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1031
Section
1031 is the section of the Internal Revenue Code
that authorizes the procedure in which an individual or
entity is able to defer payment of capital gains tax
upon the sale of business or investment property. The
seller, also known as the taxpayer, cannot sell the
property outright. The sale must be structured as an
exchange. Exchanges are completed by selling a
relinquished property and acquiring a replacement
property while adhering to strict rules created by
Congress and the IRS. The vast majority of completed
exchanges are forward exchanges where the taxpayer sells
a property, uses an intermediary to facilitate the
exchange and then purchases a replacement property at a
later time. Reverse exchanges are possible and allow a
taxpayer to effectively purchase the replacement
property prior to selling the relinquished
property.
15% and 25%
15% and 25% are the federal capital
gains tax rates applicable to the majority of real
estate sales. 15% is the standard federal tax rate on
capital gains for property held more than one year for
taxpayers above the 15% tax bracket. These same
taxpayers will typically pay 25% on capital gains
attributable to depreciations taken on the property.
Rates other than 15% and 25% may apply to a real
estate sale. The capital gain rate is 5% for taxpayers
in the 15% or under brackets and property held less than
one year is typically taxed at the taxpayer’s ordinary
income tax rate. Corporations that are Chapter C
corporations typically pay at their ordinary corporate
tax rate. Taxpayers should also be aware that they will
need to pay state tax on capital gains and a real estate
sale may cause Alternative Minimum Tax consequences. Of
course each taxpayer’s tax liability can be unique
dependent on that taxpayer’s circumstances. Completing a
1031 exchange allows the taxpayer to defer paying these
capital gains taxes on a property
sale.
2000-37
Revenue
Procedure 2000-37 created a safe harbor procedure
for taxpayers to complete a reverse exchange. Prior to
this procedure it was unclear (at best) whether or not a
taxpayer could complete a valid 1031 exchange using a
reverse procedure. Reverse exchanges arise from a timing
problem where the taxpayer is scheduled to close on the
property being purchased prior to the closing of the
property being sold. In Rev.
Proc. 2000-37, the IRS created a structure where the
purchase of a replacement property can effectively occur
prior to the sale of a relinquished property and a valid
exchange is recognized.
Reverse exchanges are
commonly referred to as “parked” exchanges. The reason
for this terminology is because in reverse exchanges an
Exchange Accommodation Titleholder (“EAT”) is used to
take title to either the relinquished propert y (front
leg reverse) or the replacement property (back leg
reverse). The property is “parked” with the EAT as the
titleholder of the property in order to complete the
exchange as planned. In fact, from the taxpayer’s point
of view the exchange is still a sale and then a
purchase. However, by using the EAT to park one property
the timing of the exchange becomes possible.
The
largest issue with reverse exchanges is financing. The
EAT is usually a special purpose entity created by the
same company providing the intermediary services. In order to “purchase” or park one
of the properties, the funds must be provided by the
taxpayer. If the taxpayer does not have the cash to
facilitate the “purchase” then any lender involved must
understand and be able to work around the unique
situation of a reverse 1031 exchange.
121
Section
121 of the Internal Revenue Code allows individuals
selling their principal residence to avoid capital gains
tax liability to the extent of $250,000 of gain for
individuals and $500,000 for married couples. The
taxpayer must have owned and used the property as their
principal residence for 2 of the last 5 years. Section
121 and section 1031 can both be used in the sale of a
single property where the character of the property is
both the principal residence for the seller and used for
business purposes. Typical examples include duplexes
where one side is owner-occupied or farm property which
includes a home and acreage. IRS
Revenue Procedure 2005-14 provides guidance on
applying section 121 and section 1031 to a single
property sale.
HR 4520
On October
22, 2004, the American Jobs Creation Act of 2004 (HR
4520) was signed. It affected taxation on the sale
of real estate by imposing a 5 year holding period on
property acquired as replacement property in a 1031
exchange and later converted to the taxpayer’s principal
residence. The upside of this legislation is that it
approved by implication the ability of a taxpayer to
convert property acquired in a 1031 exchange to
principal residence property. The property must still be
investment property (ie: rental) when acquired and the
taxpayer cannot acquire the property with specific
intent to later convert it to their principal residence.
The downside is that the Act created a 5 year holding
period between the time a taxpayer acquires the property
in an exchange and the date the taxpayer is able to sell
the property and use section 121 to avoid capital gains
tax. The t axpayer must still fulfill all the
requirements under section 121 to qualify for the
principal residence exclusion.
