Your 1031 Deferred Realty Exchange
Deferred realty exchanges under IRC section
1031 can provide significant tax benefits for taxpayers. Deferred
exchanges essentially allow a tax-free rollover reinvestment of the
equity in a relinquished property.
Questions are answered about section 1031, from
the most basic, such as what real estate is eligible for like-kind
treatment and what timelines apply, to the most complex, such as how
to structure more sophisticated transactions and realty conversions.
The role of the qualified intermediary and the implications for
partnerships and closely held entities, as well as alternatives to
section 1031 exchanges, are discussed.
1 What is a deferred realty exchange?
Under IRC section 1031, a taxpayer is allowed to
postpone the recognition of gain on the disposition of qualifying
realty by the acquisition of replacement real property that will be
later indentified and purchased within a specific period of time.
Structured properly, this deferred or nonsimultaneous exchange is
essentially a subsequent tax-free rollover of the equity on the
property being relinquished. By reinvesting the equity (as long as
there is as much debt on the new property as the mortgage payoff on
the disposed realty), capital gains tax and any IRC section 1250
unrecaptured gain taxable at the 25% rate can be completely avoided.
This will occur even when there is a liability-over-basis problem
(i.e., when the outstanding principal balance of the mortgage on the
property exceeds the realty's adjusted tax basis). In evaluating a deferred
realty exchange, the existence of certain tax attributes such as any
carryovers (NOL, capital loss, or passive activity losses) needs to
be reviewed because their availability may preclude the necessity of
using section 1031 for all or part of the transaction.
Tax deferral under IRC section 1031 does not
include any recapture of tax credits (e.g., low-income housing or
rehabilitation credits) that may be applicable if the property being
exchanged has not been held for the requisite holding period (15
years for the low-income housing credit).
2 What qualifies as like-kind realty under IRC section 1031?
Qualifying property is broadly defined, for both
the property being transferred and that received, as realty used for
investment or business purposes.
Consequently, investment realty (held for either
appreciation or rental) can be exchanged for real property used in a
trade or business. Partial realty interests such as conservation
easements and perpetual mineral or oil rights are exchangeable with
other types of realty (including a land contract in which equitable
title has been transferred), even a lease with at least 30 years
remaining (including renewal options) can be exchanged for a
fee-simple interest in realty.
If non-like-kind property is received (including
any debt relief at the end of the exchange), there will be partial
gain recognition; there is no all-or-nothing requirement of rolling
over all of the equity and existing debt to the replacement realty.
In contrast, the standard for replacement property
from an involuntary conversion under IRC section 1033 is a much
narrower one: like-use. This means that if a restaurant is destroyed
by fire, the insurance proceeds must be used to purchase or build
another one. An involuntary conversion as a result of an eminent
domain proceeding under IRC 1033(g), however, is an exception to
this section's like-use requirement and uses a like-kind standard
similar to section 1031.
This postponement of tax can be continued with
successive exchanges (stemming from the original property that was
relinquished). This postponement will become a cancellation of the
gain to the extent of the step-up in basis received by the heirs at
death for property held in the decedent's name.
3 Which real estate is not eligible for section 1031?
Personal use realty is not eligible. The personal
usage may be considered nominal or substantial pursuant to the 10%
of days rented or 14-day test under section 280A. When a mixed-use
exchange involving realty with both qualifying and personal usages
(such as an operating farm with a personal residence eligible for
IRC section 121) exists, these different usages should be addressed
through contractual allocations of the price.
Real estate should be held for the long-term
capital gain period of one year before disposition in order to
satisfy section 1031's requirement of being held for investment or
business purposes. Any replacement property received in an exchange
should also be held for more than a year.
Foreign realty is also not eligible for section
1031 treatment.
4 When is gain or loss recognized?
If an exchangor actually or constructively
receives nonlike-kind property known as boot (e.g., money or
personal property) for the relinquished realty anytime before
receiving the like-kind replacement property, the transaction is a
sale and not a deferred exchange. As a result, the structuring of a
deferred real property exchange requires documentation to support an
interdependent and integrated transaction with the sale proceeds not
being paid to the exchangor at the settlement date (or held in
escrow).
The paper trail for this documentation should
begin with the original purchase and sale agreement, which could
contain a clause such as:
The seller reserves the option to convert the
subject transaction to qualify under IRC section 1031 with the
purchaser agreeing to cooperate in the execution of any of the
required documentation (including but not limited to a four-parry
deferred exchange agreement and a qualified intermediary agreement),
provided the purchaser shall incur no additional cost or liability.
5 What is the role of the qualified intermediary in an
exchange?
