Benefits of Tax-Deferred Exchanges
The following is intended as a primer on the guidelines and restrictions set forth in Section 1031 of the Federal Tax Code, along with some illustrations of various types of tax- deferred exchanges. Hopefully, some common misconceptions about exchanging will be cleared up and encourage a property owner to take advantage of the practice. However, the decision to employ any of these strategies can only be made after an individual's overall tax "picture" is viewed by their CPA or tax lawyer.
Important Note: Whenever contemplating a tax exchange all relevant documents, i.e. Real Estate contracts, must indicate your intent to complete said exchange.
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Tax-Deferred Exchanges: An Overview |
Although most homeowners are aware of the up to $500,000 primary home exclusion provided under the Federal Tax Code, surprisingly few real estate investors (many being the same individuals) are aware of the advantages and significant tax savings afforded by IRS Section 1031. This is the section of the code that authorizes and sets forth the requirements for "tax- free exchanges", also known as "tax- deferred exchanges".
A tax-deferred exchange is a procedure in which a real property owner trades one property for another without having to pay any federal income taxes on that transaction. Under normal circumstances, the selling owner would be taxed on any gain triggered by the sale of his or her property. However, in an exchange, the tax on the transaction is deferred until a future event; usually the sale of the newly acquired property. Rather than a simple sale of one property and purchase of another, this same sale and reinvestment are carefully structured as an exchange via an exchange agreement and most often, the services of a qualified intermediary. The intermediary, for a fee, helps ensure the exchange is structured property.
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The most obvious benefit of a tax-deferred exchange is the ability to settle property without having any present tax liability. The monies that would have normally been paid to the IRS, instead, continue working for the taxpayer in the next investment property. These dollars can be compounded through a series of subsequent exchanges, with the tax liability ultimately being forgiven upon the death of the taxpayer and without his or her estate having to pay. Any heirs would acquire a stepped up basis on the inherited property, equated to the fair market value at the time of the taxpayer's death.
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The reality of "exchanging" is that the IRS regulations make the practice relatively simple and inexpensive. However, certain requirements must be met in order for a transaction to achieve tax-deferred status under Section 1031. The following paragraphs outline the most essential elements.
Real property is the usual asset in a tax-deferred exchange, though not all real property is eligible for such treatment. Qualified real property is that which is "held for productive use in a trade or business or for investment". Essentially any real property other than one's personal residence or "dealer" property (acquired for the specific purpose of resale) would pass the litmus test.
An additional and related consideration is how long a taxpayer must hold the property in order for it to qualify for tax-deferred treatment. This test applies to both the relinquished (sold) and replacement (purchased) properties, with their respective holding periods helping to establish validity of "purpose". If, for example, a property is acquired and immediately resold, it may be deemed dealer property and unqualified for tax-deferred treatment. A one year holding period, on each, always been a general rule-of-thumb.
Further, the replacement property that would be acquired in an exchange must be of a "like-kind" to the property being relinquished. Like kind is defined as "similar in nature or character, notwithstanding differences in grade or quality". Basically, all real property is like-kind. One property may be exchanged for more than one property, a duplex may be exchanged for a triples; a single family home may be exchanged for an office building. The cardinal rule is that real property may not be exchanged for personal property, and that the real property be held for business or investment purposes.
Also, in order for an exchange to be totally tax-deferred, the replacement property must be of greater value than the one being relinquished, with all equity being applied towards the acquisition of the replacement property.
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Since Section 1031 requires that an exchange rather than a sale and purchase for cash occur, there are strict limitations on the flow and handling of funds. The taxpayer cannot actually receive proceeds in the exchange transaction. He or she may not even have control of the funds (i.e. credit to his/her account, set aside, or made available for future access). This principle is that of the "constructive receipt", and its occurrence would invalidate an exchange. Even though the taxpayer/exchanger is entitled under Section 1031 to have security for his or her funds along with any interest earned on them, their access and control must be "substantially limited and restricted". This oversight is usually assigned to the qualified intermediary, who establishes an escrow account pending the completion of the exchange transaction.
