Realtors Land Institute presents Tax Deferred 1031 Real Property Exchanges A Land University Course Facilitator Guide Copyright 2004 by the, an affiliate of the National Association of REALTORS. All rights reserved. Revised.
About the The, an affiliate of the National Association of REALTORS, was founded in 1944 and is dedicated to improving the professional competence of its members in land brokerage. The Institute focuses on land brokerage transactions of five specialized types: farms and ranches; undeveloped tracts of land; transitional and development land; subdivision and wholesaling of lots; and site selection and assemblage of land parcels. Institute members also engage in other land specialties such as agribusiness, appraisal, consulting, and management. RLI also offers the Accredited Land Consultant (ALC) designation, which is awarded to those who meet educational and experience requirements. RLI's chapter marketing sessions provide a forum for members to represent client's interests, whether buying, selling, or exchanging. The Institute: Identifies its members as land consultants within the real estate profession. Develops and maintains professional standards of practice. Fosters professional expertise through educational activities Awards the professional designation of Accredited Land Consultant (ALC) to members who have meet educational and experience requirements Formulates recommendations for public policy affecting land use Advocates the wise use of land and the reasonable rights and privileges of private ownership. Endeavors, through its marketing programs, to enhance members' business activities.
The thanks the following individuals for their contributions of expertise and experience and their assistance in development of this course. Dan Page, CCIM Sarasota, Florida David Baker, ABR Spokane, Washington Richard Halderman, ALC Wabash, Indiana Copyright 2004 by the, an affiliate of the National Association of REALTORS. All rights reserved. Revised.
Tax Deferred 1031 Real Property Exchanges Table of Contents 1. Introduction...1 Course Goal...1 Course Organization and Objectives...2 2. The Fundamentals...3 1031 Exchanges a Tax Deferral, Equity Preservation Opportunity...3 Eligibility for a 1031 Exchange...5 Business and Investment Objectives for a 1031 Exchange...5 Advantages and Disadvantages of a 1031 Exchange...6 Four Basic Rules...8 Boot in 1031 Exchanges...15 Basis...19 Identifying Properties...23 Documenting Intent to Exchange...29 Reporting the Transaction...30 Types of Exchanges...31 Tenants-in-Common Exchanges...41 3. Safe Harbors and Intermediaries...45 Four Safe Harbors...45 Security or Guarantee Arrangements...45 Qualified Escrow Accounts and Trusts...46 Interest and Growth Factors...47 Qualified Intermediaries...47 Disqualification as an Intermediary...50 How Are Real Estate Agents Paid?...52 4. Practicum: Concepts in Action Case Studies...55 Case Study 4.1: Asking the Right Questions...56 Case Study 4.2: A Deferred Exchange...58 Case Study 4.3: Tenants-in Common...60 Case Study 4.4: The Family Farm...62 5. Putting it all Together...65 Recognizing and Evaluating Potential Exchange Situations...65 Finding an Accommodator/Intermediary...66 Pitfalls...68 6. Tool Kit and Resources...71 TITLE 26--INTERNAL REVENUE CODE...72 Exchange Basis Adjustment Form...76 Glossary...77 Summary of Key Documents and Court Cases...79 Sample Exchange Addendum...83 Resources...84 Capital Gain Tax Rates...86 Sale of Personal Residence Tax Summary...88 Case Study Answers...90 Sample IRS Forms...94
Facilitator Preparation Checklist 1-2 weeks prior to course Read all course material and facilitator guide information, note where you will add your own thoughts and comments. Facilitator notes are shown in the margin of this guide. Obtain information on state laws, if any, impacting 1031 exchanges Confirm time, location, room set up, and number of students Confirm availability of AV equipment (projection unit or overhead projector) projection screen, wireless mic (if needed), flip charts Plan class agenda and select course activities to include in instruction. Ask sponsor if course will be offered for CE credit and what requirements are to be met Obtain permission from publisher to photocopy any magazine, journal, or newspaper articles that will be used as handout material Download PowerPoint presentation from Course Providers Resource page to computer hard drive (for optimum performance). Make transparencies from the PowerPoint presentation if a projection unit is not available for computer hookup Practice use of PowerPoint presentation or transparencies Confirm availability of any experts who will participate in the course presentation Make copies of IRS Forms 8824 and 4797 (obtain from IRS website, www.irs.gov) and Exchange Basis Adjustment Form (see course Toolkit). During Presentation Arrive one hour before start of class Set out handouts Check AV equipment: Projection unit or overhead projector, flip charts, mic (if needed) Hook up computer to projection unit and practice blanking projection unit screen Check availability of student materials Welcome students as they arrive Inform students of agenda for class and any CE requirements Take attendance if requested by sponsor Distribute and collect evaluation forms Administer completion exam
Chapter 1 Introduction 1. INTRODUCTION Taxes are an integral part of all real estate transactions, particularly for commercial and investment property. As a cost of doing business, taxes are an important factor in calculating cash flow and return on investment while property is held in ownership, and yield when the property is sold. This course focuses on 1031 tax-deferred exchanges in real estate transactions. When property is sold outright, the realized gain is taxable, although the Internal Revenue Code (IRC) exempts limited gains from sales of a personal residence. When property held for investment or productive use in trade or business changes hands through an exchange, taxes on the gain can be deferred. Tax-deferred 1031 exchanges, referred to by its section of the IRC, enable owners of real property held for investment or productive use in trade or business to defer, not avoid, taxes that would be due upon disposition by exchanging it for other real property. The underlying philosophy of the 1031 exchange is to allow the property owner to