The qualified intermediary (QI) is an entity or
individual independent of the exchangor and not deemed to be its
agent, either objectively or subjectively. Under the objective test,
the QI cannot be the taxpayer's closing attorney or anyone else who
has had a business relationship with the exchangor during the last
two years.
The QI is the recipient of the net proceeds from
the closing of the relinquished property, with the money impounded
for subsequent reinvestment into other realty. Any earnings on these
monies may not be paid to the exchangor until the end of the
exchange.
In a four-party deferred exchange, the QI is the
fourth party, with the other three being the exchangor, the buyer,
and the replacement property owner. These relationships are defined
in the required documentation, executed with the buyer's cooperation
because of contractual requirements, using sample language described
in question 4. These documents would include notice to the parties
of the use of direct deeding, in which the exchangor would deed the
realty being disposed directly to the buyer, while the replacement
property owner's deed would name the exchanging taxpayer as the
grantee. The QI would not need to take legal title to the realty
being relinquished or exchanged.
IRS Revenue Ruling 2002-83 prohibits a QI from
using the impounded funds to acquire the property of a party related
to the exchangor to be used as the replacement realty. Such a
disposition by the related party would be deemed a sale under IRC
1031(f), precluding any party from cashing out during the two-year
period following the exchange.
6 What time limitations apply?
The key date begins with the initial transfer date
(ITD), which is the date of closing for the property being
relinquished. Forty-five days from that date, there must be a formal
identification of the choices for the replacement property.
The closing for the replacement property must
occur no later than 180 days from the ITD (unless the due date of
the individual's tax return is earlier because the exchange occurs
after October 17). While these time restrictions provide no extra
days if this deadline falls on a weekend or holiday, practitioners
should advise clients that the ITD can be postponed. This can be
accomplished through a contractual provision for the buyer to have pre-closing
occupancy with a triple net lease feature; the closing date would be
at the option of the exchanging taxpayer.
7 How must the replacement property be identified?
Replacement property is identified if it is
* identified in a written agreement (preferably
executed by the QI subsequent to the ITD) using a portion of the
impounded funds for the earnest money deposit; or
* designated as replacement property in a written
document signed by the exchangor and hand-delivered, mailed, faxed,
or otherwise received by the QI before the end of the identification
period. The property ultimately acquired must be substantially the
same as that identified. For example, if two acres are identified,
at least 75% of the acreage must be purchased as replacement
property.
The regulations permit more than one property to
be identified as replacement property. As reflected in the Exhibit,
the maximum number of replacement properties which the exchangor may
identify under the regulations is
* three properties of any fair market value (FMV);
* any number of properties, as long as the
aggregate FMV of all properties identified as of the end of the
identification period does not exceed 200% of the aggregate FMV of
all relinquished properties as of the date of transfer; or
* under the 95% rule, an exchangor is permitted to
identify any number of properties of any total value, provided that
95% of what has been identified is actually acquired within the
180-day replacement period.
Replacement property acquired during the 45-day
period reduces the number of properties that can be identified under
the rules above.
8 When may an exchangor receive money from an exchange?
The exchangor's right to receive money or other
property must be limited. These limitations provide that the
exchangor may not, pursuant to the documentation, have a right to
receive money or non-like-kind property until the earlier of-
* the end of the identification period (if the
exchanger has not identified any replacement property within 45
days);
* the receipt by the exchanger of all of the
identified replacement property (or that for which identification
has subsequently failed due to an unfulfilled material and
substantial written contingency, such as zoning approval); or
* the expiration of the 180-day reinvestment
period for a calendar-year exchangor. This could result in a
one-year tax deferral of recognizing the boot received for any
exchange by an individual after July 4 because the receipt of the
non-like-kind property occurs in the following taxable year. This
deferral also applies to a failed exchange begun after this midyear
date if the property was properly identified but never acquired for
bona fide reasons during the 180 days that followed.
Regardless of whether the exchangor subsequently
receives money or boot from the QI at the end of an exchange, IRS
Form 1099-S box 2 should be 0, and box 4 should be checked.
9 Can impounded funds held by the QI be used to pay closing
costs?
The exchangor is not deemed to be in receipt of
the funds to the extent that these are used to pay closing costs.
The regulations indicate that the use of money held by a QI to pay
transactional items will not result in the actual or constructive
receipt by the exchanger of the remaining funds. This rule applies
to costs that relate to the disposition of the relinquished property
or acquisition of the replacement property, as well as expenses
listed as the responsibility of a buyer or seller in the typical
closing statement under local standards.