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Unlike holding period timing, there are hard fast time restrictions in any deferred or non-simultaneous exchange. Closing of old property being sold/relinquished by the taxpayer activate two time clocks.
First, the taxpayer must identify (in writing) up to three replacement properties within 45 days of the sale of the relinquished property.
Secondly, the actual settlement on the replacement property must take place on the earlier of (a) 180 days after the closing of the relinquished property, or (b) the due date of the taxpayer's federal income tax return (including extensions) for the year in which the relinquished property is transferred.
Simultaneous exchanges, although less common, do take place and would not be subject to these time restrictions. (As the foregoing would suggest, a normal exchange involves relinquishing one property and replacing it with another.)
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Reverse exchanges, on the other hand, allow the taxpayer to first acquire the new property and then sell the old one, later. Although Section 1031 does not specifically define rules for a reverse exchange, they are routinely employed and are structured within the guidelines and time restrictions of a standard exchange. There are two basic formats for a reverse exchange, both of which require an intermediary to take title to at least one exchange property and also accept the burden of actual ownership (i.e. make mortgage, tax and insurance payments, collect rents, etc.)
The more common format is to have the intermediary purchase the new property with funding provided by or arranged for by the exchanger. The intermediary holds the title until the taxpayer/exchanger sells the old property, at which closing the intermediary deeds the new property to the exchanger. The second, less common type of reverse exchange, is one in which the exchanger purchases the new property and simultaneously deeds the old property to the intermediary. When the old property is sold, the intermediary deeds it to the new buyer and passes the sale proceeds to the exchanger. This scenario requires the exchanger to place a down payment on the new property approximating the amount of cash proceeds that would be realized from the sale of the old property.
The final, less common, and somewhat more complicated exchange variation is an Improvement Exchange. It is similar to a reverse exchange in that an intermediary takes title to the new/replacement property while capital improvements are being made to it. Once the improvements are completed, title then passes to the exchanger. Usually, the old/relinquished property will have been sold to fund the purchase of the improvements to the new one. However, the exchanger could fund the purchase of and improvements to the new one. However, the exchanger could fund the intermediary's acquisition and construction of the new property prior to selling the old one. Both formats would have the intermediary taking title during construction with disbursements to suppliers and contractors being facilitated through an escrow account. When completed, the property would be conveyed to the exchanger from the intermediary.
Important Note: Whenever contemplating a tax exchange all relevant documents i.e. Real Estate contracts must indicate your intent to complete said exchange.
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The Internal Revenue Service issued Revenue Procedure 2000-37 on September 15, 2000; to provide a safe harbor for taxpayers engaged in deferred (reverse) exchanges of property. Under Internal Revenue Code Section 1031, an exchange of like-kind property used for business or investment purposes is not taxable.
In recognition of the decision of Starker v. United States 602 f.2d 1341 (9th Cir. 1979), The Internal Revenue Code allows reverse exchanges of property if, at closing (the "Closing"), the taxpayer transfers property (the "Exchanger Property"), identifies the like-kind property or properties to the acquired (the "Replacement Property") within forty-five (45) days of the Closing, and acquires the Replacement Property within one hundred eighty (180) days of the Closing.
In the past, the IRS has not approved tax-free treatment for "reverse starker" exchanges. A reverse Starker exchange is one in which a plan exists to acquire the Replacement Property before the taxpayer transfers the Exchange Property. Revenue Procedure 2000-37 acknowledges that taxpayers have engaged in "parking" transactions to facilitate reverse Starker exchanges. In essence, the taxpayer "parks" the Replacement Property with another party (the "Accommodating Party"), who holds the Replacement Property until the taxpayer identifies someone who will acquire the Exchange Property. Once the acquiring property is identified, the taxpayer engages in a tax-free exchange with the Accommodating Party, who then transfers the Replacement Property to the taxpayer.
