SECTION 1031 LIKE-KIND EXCHANGES A CLOSER LOOK FOR REAL ESTATE AGENTS

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1 SECTION 1031 LIKE-KIND EXCHANGES A CLOSER LOOK FOR REAL ESTATE AGENTS Introduction One might ask, why go to the trouble of qualifying a transaction as a 1031 like-kind exchange? The Internal Revenue Code (hereinafter the Code ) is tough enough to understand without digging into a complex section that could result in more tax complications. There are many answers: 1. The most obvious reason is for tax savings. Using this and other sections of the code wisely, you can defer taxes, sometimes for the rest of your life. This means the money that would otherwise have gone to pay taxes is now available for investment, and it is, by the way, interest-free money. Because the taxes have been deferred under 1031, you are, in effect, using the money interest-free until a point far into the future. 2. You can increase the depreciable basis of the property you acquire by encumbering it with a larger debt. 3. You can add sheltered income to your investment portfolio by exchanging your unimproved land for income-producing improved land. 4. You can acquire a new property without cash, and can dispose of property via an exchange when an outright sale may not be possible in the economic climate at that time. 5. You can pick up some nontaxable cash by exchanging property, and then refinancing after the exchange. 6. You can diversify your holdings without paying the taxes associated with a sale and purchase of new holdings. 7. Because the tax savings to your client (or you, as an investor) are not only substantial, but can, with the benefits of leveraged purchasing, make a tremendous difference in the ultimate value of a real estate investment portfolio. 8. Because of the tax savings, the availability of a 1031 exchange may even make the difference between no sale at all and multiple sales (with multiple commissions). Just making the client aware of some of the possibilities of a 1031 exchange may open up all sorts of future transactions that would not otherwise have occurred to him or her. 9. Because of the flexibility built into the rules, it is not necessary to immediately find the property you wish to acquire and then arrange a simultaneous exchange for the property you are selling. In fact, there are ways to exchange your fully developed property for vacant land, build a custom building on that land, and have the entire transaction qualify under In addition, we all know that the bar is always on the rise when it comes to the obligation of a professional real estate person to be competent and well-versed with respect to the latest tax, zoning, interest rates and all other matters that may impact a client s plans. While we are all obviously liable for inaccurate or erroneous advice, 1

2 we also know we can be accountable for not offering information that a client might find valuable. Again, just the mention of what can possibly be accomplished under 1031 might be the difference between a disgruntled or even litigation-minded client and one who participates in numerous transactions that are more lucrative for you than typical sales and purchases of property. As we proceed through the course there will be numerous examples of how a particular transaction might work from a tax standpoint. While we will explain how many of the calculations are done, we will not go through every detail of the various tax calculations. Not only is it too time consuming, but those sorts of details are better left to an accountant or other professional that is accustomed to this area of taxation. Therefore, you need not be concerned with whether or not the tax result is exact to the penny. Your primary interest is in understanding how an exchange can make a substantial difference in the tax result in order that you can recognize the opportunities and explain them to your client. Finally, unless you are very familiar with some the terms used in discussing tax law, this would be a good time to review the Glossary at the end of the text. A thorough understanding of common income tax related terminology will make the discussion that follows much more understandable and much easier to follow. Of particular importance are the concepts of cost, basis, depreciation, realized gain, and recognized gain. NOTE 1: The terms "he", "she", "his", "hers", etc., are used interchangeably throughout the course, and have no meaning beyond a gender-neutral indication of the person being described. Also, whenever the term "Code" is used, the reference is to the Internal Revenue Code, unless the context or the language specifically indicates otherwise. If the student desires more detailed language or deeper research into provisions of the Code, please refer to the Web Sites portion of the course. (NOTE 2: In many segments of this course you will see a familiar pattern. First, the basic concepts or rules of the issue under discussion are outlined. Exceptions, things to look out for, or other relevant matters are mentioned. Finally, the student will be cautioned that the issue is more complex than it might appear from the discussion, and is encouraged to seek counsel with expertise in real estate tax law, including competent accountants and real estate/tax law attorneys, as well as to recommend such counsel to his/her client. While a certain amount of such advice is to be expected in any course dealing with legal issues presented to non-lawyers, it is particularly appropriate in the tax law setting. The purpose of the course is to provide the real estate professional with a better understanding of how a 1031 exchange works, and the variations of such a transaction that might be of interest to the real estate professional and his/her client. It is not intended to replace competent legal and accounting advice and direction, but neither is it intended as a "feeder" to push new clients to hire accounts and lawyers. Many professionals (especially lawyers and real estate agents) have found themselves in trouble by thinking they have the knowledge or expertise to handle an issue, only to find that a little knowledge is a dangerous thing. The most astute and successful agents/brokers are those with a broad range of knowledge of their profession and the various things that impact a 2