Examples of these expenditures include
commissions, recording or transfer taxes, and title company fees. In
addition, an exchanger's right to receive items (such as prorated
rents) that a taxpayer may receive as a consequence of the
disposition of property and that are not included in the amount
realized from the property transfer does not affect the exchange.
10 Can a real estate dealer take advantage of section 1031?
No. The property of a taxpayer can be excluded
from section 1031 even though used in a business or for investment
purposes, under the following circumstances:
* Since property must be held for business or
investment purposes in order to qualify, inventory is never deemed
eligible property under section 1031. Realty can be constructively
deemed to be inventory if, in the determination of the 1RS, a
"dealer taint" exists.
* The nature of the property is determined to be
in the hands of the person seeking the benefit of the exchange. In
other words, even if property is acquired from a dealer, the
recipient can hold the property for business or investment purposes
for a sufficient period of time in order to qualify for exchange
treatment.
* Various factors are considered in determining
dealer status, including the holding period of the property, the
number of realty sales, the percentage of the taxpayer's income that
the sales comprise, whether or not a sales agent is used in the
marketing of the properties, and to what extent the gain is
attributable to the taxpayer's efforts (e.g., subdividing and adding
improvements).
* One way of avoiding the dealer taint is to
separate the taxpayer's investment realty from potential dealer real
property. For example, if an individual is involved in the rental of
apartment buildings and is also subdividing a parcel of property
into lots, it may want to consider having the land development
activity conducted within a wholly owned Subchapter S corporation
(with the potential benefit for FICA savings through the use of
subchapter S corporation dividends).
11 What are diversification exchanges and consolidation
exchanges?
Both the diversification exchange and the
consolidation exchange refer to the fact that an exchange need not
be a one-for-one transaction. In a diversification exchange, a
taxpayer may be interested in diversifying his real estate portfolio
either to reduce the risk associated with having property in one
location or to provide smaller units of real estate for subsequent
liquidation of a portion of the original investment. This is
accomplished by exchanging one parcel for several.
In a consolidation exchange, the taxpayer has
several properties but desires to simplify a portfolio, reducing the
number of realty interests through section 1031.
Under both types, there must be strict adherence
to the time limitations outlined in question 6.
12 Because the new realty normally has the same tax basis as
the one relinquished, is it possible to increase the depreciation
deductions available on the replacement property?
Even in situations where the exchangor has not
added money to the acquisition of the replacement property, its
basis can be increased. If the total liabilities on the replacement
property exceed the debt that had existed on the relinquished
property (assuming the taxpayer does not receive any cash or other
non-like-kind property), the basis of the new property will
increase.
The depreciation deductions can be increased when
a nondepreciable asset is exchanged for a depreciable asset, such as
vacant land exchanged for an apartment building. In addition, an
exchanger could receive property which has a higher building-to-land
ratio than the one transferred.
13 What are "build to suit" and "rehab to
suit" realty exchanges?
The "build to suit" or construction
exchange involves the acquisition by the QI of vacant land on which
a structure will be built (i.e., not merely improving already-owned
property owned by the exchangor). This results in pretax dollars
from the QI's impounded funds being used (which can be supplemented
by proceeds from new debt financing). Upon the earlier of the
completion of the project or the expiration of 180 days from the ITD,
the portion constructed and considered as realty qualifies as
replacement property, provided that the "as built"
structure is substantially the same (in terms of completion) as what
had specifically been timely identified under the 45-day rule.
The "rehab to suit" exchange is similar
because the QI acquires realty which needs rehabilitation with
pretax dollars being held by the QI.
In either case, the applicable documentation
should utilize "time is of the essence" language, as well
as address the issue of liquidated damages for purposes of ensuring
the completion of the contractor's work before the end of the
exchange in order to avoid the receipt of boot. Documentation should
also require sequential deeding (as opposed to the direct deeding
referred to in question 5), in which the QI takes legal title as an
interim grantee during the construction and rehabilitation period,
eventually deeding the title to the exchangor before the expiration
of the 180-day exchange replacement period.
14 How does the concept of conversion of usage of realty apply
to section 1031 exchanges?
The bona fide conversion of usage can benefit the
only type of realty for which there is no favorable tax treatment
under the IRC: vacation homes. This type of property (along with a
personal residence in the rare case when the section 121 gain
exclusion is inadequate) should be eligible for an IRC section 1031
exchange after a year of bona fide rental activity is reported on
Schedule E of the taxpayer's Form 1040.
