Closing Costs in a §1031 Exchange: A Trap for the Unwary?

Closing statements are replete with prorations and credits that adjust the sales price.  Other line items reflect the payment of recording fees, title insurance and other transaction expenses.   Seemingly routine, the way these expenses are handled in a §1031 exchange may have unintended tax consequences.

Remember that the rationale for tax-deferral under §1031 is that the taxpayer has merely moved his investment from one property to another.  The form may have changed, but as long as the underlying investment remains unchanged no tax is due.  Any “cashing out” of the investment (i.e. reduction in equity) will be taxed.

In some instances, using exchange funds to pay closing costs or issue credits that adjust the price, may be a form of cashing out.  The result is that the transaction may be partially taxable.
Another concern is that paying certain expenses could be construed as impermissible receipt of the exchange funds.  Under the IRS regulations the taxpayer cannot have actual or constructive receipt of the exchange funds.  Improper receipt could cause the entire exchange to fail.
The IRS and case law provide very little guidance on this topic.  This article discusses the issues in general, but because of their uncertainties and technical nature, it is important that every taxpayer have his tax advisor approve each closing statement, so there are no surprises when preparing the tax return.

EXCHANGE EXPENSES

Certain items paid at a closing are considered “Exchange Expenses”.  Using exchange funds to pay those expenses will not result in a tax liability to an investor doing a §1031 exchange.  For example, Revenue Ruling 72-456 provides that if exchange funds are used to pay brokerage commissions, it does not result in the transaction being partially taxable.  There are no other clear rulings on this subject, but most tax advisors agree that the following expenses are exchange expenses and may be paid at the closing of the relinquished or replacement properties without any tax consequence:
• Brokerage commissions • Exchange fees • Title insurance fees for the owner’s policy of title insurance • Escrow fees • Appraisal fees required by the purchase contract • Transfer taxes • Recording fees  • Attorney’s fees incurred in connection with the sale or purchase of the property

NON-EXCHANGE EXPENSES

Not all expenses are Exchange Expenses.  Exchange funds can be used to pay a non-exchange expense, although doing so may result in the exchange being partially taxable.
Such payments will not invalidate the application of the Qualified Intermediary safe harbor, but they may still constitute boot to the Exchanger.  On a typical settlement statement the seller of the relinquished property will give the buyer a credit against the sales price, representing security deposits and prorated rents.  Effectively, the seller was using exchange funds to pay the security deposit and prorated rent amounts to the buyer.  To avoid a taxable event, the seller should deposit his own funds to pay those security deposits and prorated rents to the buyer, rather than giving a credit.
In addition, most tax advisors believe that fees and costs paid in connection with getting a loan to acquire the replacement property should be considered costs of obtaining the loan, not costs of acquiring the replacement property, and thus are not Exchange Expenses.  To avoid any potential tax liability, the buyer may want to deposit his own funds to pay loan related expenses.
Some non-exchange expenses create a tax liability but are offset by a deduction.  One example of this is property taxes.  Although property taxes are not an Exchange Expense, the investor will get a deduction for paying the property taxes, and that liability will be offset by a deduction.
The following items are typically found on a closing statement but are generally not considered Exchange Expenses because they do not relate directly to the disposition of the relinquished property or the acquisition of the replacement property:
• Loan costs and fees • Title insurance fees for the lender’s title insurance policy • Appraisal and environmental investigation costs that are required by the lender • Security deposits • Prorated rents • Insurance premiums • Property taxes

TRANSACTIONAL ITEMS AND CONSTRUCTIVE RECEIPT

A separate, but important, issue is whether paying a non-exchange expense from exchange funds will be construed as constructive receipt of those funds by the investor, which has the potential to disqualify the entire exchange.  Under the IRS Regulations exchange funds can be used to pay “transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).”
For example, an investor may want to use exchange funds to pay a rate lock-in fee to a lender.  Since these fees by their nature are paid before the closing, and are not strictly required for the acquisition of the replacement property, paying the fee from exchange funds may trigger a constructive receipt problem.
Since there is no clear IRS guidance, it is important that investors discuss the issue with their tax advisors before seeking to use exchange funds to pay non-exchange expenses, whether prior to, or at the replacement property closing.