Accommodation party must Own Property:
In revenue Procedure 2000-37, the IRS held that it would treat a reverse-Starker exchange as a tax-deferred exchange if and only if the Accommodating Party obtains sufficient legal rights in the Replacement Property so as to be treated as the owner for federal tax purposes. The Revenue Procedure assists taxpayers with a "genuine intent to accomplish a like-kind exchange" by providing a safe harbor in which the Accommodating Party will be treated as the owner of the property for tax purposes. Revenue Procedure 2000-37 requires that the Accommodating Party enter into a written "qualified exchange accommodation arrangement" (QEAA) with the taxpayer.
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1. The Accommodating Party must hold legal title to the Replacement Property and also hold other indicia of ownership. 2. The Accommodating Party must be taxable. If the titleholder is a partnership of a corporation, ninety (90) percent of its interests must be owned by taxable parties. 3. When ownership of the Replacement Property is transferred to the Accommodating Party, the taxpayer must have a bona fide intent to engage in a tax-free exchange involving that property. 4. Within forty-five (45) days after the transfer of the Replacement Property to the Accommodating Party, the taxpayer must identify the Exchange Property to be transferred. The taxpayer may identify alternative and multiple properties. 5. Within one hundred eighty (180) days after the taxpayer transfers the Exchange Property, the Replacement Property must be transferred to the taxpayer. 6. The time period between the Accommodating Party's acquisition of the Replacement Property and the actual exchange with the taxpayer cannot exceed one hundred eighty (180) days. 7. Within five days after the Replacement Property is transferred to the Accommodating Party, the taxpayer and the Accommodating Party must enter into a QEEA.
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Jersey Realty Exchange Corporation 2008
Jersey Realty Exchange Corporation is in their 14th year of providing consulting services and documentation to real estate investors, their accountants and tax attorneys. Since our incorporation in 1994, we helped investors exchange over two billion, two hundred million ($2,201,530,101) dollars of real estate, saving them vast sums of capital gains taxes. Following are some of the topics we encounter on a daily basis:
Exchanges of Vacation Homes
Effective March 10, 2008, the IRS issued a Revenue Procedure providing a safe harbor under which an exchange of a vacation home will not be challenged. The highlights of this safe harbor are: (1) The taxpayer owns the relinquish and replacement properties for at least 24 months immediately before/after the exchange and; (a) The taxpayer does not use the property for pleasure more than 14 days per year (or 10% of rental period, whichever is greater) in each of the two years before/after the exchange (repairs and maintenance days do not count towards personal use days) or; (b) the property is rented to an unrelated party for at least 14 days per year in each of the two years before/after the exchange. (Rentals to related parties are permitted if the related party utilizes the property as a principal residence and pays a fair market value rent.) An exchange may still fall outside the parameters of this safe harbor and meet the requirements of a Section 1031 Exchange. Taxpayers are encouraged to review their specific facts and circumstances with us to determine if they meet the statutory requirements.
Capital Gains Rates
In 2008, if your taxable income, including long term capital gains, is in the 10 percent or 15 percent brackets, your long term capital gains will not be taxed. If your taxable income, including long term capital gains, is in the 25 percent or higher brackets, a portion of the long term capital gains will be not be taxed and a portion will be taxed at a 15 percent capital gains rate. In 2008, the 25 percent bracket begins at a taxable income of $65,200 for married couples and $32,600 for single individuals. This benefit to low income taxpayers is scheduled to be repealed at the end of 2008.
Transferable Development Rights and Land-Use Credits
In a Private Letter Ruling, the IRS, relying entirely on the classification under the respective state and local law, ruled that transferable development rights and land-use credits were “like-kind’ to a fee interest in real estate and therefore, qualified in an exchange with real property under Section 1031.
Disregarded Entities
In a Private Letter Ruling, the IRS ruled the acquisition of a membership interest of a single member disregarded entity did not violate the 1031 prohibition of exchanging into partnership interests on the basis the sole member taxpayer is deemed to have acquired an interest in the real property of the disregarded entity and not an interest in a partnership.
