A 1031 Exchange (Tax-Deferred Exchange) Is One Of The Most Important Tax Deferral Strategies Remaining Available For Taxpayers. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges. Taxpayers will avoid or minimize  income taxes on the sale of property if they reinvest the proceeds in similar or like-kind property.

The 1031 Exchange Advantage permits a taxpayer to sell income, investment or business property and replace the same with like-kind Replacement Property but without having to pay federal or state income taxes on the transaction. A sale of property and subsequent purchase of a Replacement Property does not work; there must be an Exchange. The legal documents and the form of the transaction will determine if there is a 1031 exchange. The party’s intent is only one aspect. The sale and purchase escrows must be related in some aspect.

The Disadvantages of a Section 1031 Exchange include a reduced basis for depreciation deductions on the Replacement Property. The tax basis of Replacement Property will be the purchase price of the Replacement Property minus the gain which was deferred on the sale of the Relinquished Property as a result of the exchange. As a result, the Replacement Property includes a deferred gain that will be taxed in the future if the taxpayer cashes out of their investment.

Exchange Techniques. There is more than one way to structure a tax-deferred exchange under Section 1031 of the Internal Revenue Code. However, the 1991 “safe harbor” Regulations established procedures which include the use of an Intermediary, direct deeding, the use of qualified escrow accounts for temporary holding of “exchange funds” and other procedures which have Congressional and IRS approval. Therefore, the exchange needs to be structured to comply with IRS regulations. As a result, exchanges commonly use the services of a facilitator known as a Qualified Intermediary.

Exchanges can also occur without the services of an Intermediary when parties to an exchange are willing to exchange deeds or if they are willing to enter into an Exchange Agreement with each other. However, two-party exchanges are uncommon since, in the typical Section 1031 transaction, the seller of the Replacement Property is not the buyer of the taxpayer’s Relinquished Property.

If you are thinking of selling real property that you use in your trade or business or that you are holding for investment, you should consider the benefits of a like-kind exchange.

What is a like kind exchange?

In a like-kind exchange, you do not recognize any gain or loss on the disposition of real property held for the productive use in a trade or business or for investment if you dispose of the property by exchanging it solely for property of like kind that is to be held either for productive use in a trade or business or for investment.

Gain Recognized if ‘Boot’

If, in addition to receiving like-kind property, you receive cash or other property that does not qualify as like-kind property (so-called “boot”), you must recognize gain to the extent of the boot received.

Gain Deferral

In a like-kind exchange, the gain realized on the exchange of real property for replacement property does not escape tax – the tax on the gain is merely deferred until you sell the replacement property. However, by deferring the tax, you’ll have more money available to invest in another property. In effect, you receive an interest-free loan from the federal government, in the amount you would have paid in taxes. Also, any gain from depreciation recapture is postponed except to the extent you receive boot as part of the exchange and recognize gain. Further, because of the way the term “like kind” is defined, you may use the acquisition and disposition of properties to reallocate your investment portfolio (e.g., moving from commercial rental property to residential rental property) without paying tax on any gain.

IRC 1031 Qualification

To qualify as a like-kind exchange, both the property you give up (the relinquished property) and the property you receive (the replacement property) must be held for

• investment or
• productive use in your trade or business.

While taxpayers were able to use the like-kind exchange rules for exchanges of personal property in years beginning before 2018, such exchanges are no longer available  for federal income tax purposes. Only real property is eligible for the like-kind exchanges rules. Examples of property that may qualify include land, farm property, commercial  and rental houses.

The like-kind exchange rules do not apply to real property held primarily for sale. Unproductive real estate held by someone other than a dealer for future use or future realization of the increment in value is considered held for investment and not primarily for sale.

Like Kind

Also, to qualify as a like-kind exchange, the replacement property must be of a “like kind” to the relinquished property. “Like kind” refers to the nature and character of the property and not to its grade or quality. An exchange of one kind or class of property for a different kind or class is not a like-kind exchange. All qualifying real property located in the United States, improved or unimproved, is considered to be of like kind.

Deferred Exchanges

Additional requirements apply to deferred like-kind exchanges in which you do not receive the replacement property immediately upon your transfer of the relinquished property.

The Basic Rules for a 1031 Exchange

The Relinquished Property

The Relinquished Property or Properties and the Replacement Property or Properties Must Be Qualifying Property.

Qualifying Property

Qualifying property is property held for:

investment purposes or
used in a taxpayer’s trade or business.

Investment property includes real estate, improved or unimproved, held for investment or income producing purposes.

Property used in a taxpayer’s trade or business includes office facilities or place of doing business.

Real estate must be replaced with like-kind real estate. This means agricultural real property can be exchanged for residential real or commercial real properties or a combination of real properties. All that matters is that the property give up and the property or properties received must be real property as that term is defined under state law.

Non Qualifying Real Property

Property Which Does Not Qualify For A 1031 Exchange includes:

• A personal residence
• Land under development for resale
• Construction or fix/flips for resale
• Property purchased for resale
• Inventory property
• Corporate stock
• Partnership interests
• LLC membership interests
• Bonds
• Notes

Same Taxpayer

Replacement Property Title Must Be Taken In The Same Name As The Relinquished Property Was Titled.

If a husband and wife own property in joint tenancy or as tenants in common, the Replacement Property must be deeded to both spouses, either as joint tenants or as tenants in common.

Corporations, partnerships, limited liability companies and trusts must be in title on the Replacement Property the same as they were on the Relinquished Property.

The Replacement Property Must Be Like-Kind

• Improved real estate can be replaced with unimproved real estate.
• Unimproved real estate can be replaced with improved real estate.
• A 100% interest can be exchanged for an undivided percentage interest with multiple owners and vice versa.
• One property can be exchanged for two or more properties.
• Two or more properties can be exchanged for one Replacement Property.
• A duplex can be exchanged for a four-plex.
• Investment property can be exchanged for business property and vice versa.
• Agricultural property can be exchanged for commercial and/or residential property and vice versa

Personal Residences

As referenced above, a taxpayer’s personal residence cannot be exchanged for income property and income or investment property cannot be exchanged for a personal residence which the taxpayer will reside in. However, in some circumstances, vacation property can qualify if certain conditions are met. Seek professional advice from us before going that route.

Boot

Boot Received In Addition To Like-kind Replacement Property Will Be Taxable (to the extent of gain realized on the exchange). This is acceptable when a seller desires some cash or debt reduction and is willing to pay taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be completely tax free.

The term “boot” is not used in the Internal Revenue Code or the Regulations. But, it is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange.

Boot received is the money, debt relief or the fair market value of “other property” received by the taxpayer in an exchange.

Money includes all cash equivalents received by the taxpayer.

Debt relief is any net debt reduction which occurs as a result of the exchange taking into account the debt on the Relinquished Property and the Replacement Property.

“Other property” is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or “non-qualified property.” “Other property” also includes such things as a promissory note received from a buyer (Seller Financing).

A Rule Of Thumb for avoiding “boot” is to always replace with property of equal or greater value than the Relinquished Property. Never “trade down.” Trading down always results in boot received, either cash, debt reduction or both. Boot received is mitigated by exchange expenses paid.

When to Use a Like-kind Exchange

Nontaxable like-kind exchanges should be considered by taxpayers in any of the following situations:

• When a taxpayer intends to replace the real property with similar property.
• When the real property being disposed of has appreciated in value enough that a sale would result in a significant tax liability.
• When a taxpayer has nondepreciable, nonincome-producing property and wants to obtain depreciable, income-producing property. This may be particularly beneficial for taxpayers needing additional after-tax income during retirement.
• When a taxpayer wants to convert from trade or business real property (e.g., active in management) to investment real property (e.g., triple net lease property), or vice-versa.

However, in other situations taxpayers may benefit more from a taxable disposition, and should intentionally avoid or disqualify a property exchange since the nontaxable provisions are mandatory when the statutory requirements are met. These situations include the following:

• When a taxpayer has current year losses or loss carryovers (capital, net operating, charitable, etc.) that can be used to offset gain resulting from a taxable disposition.
• When a taxpayer has a built-in loss in the property being disposed of. Nontaxable exchanges not only defer taxable gains, but also losses. In such case, a nontaxable exchange would prevent the taxpayer from recognizing the loss currently.
• When a wide disparity exists between the capital gains and ordinary tax rates. Here, some taxpayers may benefit from a step-up in basis in the replacement property when a taxable sale at capital gain rates is followed by the purchase of depreciable property.
• When the gain is passive income that can be used against current or suspended passive activity losses.
• When paying tax on the gain in the current year may be more beneficial than deferring the tax because of events (such as increases in the taxpayer’s future taxable income, rising tax rates, or changes in the tax treatment of capital gains) that would produce future additional tax.

Normally, the disparity between the capital gain and ordinary income tax rates make a taxable sale followed by a reinvestment of the net proceeds a practical strategy, assuming the sale results in long-term capital gain treatment. In addition, the more the basis in the replacement property can be allocated to depreciable property and the shorter the related recovery period, the more likely a taxable sale will be a favorable alternative since it allows the taxpayer to step up basis in the replacement property.

AVOIDING LIKE-KIND TREATMENT

Situations When Like-Kind Treatment Not Advantageous

Before entering into an exchange under Code Sec. 1031, an exchanger should review the specific tax status of the property being received and the property being relinquished in order to determine the actual effects of Code Sec. 1031. Although exchangers often presume that Code Sec. 1031 is advantageous, there are situations when this presumption is not correct. Examples of situations in which an exchanger may wish to avoid like-kind treatment include:

Where there is built-in capital loss in the property being transferred that the exchanger could recognize in a sale, but not an exchange;

EXAMPLE: Abel owns Whiteacre with a cost basis of $20,000 and a fair market value of $10,000. Baker owns Blackacre with an adjusted tax basis of $2,000 and a fair market value of $10,000. Baker wants to acquire Whiteacre from Abel in a like-kind exchange. Abel does not want to acquire Blackacre but he wants to recognize a capital loss with respect to Whiteacre. If he enters into a simple like-kind exchange with Baker, Abel cannot recognize the built-in loss. Thus, it is more advantageous for Abel to sell Whiteacre, which results in recognizable loss. Note that both parties can reach their desired result by entering into a four-party exchange.

Where the exchanger has a current capital loss or net operating loss carryforward that can be used to offset all or part of the gain generated by a sale of the property;

EXAMPLE: Abel owns Blackacre with a fair market value of $10,000 and an adjusted loss basis of $5,000. Abel also has a current capital loss of $5,000. Baker owns Whiteacre and wants to acquire Blackacre in a like-kind exchange. If Abel enters into a like-kind exchange, the gain realized on the exchange is not recognized and, therefore, cannot be used to offset his current capital loss. If Abel sells the property and recognizes a gain, however, he can offset the capital loss with the gain recognized.

NOTE: If a sale generates capital gain in excess of an exchanger’s current capital loss carryforward, the exchanger may use such loss to offset the gain. This is an important factor to the extent that the property acquired is depreciable since the basis of the acquired property would be $10,000 in the case of a purchase using the proceeds of the sale, as opposed to $5,000 in the case of an exchange.

When the payment of tax in the current year is preferable to the deferral of tax. In this regard, exchangers should consider potential changes in their income, any anticipated changes in tax rates or capital gain benefits, and the anticipated holding period for replacement property received in the exchange; and

EXAMPLE: Abel wants to dispose of Whiteacre (which has appreciated in value) and obtain replacement property. Abel is not sure, however, if it is more advantageous to enter into a like-kind exchange, or a sale. If he enters into an exchange, he can defer paying tax on the gain until he disposes of the property received in the exchange. If he sells Whiteacre, he must pay a tax on the gain currently. At the time of disposition, Abel is in the 15% marginal tax bracket. If Abel believes that in future years he will be in a higher marginal tax bracket, it may be advantageous for Abel to sell the property in the current year (the proceeds of which can be used to purchase replacement property) rather than subjecting the deferred gain to an anticipated higher tax rate. Abel must consider the time period that he plans to hold onto the replacement property and assumptions as to future tax rates.

Depreciation benefits from the purchase of the replacement property are more beneficial than the cost of the tax on the capital gain from the sale of the property.