 

REFERENCES

Revenue Ruling 72-456; TAM 8328011; Treasury Regulation §§ 1.1031(k)-1(g)(6) and (7); IRS Form 8824.  – See more at: http://firstexchange.com/July2013Newsletter

-from First American Exchange Company July 2013 Exchange Update

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Don’t Jeopardize Your 1031 Exchange – from First American Exchange Company – Exchange Update Newsletter

When completing a §1031 exchange there are some little-known requirements that could potentially disqualify your tax-deferred transaction.  Here are a few that could put your exchange at risk.

Qualified Intermediary Selection

 

Someone who is acting as your agent at the time of the transaction is disqualified from acting as a Qualified Intermediary.  Who is considered an agent? Someone who has acted as your employee, attorney, accountant, investment banker or broker, or real estate agent within the two-year period ending on the date of transfer of the first relinquished property. These persons are disqualified because they are presumed to be under the Taxpayer‘­s control.  Thus, the Taxpayer is deemed to have control of the exchange funds, otherwise known as “constructive receipt”. Constructive receipt by the Taxpayer invalidates the §1031 exchange. See here for exceptions to this rule.

 

If exchange funds are set aside or otherwise made available to you, it is also considered to be constructive receipt. Of course, if you actually receive the exchange funds you will invalidate your exchange.

 

Identification Deadlines

 

The most common reason an exchange fails is missed deadlines.  Potential replacement property(ies) must be identified by midnight of the 45th day after the relinquished property transfer.  Therefore, it is advisable to begin searching for the replacement property as soon as possible. In addition, the replacement property must be received by the taxpayer within the exchange period which ends on the earlier of 180 days from the date on which the taxpayer transfers the first relinquished property, or the due date for the taxpayer’s federal income tax return for the taxable year in which the transfer of the relinquished property occurs.  Extensions may be available for Taxpayers within a Presidentially Declared Disaster Area, or in active service in a combat zone. See here for exceptions to these deadlines.

 

Same Taxpayer Rule

 

Another mistake someone could inadvertently make would be to change the manner of holding title from the relinquished property to the replacement property. As a general rule, the same Taxpayer that transferred the relinquished property should be the same Taxpayer that acquires the replacement property. There are a variety of reasons you might want to change how title is held in an exchange and some changes are allowed, but you must be sure to talk it over with your tax advisor first. You can read further details on vesting title in a §1031 exchange, here.

 

Related Party Exchanges

 

You must also give serious consideration to any relationship you might have with the seller of the replacement property. Acquiring replacement property from a related party is potentially problematic, so the facts of the transaction should be reviewed by your tax advisor before proceeding.  The IRS could view the transaction as an abusive shift of basis between related parties resulting in tax avoidance and disallow the exchange.  Exchanges involving related parties are allowed, but both parties must hold their newly acquired properties for at least two years or both exchanges will fail.  For more information on exchanging with related parties, click here.

 

First American Exchange has helped thousands of taxpayers successfully complete even the most difficult transactions. While we don’t provide tax or legal advice, we make it our business to keep you informed of your exchange deadlines and other potential pitfalls that could jeopardize your exchange.

– See more at: http://firstexchange.com/June2013Newsletter#sthash.7dRJR7Vh.dpuf

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Top Ten 1031 Exchange Misconceptions

1.  Like-kind means I must exchange the same type of property, such as apartment building for apartment building.

 

All real property is like-kind to other real property, but personal property

like-kind requirements do have some restrictions. Real property and personal property are not like-kind to one another.  To read more about like-kind real estate, go here.

 

2.  My attorney can handle this for me.

 

Not if your attorney has provided you any non-exchange related legal services within the two-year period prior to the exchange. To read more about qualified and disqualified parties, go here.

 

3.  I must literally “swap” my property with another investor.

 

No. A 1031 exchange allows you to sell your relinquished property and purchase replacement property from a third party. Watch a short video on the basic process of a 1031 exchange.

 

4.  1031 exchanges are too complicated.

 

They don’t have to be. An experienced Qualified Intermediary will work with you and your tax and/or legal advisors to make sure the process is as seamless as possible.  Go here to read frequently asked questions and answers about doing a 1031 exchange.

 

5.  The sale and purchase must take place simultaneously.

 

No. The taxpayer has 45 days to identify the new replacement property and 180 days to close.

If you would like more information on the identification time period, go here.

 

6.  I just need to file a form with the IRS with my tax return and “roll over” the proceeds into a new investment.

 

No.  A valid exchange requires much more than just reporting the transaction on Form 8824.  One of the biggest traps when not structured properly is the taxpayer having actual or constructive rights to the exchange proceeds and triggering a taxable event.  For more information on tax filing requirements, go here.

