Yes, You Can Use 1031 Exchange Funds to Improve Your Replacement Property

Many people are familiar with the “law of fixtures”.  In general, when an item of personal property becomes affixed to a parcel of real estate, that personal property is transformed into real property.  For example, a cabinet is personal property in the home improvement store.  When you bring it home and install it on your kitchen wall it becomes a fixture, and thus real property.

It seems logical, then, that improvements to a replacement property must be like-kind property.  But not so fast…

When it comes to tax-deferred exchanges, timing is everything.  Once the Exchangor takes title to the replacement property, the exchange is completed.  Subsequent improvements will not qualify for tax deferral, even if the funds come from the sale of the relinquished property.

Exchangors often ask if they can use exchange funds to purchase materials that will not be installed in the replacement property until after the closing, or pre-pay for construction services that will be performed at a future date.  The answer in both cases is “no”, even if the payments are disbursed through escrow as part of the replacement property acquisition.

Here is the reasoning.  The exchange begins when the Exchangor transfers real property.  If the Exchangor receives real property plus materials and/or construction services in return, only the real property is like-kind.  To qualify for tax-deferred treatment, the materials have to be real property (i.e. affixed) at the time the Exchangor acquires the replacement property.  Similarly, any construction services performed on the replacement property must be completed prior to closing.  Reg §1.1031(k)-1(e)(4).

So what can be done?  One possible solution is to ask the seller to make the improvements prior to closing, in exchange for a higher selling price.  The purchase contract can be structured so that the Qualified Intermediary pays exchange funds to the seller as additional earnest money deposits or as direct payment for the improvements.

If the seller will not cooperate, the alternative is an improvement exchange.  Similar to a reverse exchange, an improvement exchange requires that a third party take title to the replacement property.  The third party should not be someone who is a related party to the Exchangor under the deferred exchange regulations.  This deal structure gives you a cooperative seller who can make the desired improvements before the end of the exchange period.

In most instances the transaction will be structured in accordance with Rev. Proc. 2000-37.  The Qualified Intermediary, or an affiliate, acquires the replacement property through a single member limited liability company (i.e. Exchange Accommodation Titleholder or “EAT”).  The purchase price may be paid using exchange funds, obtaining a loan to the EAT from a bank or the Exchangor, or some combination thereof.  Unlike in a reverse exchange, the parked property should not be leased to the Exchangor, to avoid constructive receipt issues.

No matter how the transaction is structured, care must be taken to ensure that the replacement property is properly identified.  It is not enough to simply identify the underlying real property.  The improvements should also be identified, especially if they will be extensive enough to change the basic nature or character of the property.  The exchange will qualify even if the improvements are not completed prior to the end of the exchange period (unlike personal property exchanges which require that the replacement property be 100% complete).

An improvement exchange requires careful planning and involves higher transaction costs, but a properly structured improvement exchange will enable an Exchangor to get the property he wants, along with the maximum in tax deferral.

from  First American Exhange Comapny

The Exchange Update

A Newsletter For 1031 Tax-Deferred Exchanges

 

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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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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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Billionaires Weigh In…

Remember John Paulson, the fund manager who became a multi-billionaire during 2008 by massively shorting mortgage backed securities? According to Brett Arends of

 

 

The Wall Street Journal Paulson made 3 big financial calls late last year that you need to know about.  First, he said gold could go to $2,400 an ounce based on the fundamentals. Second, he said you’re better off investing in blue chip stocks with good dividend yields than bonds. And third, he said you should buy a home. Now. If you don’t own a home, buy one, if you own one home, buy another one, and if you own two homes buy a third and lend your relatives the money to buy a home”.

Why does he feel this way? Paulson anticipates the kind of inflation that causes prices of everyday goods to soar and turns homeowners into geniuses.

Brett Arends, continues, “Paulson sees inflation coming by 2012 or so. The explanation isn’t hard. Put simply: We will get inflation because we have to. We are the most indebted nation in the history of the world…There is only one plausible route out of this appalling situation. The government needs inflation. The country needs inflation. That will shrink these debts in relation to the economy, asset prices and incomes.” Although home prices could certainly still slide, add in the impending inflation and the effective price of a home increases.

