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What is a 1031 Exchange and How Can it Benefit My Investment Goals?

  
 
 

Interest in the 1031 Reinvestment has mushroomed in the last 3 years. The number of 1031 exchanges has, according to tax experts, grown by over 25% in that time. Today, 1031 exchanges are a major driving force behind activity in the commercial and investment real estate markets. So what is a 1031, what good can it do the real estate investor, and what is required to make it work for you?

Section 1031 of the US Internal Revenue Code provides, within certain limits, a way of deferring capital gains taxes on profits earned from the sale of real or personal property. Please note that this document is not intended as financial guidance in conducting your own 1031 transfers. The tax laws regarding 1031 transfers are complex. Please seek the guidance of a competent tax professional and a real estate agent who, like the owner of this site, is versed in the issue and can provide accurate professional advice. This document is intended only to give you a glimpse of the possibilities to enhance your real estate investment growth.

The first important fact to keep in mind is that 1031 exchanges do not render profits from capital gains tax free! They merely provide a deferral of such taxes. Therefore, it is often wise to combine your 1031 investment strategy with other estate planning moves that a good investment advisor may suggest and that may lessen the tax burden from those deferred capital gains taxes.

The Equal or Greater Value rule states that the thing you buy as a replacement to complete the exchange must be of equal or greater value than the property you sold. Otherwise, whatever portions of the proceeds of the sale are not reinvested will be subject to capital gains tax in that tax year. They don't get covered by the deferment.

   

Next, there is the Like Kind rule. Personal property such as collectibles and art and the like are pretty strictly controlled. Selling a priceless Monet painting and investing the proceeds in a 1929 Duesenberg Convertible will definitely not qualify, no matter how much of a work of art that automobile may be. Collectible cars for cars, art for art and so forth. Fortunately, the Like Kind rule isn't nearly so tightly interpreted when it comes to real estate. Both properties must be within the United States, but such diverse property types as apartment buildings, single-family residences, business property and undeveloped land all qualify. You can even trade 1 property for multiple properties or vice-versa. If you hold a long term lease (for more than 30 years) and have options to renew that may be exchanged for a fee interest. Be sure to check with your agent and tax advisor before ruling in or out potential 1031 real estate exchanges.

Lastly, there is the Time Issue. You must identify (in writing properly executed) the replacement property within 45 days of sale and close on it within 180 days of sale of your prior holding. Day one starts when escrow closes on the sale of your prior holding. The investor must NOT take possession of the proceeds of the sale to be exchanged. Those proceeds must be held in a trust account by an independent qualified intermediary (QI) third party. So clearly, before sale of your property, your agent needs to know of your intention to use it in a 1031 exchange.

There are very specific and rather tedious rules about identification timing and methods. Rather than try to list them all here and potentially confuse or mislead someone, let it suffice to advise that as you work with us, or with any qualified 1031 real estate exchange agent, be sure to disclose you wish to access the 1031 Tax Deferral Rule as soon as you possibly can. In this way your agent can do a much better job of ensuring that your investment growth and tax deferral interests are best served during the exchange.

 

 

WHAT DOES NOT QUALIFY?

“PROPERTY EXCLUDED FROM §1031 TREATMENT” 

 

Taxpayers nationwide are able to acquire better performing properties or meet other investment objectives by under-standing the great variety of properties that can be exchanged under Internal Revenue Code Section 1031.  There are, however, some types of assets that do not qualify for non-recognition treatment, such as:

 

1) Stock in trade or other property held primarily for sale: The exclusion encompasses two aspects - A) “Stock in trade,” which is property held for sale to customers in the ordinary course of the taxpayers’ trade or business resulting in gain taxed as ordinary income and; B) “Property held primarily for sale,” which is a much more expansive category of ex-cluded property. The word primarily is viewed as being held “principally” or “of first importance.” [Malat v. Riddell, 383 US 569, 5 L. Ed. 2d 154, 86 S. Ct. 244 (1966)]. Generally the IRS considers property held primarily for any disposition as falling into the category of property held primarily for sale. [Rev Rul 75-292, 1975-2 CB 333; Wagnesen v. Comm., 74 TC 653 (1980)]. See Asset Preservation’s flyer titled “Property Held for Sale” for a more exhaustive list of factors the IRS reviews to determine if a taxpayer is holding a property primarily for sale.

 

2) Stocks, bonds or notes: Although stocks can be exchanged in a corporate reorganization under IRC §1036(a) and certain United States bonds under IRC §1037, none of these types of transactions qualify for tax deferral under IRC §1031. 

 

3) Other securities of evidences of indebtedness or interest: The scope of this category is not clear because most of the court cases addressing this category are obsolete after the 1984 amendment excluding partnerships interests from §1031 deferral. Check with your tax and/or legal advisor. 