 

7.  1031 exchanges are only for real estate.

 

No. Almost any property, whether real or personal, which is held for productive use in a trade or business, or for investment, may qualify for tax-deferred treatment under Section 1031. For more information on personal property exchanges, go here.

 

8.  All of the funds from the sale of the relinquished property must be reinvested.

 

No. A taxpayer can choose to withhold funds or receive other property in an exchange, but it is considered boot and will be subject to federal and state taxes.  To understand more about boot, go here.

 

9.  1031 exchanges are just for big investors.

 

No. Anyone owning investment property with a market value greater than its adjusted basis should consider a 1031 exchange. To find out how to use 1031 exchanges as a retirement planning tool, go here.

 

10.  I must hold property longer than a year before exchanging it.

 

The 1031 regulations do not list a time requirement on how long you must hold property, but it does say that property must be “held for productive use in a trade or business or for investment”.

To learn more about holding period requirements, go here.

from First American Exchange Company “The Exchange Update”

 

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Can I Exchange My Vacation Home?

Rising gas prices have caused many vacation property owners to reevaluate their “get away” options. They still want a cottage on a lake, but the lake needs to be closer to home. With proper planning, a tax-deferred exchange may help them realize that goal.

How much personal use is allowed?

To qualify for tax-deferred treatment under §1031, both the relinquished and replacement properties must be held for investment purposes or for use in the taxpayer’s trade or business. Property held for personal use does not qualify.

So what about vacation homes? Personal use is usually why they were acquired, but how much personal use is too much? Hopefully the properties will appreciate in value. Is that sufficient to demonstrate the necessary investment intent? Or does the property have to be rented out to be considered an investment?

Appreciation ≠ Investment

The Taxpayers in one case faced this exact dilemma.1 They had lake property that was used 2 or 3 weekends in the summer, with maintenance visits in the off season. They exchanged for property closer to home and used it even more often. The Court disallowed the exchange, finding that the property was held primarily for personal use, not for investment.

The mere hope or expectation of appreciation was not sufficient to establish investment intent. The Taxpayers never attempted to rent either property, never claimed deductions for maintenance or depreciation and deducted the interest as home mortgage interest. Also, their failure to properly maintain the relinquished property was inconsistent with an investment intent.

The IRS Safe Harbor: Revenue Procedure 2008-16

In 2007 the Treasury Inspector General for Tax Administration issued a report recommending additional oversight of like-kind exchanges, specifically stating that: “…the IRS regulations for like-kind exchanges of second and vacation homes are complex and may be unclear to taxpayers…and little exists with respect to a published position by the IRS on like-kind exchanges involving such properties.”2

In response the IRS issued Revenue Procedure 2008-16, which provides a safe harbor. If the procedures are followed, the IRS will not challenge whether a property qualifies as being held for productive use in a trade or business or for investment. An exchange may fall outside the safe harbor and still qualify, but expect more scrutiny from the IRS.

Qualifying Properties

Both the Relinquished and Replacement Properties must have been owned by the Taxpayer for at least 24 months immediately before and after the exchange. In each of the two 12-month periods immediately before and after the exchange the Properties must be rented at a fair market value for 14 days or more. The Taxpayer’s personal use cannot exceed the greater of 14 days or 10% of the days during each 12-month period that the property was rented at a fair market value.

Personal Use

“Personal Use” is not limited just to use by the Taxpayer. It also includes use by:

• the Taxpayer’s family members;
• any other person with an interest in the unit, or their families;
• anyone using the unit under an arrangement which enables the Taxpayer to use some other dwelling unit (even if no rent is charged); or
• anyone, if the property is rented for less than fair market value rent.

Meeting the Safe Harbor

First, you must meet the ownership requirements mentioned above. You should also limit personal use of the property to the greater of 14 days per year or 10% of the rental period. If you use the property any additional days for repairs and maintenance, be ready to show proof of the actual work done

The property should be rented to an unrelated party for at least 14 days per year. However, there is no need to rent the property for more than 14 days. You may also rent the property to a related party if they use it as their principal residence and pay fair market value rent.

It is also important to treat the property as an investment. Make sure that the property is properly maintained. Deduct expenses for maintenance, utilities, insurance and depreciation. If you have a mortgage on the property make sure that it is structured as an investment loan, not as a loan for a primary residence.