Related Party Exchanges
Several IRS Private Letter Rulings (PLRs) on the subject of Related Party Exchanges have been issued during the past year. Within the 1031 regulations, a taxpayer may sell property to a related party as long as both parties comply with a two-year holding period. A 2002 IRS Revenue Procedure indicated a taxpayer may not buy replacement property from a related party. The recent IRS PLRs have resulted in favorable outcomes for property disposed of within the two year period and for taxpayers wishing to purchase replacement property from a related party. Although PLRs have no basis in law, it appears the IRS is allowing exceptions to the related party rules where it is evident the parties are not “cashing out” or “basis shifting”. (Related parties include linear relatives and entities in which the Taxpayer owns more than a 50 percent interest. Not related are aunts, uncles, in-laws, cousins, nephews, nieces and ex-spouses.)
Mixed Use Property
In 2005, the IRS issued a Revenue Procedure clarifying the exclusion of tax on properties used for both business/investment use (Section 1031) and as a principal residence (Section 121). The procedure provided guidance and examples for mixed use properties consisting of (a) two separate structures used concurrently, e.g. Duplex, (b) single structure used concurrently, e.g. Boarding house, and (c) single structure used consecutively, e.g. converting a principal residence to a rental property. The benefit of this Revenue Procedure is the exclusion of the principal residence gain ($500,000 for married couples and $250,000 for single individuals) under Section 121 before the deferral of the business/investment gain under Section 1031, hence avoiding all tax liability upon sale and allowing the taxpayer to obtain tax-free cash.
State Tax Issues
New Jersey - In September 2006, the New Jersey Administrative Code was amended to state: “A deed transferring real property from one legal entity to another legal entity that has common ownership is subject to the realty transfer fee.” Taxpayers wishing to convey property to/from an LLC, Subchapter S-Corporation, Partnership, etc. may find themselves subject to a significant transfer tax.
New Jersey - Nonresident individuals, estates or trusts selling an investment property in New Jersey after August 1, 2004, are subject to an estimated withholding tax remitted to New Jersey at the time the deed transfer is recorded. The estimated tax is a minimum of two percent of the gross sales price or 8.97% of the gain on the property. Exemptions to the withholding tax include property held by a corporation, partnership or LLC, or non-resident individuals, estates or trusts selling an investment property under a 1031 exchange. Effective November 16, 2007, nonresident individuals, estates or trusts must make an estimated tax payment for the fair market value of non like-kind property received. Examples of non like-kind property in a real estate exchange would include cash “boot” received by the taxpayer in a partial exchange, seller financing or property excluded from the real property exchange such as personal property, goodwill, and covenants not to compete with a fair market value. If the above circumstances exist, the taxpayer is required to submit the Residency Form GIT/REP-3 for the like-kind portion exempted under IRC 1031 and also Form GIT/REP-1 for the non like-kind portion of the sale not exempted under IRC 1031 along with an estimated gross income tax payment. The Sellers Residency Certification/Exemption form GIT/REP-3 has been revised to reflect this change. The exemption to the withholding tax for individuals, estates and trusts is located on the Seller’s Residency Certification/Exemption form, box 7.
Pennsylvania - All taxpayers domiciled in Pennsylvania, except C-Corporations, who exchange real and personal property within the fifty states, must recognize gain on the sale of the property on their Pennsylvania tax return. The deferral of gain under Section 1031 still applies for federal taxes and the remaining forty-nine states.
Maryland - Nonresidents of Maryland who have not reported rental income in Maryland are being denied a waiver of the six percent withholding tax when exchanging property.
South Carolina - Nonresident Taxpayers exchanging property in South Carolina must place an estimated withholding tax in escrow with a Qualified Intermediary in the event the exchange fails or results in “boot”. The buyer of the taxpayer’s property is ultimately responsible for remitting the tax to the South Carolina Department of Revenue.
Oregon - Beginning January 1, 2008, nonresident individuals conveying certain real property will be subject to a withholding tax unless the seller submits an exemption form to the state. Included as an exemption are Section 1031 exchanges.
West Virginia - Beginning January 1, 2008, nonresident individuals conveying certain real property will be subject to a withholding tax unless the seller submits an exemption form to the state. Included as an exemption are Section 1031 exchanges.
