realestate

1031 TAX EXCHANGE INFO
I hope you find this brief collection of information helpful.

A 1031 tax deferred property exchange is an exchange of like kind property in which capital gains tax deferral is available to owners of real estate, who sell their investment, rental, business or vacation real estate, and reinvest the net proceeds in other real estate. Real Estate held for these purposes are called like-kind/1031 properties.

Property owners may sell like-kind properties and defer taxes on the profits by meeting the requirements of Internal Revenue Code (IRC) 1031 exchange. The purpose of the 1031 Exchange is to allow sellers of like-kind property to buy replacement property of like-kind within a specific time period and defer taxes. This allows property owners to invest in properties with a better risk reward ratio, no management responsibility, increase tax write offs and often, significantly increase their cash flow.

Sellers have a maximum of 180 calendar days from the closing of the initial sale of the relinquished property to complete the exchange into the replacement property. Within the first 45 days of this period a seller must designate candidate properties and properly identify them to the IRS usually through a Qualified Intermediary, also known as an Exchange Accommodator. A seller may identify up to three properties regardless of value, a group of properties with a combined value that does not exceed 200 percent of the value of the initial property sale or any number of properties of any value as long as the final value of the properties exchanged into is equal to 95% of all of the properties identified. The funds in a trust account with the Qualified Intermediary can be used as earnest money in the purchase of designated property once all IRS requirements for a 1031 transaction are met.

If no new properties are identified in the first 45 days and no designated transaction is completed during the full 180 day period, the funds in the trust account will be liquidated and the sale proceeds taxed at the prevailing state and federal capital gains and depreciation recapture taxes.

Many investors don't take advantage of 1031 exchanges because of the fear of the 45 day identification period. This fear is supported by numerous horror stories of failed exchanges and the resulting devastating taxes that can result from such failures.

With proper planning and the right resources investors can navigate the waters of a 1031 exchange unscathed and frequently double or triple their spend able income and diversify their portfolio thus reducing risk.

What is requires to do this is a good grasp of the exchange process, a clear set of investment objectives and a plentiful and consistent source of quality replacement properties.

It is generally understood that in order to take advantage of the tax deferral benefits of a 1031 exchange the guideline to be adhered to is that an investor must replace the relinquished property with one that is considered “like kind.” Like kind is defined as “any other real estate held for productive use in a trade or business investment” and refers to the nature or character and not the grade or quality of the property. For example a vacant lot held for investment can be exchanged for a class A medical office building.

A less well known fact is that Regulation 1.1031(a)-1(c)(2) allows the investor to exchange conventionally owned real estate for a leasehold interest. A leasehold interest is one where the investor does not own the ground but rather has a right to a stream of income for a prescribed period of time. Generally, the reason an investor would consider a leasehold interest is a higher level of income than could not otherwise be realized from the same tenant.

The requirement to acquire a leasehold interest as replacement property when doing a 1031 exchange is that there be at least thirty (30) years remaining in the lease term. It is interesting to note that the term(s) of renewal options may be included when determining whether the leasehold interest has a remaining term of 30 years or more or not. In one case the court held that the initial term of 5 years with 10 optional renewal periods of 5 years each was considered “like kind.”

The benefits of exchanging into a long term net lease investments (be it an outright purchase or a leasehold interest) is that they provide stable, predictable income and generally minimize if not eliminate the management headaches associated with investment property. Frequently net leased properties are secured by well-recognized national companies who have been rated by Standard & Poors and Moody’s.

When considering a 1031 exchange and investing in net lease or leasehold properties the investor should seek out expert guidance from their CPA and/or real estate attorney prior to finalizing any investment decisions.

to qualify for 1031 Exchange tax deferral?
One of the most frequently asked a question regarding 1031 exchanges is how long the investor should hold their property to qualify for an exchange. Key to understanding the answer to this question is that the intent of the exchanger must be to hold the property for investment or use in a trade or business.

The IRS is clear on what does not qualify for a 1031 Exchange regardless of the holding period. This includes properties sold by dealers who hold property for sale and not for investment, and properties sold by investor's who flip them, owning them long enough to resell for a profit

The holding time is a clear demonstration of intent, the longer the investor holds the property, the better. An investor with the ability to provide two years' tax returns showing rental income, expenses, and depreciation has proven to be a good indication of intent to hold property for investment purposes.

The outcome of many court cases suggests that two years of tax returns are a good indicator of intent. The IRS recognizes these court cases but is more likely to audit a 1031 exchange where the property was held for less than a year and a day.

The issue here is not only the number of tax returns filed but also how long the property was actually held. Theoretically an investor could buy a property on December 31 of one year and sell it on January 1 of the next year holding the property for all of one day. It's true the investor could file two years of tax returns but the intent could be seriously questioned based upon the actual time the property was held.