Vacation Homes Outside the United States

What if you own a vacation property located outside the United States? In some cases you can still benefit from a 1031 exchange. Real estate located outside the United States is not like-kind to real estate in the 50 states, even if it is located in an affiliated commonwealth or territory, such as Puerto Rico.3 However, you can exchange “foreign for foreign”, (e.g. Belize for Bermuda) as long as the other requirements are met.

A tax-deferred exchange is one of the few wealth building tools available to virtually any investor. Taxpayers should consider the benefits of a tax-deferred exchange whenever they plan to sell property that is not their principal residence.

from First American Exchange Company –

The Exchange Update

A Newsletter For 1031 Tax-Deferred Exchanges

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1031 Treatment for Conservation Easements

The decline in real estate development has provided an unexpected opportunity for land preservation. Large tracts of land that were slated for new construction are now being sold in whole or in part to local and regional municipalities or open space organizations. Certainly the sale of the entire fee interest in land held for productive use in a trade or business or for investment would likely qualify for a §1031 exchange. Interestingly, the sale of less than a fee interest may also qualify for tax-deferral under §1031 if certain criteria are met.

The IRS has issued several private letter rulings finding that certain types of conservation and agricultural easements are like-kind to real estate. A conservation easement is a voluntary agreement that allows a landowner to limit the type or amount of development on their property while still retaining ownership of the land1. Generally, the easement needs to be perpetual in nature and considered an interest in real estate for state law purposes.

Typically the land owner receives cash in exchange for granting the easement. Sometimes more than one government agency is involved in the transaction, such as a matching funds agreement between a county and state. In those cases there may be issues coordinating the timely payment of funds from each agency. It is a good idea to confirm how and when the sales price will be paid before entering the transaction.

There have been instances where the land owner received compensation other than cash in exchange for the easement. In a private letter ruling2 the IRS approved an exchange where the taxpayer received stewardship credits as compensation.3

First, using a Qualified Intermediary, the taxpayer conveyed the relinquished property by granting the county a perpetual restrictive stewardship easement over ranch land in return for stewardship credits equal to the value of the property rights that the taxpayer permanently relinquished. During the exchange period, the taxpayer converted the credits to cash by selling them to a third party buyer. The cash was then used to purchase the replacement property. The taxpayer was never in receipt of the credits or the relinquished property proceeds during the exchange period. The stewardship easement was held to be like kind to a fee interest in real estate.

The IRS based its decision on the fact that the stewardship easement was considered an interest in real property under state law and that the easement was perpetual. The ruling also discussed how the sale of the easement significantly and permanently restricted the future use of the taxpayer’s property such that the fair market value of the property, if sold, would be impaired.

In summary, remember that a §1031 exchange opens many investment opportunities for property owners. Do not assume that you can only exchange fee interests for other fee interests. There are many other possibilities, including conservation easements, leasehold interests and water rights. Please feel free to contact your local First American Exchange Company office to discuss your options: (800) 556-2520; 1031@firstam.com.

from First American Exchange Company Newsletter

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Converting Investment Property to Your Primary Residence

Exclusion of Gain from Sale of Residence

Many people are aware that they can sell their primary residence and not pay taxes on a significant amount of gain. Under Section 121 of the Internal Revenue Code, you will not owe capital gains taxes on up to $250,000 of gain, or $500,000 of gain if you are married and filing jointly, when you sell a home that you used as your primary residence for at least two of the previous five years. Taxpayers can take advantage of this exclusion once every two years.

Property Converted from Investment to Primary Residence

Taxpayers used to be able to trade into a rental, rent the home for a while, move into it and then exclude all or some of the gain under Section 121. Provided they lived in the home as their primary residence for at least two years, they could sell it and exclude the gain under Section 121 up to the maximum level of $250,000/$500,000. In recent years Congress enacted two amendments to Section 121 in order to limit the benefits of Section 121 when the property has been used as a rental.

First, if you acquire property in a 1031 exchange and then convert it to your primary residence, you must own it at least five years before being eligible for the Section 121 exclusion.

Second, the amount of gain that you can exclude will be reduced to the extent that the house was used for something other than a primary residence during the period of ownership. The exclusion is reduced pro rata by comparing the number of years the property is used for non-primary residence purposes to the total number of years the property is owned by the taxpayer.