Nevada - Effective July 1, 2007, Nevada signed a law to protect 1031 exchange consumers by placing the licensing and regulation of Qualified Intermediaries under the Nevada Department of Business and Industry’s Financial Institutions Division, which has oversight of state-chartered lending and depository institutions.
For additional no-cost information call:
George M. Christofely, CPA
Vice President and General Manager
JERSEY REALTY EXCHANGE CORPORATION
701 West Avenue * Ocean City, New Jersey 08226
609-391-1031*Toll Free 888-871-1031* Fax: 609-391-0101
This publication is designed to provide accurate information on tax deferred exchanges. The publisher is not engaged in rendering legal or accounting services. If legal or tax advice is required, the services of a competent professional should be sought.
Jersey Realty Exchange Corporation 2007
Jersey Realty Exchange Corporation is in their 13th year of providing consulting services and documentation to real estate investors, their accountants and tax attorneys. Since our incorporation in 1994, we helped investors exchange approximately two ($2) billion dollars of real estate, saving them vast sums of capital gains taxes. Following are some of the topics we encounter on a daily basis:
Related Party Exchanges
Several IRS Private Letter Rulings (PLRs) on the subject of Related Party Exchanges have been issued during the past year. Within the 1031 regulations, a taxpayer may sell property to a related party as long as both parties comply with a two-year holding period. A 2002 IRS Revenue Procedure indicated a taxpayer may not buy replacement property from a related party. The recent IRS PLRs have resulted in favorable outcomes for property disposed within the two year period and also for taxpayers wishing to purchase replacement property from a related party. Although PLRs have no basis in law, it appears the IRS is allowing exceptions to the related party rules where it is evident the parties are not “cashing out” or “basis shifting”. (Related parties include linear relatives and entities in which the Taxpayer owns more than a 50 percent interest. Not related are aunts, uncles, in-laws, cousins, nephews, nieces and ex-spouses.)
Mixed Use Property
In 2005, the IRS issued a Revenue Procedure clarifying the exclusion of tax on properties used for both business/investment use (Section 1031) and as a principal residence (Section 121). The procedure provided guidance and examples for mixed use properties consisting of (1) two separate structures used concurrently, e.g. Duplex, (2) single structure used concurrently, e.g. Boarding house, and (3) single structure used consecutively, e.g. converting a principal residence to a rental property. The benefit of this Revenue Procedure is the exclusion of the principal residence gain ($500,000 for married couples and $250,000 for single individuals) under Section 121 before the deferral of the business/investment gain under Section 1031, hence avoiding all tax liability upon sale and allowing the taxpayer to obtain tax-free cash.
Private Annuity Trusts
The IRS has issued proposed regulations to prohibit the exchange of highly appreciated property for annuity contracts, hence making these transactions taxable at the time of the attempted exchange. If adopted, the regulation would apply retroactively to exchanges taking place after October 18, 2006. We will keep you apprised of developments as they occur and highly recommend the taxpayer avoid this type of replacement vehicle.
State Tax Issues
New Jersey - In September 2006, the New Jersey Administrative Code was amended to state: “A deed transferring real property from one legal entity to another legal entity that has common ownership is subject to the realty transfer fee.” Taxpayers wishing to convey property to/from an LLC, Subchapter S-Corporation, Partnership, etc. may find themselves subject to a significant transfer tax.
New Jersey - Nonresident individuals, estates or trusts selling an investment property in New Jersey after August 1, 2004, are subject to an estimated withholding tax remitted to New Jersey at the time the deed transfer is recorded. The estimated tax is a minimum of two percent of the gross sales price or 8.97% of the gain on the property. Exemptions to the withholding tax include property held by a corporation, partnership or LLC, or non-resident individuals, estates or trusts selling an investment property under a 1031 exchange. The exemption to the withholding tax for individuals, estates and trusts is located on the Seller’s Residency Certification/Exemption form, box 7.
Pennsylvania – All taxpayers domiciled in Pennsylvania, except C-Corporations, who exchange real and personal property within the fifty states, must recognize gain on the sale of the property on their Pennsylvania tax return. The deferral of gain for federal and the remaining forty-nine states still applies.
