Real Estate taxation University of Houston Law Center October 23 2014 Austin C Carlson Gray Reed amp McGraw PC acarlsongrayreedcom 1031 Basics Mandatory Application of 1031 deferral rules required but easy to bust ID: 277401
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1031 Exchanges
Real Estate taxation, University of Houston Law Center
October 23, 2014
Austin C. Carlson, Gray Reed & McGraw, P.C.
acarlson@grayreed.comSlide2
1031 Basics
Mandatory
: Application of 1031 deferral rules required (but easy to bust).
Gain/Loss: Gain recognized to the extent of boot; Loss not recognized.Basis: Carryover basis in old property, adjusted by: subtracting (i) cash received, and (ii) liabilities assigned to other party and; adding (i) cash paid, (ii) liabilities assumed, and (iii) gain recognized.Holding Period: Tacking for qualifying property. Begins on exchange date for non- qualifying property.
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1031 Exchanges, Real Estate Taxation, October
23,
2014Slide3
I.R.C. 1031(a)(1) - The Basic Rule
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.1031 Exchanges, Real Estate Taxation, October 23, 20143Slide4
(a) property
I.R.C. 1031(a)(2) – Non-Qualifying Property
Stock in trade or other property held primarily for sale;
Stocks, bonds, or notes;Other securities or evidences of indebtedness or interest;Interests in a partnership;Certificates of trust or beneficial interests; andChoses in action.41031 Exchanges, Real Estate Taxation, October 23, 2014Slide5
Other Non-Qualifying Property
Personal Use
Property
(but vacation homes can sometimes qualify see Rev. Proc. 2008-16)Dealer Property (inventory) – Last Week’s Lecture5(a) property1031 Exchanges, Real Estate Taxation, October 23, 2014Slide6
Qualifying Property
Generally real estate, but
includes personal property (e.g. work trucks, airplanes).
Can be used in trade or business.TIC interests can be exchanged.6(a) property1031 Exchanges, Real Estate Taxation, October 23, 2014Slide7
(b) Held for productive use in a trade or business
OR
for investment
Minimal amount of personal use is allowed.“Held for” is different from “used for” depreciation test.Held for investment test is applied at the time of the exchange – intent can change (Rev Rule 57-244).No clear holding period, however properly acquired for an exchange does not satisfy test (Rev Rule 84-121).71031 Exchanges, Real Estate Taxation, October 23, 2014Slide8
Can an exchange by former partner of property from a partnership qualify? Maybe: TCM case.
Better way to structure:
Facts
: A, B, and C own partnership ABC in equal shares. ABC owns a single asset, raw land acquired for investment. A and B want to sell the land, C wants to exchange.8(b) Held for productive use in a trade or business OR for investment1031 Exchanges, Real Estate Taxation, October 23, 2014Slide9
(c) exchanged solely for
Exchange – can be between 3 and even 4 parties.
Solely – Gain deferral is limited to value received in like kind property. Gain recognized on boot.