continue an investment and defer the taxes that would ordinarily be due on the gain from a sale. Slide 1 Welcome Slide 2 As a Courtesy Real estate exchanging is a powerful sales tool that can save clients valuable tax dollars. A real estate professional whose business includes commercial and investment property and agricultural land can provide a valuable service for clients by recognizing situations in which a taxdeferred exchange could save tax dollars and by helping them formulate the transaction. In the case of tax-locked properties, or properties that have greatly appreciated in value, the 1031 exchange offers a taxdeferred method for disposing of a property and acquiring another. WELCOME students and INFORM them of the course goal and objectives. Course Goal The goal of this course is to teach real estate practitioners to recognize and evaluate situations in which a 1031 tax-deferred exchange would be advantageous for a client, explain the tax saving benefits of the 1031 exchange as an alternative to selling and buying replacement real estate, and work with the client and a team of experts to structure the transaction. It is assumed that the student is experienced in handling real estate transactions, is familiar with basic tax terminology, and has a working knowledge of how real estate income and transactions are taxed. Slide 3 Course Goal 1
Tax Deferred 1031 Real Property Exchanges Course Organization and Objectives Slide 4 Objectives Slide 5 Objectives Objectives Gain an understanding of how the rules governing 1031 tax-deferred real property exchanges are applied and how transactions are put together. Explain the tax deferral benefits of a 1031 exchange. Recognize and evaluate situations in which a 1031 tax-deferred exchange could be to the client s advantage. Involve and work with intermediaries and other experts to structure the transaction. Course Organization The course material is organized as follows: Slide 6 Day One Slide 7 Day Two INFORM students of the schedule for the course, including breaks and lunch arrangements, if any. ENCOURAGE participants to ask questions and share their experiences with the class. Day One The Fundamentals: The first portion of the course covers the principles of 1031 tax-deferred real property exchanges. Safe Harbors and Intermediaries: Most exchanges necessitate use of a safe harbor and an accommodator or intermediary to structure the transaction. Intermediaries are experienced in handling the complexities of exchanges and assuring that the goal of tax deferral is met. Day Two Practicum: The workshop portion of the course helps participants put concepts into action by working through case study examples. Putting the Deal Together: In the final portion of the course, the focus is on recognizing and evaluating potential exchange situations, counseling the client, finding a qualified intermediary, and avoiding pitfalls in exchange transactions. Completion Exam: Successful completion of this open-book exam is required for credit toward the Accredited Land Consultant designation, which is awarded by the. 2
Chapter 2 The Fundamentals 2. THE FUNDAMENTALS 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. -Internal Revenue Code, 26USC 1031 1031 Exchanges a Tax Deferral, Equity Preservation Opportunity One of the most powerful tools for helping clients sell appreciated business, farm, and investment real estate is the Section 1031 exchange. It is a powerful tool because it accomplishes two positive economic outcomes for the property owner: Deferral of capital gain taxes that would ordinarily be due upon sale. Preservation of equity. In structuring a real estate deal, business reasons should always be the driving factor for deciding to sell a real property and acquire another one. If the deal makes sense from a business perspective, then structuring the transaction as a 1031 exchange can produce significant tax dollar savings for the seller. Exchanging properties involves complexities and costs and, as such, probably makes most sense when the potential tax liability outweighs both. There will be instances when the outright sale of a property and recognition of the resulting gain makes the best business and economic sense, and helping the client evaluate these situations is one of the objectives of this course. PARAPHRASE the course text, based on the PowerPoint Slides. DISPLAY the PowerPoint slides as indicated. Slide 8 Two Positive Economic Outcomes Slide 9 When... When a tax-deferred exchange of properties makes business sense, you, as a real estate professional, can provide a valuable service. From a tax standpoint, real property 1031 exchanges require careful compliance with IRC regulations on time limits, property qualifications, exchanged values, reporting, and documentation. From a business standpoint, exchanges require identification of exchangeable properties and negotiation with replacement property owners to structure the deal. The complexities of the exchange and most exchanges are more complex than a simultaneous swap of equally valued properties require a team of professional advisors, such as a CPA, attorney, tax accountant, financial planner, lender, escrow holder, professional accommodator, and intermediary. The costs of a failed exchange in 3
Tax Deferred 1031 Real Property Exchanges Slide 12 R.E. Professional s Role Slide 10 Basic Concept Slide 11 Basic Concept Slide 13 Eligibility EMPHASIZE that the 1031 exchange is a tax savings opportunity, not a loophole. DESCRIBE how the 1031 tax exchange provisions parallel the pre-1997 tax provisions for deferral of capital gains on sale of a personal residence (section 1034). Prior to 1997, capital gains tax on the sale of a personal residence was deferred if the seller purchased a more expensive home; REFER students to the Sale of Personal Residence Tax Summary in the Toolkit and Resources Section. unanticipated tax dollars owed, lost time, and lost investment opportunity, make the involvement of experts essential. As a real estate professional, you can perform a valuable service by helping your client think through the pros and cons of a property exchange, identify exchangeable properties, and interface with the other professional advisors involved in the transaction. The role of professional advisors is to assure compliance with the regulations that make 1031 tax-deferred real