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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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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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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Is it ok to buy from or exchange with a related party?

 

   

Buying a replacement property from mom and dad in a 1031 exchange may be possible after all! In three separate Private Letter Rulings (PLR’s), 200616005, 200810016 and 200807005, the IRS ruled that if the taxpayer is buying a replacement property from a related party and the related party also does a 1031 exchange, then the exchange would be all right.

A related party is defined as a family member of lineal decent or a person owning more than 50% of an entity. The IRS has looked unfavorably on a taxpayer purchasing their Replacement Property from a related party in a 1031 exchange. The reason Congress addressed related parties in the tax code was its concern over possible basis shifting to avoid paying taxes. In the latest PLR’s, the IRS reasoned that since the parties did not cash out, there was no intent to avoid tax.A PLR is written specifically for the taxpayer that petitions the IRS for a ruling, therefore PLR’s are not tax precedent. They do, however, give an indication of the IRS interpretation of the tax code. The fact that we now have three PLR’s supporting the same argument, gives some comfort that if the taxpayer and the related party perform a 1031 exchange it would be acceptable to the IRS.

If a taxpayer is considering buying a replacement property from a related party in a 1031 exchange they should always seek good tax council.

from Starker News 2nd Qtr. 2011

 

 

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