The question that arises is: How long after an
exchange can the replacement property received under section 1031 be
converted to personal use without jeopardizing the individual's
original exchange? While there is no statutory, judicial, or
administrative authority on this point, most advisers would
recommend a substantial period of time (e.g., three years) before
considering the conversion of business or investment realty to
personal use. After this time, the taxpayer may then be able to
qualify this property as a personal residence in order to take
advantage of the IRC section 121 gain exclusion after subsequently
satisfying the two-year holding period requirement.
15 Can an operating business be exchanged under section 1031?
Yes, when an exchange involves an operating
business, section 1031 applies separately to both the realty and
personalty (a "mixed property exchange"). Personal
property is more difficult to configure under section 1031 because
the definition of like-kind involves the concept of
"like-class" under the Treasury Regulations. The resulting
complexities in the tangible personal property area mean that office
equipment and a business auto are not like-class and thus not
like-kind. With respect to the business' intangible property,
goodwill of one operating business cannot be exchanged for that in
another. As addressed in question 4, it is important to attempt to
match allocations (based on fair market value) between the
relinquished property and the acquired property. Consequently, there
is a need to establish exchange categories that can qualify (e.g.,
realty and like-class personal property) and those that are never
eligible (e.g., goodwill and inventory).
16 What is a "Reverse Starker" exchange?
A "Reverse Starker" exchange occurs when
a taxpayer needs to either contract or acquire the replacement
property before the title closing for the property being
relinquished. Revenue Procedure 2000-37 provides a set of safe
harbor guidelines:
* An exchange accommodation titleholder (EAT) can
also be the QI. The EAT acquires and reports the beneficial
ownership or title of the replacement property before there has been
a disposition of the property relinquished by the exchangor.
* The exchanging taxpayer or a related party may
advance money or guarantee loans to be used toward the acquisition
of the replacement property by the EAT. In addition, the exchangor
may use or lease the property being held by the EAT as well as
provide management and construction services such as would be
required for the build-to-suit or rehab-to-suit exchanges discussed
in question 13. Any of these arrangements between the exchangor and
the EAT can be for less than full and adequate consideration.
* Five days after the EAT acquires the title, a
qualified exchange accommodation agreement (QEAA) must be executed
between the parties; 45 days from the date of the EAT's realty
acquisition, the exchangor must identify the property to be disposed
of within 180 days (whose closing proceeds will be used to acquire
the replacement realty from the EAT).
17 How does seller financing affect a section 1031 realty
exchange?
The following are the implications when a purchase
money mortgage is received in an exchange:
* The debt instrument should name the QI as the
initial mortgagee and be executed by the buyer-mortgagor of the
property being relinquished.
* Upon receipt of the mortgage receivable at the
end of the exchange period, the exchangor must still recognize gain
under the installment sale rules, pursuant to IRC section 453.
* When the QI receives a purchase money mortgage
in an exchange, there are two alternatives to recognizing gain:
* the mortgage could be discounted to cash by the
QI, with the net proceeds put toward the replacement property, or
* the mortgage could be assigned by the QI and put
toward the acquisition of the replacement property, whose seller
would accept the face value of the mortgage as consideration. In
this case, the mortgage is secured by both the relinquished and the
replacement properties as an inducement for the replacement property
owner to accept this mortgage as consideration.
18 What happens when the owners of partnerships and
multimember LLCs disagree on the disposition of the entity's
realty?
Even when the sole asset of a partnership or LLC
is realty, the interest in the entity is considered to be a form of
intangible personal property in the hands of the partner or member.
Accordingly, an exchange of an interest in an entity-holding realty
for real estate is not considered the exchange of like-kind assets.
In addition, the holding period (for purposes of calculating the
timeframe discussed in question 3) for any realty distributed from
an entity to its owners will begin upon receipt of the property.
When a partnership wishes to dispose of realty,
there may be a difference of opinion between partners who wish to
reinvest under section 1031 and those who wish to cash out. One
solution is to have those partners who desire to remain in the
partnership make a liquidating distribution to the others. Provided
there is no technical termination of the partnership, the partners
cashing out can receive consideration for their partial interests,
while the remaining partners take advantage of section 1031, with
the partnership as the exchanging taxpayer.
Revenue Procedure 2002-32 has recently provided
insight in the area of partial realty interests or undivided
fractional interests (UFI), which are being considered either as the
replacement realty or as the property to be relinquished in an
exchange. Revenue Procedure 2002-32 addresses the prerequisites for
submitting a Private Letter Ruling request to the IRS regarding a
nonpartnership tenant in common (TIC) arrangement by noting:
* There must be pro-rata sharing (in proportion to
the TIC co-owner's percentage interest in the underlying title) of
profits, expenses, cash distributions, and indebtedness.