Maryland – Nonresidents of Maryland who have not reported rental income in Maryland are being denied a waiver of the six percent withholding tax when exchanging property.
Mississippi – Taxpayers exchanging property from Mississippi to another state are subject to a five percent tax in Mississippi.South Carolina – Nonresident Taxpayers exchanging property in South Carolina must place an estimated withholding tax in escrow with a Qualified Intermediary in the event the exchange fails or results in “boot”. The buyer of the taxpayer’s property is ultimately responsible for remitting the tax to the South Carolina Department of Revenue.
Real Property – What is “Like-Kind”
Exchanging real property within Section 1031 of the tax code provides a taxpayer with many opportunities to diversify their investments. Often, the determination of whether a property is “real property” lies within state law. The more common exchanges may involve an apartment building for a vacant lot, a duplex for a single family dwelling, and so on. Less common, albeit viable options, include exchanging the previously mentioned real property for tenant-in common interests, conservation easements, leases with terms of 30 years or more, co-operative apartments, timber rights, water rights, oil, gas and mineral interests, supply contracts, and many more. Call us for additional information.
Personal Property and Intangibles Too!
“Like-Kind” exchanges are not limited to real property. Personal property can be exchanged for other like-class personal property and certain intangibles are exchangeable for other intangibles. The more common exchanges may involve furniture, fixtures, equipment and liquor license upon the sale of a restaurant, bar, motel or bed and breakfast inn. Less common in the Northeast are exchanges of airplanes, fleets of autos, boats, livestock and copyrights, to name a few. It is imperative to involve us in the initial contract negotiations to help identify exchangeable versus non-exchangeable assets. For example, goodwill is not exchangeable and may result in an unexpected tax liability for the taxpayer.
Frequently Asked Questions
Can 1031 funds be used as a good faith deposit for replacement property and who is allowed to receive these funds without disqualifying the exchange? Funds held in a 1031 exchange can be utilized for a good faith deposit on replacement property providing a signed Agreement of Sale is assigned to the Qualified Intermediary and the funds are not being forwarded to an agent of the taxpayer. Title companies and Seller’s agents are generally safe harbors, or as an alternative, we can issue an escrow letter verifying the amount of funds held in the 1031 account.
Can my attorney act as a closing agent in a 1031 exchange? Attorneys acting as closing agents at the direction of the Qualified Intermediary are common practice. However, attorneys performing legal services for the taxpayer during the past two years, other than the exchange transaction, are considered “disqualified persons” and may jeopardize the exchange. An astute Qualified Intermediary will suggest an alternative means of completing the exchange.
Do vacation homes qualify for 1031 exchanges? Vacation homes may qualify as investment property under the definition of Section 1031 if the personal use is minimal, or if the property is also rented. If the property is held for two or more years, the IRS evaluates the predominate use of the property and intent of the taxpayer for the two years leading up to the exchange and the two years following the acquisition of the replacement property. The evaluation period is equal to the ownership period where ownership is less than two years.
Can I acquire replacement property in an exchange prior to selling my property? Under the safe harbor of Reverse Like-Kind Exchanges, the IRS permits the acquisition of replacement property prior to selling the relinquish property. However, the acquisition is made by an Exchange Accommodation Titleholder on behalf of the taxpayer. The Taxpayer should anticipate additional time constraints, fees, transfer taxes, and financing costs when desiring to enter into a Reverse Exchange. Call us for more details.
Can U.S. property be exchanged for foreign property? Property located within the United States is not like-kind to property located outside the United States with exceptions for a few U.S territories, e.g. U.S. Virgin Islands (certain conditions apply).
For additional no-cost information call:
George M. Christofely, CPA
Vice President and General Manager
JERSEY REALTY EXCHANGE CORPORATION
701 West Avenue * Ocean City, New Jersey 08226
609-391-1031*Toll Free 888-871-1031* Fax: 609-391-0101
This publication is designed to provide accurate information on tax deferred exchanges. The publisher is not engaged in rendering legal or accounting services. If legal or tax advice is required, the services of a competent professional should be sought.
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