For example, a married couple uses a tax deferred exchange under Section 1031 to acquire a house as investment property. The couple rents the house for three years, and then moves into it and uses it as their primary residence for the next three years. The couple sells the property at the end of year 6, netting a total gain of $800,000. Instead of being able to exclude $500,000, the couple will not be able to exclude some of the gain based on how many years they rented the house. Since they rented it for three years out of six, 50% of the gain, or $400,000, will not be able to be excluded. Because of this new limitation, the couple will be able to exclude $400,000 of the gain rather than $500,000.

Exceptions

There are a couple of exceptions to this restriction. If the house was used as a rental prior to January 1, 2009, the exclusion is not affected. Using the example provided above, if the three year rental period occurred prior to January 1, 2009, the exclusion would not be reduced and the couple would be able to exclude the full $500,000.

Another important exception is that property that is first used as a primary residence and later converted to investment property is not affected by these restrictions on excluding gain. For example, if you own and live in a house for 18 years and then you move out and rent the house for two years before selling it, you can receive the full amount of the exclusion. Because your investment use occurred after the last day of use as a primary residence, all of the gain accumulated over your 20 year ownership of the property can be excluded, up to $250,000, or $500,000 for married couples.

Combining Exclusion with 1031 Exchange

Fortunately, the rules are favorable to taxpayers who have more than $250,000/$500,000 of gain and are looking to combine Section 1031 with Section 121 to both exclude and defer tax. When the property starts out as a primary residence and then is converted into an investment property, you can exclude gain under Section 121, and then defer tax on the remaining gain, provided you comply with the requirements of both Section 1031 and Section 121.

The Internal Revenue Code still provides investors with favorable options for exclusion of gain and tax deferral. The rules can be complicated, but with the right planning taxpayers can still make the most of their real estate investments. For additional information about the 1031 exchange process or to open an exchange contact us at First American Exchange.

References: Internal Revenue Code §121; Housing Assistance Tax Act of 2008 (H.R. 3221).

from

The Exchange Update

A Newsletter For 1031 Tax-Deferred Exchanges by First American Exchange Company

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Structuring an Option with a 1031 Exchange

In a slower economy financing is often difficult to find, leaving willing buyers and willing sellers without the means to complete their transactions.  Through the use of options, either alone or in connection with a lease arrangement, some measure of certainty can be achieved. 

An option is a unilateral agreement between the property owner and a potential buyer.  In a typical situation the buyer makes a one-time cash payment to the owner.  In return, the buyer receives the exclusive right to purchase the property at a set price during the option period.

A lease with an option to buy is a similar tool that many investors turn to as a way to move their deals forward.  This structure has benefits for both parties.  In addition to the payment for the option right, the property owner receives monthly rental income and the knowledge that a committed buyer is waiting in the wings.  The tenant benefits by having the present use of the desired property, while locking up the future acquisition of the property at a pre-determined price.

So what does this mean in the context of a §1031exchange?  Can a lease be used to extend the exchange period?  How are option payments treated?  Can an option be exchanged?

Lease with Option to Buy

 

A lease with an option to buy is a legitimate way for the property owner to attempt to lock in a buyer, and for the buyer to lock in a property. 

If the property owner intends to do an exchange, the exchange typically will not start until the property is transferred to the buyer by delivery of the deed at a closing.  Nevertheless, there are some situations where the parties transfer all of the benefits and burdens to the tenant/buyer before the closing, and in these cases the IRS may apply the benefits and burdens test and decide that the transfer (for tax purposes) had occurred earlier.  An example of this is a lease with option payments that are so large relative to the fair market value of the property that it is a virtual certainty that the buyer will exercise the option. 

Option Payments

 

What about the option payments themselves?  Generally, option payments are not taxable until the option is exercised or forfeited.  If the owner is doing a §1031exchange and receiving option payments that are applicable to the purchase price, most tax advisors recommend that the owners have the qualified intermediary hold the option payments.  Alternatively, the owner should consider sending the option payments to the closing or escrow agent prior to the closing so that the funds can be added to the exchange proceeds.  If the owner chooses to retain the payments they will be taxable boot.

Trading Options

 

In some situations the option holder may decide not to exercise the option.  The option may still have value, however, especially if the current market value of the property has appreciated above the fixed option price.  Can the option be transferred by the option holder as part of a tax-deferred exchange?  There is not much authority dealing with the tax treatment of options or other contract rights in a §1031exchange, but interestingly, in the case that established the validity of deferred exchanges, the taxpayer received only a contract right as his replacement property.  