property exchanges possible. Your role as a real estate professional is to help the client make the best business decisions with regard to property exchanges, assemble the team of experts, and see the transaction through to a successful outcome. The basic concept of the 1031 exchange is to enable the investor to continue an investment without adverse tax consequences. The underlying philosophy of the exchange is that income tax should not apply as long as the investment remains intact in the form of real estate. Many real estate investors are locked into ownership of property with large, unrealized capital gains; this may be particularly true for owners of agricultural land in the path of urban and resort development. If sold, the federal capital gains tax liability of five to fifteen percent (25 percent for cost recovery [depreciation] recapture) for transactions after May 5, 2003 would reduce the dollars available for reinvestment in other real estate. For many, Internal Revenue Code Section 1031 and the related regulations are a solution to the tax-locked property dilemma. It permits the investor to exchange real estate for other real estate with little or no recognition of gain. The result is that all of the investor s equity is available as consideration toward the "purchase" of the replacement property. 4
Chapter 2 The Fundamentals Eligibility for a 1031 Exchange Eligibility for a tax-deferred exchange of real property is determined by the nature of the properties involved, not the status of the taxpayer. The property must be held for investment or productive use in trade or business, and exchanged for like-kind property. Individuals and corporations both can take advantage of the tax deferral opportunity if the property meets this qualification. The distinction between property held for investment or productive use in trade or business and a personal residence may seem like a straightforward delineation. The distinction can become complicated when, for example, an owner occupies a unit in a multi-family building, or a tract of agriculture land includes a farmhouse, or a resort property is rented for part of the year. Situations like these examples will be covered later in the course presentation. Business and Investment Objectives for a 1031 Exchange If real estate professionals are familiar with the business and investment objectives that can be accomplished through 1031 exchange, they can spot the tax-saving opportunities for their clients and play a valuable role in business and financial planning. Business and investment objectives include: Diversify or consolidate Diversify one large investment into several properties or consolidate multiple investments. Farm operators may want to consolidate scattered acreages. Financial strategy Replacement property can be sought to increase cash flow or for appreciation potential based on the owner s business and financial goals. Change of lifestyle Particularly in the case of retirement, a property owner may wish to reduce day-to-day management responsibilities. EMPHASIZE that what is actually deferred is recognition of the gain for tax purposes. The amount of tax paid when the gain is recognized in the future, if ever, is determined by the taxpayer s situation then, not at the time (past) of the exchange transaction. Slide 14 Business Objectives STATE that while a sell/buy transaction may also accomplish these objectives, a 1031 exchange has the added advantage of tax deferral. Relocation If owners move or retire to other locales, they may prefer to relocate property holdings, especially resort properties. 5
Tax Deferred 1031 Real Property Exchanges Estate planning Upon death of the property owner, deferred tax on capital gains is forgiven and heirs receive a stepped-up basis equivalent to fair market value (except for the year 2010). 1 Business needs A growing or changing business may require a different amount or type of space, such as a larger warehouse facility, or more acreage. Avoid cost recovery (depreciation)) recapture Some property sales can trigger cost recovery (depreciation) recapture with negative results for the taxpayer; this is avoided in an exchange transaction because the basis is carried over to the replacement property from the relinquished one. Slide 15 Advantages NOTE: heirs always receive a stepped-up basis. Slide 16 Disadvantages Slide 17 Capital Gains & Income Tax Rates Advantages and Disadvantages of a 1031 Exchange Along with a familiarity of the business and investment objectives that can be accomplished, knowing the advantages and disadvantages of a 1031 exchange helps the real estate professional counsel the client about the suitability of the transaction. Advantages Capital gains tax is deferred on the sale of property. Heirs receive a stepped-up basis equivalent to the fair market value and tax on accumulated capital gains is forgiven. Tax-locked property is freed up, particularly properties that have been held for a long period of time and greatly appreciated in value. Money that would have gone to pay taxes can be available for reinvestment. Disadvantages Future capital gains tax rates could be higher or the taxpayer could be in a higher bracket when the gain is ultimately recognized. Basis in the replacement property is lower than if purchased outright, due to transfer of basis from the relinquished property. Exchange transactions can be complex and expensive. The transaction costs and lowered basis may outweigh the tax benefits of selling a property and buying another outright. 1 In 2010, for one year, the estate tax will be entirely repealed and the taxpayer s basis will be carried over to heirs. The current estate tax law will expire on December 31, 2010 and revert to the prior (pre-2001) law. 6
Chapter 2 The Fundamentals Losses cannot be recognized at the time of the transaction. Recognition of losses is also deferred. There are tax consequences if the net proceeds are not reinvested in real estate. Time limits must be strictly adhered to or the exchange will fail and be subject to taxation. Advantages Capital gains tax is deferred Heirs can receive a stepped up basis and tax on accumulated gains forgiven Taxed-locked property freed up Money available for reinvestment instead of taxes Disadvantages Future tax rates could be higher Transfer of basis from relinquished property Transactions can be costly and complex Losses cannot be recognized Time limits must be strictly adhered to Net proceeds must be invested in real estate REVIEW trends in capital gains tax rates. NOTE that during periods when the capital gains tax rate is high, tax deferred exchanges are advantageous. In contrast, in a period of rapid appreciation and low capital gains tax rates, an exchange may not be advantageous because of transfer of basis. 7
