William J. Gessner, Esq.

Transcription

1 Exchange Solutions Group, LLC William J. Gessner, Esq. Senior 1031 Exchange Counsel Tax Deferred Exchanges Nationwide A Presentation for: Maryland Association of CPAs September 22, 2011 William J. Gessner, Esq. Former Vice President and Regional Manager of First Republic Exchange Company (OREXCO) and LandAmerica 1031 Exchange Services, Inc. Graduate of University of Baltimore School of Law (JD) Conducted exchanges on single assets ranging from $25,000 to over $350,000, Expertise in Forward, Reverse & Build to Suit exchanges Specific asset experience in office buildings, retail, NNN, hotels, beach houses, multi-family, & land. Expert Witness President Catholic Business Network of Montgomery County. 1

2 I.R.C Why is my C.P.A. Smiling? The Basics: Since 1921, there has been an exception in the tax Code that Capital Gain Tax is deferred when investment property is exchanged as opposed to sold. 2

3 What Tax is Deferred by 1031??? Capital Gain Tax has 2 Components: 1. Tax due on the profit earned on the sale of investment or income property. The profit earned is the appreciation in value of the property and is determined by gross sales price minus the adjusted basis minus the cost of sale. 2. Tax due on the recapture of depreciation previously taken by Taxpayer during the time Taxpayer owned the property. What are the Tax Rates? Federal Capital Gains rate: 15% Federal Depreciation Recapture Tax: 25% 3

4 Calculating Capital Gain Step One: Calculate Adjusted Basis Fair Market Value Original Purchase Price $300,000 Add Capital Improvements 50,000 Minus Depreciation 150,000 Equals Adjusted Basis 200,000 Step Two: Calculate Capital Gain FMV or Sales Price $450,000 Capital Improvements Original Purchase Price Depreciation Recapture Capital Gain Minus Adjusted Basis 200,000 Minus Cost of Sale 10,000 Equals Capital Gain 240,000 Adjusted Basis Federal Tax Treatment Step Three: Calculating Capital Gain Taxes Total Capital Gain $240,000 with Depreciation Recapture of $150,000. Recaptured Depreciation Tax Rate = 25% $150,000 x 25% $37,500 + Appreciation Gain Tax Rate = 15% $90,000 x 15% $13,500 15% 25% TAXES Capital Gain Total Taxes Due $51,000 4

5 Who Can Take Advantage of 1031 s? Any tax paying entity is entitled to the benefits of Section Corporations, Partnerships, Individuals, Limited Liability Companies, and Trusts can take advantage of Section Non U.S. citizens who own property in the U.S. can use the Section 1031 exception to their benefit. Why Exchange? Improve investment performance Change property types Consolidate (many properties into few) Diversify (few properties into many) Life transition Relocate Change tenants Change management Expand into larger building (headquarters or plant) Defer maintenance 5

6 Back to Basics The Code: Internal Revenue Code Section 1031 Exchange of Property Held for Productive Use or Investment (a) Non-recognition of Gain or Loss From Exchanges Solely in Kind (1) In general 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. CRITICAL Property must be held FOR: (1) INVESTMENT PURPOSES; OR (2) PRODUCTIVE USE IN A TRADE OR BUSINESS 6

7 Property must not be: Used exclusively as a Primary Residence (Second/Vacation Home) Held Primarily for Sale (Dealer Property) There Are Four (4) Basic Requirements Under Section

8 First Requirement: 1. A 1031 Transaction must involve a transfer of Real or Personal Property Qualifying Real Property Multi-Family Shopping centers Medical facilities Warehouses NNN (CVS, Wal-Mart) Factories Hotels Beach Rentals Vacant land Oil, gas, mineral, water rights Leases (30 year term remaining) Office Buildings 8

9 Qualifying Personal Property Airplanes Boats Tractors Trailers Licenses Copyrights Equipment Livestock Property Excluded from 1031 Treatment Stocks, bonds or notes Other securities or evidences of indebtedness or interest Interests in a Partnership Certificates of trust or beneficial interest Choses in action Primary residences U.S. property for foreign property Good Will Inventory / Property held primarily for resale 9

