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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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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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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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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Top Ten Identification Rules for 1031 Exchanges

For a successful 1031 exchange, it is important to understand and comply with the 1031 exchange identification rules.  These rules are not that complicated, but a failure to follow the rules may ruin your exchange.  Here are the top ten things to remember when identifying replacement property in an exchange:

  1. Deadline and General Rules.  The taxpayer has 45 days from the date that the relinquished property closes to identify the replacement property that he intends to acquire in the exchange.  If there is more than one relinquished property in one exchange, the 45 days are measured from the date the first relinquished property closes.  The property identified does not have to be under contract, and the taxpayer does not have to acquire everything that he identifies.  It is important to note, however, that the taxpayer is not allowed to acquire anything other than the property that he has identified, and a failure to comply with the identification rules can ruin the whole exchange.  
  2. 3 Property Rule.  There are rules that limit how many properties the taxpayer may identify.  In most cases taxpayers use the three property rule.  The taxpayer may identify up to three replacement properties and may acquire one, two or all three of those.    
  3. 200% Rule.  If the taxpayer wants to identify more than three properties, he can use the 200% rule.  This rule says that the taxpayer can identify any number of replacement properties, as long as the total fair market value of what he identifies is not greater than 200% of the fair market value of what was sold as relinquished property.  First American Exchange recommends that taxpayers build in a “cushion” by identifying properties that are worth less than what is permitted, in case some properties are later determined to have a higher value than what was originally estimated. 
  4. 95% Rule.  There is another rule that is not commonly used by investors.  The 95% rule says that a taxpayer can identify more than three properties with a total value that is more than 200% of the value of the relinquished property, but only if the taxpayer acquires at least 95% of the value of the properties that he identifies.  Essentially, the taxpayer will need to acquire everything that he has identified to make this work, and that is why it is not relied on too often. 
  5. Property Acquired in 45 Day Period.  Any property that is actually acquired during the 45 day identification period is deemed to be properly identified.  It’s important to note that if some property is acquired during this period and some property is acquired later using another one of the identification rules, the property acquired during the first 45 days needs to be counted as one identified property.  For example, if you acquire one property during the first 45 days and you plan to use the 3 property rule and buy more properties after the 45 days, you only have two more properties to identify because you have already used up one. 
  6. Manner of Identification.  The identification must be in writing and signed by the taxpayer, and the property must be unambiguously described.  This generally means that the taxpayer identifies either the address of the property or its legal description.  A condo should have a unit number, and if the taxpayer is buying less than a 100% interest, the percentage share of what is being acquired should be noted. 
  7. Who Must Receive the Identification.  The taxpayer must send the identification notice either to:
     
    1)  The person obligated to transfer the replacement property to the taxpayer (such as the seller of the replacement property) or;
    2)  To any other person “involved” in the exchange (such as the qualified intermediary, escrow agent or title company), other than a “disqualified person,” such as an agent or family member of the taxpayer.  Most identification notices are sent to the qualified intermediary.
     
  8. Replacement Property Must be Same as What Was Identified.  The taxpayer must receive “substantially the same” property as he identified.  The regulations contain four examples to illustrate what “substantially the same” means.  In one example, the taxpayer identifies two acres of unimproved land and then acquires 1.5 acres of that land.  The property acquired is substantially the same because what the taxpayer received was not different in nature or character from what was identified, and the taxpayer acquired 75% of the fair market value of the property identified.  In another example, the taxpayer identifies a barn and two acres of land, and then acquires the barn with the land underlying the barn only.  The IRS says that the property acquired was not substantially the same as the property identified because it differed in its basic nature or character.  
  9. Property to be Constructed.  If the replacement property is under construction at the time of identification, the taxpayer must include not only the address or legal description of the property, but also must include a description of what is to be constructed on the property.  
  10. Reverse Exchanges.  If the taxpayer is doing a reverse exchange where the accommodator acquires the replacement property before the taxpayer closes on the sale of the relinquished property, the taxpayer must identify in writing what he intends to sell and that identification must be sent no later than 45 days after the accommodator closes on the replacement property. 

from The Exchange Update Newsletter by First American Exchange Company

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