3 transaction (price, location, competition, financing, zoning, water, etc.), who use that knowledge to recognize areas in which a specialist is necessary, and are not reluctant to suggest or bring in the specialist(s). I. The Basics A. The Code Before breaking the subject into manageable bites, let s look at the Code section itself: The full text of 1031 can be found in the Exhibits section at the end of the text, and we will look at various portions of the full text as we proceed through the course. In fact, it will be helpful in your study of this subject if you either print or remove the full text of 1031 to have handy For starters, however, the relevant portion of 1031 says: 3

4 No gain or loss shall be recognized in the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. (emphasis added) Why such a provision in the first place? The answer most commentators and experts provide is that 1031 is an effort to recognize what is really occurring. A taxpayer (hereinafter sometimes referred to as TP ) is changing the form of an investment, but it is still an investment. Selling a large tract of vacant land and then purchasing a new apartment building is much different than selling $100,000 worth of stock and purchasing that apartment building. In addition, we must remember that although the purpose of the Code is to raise money to fund the federal government s programs, the Code is now and always has been a tool for social engineering and the encouragement of business. When the government determined that home ownership was a desirable matter, real estate taxes and interest paid on home loans became deductible. When the powers-that-be wanted to encourage the use of solar energy for domestic water and space heat, the Code sprouted rules allowing for a large same-year write off of the cost of purchasing and installing such equipment. Income tax rate cuts are viewed by many as stimulating to the national economy, and are enacted for that purpose. So, understanding that a tax imposed on a theoretical gain where a TP was merely continuing the investment in an illiquid asset, 1031 was proposed and was enacted in A subsidiary reason was that discovering and pursuing the innumerable exchanges that took place each year was too great an administrative burden, so making this sort of transaction legal from a tax standpoint was beneficial to the IRS. As with many portions of the Code, the simple language of the beginning of a section is then rendered extremely complex and confusing by several pages of definitions, exceptions, and explanations of what the section really means. In addition, there are, revenue rulings, private letter rulings, regulations, revenue procedures, and court cases to further muddy the water. While the course will at least mention and briefly discuss as many of the finer points as possible, remember that the purpose is to give you sufficient information to recognize possibilities and problems, not to make you an expert in 1031 exchanges. What is a 1031 exchange? In its simplest form, your client, who will be the taxpayer or TP from this point forward, wants to sell his property and then invest the cash he gets out of it into a new, larger income property. (The Code refers to the property being sold as relinquished property, and the property being acquired as the replacement property. However, to make the discussion simpler and the properties easier to identify and remember, from this point forward, we will sometimes refer to the property being sold as the old property, and the property being purchased by TP as the new property.) If the TP follows the initial plan, selling the old property, paying the tax on the profit, and then buying the new property, he will have less cash to invest, a chunk 4

5 of it obviously having gone to pay the federal, and perhaps state, income taxes on the profit. However, if he participates in a 1031 exchange, he can defer the tax and, in some instances, avoid paying it at all. Here s how it works: Example: TP owns a building purchased 10 years ago at $30,000 TP s basis is $20,000, and the property is worth $115,000, with a loan of $50,000 TP wants to purchase a larger, more expensive property for investment income. If TP sells the property at $115,000, and paid $15,000 in closing costs and commissions, TP would have $50,000 cash to work with (115,000-$15,000 closing costs and $50,000 loan payoff). However, the tax on our imaginary transaction is $16,000, leaving only $34,000 to apply toward the next purchase. However, if the TP does a like-kind exchange, the tax is deferred, which means our TP-client has $50,000 to apply to the next property. Obviously, this permits a higher down payment, lower purchase money loan, etc. In addition, it may earn you some additional commission money on the exchange, because you will also be involved in that transaction. In today s market, $16,000 is probably not that significant. However, the same types of ratios can apply if you are dealing with larger numbers. If you were to merely add a couple of zeros to the foregoing numbers, and could therefore defer $1,600,000 in taxes rather than $16,000, the difference in your client s bargaining position on the price of the new property and the terms of the acquisition loan is obviously significant. A purchaser with an additional $1,600,000 available as a down payment is in a much better position to deal with the seller and his, the client s, banker. NOTE: Like-kind exchanges are not limited to real estate. However, the rules are a little different for items of personal property, and, unless specifically pointed out or discussed, all comments and rules in the course deal with 1031 real estate exchanges. 5

6 B. Elements of a 1031 Exchange For simplicity of discussion, we have broken these elements in to seven (7) requirements or rules that must be met to qualify the exchange under Many authorities consider qualified and like-kind as a single requirement, but we will consider them separately. These requirements are: 1. Both the old and new properties must qualify as investment or business use. If both properties qualify, almost any type of real estate can be exchanged. 2. The properties must be like-kind. 3. Unless it is a simultaneous exchange of properties, you have 45 days from the closing of the sale of the old property to list or identify the new properties you may wish to acquire. 6