EXAMPLE: Abel has an adjusted tax basis of $60,000 in Property B which has a fair market value of $100,000. At an assumed capital gains rate of 20%, the current tax on the sale of B is $8,000 ($40,000 gain × 20%). If Abel exchanges B for Property W pursuant to Code Sec. 1031, he has a carryover basis in W of $60,000. If, on the other hand, Abel sells B and purchases W for $100,000, he will have a cost basis of $100,000. This creates additional depreciation deductions of $40,000 assuming all of W is depreciable. This depreciation is deductible against ordinary income in future years. Thus, the cost of the tax paid upon the sale of the property is clearly less than the benefit derived from the potential increased depreciation deduction. This is particularly important if there is a preferential capital gains rate. In that case, the deferred depreciation deductions will offset income subject to tax at ordinary income rates, while Abel pays tax currently on the gain at a preferential capital gains rate.
NOTE: Lost depreciation benefits are also a factor in the event the property being transferred in a Code Sec. 1031 exchange was acquired before the accelerated cost recovery system rules were adopted in 1981. In that event, the exchanger not only takes a carryover basis in the replacement property, but under Code Sec. 168, will be unable to use any accelerated cost recovery method.

Recapture:

Notwithstanding the general deferral of taxes on an exchange, Code Sec. 1245 and Code Sec. 1250 include provisions requiring the recapture of any depreciation involved in the event gain is realized in the exchange. This issue may be particularly troublesome with respect to nonresidential real property subject to recapture under Code Sec. 1245.

Methods of Avoiding Like-Kind Treatment

Lack of Mutual Dependency

Avoiding the mandatory nature of Code Sec. 1031 requires breaking the “mutual dependency” of the transaction. For example, many exchangers enter into a deferred exchange agreement as a matter of course when selling property that may qualify for exchange treatment. In the event that it is determined after the agreement is executed that exchange treatment would not be beneficial, the exchanger may attempt to avoid Code Sec. 1031 by allowing the time periods contained in the agreement to identify and close on the replacement property to lapse. This allows the exchanger to then gain unrestricted control of the proceeds and use those proceeds to acquire suitable property, thereby destroying the mutual dependency of the agreement.

Substance Versus Form

In order to receive like-kind exchange treatment, an exchanger must satisfy both the formalistic and substantive requirements of Code Sec. 1031 . Thus, an exchanger can avoid exchange treatment by structuring the transaction as something other than a like-kind exchange. If an exchanger purposely fails to meet the formal requirements under Code Sec. 1031 , but the substance of the transaction still resembles a like-kind exchange, the IRS and the courts generally will treat the transaction as an exchange and the exchanger will receive nonrecognition treatment. Rev. Rul. 61-119, 1961-1 C.B. 395 ; Greene, Joanne, (1991) TC Memo 1991-403, PH TCM ¶91403, 62 CCH TCM 512 . See Redwing Carriers Inc v. Tomlinson, (1968, CA5) 22 AFTR 2d 5448, 399 F2d 652, 68-2 USTC ¶9540 ; Biggs, Franklin B., (1978) 69 TC 905, affd (1980, CA5) 47 AFTR 2d81-484, 47 AFTR 2d 81-484, 632 F2d 1171, 81-1 USTC ¶9114. But see Young, Robert G., (1985) TC Memo 1985-221, PH TCM ¶85221, 49 CCH TCM 1439 ; Swaim, Emsy H. v. U.S., (1979, DC TX) 45 AFTR 2d 80-1276, 79-2 USTC ¶9462, affd & revd (1981, CA5) 48 AFTR 2d 81-5653, 651 F2d 1066, 81-2 USTC ¶9575.

NONTAX CONSIDERATIONS IN REAL ESTATE LIKE-KIND EXCHANGES

It is axiomatic that undertaking a like-kind exchange of real property means that the taxpayer will continue to own real property when the exchange is completed. Taxpayers who intend to sell property should consider many tax and nontax factors before deciding whether a like-kind exchange is the best option. The following are examples of nontax reasons for continuing to invest in real property following a sale:

• Consolidating investments by exchanging several small properties for one larger replacement property;
• Diversifying investments by exchanging one property for several smaller replacement properties in different locations;
• Eliminating property management problems on one property by acquiring either a problem-free property or an interest in a larger property that employs a third party property management company;
• Replacing property having limited potential for appreciation with property having greater potential for appreciation;
• Realigning some or all of a real estate investment portfolio by exchanging high-risk, high-yield property for low-risk, low-yield property, or vice versa;
• Increasing cash flow by exchanging property with limited cash flow for property with greater cash flow;
• Relocating a business by exchanging the property on which it is located for property in a different area;
• Replacing an aging commercial facility with a modern, newly constructed commercial facility;
• Increasing investment leverage by acquiring property with a smaller ratio of equity to fair market value; and
• Terminating a problem joint ownership by exchanging joint interests for separate properties.Non tax considerations may also lead the taxpayer to liquidate, rather than continue, an investment. The taxpayer may need cash liquidity or wish to invest in another form of investment. The taxpayer may be willing to pay the tax on the gain to obtain steady income with less risk. For example, a taxpayer may prefer a passive investment such as bonds or treasury bills rather than real estate.

Real Estate Interests Which Qualify as Like-Kind for a 1031 Exchange

There a surprising number of property types that are deemed ‘like kind’ under the tax free exchange rules. As examples, the  following types of real estate interests are deemed by Congress and the IRS to qualify as like-kind to each other for a 1031 Exchange:

• Fee interest
• Fractional (tenancy-in-common) interest
• Leasehold interest, 30-year plus lease
• Easements for conservation
• Easements for right of way
• Water rights
• Mineral Rights
• Oil & Gas interests
• Transferrable Development Rights
• Mutual Irrigation Ditch Stock
• City real property for a ranch or farm. See Treas Reg §1.1031(a)?1(c); Hubert Rutland, TC Memo 1977?8.
• Rental income property (house and land) for farmland and improvements but not farm machinery. See Rev Rul 72?151, 1972?1 Cum Bull 225.
• Improved real property for unimproved real property. See Treas Reg §1.1031(a)?1(b)?(c); Earlene T. Barker (1980) 74 TC 555. See §2.65 for further discussion of improvements.
• An exchange among cotenants of two or more parcels of real property so that each ends up with sole ownership of one of the parcels. See Rev Rul 79?44, 1979?1 Cum Bull 265; Rev Rul 73?476, 1973?2 Cum Bull 300; IRS Letter Ruling 9525038. See also IRS Letter Ruling 9609016.take care, however, in evaluating exchanges of property held in cotenancy because the interests exchanged may be treated as partnership interests, precluding nonrecognition treatment. See M.H.S. Co., TC Memo 1976?165, aff’d per curiam (6th Cir 1978) 575 F2d 1177.
• A 50 percent tenant-in-common interest in old-growth timberlands for a 100 percent interest in half of such timberlands. See IRS Letter Ruling 199926045. See also IRS Letter Ruling 199945046.
• A fee for a fee subject to an unexercised option. See Boise Cascade Corp., TC Memo 1974?315. See also Cary A. Everett, TC Memo 1978?53.
• A fee for the contractual right to purchase real property or equitable fee title subject to conditions precedent. See Biggs v Commissioner (5th Cir 1980) 632 F2d 1171; Starker v U.S. (9th Cir 1979) 602 F2d 1341.
• A remainder interest in one property for a remainder interest in another property. See Rev Rul 78?4, 1978?1 Cum Bull 256.
• A remainder interest in one property for a life estate in another property when the life tenant has a life expectancy of at least 30 years. See Rev Rul 72?601, 1972?2 Cum Bull 467.
• An agricultural conservation easement in perpetuity in a farm, found to be real property under state law, for a fee simple interest in real property. See IRS Letter Ruling 9232030. See also IRS Letter Ruling 200201007 and companion IRS Letter Rulings 200203033 and 200203042.
• Agricultural conservation easements over two farms for fee simple title in a different farm. See IRS Letter Ruling 9851039.
• A perpetual conservation easement encumbering real property for a fee simple interest in either farm land, ranch land, or commercial real property. See IRS Letter Ruling 9601046 (the conservation easement in question was granted by the taxpayer to the federal government over real property the taxpayer had held for many years for productive use in the business of cattle grazing and duck hunting).
• A scenic conservation easement, found to be real property under state law, for a fee simple interest in timberland, farmland, or ranch land. See IRS Letter Ruling 9621012.
• Raw land acquired by taxpayers for future use as a mobilehome park, on which taxpayers operated sand mining business under a nontransferable mining permit, for land and buildings. See Larry L. Beeler, TC Memo 1997?73.
• Transferable development rights associated with real property for a fee interest in real property. IRS Letter Rulings 200805012, 200901020.
• A utility easement for another utility easement. See IRS Letter Ruling 9814019.
• Replacement property for involuntarily converted outdoor advertising displays, which the taxpayer elected to treat as real property under an IRC §1033(g)(3)(C) election. See IRS Letter Ruling 200041027.
• Standing timber to be severed by the buyer, found to be a transfer of real property under state law, for a fee interest in land. D. G. Smalley (2001) 116 TC 450.
• The conversion of a stock cooperative into a condominium. See IRS Letter Rulings 200137032 and 200631012.
• An exchange of old growth timber for reproductive timber. See IRS Letter Ruling 200541037.
• Coal supply contracts for a fee interest in a gold mine. See Peabody Natural Resources Co. (2006) 126 TC 261. For discussion of supply contracts, see §2.68.
• An exchange of a perpetual stewardship easement for fee interest in real property. IRS Letter Rulings 200649028, 200651018, and 200651025.

The Basic Types of Exchanges

Simultaneous Exchanges

A Simultaneous Exchange is an exchange in which the closing of the Relinquished Property and the Replacement Property occur on the same day, usually back to back. There is no interval of time between the two closings. This type of exchange is covered by the Safe harbor Regulations.

Delayed Exchanges

A Delayed Exchange is an exchange where the Replacement Property is acquired at a later date than the closing of the sale of the Relinquished Property. The exchange is not simultaneous or on the same day. This type of exchange is sometimes referred to as a “Starker Exchange” after the well known Supreme Court case which ruled in the taxpayer’s favor for a delayed exchange before the Internal Revenue Code provided for such exchanges. There are strict time frames established by the Code and Regulations for completion of a delayed exchange, namely the 45-Day Clock and the 180-Day Clock (see detailed explanation below).

Reverse Exchanges

A Reverse Exchange (Title-Holding Exchange) is an exchange in which the Replacement Property is purchased and closed on before the Relinquished Property is sold. Usually the Intermediary takes title to the Replacement Property and holds title until the taxpayer can find a buyer for the Relinquished Property and close on the sale under an Exchange Agreement with the Intermediary. Subsequent to the closing of the Relinquished Property (or simultaneous with this closing), the Intermediary conveys title to the Replacement Property to the taxpayer. The IRS has issued safe harbor guidance on Reverse Exchanges (see below).

Improvement Exchanges

An Improvement Exchange (Title-Holding Exchange) is an exchange in which a taxpayer desires to acquire a property and arrange for construction of improvements on the property before it is received as Replacement Property. The improvements are usually a building on an unimproved lot, but can also include enhancements made to an already improved property in order to create adequate value to close on the Exchange with no boot occurring. The Code and Regulations do not take into account for exchange purposes improvements made to a property after the closing on the Replacement Property has occurred. Therefore, it is necessary for the Intermediary to close on, take title and hold title to the property until the improvements are constructed and then convey title to the improved property to the taxpayer as Replacement Property. Improvement Exchanges are done in the context of both Delayed Exchanges and Reverse Exchanges, depending on the circumstances. The IRS has issued safe harbor guidance on Reverse Exchanges (including title-holding exchanges for construction or improvement)

The “Held For” Requirement for 1031 Property Received or Exchanged

In order to qualify for a 1031 Exchange, the Relinquished and the Replacement Properties must both have been acquired and “held for” investment or for use in a trade or business. The amount of time that the property must be “held for” use in a trade or business is not specified in either the Code or the Regulations.