Tax Deferred 1031 Real Property Exchanges Slide 18 Four Basic Rules Four Basic Rules There are four basic rules that must be followed in a 1031 exchange. Real estate professionals need to know, and should probably memorize, these four fundamental principles of 1031 exchanges. All four conditions must be met, because if they are not the exchange will fail and all tax benefits will be lost. If neither of the first two conditions is met at the outset, there is no basis for pursuing a 1031 exchange. Four Basic Rules of 1031 Exchanges 1. Property must be held for investment or productive use in trade or business. 2. Property must be exchanged for like-kind property. 3. Replacement properties must be identified within 45 days after the relinquished property is transferred. 4. The exchange must be completed (replacement property received) by the earlier of 180 days or the tax return due date. Rule #1 Property must be held for investment or productive use in trade or business Slide 19 Rule 1 Qualified Property Both the exchanged (relinquished) property and the received (replacement) property must be held for productive use in trade or business (1231 property), or for investment (1221 property). Rental properties and farms are good examples of property held for use in business. A personal residence and property held primarily for sale, known as dealer property are not qualified property types. The classification of the relinquished property at the time of exchange and classification of the replacement property when received determines if the properties qualify for 1031 treatment. Therefore, for the relinquished property, classification is determined by how the taxpayer treated the property trade, business use, or investment. For property received, it is what the taxpayer will do with the property trade, business use, or investment. Since personal residences cannot be exchanged under the 1031 provisions, it is not possible to exchange business property for a personal residence. Some properties have more than one classification at the time of sale. For example, if a farmer sells or exchanges a farm including a personal 8
Chapter 2 The Fundamentals residence, the sale is allocated for tax purposes between the real estate held for personal use (for example, a personal residence that is part of a farmstead) and that held for use in a trade or business the productive acreage. Another example is the sale of a duplex where the seller lives in one unit and rents out the other unit. In a mixed-use property, such as a multi-family rental property in which the owner occupies a unit as a personal residence, the rental portion of the building could be disposed of as an exchange and the personal-use portion would receive capital gains tax treatment. (See tax treatment of personal residence in Toolkit and Resources section). Vacation Properties Can be a Problem Area the 14 Day Rule Exchanges of a vacation property can be problematic if there is any personal use of it. The IRC stipulates that a dwelling unit is considered a personal residence if during the tax year the owner occupied it more than the greater of fourteen days or ten percent of the total days it was rented to others at a fair rental price. An allowance is made for any day that is spent working substantially full-time on repairs and maintenance. This occupancy rule also applies to a family member, a person who has an interest in the property, a below-market rental, or an arrangement that lets the owner use some other dwelling. If the vacation property is deemed to be a personal residence, then it is ineligible for a 1031 exchange. If a vacation property is held as an investment and never occupied by the owner, it is clearly eligible for a 1031 exchange. If a property is occupied for personal use at any time during a year, the period of personal use must be carefully documented in order to meet the fourteen-day rental rule requirements. The difficulty for vacation properties lies in credibly documenting occupancy. Dealer Property Does Not Qualify for 1031 Exchange Dealer property is held primarily for stock in trade as part of a sales inventory. It is specifically excluded from 1031 treatment. If dealer property is sold or exchanged at a gain, the gain is taxed as ordinary income. If dealer property is sold or exchanged at a loss, the loss is deductible as an ordinary loss. To be classified as dealer property, the property must be held at the time of sale or exchange primarily for sale in the ordinary course of business. Typical examples of dealer property are subdivision lots held by the developer and condominium units held by the condo converter. These properties, in the hands of the developer and the converter, do not qualify for section 1031 treatment. The same property may qualify in the hands of another taxpayer who holds, or intends to hold, the property for business or investment use. Also, a dealer in one property may not be a dealer in another property, and if Slide 20 Rule 1 NOTE that vacation properties used by the owners a couple of weeks each year can present a problem. It may be difficult to document that the owner s occupancy does not violate the 14- day rule and, therefore, some advisors would counsel the owner to keep the vacation property strictly rental. REFER students to the Toolkit and Resources Section for a summary of this regulation. Slide 21 Rule 1 Slide 22 Qualified Property 9