7 4. Again, if it is not a simultaneous exchange, you have 180 days to close the purchase of the new property or properties. 5. You must use a Qualified Intermediary (hereinafter QI ) to prepare the paperwork and hold the proceeds of the sale of the old property. The QI must meet the definition of a QI in the Code. 6. Title to the new property must be taken exactly as you held title to the old property. 7. To defer all tax on the gain, you must pay a price for the new property at least equal to the selling price of the old property, and all cash from the sale must be reinvested in the new property. We will look at each of these elements, and explore some of the interesting variations that can be of benefit to your client. 1. Qualified Property Both the old and new properties must be qualified and must be like kind. What does this mean? The Code divides real estate in to property held for business use ( 1231), property held for investment ( 1221), property held for personal use, and property held primarily for sale (also referred to as dealer property. Only property described under 1221 and 1231 qualify for like-kind exchange treatment under Before we cover what property qualifies, note that there are six (6) specific types of property that do not qualify for 1031 treatment: Stock in trade or other property held primarily for sale Stocks, bonds or notes Other securities or evidences of indebtedness or interest 7

8 Interests in a partnership (we will discuss later a big exception to this one) Certificates of trust or beneficial interests Choses in action (a right to something such as payment of a debt or damages for injury, that can be recovered in a lawsuit With those exclusions in mind, let s look at what does constitute qualified property for a 1031 exchange. Real estate used in business is 1232 property. The two types of business real estate are: 1. Property occupied by the TP and used in the TP s business, such as the factory used to produce the TP s products, and perhaps a storage warehouse to the TP uses to hold unsold inventory. 2. Rental income property. For example, a factory property owned by the TP and leased to a third party qualifies the property as being used in a trade or business. Likewise, an apartment building rented to third party tenants would also qualify as property used in a trade or business. While both the new and the old property must be qualified under the rules, it is important to remember that they need not both be under the same definition. That is, if the old property is real estate used in business, such as the factory described in paragraph 1, above, and the new property is an apartment building as described in paragraph 2, both properties qualify and meet the qualify requirement of the Code. Real Estate held for investment is 1221 property. It means property held primarily for appreciation in value due to location, the passage of time, and other factors outside the activities of the owner. Raw land, for example, is presumed to be held for appreciation. However, if your primary business is purchasing raw land, having it subdivided, and then building and selling homes, that land would almost certainly not be deemed investment real estate for purposes of On the other hand, even if the raw land had been purchased with future development in mind, if you did not develop it but at a later time offered it for sale, still as raw land, it most likely could be considered 1221 investment property and could be used in a 1031 exchange. 8

9 2. Like-kind Property The next requirement is that the property be like-kind. This is sometimes considered the most confusing aspect of a 1031 discussion. Like-kind does not mean the same as or identical to. Like-kind is a term defined by the Code strictly for purposes of defining the rules under which the income tax on an exchange of this type of property can be deferred. Bearing this in mind, the test for like-kind is whether the real estate in question falls under the definition of either real estate used in a business ( 1231) or real estate held for investment ( 1221). In addition, both the old and the new property must be located in the same country to be deemed like-kind. Qualified property that is in any of the 50 United States 9

10 is like-kind if exchanged for other qualified property in any of the 50 United States. By process of elimination then, if either the old or new property is outside the U.S., it would not be qualified and would be treated as boot. (Glossary) However, both the old and the new properties are located in the same foreign country, are otherwise qualified properties, and would be subject to an income tax upon sale, they would most likely qualify for 1031 exchange treatment also. 3. Identification of New or Replacement Property (45-day rule) Unless the exchange of properties is simultaneous, the next requirement is that the TP identify the property or properties that the TP may wish to acquire in exchange for the old property. One of the developments in the 1031 area has been the delayed or deferred exchange. It is unusual and very fortunate if a TP can locate just the new property she wants together with an owner that is willing to accept the TP s property in an exchange. Even if that unusual circumstance should occur, the current owner of the new property will usually want to sell it, not just exchange it. That brings about the need to find a third party to purchase the old property once the exchange has been completed. 10