The position of the IRS has been that if a taxpayer’s property was acquired immediately before an exchange, or if the Replacement Property is disposed of immediately after an exchange, it was not held for the required purpose and the “held for” requirement was not met.

There is no safe harbor holding period for complying with the “held for” requirement. The IRS interprets compliance based on their view of the taxpayer’s intent. Intent is demonstrated by facts and circumstances surrounding the taxpayer’s acquisition of ownership of the property and what the taxpayer does with the property. The courts have been more liberal than the IRS on these issues.

Here are some examples of transactions that should be considered to have potential for a finding by the IRS that the “held for” requirement has not been met:

• The taxpayer acquires Replacement Property and immediately lists the property for sale. The IRS will interpret the intent to acquire the property for resale instead of for investment purposes.
• The taxpayer receives the Relinquished Property by deed from a partnership and immediately proceeds to sell/exchange it (aka “drop and swap”).
• The taxpayer acquires Replacement Property and immediately converts the property to a personal residence.
• The taxpayer acquires Replacement Property and immediately transfers the property to a corporation, partnership or LLC.

A cushion of time between events such as these is desirable to reduce the risk of possible “held for” issues in an exchange. Exchange Professionals recommend one year for the Replacement Property. The IRS has ruled that two years was adequate in a private letter ruling (Ltr Rul 8429039) but this was not made mandatory. In any event, the burden is on the taxpayer to support compliance with the “held for productive use in investment or a trade or business” requirement.

Delayed Exchanges – The Exchange Process and Time Clocks

A taxpayer desiring to do a 1031 Exchange lists and/or markets the property for sale in the normal manner without regard to the contemplated 1031 Exchange. A buyer is found and a contract to sell the property is executed. Accommodation language is usually placed in the contract securing the cooperation of the buyer to the seller’s intended 1031 Exchange, but such accommodation language is not mandatory.

When contingencies are satisfied and the contract is scheduled for a closing, services of an Intermediary are arranged. The taxpayer enters into an Exchange Agreement with the Intermediary, which permits the Intermediary to become the “substitute seller” in accordance with the requirements of the Code and Regulations.

The Exchange Agreement usually provides for:

• An assignment, to the Intermediary, of the seller’s Contract to Buy and Sell Real Estate.
• A closing where the Intermediary receives the proceeds due the seller at closing. Direct deeding is used. The Exchange Agreement will comply with the requirements of the Code and Regulations wherein the taxpayer can have no rights to the funds being held by the Intermediary until the exchange is completed or the Exchange Agreement terminates. The taxpayer cannot touch the funds.
• An interval of time where the seller proceeds to locate suitable Replacement Property and enter into a contract to purchase the property. The interval of time is subject to the 45-Day and 180-Day rules.
• An assignment, to the Intermediary, of the contract to purchase Replacement Property.
• A closing where the Intermediary uses the exchange funds in its possession and direct deeding to acquire the Replacement Property for the seller.

The 45-Day Rule for Identification. The first timing restriction for a delayed Section 1031 exchange is for the taxpayer to either close on the purchase of the Replacement Property or to identify the potential Replacement Property within 45 days from the date of transfer of the Relinquished Property. The 45-Day Rule is satisfied if Replacement Property is received before 45 days have expired. Otherwise, the identification must be by written document (the identification notice) signed by the taxpayer and hand delivered, mailed, faxed, or otherwise sent to the Intermediary. The identification notice must contain an unambiguous description of the Replacement Property. This includes, in the case of real property, the legal description, street address or a distinguishable name.

The 45-Day Rule for Identification imposes limitations on the number of potential Replacement Properties, which can be identified and received as Replacement Properties. More than one potential Replacement Property can be identified by one of the following three rules:

• The Three-Property Rule – Any three properties regardless of their market values.
• The 200% Rule – Any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate FMV of all of the exchanged properties as of the initial transfer date.
• The 95% Rule – Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified.

Although the Regulations only require written notification within 45 days, it is recommended practice for a solid contract to be in place by the end of the 45-day period. Otherwise, a taxpayer may find himself unable to close on any of the properties which are identified under the 45-day letter. After 45 days have expired, it is not possible to close on any property which was not identified in the 45-day letter. Failure to submit the 45-Day Letter causes the Exchange Agreement to terminate and the Intermediary will disburse all unused funds in his possession to the taxpayer.

The 180-Day Rule for Receipt of Replacement Property. The Replacement Property must be received and the exchange completed no later than the earlier of

• 180 days after the transfer of the exchanged property or
• The due date of the income tax return, including extensions, for the tax year in which the Relinquished Property was transferred.

The Replacement Property received must be substantially the same as the property that was identified under the 45-day rule described above. There is no provision for extension of the 180 days for any circumstance or hardship. There are provisions for extensions for presidentially declared disaster areas.

As noted above, the 180-Day Rule is shortened to the due date of a tax return if the tax return is not put on extension. For instance, if an Exchange commences late in the tax year, the 180 days can be later than the April 15 filing date of the return. If the Exchange is not completed by the time for filing the return, the return must be put on extension. Failure to put the return on extension can cause the replacement period for the Exchange to end on the due date of the return. This can be a trap for the unwary.

Reverse Exchanges – The Exchange Process and Time Clocks

Safe Harbor Reverse Exchanges – Rev. Proc. 2000-37 issued by the IRS on September 15, 2000 established recognition of and “safe harbor” guidance for Reverse Exchanges complying with the guidelines. These are known as “Safe Harbor Reverse Exchanges.” Reverse Exchanges which are not in compliance with the guidelines are not prohibited by Rev. Proc. 2000-37 but must stand or fall on their own merits and are referred to as “Non-Safe Harbor Reverse Exchanges.”

Reverse Exchanges of either type are common and occur when a taxpayer arranges for an Exchange Accommodation Titleholder (EAT) (usually the Intermediary) to take and temporarily hold title to Replacement Property before a taxpayer finds a buyer for his Relinquished Property. Sometimes the exchange accommodation titleholder will take and hold title to the Relinquished Property until a buyer can be found for it. Reverse Exchanges of either type are useful in circumstances where a taxpayer needs to close on the purchase of Replacement Property before a Relinquished Property can be sold or where the taxpayer desires ample time to search for suitable Replacement Property before selling a Relinquished Property which starts the 45-day and 180-day clocks for Delayed Exchanges. Reverse Exchanges are also common where a taxpayer wants to acquire a property and construct improvements on it before taking title to the property as Replacement Property. This is necessary if the value of the improvements is important for replacing with property of equal or greater value in order to avoid a taxable “trade-down.”

Rev. Proc. 2004-51 issued in 2004 added an additional requirement for Reverse Exchanges to be under the safe harbor “umbrella.” Any property which has been previously owned by the taxpayer within the prior 180 days is declared ineligible for protection under the Rev. Proc. 2000-37 safe harbor procedures.

The Safe Harbor Reverse Exchange Time Clocks. The safe-harbor procedures impose compliance requirements which require analysis for impact and planning that can be summarized as follows:

The 5-Day Rule. A “Qualified Exchange Accommodation Agreement” must be entered into between the taxpayer and the exchange accommodation titleholder (Qualified Intermediary in most cases) within five business days after title to property is taken by the exchange accommodation titleholder in anticipation of a Reverse Exchange.
The 45-Day Rule. The property to be “relinquished” (the Relinquished Property) must be identified within 45 days. More than one potential property to be sold can be identified in a manner similar to the rules of delayed exchanges (i.e., the three-property rule, the 200% rule, etc.)
The 180-Day Rule. The Reverse Exchange must be completed within 180 days of taking title by the exchange accommodation titleholder.

The 180-Day Clock. as with Delayed Exchanges, Reverse Exchanges must be completed within 180 days. Prior to the issuance of Rev. Proc. 2000-37 there was no statutory limitation of time in which to be in title. It was common for the Exchange Accommodation Titleholder to be in title on the parked property for a year or more. The taxpayer would search for a buyer for his Relinquished Property or have improvements constructed on the property being held by the Titleholder. 180 days may be a suitable time for a buyer to be found for the Relinquished Property. However, 180 days is a problem with respect to construction/improvement exchanges. The 180 day time limit within which to complete a Safe Harbor Reverse Exchange is probably insufficient for most large “build to suit” exchanges.

What if the taxpayer has not yet found a buyer for his Relinquished Property by the end of 180 days? In this case, the taxpayer can discontinue his attempt to accomplish a Reverse Exchange and take deed to the Replacement Property. The taxpayer may decide to extend his Reverse Exchange outside of the protection of the safe harbor procedures. The safe harbor guidance issued by the IRS is not mandatory. Reverse Exchanges that do not comply with the requirements of Rev. Proc. 2000-37 stand or fall on their own merits and should be considered to have a higher degree of audit risk.

Rev. Proc. 2000-37 imposes responsibilities and burdens on the Exchange Accommodator Titleholder. The Accommodator is required to report, for federal income tax purposes, the “tax attributes” of ownership of the property it is in title on. Rents and expenses attributed to ownership of the property may have to be reported by the Accommodator. It is unclear if the Accommodator has to also report depreciation on the property it is in title on just as a true owner would be compelled to do.

The Role Of the Qualified Intermediary

The role of the Qualified Intermediary is essential to completing a successful and valid delayed exchange. The Qualified Intermediary is the glue that puts the buyer and seller of property together into the form of a 1031 Exchange. Where such an intermediary (often called an exchange facilitator) is used, the intermediary will not be considered the agent of the taxpayer for constructive receipt purposes notwithstanding the fact that he may be an agent under state law and the taxpayer may gain immediate possession of the money or property under the laws of agency.

In order to take advantage of the qualified intermediary “safe harbor” there must be a written agreement between the taxpayer and intermediary expressly limiting the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the intermediary.

A Qualified Intermediary is formally defined as a person who is not the taxpayer or a disqualified person and who enters into a written agreement (the “exchange agreement”) with the taxpayer. The Qualified Intermediary acquires the Relinquished Property from the taxpayer, transfers the Relinquished Property to the buyer, acquires the Replacement Property and transfers the Replacement Property to the taxpayer. The Qualified Intermediary does not actually have to receive and transfer title as long as the legal fiction is maintained.

The Intermediary can act with respect to the property as the agent of any party to the transaction and further, an Intermediary is treated as entering into a contract for sale if the rights of a party to the contract are assigned to the Intermediary and all parties to the contract are notified in writing of the assignment on or before the date of the relevant transfer of property. This provision allows a taxpayer to enter into a contract for the transfer of the Relinquished Property and thereafter to assign his rights in the contract to the Intermediary. Providing all parties to the agreement are notified in writing of the assignment on or before the date of the transfer of the Relinquished Property, the intermediary is treated as having entered into the contract and after completion of the transfer, as having acquired and transferred the Relinquished Property.

There are no licensing requirements for Intermediaries established by the IRS. They need merely be not an unqualified person as defined by the Internal Revenue Code in order to be qualified. The Code prohibits certain “agents” of the taxpayer from being qualified. Accountants, attorneys and realtors who have served taxpayers in their professional capacities within the prior two years are disqualified from serving as a Qualified Intermediary for a taxpayer in an exchange. Related parties are also disqualified.

Criteria for Selecting a Qualified Intermediary

Intermediaries serve as a limited purpose depository institution and hold all of the Exchange Cash during the course of a 1031 Exchange. As a result, Intermediaries usually hold substantial sums of money on behalf of their exchange clients. With the exception of a few states, including Nevada, California, Idaho, Colorado and Arizona, there are no federal or state regulations or supervision of Intermediaries. Taxpayers are unsecured creditors when an Intermediary becomes bankrupt or insolvent. Funds held by Intermediaries are invested in a variety of ways, including pooled cash funds with stock brokerages and segregated liquid asset money market accounts. Obviously, the selection of an Intermediary who will be entrusted with the funds of a 1031 Exchange is an important matter.

Intermediaries offer widely varying services and have widely varying professional training, skills and competence. Intermediaries are usually attorneys, tax accountants, bank affiliates, title company affiliates or realtors. Many Intermediaries have no training as a tax professional or as an exchange professional and offer no consultation to a taxpayer on tax issues related to the exchange or on the technical requirements for completion of a successful exchange. Some Intermediaries simply bank funds.