91031 Exchanges, Real Estate Taxation, October 23, 2014Slide10
(d) property of like
kind
Real property for real
property; personal for personal (state law controls).U.S. situs property for U.S. situs property.101031 Exchanges, Real Estate Taxation, October 23, 2014Slide11
(e) which
is to be held either for productive use in
a
trade or business or for investment.Investment and business use can be exchanged.Must continue to be used for investment or business use (no personal use conversion).111031 Exchanges, Real Estate Taxation, October 23, 2014Slide12
Calculation of Gain – Cash Received
Example:
Taxpayer exchanges land (Basis: $50,000, FMV: $80,000)
for land with FMV of $60,000 and $20,000 cash.Gain RealizedFMV of Property Received $60,000 + Cash Received $20,000 – Basis ($50,000) $30,000Gain Recognized $20,000(Limited to Boot)
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1031 Exchanges, Real Estate Taxation, October
23,
2014Slide13
Calculation of Gain – Mortgage Assumed
Example:
Taxpayer exchanges land (Basis: $50,000, FMV: $80,000, $20,000 mortgage)
for land with FMV of $60,000.Gain RealizedFMV of Property Received $60,000 + Mortgage on Old Prop. $20,000 – Basis ($50,000) $30,000Gain Recognized $20,000(Limited to Boot)131031 Exchanges, Real Estate Taxation, October
23, 2014Slide14
Calculation of Gain – Netting Mortgages
Example:
Taxpayer exchanges land (Basis: $50,000, FMV: $80,000, $40,000 mortgage)
for land with FMV of $60,000, $20,000 mortgage.Gain RealizedFMV of Property Received $60,000 + Mortgage on Old Property $40,000 - Mortgage on New Property ($20,000) - Basis ($50,000) $30,000 Gain Recognized $20,000(Limited to Netted Mortgages) 14
1031 Exchanges, Real Estate Taxation, October
23,
2014Slide15
Calculation of Basis After Exchange
Example:
Taxpayer exchanges land (Basis: $50,000, FMV: $80,000, $40,000 mortgage)
for land with FMV of $60,000, $20,000 mortgage.BasisCarryover Basis $50,000 -Mortgage on Old Property ($40,000) + Mortgage on New Property $20,000 + Gain Recognized $20,000 $50,000 Other party’s basis increases by $20,00015
1031 Exchanges, Real Estate Taxation, October 23, 2014Slide16
Types of Exchanges
Simultaneous
Two Party
Three (plus) Parties : (i) Unilateral; (ii) Bilateral with Seller; or (iii) Bilateral with PurchaserDeferredStarkerReverse Starker161031 Exchanges, Real Estate Taxation, October 23, 2014Slide17
Brief History of 1031 Exchanges
1921: First introduced in the Revenue Act of 1921 – securities and non- like-kind property if property did not have a “readily realizable market value”
1925: Non-Like Kind eliminated in 1925
1935: Board of Tax Appeals approved a Qualified Intermediary Exchange1954: Changed to Section 1031 from 112(b)(1) – present day definition adopted1979: Starker vs. U.S. (602 F.2d 1341)1984: In response to Starker, 180 day/45 day rules, also disallowance of exchange of Partnership Interest1989: Domestic and Non-Domestic Restriction; Related Party 2 Year Holding period171031 Exchanges, Real Estate Taxation, October 23, 2014Slide18
Brief History of 1031 Exchanges (Cont’d)
1990/91: Present day regulations issued
2000: Revenue Procedure 2000-37 – Safe Harbor for Reverse Starker Exchanges
2002: Revenue Procedure 2002-22 – Tenant-In-Common (TIC) Property Guidelines2005: Revenue Procedure 2005-14 – 1031 Exchanges Can be Combined with 121 Exclusion2008: Revenue Procedure 2008-16 – Safe Harbor rules for 2nd Homes181031 Exchanges, Real Estate Taxation, October 23, 2014Slide19
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Three Party Exchanges : Unilateral Transfers
Purchaser
TaxpayerSeller$Seller’s PropertyTaxpayer’s PropertyNotesExplicitly approved by Rev. Rule 90-34, 1990-1 C.B. 1541031 Exchanges, Real Estate Taxation, October
23, 2014Slide20
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Three Party Exchanges : Bilateral Exchange with Seller
Purchaser
TaxpayerSeller$Seller’s PropertyTaxpayer’s PropertyNotesSeller must actually take legal and beneficial ownership of taxpayer’s property, either
as the buyer or as buyer’s agent.
Leslie Q. Coupe,
52 T.C. 394.
Taxpayer’s Property
1031 Exchanges, Real Estate Taxation, October
23,
2014Slide21
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Three Party Exchanges: Bilateral Exchange with Purchaser
Purchaser
TaxpayerSeller$Seller’s PropertyTaxpayer’s PropertyNotesMust show (i)
taxpayer intended and was only obligated to make an exchange rather than a sale; (ii) an exchange actually occurred between taxpayer
and
purchaser
, and (iii)
purchaser
used its own funds to acquire ownership of the property temporarily for itself.
Alderson v.
Comm’r
, 317 F.2d 790.