11 Faced with this type of problem, in the 1970 s a taxpayer named Starker sold some timberland using a Fortune 500 company as a qualified intermediary (don t worry about the QI at this point, it will be covered a couple of sections on). Starker directed the QI to use the proceeds of the timberland sale to acquire several pieces of new property over a period of two years. He claimed this was a like-kind exchange under The IRS disagreed and the issue was fought through the courts and the 9 th Circuit found the transactions qualified as 1031 like-kind exchanges under the Code as then written. The Congress was unhappy with what appeared to be an unlimited timeframe within which a taxpayer could use It therefore amended 1031 to add two time limits, the first being the 45-day identification rule in 1031(a)(3): For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if - (A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or Although it states the requirement in a backward approach (the new property doesn t qualify as like-kind if it is not identified on or before 45 days after the old property is sold), the net effect is once the old property is sold, the TP must identify the new property on or before 45 days have expired. These are calendar days, not business days, and no extensions are allowed. The next section will teach you what identify means, including the rules that can limit the TP s choices. Identify does not just mean the TP lists a bunch of properties that she might wish to have in place of the old property. To properly identify the new property, the TP must: Provide a specific description, such as name of building, address, legal description, etc. Identify EITHER o Any three (3) properties, regardless of value, or o More than 3 properties so long as the total value of those properties is not more than twice the value of the old property (the 200% rule). If there is more than one old property transferred, and those transfers take place on different dates, the 45-day period begins on the date of the earliest transfer. 11

12 The list must be a written document, signed by the TP and hand delivered, mailed, telecopied, faxed or otherwise delivered to the QI or any other person involved in the exchange other than the TP. If the TP wishes to do so, the list of identified properties can be amended by replacing one or more new identified properties IF, AND ONLY IF, the substitution is completed before the 45-day deadline expires. Note that if the new property consists of more than one property, any property actually received before the 45 days expires is considered identified without further action by the TP. 4. The 180-day rule Once again, if the transaction was not a simultaneous exchange, the TP must close the purchase of the new property no later than the earlier of: midnight of the180th day from the initial transfer of the old property, or the due date (including extensions) for the TP s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs. For many taxpayers that wish to participate in a 1031 delayed exchange, this time limit is not a great concern. They are typically able to locate the new property and complete the transaction within the 180-day limit. 12

13 However, think about the problem of exchanging a developed property, such as a factory, for an undeveloped tract upon which the TP wishes to build a larger factory. You will see later that the rules allow for this type of exchange, and for the cost of the new factory to be included in the calculations of the cost of the new property. But, the only portion of the new factory that can be included in the calculation is the portion that is completed within the 180 days. Given that most large construction projects cannot be completed within such a short period, the TP runs the risk of incurring a substantial tax despite his or her best efforts to comply. Another area to watch out for in the construction area is that the property that has been identified is substantially the same as the property that the TP receives at the time of the actual exchange. We know that there are often numerous changes from the original plans for any construction project, let alone a large one. The risk is that the changes are so substantial that the IRS takes the position that the property delivered is not the same property that was identified at the time of the 45-day notice. There is no easy answer to this issue; however, one can see the importance of being as certain as possible about the description and details of the construction project that is identified as the new property. 5. The Qualified Intermediary The next requirement to qualify for a 1031 exchange is the use of a qualified intermediary, or QI. One of the philosophical theories behind the tax-free exchange policy is that the transactions necessary to convert one investment into another of like-kind is that these transactions are truly just exchanges of properties rather than a sale of one property and subsequent purchase of a new or replacement property. In a simultaneous exchange, there is not, in tax terms, a sale, merely an exchange. To maintain that legal fiction in the case of a non-simultaneous exchange, the Code creates the QI concept. 13

14 1031 does not define QI, it merely lists those who cannot be a QI, and are therefore disqualified: TP s attorney TP s CPA TP s real estate agent Any relative of the TP Any employee of the TP Any business associate of the TP The goal is that the QI must be a completely independent party. You may recall that the QI is the party that holds the proceeds from the sale of the old property, using those proceeds to purchase the new property that is ultimately deeded to the TP. The theory here is that the TP has no control over or access to the funds, and so has never actually received the funds from the sale. You will see later this is another fiction created by the Code to support the theory that a delayed exchange is actually the same as a simultaneous exchange. That is not to say there is anything wrong with this method of reasoning, but it is sufficiently tortuous that it requires substantial and carefully drafted paperwork to satisfy the Code requirements. The existence of the QI concept created a substantial new business. There are literally thousands of businesses around the U.S. that hold themselves out as QI s. Most promote themselves as sufficiently experienced and knowledgeable in 1031 exchanges that they can handle all the paperwork, the disbursement of funds, and the recording of documents involved in the transactions. Because they are truly independent of the TP, they meet the Code test and can be of tremendous assistance in seeing that the transactions proceed as required. A few of these QI s are included on the Web Sites page. CAVEAT: While many companies are in the QI business, this area is not regulated by state or federal laws. Therefore, a TP is well-advised to do some serious homework before retaining a QI. A 1031 exchange will involve hundreds of thousands, if not millions, of dollars in terms of the value of the property to be exchanged and the cash involved. Much of that cash may be held by the QI for a period of time until a delayed exchange is completed. It is not only prudent but essential that the QI be checked out the way any potential professional would be. This means asking for and contacting references, perhaps having the TP s attorney and/or CPA interview the QI, and even determining if the QI is bonded. This is not to suggest that QI s are dishonest, but merely to suggest that in the absence of any sort of regulatory oversight, the consumer that proposes to use a QI should be every bit as careful as they would be in selecting an accountant, lawyer or CPA. In that regard, your client s attorney and/or CPA may have worked with a local QI and provide adequate assurance of its competence and integrity. 14