Intermediaries take their fees or compensation in a variety of ways. Some Intermediaries charge little or no fees for their services and retain all or a portion of the interest earned on the funds in their possession. Some Intermediaries charge higher fees for their services and forward all interest earned on funds in their possession to the client at the end of the exchange. Some do a little of both. Interest earned on funds held by an Intermediary can vary widely also, depending on where the funds are invested or held on deposit.

Here are some of the things taxpayers should consider when engaging the services of an Intermediary:

• Does the Intermediary have tax professionals or Certified Exchange Specialists capable of consulting you on 1031 tax issues?
• Does the Intermediary deposit Exchange Funds in segregated and FDIC insured accounts?
• Is the Intermediary a member of the Federation Of Exchange Accommodators, a professional organization that expects its members to perform services at the highest level of competence and trust?
• Does the Intermediary have experience and a verifiable reputation?
• Is the Intermediary willing to meet with you, consult with you on exchange strategies, issues and execution of exchange documents?
• Is the Intermediary bonded with a fidelity bond?
• Are Exchange Funds available for disbursement within 24 hours?
• Does the Intermediary manage closings in order to avoid inadvertent boot and related taxes, which can cost you more than the fees they charge?

The Rules of “Boot” in a Section 1031 Exchange

A Taxpayer Must Not Receive “Boot” from an exchange in order for a Section 1031 exchange to be completely tax free. Any boot received is taxable (to the extent of gain realized on the exchange). This is acceptable when a seller desires some cash and is willing to pay some taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be tax free.

The term “boot” is not used in the Internal Revenue Code or the Regulations, but is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange. Boot received is the money, debt relief or the fair market value of “other property” received by the taxpayer in an exchange. Money includes all cash equivalents received by the taxpayer. Debt relief is any net debt reduction which occurs as a result of the exchange taking into account the debt on the Relinquished Property and the Replacement Property. “Other property” is property that is non-like-kind such as personal property received in an exchange of real property, property used for personal purposes, or “non-qualified property.” “Other property” also includes a promissory note received from a buyer (Seller Financing).

Boot can be in advertent and result from a variety of factors. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided. The most common sources of boot include the following:

• Cash boot received during the exchange. This will usually be in the form of “net cash received” at the closing of either the Relinquished Property or the Replacement Property.
• Debt reduction boot which occurs when a taxpayer’s debt on Replacement Property is less than the debt which was on the Relinquished Property. As with cash boot, debt reduction boot can occur when a taxpayer is “trading down” in the exchange.
• Sale proceeds being used to service costs at closing which are not closing expenses. If proceeds of sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to bring cash to the closing of the sale of their Relinquished Property to pay for the following non-transaction costs:
  • Rent prorations.
  • Utility escrow charges.
  • Tenant damage deposits transferred to the buyer.
  • Property tax prorations? Possibly, see explanation below.
  • Any other charges unrelated to the closing.

Tax prorations on the Relinquished Property settlement statement can be considered as service of debt based on PLR 8328011. Under this rationale exchange cash used to service tax prorations should not result in taxable boot. However, taxpayers may want to bring cash to the Relinquished Property closing anyway in order to resolve this issue.

Excess borrowing to acquire Replacement Property.

Borrowing more money than is necessary to close on Replacement Property will cause cash being held by an Intermediary to be excessive for the closing. Excess cash held by an Intermediary is distributed to the taxpayer, resulting in cash boot to the taxpayer. Taxpayers must use all cash being held by an Intermediary for Replacement Property. Additional financing must be no more than what is necessary, in addition to the cash, to close on the property.

Loan acquisition costs for the Replacement Property, which are serviced from exchange funds being brought to the closing. Loan acquisition costs include origination fees and other fees related to acquiring the loan. Taxpayers usually take the position that loan acquisition costs are being serviced from the proceeds of the loan. However, the IRS may take a position that these costs are being serviced from Exchange Funds. There is no guidance which is helpful in the form of Treasury Regulations on this issue at the present time.

Non-like-kind property which is received from the exchange, in addition to like-kind property (real estate). Non-like-kind property could include the following:

• Seller financing, promissory note.
• Furniture and fixtures acquired with purchase of real estate.
• Sprinkler equipment acquired with farm land.

Boot Offset Rules – Only the net boot received by a taxpayer is taxed. In determining the amount of net boot received by the taxpayer, certain offsets are allowed and others are not, as follows:

• Cash boot paid offsets cash boot received (but only at the same closing table).
• Cash boot paid at the Replacement Property closing table does not offset cash boot received at the Relinquished Property closing table (Reg. section 1.1031(k)-1(j)(3) Example 2). This rule probably also applies to inadvertent boot received at the Relinquished Property closing table because of prorations, etc. (see above).
• Debt incurred on the Replacement Property offsets debt-reduction boot received on the relinquished property.
• Cash boot paid offsets debt-reduction boot received.
• Debt boot paid never offsets cash boot received (net cash boot received is always taxable).
• Exchange expenses (transaction and closing costs) paid offset net cash boot received.

Rules of Thumb:

• Always trade “across” or up. Never trade down (the “even or up rule”). Trading down always results in boot received, either cash, debt reduction or both. The boot received is mitigated by exchange expenses paid.
• Bring cash to the closing of the Relinquished Property to pay for charges which are not transaction costs (see above).
• Do not receive non-like-kind property (or if you do, pay for it).
• Do not over finance Replacement Property. Financing should be limited to the amount of money necessary to close on the Replacement
• Property in addition to exchange funds which will be brought to the Replacement Property closing.

Related Party Exchanges
(Two-Year Holding Period Requirement)

Exchange of property between related parties. There is a special rule for exchanges between related parties (IRC §1031(f)), which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years following the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two-year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs.

Sale to an unrelated party, replacement from a related party. A taxpayer will often desire to sell to an unrelated party and receive Replacement Property from a related party. This type of related party transaction does not work, according to the IRS, if the related party receives cash (Rev. Rul. 2002-83). The IRS reasons that if the taxpayer or a related party “cashes out” of property in this manner, IRC §1031(f)(4) “kicks in” and the exchange is disallowed. However, if the related party is also doing an exchange (and is not “cashing out”) then it is okay to receive Replacement Property from a related party according to PLR 200440002 and PLR 200616005.

Sale to a related party, replacement from an unrelated party. A taxpayer will often sell to a related party but receive Replacement Property from an unrelated party. This is OK but it has been unclear whether the related party was required to hold the property it acquired from the taxpayer for two years. Instructions to Form 8824 seem to imply that the two-year rule applies. However, PLR 200706001, PLR 200712013 and PLR 200728008 released in 2007 say that the two-year rule does not apply to a related party who purchased the Relinquished Property from the taxpayer.

Related parties under the rules are the following:

• Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.);
• An individual and a corporation when the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
• Two corporations that are members of the same controlled group as defined in IRC §1563(a), except that “more than 50%” is substituted for “at least 80%” in that definition;
• A trust fiduciary and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
• A grantor and fiduciary, and the fiduciary and beneficiary, of any trust;
• Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts;
• A tax-exempt educational or charitable organization and a person who, directly or indirectly, controls such an organization, or a member of that person’s family;
• A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest, or profits interest, in the partnership;
• Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation;
• Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; or
• An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.
• Two partnerships if the same persons own directly, or indirectly, more than 50% of the capital interests or profits in both partnerships, or
• A person and a partnership when the person owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership.

A disqualifying disposition does not include dispositions by reason of the death of either party, the compulsory or involuntary conversion of the exchanged property if the exchange occurred before the threat or imminence of the conversion, or dispositions where it is established to the satisfaction of the IRS that neither the exchange nor the disposition had as one of their principal purposes the avoidance of federal income tax.

Multiple-Asset Exchanges

A Multiple-Asset Exchange occurs when a taxpayer is selling/exchanging a property which includes more than one type of asset. A common example is a farm property including a personal residence.

The Treasury Department has issued Regulations, which govern how multiple-asset exchanges are to be reported. The Regulations establish “exchange groups” which are separately analyzed for compliance with the like-kind replacement requirements and rules of boot. Farmland must be replaced with qualifying like-kind real property. A personal residence is not 1031 property and is accounted for under the rules applicable to the sale of a personal residence.

The Multiple-Asset Regulations are ambiguous concerning how the personal residence portion of a multiple-asset exchange should be accounted for. However, it is common practice for the closing on the Relinquished Property to be bifurcated into two separate closings; one for the personal residence and the other for the remainder of the property. The proceeds applicable to the sale of the personal residence are usually disbursed to the taxpayer and not retained by the Intermediary in the exchange escrow. The balance of the proceeds is retained by the Intermediary for use in acquiring like-kind Replacement Property under the Exchange Agreement.

Another common example of multiple-asset exchanges is a real property sale that includes personal property (i.e. furniture and appliances). Hotel properties are a good example of a multiple-asset exchange including real and personal property.

Even a sale/exchange of a rental property includes a combination of real and personal property. In practice, the value of the personal property that is transferred with a rental property is commonly disregarded for calculation and income tax reporting purposes. However, there is no de minimus rule which permits a taxpayer to disregard the value of personal property, even if it is nominal.

The Multiple-Asset Regulations are complex and require the services of YAHNIAN LAW CORPORATION for analysis purposes and income tax reporting. The tax professional is essential and will help in determining values, allocations of sale price and purchase prices to the elements of the transaction. Exchanges that include personal property of significant value should be referenced in the contract as it is non-qualifying property.

Partnership And Co-Ownership Issues

Investment real estate is commonly owned by co-owners in a partnership containing two or more partners or by co-owners as tenants in common. An exchange of a tenant in common interest in real estate poses no problems and is eligible for 1031 Exchange treatment. However, an exchange of an interest in a partnership is not permitted under the Code and Regulations.

If a partnership owns property and desires to sale/exchange the property, then the partnership is the entity that is the Exchanger and party to the Exchange Agreement. The partnership will take title to the Replacement Property.

Frequently, individual partners in a partnership desire to take their share of the proceeds of sale of the partnership property, replace with qualifying 1031 Replacement Property in their own names and end their relationship with the partnership. This presents problems that require careful planning and is not without tax risk.

If a partnership involving two or more partners wishes to discontinue the partnership, sell the property, and go their separate ways with either the cash or a 1031 Exchange, it is necessary for the individual partners to receive deed to the property in advance of the sale. This is done in the context of a distribution of property from the partnership to its partners who then hold the property as tenants in common. Each individual partner then is positioned to sell or exchange his tenancy in common ownership in the real estate. This is known in the industry as a “drop and swap” and is often done at the same closing table. However, it is better for the “drop” to be performed some time before the “swap” is done in order to comply with the “held for investment” rule by the individual partners. Simultaneous “drop and swaps” have been challenged in past years by the IRS. The courts have been more lenient.

If a partnership with multiple partners wishes to exchange property in the name of the partnership but some of the partners want to “cash out” or go separate ways, it is common for the partnership to do a “split-off.” The partnership distributes tenancy in common title to a portion of the partnership property to those individual partners who wish to proceed in separate directions, and the partnership (and its remaining partners) proceed with an exchange in the name of the partnership.

The services of YAHNIAN LAW CORPORATION are essential for tax planning and structuring for successful exchanges of partnership and co-ownership interests in real estate.

What is a TIC?
(Tenancy In Common Investments)

Tenancy in common investments (“TIC” or “TIC Investments”) have become a booming industry in the United States in recent years. A tenancy in common investment (better known as a TIC) is an investment by the taxpayer in real estate which is co-owned with other investors. Since the taxpayer holds a deed to real estate as a tenant in common, the investment qualifies under the like-kind rules of IRC §1031. TIC investments are typically made in projects such as apartment houses, shopping centers, office buildings, etc. TIC sponsors arrange TIC syndications to comply with the limitations specified by the IRS with Rev Proc 2002-22 which, among other things, limits the number of investors to 35.