Seller’s Property
1031 Exchanges, Real Estate Taxation, October
23,
2014Slide22
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Deferred Exchanges
1031 Exchanges, Real Estate Taxation, October
23, 2014Slide23
Identification and Receipt Requirements
The 45 Day Identification Period
Unambiguously described in a written document
Two rules for identifying properties:Three property rule; and200% percent ruleTwo exceptions to the rules:Property received before the end of ID periodProperty received by end of EXCHANGE period equals at least 95% of FMV of properties identifiedCan revoke a property before end of period by written documentThe 180 Day Exchange PeriodEarlier of 180 days after relinquished property or the due date (with extensions) of the taxpayer’s income tax return231031 Exchanges, Real Estate Taxation, October 23,
2014Slide24
Escrows, Trusts, and Qualified Intermediaries
Gain or loss is recognized if Taxpayer actually
or constructively receives
money or other property before receiving the replacement property. Reg. Section 1.1031(k)-(1)(f)(1).Issue: Relying on promise to receive replacement property (vs. simultaneous exchange). What type of arrangements will cause constructive receipt?Example: Reg. Section 1.103(k)-1(f)(3) – Unrestricted right to demand payment before end of exchange period241031 Exchanges, Real Estate Taxation, October 23, 2014Slide25
Regulation Safe Harbors
Qualified Escrow Accounts and Trusts
Security or Guaranty Arrangements
Qualified IntermediariesInterest and Growth Factors251031 Exchanges, Real Estate Taxation, October 23, 2014Slide26
Safe Harbor: Qualified Escrow Accounts and Trusts
Qualified Escrow:
Escrow holder is neither the taxpayer nor a disqualified person
Agreement expressly subjects right to receive, or otherwise obtain cash to the withdrawal limits (discussed in the next slide)Qualified Trust:Trustee is neither the taxpayer nor a disqualified personTrust terminates at the time the taxpayer has the unrestricted right to the cashTaxpayer may receive money or other property directly from a party without affecting the rules261031 Exchanges, Real Estate Taxation, October 23, 2014Slide27
Withdrawal Limitations
No right to receive before:
End of identification period if taxpayer has not identified land;
Receipt of all replacement property;End of the exchange period;A material and substantial contingency after the identification period that:Relates to the deferred exchangeIs provided for in writingIs beyond the control of the taxpayer271031 Exchanges, Real Estate Taxation, October 23, 2014Safe Harbor: Qualified Escrow Accounts and TrustsSlide28
Examples of Allowed Language
Taxpayer may demand funds in escrow at any time after the later of [end of exchange period].
Taxpayer may demand funds in escrow if the replacement property is destroyed, seized, requisitioned, or condemned.
Note: Items that can be received (Reg. Sec. 1.1031(k)-1(g)(7)Items not included in the disposition of property (e.g. prorated rents)Items related to disposition of property and appear under local standards in the closing statements (e.g. commissions, prorated taxes)281031 Exchanges, Real Estate Taxation, October 23, 2014Safe Harbor: Qualified Escrow Accounts and TrustsSlide29
Safe Harbor: Security or Guaranty Arrangements
Constructive receipt does not occur merely because the taxpayer’s right to receive payment is secured or guaranteed.
Reg. Section 1.1031-(k)-1(g)(2).
Safe Harbor Arrangements:Mortgage, deed or trust, or other security interest in property.Standby letter of credit as long as taxpayer can’t draw unless in case of default.Guaranty of third party.291031 Exchanges, Real Estate Taxation, October 23, 2014Slide30
Safe Harbor: Interest and Growth Factors
Growth Factor
- Compensation for time that the property is in the hands of the transferee.
Taxable as interest income. Reg. Section 1.1031(k)-1(h)(2).Present if the amount of money the TP is entitled to depends on the length of time between property exchanges. Reg. Section 1.1031(k)-1(h)(1).Right to receive the growth factor must be subject to the Withdrawal Limitations.301031 Exchanges, Real Estate Taxation, October 23, 2014Slide31
Safe Harbor: Qualified Intermediaries
QI
– Person who is neither the taxpayer or a disqualified person with written agreement under which the QI acquires and transfers the relinquished property AND acquires and transfers the replacement property.