2007-12
Effective January 23,
2007, IRS
Revenue Procedure 2007-12 set forth a new version of
the certification form that a real estate closer must
obtain in order to avoid 1099 reporting on the sale of a
principal residence. According to Treasury Regulations,
a real estate closing agent must provide a 1099 to both
the IRS and the seller for real estate sale transactions
by individuals unless the seller signs a certification
stating that the principal residence exclusion applies.
This Revenue Procedure adds 2 new statements to be
certified by the seller in addition to the 4 statements
that the certification form previously included. Those
statements relate to the 5 year holding period rule
noted in HR
4520 above and require that the seller certify that
they (or a pass through basis donor) have not acquired
the property in a 1031 exchange. If the seller has
acquired the property in an exchange and 5 years has not
passed then the principal residence exclusion does not
apply.
45
45 is the number of days
allowed by the Internal Revenue Code for a taxpayer to
properly identify replacement property(ies) (or
relinquished properties in a back leg reverse exchange).
The 45 day period begins to run on the day of the
closing of the relinquished property for a forward
exchange. This time period is calculated using calendar
days and is strictly enforced by the IRS. To properly
identify a replacement property the taxpayer must
provide a written, signed and unambiguous description of
the replacement property within this time frame. There
are 3 options for the number of replacement
property(ies) that can be identified. Only one of the 3
options must be followed to have a valid identification.
The 3 options are:
- 3 properties - Up to any three properties
regardless of their market values.
-
The 200% Rule - Any number of
properties as long as the fair market value of the
replacement properties do not exceed 200% of the fair
market value of the exchanged property.
-
The 95% Rule - Any number of
replacement properties if the fair market value of the
properties actually purchased is at least 95% of the
fair market value of all the replacement properties
identified. In other words, the taxpayer must purchase
no less than 95% of the value of all properties
identified.
Except for the 95% rule, it is not
necessary to purchase all identified properties,
however, the taxpayer cannot purchase a property that
was not identified within the 45 days and claim a valid
exchange. The 45 day identification requirement is
satisfied if replacement property is received (closed
on) before 45 days has expired. The IRS does allow
flexibility to revoke and change an identification
within the 45 days.
180
180 days
is the exchange period in which the taxpayer must
complete the exchange in both forward and reverse
exchanges. In a forward exchange this time period runs
from the closing date of the property sold by the
taxpayer and requires that the taxpayer close on the
purchase of the replacement property within 180 days.
This time period may be shortened if the due date for
the taxpayer’s tax return falls within the 180 days. For
example, if a taxpayer sells a relinquished property in
December that taxpayer must complete the exchange before
the due date of the taxpayer’s tax return on April 15th
(March 15th for a corporate return) in order to properly
report a completed exchange. If the full 180 days is
needed a taxpayer can file for an extension. This time
period is also a strictly enforced calendar day time
frame.
QI
QI stands for qualified
intermediary. The IRS restricts the taxpayer’s ability
to have actual or constructive receipt of the proceeds
funds from the sale of the relinquished property during
the exchange. The qualified intermediary is hired to
hold those proceeds to avoid receipt by the taxpayer.
The definition of qualified intermediary is set forth in
the Treasury Regulations and was presumably created to
ensure that the party playing this role is independent
of and not subject to influence by the taxpayer.
Qualifying to act as a 1031 exchange intermediary is not
an objective standard as one might expect. It has
nothing to do with competency or acquiring some sort of
license or permit. Rather, it is determined for each
exchange by the relationship between the taxpayer and
the prospective intermediary. An intermediary may be
qualified to act as an intermediary for one taxpayer and
not for another. The Treasury Regulations provide that
any person or entity can act as an intermediary un less
they fall into one of 3 categories of persons or
entities that are disqualified. Those 3 categories are:
-
The agent of the taxpayer.
Examples include the taxpayer’s attorney, accountant,
employee, real estate agent or broker. Routine
financial and title insurance services as well as
services with respect to properties intended to be
part of an exchange are excluded;
-
Someone related to the taxpayer.
Examples include the taxpayer’s spouse, parent,
sibling or a business in which the taxpayer owns 11%
or more and;
-
Someone related to the agent of the
taxpayer. This third category is much lesser known
and uses the other 2 categories to disqualify an
intermediary. Examples include a title company
partially or wholly owned by an attorney or real
estate broker where that attorney or broker has
provided services to the
taxpayer.
g(6)
Section
1.1031(k)-1(g)(6) (pages 106-107) of the Treasury
Regulations is commonly referred to as the g(6)
regulations. This section states the rules regarding
when a taxpayer can receive exchange funds in the event
that the taxpayer desires to cancel an open exchange.