15 6. Title to the New Property The Code also requires that title to the new property be taken exactly as it was held in the old property. This does not limit the person or entity that can use Any individual or business entity (corporation, partnership, trust, limited liability company, etc.) can do a like-kind exchange. However, the entity or person that takes title to the new property must be the same entity or person that held the title to the old property. The test is whether, when filing an income tax return involving the new property, exactly the same name appears as the TP. 15

16 Therefore, if your TP client is a corporation, the title holder of the new property must be the same corporation. If John and Mary are married, the title to the new property must also be in John and Mary. However, if John and Mary are brother and sister, and file separate individual returns, Mary could, under the rules, exchange for any new property in her name alone. (but see Related Parties, below.) The problem this creates most frequently involves partnerships or limited liability companies. Often one or more members or partners in the entity want to receive cash, while the remaining members or partners wish to use 1031 to acquire a larger property. There are ways to solve the problem, and they will be discussed in the Variations unit. A. A sort of subsidiary issue is the related party rule. This rule states that there shall be no nonrecognition of gain or loss under this section (1031)... if: The TP exchanges property with a related person, and, The TP uses 1031 to not realize a taxable gain, and, Less than two (2) years after the last transfer in the exchange either the TP or the related party disposes of the property that person received. For purposes of this rule, related person means any person having a relationship to the TP described in 267 (b) and

17 (B)(1) of the Code. These are long lists, but the essence of them is that family members (brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants), corporations that are 50% or more owned by the TP, directly or indirectly, trusts, 50% or more owned partnerships, etc., are all deemed related. The result is that attempts at transfers between family members or entities that the TP controls, directly or indirectly, will be disallowed under Price and Cash Reinvestment Rule Finally, in order to defer all tax on the gain, the TP must pay at least as much for the new property as the selling price of the old property, and all cash from the sale of the old property must be reinvested in the new property. An example of how this rule works: Sale price of Old Property $100,000 Debt Payoff at closing -40,000 17

18 Cash to QI: $ 60,000 Now, if the TP directs the QI to purchase new property that costs $90,000, this does not defeat the exchange; however, the difference between the sales price of the old and new properties ($10,000) is taxable. That difference is called boot, and will be discussed in a later section. However, the point here is that because the purchase price of the new property was less than the sale price of the old property, some of the gain is taxable. Let s change the facts a little. This time, TP buys a new property for $150,000, with a loan of $100,000 and $50,000 cash down. This means the TP used only $50,000 of the $60,000 received from the sale of the old property. Again, that $10,000 will be taxable as boot, even though the purchase price of the new property was greater than the sales price of the old property. Notice that in both situations, the transaction still qualifies as a 1031 exchange; the flaw in the transactions is that by not observing the purchase price and the cash reinvestment rule, the additional cash is treated as boot, and is taxable. This boot is taxable up to but not exceeding the profit on the transaction. In other words, if the boot is $10,000, but the profit on the deal is $5,000, the tax would be based on the $5,000 figure. According to the experts, there is a common misconception that the debt on the new property has to be equal to or greater than the debt that was paid off on the old property. This is not true. So long as the purchase price of the new property is equal to or greater than the sales price of the old property and all of the cash received in the sale of the old property is reinvested in the new property, there should be complete deferral of income tax on the transaction. II. Boot: Extra Cash in the Deal Now that we know the basic elements of a 1031 exchange, we will examine more closely an area that can cause unintended and unpleasant tax consequences. You recall that the last element necessary to qualify the transaction for deferral of all capital gains tax was the purchase price/cash reinvestment rule. If this rule was not followed, we learned that the shortfall in either the purchase price of the new property or in the amount of cash reinvested would be treated as boot, and would be taxable, at least up to the total profit on the transaction. In its typical backward fashion, the Code states: 18

