment or business real or personal property without paying income tax on the transfer. Acquire new/different investment or business property. Limited to business or investment real and personal property not available for personal use property, stocks, etc. Basis of replacement property is the basis in the relinquished property limits depreciation. Form over substance (but substance still counts). The forms of the documents and the proper steps in the transaction are critical shortcuts, lack of attention to the form and timing requirements, can be fatal to the exchange. Importance of qualified parties - even if the forms and timing are good, using disqualified parties can doom the exchange: Escrow Agents Qualified Intermediaries 3

4 Exchange Accommodation Titleholder Disqualified parties include: Anyone related to the taxpayer Anyone who has or has had, within the past 24 months, a professional or financial relationship with the taxpayer, including: Attorney Accountant Financial advisor Real estate agent IMPORTANCE OF COMMUNICATION CLIENT-ATTORNEY-ACCOUNTANT- FINANCIAL ADVISOR Establish 1031 Team (accountant, attorney, Qualified Intermediary ( QI ), Exchange Accommodation Titleholder ( EAT ), etc.) before the Taxpayer s property ( Relinquished Property ) is put on the market or the property to be acquired by the Taxpayer (the Target Property or the Replacement Property ) is acquired. 4

5 Establish a transaction checklist and assign transaction responsibilities before the transaction begins moving forward Keep the 1031 Team advised of all events before or as they occur THE BASICS The Relinquished Property must be qualifying property, that is, real or personal property held by the Taxpayer for investment or in a trade or business. NOT personal use property Some limits on personal property The Replacement Property must be like-kind property Same nature, class or quality Quality or grade does not matter Improved real property may be exchanged for unimproved real property Real and personal property may be exchanged for real and personal property Taxpayer s taking (or controlling) cash or other non-like kind property before exchange is complete will defeat the exchange Time limits in deferred exchanges are critical 5

6 Facilitators (QIs and EATs) must be qualified, that is, unrelated to the Taxpayer TYPES OF EXCHANGES Simultaneous Exchanges Delayed Exchanges Reverse Exchanges Build-to-suit Exchanges THE HELD-FOR REQUIREMENT Must be held for investment or in a trade or business Not held-for property: Inventory property is not held-for property Personal residence is not held-for property Land held for resale is not held-for property Corporation common stock is not held-for property Timing: no safe harbor but two years has been deemed an adequate time to hold Replacement Property acquired in an exchange one year is possible depends on the circumstances the burden is on the taxpayer 6

7 EXCHANGES MUST BE IN THE SAME NAME The Taxpayer who is conveying the Relinquished Property must be the same Taxpayer who acquires the Replacement Property BOOT IS TAXABLE Cash is always boot. Constructive receipt of cash makes the cash boot Always replace with equal or greater value property. TYPES OF EXCHANGES Simultaneous exchanges Delayed ( Starker ) exchanges Reverse exchanges: Exchange First (park Relinquished Property) Exchange Last (park Replacement Property) Use Exchange Accommodation Titleholder (EAT) Use Qualified Exchange Accommodation Agreement (QEAA) 7

8 Improvement, Construction, or build-to-suit exchange Must use Exchange Last reverse exchange with EAT and QEAA DELAYED EXCHANGES Exchange Agreement with QI or EAT Identification the 45 day rule Three-property rule 200% Rule 95% Rule Written notice of Identification Counting days: To whom? EAT Description of Replacement Property Within 45 calendar days from the date when the triggering event occurs, Replacement or Relinquished Property must be identified Within 180 calendar days from the date when the triggering event occurs: 8

9 Relinquished Property must be sold and conveyed to third party, and Replacement Property must be conveyed to the Taxpayer Triggering events are the dates of transfer of title, not the date of entering into QEAA WHO IS THE QI OR THE EAT Not the taxpayer Not a disqualified person such as Family members of the Taxpayer Controlled entities of the Taxpayer Agent of the Taxpayer Employee of the Taxpayer Attorney for the Taxpayer Accountant for the Taxpayer Investment banker for the Taxpayer Real estate agent or broker for the Taxpayer 9

10 Service providers title insurance companies, escrow agents, qualified intermediaries, etc, may be QIs and EATs REVERSE EXCHANGE where the Taxpayer must control the title to Replacement Property before transferring Relinquished Property In 2000, IRS established guidance - Rev. Proc safe harbor QEAA (Qualified Exchange Accommodation Agreement) is required Taxpayer must enter into QEAA with EAT QEAA must be entered into within 5 days following transfer of target property to EAT QEAA must satisfy IRS requirements: Designation of an EAT EAT will hold legal title to the target property State a bona fide intent to do an exchange EAT will file federal tax returns relating to the ownership of the Replacement Property 10

