IRC 1031 Tax Deferred Exchange Exchanges. Whitney Brennan Vice President Southeast Region, IPX

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1 IRC 1031 Tax Deferred Exchange 1031 Exchanges Whitney Brennan Vice President Southeast Region, IPX1031 1

2 Course Objectives Today s program is designed to help you better understand: Objective 1 Objective 2 Objective 3 What is I.R.S. Code Section 1031 An explanation of the basic applicability and benefits of 1031 Exchanges Exchange Process Revealed A review of the qualifications, requirements, and restrictions pertaining to 1031 Exchanges, including time for identification, time for replacement, investment intent and holding periods, property value requirements, cash out and boot, like kind property, rules of identification, taxpayers, and selecting a Qualified Intermediary. Tax Strategies A review of the benefits of 1031 Exchanges including tax deferral for the taxpayer, and client development and retention for the Real Estate Professional. 2

3 Internal Revenue Code Section 1031 No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment DEFERS taxes 1031 is NOT a tax free transaction If the sale of investment property would have a capital gains tax consequence, the investor can defer the capital gains tax by reinvesting the proceeds in another investment property; in this event, the sales contract should include exchange cooperation language. 3

4 Tax Update Higher Capital Gains Tax 3.8% Healthcare Tax Depreciation Recapture Tax State Taxes 4

5 Higher Capital Gains Tax Single investors exceeding the $400,000 income threshold and married couples exceeding the $450,000 income threshold now pay the new 20% capital gains tax rate. 5

6 3.8% Healthcare Tax The Healthcare and Education Reconciliation Act added a 3.8% Medicare surtax on net investment income. Applies to individual earning over $200,000 and married couples earning over $250,000 Net investment income includes: dividends, capital gains, retirement income and income from partnerships 6

7 Depreciation Recapture Tax Depreciation is a way to obtain a tax deduction by spreading the cost of the real estate over period of time. As a result, depreciation reduces the property s adjusted cost basis. Upon sale, the part of the gain that is related to depreciation will be taxed at the rate of 25%. 7

8 State Taxes Certain states, such as California, have a 13.3% top tax rate North Carolina 5.8% South Carolina 7.0% Georgia 6.0% 8

9 Sale vs. Exchange 1 st CALCULATE NET ADJUSTED BASIS Original Purchase Price (Basis) $500,000 plus Capital Improvements + $50,000 minus Depreciation $150,000 equals NET ADJUSTED BASIS $400,000 2 nd CALCULATE CAPITAL GAIN* Sales Price $1,200,000 minus Net Adjusted Basis $400,000 minus Cost of Sale $80,000 equals CAPITAL GAIN $720,000 9

10 Sale vs. Exchange (cont.) 3 rd CALCULATE CAPITAL GAIN TAX DUE Recaptured Depreciation (25%) $150,000 x 25% = plus Federal Capital Gain (20)% $720,000 $150,000 X 20 = plus Medicare Surtax (3.8%) $720,000 x 3.8%= plus State Tax (NC 5.8%) $720,000 x 5.8% = $37,500 + $114,000 + $27,360 + $41,760 TOTAL TAX DUE $220,620 10

11 What is Like Kind Property? In an IRC 1031 real property exchange, you can exchange real property for any other real property in the United States or its possessions, if said property is held for productive use in a trade or business or for investment purposes. Retail % Interest as a TIC Apartments Commercial Single Family Raw Land Industrial Property 11

12 Like Kind Property (cont.) With the proper intent, the following are examples of likekind real property exchanges: Residential for commercial Commercial for industrial Single family for multi family Non income vacant land for income producing Swamp land for Bank building 12

13 Like Kind Property (cont.) IRC 1031 does not apply to any exchange of: Stock in trade or other property held primarily for sale (i.e. property held by a developer, flipper or other dealer) Securities or other evidences of indebtedness or interest Stocks, bonds, or notes Certificates of trust or beneficial interests Interests in a partnership Choses in action (rights to receive money or other property by judicial proceeding) Foreign property (real or personal) for U.S. based property Goodwill of one business for goodwill of another business 13