* Up to 35 TIC co-owners are permitted to own a
single parcel (or multiple parcels that are contiguous or related in
use).
* Customary investment real estate activity may be
undertaken by the TIC co-owners (e.g., repair and maintenance);
business involvement may not.
* The use of a common bank account for the benefit
of the TIC co-owners is acceptable as long as separate reporting is
provided to the co-owners.
* An annually renewable contact with a leasing
management company, and arrangements such as voting agreements, call
options, and rights of first offer or refusal among the TIC
co-owners, are permissible with certain restrictions.
As a result of the limitations contained within
Revenue Procedure 2002-32, advisers may want to consider a master
lease for multitenant property that provides for a sublessor (such
as the sponsor packaging the TIC interests) to pay a net lease
amount to the co-owners.
Several recent private letter rulings have
permitted taxpayers disposing of individually owned realty to
receive the membership interest in a single-member LLC that owns the
replacement real property. This arrangement may be beneficial to
taxpayers concerned about liability exposure. The use of LLCs as the
preferred entity for realty holdings is discussed in two of the
author's previous articles, "Twenty Questions on Selection of a
Legal Entity" (The CPA Journal, August 1999) and "Twenty
Questions on Protecting Business and Family Assets" (The CPA
Journal, February 2000).
Though the subject article emphasizes deferred
section 1031 exchanges undertaken by individual taxpayers, all of
the various types of business organizations, including trusts, are
able to utilize section 1031 by disposing of entity-owned realty and
later acquiring replacement real property.
19 Is there an alternative to IRC section 1031, particularly
when the real estate is held by a partnership or LLC?
An alternative to section 1031 exchanges is the
use of an umbrella partnership real estate investment trust (UPREIT),
which involves a tiered ownership structure encompassing a realty
operating partnership (OP) and a REIT that is a partner in the OP.
Property owners wishing to divest their realty can
contribute their property to the OP and, pursuant to IRC section
721, receive a tax-free partnership interest in the OP. This
interest is convertible after a period of time into cash or shares
of the REIT. When there is a liability-over-basis problem with
respect to realty contributed to the OP, consideration should be
given to the transferors guaranteeing a portion of the underlying
property debt held by the OP. (For more information, see
"Planning for UPREIT Transactions When Selling Partners Want to
Go Their Separate Ways," Journal of Taxation, April 1999.)
20 How can a charitable remainder trust be used as an
alternative?
If a taxpayer wishes to avoid taxes on the
disposition of real property and does not wish to take advantage of
section 1031 (or has not utilized a self-directed IRA for the
holding and tax-free dispositions of realty), there is another
option. Prior to the execution of a contract to sell highly
appreciated realty held for investment or business purposes, a
taxpayer may consider donating this property to a newly created
charitable remainder trust (CRT). This CRT will then sell the
property and avoid capital gains tax. The CRT would pay an income
for the life of the original owner based upon the pretax value of
the donated property. This income stream is usually higher than that
which would be obtained by reinvesting the after-tax sale proceeds
in a certificate of deposit from a taxable transaction. Not only are
the sale proceeds removed from the taxpayer's estate, there is also
the benefit of a charitable income tax deduction for income tax
purposes (subject to the AGI limitations, with a five-year carryover
period for any excess) based on the actuarial value of the remainder
interest received by the charity.
A wealth replacement trust (WRT) may be used in
conjunction with a CRT, since the latter does not provide any
benefit of the trust principal to family members (i.e., the
remainder is directed to charity). As a result, the life insurance
industry developed the concept of having a portion of the tax
savings/cash flow obtained from the CRT applied toward the purchase
of life insurance (such as a second-to-die policy) that is held by
the WRT as applicant, owner, and beneficiary of a policy insuring
the husband and wife as grantors. The WRT is similar to a life
insurance trust with a "Crummey" feature (see
"Answers to 20 Questions on the Use of Trusts," The CPA
Journal, September 1998). Upon the death of the insured, the
insurance proceeds held by the trust are used to replace the wealth
that has been "lost" to charity.
IRC section 1031 offers a number of
opportunities because of its flexibility. Nevertheless, tax cases
have consistently indicated that the required documentation (along
with the procedures for implementing a deferred realty exchange)
must be, in the words of the courts, "bulletproof" in
order to avoid problems at an IRS audit.
Author Peter A. Karl,
III, JD, CPA, is a partner with the law firm of Paravati, Karl,
Green & DeBella in Utica, N. Y., and a professor of law and
taxation at the State University of New York-Institute of Technology
(Utica-Rome). He is also the author of www.1031exchangetax.com.
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