Posted almost 10 years ago

Wealth Preservation Strategy: The Anatomy Of A 1031 Exchange

Nothing in this blog constitutes legal advice. If you require legal advice, then please consult with a lawyer instead of this blog.

The sale of real estate in the United States frequently results in a significant tax burden to the seller. When investment and income producing real estate is sold, the general rule under the tax code requires the seller to pay capital gains tax on the profit at the time of sale. The tax rate applied to most investment real estate sales is 15%.1 However, Section 1031 of the tax code provides an exception to the general rule. According to the Internal Revenue Code (“IRC”), 26 U.S.C. § 1031(a)(1): “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” 2

The 1031 exchange provides one of the most valuable and frequently used wealth-preservation strategies in these real estate transactions. This allows the seller to defer payment of the capital gains taxes through the acquisition of a new “like-kind” property. According to the Statistics of Income Division of the Internal Revenue Service, corporations, partnerships, and individuals collectively made 1,276,406 “Like-Kind Property Exchanges” filings, using Internal Revenue Service (“IRS”) Form 8824, between 2007 and 2011.3 During that same five-year period, those parties deferred a total of $253,429,207 in capital gains tax.

How do you qualify for a 1031 Exchange? The IRS allows four types of exchanges: simultaneous, deferred, reverse, and built-to-suit exchanges.4 To qualify in deferred exchanges involving real estate assets, a party must adhere to the rules explained below. The first step requires a determination of whether the deferred exchange satisfies the four elements of §1031(a)(1):

1. Held-For. The first prong requires the new property (herein the “replacement property”) to be held for the same purpose as the property being sold (herein the “relinquished property”). Both properties may, for instance, be held for investment purposes. Under the federal tax code though, a property is not held for investment, if losses from the sale cannot be deducted. The tax code does not explicitly define the length of time a property must be held as an investment. At the time of the exchange though, a seller must have a subjective intention to hold for investment. The intention of the seller can be established through a number of factors, which includes length of ownership, prior use consistent with an investment or business, and a tax reporting history.5

2. Productive Use. The second prong requires both the relinquished property and replacement property to have a “productive use” in a trade, business, or for investment purposes. The tax code allows an investor a minimal amount of personal use, under certain situations. Additionally, vacation homes may qualify as an investment, provided that the home is both: (1) rented and (2) personal use is of the property is infrequent.

3. Exchanged. The third prong states that an actual conveyance of the relinquished property, as well as the replacement property, must occur within the required period, generally 180 days following the sale or transfer of the relinquished property.

4. Like-Kind Property. The fourth prong requires the replacement property to be of “like-kind” to the relinquished property. One kind or class of property cannot be exchanged for property of a different kind or class. The words “like-kind” means the nature or character of the replacement property, but not necessarily its grade or quality. Since grade and quality aren’t considerations, exchanges involving real estate that has been improved for unimproved real estate may qualify, provided that both are of the same classification. However, tax courts have held exchanges of real estate for improvements on land, where the same taxpayer owns both parcels, fail to satisfy the IRC §1031 requirements. See DeCleene v. Commissioner, 115 T.C. 457 (2000) 6; Bloomington Coca-Cola Bottling Co. v. Commissioner, 189 F.2d 14 (7th Cir. 1951). 7

How does one execute a valid deferred exchange? To execute a valid deferred exchange, the party selling investment real estate (herein “seller” or “taxpayer”) must follow these eleven steps to maintain compliance with the applicable tax code:

1. Sales Agreement. The taxpayer must first enter into a traditional real estate sales contract with a buyer for the sale of the relinquished property.

2. Qualified Intermediary Agreement. The taxpayer then designates a Qualified Intermediary (“QI”), who facilitates the exchange process. The taxpayer must enter into a formal agreement with the QI, known as an “Exchange Agreement.” To qualify as a proper QI, that person must satisfy all of the rules under the tax code. The QI cannot be the taxpayer or any other disqualified person, such as the “taxpayer’s employee, attorney, accountant, investment banker, investment broker, real estate agent or real estate broker within the last 2-year period.”8

3. Assignment of Sales Contract. Once the purchase and sales contract has been signed, the taxpayer assigns that contract for the sale of the relinquished property over to the QI. Prior to the closing, the taxpayer should provide notice of the assignment, in writing, to the buyer

4. Sales Proceeds Transfer. At the closing, the QI conveys the relinquished property over to the buyer. For the purposes of this step, the QI steps into the shoes of the seller, so the QI should be identified as such on the HUD-1 settlement. The net sales proceeds from the sale of the relinquished property are paid to the QI, and then moved into a short-term escrow or investment account on behalf of the taxpayer. The taxpayer cannot receive, obtain, or use the benefits of the exchange proceeds, and there can be no sale proceeds receipt.

5. Tile Conveyance to Buyer. After the net sales proceeds have been transferred, the taxpayer then transfers title in the relinquished property over to the buyer.

