All Forum Posts by: Bill Exeter

See my comments in recent post.  This will not qualify for 1031 Exchange treatment under the present structure and "use." 

Part of the property is your primary residence, which does not qualify for 1031 Exchange treatment. The other part sounds like it was a rehab and now held for sale, which does not qualify for 1031 Exchange treatment.  If you have your mom live there without any rental income, it is not considered held for investment but is rather held as a second home and does not qualify for 1031 Exchange treatment.  The property that you sell and then purchase through a 1031 Exchange must be held for rental, investment (capital appreciation), or used in a business. 

@Sung Yu the above posts are right on the money.  You must have the intent to hold the relinquished property and the replacement property for rental, investment or business use.  The longer you hold the property for investment the easier it is to demonstrate that you did in fact intend to hold the property for rental or investment purposes.  However, there is no specific holding period contained in the tax code or regulations and there is no "safe harbor."  It all boils down what you can demonstrate should you get audited. 

Most advisors consider the two (2) year holding period mentioned above to be very safe, but remember it is your intent that matters. 

Actually, it is possible do structure a 1031 Exchange on the sale of one or more relinquished properties and then using the proceeds through the 1031 Exchange to construct improvements on real property you already own. However, there is no way to do so without risk.The Internal Revenue Services issues three (3) Private Letter Rulings (PLRs) that allowed the taxpayers to do just this. The PLRs and Risks are discussed below.

The general idea is that you must acquire an interest in real property you do not already own, and since you already own the subject real property you want to build on, the transaction must be structured so that you are creating an interest in real property you do not already own (in fact, it does not yet exist). Essentially, your new replacement property will consist of (1) a thirty plus year ground lease on the real property you already own; and (2) new capital improvements made on the real property you already own pursuant to the new thirty plus year ground lease. The new ground lease and capital improvements represent the interest in real property you do not already own (and that is being created through this transaction). These structures are significantly more complicated than a typical 1031 Exchange structure and there are inherent risks involved in the transaction, some of which are discussed below. You and your legal, tax and financial advisors should review this transaction in greater detail, especially the PLRs, to ensure you understand the significant risks involved and are structuring the transaction as close as possible to the PLRs to mitigate some of the risks.

This transaction involves the sale of your relinquished property through a Qualified Intermediary. The Exchange Accommodation Titleholder ("EAT"), often a sister company to the qualified intermediary, will form a single-member limited liability company and disregarded entity or ("SMLLC") to serve as the lessee. You will lease the real property that you already own to the SMLLC. This thirty plus year ground lease begins to create an interest in real property that did not exist before. The SMLLC will begin construction of the capital improvements on the real property you already own in the name of and on behalf of the SMLLC. The thirty plus year ground lease plus the new capital improvements made to or on the real property leased by the SMLLC creates and represents the new interest in real property that you will be identify and acquire as your replacement property in your 1031 Exchange.

RISKS

Private Letter Rulings

There are three (3) Private Letter Rulings (“PLRs”) that address this 1031 Exchange structure, which are as follows:

Private Letter Ruling Number 2014-08019
Private Letter Ruling Number 2003-29021
Private Letter Ruling Number 2002-51008

PLRs can only be relied upon by the individual taxpayers that requested the PLRs. PLRs can NOT be used or cited as precedent should you be audited, and it is always possible that the IRS could still disallow this 1031 Exchange. PLRs will rarely match your proposed transaction structure. Deviations from the PLRs will significantly increase the risk to you since your transaction did not follow the PLRs exactly.

Deviation from Private Letter Rulings

There are a couple of areas where transactions deviate from the three (3) Private Letter Rulings discussed above. First, the three (3) Private Letter Rulings will likely not be directly on point, so there will be some inherent risk in that you will not be able to follow the Private Letter Rulings exactly as they were issued. Second, the ownership of the relinquished property and the replacement property in the three (3) Private Letter Rulings involved two distinctly different taxpayers. The relinquished property was owned by one taxpayer and the replacement property was owned by a different taxpayer, although related parties or entities. The ownership of your relinquished property and your replacement property may be owned or held by the same taxpayer as opposed to different taxpayers. This is likely a very significant deviation. The ownership could be changed prior to structuring the parking arrangement, but last-minute changes without time to season the ownership change would significantly increase the risk the transaction could be disallowed as a step transaction under audit. Deviations from the Private Letter Rulings will significantly increase your risk of structuring this type of advanced 1031 exchange.

You should discuss this more advanced 1031 Exchange structure in greater detail with your legal, tax and financial advisors to determine your comfort level with this complicated 1031 Exchange structure and the inherent risks involved.

@David C. is absolutely correct.  The Title Holding Trust or Land Trust will keep your name of the public record, but it can also complicate the property ownership and management.  You have to determine if the additional complications and costs are worth the investment in a Title Holding Trust or Land Trust.  

Qualified Intermediaries come in all shapes and sizes.  The first thing to know is that the 1031 Exchange Qualified Intermediary industry has no licensing or regulatory body.  There are very few Qualified Intermediaries with any kind of regulatory oversight.  Regulatory oversight is critical.  I've seen numerous QI's fail during my 40 years in the business, and most of the failures would have been prevented had their been government oversight.  It is not the size necessary that matters, but whether they have regulatory oversight and how they are managed. 

You should also check to ensure they have Errors & Omissions insurance, Fidelity Bond coverage, and a Financial Institution Blanket Bond.

Some are more consultative and advisory and provide guidance, while others are just processors.  Be ware of the ones that get compensated on the back end by trying to refer you to replacement property solutions that compensate them.  

I would not say the IRS doesn't like the process.  The IRS has issued three (3) Private Letter Rulings that specifically allowed these types of transactions, but you are certainly right about the time, money, risk and cost prohibitive in many cases. 

Hi Dan, 

Thank you so much for the shout out. 

Hi JF, 

You can certainly sell one (1) relinquished property and acquire two (2) separate replacement properties as long as the total purchase amount is equal to or greater than the net sale price of your relinquished property.  It also diversifies your holdings, cash flow, risks, etc.  

Generally, you must acquire property that you do not already own.  Most people will tell you that your second choice can't be done, but the IRS has issued two (2) Private Letter Rulings on point where they did allow the taxpayer to build on property they already owned through a 1031 Exchange.  However, there is no way to do this without risk.  PLRs can't be cited as precedent, so you could do exactly the same thing as the other taxpayers in those PLRs and the IRS can still disqualify the 1031 Exchange and the more your transaction deviates from the PLRs the more risk you take on.  ADUs can be extremely difficult to structure since they are usually on the same parcel/parcel number.  

Good morning GP, 

If your property sells for $300,000, your "net sale price" after deducting your routine selling expenses (brokers commission, title, escrow, closing attorney, documentary transfer tax, etc.) will likely be around $275,000 (ish).  This is the magic number in a 1031 Exchange.  You need to acquire one or more replacement properties that are equal to or greater than $275,000 (ish).

The selling expenses, costs and fees are what they are.  The successful sale is all about having the right team around you.  A good realtor that knows the market where the property is located, a good tax advisor that understands real estate and 1031 Exchanges, a good closing agent, and a good Qualified Intermediary that can walk you through the 1031 Exchange process.  

I would be very careful in working with a 1031 Exchange Qualified Intermediary that provides ("sells"0 replacement property solutions as part of their services.  You should work with a Qualified Intermediary that is going to focus on administering the 1031 Exchange and not trying to get paid on the back end.  This avoids any conflicts of interest.  Certainly partnering with companies that have consistent replacement properties available makes sense if the properties meet your investment guidelines.