While investor's holding periods of less than a year have held up in court, the investor had the costly expense of going to court to defend their position. Some experts like to point to these cases as validating short term holds. However, the same experts frequently fail to point out that these cases generally fail, and neglect to mention the amount of time and money it took to litigate the investor's point of view.

Most tax advisors will recommend that an exchanger hold the property for at least a year and a day to demonstrate intent. An investor should discuss in detail the holding period of an investment with their tax advisors when a 1031 exchange is part of its investment strategy.

When involved in a 1031 exchange, generally, expenses that are considered non-recurring, such as real estate commissions, will reduce the value requirement of the replacement property and not create a tax liability.

Expenses that can create a tax liability, and not permitted to reduce the value of the replacement property if paid with exchange funds, generally, are expenses that are recurring such as property taxes or insurance.

Examples of non recurring expenses related to the purchase, sale and exchange are considered allowable and can include the following:

• Real estate commissions
• Referral Fees
• Title insurance premiums
• Closing or escrow fees
• Recording Fees
• Legal or Attorney Fees
• Tax Advisor or Accounting Fees
• Transfer taxes
• Notary fees

Expenses that are considered not part of an exchange and are generally disallowed can include:

• Loan Fees
• Loan Points mortgage insurance costs
• Property taxes
• Prorated Rent
• Insurance Premiums
• Security Deposits
• Payoff of credit card debt
• Lender's title insurance
• Credit Reports

Non exchange expenses paid with exchange funds are taxable but can be offset by other items such as prepaid taxes. One option is to pay recurring expenses with non 1031 funds to avoid creating taxable boot in the 1031 exchange.

Items such as prorated tax payments or security deposits owed to the buyer can be treated as non-recourse debt if handled properly and can be offset against debt assumed on the new replacement property.

Investors should carefully review all aspects of their 1031 exchange with their tax and or legal advisor fully understand and plan for possible tax consequences.

History of the 1031 Exchange:
The ability to defer capital gain taxes on the sale of property has been around since 1921. In 1935 the Board of Tax Appeals approved the first modern tax-differed exchange using Qualified Intermediaries.

The 1954 Amendment to the Federal Tax Code changed Section 112 (b)(1) number to Section 1031 of the Internal Revenue Code and adopted the present day definitions and description of the tax –deferred like-kind exchanges.

The Starker family tax-deferred like-kind court decision established the need for regulations regarding delayed tax-deferred exchanges. This now famous case prompted the United States Congress to eventually adopt the 45 calendar day Identification Deadline and the 180 calendar day Exchange Period as part of the Deficit Reduction Act of 1984.

The Tax Reform Act of 1986 eliminated accelerated depreciation and put like-kind exchanges in the limelight as being one of the few income tax benefits left for real estate investors.

The Revenue Reconciliation Act of 1989 disqualified like-kind exchanges between domestic and non-domestic properties and placed a two year holding period requirement on related party exchanges.

Revenue Procedure 2000-37 gave investors guidelines on how to structure reverse tax-deferred like-kind exchanges transactions.

Revenue Procedure 2002-22 provided investors with additional like-kind replacement property options that had not existed before- Co-Ownership of Real Estate (CORE). CORE is most frequently referred to as Tenant in Common or TIC investments.

Revenue Procedure 2005-14 made effective on January 27, 2005 made it possible for the first time for homeowners to use the tax-deferral mechanism of Section 1031 on their primary residence, if specific steps outlined in the code were carefully followed.

The introduction of Revenue Procedure 2002-22 has arguably had the most significant impact on the tax-deferred like-kind exchange industry since the Tax Reform Act of 1986. It provided Investors with an additional like-kind replacement property option that had not existed before — Co-Ownership of Real Estate (CORE) — and is partially responsible for the explosive growth in the number of tax-deferred like-kind exchange transactions between 2002 and 2005.

Recent legislation indicates that the legislative pendulum may be swinging in the other direction: the most recent modification within the realm of Section 1031 served to expand its application, rather than restrict it.

Revenue Procedure 2005-14 was issued and made effective on January 27, 2005 and made it possible for the first time for homeowners to use the tax-deferral mechanism of Section 1031 on their primary residence, if done in conjunction with the specific strategy delineated under the Revenue Procedure.

So long as the property in question satisfies the requirements for both Code Sections 1031 and 121, then the Section 121 Exclusion operates to exclude from taxable income either 250,000 or 500,000 in capital gain from the sale, exchange or disposition of the property and any additional gain may be deferred by reinvesting in like-kind replacement property through a tax-deferred like-kind exchange.

These issues are very complex and require the assistance of an experienced advisor! Contact me and I will help you connect with a qualified person, to help and assist you through every step of the process.