Tax Deferred 1031 Real Property Exchanges the second property is held by the same party without dealer status then that property may qualify for exchange treatment. Primarily for sale is the most important factor. It does not have to constitute more than fifty percent of the purpose, it need only be the most important. However, the courts have ruled that, if an owner acquires a property for rental or investment use, but also plans to sell the property and realize a gain if the original plan becomes unfeasible, then the property is not held primarily for sale. Slide 23 Rule 1 POINT OUT that if a property owner, of land for example, becomes partner in a joint venture or participates in development, the owner is considered a dealer. The activity "in the ordinary course of business" must be directly related to the sale of that property and there must be a substantive business activity directly related to the property. Two substantive activities are sales activities related to the property and physical improvements to it. If a parcel of land is bought, subdivided, and houses for sale are built on it, it is clearly dealer property. But if a parcel of land is bought and subdivided, then sold in the form of an unsolicited offer it qualifies for capital gains tax treatment, because there was no business activity related to the property. Real Estate Agents Are Not Automatically Dealers Licensed real estate brokers and salespersons are not by this definition dealers, because they do not own the properties that are sold. The practice of listing and selling real property does not qualify the real estate professional as a dealer. In Scheuber v. Com. 371 F2nd 996, it was held that properties, purchased by a licensed real estate broker (who intended ultimately to sell) and held for realization of appreciation in value over a substantial period of time, were capital assets. If the property is listed with a licensed real estate broker, the sales activities of the real estate broker are not considered to be the sales activities of the owner. The Court has held that the real estate activities of corporations owned or controlled by an individual cannot be attributed to him even though he may be engaged full-time as an officer of the corporation. 10
Chapter 2 The Fundamentals Unqualified Property In addition to a personal residence and dealer property, the following assets are specifically disqualified for 1031 exchanges: Stocks, bonds, notes Choses in action 2 (accounts receivable) Certificates of trust or beneficial interests Securities or evidences of indebtedness or interest Interest in a partnership Yes 1031 Qualified Property No Property held for investment or productive use in trade or business Dealer property; Stock in trade or other property held primarily for sale in the ordinary course of business Stocks, bonds, notes Choses in action Certificates of trust or beneficial interests Securities or evidences of indebtedness or interest Interest in a partnership Personal residence 2 Chose is a French word meaning thing. In law, it applies to personal property. Choses in possession are personal things of which one has possession; choses in action are things one does not have in possession, but has a right of action for their possession. Choses in action are rights to recover a debt or receive money, or damages for breach of contract, or for a tort connected with a contract. These rights cannot be enforced without action and therefore are termed choses (things) in action. 11
Tax Deferred 1031 Real Property Exchanges Slide 24 Rule 2 Slide 25 Rule 2 Rule #2 Property must be exchanged for like-kind property The properties exchanged must be of a like kind. For purposes of section 1031, all real estate that is held for investment or productive use in trade or business is like kind. Property that is not like kind or cash included in an exchange is taxable boot. Like kind refers to the nature or the character of the property, not to its grade or quality. Exchanges of improved property for unimproved property and city property for country property are considered like kind. Real property within the United States (i.e., the fifty states and District of Columbia) is not treated as property of like kind if exchanged for property outside of the U.S.; foreign property is disqualified as either a replacement or relinquished property. Under a special treaty, property located in the U.S. Virgin Islands is treated as property located in the fifty states. EMPHASIZE that assets may be exchanged for assets in the same general asset class, but not between asset classes. For example, a trade of an airplane for a bus would not be like kind. Classification of like-kind assets was changed to the NAICS at the end of 2004 An Interesting Note: In an exchange of livestock gender matters; animals of different genders are not considered like kind. A trade of a bull for a cow is not like kind. Tangible depreciable personal property held for investment or productive use in trade or business can be exchanged; some examples are office furniture and fixtures, trucks, tractors, airplanes, and computer equipment. These assets can be traded as like kind if traded for an asset in the same asset class set forth in the North American Industry Classification System (NAICS). Prior to 2004, the classification system in use was the Standard Industrial Classification (SIC) System. Copies of the NAICS Manual are available from the National Technical Information Service of the Department of Commerce, or online at www.census.gov/naics. 12
Chapter 2 The Fundamentals Rule #3 Replacement property must be identified within 45 days Replacement property must be identified no later than 45 days after the date of transfer of the relinquished property. The identification period starts on the day that the title to the relinquished property is transferred and ends 45 days later. If more than one property is relinquished, the 45-day identification period begins when the first property is transferred. Rule #4 Exchange must be completed within 180 days or by tax due date The replacement property must be transferred to the taxpayer before the earlier of 180 days after the date of transfer of the relinquished property, or the due date, including extensions, of the tax return for the tax year of the exchange. If the exchange transaction is not completed within these time requirements, the property received will not qualify as like kind; it will be treated as taxable boot received. For this reason, exchanges initiated after October 15 th of a year require particular vigilance of this deadline for calendar-year taxpayers. The 180-day rule essentially forces an exchange to be completed within the same tax year that it is initiated. And, while the tax return due date may be extended, the 180-day limit cannot. Slide 26 Rule 3 Slide 27 Rule 4 13