  

4) Interests in a partnership: In 1984, the exclusion of an interest in a partnership was added to the Internal Revenue Code. [Tax Reform Act of 1984, Pub. L. No.98-369, 98 Stat.494: IRC §1031(a)(2)(D)]. Although a partnership or limited liability company (LLC) can perform an exchange at the entity level, the individual partnership interest or LLC member interest is excluded. However, an interest in a partnership that has made a valid election under IRC §761(a), to be excluded from the application of subchapter K, is treated as an interest in each of the assets of the partnership and not as an interest in a partnership. A thorough discussion is beyond the scope of this article and taxpayers should get guidance from their tax and/or legal advisors regarding timing and other issues involving exchanges where property has been held in a partnership or LLC.

  

5) Certificates of trust or beneficial interests: These represent a right to an interest in the stock or a corporation and are not considered real property.

  

6) Choses in action: A chose in action is a right to recover or receive money or other consideration or property, but a chose in action is not considered property in itself. Courts typically look to state law for the definition of a chose in action. [See Miller v. United States, 63-2 USTC & 9606, SD Ind 1963]. The chose in action exclusion is vague due to the difficulty in defining the term itself and it has rarely been used to disallow non-recognition treatment in an exchange. Some major league player contracts have been considered a chose in action and denied exchange treatment. [Ltr Rul 8453034; Heltzer v. Comm., TC Memo 1991-404, 62 TCM 518, 537].

More Info.............

A common but often misunderstood principle among those familiar with tax deferred exchanges under Internal Revenue Code Section 1031 is the notion that the vesting of the replacement property acquired in the exchange must match the vesting of the property sold by the taxpayer. In other words, if title to the property relinquished in the exchange is in a corporation, then title to the replacement property must be acquired by the same corporation.  Although the foregoing statement may be true in many cases, it is merely a guideline for structuring an exchange. What is required to complete an otherwise valid §1031 exchange is that the “tax owner” of the relinquished property must acquire tax ownership of replacement property within the exchange period permitted under §1031. Fortunately, there are many ways to acquire

tax ownership of property that can involve the use of certain business entities or trusts that are disregarded for federal income tax purposes.  Through the use of these entities in a tax deferred exchange, a wide variety of structuring opportunities become available, some of which can address an exchange clients other investment goals such as limited liability and succession planning.  In these cases, the vesting of the relinquished property may be very different than the vesting of the replacement property, although tax ownership of the replacement property is the same both before and after the exchange.

 

To make sense of the proposition set forth above, it is necessary to distinguish between: (i) federal tax ownership, (ii) state law ownership, and (iii) vesting.  In any given case, all three indicators of ownership might match up, such as an individual who holds title to investment property as “John Smith, an unmarried man”.  But even in this simple case, Mr. Smith might not actually own the property to which he holds title under state law or federal tax law. For example, many states recognize nominee arrangements under which Mr. Smith might hold title for the benefit of another person who actually owns the property. If there were such a nominee arrangement, Mr. Smith would be the record title holder, but not the tax owner or the state law owner of the property.  If Mr. Smith sells property that he holds as nominee for Mr.

Saunders, then the gain on the sale would be reported by Mr. Saunders.

 

Similarly, if title to property is held in the ABC limited liability company (ABC LLC), we know what vesting should look like and that the state law ownership rests in the limited liability company, but who is the tax owner?  The answer depends on how ABC LLC is characterized for federal income tax purposes.  If the company has elected to be taxed as a corporation, then tax ownership would be in the company.  If the limited liability company has more than one member and has not elected to be treated as a corporation for tax purposes, then it is treated as a partnership for federal income tax purposes and, again, the company is the tax owner of the property.  If, however, Mr. Smith is the sole member of ABC LLC and the company has not elected to be treated as a corporation for federal tax purposes, then Mr. Smith is the owner of the

property for federal income tax purposes. Under federal tax law, a single member limited liability company is a “disregarded entity” and its assets are treated as owned by the sole member of the company.  Thus, if Mr. Smith sells property in a § 1031 deferred exchange (property that was titled in his name), he could acquire property in ABC LLC provided that he is the sole member and the company is a disregarded entity.  The same result would follow where ABC LLC sells relinquished property and Mr. Smith acquired replacement property in his individual name.

 

Revocable trusts are another area where tax ownership, state ownership and vesting may diverge.  During the lifetime of the person who forms a revocable trust (a Grantor) and during the time he or she retains the right to revoke the trust, federal law treats the Grantor as the tax owner of assets held in the trust.  So, as the Grantor, Mr. Smith is the tax owner of assets held is his revocable trust, but the trust is treated as an entity under state law and for purposes of vesting and ownership of trust property.  Thus, Mr. Smith might sell property owned by his revocable trust as part of a tax deferred exchange and acquire replacement property in his own name.  Alternatively, if Mr. Smith sells property owned by his trust, he could also acquire replacement property in a disregarded limited liability company in which he was the sole

member, or, he could acquire replacement property in a disregarded limited liability company owned solely by Mr. Smith’s revocable trust.