10 Second Requirement: 1. A 1031 Transaction must involve a transfer of Real or Personal Property; and 2. That property must be held for a Qualified Purpose, either as an investment, or used in a trade or business The Property Must be Held for a Qualified Purpose To qualify for Exchange consideration the Code specifically states that property must be held by the Taxpayer, for either 1) Productive use in a trade or business; or 2) For Investment. Taxpayer s purpose for holding is critical: Fact Sensitive Determined at the time of exchange Applies to Both Properties NOTE: Holding Is NOT Based on Length of Time. 10

11 Third Requirement: 1. A 1031 Transaction must involve a transfer of Real or Personal Property; and 2. That property must be held for a Qualified Purpose, either as an investment, or used in a trade or business; 3. The Relinquished Property must be Like-Kind with the Replacement Property Real Property Exchanges SFR Rental Multi-family Office Retail Industrial Hospitality Medical Care Land SFR Rental Multi-family Office Retail Industrial Hospitality Medical Care Land 11

12 Non Like-Kind Money, cash or cash equivalents Personal Property for Real Property Inventory: Property held primarily for sale Fourth Requirement: 1. A 1031 Transaction must involve a transfer of Real or Personal Property; and 2. That property must be held for a Qualified Purpose, either as an investment, or used in a trade or business; 3. The Relinquished Property must be Like-Kind with the Replacement Property; and 4. The transaction must be an Exchange as distinguished from a sale with a new purchase 12

13 Compare a Sale and Purchase vs. an Exchange The essence of a Sale and Purchase of real estate is the receipt of cash for property. The essence of an Exchange is the transfer of property for property. The Exchange is what distinguishes a Section 1031 tax-deferred transaction from a Sale and Purchase. Final Regulations Safe Harbors The Final Regulations addressed previously unanswered issues concerning the role of intermediaries and set forth Safe Harbors for structuring delayed exchanges. If a 1031 transaction falls within a safe harbor, IRS will not challenge the structure in an audit. 13

14 Qualified Intermediaries.QIs A Qualified Intermediary (QI): Is not the Taxpayer or a disqualified person, and (1) Enters into a written agreement with Taxpayer (Exchange Agreement), (2) Acquires Relinquished Property from Taxpayer, (3) Transfers Relinquished Property to Third Party Buyer, (4) Holds exchange funds, (5) Acquires Replacement Property from Third Party Seller, and (6) Transfers Replacement Property to Taxpayer. Who is a Disqualified Person? (Who cannot be a Qualified Intermediary?) 1. Any person related to the Taxpayer. 2. Any entity that is either controlled by the Taxpayer or a relative of the Taxpayer. 3. An Attorney, Accountant, Investment Banker or Broker, Real Estate Agent or Broker who has provided routine services to the Taxpayer within the two-year period ending on the date of transfer of the Relinquished Property. 4. Any person who was Taxpayer s employee, within the two-year period, ending on the date of transfer of Relinquished Property. 14

15 Types of Exchanges Deferred (aka Delayed) Simultaneous Construction (aka Build-To-Suit) Reverse Reverse Construction Non-Safe Harbor Reverse Personal Property What do you need for a valid exchange? Proper exchange documents! Proves INTENT Prevents CONSTRUCTIVE RECEIPT Provides ACCOMMODATING PARTY 15

16 TIMING IS EVERYTHING IDENTIFICATION PERIOD Begins on the date the Taxpayer transfers the Relinquished Property and ends at MIDNIGHT on the 45 th day thereafter EXCHANGE PERIOD Begins on the date the Taxpayer transfers the Relinquished Property and ends on the earlier of: The 180 th day thereafter; OR The due date for the Taxpayer s tax return, including extensions. 16

17 IDENTIFICATION MUST BE: In writing Unambiguous (The house on Main St.) Signed by the Taxpayer Sent before midnight of the 45 th day Can be revised or revoked before the 45 th day What can be identified? 17

18 Taxpayer can identify: 1. Three Properties without regard to the fair market value of the properties. 200% Rule 2. Any number of properties as long as the aggregate Fair Market Value as of the end of the Identification Period does not exceed 200% of the aggregate FMV of all of the relinquished properties as of the date the relinquished properties were transferred. (Foreclosures) 18

19 95% RULE 3. Any number of replacement properties as long as replacement properties worth at least 95% of the aggregate Fair Market Value of all identified replacement properties are received. For a successful Exchange, you must also beware of The Hidden Hazards 19