11 Relinquished or Replacement Property must be identified within 45 days after transfer of title to target property to EAT alternate or multiple Replacement Properties may be identified Transfer of title to Replacement or Relinquished Property to taxpayer must occur within 180 days following transfer of title to EAT EAT may lease the Replacement or Relinquished Property to Taxpayer QEAA may assign management responsibility for the Replacement or Relinquished Property to the Taxpayer QEAA may assign responsibility for construction management of Replacement Property (build-to-suit) to Taxpayer Taxpayer may guarantee financing of Replacement Property to be acquired by the EAT Rev. Proc is a safe harbor, not a requirement Taxpayer can structure outside of the safe harbor but has the burden of proof EXCHANGE FIRST/EXCHANGE LAST REVERSE EXCHANGES Exchange Last 11

12 EAT sets up Single Purpose Entity ( SPE ) to take title to the Replacement (Target) Property first Taxpayer arranges for financing for acquisition of Target Property Taxpayer may provide financing or may guarantee financing for acquisition Financing is non-recourse as to EAT Relinquished Property must be identified in writing to the EAT within 45 days Multiple Relinquished Properties can be identified Relinquished Property must be sold and conveyed by Taxpayer to Purchaser within 180 days not under contract SOLD and conveyed out of Taxpayer Exchange First EAT takes title to the Relinquished property first Replacement Property must be identified in writing to EAT within 45 days of the date when the EAT takes title to the Relinquished Property Multiple properties can be identified, subject to limits 12

13 Title to Replacement Property must be transferred to Taxpayer within 180 days Title to Relinquished Property must be transferred to Purchaser within 180 days IMPROVEMENT, CONSTRUCTION, OR BUILD-TO-SUIT EXCHANGE Must use Exchange Last reverse exchange with EAT and QEAA To qualify for safe harbor treatment: Title to Replacement Property must be taken by the EAT EAT and contractor enter into construction contract QEAA provides that Taxpayer will be construction manager Funding from acquisition and construction comes from loan to EAT Taxpayer may make loan or guarantee loan Interest accrues until exchange is completed Construction period depreciation deferred Relinquished property must be identified within 45 days Construction must be completed within $180 days, or 13

14 Structure QEAA so that construction can be competed/materials delivered and paid for outside of 180 day period no safe harbor -, or Any unused construction funds are boot DROP AND SWAP AND OTHER VARIATIONS ON THE THEME Property held in a partnership or corporation may be distributed to the partner or shareholder and then exchanged for like kind property, however, great care must be taken in structuring the transaction consult with a qualified exchange specialist before attempting Installment sales (where the Taxpayer finances the acquisition of Relinquished Property by the third party purchaser) may be used in a 1031 exchange, however, great care must be taken in structuring the transaction consult with a qualified exchange specialist before attempting Exchange transactions with related parties are permissible, however, they are subject to special rules (such as the two year holding period rule) and great care must be taken in structuring the transaction consult with a qualified exchange specialist before attempting Other structures not covered by the safe harbor requirements may be used to accomplish a 1031 exchange, however, if the transaction is not structured to comply with the safe harbor rules, the Taxpayer has the burden of proving 14

15 compliance with Section 1031 and great care must be taken in structuring the transaction consult with a qualified exchange specialist before attempting DO YOUR HOMEWORK Like many other complex legal and accounting issues, 1031 exchange transactions require specific knowledge of the applicable statutes, rules, revenue procedures, and other sources of information, forms, and cautions concerning 1031 exchanges. All of the guidance that you need is readily available just Google Experience and practice also counts if you have any questions or are not sufficiently familiar with 1031 to structure the transaction yourself, consult with a qualified exchange specialist before attempting. IS IT WORTH THE TIME, COST, AND RISK? Before recommending a 1031 exchange to the Taxpayer, estimate the actual tax deferral/tax saving Typically, the Taxpayer should be prepared to pay fees and expenses of between $7,500 and $15,000 (over and above the normal transaction cost) for structuring even a relatively straightforward 1031 exchange; more complex exchanges can cost considerably more 15

16 All exchanges represent a tax risk greater than a normal real estate sale transaction; safe harbor exchanges are relatively safe but still present risks of timing, qualified property, etc. Exchanges only defer taxes; they do not avoid taxes Depreciation is limited to the Taxpayer s basis in the Replacement Property that is essentially the Taxpayer s basis in the Relinquished Property, plus transaction costs DISCLAIMER The material in this presentation is of the nature of general comment only and is not intended to be a comprehensive exposition of all potential issues arising from this subject matter. It is not offered as advice on any matter and should not be taken as such. Kenlan, Schwiebert, Facey & Goss, PC and the author disclaim all liability to any person in respect of anything done or permitted to be done or omitted to be done wholly or partly in reliance upon the whole or part of this presentation. Before action is taken or decision not to act is made, specific legal and tax advice should be obtained in light of the relevant circumstances and no reliance should be placed on the statements made in this presentation. 16