1031 EXCHANGE Q & A

Topic 1 - Introduction

This topic introduces real estate exchanges and focuses on the deferred exchange and how vital the deferred exchange regulations are in planning and executing real estate exchanges.

DO YOU REALLY WANT TO MAKE AN EXCHANGE???

Before getting started planning an exchange for your property to save taxes, take a closer look. You might find an exchange is unnecessary or because there would be a loss or very small gain recognized if you sell the property outright. Or, after a lot of work and expense, discover one of the properties does not qualify.

Here´s a real life experience of a taxpayer who went to great lengths and difficulties to make an exchange that converted lower tax rate capital gains into higher tax rate ordinary income.

Taxpayer owned an apartment house subject to capital gains tax if he sold the property. Instead, he exchanged it for a large parcel of investment  and rolled the lower basis of the apartment house into the land under the substituted basis rules. He was planning to subdivide the land two or three years later and build homes for sale. By careful planning and lots of work, here is what he accomplished:

The large gain from the sale of the apartment house was deferred for tax purposes by rolling over into the investment land, thus lowering the basis of the land by the amount of the gain.

Later when he reclassified the land from investment property (capital gains) to dealer property (ordinary income), his profit (ordinary income) from the sale of each home and lot was increased by the amount of deferred gain resulting from the exchange.

Here is a question from one of our readers illustrating this very important point:

I have a prospect that purchased a condo here in Vegas. The intention of the purchase was to rent it out.  They purchased the property with an owner occupied loan-planed on living in it for a few months then renting it out and buying their dream home. The first month, they met some folks in the association who informed them that the CC&R's will not allow owners to rent their properties!  Neither the agent who sold them the home or the sellers informed them of this dilemma.

If they were to sell the condo...could they use a 1031 exchange, since they purchased it with the 'intent' to rent?

We answered: If the clients sold the condo right now, would the amount realized from the sale (sales price minus all selling expenses including commissions, etc.) be more than their cost of the condo including closing costs? This is often the case on quick sales like this. If there is no gain, the question of exchange is moot. If there is a gain, the property should qualify for §1031 treatment since the need and decision to sell are considered an unrelated event to the purchase.

Special attention must also be given to the exchange of depreciable property that has appreciated in value. Since the basis of the old property is "substituted" into the new property, your depreciation deductions may be affected. On the other hand, a sale and purchase could result in a higher cost basis in the new property and higher depreciation deductions.

To understand §1031, you must look to its legislative design. Congress intended non-recognizable taxable gain or loss if the Replacement Property received is merely a continuation of your old property investment. To qualify, you must structure and complete your exchange transaction in accordance with the requirements of §1031. Your intent doesn't count - what you actually do is what determines if you qualify or not. However, if the transaction is ambiguous, the Courts may look to intent of the parties. See Step Transactions and Substance over Form Doctrines-for more discussion on this matter.

Section 1031 provides for nonrecognition of gain or loss if three conditions are met:

1.Only property held for investment or use in your trade or business qualifies for §1031 exchanges. Both the property exchanged by you and the property received by you must be qualified. Personal use property such as your personal residence does not qualify. Nor does "dealer" property.

2.The properties must be of like-kind. They do not have to be identical. This is a very broad definition. All qualified real estate is of like-kind with all other qualified real estate.

3.There must be an actual exchange of properties. There can be a transfer of money with the qualified property. This will not disqualify the exchange. Taxpayers lose most tax cases involving exchanges because their transaction fails to meet the requirements of §1031 for a reciprocal transfer of property.

Structuring and executing an exchange of real estate must be done correctly. If not, the transaction is treated as a sale. The Internal Revenue Code and related regulations all refer to the transaction as a "sale or exchange" and the rules for distinguishing between the two are steadfast and unwavering. You will not get §1031 treatment merely if you intend to exchange-you must actually make an exchange of your property.

Parallel Point 1-1

You find a choice apartment house property for sale. You know of a buyer who would be willing to pay top dollar for the property. You decide to acquire the property and sell the buyer a two-year option to buy the property. In the meantime you will operate it as a rental income property. You currently own a commercial property you want to sell now but your accountant advises you need another capital gain this year like you need a hole in your head.

You enter into an exchange agreement to sell your commercial property and acquire the choice apartment house with the plan of selling the option, operating the property until the option is exercised, and taking your total gain in that taxable year.

The exchange will be disallowed and treated as a sale. Not only does the step transaction doctrine apply and collapse the exchange but also the act of selling the option at time of acquisition reclassifies the rental property as real estate held for sale in the ordinary course of business.

The deferred exchange is designed to solve this dilemma. It permits you to "sell" your property now and use the proceeds to buy the Replacement Property later. As long as it's done following the rules with a Qualified Intermediary, you get §1031 treatment.

A deferred exchange is an exchange in which you transfer qualified property called the "Relinquished Property" and subsequently receive qualified property as consideration. The property received is called Replacement Property.