These regulations coincide with the taxpayer’s lack of
ability to have receipt of the exchange funds during an
exchange and they must be included in the exchange
agreement between the taxpayer and the intermediary to
have a valid exchange. The return of funds follow these
rules:
These regulations can also come into
play on the closing of the replacement property being
purchased by the taxpayer. If a taxpayer receives funds
at the closing on the replacement property, which often
occurs when the taxpayer takes out a mortgage loan in
excess of the total funds needed to complete the
purchase, the IRS may view this as a g(6) violation if
the regulations concerning the release of funds are not
followed.
LLC
LLC stands for
Limited Liability Company which is a type of business
entity. LLCs are a creation of state law but have
federal tax law implications. The significance for 1031
exchanges comes in the form of the “same taxpayer” rule.
This rule states that the same taxpaying person or
entity must sell the relinquished property and purchase
the replacement property in order for a valid exchange
to have taken place. One exception to this rule is that
an individual who is in title to the relinquished
property can acquire the replacement property in a
single member disregarded LLC. The IRS considers this
LLC the “same taxpayer” as the individual. Also, under
Rev.
Proc. 2002-69, if a husband and wife are the only
members of an LLC in a community property state (such as
Wisconsin) that LLC can still be considered a “single
member” disregarded LLC for tax purposes.
A
taxpayer must also be wary of how title to the
replacement property is held. For instance, if a
taxpayer were to purchase replacement property with
another individual using the name of a partnership as
the titleholder, a violation of the “same taxpayer” rule
has likely occurred. This taxpayer has purchased a
partnership interest and not real estate as required by
the exchange regulations. Another example may occur when
a taxpayer, who was the sole owner of the relinquished
property, places a spouse on the title to the
replacement property. The IRS may view this transaction
as a purchase by the taxpayer of only ½ of the
replacement property and a gift to the spouse of the
other ½ of the exchange funds. Depending on the market
values of the properties involved this could create tax
consequences.
8824
8824
is the IRS form to be filed with a taxpayer’s 1040 form
to report a 1031 exchange.
FMV
FMV
stands for fair market value. In order for a taxpayer to
enjoy the maximum capital gains tax deferral, the
replacement property must be equal or greater in fair
market value to the relinquished property. The taxpayer
must also be careful to send all the net proceeds funds
from the relinquished property sale through the exchange
and reinvest those funds in the replacement property.
LIKE KIND
The first sentence in Section
1031 of the Internal Revenue Code states that
property must be exchanged for property of “like kind.”
This language produces some of the largest myths in
exchanging when taxpayers believe that they must
exchange property for another of similar use.
Actually, all real estate is considered like
kind to real estate so long as it is held for productive
use in a trade or business or for investment purposes.
For example, improved real property can be exchanged for
unimproved real property, a duplex can be exchanged for
a four-plex, rental property can be exchanged for retail
property, office property can be exchanged for a
warehouse, etc.
Personal property exchanges are
more restrictive when determining like kind and a
taxpayer should consult with their tax professional
regarding exchanges of personal
property.
TIC
TIC stands for
tenant-in-common which is a form of common ownership of
real estate that has existed for centuries. It is now a
term for a growing industry that sprung up beginning
primarily in 2002 with a Revenue Procedure that allowed
certain property investment structures to be classified
as real estate, thus, allowing 1031 exchange taxpayers
to buy into these replacement properties.
The TIC
industry markets large institutional grade properties,
such as office buildings, to 1031 exchange taxpayers who
desire a passive investment with a cash flow return on
that investment. The taxpayer becomes one of possibly
dozens of individuals who own a fraction of that
property as common owners.
These investments are
primarily offered through securities broker/dealers who
“sell” the taxpayer the fractional ownership interest in
a property being offered by a sponsor who arranges the
transaction.
Contact information:
Patrick
Harrigan
patrick.harrigan@1031intermediaryservices.com
Patrick T. Harrigan has over 10 years of
experience with real estate transactions and has focused his efforts exclusively on 1031
exchanges for over 3 years.
Patrick received his Juris Doctorate degree from Hamline
University School of Law and his Bachelor of Science
degree in Political Science from the University of
Wisconsin-Green Bay. He is a member of the State Bar of
Wisconsin and the Minnesota State Bar
Association. He is a frequent speaker on the process of
completing 1031 exchanges and member of the Federation
of Exchange Accommodators.
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