19 (b) Gain from exchanges not solely in kind If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property (b), IRC In simpler language, if the TP receives some new property that does not qualify as like-kind, the fair market value of that property, as well as any cash received, then the gain on the transaction becomes immediately taxable. The limit on the amount that is taxable is the cash and fair market value of the non like-kind property that is received. Any such non like-kind property and cash is referred to as boot. However, remember that there is a limit on the amount that can be taxed in this situation. That limit is the lesser of the capital gain or the value of the money and non like-kind property received. If the boot has a total value of $25,000, but the gain is $50,000, the tax would be based on $25,000. If the boot has a total value of $50,000, but the gain on the transaction was $25,000, the tax would once again be based on $25,000. Before we look at how boot is calculated, it is important that you understand the difference between realized gain and recognized. For purposes of a 1031 transaction: Realized gain is the amount received in the transaction (both like-kind and non like-kind property, including cash) minus the basis in the old property. The formula would be: Value of all property received basis in old property = realized gain. Another way to think of it would be that realized gain is the profit on the transaction, ignoring the effects of Recognized gain is the amount or portion of the realized gain that is taxable. It could be referred to as the amount that will be taxable in the current tax period after application of the deferral rules under Presuming 1031 applies to the transaction, recognized gain will always be less than realized gain. Yet another way to think of these concepts is that realized gain is the amount of profit your client actually made on the transaction, while recognized gain is the amount the client will owe taxes on. 19

20 Here are some examples of how boot is calculated. Remember, the transaction qualifies as a 1031 exchange, which means that at least a portion of the tax on the profit will be deferred. Example 1: TP owns investment property with a basis of $10,000 and fair market value of $50,000. The second party also owns investment property with a basis of $25,000 and fair market value of $50,000. They exchange their properties in a 1031 exchange. TP has a realized gain of $40,000 ($50,000 value of property received minus $10,000 basis = $40,000. However, TP does not recognize gain at the time of the exchange because the all property received is qualified and like-kind. Therefore, the tax on the gain is deferred. The second party has a realized gain of $25,000 ($50,000 value of property received minus $25,000 basis). And, because the property received was all qualified, like-kind property, the second party likewise has no recognized gain, with all tax being deferred. Example 2: TP owns investment property with a basis of $50,000 and fair market value of $80,000. TP exchanges the old property for qualified investment property with a fair market value of $60,000 plus cash of $20,000. TP has a realized gain of $30,000 ($80,000 value of property received minus $50,000 basis = $30,000. Because cash if not qualified property, the TP has a realized gain of $20,000, the value of the cash or boot received. As you can see, even though this transaction did not achieve complete tax deferral, there was still benefit to the TP because while there was a real gain of $30,000, the tax due will be calculated only on $20,000. Example 3: You recall that boot includes not only cash, but also any other property received by the TP that does not qualify as 1031 exchange property. 1031(a)(2) lists such non-qualifying property as including stocks, bonds, notes, partnership interests, beneficial interests in choses in action, and any other property that fails the like-kind test. Here is how boot would be calculated in a transaction that includes both qualifying and non-qualifying property: TP exchanges a large, unimproved parcel with a fair market value of $500,000, and TP receives a shopping center with fair market value of $250,000, maintenance equipment worth $50,000 and a promissory note of $200,000. The unimproved parcel and the shopping center are clearly qualifying, like-kind property. The maintenance equipment is qualifying property that can be exchanged under 1031; HOWEVER, it is not like-kind as compared to the unimproved parcel. 20

21 The promissory note is non-qualifying property. The result is our TP client has received boot in the amount of $250,000, consisting of the $50,000 in maintenance equipment and the $200,000 promissory note. Example 4: Another area of boot that can create problems involves exchanges in which the properties are not of approximately equal value. The IRS may look at this type of transaction as an attempt to hide boot, and therefore attach the transaction as being only a partial qualification under For example: TP and her business associate own equal tenant-in-common interests in two separate parcels of investment property. They have a falling out, and TP sues her associate for breach of contract, breach of fiduciary duty, and anything else the lawyer can think of. TP and her associate arrive at a settlement. TP deeds her interest in Parcel A to her associate, and the associate deeds his interest in Parcel B to TP. The result is that TP owns 100% of Parcel B and the associate owns 100% of Parcel A. If Parcels A and B are approximately the same value, the transaction should qualify for complete deferral of tax under HOWEVER, if Parcel B is substantially more valuable than Parcel A, the IRS would take the position that TP had received boot. It would claim that TP ended up with a more valuable parcel than her associate because what the transaction really involved was a transfer of Parcel B to TP in exchange for her interest in Parcel A plus a release of TP s claims against the associate. As we learned before, choses in action are not qualifying property; therefore, the IRS would argue that the associate received both qualifying property (the TP s interest in Parcel A) and boot in the form of a release of TP s claim against the associate. So, while the associate has eliminated the TP s claim against the associate, he has created a claim against the TP in favor of the IRS!! In analyzing these types of transaction, remember that, depending on the structure of the transaction, both parties to an exchange can be considered to either be giving or receiving boot. It is important to look at the property going both directions and analyze each side of the transaction for anything that might be boot. A. Treatment of Liabilities Another trap for the unwary in the area of boot is the debt that is associated with the properties being transferred. Treasury Regulation (d)-2 states in part:... the amount of any liabilities of the taxpayer assumed by the other party to the exchange (or of any liabilities to which the property exchanged by the taxpayer is subject) is to be treated as money received by the taxpayer upon the exchange. 21