Other issues to consider are whether options are like kind only to other options or whether they can be considered like kind to a fee interest in real estate, and whether granting an option can make the relinquished property be treated as property held for sale rather than held for investment purposes. 

In summary, when financing is difficult to obtain, an option, especially when combined with a lease, can help the transaction move forward.  Always consult your tax professional prior to structuring an option transaction.  First American Exchange is always available to help you set up your next 1031 exchange.

The Exchange Update

A Newsletter For 1031 Tax-Deferred Exchanges

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Refinancing Before or After a 1031 Exchange

A common question that we are asked when working with investors contemplating a 1031 tax deferred exchange is:  Can I refinance the property and pull out cash before or after I complete my exchange?  Unfortunately there is no clear cut answer to this question, but hopefully the information in this article will provide you with some clarity. 

 In order to completely defer all tax in a 1031 exchange, you need to acquire property equal to or greater in value than the property you have sold, and you need to reinvest all of the net cash you receive from the sale of the relinquished property.  Because of the rule which requires you to reinvest all of the equity, when you refinance right before or after a 1031 exchange, the IRS may question whether you refinanced to avoid complying with the 1031 rules or whether you did it for a legitimate business purpose. 

Under the step transaction doctrine, the IRS may argue that what you did in several steps (close your exchange as step one and refinance your property as step two) was really all a part of one transaction.  Under that theory, the IRS could take the position that you may be considered to have taken cash boot in your exchange.  If that happens, an exchange that you thought was completely tax-deferred would be at least partially taxable.  It is important to consult with your tax advisor when deciding whether and how to refinance properties that are involved in an exchange. 

Here are a few suggestions that you may want to consider:

  • The loan should have a clear business purpose which should be well documented in your files.  For example, the maturity date of the loan may be approaching and you may want to set up a refinance prior to the exchange in case the exchange does not go through.  Other potential business purposes may be to get a lower interest rate or to buy property that is not a part of the exchange. 
  • If you schedule your refinance and exchange so that there is as much time in between them as possible, it should make it less likely that you are audited concerning this issue.  It should also strengthen your argument that the refinance was not set up to avoid the 1031 exchange rules.  If you intend to refinance your relinquished property, you may want to refinance it before you list it for sale.  
  • Some tax advisors believe that it is better to refinance the replacement property after an exchange rather than to refinance the relinquished property before an exchange.

In any event, it is important to consider the risks and discuss your plans with your tax advisor. 

from the First American Exchange Company October Newsletter “The Exchange Update”

 

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Improvement Exchanges for Commercial and Residential Property

In the current real estate market there are many opportunities to acquire distressed property at a fraction of the price. Investors can take advantage of this market by selling their relinquished property in a 1031 tax deferred “improvement” exchange and purchasing replacement property that might need construction work or improvements.    

The improvement exchange, also known as a build-to-suit or construction exchange, allows an investor to use the proceeds from the sale of the relinquished property not only to acquire replacement property, but also to make improvements to the property.  For example:

If an investor sells relinquished property with a fair market value of $1 million, debt of $200,000 and equity of $800,000, he must acquire a property equal to at least $1 million and must invest at least $800,000 into that property in order to completely defer his tax in a 1031 exchange.  In an improvement exchange, however, the investor could acquire property worth only $300,000, borrow an additional $200,000 and spend the remaining $500,000 of exchange proceeds plus the $200,000 in loan funds on improvements to the property.  This would use up the remaining cash and increase the fair market value of the replacement property to $1 million, resulting in a fully tax deferred exchange.

Structuring an Improvement Exchange

An improvement exchange is accomplished by having a separate entity called an “exchange accommodation titleholder” or “EAT” temporarily take title to the replacement property while the improvements are being made.  The EAT is necessary because any work done to the property after the investor takes title to it is not considered like kind property and therefore will not increase the value of the property for exchange purposes. First American Exchange creates and owns this entity which holds title to the property for up to 180 days.  During that time frame the investor controls the construction, not First American Exchange.  The costs of construction are paid for either by the investor, a loan, or by using the funds from the sale of the relinquished property.

Benefits and Drawbacks of Doing an Improvement Exchange

The benefits of doing an improvement exchange include the ability to buy property that is lower in value compared to the relinquished property while still having a completely tax-deferred exchange, and to use exchange funds rather than loan proceeds to fund construction. 