Similarly, Warren Buffet, an internationally recognized billionaire, in his economic outlook earlier this year noted, ” A housing recovery will probably begin within a year or so”. Buffet is considered a long-term investor, not a timer. He tends to be early in his projections however

 

Buffet has let it be known Berkshire is ramping up spending and acquisitions at its housing-related businesses

This is still not a market where flipping homes would be an effective investor strategy.  However, mortgage rates are still at an all time low and the real estate market is 30% down from its peak according to Standard & Poor’s Case-Shiller Index. This buyer’s market of both a housing market low and an inflationary low means these factors could make real estate a good long-term investment.

from Starker New 2nd Qtr. 2011

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Acquiring 1031 Exchange Property through Short Sales, Auctions and Foreclosures

Distressed sales continue to account for a significant portion of the sales volume in many markets.  Investors with access to cash are acquiring properties in short sales, auctions and foreclosures, and in some cases they are selling properties in a 1031 exchange and using their exchange funds to acquire these distressed properties. 

Investors who sell property in an exchange and use the funds to acquire property that is being sold by a lender in a short sale, auction or foreclosure need to keep in mind the 1031 exchange rules that may complicate the process. 

Timing

In a short sale, the bid package must be approved by the lender that owns the property, and in some cases this approval may take longer than expected.  Lenders appear to be approving packages more quickly, but an investor needs to pay attention to the timing.  In a 1031 exchange, the investor must identify replacement property within 45 days and close within 180 days after the close of the property being sold (relinquished property).   

Constructive Receipt

In order for a sale followed by a purchase to be considered an exchange for tax purposes, the investor cannot have control of the funds from the sale.  The qualified intermediary must hold the funds and the regulations say that the funds should only be delivered to the seller of the replacement property after the investor assigns to the intermediary his rights under the purchase contract.  If the funds are sent (as a deposit or as the purchase price) to the seller before the investor assigns his rights under a signed purchase agreement to the intermediary, there is a possibility that the 1031 exchange could be disqualified. 

Because of this rule, it can be difficult to acquire foreclosure or auction property in an exchange.  In a foreclosure, there is no contract to assign.  In an auction, there may not be a contract, but even when there is a contract, the seller often requires the successful bidder to make a deposit before the contract is signed.  In that case, investors will sometimes use their own funds to make the deposit rather than risk causing their exchange to be disqualified. 

In a short sale, some lenders will also require a deposit before the lender will sign the purchase agreement.  In order to avoid the constructive receipt issue, many investors will use their own funds to make the deposit and get reimbursed later from their exchange funds. 

Cooperation

In a 1031 exchange, the investor must assign its rights to the qualified intermediary under the purchase and sale agreement, and all of the parties to the transaction must be notified of this assignment.  Typically, in a replacement property closing, the seller signs a document acknowledging notice of this assignment; however, in some cases a lender selling property in a short sale may refuse to sign this acknowledgement.  One solution that some investors use is to ask the escrow agent or closing agent to state in writing that they sent the notice of assignment to the lender.  This gives the investor evidence that they have complied with this requirement in case they are audited. 

Another typical practice in an exchange is to show the qualified intermediary as the seller or buyer on the settlement statement.  Sometimes lenders who are selling property in a short sale won’t allow escrow to list the intermediary on the statement.  Although this is not ideal for the investor, most tax advisors feel that it should not adversely affect the exchange as long as the exchange documents are signed before the closing of the relinquished property and the investor does not touch any of the exchange funds. 

Reverse Exchanges

It also may be difficult to do a reverse exchange when the qualified intermediary is taking title to property that is being sold in a short sale because the lender may not allow the intermediary to go on title.  This possibility should be explored before planning a reverse exchange with property being sold in a short sale.

All of these details should be thoroughly investigated and resolved before attempting to combine a 1031 exchange with a short sale, foreclosure or auction. 

from The Exchange Update Newsletter by First American Exchange Company

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