 

In most of the foregoing examples, a valid exchange can be accomplished in circumstances where the vesting of the relinquished property does not match the vesting of the replacement property, so the notion that vesting of the relinquished property and the replacement property must be the same is not a hard and fast rule. What matters is that the tax owner of the relinquished property acquires tax ownership of replacement property.  The determination of tax ownership is not always a simple matter, especially for those not steeped in federal tax law, but accountants and tax attorneys can assist in structuring an exchange transaction to maximize the taxpayer’s advantage. In the last example in the proceeding paragraph in which Mr. Smith relinquishes property owned in his revocable trust and  acquires

replacement property in a disregarded limited liability company owned solely by Mr. Smith’s revocable trust, Mr. Smith not only obtained tax deferral under §1031, he obtained limited liability under state law that would protect the trust and himself from liabilities that might arise out of his ownership and operation of the property, and ensured that the property was properly held in his trust to be disposed of in accordance with his overall estate plan.

 

Asset Preservation, Inc. encourages clients to obtain competent tax and legal advice in structuring an exchange transaction.  As an experienced qualified intermediary, we have seen a broad array of transactions that qualify as tax deferred exchanges under IRC §1031.  However, because of the non-tax considerations surrounding the structure of an exchange transaction (such as limited liability, liability protection and succession planning), many exchange clients would benefit by consulting their personal tax or legal advisors before engaging in an exchange transaction.

 

Additional resource information-

The Federal Tax Code provides ways a property owner can dispose of, exchange or sell an appreciated property and receive tax benefits. Some alternatives are described below.

 

IRC Section 121 enables a homeowner to exclude capital gain taxes (up to $250,000 if filing as a single, and $500,000 if married and filing jointly) if living in the house as a primary residence for two of the last five years. Partial exemption is also available in certain unforeseen circumstances such as a move of more than 50 miles in employment, health or medical reasons, divorce or death.  Revenue Procedure 2004-51 also allows a property owner to convert a primary residence to a rental property, and later take advantage of both capital gain tax exclusion under §121 and tax deferral under §1031 by exchanging into a replacement property held for investment or for use in trade or business.

 

IRC Section 453 (Installment Sale) allows a property owner who sells a property on an installment basis to defer paying capital gain taxes to future tax years when installment payments are actually received. Essentially, the property owner provides “seller carryback financing” for the buyer and only pays capital gain taxes as the payments are received over time. A variation on this strategy is sometimes called the structured sale. In a structured sale, the seller carryback note that is held by the seller is assigned over to a high quality alternate obligor (often a financial services company or life insurance company with high insurance ratings) who then makes payments to the seller over time under the terms of the note.

 

IRC Section 721 provides tax deferral to investors who contribute their property into a partnership entity to the extent that the contributor receives an interest in the partnership. Certain investment strategies are designed to take advantage of §721 including an operating partnership (OP) created by a Real Estate Investment Trust (REIT) sometimes referred to as an "Umbrella Partnership" or UPREIT. In exchange for the property contributed to the UPREIT under §721, the investor receives units in the operating partnership (OP Units). The capital gain taxes remain deferred as long as the UPREIT holds the property and the investor holds the OP Units.

 

IRC Section 1031 allows a property owner to defer capital gain taxes on the sale of any property held for investment or use in a trade or business when exchanged for “like-kind” property to be held for investment or use in a trade or business.

 

IRC Section 1033 provides tax deferral on the conversion of property destroyed in a casualty event or that is taken by a governmental entity through condemnation. To the extent that the property owner reinvests the compensatory proceeds for the loss in property that is similar or related in purpose or use, §1033 permits the property owner to defer recognition of gain.

 

A Charitable Remainder Trust permits a property owner to contribute appreciated property to a Charitable Remainder Trust (CRT) for the benefit of a designated charity. The contributor (called a donor) receives a charitable tax deduction on the transfer of the property to the CRT.  Having acquired the donated property, the trustee of the CRT can sell the property (at no gain to the trust) and reinvests the proceeds in income producing investments. A CRT is usually designed to pay an annuity to the donor over the donor's life or over the joint life of the donor and the donor's spouse. Any value remaining in the CRT at the donor's death passes to the charitable remainder beneficiary. There are many types of CRTS, a few of which include; A) charitable remainder annuity trust (CRAT) which pays a fixed dollar amount annually; B) charitable remainder unitrust which pays a fixed percentage of the trust’s assets annually; C) charitable pooled income fund which is set up by the charity allowing many donors to contribute. Consult with your tax and/or legal advisor for more information on CRTs or any tax strategy.



What is a 1031 Exchange?