This type of an investment can appeal to taxpayers who are tired of managing real estate. TICs can provide a secure investment with a predictable rate of return on their investment. Management responsibilities are provided by management professionals. Cash returns on these types of investments are typically in the 6% to 7% range. Syndicators of TICs are called “sponsors.” Investment offerings can be made directly by the sponsor or by brokers who can assist taxpayers with an assortment of offerings currently on the market.

TIC investments are treated by most sponsors as securities because they meet the definition of securities either in the state where the property resides or in the various states where the sponsor intends to offer the investment for sale. The SEC has not ruled on this issue but most states are quite clear in their statutes that these investments are securities under state law. This means that only licensed security dealers may market these investments. However, even though the investments may be securities under state law, the investment is a real estate investment for purposes of §1031.

Some sponsors of TIC investments structure their TIC so that the investment is a real estate investment not subject to state security laws. Usually this means that the TIC sponsor will not be responsible for management of the investment and independent management will be employed.

TIC investments are commonly structured in one of the following ways:

• A single-tenant property with an established credit rating,
• Multiple tenants subject to a single master lease with the TIC sponsor who subleases to the tenants,
• Multiple tenants each with separate leases managed by professional management.

Taxpayers considering a TIC investment should be prepared for an investment which may last for several years with limited liquidity. As with any other real estate investment, an investment in a TIC can be subject to various business risks. Taxpayers should research track records and management performance of sponsors who are offering TIC investments. They should also carefully review any available proforma operating statements and prospectus. A financial advisor should be consulted when necessary.

What Attorneys, CPAs, Financial Planners and Realtors Should Know About 1031 Exchanges

Business Advisors, including Attorneys, CPAs and Financial Planners as well as Realtors are Often the First to Recognize the Potential Benefits of a Section 1031 Exchange to a seller of real estate. When a seller is going to replace qualifying real estate with replacement real estate, a Section 1031 Exchange should be suggested. It is possible for a seller to employ the services of an Exchange Intermediary at any time after a contract is executed up to the day of closing on the contract. It is too late after the closing has occurred.

Accommodation Language in the Contract. Accommodation language is usually placed in the Contract to Buy and Sell Real Estate wherein the other party to the contract is informed and agrees to cooperate with the 1031 exchange. Typical accommodation language might read as follows:

• For a Seller – “A material part of the consideration to the seller for selling is that the seller has the option to qualify this transaction as a tax deferred exchange under Section 1031 of the Internal Revenue Code. Purchaser agrees to cooperate in the exchange provided purchaser incurs no additional liability, cost or expense.”
• For a Buyer – “This offer is conditional upon the seller’s cooperation at no cost to allow the purchaser to participate in an exchange under Section 1031 of the Internal Revenue Code at no additional cost or expense. Seller hereby grants buyer permission to assign this Contract to an Intermediary not withstanding any other language to the contrary in this Contract”.

Accommodation language is not mandatory and can be omitted if it puts the taxpayer at a disadvantage for other parties to know about his plan to sell and replace property under IRC §1031 and related closing pressures under the exchange ’time clocks.”

Assignment of Contracts. If a Realtor knows that a buyer intends to assign the contract to an Intermediary in connection with an exchange, it is helpful to reference the buyer as “John Doe or Assigns” on the contract.

Another way to make the contract “assignable” is for an addendum to the contract to be prepared by the Realtor making the contract “assignable.”

Settlement Statements. Section 1031 of the Internal Revenue Code imposes no requirements and provides no guidance with respect to preparation of settlement statements for an exchange of property. The Colorado Real Estate Commission has no special requirements concerning exchanges involving an Intermediary.

Intermediaries often instruct closers to name the Intermediary as the seller of a property on behalf of their client. This is not required by IRC §1031 and creates additional closing burdens since it requires the Intermediary to sign the settlement statements.

An occasional (but unnecessary) practice is for the title company closing on the transaction to prepare a second set of settlement statements in which the Intermediary is shown as a buyer and seller. The Intermediary’s set of statements “mirror” each other as to debits and credits. The thinking here is that the settlement statements should reflect a “chain of title.” This practice is not required by IRC §1031.

Recommendation:  prepare one set of settlement statements in the normal manner which total to zero proceeds due to or from the Exchanger. The settlement statements should be made to total to zero proceeds due to or from the Exchanger by showing a debit or credit for “Exchange Funds – 1031 Corporation” as a transaction item “above the bottom line”. The amount of “Exchange Funds” is the amount of funds being transferred to or from the Intermediary in connection with the closing.

Vacation Homes and 1031 Exchanges

Can a vacation home qualify for a 1031 Tax-Deferred Exchange? Most tax and exchange professionals think so to the extent that the vacation home is used partly for rental purposes. For instance, if the vacation home is used 50% for personal use and 50% for rental or investment purposes, then 50% of the property is qualifying property held for investment purposes under IRC § 1031. The personal use portion of the vacation home will not be eligible for 1031 Exchange treatment. If the vacation home is used 100% for personal use, forget it _ it does not qualify under IRC §1031.

What if the vacation home is used partly for personal use and partly for investment purposes but is never rented out? In this case, the answer is “it depends.” It depends on the amount of personal use of the property by the taxpayer. Property held for personal use does not qualify as investment property (IRC § 1031(a)). However, mere incidental personal use of property that is otherwise considered investment property does not disqualify the property from 1031 Exchange treatment (PLR 8103117). “Incidental personal use” is not defined by the Code, Regs. or by other guidance issued by the IRS. Personal use of a vacation home for anything other than “incidental personal use” will disqualify a property if it is never rented out by a taxpayer.

Under what circumstances can all of the vacation home (100%) qualify for a 1031 Exchange? Code Section 280A(d) provides that a taxpayer’s dwelling is a 100% rental property (and not a “residence”) if the taxpayers personal use of the property is less than the greater of –

• 15-days, or
• 10% of the number of days during the year for which the dwelling is rented (at fair market value rents).

Personal use includes use by members of the taxpayer’s family. Personal use does not include work-days a taxpayer is at the residence. The purpose of IRC §280A is to limit deductions with respect to the rental use of a residence. Does 280A also define a property for purposes of a 1031 Exchange? Most tax and exchange professionals do not think so. However, compliance with the minimal personal use provisions under IRC §280A could be considered to be a “good bet” for qualification of the property as a 100% eligible property for 1031 Exchange treatment. Also, see (below) the new “safe-harbor” Rev. Proc. Issued by the IRS in March 2008 which uses language similar to IRC §280A.

If none of these rules will work for a taxpayer because of disqualifying personal use of the vacation home, then the taxpayer should consider converting the property to a qualifying investment property by discontinuing all personal use for a year or more to position the property for a 1031 Exchange. At the same time, be sure to report all of expenses related to the property as “investment related expenses.” Renting the property will be a definite help for this purpose but is not mandatory.

Safe Harbor – The IRS issued Rev. Proc. 2008-16 in March, 2008 for taxpayers who want assurance that their vacation home is a qualifying investment. The Rev Proc applies to any residence owned by the taxpayer in addition to a primary residence so it is broader in its application than to mere “vacation homes.” It is effective for exchanges of homes occurring after March 9, 2008.

The IRS says they will not challenge whether a residence qualifies as property held for use in a trade or business or for investment for purposes of §1031 if the following requirements are met:

The relinquished residence is owned by the taxpayer during the 24-month period ending on the day before the date of the exchange,
The replacement residence is owned by the taxpayer during the 24-month period beginning on the day after the date of the exchange, and
Within each of the two 12-month periods immediately before the exchange and within each of the two 12-month periods immediately after the exchange –
the residence is rented to another person or persons at a fair rental for at least 14 days, and
the period of personal use does not exceed the greater of 14 days or 10% of the days the residence is rented at a fair rental.

Personal Use – Rev Proc 2008-16 provides that personal use occurs on any day on which a taxpayer is treated as having used the dwelling unit for personal purposes under §280A(d)(2) (taking into account §280A(d)(3) but not §280A(d)(4)). Therefore, a taxpayer is generally treated as using a residence for personal purposes for a day if the unit is used for personal purposes by:

The taxpayer or any other person who has an interest in the dwelling unit or by a member of the family of the taxpayer or the other person;
Any individual who uses the unit under a reciprocal use arrangement; or
By any individual (other than an employee whose use is excludable from income under §119-Use for the convenience of the employer) unless, for that day, the dwelling unit is rented for a fair rental.

Fair Rental – A “fair rental” is determined based on all the facts and circumstances when entering the rental agreement

Failure to meet the new safe-harbor requirements does not mean that the exchange automatically does not qualify for §1031 treatment. But it does mean that the IRS could challenge the taxpayer’s exchange.

IRS Issues Safe Harbor for 1031 Exchanges of Residences
(Including Vacation Homes)

Rev Proc 2008-16 provides a “safe harbor” for dwelling units given and received in an exchange will qualify for §1031 treatment. This Rev Proc is only a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies as property held for use in a trade or business or for investment for purposes of §1031. Failing to meet the safe harbor should not mean that the exchange automatically does not qualify for §1031 treatment.

A dwelling unit is real property with a house, apartment, condominium, or similar improvement that provides basic living accommodations, including sleeping space, bathroom and cooking facilities. Therefore, a dwelling unit is a residence.

Safe-Harbor – The IRS says they will not challenge whether a dwelling unit qualifies as property held for use in a trade or business or for investment for purposes of §1031, if the following requirements are met:

• The relinquished residence is owned by the taxpayer during the 24-month period ending on the day before the date of the exchange,
• The replacement residence is owned by the taxpayer during the 24-month period beginning on the day after the date of the exchange, and
• Within each of the two 12-month periods immediately before and after the exchange, the residence is rented to another person or persons at a fair rental for at least 14 days, and
• the period of personal use does not exceed the greater of 14 days or 10% of the days the residence is rented at a fair rental.

Personal Use – Rev Proc 2008-16 provides that personal use occurs on any day on which a taxpayer is treated as having used the dwelling unit for personal purposes under IRC §280A(d)(2) (taking into account §280A(d)(3) but not §280A(d)(4)). Therefore, a taxpayer is generally treated as using a residence for personal purposes for a day if the unit is used by:

The taxpayer or any other person who has an interest in the dwelling unit or by a member of the family of the taxpayer or the other person;
Any individual who uses the unit under a reciprocal use arrangement; or
By any individual (other than an employee whose use is excludable from income under §119-Use for the convenience of the employer) unless, for that day, the dwelling unit is rented for a fair rental.

Basic §1031 Exchange Vocabulary

Code Sec. 1031 practitioners commonly use the following words when advising regarding Code Sec. 1031 exchanges or discussing Code Sec. 1031 issues.

(g)(6) Restrictions:

Restrictions imposed by the Income Tax Regulations and the exchange agreement that prohibit the early distribution of the exchange proceeds. The (g)(6) restrictions help avoid the exchanger’s constructive receipt of the exchange proceeds.

Accommodation Titleholder:

An individual or other legal entity engaged by the exchanger to hold title to replacement property or in rare cases, relinquished property, to facilitate a parking transaction. This term is generally used to define the accommodator in non-safe harbor parking transactions.

Adjusted Tax Basis:

The adjusted tax basis of property used to compute gain or loss on the disposition of property and to compute depreciation. As a general rule, the adjusted tax basis is the acquisition cost, plus the cost of capital improvements, less depreciation.

Boot:

Money or non like-kind property consideration received in connection with an exchange.

Constructive Receipt:

A technical federal income tax concept that treats an exchanger as receiving property or cash even though such payment of cash is not legally transferred to the exchanger. Generally, an exchanger is in constructive receipt of property or cash if the exchanger has the unrestricted use of the property or cash. Receipt by a qualified intermediary of the exchange proceeds should avoid constructive receipt.

Dealers and Developers:

Dealers and developers are individuals or other legal entities that generally hold property for resale. Such property does not qualify for Code Sec. 1031 treatment. Dealer and developers may, however, exchange property held for investment or use in a trade or business if certain requirements are satisfied.

Exchange Accommodation Agreement:

A contract entered into between the exchanger and an exchange accommodation titleholder providing that the exchange accommodation titleholder will take title to either the replacement property or relinquished property and hold it under the exchanger’s supervision.