Reg. Section 1.1031(k)-1(g)(4)(iii).Direct Deeding is Permitted. Rules must be followed “with precision”. TAM 2001300001. Form over Substance311031 Exchanges, Real Estate Taxation, October 23, 2014Slide32
Disqualified Persons
Taxpayer’s “Agent”
Expanded definition of Agent: a person who has been the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker, within the two year period ending on the date of the transfer of the first of the relinquished properties.
Reg. Section 1.1031(k)-1(k)(2).Related parties rules of I.R.C. Section 267(b) and 707(b)Family Members, Entities (individual owns 10% directly or indirectly), Commonly Controlled Entities, TrustsPersons related to “Agents”321031 Exchanges, Real Estate Taxation, October 23, 2014Slide33
Mechanics of a Typical Transaction
Taxpayer and purchaser enter into an Earnest Money Contract.
Taxpayer and purchaser enter into Purchase and Sales Agreement.
Need clause establishing intent to engage in a deferred like-kind exchange through Q.IClause allowing assignment of Sales Agreement to QI.Assign Earnest Money Contract and Purchase and Sales Agreement to QI (instructs direct deeding).Give notice to purchaser for assignments.Identify replacement property and give written notice to QI.331031 Exchanges, Real Estate Taxation, October 23, 2014Slide34
Mechanics of a Typical Transaction (Cont’d)
Close on replacement
property within 180 days.
Execute Purchase and Sale Agreement with respect to replacement property.Need clause establishing intent to engage in a deferred like-kind exchange through QI.Clause allowing assignment of Sales Agreement to QI.Execute Assignment of Purchase and Sale Agreement in favor of QI (instructs direct deeding).Deliver notice to seller. File IRS Form 8824 for tax year in which property is relinquished.341031 Exchanges, Real Estate Taxation, October 23, 2014Slide35
Reverse Starker Transactions
Starker case allowed a reverse transaction within 5 years
Rev. Proc. 2000-37 provided response that adopts many of the same rules as a Starker transaction (45 day ID period, 180 day exchange period).
Parking Arrangements Issue – Is the accommodation party the owner of the property for federal income tax purposes? Solution: QEAA351031 Exchanges, Real Estate Taxation, October 23, 2014Slide36
Qualified Exchange Accommodation Arrangements
Qualified indicia of ownership
C
an’t be a disqualified person, must be subject to federal income tax on interest.Legal title or interest in an entity that is disregarded entity (e.g. single-member LLC).Bona fide intent of taxpayer at time of transfer for 1031 exchange to occur.Within 5 days of transfer, enter into qualified exchange accommodation agreement.45 day/180 days rules --similar to Starker transaction.361031 Exchanges, Real Estate Taxation, October 23, 2014Slide37
Permissible Arrangements in a QEAA
Exchange accommodation titleholder (EAT) can also be QI.
Taxpayer can indemnify or reimburse EAT for costs and loan or advance funds to EAT.
EAT can lease property to taxpayer or other party.Taxpayer can manage the property or supervise improvements.Taxpayer and EAT can enter into puts and calls during the exchange period.Taxpayer and EAT can provide for arrangements to take into account variation of price of the property.Can the taxpayer use his own property as replacement property? Maybe.371031 Exchanges, Real Estate Taxation, October 23, 2014Slide38
Issues with Related Parties
Related party definition less broad than disqualified person (only I.R.C. 267(b) rules).
Two year holding period for land with exceptions:
Disposition occurs after the death of a taxpayer or related person;Compulsory or involuntary conversion; andEstablished to the satisfaction of the Secretary of non-avoidance purpose.Catch-all anti-avoidance provision: applied to “any exchange which is part of a transaction… structured to avoid the purposes of this subsection.” I.R.C. Section 1031(f)(4).381031 Exchanges, Real Estate Taxation, October 23, 2014Slide39
Tax Compliance: Required 1031 Reporting
Form 8824
Filed With tax return for the year including extensions (remember 180 day rule with extensions).
Asks for specific dates relating to the identification and replacement periodsRelated Parties – Must also file 2 years following the year of a related party exchange.Gains Reported on Form 4797 (Trade or Business/Non-Capital Assets) or Schedule D (Capital Assets).Form 1099 Reporting Requirement.391031 Exchanges, Real Estate Taxation, October 23, 2014