6. Replacement Property Identification. Next, the taxpayer must unambiguously identify the “replacement property” to be purchased and notify the QI within 45 days following the transfer date of the relinquished property sale. The identification must be done in writing, include the legal description of the replacement property, and be signed by the taxpayer and hand delivered.10 The tax code allows a taxpayer to identify up to three properties, without the need for valuation. However, if the taxpayer wishes to identify more than three properties, then the following two additional rules kick in. First, the 200% rule allows a taxpayer to identify unlimited properties, as long as the aggregate fair market value does not exceed two hundred percent of the value of the relinquished property. Second, the 95% rule allows a taxpayer to identify any number of properties, as long as the properties actually received are at least ninety-five percent of the aggregate fair market value of all the potential replacement properties.The replacement property is also subject to geographic restrictions. Under the tax code, the geographic footprint includes all 50 states, the District of Columbia, and Virgin Islands; however, a property in the Virgin Islands will only be recognized, if the taxpayer received income from that island.

7. Replacement Property Purchase Contract. Next, the taxpayer must enter into a legally binding purchase and sales contract with the seller of the replacement property.

8. Assignment of Purchase Contract. The real estate purchase contract for the replacement property is then assigned over to the QI, who steps into the shoes of the taxpayer. Again, the seller of the replacement property should be notified, in writing, of the assignment to the QI on or before the closing date.

9. Closing on Replacement Property. The replacement property closing date must occur on the earlier of: (1) 180 days following the transfer date of the relinquished property, or (2) the due date of taxpayer’s tax return for the year in that the relinquished property transfer occurred. Here, the QI is effectively the buyer in the transaction, so the QI must be identified as such on the HUD-1 settlement statement.

10. Tile Conveyance to Taxpayer. At the closing, the seller transfers title in the replacement property over to the taxpayer.

11. Proceeds Transfer. The last step requires the QI to transfer the net sales proceeds held in escrow from the first transaction to the seller of the replacement property in the second transaction. If residual proceeds remain, then these are transferred over to the taxpayer. The QI will then transfer the replacement property over to the Taxpayer.

Deferred exchanges involving real estate present a number of legal issues that sometimes end up in litigation. The IRS challenged the validity of 1031 exchanges in two recent cases: Reesink v. Commissioner and Adams v. Commissioner.

Tax advisors frequently tell clients that a replacement property ought to be held as an investment property for two or more years following the conveyance. In Reesink, this particular legal issue was raised.The facts demonstrate that Mr. Reesink reinvested $425,000 in profits received from the sale of his San Francisco investment property into a new single-family home. 11 Following an unsuccessful eight-month long search for renters, Mr. Reesink changed course and converted the home into his primary residence. The IRS later concluded that Mr. Reesnik’s 1031 exchange did not meet the regulatory requirements, asserting that he had acquired the replacement property with the goal of making it his personal home. Strong consideration was placed on the fact that Mr. Reesink made a good faith effort to rent the replacement property. The Tax court determined that Mr. Reesink intended to hold the property for investment at the time of exchange. Ultimately, it ruled in his favor of Mr. Reesink, and upheld the transaction as a valid exchange of investment properties.

In Adams, the legal issue was whether the taxpayer intended to offer the replacement property as a gift. Mr. Adams used the proceeds from the sale of his long-term rental property, a former primary residence that he converted years earlier, to purchase a new home.12 The replacement property acquired by Mr. Adams was leased to his son for less than fair market rent. In exchange for the discounted rent, his son made significant renovations to the home. After learning of the facts, the IRS claimed that the rental agreement in place constituted a gift from Mr. Adams to his son, so it did not qualify as a proper 1031 exchange. The Tax court disagreed with the assertion made by the IRS, holding the replacement home purchased by Mr. Adams was held as an investment property, and met the 1031 exchange requirements. The court reasoned that the son’s efforts to improve the replacement property offset any discounted rate from Mr. Adams. In turn, this produced a fair market rental rate.

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Footnotes:

1 IBV Advisory Group, Can I Turn a Tax Deferred 1031 Exchange Investment Property Into My Personal Residence? Recent Tax Court Cases Say “Yes”.

2 26 U.S.C. § 1031(a)(1).

3 Internal Revenue Service, SOI Tax Stats – Business Tax Statistics, Form 8824 (Data for Like-Kind Property Exchanges. 1995–2011).

4 Mark A. Anderson, Like-Kind Exchanges, Barber Emerson, L.C., May 2012.

5 Apie Exchange, HOW LONG MUST AN INVESTMENT PROPERTY BE HELD

FOR THE IRS TO CONSIDER IT A “LIKE-KIND” PROPERTY? (#27).

6 DeCleene v. Commissioner, 115 T.C. 457 (2000).

7 Bloomington Coca-Cola Bottling Co. v. Commissioner, 189 F.2d 14 (7th Cir. 1951).

8 Mark A. Anderson, Like-Kind Exchanges, Barber Emerson, L.C., May 2012..

9 26 U.S.C. §1031(a)(3).

10 Gary S. Joiner, Esq., Deferred Like-Kind Exchanges of Real Property.

11 Reesink v. Commissioner; T.C. Memo 2012-118.

12 Adams v. Commissioner, T.C. Memo 2013-7.

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The information and materials on this blog are provided for general informational purposes only, and were done so by a law student. This information is not intended to be legal advice. The law changes frequently and varies from jurisdiction to jurisdiction. Being general in nature, the information and materials provided may not apply to any specific factual and/or legal set of circumstances. No attorney-client relationship is formed nor should any such relationship be implied. Nothing on this blog is intended to substitute for the advice of an attorney, especially an attorney licensed in your jurisdiction. If you require legal advice, please consult with a competent attorney licensed to practice in your jurisdiction.