Exchange Accommodation Titleholder:

An individual or other legal entity engaged by the exchanger to hold title to replacement property or, in rare cases, relinquished property, to facilitate a parking transaction. This term is generally used to define the accommodator in safe harbor parking transactions.

Exchange Agreement:

A contract entered into between an exchanger and a qualified intermediary providing, among other things, that the qualified intermediary will facilitate the exchange and hold the Exchange Proceeds subject to the (g)(6) Restrictions.

Exchange Clauses or Cooperation Clause:

The earnest money contract or purchase and sale agreement begin the paper trail that distinguishes the transaction as a Code Sec. 1031 exchange. An exchange or cooperation clause helps establish the exchanger’s intent to make an exchange and further seeks cooperation from the other party to accept an assignment of the sales contract.

Exchange Facilitator:

A general term used to refer to those individuals or other legal entities that facilitate Code Sec. 1031 exchanges. The term exchange facilitator is broad enough to include qualified intermediaries and exchange accommodation titleholders.

Exchange Period:

That period ending 180 days following the date the relinquished property is transferred. The exchange period will be cut short if the exchanger files the tax return for the taxable year of the exchange prior to the 180th day. The first day of the exchange period is the day after the transfer of the relinquished property.

Exchange Proceeds:

Consideration received for the relinquished property. Generally, in a deferred multi-party exchange, a qualified intermediary receives exchange proceeds.

Exchanger:

An individual or entity pursuing a Code Sec. 1031 exchange.

Identification Period:

That period ending forty-five (45) days following the date the relinquished property is transferred by the exchanger. The first day of the identification period is the day after the transfer of the relinquished property.

Qualified Intermediary:

An individual or other legal entity that satisfies several requirements in the Income Tax Regulations. Qualified intermediaries are often used to facilitate Code Sec. 1031 exchanges.

Realized Gain:

The realized gain is the difference between the sales price received for a property and its adjusted tax basis.

Recognized Gain:

That portion of the realized gain that is required to be reported as income on a federal income tax return.

Related Parties:

The parties related to the exchanger as defined by Code Sec. 267(b) and Code Sec. 707(b)(1) . The definition of related party includes, but is not limited to, a spouse, ancestors, descendants, and brothers and sisters. Not related to the exchanger are aunts, uncles, cousins, nieces and nephews, in-laws, ex-spouse, employees, business associates, and friends. Further, corporations and partnerships are related to the exchanger if the exchanger owns more than a fifty percent (50%) interest in such entity. As discussed in the section on related parties, the group of persons treated as related parties is quite large and sometimes complicated to determine.

Relinquished Property:

Property an exchanger transfers in an exchange.

Replacement Property:

Property an exchange identifies and ultimately receives in an exchange.

Safe Harbor:

Structure approved by the IRS, which if followed, will produce a foreseeable tax consequence. For example, the use of a qualified intermediary or exchange accommodation titleholder under the Income Tax Regulations and Rev. Proc. 2000-37 creates safe harbors. Following the rules pertaining to these safe harbors allows an exchanger to know the tax consequences of a transaction. Structuring a transaction outside the safe harbors creates some uncertainty regarding the tax consequences of the transaction.

Sales Price:

The contract price of the property less closing costs. Also referred to as the net sales price.

Seller Financing:

A financing arrangement under which the seller of property provides the buyer with the financing needed to acquire the property. The financing is often a note from the buyer secured by the property without money changing hands.

At-risk limitations: The at-risk limitations are provisions of IRC §465 that limit a taxpayer’s deductible loss for income tax purposes to the amount that the taxpayer has at risk in the activity generating the loss. Because the at-risk limitations apply to real property, a taxpayer can deduct losses from a real property investment only to the extent of the amounts personally invested or for which the taxpayer is personally liable (recourse debt).

Buyer: In this book, buyer refers to the party that ultimately acquires the relinquished property on completion of the exchange transaction.

Buyer cooperating three-party exchange: A buyer cooperating three-party exchange is one in which the buyer of the relinquished property acts as the intermediary in the exchange by acquiring the replacement property from the seller and conveying it to the taxpayer in exchange for the relinquished property.

Chief Counsel advice: Chief Counsel advice refers to written guidance issued by the National Office of the Chief Counsel of the Internal Revenue Service to the IRS and Treasury (IRC §6110(i)). This guidance takes a variety of forms including Chief Counsel memorandums (CCM), general counsel memorandums (GCM), field attorney advice (FAA), and field service advice (FSA). The purpose of Chief Counsel advice is to advise IRS personnel on legal matters at varying stages of development. Chief Counsel advice cannot be cited as precedent (see IRC §6110(k)(3)), although it may influence an agent or appellate conferee’s evaluation of a matter. See §1.13. See also General counsel memorandum; Field service advice.

Chief Counsel memorandum: See Chief Counsel advice.

Escrow agents or officers: In real property transactions, the escrow agent or officer is the entity or person that receives documents and funds from the principals in the transaction (e.g., the buyer, seller, and exchanger), holds the documents and funds, and delivers them on the occurrence of specified conditions in accordance with instructions from the principals. In some regions, escrow agents are employed to structure the exchange itself.

Exchange counterparty: In all exchange transactions, the taxpayer actually does or is deemed to swap properties with another party referred to as the exchange counterparty. In a deferred exchange, when the buyer of relinquished property and the seller of replacement property are different parties, an intermediary generally serves as the exchange counterparty.

Exchange equity credit: Exchange equity credit is the amount held by the intermediary in a deferred exchange, for the benefit of the exchanger, after selling the relinquished property. The intermediary applies the exchange equity credit to one or more items of replacement property.

Exchange escrow: An exchange escrow is the escrow through which properties are exchanged between two parties. In a seller-cooperating three-party exchange, the taxpayer and the seller are the parties to the exchange escrow. See §1.40. In a buyer-cooperating three-party exchange, the buyer and the taxpayer are the parties to the exchange escrow. In a four-party exchange, there is typically no exchange escrow; rather, the deeds for transferring the properties between the taxpayer and the intermediary are recorded as an accommodation in the sale escrows.

Exchanger: Exchanger is a term often used in exchange agreements to describe the taxpayer, i.e., the party intending to complete an exchange to obtain nonrecognition treatment under IRC §1031. See also Taxpayer.

Facilitator: See Intermediary.

Field attorney advice: See Chief Counsel advice.

Field service advice: A field service advice is a memorandum prepared by the National Office of the Chief Counsel of the Internal Revenue Service, analyzing issues presented by an agent relating to an ongoing audit. Unlike letter rulings and technical advice memorandums, a field service advice is not binding, although it generally influences an agent or appellate conferee’s evaluation of a case. Field service advice may not be cited as authority or precedent in any tax controversy.  See also Chief Counsel advice; Letter rulings; Technical advice memorandum.

Four-party exchange: A four-party exchange involves the taxpayer, the buyer, the seller, and an independent intermediary to facilitate the exchange. The taxpayer transfers the relinquished property to the intermediary, who sells it to the buyer, uses the proceeds to purchase the replacement property from the seller, and then transfers the replacement property to the taxpayer. A four-party exchange can be simultaneous or nonsimultaneous.

General counsel memorandums: General counsel memorandums (GCM) are legal memorandums prepared by the National Office of the Chief Counsel to provide legal advice to branches of the Internal Revenue Service. GCMs cannot be cited as precedent. IRC §6110(k)(3).  See also Chief Counsel advice; Letter rulings, Technical advice memorandum.

Intermediary: A party who receives and transfers a taxpayer’s relinquished property to a buyer and receives and transfers a taxpayer’s replacement property from a seller, thus facilitating an exchange transaction by eliminating the need for buyer or seller cooperation in the exchange. See also Four-party exchange; Deferred exchange.

Letter rulings: Letter rulings are written advice issued by the Internal Revenue Service, on written request from taxpayers, regarding the tax treatment of their specific proposed transactions. Letter rulings may be relied on by the taxpayers involved but may not be used or cited as precedent by anyone else, unless the IRS establishes otherwise by regulation. IRC §6110(j)(3). Letter rulings are also called private letter rulings and private rulings.. See also Revenue ruling; Technical advice memorandum.

Like-kind exchange: Exchanges under IRC §1031 are alternatively referred to as “like-kind,” “tax-deferred,” “tax-free,” and “nontaxable” exchanges. “Like-kind exchange” is the most accurate term used to refer to transactions that are the subject of IRC §1031.

Nonqualifying property: As used in this book, nonqualifying property is any property that is excluded property ( property not held for the required business or investment purpose, or non-like-kind property ). .

Nonrecourse financing: If a loan is secured by specified collateral and, under the terms of the loan or the antideficiency laws, the lender’s only recourse in the event of default is to foreclose against the security, that financing is called nonrecourse financing. See also Qualified nonrecourse financing.

Other property: Other property consists of nonqualifying property received by the taxpayer in the exchange. . See also Nonqualifying property.

Passive loss rules: Losses from a passive activity generally may be offset only against gains from passive activities?not gains from other types of activities. The rules governing these offsets are known as the passive loss rules. Passive activity includes the conduct of a trade or business in which the taxpayer does not materially participate, or engaging in rental activity above a certain dollar threshold regardless of the taxpayer’s participation. IRC §469.

Private letter ruling: See Letter rulings.

Private rulings: See Letter rulings.

Qualified nonrecourse financing: Qualified nonrecourse financing is financing on real property that is (1) borrowed from a qualified person (generally someone actively and regularly engaged in the business of lending money, but not the seller of the property), (2) borrowed from a government entity, or (3) guaranteed by a government entity, which the taxpayer is not personally liable to repay and which is not convertible debt. IRC §465(b)(6). As an exception to the at-risk limitations, a borrower who receives qualified nonrecourse financing is still considered at risk in terms of qualified nonrecourse financing. IRC §465(b)(6)(A). . See also At-risk limitations; Nonrecourse financing.

Relinquished property: Relinquished property is the property given up by the taxpayer in an exchange.

Replacement property: Replacement property is the property ultimately received by the taxpayer in an exchange.

Revenue procedure: A revenue procedure is a statement of procedure issued by the National Office of the Internal Revenue Service that affects the rights or duties of taxpayers or other members of the public under the Internal Revenue Code and related statutes, or information that, although not necessarily affecting the rights and duties of the public, should be a matter of public knowledge. Treas Reg §601.601(d)(2)(i)(b).

Revenue ruling: A revenue ruling is a statement of the Internal Revenue Service’s conclusion on the application of the law to a specific set of facts. Taxpayers and IRS personnel are expected to rely on these published rulings as precedent. Rev Proc 89?14, 1989?1 Cum Bull 814. Courts generally do not regard revenue rulings as binding on them.

Reverse exchange: A reverse exchange is a form of nonsimultaneous exchange in which the taxpayer receives the replacement property before transferring the relinquished property.

Round-robin exchange: A round-robin exchange is a type of three-party exchange in which each party has contractual obligations to transfer his or her relinquished property to a different party than the one from whom the replacement property will be received.

Seller: In this article, the seller is the party that owns the replacement property before the exchange transaction occurs. The seller sells the replacement property to the buyer in a buyer-cooperating three-party exchange or to an intermediary in a four-party exchange. In a seller-cooperating three-party exchange, the seller transfers the replacement property to the taxpayer in exchange for the relinquished property and then sells the relinquished property to the buyer.

Seller cooperating three-party exchange: A three-party exchange in which the taxpayer transfers the relinquished property to the seller of the replacement property in exchange for the replacement property, and the seller of the replacement property then sells the taxpayer’s relinquished property to the buyer of the relinquished property.

Substance-over-form doctrine: Under the substance-over-form doctrine, the courts and the Internal Revenue Service determine tax consequences based on the substance of a transaction rather than its form, if the form chosen by the taxpayer is a legal construct that does not reflect the economic realities of the transaction. Commissioner v Court Holding Co. (1945) 324 US 331, 334, 65 S Ct 707.

Suspended loss: For any taxable year, a taxpayer generally may not deduct the excess of losses from passive activities over income from passive activities sustained or earned during that year. IRC §469(a). The net losses from passive activities that are disallowed are carried over and treated as losses from passive activities in the next taxable year. IRC §469(b). The net passive losses that are carried over are referred to as suspended losses. When the passive activity that generated suspended losses is disposed of by the taxpayer in an otherwise taxable transaction, the suspended losses are treated as a loss that is not from a passive activity. . See also Passive loss rules.