14 Basic 1031 Rules In order to obtain a deferral of the entire capital gain tax the Exchanger must: 1. Purchase property of EQUAL OR GREATER value. 2. Reinvest ALL of the net proceeds from the relinquished property. 3. Obtain EQUAL OR GREATER financing on the replacement property than was paid off on the relinquished property. Replacement property debt can be offset with cash put into the exchange. 4. Receive nothing in the exchange but like kind property. To the extent the Exchanger fails to observe these rules they will be subject to capital gain tax. 14

15 Thumbnail Test For 100% deferral in value debt Spend ALL net proceeds 15

16 What is Boot? Any non like kind property received in an exchange Cash, installment note, debt relief or personal property Partially tax deferred exchange is valid Where exchanger receives like kind property and boot 16

17 Boot: Run The Numbers For full tax deferral, a Taxpayer must meet two requirements: 1. Reinvest all net exchange proceeds 2. Acquire property with the same or greater debt. Relinquished Value $1,000,000 Debt $300,000 Cost of Sale $60,000 Net Proceeds $640,000 17

18 Boot: Run The Numbers The Taxpayer acquired property of greater value, reinvesting all net proceeds and increasing the debt on the replacement property. Relinquished Replacement Boot Value $1,000,000 $1,300,000 Debt $300,000 $660,000 $ 0 Cost of Sale $60,000 Net Proceeds $640,000 $640,000 $ 0 Analysis: There is no boot. 18

19 Boot: Run The Numbers The Taxpayer acquired property of a lower value, keeps $100,000 of the net proceeds and acquired a replacement property with $40,000 less debt. Relinquished Replacement Boot Value $1,000,000 $800,000 Debt $300,000 $260,000 $ 40,000 Cost of Sale $60,000 Net Proceeds $640,000 $540,000 $ 100,000 Total Boot $ 140,000 Analysis: This results in a total of $140,000 in boot. ($40,000 mortgage boot and $100,000 in cash boot = $140,000) 19

20 The Exchange Process 20

21 Delayed Exchange Time Limits Day Rule The Exchanger must identify the potential replacement property or properties within the first 45 days of the 180 day Exchange period Day Rule The Exchanger must acquire the replacement property or properties within 180 days, or the date the Exchanger must file a tax return (including extensions) for the year of the transfer of the relinquished property, whichever occurs first. 3. There are no extensions for Saturdays, Sundays, or holidays. 4. The time limits begin to run on the date the Exchanger transfers the relinquished property to the buyer. 5. The date of transfer will be the date of recording or transfer of the benefits and burdens of ownership, whichever occurs first. 21

22 Exchange Identification Rules 1. Three Property Rule The Exchanger may identify up to three properties of any value % Rule The Exchanger may identify more than three properties if the total fair market value of what is identified does not exceed 200% of the fair market value of the relinquished property % Exception If the Exchanger identifies properties in excess of both Rule 1 and Rule 2, then the Exchanger must acquire 95% of the value of all properties identified. 22

23 Procedures for Property Identification 1. The property identification must be delivered to a party to the exchange that is not a disqualified party (e.g., the Qualified Intermediary). 2. It must be in writing and signed by the Exchanger. 3. It must be unambiguous (site specific). 4. It must be delivered, mailed, faxed, or otherwise sent within the 45 days. 5. An identification can be revoked within the 45 days, but the revocation must also follow steps 1 through 4. 23

24 Safe Harbor Restrictions To qualify as a Safe Harbor against actual or constructive receipt of the exchange funds, the Exchange Agreement must limit the Exchanger s right to receive, pledge, borrow, or otherwise receive the benefit of money or other property except: 1. After the end of the 45 day Identification Period, if Exchanger has not identified any replacement property; OR 2. If Exchanger has identified replacement property; then upon or after receipt by Exchanger of all replacement property to which Exchanger is entitled under the Exchange Agreement; OR 3. If Exchanger has identified replacement property; then upon or after the occurrence, after the end of the Identification Period, of a material and substantial contingency that: (a) relates to the exchange, (b) is provided for in writing and (c) is beyond the control of Exchanger and of any disqualified party, other than the party obligated to transfer replacement property to Exchanger; OR 4. After the end of the 180 day Exchange Period. 24