The IRS regulation explaining how to put together the §1031 deferred real estate exchange is one of the most powerful tools for selling appreciated business, farm, and investment real estate without recognition of gain for income tax purposes. It spells everything out-step by step. Just follow the rules and you can sell your appreciated property, use the cash proceeds to buy your Replacement Property and qualify for the full benefits of nonrecognition of gain under Section 1031. The regulation has the weight of law and all parties must follow it-even the IRS.

One of the outstanding features of the deferred exchange regulation is it establishes and defines the Qualified Intermediary (QI) as your vehicle to qualify for the safe harbor procedures you must follow to get non-recognition of gain treatment on your deferred exchange.

After the transaction is completed, you and your QI settle up. Your tax reporting of the exchange is easy to figure. You simply measure what you put into the exchange-Relinquished Property and boot-against what you take out after your settlement with the QI§-Replacement Property and boot.

To understand §1031, you must look to its legislative design. Congress intended non-recognizable taxable gain or loss if the Replacement Property received is merely a continuation of your old property investment. To qualify, you must structure and complete your exchange transaction in accordance with the requirements of §1031. Your intent doesn't count - what you actually do is what determines if you qualify or not. However, if the transaction is ambiguous, the Courts may look to intent of the parties. See Step Transactions and Substance over Form Doctrines-for more discussion on this matter.

Section 1031 provides for nonrecognition of gain or loss if three conditions are met:

1.Only property held for investment or use in your trade or business qualifies for §1031 exchanges. Both the property exchanged by you and the property received by you must be qualified. Personal use property such as your personal residence does not qualify. Nor does "dealer" property.

2.The properties must be of like-kind. They do not have to be identical. This is a very broad definition. All qualified real estate is of like-kind with all other qualified real estate.

3.There must be an actual exchange of properties. There can be a transfer of money with the qualified property. This will not disqualify the exchange. Taxpayers lose most tax cases involving exchanges because their transaction fails to meet the requirements of §1031 for a reciprocal transfer of property.

Structuring and executing an exchange of real estate must be done correctly. If not, the transaction is treated as a sale. The Internal Revenue Code and related regulations all refer to the transaction as a "sale or exchange" and the rules for distinguishing between the two are steadfast and unwavering. You will not get §1031 treatment merely if you intend to exchange-you must actually make an exchange of your property.

Parallel Point 1-1

You find a choice apartment house property for sale. You know of a buyer who would be willing to pay top dollar for the property. You decide to acquire the property and sell the buyer a two-year option to buy the property. In the meantime you will operate it as a rental income property. You currently own a commercial property you want to sell now but your accountant advises you need another capital gain this year like you need a hole in your head.

You enter into an exchange agreement to sell your commercial property and acquire the choice apartment house with the plan of selling the option, operating the property until the option is exercised, and taking your total gain in that taxable year.

The exchange will be disallowed and treated as a sale. Not only does the step transaction doctrine apply and collapse the exchange but also the act of selling the option at time of acquisition reclassifies the rental property as real estate held for sale in the ordinary course of business.

The deferred exchange is designed to solve this dilemma. It permits you to "sell" your property now and use the proceeds to buy the Replacement Property later. As long as it's done following the rules with a Qualified Intermediary, you get §1031 treatment.

A deferred exchange is an exchange in which you transfer qualified property called the "Relinquished Property" and subsequently receive qualified property as consideration. The property received is called Replacement Property.

The IRS regulation explaining how to put together the §1031 deferred real estate exchange is one of the most powerful tools for selling appreciated business, farm, and investment real estate without recognition of gain for income tax purposes. It spells everything out-step by step. Just follow the rules and you can sell your appreciated property, use the cash proceeds to buy your Replacement Property and qualify for the full benefits of nonrecognition of gain under Section 1031. The regulation has the weight of law and all parties must follow it-even the IRS.

One of the outstanding features of the deferred exchange regulation is it establishes and defines the Qualified Intermediary (QI) as your vehicle to qualify for the safe harbor procedures you must follow to get non-recognition of gain treatment on your deferred exchange.

After the transaction is completed, you and your QI settle up. Your tax reporting of the exchange is easy to figure. You simply measure what you put into the exchange-Relinquished Property and boot-against what you take out after your settlement with the QI§-Replacement Property and boot.

Topic 2 - Qualified Property

After recognizing an exchange opportunity, you must determine if the properties involved in the exchange qualify for §1031 treatment. I have seen exchangers go to lots of time and trouble to set up an exchange, only to discover that one or both of the properties did not even qualify. What a waste of time and money. This chapter explains how to avoid this common problem. It teaches how to determine the classification of real estate for §1031 exchange purposes, which classifications qualify, and which don’t. Like-kind property as defined in §1031 is explained and detailed. Other topics include real estate options, foreign real estate, partnerships and time holding considerations.

 

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Qualified Property - Topic 2

The first thing to do when considering a sale of appreciated real estate is to determine if property you are selling and property you are buying qualify for §1031 treatment. This is key step. Many real estate professionals and investors get involved in exchanges only to discover that one or more of the properties did not qualify for §1031 treatment. No matter how brilliant the transaction-no exchange. They could have saved a lot of time and money by first establishing the tax classification of the properties to see if all qualified.