22 In other words, in calculating boot, and therefore what amount, if any, may be taxable now as opposed to deferred, you must consider the debt that is attached to each property. If both properties involved in the exchange have debt, the Code allows you to net them for purposes of calculating boot. That is, the amount of the debt on the old property, whether paid off by the closing of the transaction or remaining on the old property, is netted against the debt that is conveyed with the new property. Example: TP owns the Tan Apartments with a basis of $100,000, a loan of $80,000, and fair market value of $200,000. Trader 2 owns the Blue Apartments with a basis of $175,000, a mortgage of $150,000, and fair market value of $250,000. In the exchange, TP transfers the Tan Apartments to Trader 2, and receives $40,000 cash plus the Blue Apartments, while Trader 2 receives the Tan Apartments. Both apartment complexes are transferred with their existing loans in place. With those basic facts, the analysis of the tax impact is for both parties: Taxpayer: o Receives $250,000 in real estate plus $40,000 cash plus relief from $80,000 in debt on apartments transferred, for total consideration of $370,00. o From the $370,000 we subtract $100,000, the basis of the Tan Apartments, and the debt that remains on the Blue Apartments, $150,000, for a remaining total of $120,000. o Those two calculations have the effect of netting the liabilities-we added the $80,000 debt for the Tan Apartments that were transferred and subtracted the $150,000 for the Blue Apartments that were received. o The remaining $120,000 is the gain realized by TP on this transaction. o The next step is to determine the gain that must be recognized. Remember, realized is the actual profit on the deal, recognized is the amount that cannot be deferred and must bear a tax now as a result of the transaction. o Recall that TP received $40,000 cash as part of the deal. We know that cash is non-qualifying property, or boot. o We also know that the liabilities are netted; so, having been relieved of the $80,000 debt on the Tan Apartments, but having received the $150,000 debt on the Blue Apartments, our TP has no net boot received other than the $40,000 cash. (Note: the excess debt our TP received is not offset against the cash.) o Therefore, the $40,000 is treated as boot and our TP must, on the next tax return, recognize $40,000 of the $120,000 gain we calculated before. 22

23 Trader 2 o Receives $220,000 in real estate plus relief from $150,000 in debt on apartments transferred, for total consideration of $370,000. o From the $370,000 we subtract $175,000, the basis of the Blue Apartments, plus the $40,000 cash given plus the debt that remains on the Tan Apartments, $80,000, for a remaining total of $75,000. o As before, the effect of the calculations is to net out the liabilities. o The remaining $75,000 is the gain realized by Trader 2 on this transaction. o The next step is to determine the gain that must be recognized. Remember, realized gain is the actual profit on the deal, recognized gain is the amount that cannot be deferred and must bear a tax now as a result of the transaction not being fully tax-deferred. o Under Treasury Reg (d)(2), consideration received in the form of cash is not offset against consideration given in the form of property subject to a liability. That is, the $40,000 received by Trader 2 cannot be offset by the $150,000 debt to which the received property is subject (the $150,000 mortgage). o This means that there are no offsets to the gain, and Trader 2 must also recognize the full $75,000 capital gain on the next tax return. This is a somewhat confusing concept. Boot given in the form of cash or other property may be netted against boot received in the form of an assumption or receipt of liability of the property transferred. Those same regulations do not permit the offset of consideration received in the form of cash against consideration given in the form of property subject to a liability. On the face of it, this seems contradictory. However, the Tax Court provides this explanation :... a taxpayer who receives cash... to compensate for a difference in net values must recognize a gain... to the extent of the sum of the cash received and the net difference in favor of himself between the mortgage of the property transferred and the mortgage on the property received. Furthermore, he cannot offset the cash boot received by the net of the mortgages eve if the property he receives has a larger mortgage. Barker v Commissioner, 74 T.C. 555 (1980) In all candor, it isn t much of an explanation. It merely restates the rule without providing an explanation or the rationale for the rule. That being said, the important thing to remember is that this is how the rule works. 23

24 III. Title Issues We know from an earlier section that one of the requirements to qualifying for 1031 exchange treatment is that the title to the new property must be held in exactly the same manner as title to the old property. In many transactions, probably the majority, this is not a serious issue. If the investor held title to a group of apartments as a sole proprietor, limited liability company (LLC), corporation, etc., the investor merely takes title to the new property in the same way, and the requirement is satisfied. However, as business dealings grow more complex, and particularly as member of a partnership, joint venture or LLC grow older or need to liquidate their investments for such things as medical expenses, education of children, or even retirement, the transactions can become much 24

