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1031 Exchanges

1031 Exchanges. Real Estate taxation, University of Houston Law Center October 23, 2014 Austin C. Carlson, Gray Reed & McGraw, P.C. acarlson@grayreed.com. 1031 Basics. Mandatory : Application of 1031 deferral rules required (but easy to bust).

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1031 Exchanges

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  1. 1031 Exchanges Real Estate taxation, University of Houston Law CenterOctober 23, 2014Austin C. Carlson, Gray Reed & McGraw, P.C.acarlson@grayreed.com

  2. 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  3. 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, 2014

  4. (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; and • Choses in action. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  5. (a) property Other Non-Qualifying Property • Personal Use Property (but vacation homes can sometimes qualify see Rev. Proc. 2008-16) • Dealer Property (inventory) – Last Week’s Lecture 1031 Exchanges, Real Estate Taxation, October 23, 2014

  6. (a) property 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  7. (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). 1031 Exchanges, Real Estate Taxation, October 23, 2014

  8. (b) Held for productive use in a trade or business OR for investment 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  9. (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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  10. (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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  11. (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). 1031 Exchanges, Real Estate Taxation, October 23, 2014

  12. 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) $30,000 Gain Recognized $20,000(Limited to Boot) 1031 Exchanges, Real Estate Taxation, October 23, 2014

  13. 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) $30,000 Gain Recognized $20,000(Limited to Boot) 1031 Exchanges, Real Estate Taxation, October 23, 2014

  14. 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) 1031 Exchanges, Real Estate Taxation, October 23, 2014

  15. 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 $20,000 1031 Exchanges, Real Estate Taxation, October 23, 2014

  16. Types of Exchanges • Simultaneous • Two Party • Three (plus) Parties : (i) Unilateral; (ii) Bilateral with Seller; or (iii) Bilateral with Purchaser • Deferred • Starker • Reverse Starker 1031 Exchanges, Real Estate Taxation, October 23, 2014

  17. 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 Exchange • 1954: Changed to Section 1031 from 112(b)(1) – present day definition adopted • 1979: Starker vs. U.S. (602 F.2d 1341) • 1984: In response to Starker, 180 day/45 day rules, also disallowance of exchange of Partnership Interest • 1989: Domestic and Non-Domestic Restriction; Related Party 2 Year Holding period 1031 Exchanges, Real Estate Taxation, October 23, 2014

  18. 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 Guidelines • 2005: Revenue Procedure 2005-14 – 1031 Exchanges Can be Combined with 121 Exclusion • 2008: Revenue Procedure 2008-16 – Safe Harbor rules for 2nd Homes 1031 Exchanges, Real Estate Taxation, October 23, 2014

  19. Three Party Exchanges : Unilateral Transfers Purchaser $ Taxpayer’s Property Taxpayer Seller Seller’s Property Notes Explicitly approved by Rev. Rule 90-34, 1990-1 C.B. 154 1031 Exchanges, Real Estate Taxation, October 23, 2014

  20. Three Party Exchanges : Bilateral Exchange with Seller Purchaser $ Taxpayer’s Property Taxpayer Seller Taxpayer’s Property Seller’s Property NotesSeller 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  21. Three Party Exchanges: Bilateral Exchange with Purchaser Purchaser $ Taxpayer’s Property Seller’s Property Seller’s Property Taxpayer Seller NotesMust 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  22. Deferred Exchanges 1031 Exchanges, Real Estate Taxation, October 23, 2014

  23. Identification and Receipt Requirements The 45 Day Identification Period • Unambiguously described in a written document • Two rules for identifying properties: • Three property rule; and • 200% percent rule • Two exceptions to the rules: • Property received before the end of ID period • Property received by end of EXCHANGE period equals at least 95% of FMV of properties identified • Can revoke a property before end of period by written document The 180 Day Exchange Period Earlier of 180 days after relinquished property or the due date (with extensions) of the taxpayer’s income tax return 1031 Exchanges, Real Estate Taxation, October 23, 2014

  24. 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 period 1031 Exchanges, Real Estate Taxation, October 23, 2014

  25. Regulation Safe Harbors • Qualified Escrow Accounts and Trusts • Security or Guaranty Arrangements • Qualified Intermediaries • Interest and Growth Factors 1031 Exchanges, Real Estate Taxation, October 23, 2014

  26. 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 person • Trust terminates at the time the taxpayer has the unrestricted right to the cash • Taxpayer may receive money or other property directly from a party without affecting the rules 1031 Exchanges, Real Estate Taxation, October 23, 2014

  27. Safe Harbor: Qualified Escrow Accounts and Trusts 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 exchange • Is provided for in writing • Is beyond the control of the taxpayer 1031 Exchanges, Real Estate Taxation, October 23, 2014

  28. Safe Harbor: Qualified Escrow Accounts and Trusts 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) 1031 Exchanges, Real Estate Taxation, October 23, 2014

  29. 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  30. 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  31. 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 Substance 1031 Exchanges, Real Estate Taxation, October 23, 2014

  32. 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, Trusts • Persons related to “Agents” 1031 Exchanges, Real Estate Taxation, October 23, 2014

  33. 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.I • Clause 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  34. 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  35. 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: QEAA 1031 Exchanges, Real Estate Taxation, October 23, 2014

  36. Qualified Exchange Accommodation Arrangements • Qualified indicia of ownership • Can’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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  37. 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

  38. 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; and • Established 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). 1031 Exchanges, Real Estate Taxation, October 23, 2014

  39. 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 periods • Related 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. 1031 Exchanges, Real Estate Taxation, October 23, 2014

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