Tax Deferred 1031 Real Property Exchanges Slide 28 Rule 4 EMPHASIZE that 180 days does not equal six months, therefore it is important to count the days on the calendar. The tax due date may intervene. Time Clock 1031 Tax-deferred Exchange Property Relinquished Begin Exchange March 1 Property Relinquished Begin Exchange Dec 1 30 days 30 days 45 days Repalcement Property Identified Identify Property April 14 45 days Repalcement Property Identified Identify Property Jan 14 60 days 60 days 90 days 90 days 120 days 120 days 150 days Earlier of 180 days or tax return due date Replacement Property Received Complete Exchange April 15 136 days * Earlier of 180 days or tax return due date Replacement Property Received Complete Exchange August 27 180 days * May file for an extension but exchange must be completed within 180 days. Slide 29 FIRPTA Remember: If property is located outside of the 50 U.S. States, District of Columbia, or U.S. Virgin Islands, it is not eligible for a 1031 exchange. Slide 30 Taxpayer Identification Number Actual Exchange Must Occur Finally, section 1031 provisions require that an actual exchange, a reciprocal transfer of property, takes place. An intention to exchange is not sufficient. A transfer of property for money consideration only is not an exchange; it would be considered a sale of a property and a purchase of another. Exchanges Involving Foreign Taxpayers Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) regulations apply to transactions in which the transferor (seller) is a non- U.S. taxpayer (individual or organization) and the property is a U.S. real property interest (USRPI). Generally, FIRPTA requires that the transferee (buyer), or the withholding agent (often the real estate agent) withhold ten percent of the amount realized by the transferor at closing and remit the withheld amount to the IRS by the 20 th day after the transaction. A foreign taxpayer may avoid the withholding requirement by providing a certification that the property is not a U.S. real property interest or the transferor is not a foreign person. If a real estate agent involved in the transaction has actual knowledge that these certifications are false and conceals this information, the agent is held liable for the tax, up to the amount of compensation received from the transaction. These regulations apply to both property sales and exchanges. 14
Chapter 2 The Fundamentals Since November 8, 2003, the IRS has required that all non-u.s. persons provide a Taxpayer Identification Number (TIN) when they buy or sell U.S. real property. The TIN is for an individual who cannot or does not qualify to receive a Social Security number. The exchanger/transferor must provide a tax identification number (TIN) on any tax withholding documents. The amount of time required (6-8 weeks or more) to obtain a TIN is an issue for exchanges. However, if a TIN is not available at the time of settlement, the IRS will accept an application for a TIN along with a tax withholding certificate. The September 2003 rulings also provided that the expedited non-recognition notice procedure [Reg Section 1.1445-2(d)(2)] cannot be used in a deferred exchange in order for a foreign seller to avoid withholding. The rationale is that transferee cannot be sure at the time of closing that the transaction will eventually qualify for a 1031 exchange, such as meeting time requirements, or that it will be entirely tax-free with no boot received by the foreign transferor. NOTE: The amount of time required (6-8 weeks or more) to obtain a TIN can be an issue for exchanges. Boot in 1031 Exchanges Boot is any cash and unlike property received in the exchange and is taxable. If boot is received in an exchange, its fair market value is recognized as a taxable gain. The amount is determined by the amount of cash received plus the fair market value of unlike property received. Boot = Cash and or Unlike Property Slide 31 Boot Slide 32 Boot 15
Tax Deferred 1031 Real Property Exchanges NOTE that cash in an exchange is always taxable. NOTE that tax on an exchange may be totally deferred or partially deferred. DISTRIBUTE copies of the Exchange Adjustment Form (page 76). INFORM students that this form is helpful in organizing and calculating exchange data. Slide 33 Boot Slide 34 Boot WORK through the example. Time allowing add an example from your own experience. Examples of boot include cash, debt relief, and any other unlike property. Unlike property may be property that falls into the asset classes defined by the IRC as exchangeable, but is not real property. For example, an airplane cannot be exchanged for real estate. Other examples of unlike property include gold, silver, foreign currency, motor homes, precious stones, and real estate to be used as a personal residence. The section 1031 tax-deferred provisions do not apply to unlike property transferred as boot in an exchange. A gain or loss will be recognized if boot is given in unlike property, other than cash. The transaction is treated as a sale of the unlike property and the regular gain and loss tax rules apply. The gain or loss is the difference between the adjusted basis in the unlike property and the fair market value at the time of the exchange. Receiving boot in a like-kind exchange does not defeat the exchange; it introduces a taxable gain into the transaction. Only the gain that results from cash and unlike property is taxable and it cannot exceed the amount of gain that would be recognized if the property was sold in a taxable transaction. The taxable gain is determined by comparing the fair market value of boot with the gain that would result from selling the property. The taxable gain is the smaller of these two amounts. Example 2.1 Real estate with an adjusted basis of $30,000 is exchanged for other real estate with a fair market value of $100,000, plus $35,000 boot. Total consideration received... $135,000 Less adjusted basis... $30,000 Total realized gain... $105,000 GAIN Total boot received... $35,000 Taxable gain is the smaller of the two... $35,000 (ONLY TO THE EXTENT OF BOOT RECEIVED) The character of taxable gain is determined by the property sold, not by the character of the consideration received. If the real estate traded is capital gain real estate, any gain recognized from boot received will be capital gain. If the property is subject to cost recovery (depreciation) recapture, the ordinary income from recapture will be recognized before the capital gain. 16