20 Hazard: Taxpayer control of Proceeds C Q I B Not Like Kind A B A Constructive receipt Potential Hazard: Settlement Statements Improperly Drafted Cash due Seller 20

21 Potential Hazard: Related Parties Potential Hazard: Change of Entity Taxpayer Entity must NOT change! The Taxpayer that sells must be the Taxpayer that buys B A Old property as ABC Partnership B New property as DEF Partnership 21

22 However!! A DISREGARDED ENTITY may be substituted for the Taxpayer... An Individual Taxpayer may purchase in a Single Member LLC Danger: Failure to Trade Up or Trade Even Two (2) Rules of Thumb: 1. Equal or Increased Sales Price. 2. All Cash or Equity Applied to Acquisition. 22

23 Complex Exchanges Reverse Exchanges Build to Suit Exchanges Reverse Construction Exchanges Distressed Properties Oh My! 23

24 A Primer A Reverse Exchange is a Section 1031 transaction where the Replacement Property is acquired before the Relinquished Property is transferred. A Reverse Exchange is generally more complex, with more requirements and greater costs. However, as we ll find out, a Reverse Exchange may make economic sense in today s complex world. Why can t we just keep it straight (deferred)? Reasons to do a Reverse... Sale contingencies on Relinquished Property not removed before Replacement Property closing. No Buyer for Relinquished Property. Taxpayer must close or lose earnest money deposit on Replacement Property. Multiple Relinquished Properties cannot all be sold prior to Replacement Property Purchase. 24

25 Revenue Procedure Provides a Safe Harbor Relinquished or Replacement Property can be parked 180-days To Complete Must have Bona Fide Intent to do an Exchange Two Reverse Types Sanctioned FRONT LEG BACK LEG EAT holds title to relinquished property AKA Exchange First EAT holds title to replacement property AKA Exchange Last Both types are similar to a deferred exchange with an additional party the EAT. 25

26 The most common reverse structure is the Back Leg Reverse Exchange where the EAT takes title and parks the Replacement Property. The Replacement Property remains parked until Taxpayer locates a buyer for the relinquished property. In this structure, the exchange does not begin until the buyer is located, but the 180 day time limit begins on the day that the EAT takes title to the Replacement Property. 26

27 Typical deferred exchange with an Added Party EAT C Buyer of your property ESG Q I You the Taxpayer A EAT B Seller of replacement property EAT holds title to the replacement property TP loans cash to the EAT plus arranges all other financing necessary to acquire replacement property B nonrecourse to the EAT The EAT parks B until TP has buyer for relinquished property C Back Leg Reverse EAT $ A B B 27

28 Back Leg Reverse EAT holds title to the replacement property EAT TP has 45 days to identify relinquished properties to EAT B B A The Exchange Occurs Within 180 Days C Q I EAT B Net proceeds paid to TP to satisfy acquisition loan to EAT A B $ 28

29 Can Improvements be made to the Parked Property? YES!! EAT can add improvements to Replacement Property. And the Taxpayer can be the Construction Manager. Examples: Repairs, Renovations, New Construction. Known as a Build to Suit or Construction Reverse Exchange. What if business requirements demand that the Taxpayer, and not the EAT, acquire title to the Replacement Property? Can this taxpayer still complete a reverse exchange? 29

30 Front Leg Reverse Exchange Less Common. but very useful! EAT holds title to the Relinquished Property The Taxpayer parks the Relinquished Property with the EAT, and immediately proceeds to acquire title to the Replacement Property. Taxpayer is actually completing his exchange first. When an ultimate Buyer is located, the EAT transfers title to the parked property to the Buyer. 30

31 Question FRONT LEG EAT holds title to relinquished property BACK LEG EAT holds title to replacement property AKA Exchange First AKA Exchange Last Which is better? As my CPA daughter and son say. it depends! Advantages of a Front Leg No Third Party Lender Issues Puts Taxpayer in Title on Replacement Property immediately Taxpayer can begin depreciating Replacement Property Timing Issues Environmental issues Advantages of a Back Leg Phase One usually available No Due on Sale Clause Issues EAT can add improvements to Replacement Property Time to decide which relinquished property to exchange 31