Tax-deferred exchange: See Like-kind exchange.

Taxpayer: All exchanges and their tax ramifications are analyzed from the point of view of a specific taxpayer. For example, if party A to a two-party exchange owns property 1 and party B to that exchange owns property 2, the relinquished property (i.e., the property given up by the taxpayer) will be property 1 if party A is viewed as the taxpayer but property 2 if party B is viewed as the taxpayer. Attorneys normally think of their client as the “taxpayer” for these purposes, but all parties to an exchange transaction are likely to have tax consequences resulting from the transaction. . See also Exchanger; Relinquished property.

Technical advice memorandum: A technical advice memorandum (TAM) is a written statement issued to a district director of the Internal Revenue Service on a closed and completed transaction in connection with the examination of a taxpayer’s return or consideration of a taxpayer’s refund claim. A TAM may not be used or cited as precedent by anyone other than the taxpayer involved unless the IRS establishes otherwise by regulation. IRC §6110(b)(1), (k)(3).

Three-party exchange: A three-party exchange is one in which three principal parties are involved. It may be structured as a buyer cooperating, seller cooperating, or round-robin exchange. A three-party exchange does not involve an independent intermediary. . See also Round-robin exchange; Buyer cooperating three-party exchange; Seller-cooperating three-party exchange.

Two-party exchange: A two-party exchange is a reciprocal transfer of properties in which each party is both a transferor of relinquished property and a recipient of replacement property.. See also Relinquished property; Replacement property.

IMPROVEMENTS EXCHANGES

An exchanger may wish to dispose of real property and use the sale proceeds to construct improvements on other property. This is an improvements exchange. The availability of Code Sec. 1031 nonrecognition depends upon who owns the land on which the improvements will be constructed and how the transaction is structured.

Construction on Replacement Property

An exchanger may obtain like-kind exchange treatment by exchanging relinquished property for replacement property that will have an improvement constructed on it before the exchanger receives the replacement property. Coastal Terminals Inc v. U.S., (1963, CA4) 12 AFTR 2d 5247, 320 F2d 333, 63-2 USTC ¶9623. This can be accomplished either through an exchange accommodation titleholder (EAT) in a reverse exchange or as a deferred exchange. If through an EAT, the EAT will acquire raw land, construct improvements while on title to the raw land, and transfer the land and improvements to the exchanger in exchange for the relinquished property. This transaction will satisfy for the Rev. Proc. 2000-37 safe harbor,  if the exchanger satisfied all of the requirements. If structured as a deferred exchange, the exchanger will transfer relinquished property and direct the buyer to transfer proceeds to a qualified intermediary. The qualified intermediary will use the proceeds to acquire improved property. This requires the seller to construct the improvements.

Construction on Existing Property

An exchanger may not obtain like-kind exchange treatment if property is disposed of and the proceeds are used to improve property the exchanger owns. Bloomington Coca-Cola Bottling Co v. Com., (1951, CA7) 40 AFTR 648, 189 F2d 14, 51-1 USTC ¶9320. At one point, practitioners speculated that exchangers could lease property to an exchange accommodation titleholder (EAT) under a lease of more than 30 years, direct the EAT to construct improvements, and then reacquire the lease and improvements. In Rev. Proc. 2004-51, however, the IRS made clear that Rev. Proc. 2000-37  does not apply to such transactions.

In DeCleene, Donald, (2000) 115 TC 457, the exchanger attempted to do an improvements exchange using property the exchanger already owned. The transaction in DeCleene involved an attempt by the exchanger to sell undeveloped property to an unrelated party, have the unrelated party construct a new building on the property, and have the unrelated party transfer the property and newly constructed building back to the exchanger in exchange for another property the exchanger owned. Because this transaction occurred before Rev. Proc. 2000-37 was published, the exchanger was unable to use that safe harbor. Nonetheless, the exchanger argued that the transaction should qualify for Code Sec. 1031 nonrecognition. The Tax Court disagreed. In holding that the transaction did not qualify for like-kind exchange treatment, the court found that the attempted sale of the undeveloped property to the unrelated party was a sham transaction. Thus, the unrelated party was never deemed to be the beneficial owner of the property on which the building was constructed. Instead, the exchanger was deemed to be the owner of the property at all times. This being the case, the later transfer could not qualify for Code Sec. 1031 nonrecognition.

Construction on Related-Party Property

The IRS allowed an exchanger to structure an improvements exchange involving related-party property using the Rev. Proc. 2000-37 safe harbor.

IRS Letter Ruling 200251008 endorses use of an exchange accommodation titleholder (EAT) under Rev. Proc. 2000-37 in an improvement exchange, thus eliminating the practical problems previously inherent in such transactions. In addition, that ruling endorses improvements exchanges between an exchanger and a related person where the related person does not cash out its investment.

Since publishing IRS Letter Ruling 200251008, the IRS has issued IRS Letter Ruling 200329021, on slightly different facts. IRS Letter Ruling 200329021 involved an exchanger who was the wholly owned subsidiary of Parent. Parent had entered into a long-term lease (a 20-year initial period with four five-year renewal options) before the date the exchanger contemplated disposing of its property (RQ) as part of a Code Sec. 1031 exchange.

In IRS Letter Ruling 200329021, the exchanger wished to dispose of RQ and use the proceeds to construct improvements on the property leased to Parent. The steps of the exchange were as follows:

(1) To structure the transaction as a qualified exchange accommodation arrangement (QEAA). QEAA under Rev. Proc. 2000-37, Parent assigned the leasehold to a limited liability company (LLC) wholly owned by an EAT. At the time of the assignment, the leased property was unimproved, except for demolition of the existing building on the site and rough grading (all performed by the landlord). At the time Parent assigned the lease to LLC, Parent also invoiced LLC for soft costs (i.e., engineering, surveys, etc.) associated with the LLC’s construction of the improvements. Parent did not, however, invoice LLC for other costs incurred to enter into the lease;
(2) Under Parent’s direction, LLC constructed improvements. The exchanger disposed of RQ with the proceeds going to a QI. Those proceeds were then advanced to LLC to fund construction of the improvements. LLC first used a portion of its first advance from the QI to reimburse Parent for the invoiced costs. It also paid the construction contractor for the costs of construction from the advances from the QI; and
(3) Before the earlier of the date that was 180 days after Parent assigned the leasehold to LLC and the date that was 180 days after the exchanger transferred RQ, the LLC assigned the leasehold with improvements to the exchanger.

The IRS ruled that to the extent the improvements were complete when the leasehold was assigned to the exchanger, the transaction qualified for Code Sec. 1031 nonrecognition. In addition, the IRS also ruled that, despite the fact that the exchanger and Parent were related, since both the exchanger and Parent “continue to be invested in exchange properties, both will remain so invested for a period of not less than two years following the exchange, and neither is otherwise cashing out its interests, gain recognition is not triggered under §1031(f)(4).” IRS Letter Ruling 200329021. Thus, the IRS endorsed the use of a lease assignment (in lieu of a sublease) by a related party to an EAT in a related-party improvements transaction. Because these transactions involve leases, they are referred to as leasehold improvements exchanges. They have become quite common in the real estate industry.

PLANNING POINTER: In advising whether to lease property from a related party to an EAT or transfer the property to an EAT, tax advisors must consider whether the property owned by the related party has high basis that would allow a tax-free cashout. Using a long-term lease helps to avoid this possibility.

Option Payments and Other Cash Received Before Exchange

Not all pre-exchange cash receipts by the Seller from Buyer are boot nor treated as income in the year of receipt by the Seller.

Frequently, a taxpayer receives cash from a potential buyer either as consideration for an option to purchase the property at a later date or as an earnest money deposit. The taxpayer may receive these funds before a like-kind exchange of the subject property is being considered, or in anticipation of a like-kind exchange. A careful analysis of the tax effect of the payment is necessary at each stage of the transaction to ascertain when, and if, the payment is treated as income to the seller.

The general rule for option payments is that their receipt is not an income-recognition event until the option transaction is complete either by sale of the property or by expiration of the option. Similar rules apply to an earnest money deposit made in consideration of a purchase and sale agreement: The payment is not income to the seller until the transfer contemplated by the contract has been executed. IRC §1234.

EXAMPLE 1: A taxpayer and a buyer enter into an option agreement on 1/1/X1 for Whiteacre, a parcel of raw land in which the taxpayer has a basis of $90,000, which is being held for investment purposes. In consideration for the taxpayer’s agreement to convey Whiteacre to buyer at any time on or before 12/31/X2, the buyer makes a nonrefundable payment of $10,000 to the taxpayer. Both the buyer and the taxpayer agree that the payment will be a credit against the purchase price if the buyer exercises the option before it expires. If so, the taxpayer does not recognize income on receipt of the option payment. IRC §1234.

These rules do not change when a taxpayer anticipates undertaking a like-kind exchange but has not yet conveyed the relinquished property to the buyer. Receipt of cash before a like-kind exchange neither results in income to the seller nor “taints” the cash as boot for IRC §1031 purposes. If the seller subsequently conveys both the option payment or earnest money proceeds to a qualified intermediary (QI) before or concurrent with the conveyance of the relinquished property, and the QI subsequently exchanges the relinquished property and the proceeds of the option payment or earnest money deposit for a replacement property that is conveyed to the taxpayer, then the cash will not be treated as cash boot received for §1031 purposes.

EXAMPLE 2: Assume the same facts as in Example 1, except that on 6/1/X2, the buyer exercises the option right to purchase Whiteacre for $100,000. In anticipation of the sale of the property to the buyer, the taxpayer enters into an exchange agreement with the QI meeting the requirements of Treas Reg §1.1031(k)-1(g) and concurrently transfers $10,000 to QI, who subsequently gives the buyer a $10,000 credit, and conveys Whiteacre to the buyer for $90,000 cash. The taxpayer later identifies replacement property and the QI purchases it on the taxpayer’s behalf for $100,000 cash, using the $10,000 transferred to the QI by the taxpayer and the $90,000 paid by the buyer. Result: The taxpayer realizes gain of $10,000, but no gain is recognized. See IRS Letter Ruling 7952086.

Crucial to this analysis is the taxpayer’s transfer of the option or deposit money to the QI before the exchange. If the taxpayer does not convey the option proceeds to the QI before the exchange, the cash option or earnest money payment would be treated as boot. If, in this example, the taxpayer did not transfer $10,000 to the QI, and instead purchased replacement property for $100,000 with $90,000 cash proceeds from sale of the relinquished property and $10,000 mortgage loan proceeds on the replacement property, the taxpayer would have cash boot of $10,000 in the exchange and, thus, have realized and recognized gain of $10,000.

A taxpayer who receives option payments from the buyer of the relinquished property and retains the payments following transfer of the property must treat the option payments as cash boot in the year of the exchange. See IRS Letter Ruling 9413024.

Exchanges Involving Pass-through Entities

There is some controversy over what is considered property held for investment when immediately subsequent to the exchange, the property is transferred to a pass-through entity. In Magneson, the 9th Circuit held that property that was acquired in a like-kind exchange as an investment but immediately contributed to a California general partnership (which held only the one property) did not lose its status as investment property. The Court held that the transfer of the property was a continuation of the investment, unliquidated, but modified in form. They based their opinion largely on the fact that, after the transfer, the Magnesons still owned and managed (as general partners) the same portion of the property.

Accordingly, it is questionable whether a transfer by an individual to a limited partnership, LLC, or S corporation would be exempt under the facts of this case, since the rights of the owners would be different. It is also doubtful that the Court would reach the same decision if the Magnesons had contributed the property to an entity that held additional properties, thereby diversifying their holdings.