The principal drawback of doing an improvement exchange is that the work must be done within the 180 day period in order to have any effect on the exchange.  In addition, improvement exchanges can be more costly due to fees and costs of an additional closing and formation of the EAT. 

Planning for an Improvement Exchange

For those intending to do an improvement exchange, planning ahead is essential. 

  • First, include a provision in the purchase contract that it is assignable in connection with a 1031 exchange.  This is necessary because the EAT, rather than the investor, will be taking title to the replacement property.  
  • Contact First American Exchange and your lender early in the process.  Typically the EAT signs the loan documents and the loan must be completely non-recourse to the EAT.    
  • Get an accurate estimate of the amount of time it will take to complete the construction project.   Although the construction does not have to be complete at the expiration of the 180 day period, the only improvements that will affect the value of the replacement property for exchange purposes are the improvements that are done as of the date that the EAT transfers the replacement property to the exchangor.  
  • Finally, always consult with your tax advisor before doing any exchange, including an improvement exchange. 

By properly structuring an improvement exchange, the investor should have much more flexibility in finding appropriate properties and at the same time completely defer all capital gains tax. 

from First American Exchange Company “The Exchange Update”

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Seller Financing Strategies and 1031 Exchanges

In this real estate market where financing is sometimes not readily available, sellers who are motivated to sell may offer to finance a portion of the purchase price.  At the closing, the buyer deposits some cash and signs a seller carryback note for the balance.  If structured as an installment sale under IRC Section 453, the seller pays tax on any gain as the payments are received rather than paying tax on the gain in the year of sale for the entire purchase price.

If the seller is also contemplating a tax deferred exchange under IRC § 1031, he will have to decide how to treat the seller carryback note. The note can either be kept outside of the exchange or, under the limited conditions described below; it can be included in the exchange.

NOTE IS NOT INCLUDED IN THE EXCHANGE

 

In most cases where there will be seller carryback financing, the note is not included in the 1031 exchange. The note is taxable boot, but the tax is paid over time as payments are collected.  For example, if you sign a five year note and pay a portion of the principal balance each year, the tax obligation will also be spread out over that five year period.   

When the note is not a part of the exchange, it should be payable to the seller and delivered directly to the seller at the time of closing. Only the cash proceeds received from the sale are delivered to the Qualified Intermediary (QI) and used as exchange funds.

NOTE IS INCLUDED IN THE EXCHANGE

 

If an investor wants to defer all of the gain in a 1031 exchange, including the amount represented by the note, he has several options. In each case, the note should be made payable to the QI.  The QI collects all of the payments during the term of the exchange and they become part of the exchange proceeds.

In order for the note to be used as part of the exchange, it must either be converted to cash prior to the purchase of the replacement property or the seller of the replacement property must agree to accept the note as payment for the property.

Convert the Note to Cash

There are several ways in which an investor may be able to convert the note to cash prior to his purchase of the replacement property. First, the note can be a short term note that matures before the investor intends to buy the replacement property. The note payments are made to the QI and they become exchange proceeds. Once the note is paid in full, the QI uses that cash to purchase the replacement property. Because the note would have to be completely paid during the exchange period, the maximum term of the note is the earlier of 180 days or when the replacement property closing occurs.

The second option is for the investor to buy the note from the QI. In order to avoid the possibility of constructive receipt, most tax advisors recommend that this occur at the closing of the replacement property. The QI then uses the funds to purchase the replacement property at that closing.

Finally, the investor can arrange for an unrelated third party to buy the note. The proceeds from the sale would go directly to the QI as exchange proceeds, and the QI uses those proceeds to buy the replacement property. 

Use the Note to Purchase Replacement Property

Occasionally, a seller is able to use the note as partial payment for the replacement property.  In this scenario, the QI assigns the note to the seller of the replacement property at the closing.

HARD MONEY LOANS

 

Some sellers elect to lend the money to the buyer of the relinquished property up front as a “hard money loan” rather than through seller carryback financing. Using this option, the seller acts as a third party lender and deposits cash in the amount of the loan into escrow. The buyer uses the loan funds to acquire the property, and then escrow delivers those funds to the QI for use in the exchange.

CONCLUSION

 

When combining a seller carryback note with a 1031 exchange, it’s important to carefully examine all the options and consult with your tax advisor and First American Exchange prior to setting up the transaction.

from “The Exchange Update” by First American Exchange Company

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