Chapter 2 The Fundamentals Debt Assumption and Mortgage Relief as Boot If either party assumes any of debts or liabilities of the other as part of the exchange, the amount of liability is treated as cash boot. An illustration follows, although in practice most financing arrangements include a due on sale provision that bars assumption of the mortgage by another party. Example 2.2 Allen exchanged real estate with an adjusted basis of $30,000 for other real estate with a fair market value of $100,000. In addition, he received $35,000 cash and the other party assumed a mortgage of $25,000. Step 1 - Total gain realized FMV of like-kind property Allen received... $100,000 Cash boot received... $35,000 Mortgage assumed by other party... $25,000 Total consideration Allen received... $160,000 Less basis of property given up... $30,000 Total gain realized... $130,000* Step 2 - Total boot received by Allen Mortgage assumed by other party... $25,000 Cash received... $35,000 Total boot received... $60,000* * lesser of two Slide 35 Boot Slide 36 Boot Example 2.2 Slide 37 Boot WORK through the example. Time allowing add an example from your own experience. Step 3 - Taxable gain Lesser amount is taxable gain... $60,000 Figuring Net Mortgage Relief Exchange transactions become more complicated when both properties are mortgaged. If both parties assume the liabilities of the other, the liabilities of one are offset against the liabilities of the other. Only the excess is treated as net boot given or received. The mortgages are netted the mortgage assumed is subtracted from the mortgage on the relinquished property. If the assumed mortgage is less than the mortgage on the relinquished property, the net liability called mortgage relief is treated as boot received. If the assumed mortgage is more than the mortgage on the relinquished property, the excess is counted as boot paid in. While a mortgage on relinquished property is counted as boot received, a mortgage assumed may be offset against this boot. This is called "netting the liabilities. When the mortgage assumed is more than the WORK through the examples. Slide 38 Boot - Netting the Liabilities 17
Tax Deferred 1031 Real Property Exchanges mortgage given up, the excess is treated as boot paid, but is subject to the following offset rule: mortgage boot paid offsets mortgage boot received, but does not offset cash or unlike property boot received. Slide 39 Boot Example 2.3 Slide 40 Boot Slide 41 Boot Example 2.4 Example 2.3 Christine exchanged land with a mortgage of $10,000 for land with a mortgage of $15,000. In addition, she received cash boot of $6,000. After offsetting the mortgages, she has paid $5,000 mortgage boot, but is not allowed to deduct this boot paid from the cash boot received. Her taxable boot received is $6,000. Treatment of Selling Expenses Transaction costs reduce both recognized and realized gain on the sale side and increase basis on the purchase side. Selling expenses include brokerage commissions and other closing costs such as title policy, escrow, and recording fees. Depending on the party that is obligated to pay, the value of the asset is adjusted accordingly. Expenses paid by the seller (exchanger) reduces the recognized and realized gain; expenses paid by the buyer are added to basis. Example 2.4 Revenue ruling 72-456 allows the broker s commission to be treated as property boot given and an offset against debt relief or property boot received, thus reducing the amount of taxable net boot received by the exchanger. Dave owned property with an adjusted basis of $30,000 and exchanged it for like-kind property with a fair market value of $100,000 plus $35,000 cash. He paid a $9,000 commission to his real estate broker. Dave s taxable gain is limited to the net boot he received $26,000. If no cash or property boot is received in the exchange, but there is net mortgage relief, sales expenses may be offset against net mortgage relief. However, if the offset creates a "loss", it cannot be deducted. 18
Chapter 2 The Fundamentals Offset Rules Cash boot paid offsets boot received. Mortgage boot paid offsets mortgage boot received Mortgage paid, if more than mortgage assumed, may not offset cash or unlike property Other boot paid may be treated as the purchase price for non-like kind property received Selling expenses offset boot received Selling expenses may offset net mortgage relief if no cash or unlike property boot is received Recognized gain may be offset by suspended losses Slide 42 Boot Offset Rules Slide 43 Slide 44 Basis Basis The term basis is the cost of a property for tax purposes. When a property is purchased outright, the purchaser s basis is the price paid for the property plus acquisition costs. Over the term of ownership, the basis of the property may change, resulting in an adjusted basis. Capital improvements to the property increase the owner s basis. Items for which the owner receives a tax benefit, such as cost recovery (depreciation), decrease basis. Anything that increases basis decreases the amount of gain, and vice versa. When the property is sold or exchanged the difference, negative or positive, between the sales price and the seller s basis in the property will determine the amount of capital gain and capital gain tax. Adjusted basis is a very important factor in real property exchanges because the basis in the relinquished property is carried over to the replacement property, regardless of the fair market value of either of the properties. This carryover of basis can be one of the disadvantages of an exchange transaction. The real estate professional should help the client carefully evaluate if it would be more advantageous to sell the current property, pay the resulting capital gains tax and purchase a property outright, resulting in a new basis, or opt for the tax-deferred benefit of an exchange with a carried-over basis, below the cost of the replacement property. NOTE that the term cost recovery is preferable to depreciation. The term depreciation implies reduced economic value or viability of an asset. Slide 45 Slide 46 Basis Slide 47 Increases in Basis Slide 48 Decreases in Basis 19