Some taxpayers have also used the Magneson decision to justify distributing partnership property to partners to allow some partners to take advantage of the like-kind exchange rules to dispose of their interest in a partnership asset when other partners wanted to sell their interests in the property. It is not certain how such transactions will be taxed. Obviously, the more time between the distribution of the property and the sale of the property, the more likely it is that the IRS will concede that the property was held for use in a trade or business or for investment by the owners. It is best if the property is distributed before the sales contract is signed to provide a strong argument that the partners receiving the property have a substantial risk that the sale is not certain. Another problem that may arise with such a transaction is that the partners holding the distributed property as tenants in common may be deemed to enter into a new partnership. If so, IRC Sec. 1031 will not apply since the new partnership will be treated as the seller. This may be sidestepped by entering into a net lease with a lessee and then electing out of partnership tax treatment. Without the net lease, the IRS still has the ability to argue that the tenants in common are engaged in a trade or business, denying them the ability to elect out of partnership tax treatment.

Although partnership interests do not qualify as like-kind property under the rules of IRC Sec. 1031, partnerships can make like-kind exchanges of their qualifying assets. Practitioners should note that in TAM 9818003, the partners in a partnership tried to circumvent the rules disallowing the like-kind exchange of partnership interests by entering into a deferred like-kind exchange of the partnership’s only asset, with the qualifying properties being distributed to the partners in liquidation of their interests, rather than to the partnership. In this situation, the IRS held that the partnership did not enter into an exchange qualifying for nonrecognition treatment. The IRS has privately ruled that when a limited partnership relinquished property in a like-kind exchange and created a disregarded wholly owned LLC to receive all of the ownership interests in a partnership owning the replacement property, a gain deferral under IRC Sec. 1031 was allowed (Ltr. Rul. 200807005).

Note that IRS rulings and court cases have addressed whether the qualified use of property (a requirement for a successful Section 1031 exchange) can be attributed from a partnership to a partner or vice versa. Since there is currently no clear answer concerning this issue, be careful when structuring Section 1031 exchanges where property is contributed to a partnership in anticipation of exchanging that property in a like-kind exchange. The property received in the exchange is contributed to a partnership by a partner subsequent to that partner’s receipt of the property in a like-kind exchange, the property to be exchanged is distributed to the partners in anticipation of the exchange, or the property received by a partnership in a like-kind exchange is distributed to the partners immediately after the exchange. In such cases, at a minimum, practitioners should consider having the client transfer the property before entering into a binding agreement to exchange the property. The longer the property is held between the date of transfer and the date of exchange the better. The IRS, in Ltr. Rul. 8429039 provided that a two-year holding period is sufficient to ensure treatment as a tax-free exchange (all other tests being met). It appears that any holding period shorter than 24 months, while not disqualifying the transaction from Section 1031 treatment, will make the transaction suspect in the eyes of the IRS.

When determining whether a like-kind exchange is feasible, differentiate between a partnership interest and an undivided fractional share (which can be exchanged by a co-owner under the Section 1031 rules-see Rev. Proc. 2002-22). This should not be difficult in the case of an interest in an LLC taxed as a partnership, since the formation of an LLC requires filing written documents with the state of formation (as opposed to a partnership, which may be formed based on an oral agreement).

Section 1245 and 1250 Recapture

If property subject to Section 1245 depreciation recapture is transferred, recapture income is triggered to the extent of (a) gain recognized on the exchange determined without regard to Section 1245 recapture plus (b) the FMV of like-kind property received that is non-Section 1245 property and that is not taken into account under item (a) [IRC Sec. 1245(b)(4)]

Basis of Property Received

If an exchange is taxable under IRC Sec. 1031, gain or loss is recognized, and the basis of property received in the exchange is the property’s FMV. If the exchange qualifies for nonrecognition, the basis of property received must be adjusted to reflect any deferred gain or loss. The basis of like-kind property received in a Section 1031 exchange is determined as follows:

Adjusted basis of like-kind property given
+

Adjusted basis of boot (other property or cash) given (if any)
–

Loss recognized (if any) on boot given
+

Gain recognized (lesser of gain realized or boot received) on exchange (if any)
–

FMV of boot received (if any)
=

Basis of like-kind property received

Holding Period for Property Received

The holding period of property surrendered in a Section 1031 exchange carries over and tacks on to the holding period of the like-kind property received [IRC Sec. 1223(1)]. The boot received has a new holding period (beginning on the date of exchange) rather than a carryover holding period.

Note: Depreciation recapture potential also carries over from the property transferred to the property received in a like-kind exchange.

Bankrupt or Insolvent Qualified Intermediaries

Deferred exchanges frequently are arranged using a third party QI.  Because IRC Sec. 1031 does not provide for an extension of the statutorily mandated period to complete a like-kind exchange, a problem has been created because QIs have filed for bankruptcy, jeopardizing the like-kind exchanges they were handling for clients. Rev. Proc. 2010-14 provides a safe harbor method of reporting gain or loss for certain taxpayers who initiate deferred like-kind exchanges, but fail to complete the exchange because a QI defaults on its obligation to acquire and transfer replacement property to the taxpayer.

Rev. Proc. 2010-14 generally provides that a taxpayer recognizes gain on the disposition of relinquished property only as required under the safe harbor gross profit ratio method described therein. A qualifying taxpayer may report gain realized on the disposition of the relinquished property as the taxpayer receives payments attributable to the relinquished property using the safe harbor gross profit ratio method. Under this method, the portion of any payment attributable to the relinquished property that is recognized as gain is determined by multiplying the payment by a fraction, the numerator of which is the taxpayer’s gross profit and the denominator of which is the taxpayer’s contract price. Any required depreciation recapture is taken into account in accordance with IRC Secs. 1245 and 1250, except that the recapture income is included in income in the tax year in which gain is recognized to the extent of the gain recognized in that tax year.

The following definitions apply solely for purposes of the safe harbor gross profit ratio method:

a. Payment Attributable to the Relinquished Property. This is a payment of proceeds, damages, or other amounts attributable to the disposition of the relinquished property (other than selling expenses), whether paid by the QI, the bankruptcy or receivership estate of the QI, the QI’s insurer or bonding company, or any other person. The amount of satisfied indebtedness (any mortgage or encumbrance on the relinquished property assumed or taken subject to by the buyer or satisfied in connection with the transfer) in excess of the adjusted basis of the relinquished property is treated as a payment attributable to the relinquished property in the year in which the indebtedness is satisfied.
b. Gross Profit. This is the selling price of the relinquished property, minus the taxpayer’s adjusted basis (increased by any selling expenses not paid by the QI using proceeds from the sale of the relinquished property).
c. Selling Price. The selling price is generally the amount realized on the sale of the relinquished property, without reduction for selling expenses. However, a special provision applies if a court order, confirmed bankruptcy plan, or written notice from the trustee or receiver, issued by the end of the first tax year in which the taxpayer receives a payment attributable to the relinquished property, specifies an amount to be received by the taxpayer in full satisfaction of the taxpayer’s claim. In such cases, the selling price is the sum of the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) received or to be received, and the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.
d. Contract Price. This is the selling price minus the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.

The total gain (including recapture income) recognized under the safe harbor should not exceed the sum of (a) the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) and (b) the satisfied indebtedness not in excess of basis, minus the adjusted basis of the relinquished property. Adjustments to the gain determined using the safe harbor gross profit ratio method  should be made in the last tax year in which the taxpayer receives a payment attributable to the relinquished property.

Under the safe harbor, a taxpayer may claim a Section 165 loss deduction for the amount, if any, by which the adjusted basis of the relinquished property exceeds the sum of (a) the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) plus (b) the amount of any satisfied indebtedness not in excess of basis. A taxpayer who may claim this loss deduction may also claim a loss for the amount of any gain recognized under the safe harbor in a prior tax year. The timing for claiming any loss is determined under the general rules of IRC Sec. 165, and the character of any loss is determined under the normal capital gain rules (IRC Secs. 1201-1298).

For purposes of applying the safe harbor gross profit ratio method , the selling price, the contract price, and any payment attributable to the relinquished property must be reduced by the amount of any imputed interest allocable to the payment as determined under IRC Sec. 483 or 1274. For purposes of applying the imputed interest rules, the taxpayer is treated as selling the relinquished property on the date the bankruptcy plan or other court order that resolves the taxpayer’s claim against the QI is confirmed (the “safe harbor sale date”). (See section 709 for a full discussion of OID and the safe harbor.) As a result, if the only payment in full satisfaction of the taxpayer’s claim is received by the taxpayer within six months after the safe harbor sale date, no interest is imputed. The selling price determined under the safe harbor rules (see paragraph 714.69) is used to determine whether IRC Sec. 483 (in general, sales for $250,000 or less) or IRC Sec. 1274 (in general, sales for more than $250,000) applies to a transaction.

If exchange funds held by the QI were treated as an exchange facilitator loan (see paragraph 714.83), and the loan otherwise met the requirements of Reg. 1.7872-5(b)(16) (the amount of the exchange treated as loaned did not exceed $2 million and the duration of the loan was six months or less), the IRS will continue to treat the loan as meeting the requirements of Reg. 1.7872-5(b)(16) until the safe harbor sale date, even if the duration of the loan exceeds six months solely due to the QI default. In addition, if an exchange facilitator loan exceeds $2 million, the IRS will not impute additional interest on the loan after the date of the QI default. However, interest may be imputed under IRC Sec. 483 or 1274, as previously described.

Example : Deferring gain under the safe harbor for QI bankruptcies.
Clancy is an individual who uses the cash method of accounting and files federal income tax returns using a calendar year. Clancy owns a 10-acre parcel of land in Peoria as an investment. The parcel’s FMV is $150,000 and its adjusted basis is $50,000. Clancy enters into an agreement with a QI, Quincy Investments (Quincy) to facilitate a deferred like-kind exchange. On May 6, Year 1, Clancy transfers the Peoria property to Quincy, and Quincy transfers it to a third party in exchange for $150,000 cash. Clancy intends that the $150,000 held by Quincy be used to acquire Clancy’s replacement property. On June 1, Year 1, Clancy identifies a 5-acre tract of land in Urbana as replacement property. On June 15, Year 1, Quincy notifies Clancy that it has filed for bankruptcy protection and cannot acquire replacement property. Consequently, Clancy fails to acquire the Urbana property or any other replacement property within the exchange period.

As of the end of Year 1, Quincy’s bankruptcy proceedings are ongoing and Clancy has received none of the $150,000 proceeds from Quincy or any other source. On July 1, Year 2, Quincy exits from bankruptcy, and the bankruptcy court approves the trustee’s final report, which shows that Clancy will be paid, in August of Year 3, $130,000 in full satisfaction of Quincy’s obligation under the exchange agreement. Clancy receives the $130,000 payment on August 1, Year 3, and does not receive any other payment attributable to the relinquished property. Assume that the selling price of the Peoria property is less than $250,000 and that, based on IRC Sec. 483, $5,000 of the $130,000 payment is unstated interest.
Clancy falls within the scope of Rev. Proc. 2010-14 and may report the failed like-kind exchange due to Quincy’s default under the safe harbor rules. He is not required to recognize gain in Year 1 or Year 2 because he did not receive any payments attributable to the relinquished property in those years. IRC Sec. 483 applies to Clancy’s payment in Year 3 because it was due more than six months after the safe harbor sale date, and he received the payment more than one year after that date. Consequently, Clancy’s selling price is $125,000 ($130,000 minus the $5,000 of unstated interest). His contract price is also $125,000 because there is no assumed or satisfied indebtedness. Clancy’s gross profit is $75,000 [the selling price ($125,000) minus the adjusted basis ($50,000)]. His gross profit ratio is 75/125 (the gross profit over the contract price). Clancy must recognize gain in Year 3 of $75,000 [the payment attributable to the relinquished property ($125,000) multiplied by his gross profit ratio (75/125)]. In addition, he must include $5,000 of the $130,000 payment as interest income in Year 3. Even though the payment attributable to the relinquished property ($125,000) is less than the $150,000 proceeds received by the Quincy, Clancy is not entitled to a loss deduction under IRC Sec. 165 because this payment exceeds his adjusted basis in the relinquished property ($50,000).

Planning Tip: Taxpayers planning to use a deferred like-kind exchange may want to consider using a permitted security device, such as a standby letter of credit, qualified escrow, or qualified trust, which affords a measure of safety when using a QI [Regs. 1.1031(k)-1(g)(2) and (g)(3)].