25 more complex. For any number of reasons, one or more members of the group may wish to be cashed out. The remaining members may wish to go on to a larger investment. Whatever the reason, if it is clear that the composition of the new entity will be different from the original group, it appears 1031 will not apply because title to the new property will, by definition, be held differently than was the old. Prior to the 1984 Tax Reform Act, investors utilized some rather convoluted methods to permit their transactions to qualify for 1031 treatment. Some of these efforts resulted in prolonged litigation with the IRS, but the courts tended to be somewhat lenient, reasoning that the underlying theory of 1031 nonrecognition is the continuity of investment by the taxpayer(s). The Tax Court generally would permit 1031 qualification if the underlying assets of the old and new general partnerships were qualifying assets under the Code. That is, the court examined the economic reality of the transaction rather than relying solely on the issue of how title was held. This IRS approach to denying the benefits of 1031 treatment to partnerships led to a variety of different schemes to avoid characterization as partnerships. In Chase v. Commissioner, 92T.C. 874 (1989) the partnership issued a deed conveying an undivided percentage interest in the partnership property to the taxpayer. The taxpayer never received any rental income directly for the tenants, never paid any operating expenses, and the deed was not recorded until; immediately before the closing of the sale. The court held that in substance, (the partnership) disposed of the apartments, not the individual, and therefore there was no 1031 exchange. There are several variations created by innovative tax planners, including the drop and swap (distribution of partnership property followed by the exchange, the preplanned contribution of property into a partnership, and the swap and drop (a partnership level exchange followed by disposition of the property). These are all complex transactions, and should be undertaken only after careful disclosure of all facts to the client s tax advisors, and careful planning. However, the point is that there are ways for partnerships to benefit from a 1031 exchange. IV. Variations and Creative Use of 1031 A. Reverse Exchanges and Revenue Procedure The foundation of the reverse or deferred exchange (reverse and deferred will be used interchangeably in this discussion) is the case of Starker v. U.S., 602 F.2d 1341 (9 th Cir. 1979). You may recall we discussed this case in the Identification of New or Replacement Property unit. In the Starker case, the taxpayer had, over a 2-year period, exchanged timberland for multiple purchases of replacement real property identified by the taxpayer after the sale of the timberland, using a Fortune 500 company as the intermediary. The IRS 25

26 challenged the nonrecognition of gain, and the battle was fought through the courts for a number of years. The Ninth Circuit Court of Appeals, often characterized in recent years as the Ninth Circus Court due to the extraordinarily high rate of reversals of its opinions by the U.S. Supreme Court, adopted the taxpayer s argument, and permitted nonrecognition of the gain under In response, the Congress adopted 1031(a)(3), which crated the 45-day identification period and the 180-day replacement period we have previously discussed. However, in its preamble, IRS Regulation (k)-1 states that the deferred exchange rules did not apply to a reverse Starker exchange, that is, an exchange in which the replacement property is acquired before the relinquished or old property is transferred. This situation created an obvious predicament for the taxpayer. If the taxpayer was obligated to close on the sale of the replacement property, but there has been a delay in the closing of the sale of the relinquished property, the regulation would seem to preclude nonrecognition of the gain. Prior to Rev. Proc , the most commonly used method of avoiding this nonrecognition risks was to park the replacement property with an accommodation party, with that party holding the replacement property until the taxpayer identified the property he intended to relinquish. A variation on the parking approach was for the accommodation party to acquire the replacement or new property on behalf of the taxpayer, and then immediately exchange it for the old or relinquished property. The accommodation party then held the old property until the taxpayer could arrange for a sale to a third party. While these parking approaches often worked, they were still considered risky in that they were subject to challenge by the IRS. To remedy this situation, and, according to the language of the document, Rev. Proc was adopted... in the best interest of sound tax administration, to provide taxpayers with a workable means of qualifying their transactions under The purpose is to provide a safe harbor under which the IRS will not dispute: (1) the qualification of property as either replacement property or relinquished property for purposes of 1031 of the Code; or (2) the treatment of the exchange accommodation titleholder (accommodation party) as the beneficial owner of such property if the property is held in compliance with a qualified exchange accommodation agreement (QEAA). Rev. Proc details the requirements of a QEAA. As with most tax law, the language can be a little tedious. Therefore, the key words or phrases in the following requirements are in bold type to help you remember them. A QEAA must include: Qualified indicia of ownership of the property must be held by an accommodation party that is not the taxpayer or a disqualified person. Qualified indicia of ownership is defined as legal title to the property, though there are other indicia that can be considered. 26