Tax Deferred 1031 Real Property Exchanges Adjustments to Basis in an Exchange Increases in Basis Cash paid in to balance equities, when the relinquished property is of lesser value than the replacement Liabilities/debts assumed on the replacement property Improvements to the property Acquisition costs (closing costs) Slide 49 Equity Slide 50 Basis Decreases in Basis Cost recovery (depreciation) Cash or nonqualified property received in the exchange Debt relief on the relinquished property Reimbursement from an insurance policy for casualty or theft loss 20
Chapter 2 The Fundamentals Exchange Basis Adjustment Form Realized Gain(Loss) Computation 1. Market value of property conveyed... $ 2. Less disposition costs... $ 3. Less basis at time of disposition... $ 4. Equals: realized gain (loss) * $* * If a (loss) skip to line 9 Sum of unlike property received Recognized Gain Computation A. Cash... $ B. Boot... $ C. Net loan relief... $ Sum of A, B & C above... $ $ $ (Realized gain line 4) (Sum of A, B, & C above) 5. Recognized Gain... $* * recognized gain is lesser of line 4 or sum of A, B, C. Computation of Unrecognized Gain 6. Realized gain (line 4)... $ 7. Less recognized gain (line 5)... $ 8. Equals: unrecognized gain... $ Computation of Substitute Basis in Replacement Property 9. Market value of acquired property... $ 10. Less unrecognized gain (line 8) or Plus realized gain (line 4) if loss... $ 11. Plus acquisition costs... $ 12. Equals: substitute basis... $ Allocation of Substitute Basis 13. Land allocation... % $ 14. Improvement allocation... % $ 15. Personal property allocation... % $ Form reprinted with permission of the CCIM Institute. 21
Tax Deferred 1031 Real Property Exchanges Slide 51 Exchange with Installment An installment note may be helpful when alternative minimum tax is an issue. Slide 52 Slide 53 Example 2.5 INFORM students that this example is included for illustration purposes. Most practitioners report that this type of transaction occurs infrequently. Exchange with Installment In the preceding examples, the fair market value of net boot received is added up and treated as recognized gain in the year of the exchange. However, there is an exception if an installment note is part of an exchange. Although the fair market value of the installment note received is boot and recognized as gain under exchange rules, this gain can be reported using the installment method of tax reporting. When an exchange includes an installment note, both exchange and installment rules apply. Section 1031 provisions limit the recognized gain to the fair market value of the net boot received. After the recognized gain is figured, the installment rules (which are elective) apply. The installment sale contract price does not include the fair market value of the like-kind property received in the exchange. Therefore, like-kind property received in the exchange is not treated as payment received. The installment sale gross profit (recognized gain) is reduced by gain not recognized in the exchange. Following is an example of a deferred exchange with installment note. Notice that the installment sale gross profit is limited by application of Section 1031 provisions since no gain is recognized from the like-kind property received. Example 2.5 Frank owned, free and clear, an investment property with a fair market value of $100,000 and a basis of $30,000. If he made a cash sale, he would be taxed on $70,000. Frank decided to make a like-kind exchange for an investment property owned by George. The fair market value of George s property is $75,000. Frank receives George s property in the exchange and agrees to accept an installment note for $25,000 to balance the equities. Frank receives no payments of principal in the year of sale. Section 1031 rules apply first and limit Frank s gross profit to $25,000 the amount of boot taken back in the exchange. The installment contract price is $25,000; the $75,000 parcel of like-kind property he received is not treated as part of the contract price. Frank s gross profit percentage is 100% the gross profit of $25,000 divided by contract price of $25,000. Since he did not collect any 22
Chapter 2 The Fundamentals payments in the year of sale, he has no recognized gain in the year of the exchange. Each year following, 100% of the principal collected that year will be recognized as taxable capital gain and no interest or penalties will be assessed because the gain was postponed. Identifying Properties There is no limit on the number or value of properties that may be relinquished in an exchange. Regardless of the number of relinquished properties that will be transferred as part of the same exchange, there are limitations on how many replacement properties may be identified. One of the following identification rules must be followed. Three Property Rule The maximum number of replacement properties that may be identified is three without regard to the fair market value of the properties. 200 Percent Rule Any number of properties may be identified as long as the aggregate fair market value is not more than 200 percent of the aggregate fair market value of all the relinquished properties. The fair market value of the replacement properties is figured as of the end of the identification period. The fair market value of the relinquished properties is figured as of the date they are transferred. Slide 54 Identifying Properties Slide 55 Three Property Rule Slide 56 200 Percent Rule For purposes of applying the three-property rule and the 200 percent rule, all identifications of property as replacement property are taken into account, but revoked property identifications do no have to be included. If, as of the end of the 45-day identification period, more than the permitted number or value of properties has been identified, the transaction will be regarded as if no replacement property has been identified. 95 Percent Rule If the exchange has failed to comply with the three-property rule and the 200 percent rule, there is still a possibility that the transaction will be treated as an exchange if it meets the test of the 95 percent rule. Any number of properties may be identified if by the end of the exchange period (180 days or tax due date), the aggregate fair market value of property acquired is at least 95 percent of the aggregate fair market value of all property identified. Any replacement property received during the identification period will be treated as identified. Slide 57 95 Percent Rule 23