32 Why Reverse Exchanges Work No requirement for arms-length terms under Rev. Proc Permitted agreements include: TP can loan money or guarantee TP or a related party can manage property TP can oversee improvements Parked property can be triple-net leased to TP or to a related party Ability to adjust estimated values of relinquished property When is a Reverse Exchange economically superior to a Forward Exchange? When both the Relinquished and Replacement Properties are producing significant income! Taxpayer gets the benefit of both! 32

33 So much for a simple decision A Reverse Exchange is more complex, with more requirements and greater costs. BUT.do a Cost-Benefit Analysis before deciding. A Reverse Exchange may make economic sense. Remember Trade Up or Trade Even? 1. Equal or Increased Sales Price. 2. All Cash & Equity Applied to the Acquisition. BUT what if there s no EQUITY??? 33

34 Foreclosure - a Taxable Event Distressed owners often focus on harsh financial situation and ignore the potential tax consequences. Unfortunately, the IRS treats a foreclosure as a sale (Comm. V. Tufts) Recourse loan treatment: Tax liability calculated by taking the difference between property s fair market value and its adjusted basis Non-recourse loan treatment: Tax liability calculated by taking the difference between a property s outstanding mortgage balance and the property s adjusted tax basis Cash profit: NONE Recession comes...tenant leaves and loan is now due. What now? Hand back the keys and do a deed in lieu of foreclosure or just let the bank foreclose. Causes a taxable event. Renegotiate the loan with lender. If a CMBS loan, difficult at best. Is staying in the deal desirable? Contribute or find additional equity. Dilutes ownership with new investor 34

35 Or Acquire a zero cash-flow investment as part of a 1031 tax deferral strategy What are Zeroes and. Why Should I Care? Zeroes are highly leveraged properties, usually 88% plus, with credit rated tenants (CVS, Walgreen s, etc.), and all rental income dedicated towards debt service, thus producing zero cash flow for the property owner. When utilized in a 1031 tax deferred exchange, a Zero is a unique form of Replacement Property which, under certain circumstances, enables the property owner to defer the taxes resulting from the transfer of a distressed and/or highly leveraged Relinquished Property. 35

36 Result of handing back the keys? Non-Recourse Loan Scenario Loan Balance $13,819,426 Less: Adj. Tax Basis $2,692,308 Phantom Income $11,127,119 Tax Calculation % $2,781,780 Cap 15% $0* State 5% $556,356 Total Tax Due $3,338,136 *Accumulated depreciation exceeds the gain therefore the entire gain is taxed at 25%. Immediate Tax Savings Tax Payment Summary % $2,781,780 Cap 15% $0 State 5% $556,356 Total Tax Due $3,338,136 OR Cost of Zero 10.5% $1,451,040 Cash Savings Cost of Taxes $3,338,136 Cost of Zero $1,451,040 Cash Savings $1,887,096 36

37 Benefits of a zero cash flow investment Bond wrapped around real estate Investment grade tenant Absolute NNN lease Long term lease (20+ years) Single tenant property Equity priced as a % of the debt Meets 1031 guidelines Loan terms for Zeros Reflects credit worthiness of tenant and lease structure. Non-recourse, high leverage 90%+ DSCR= 1.0 (Rent=Debt Service) Loans are typically self liquidating 20+year terms Non re-financeable debt (Defeasance/yield maintenance) 37

38 Real Estate Fundamentals Still Apply Location, Location, Location Residual Value CAP rate Overall pricing Likelihood of renewal Available Zeroes include drug stores, grocery stores, GSA leases, other unique types of properties. Works in foreclosure and distressed situations as well as the sales of highly leveraged properties. Results of this Strategy Own real estate of the same or greater value. Have a credit rated tenant Taxes are deferred Depending on tax basis, some depreciation Depending on property cost segregation opportunity may exist. Have possible asset appreciation LIVE FOR ANOTHER DAY 38

39 Examples. Exchange Solutions Group, LLC QUESTIONS????? 39

40 William J. Gessner, Esq. Senior 1031 Exchange Counsel Tax Deferred Exchanges Nationwide Exchange Solutions Group, LLC Sunset Hills Road, Suite 300 Reston, VA x703 wwww.linkedin.com/billgessner 40