Section 1031 exchanges are called by many names. Nontaxable exchanges, Like-Kind exchanges, and so on. But using the name like-kind can be confusing. To meet the requirements of §1031, both Relinquished Property and Replacement Property must qualify. In other words, both the property you are selling and the property you are buying must be qualified property of like-kind. If not, your exchange will fail and be classified as a sale. This is so important it needs repeating:

To be a like-kind exchange, the property must be both (1) qualifying property and (2) like-kind property.

For income tax purposes, real estate is divided into four classifications. Classification is made as of the date the transaction is made. The classifications are:

1.Held for business use (§1231)

2.Held for investment (§1221)

3.Held for personal use

4.Held primarily for sale (dealer property)Also see x

The first two classifications-held for business and held for investment-qualify for §1031 treatment. The second two-held for personal use and dealer property-do not.

The property you trade away is called Relinquished Property. The property you receive is called Replacement Property. You must actually own the Relinquished Property and must acquire ownership of the Replacement Property.

âNote: See Title Issues.

In Chase v. Comm., 92 TC 874 (1989), §1031 treatment was denied where a partnership-owned building was exchanged for a building that went directly to some of the limited partners. This was not eligible for 1031 treatment since neither the partnership nor the partners were owners on both ends of the transaction.

Some properties have more than one classification at the time of sale. For example, a farmer sells his farm including his personal residence. The sale or exchange is allocated between the real estate held for personal use (the personal residence) and the real estate held for use in a trade or business (the farm). Another example is the sale or exchange of a duplex where the seller lived in one unit and rented out the other unit. The sale would be allocated.

1. Real Estate Held for Personal Use    

This classification includes your primary residence, vacation homes and other property held for personal use. Your primary residence includes the dwelling unit and the land it's located on. The land alone, however, is not a residence. Land included with the sale of your personal residence might present an allocation problem. The question is-how much land can be sold with your personal residence and qualify for §121 exclusions? IRS has issued no definitive rules. Rather, each case is looked at separately. In Rev Proc 87-3, IRS says whether or not an owner uses property as a personal residence depends on all the facts and circumstances in each case, including the good faith of the owner. If any of the land is used for business or held for investment at the time of sale, an allocation of classification must be made.

The IRS and court cases have allowed up to 65 acres of land to be included as part of the residential classification. However, the rules indicate that more acres could be included if the facts and circumstances so warrant.

If real estate held for personal use is sold at a gain, gain not excluded under §121 is treated as a capital gain and subject to tax. If sold at a loss, the loss is personal and not deductible.

Exchange Treatment - Real estate held for personal use does not qualify for §1031 like-kind exchange treatment.

Interest paid to acquire a personal residence and one second home may be deducted as home mortgage interest if otherwise qualified.

For an in-depth discussion of exchanging vacation homes, see Special Issues in Chapter Eleven.

2. Real Estate Held for Use in a Trade or Business

This property is known as §1231 real estate. There are two types of real estate used in a trade or business:

1.owner occupied, and,

2.property is used in the owner's trade or business.

The act of renting real property qualifies it as property used in a trade or business.

Net gains from the sale or exchange of §1231 property are taxed as long-term capital gains. However, if the holding period is short, the gain may be recognized as ordinary income. Net losses are deductible as ordinary losses.

Exchange Treatment - IRC Section 1231 property qualifies for §1031 like-kind exchange treatment.

Interest paid to acquire §1231 real estate is deducted as business interest against the operation of the real estate business activity.

3. Real Estate Held for Investment

Investment real estate is a capital asset (IRC Section 1221). It's property held primarily for appreciation of value due to location, passage of time and other factors outside the activities of the owner. It is treated as a portfolio investment asset. An example of investment real estate is raw land held for appreciation. Even if purchased with the idea you might someday develop the property, if you don't develop it (for any reason), the property will not lose its classification as investment property.

Real estate used in a trade or business is not held for investment. Real estate held for personal use is not held for investment. If you have trouble understanding this, you are not alone. Many real estate people have trouble with this. After all, they have been selling property for years as a good investment. But remember, we are dealing with taxation here-not financial investments. The tax treatment of investment property is different than the tax treatment of business property-and the differences are profound.

If sold at a gain, the gain is a capital gain. If sold at a loss, the loss is a capital loss subject to the capital loss limitation rules.

Exchange Treatment - Investment real estate qualifies for §1031 like-kind exchange treatment.

Interest paid to acquire §1221 property is treated as investment interest and may be subject to special deduction limitations.

Real Estate Held for Sale to Customers

This classification is known as dealer property. To be classified dealer property, the property must be held at the time of sale or exchange

primarily for sale

to customers

in the ordinary course of business.

All three elements must exist at the time of sale or exchange or the property will not be classified dealer property. Primarily for sale means of the first importance. It does not have to constitute more than 50% of the purpose-it need only be the most important. The Supreme Court said, "If an owner acquires a property for rental or investment use, but also plans to sell the property and realize gain in any way he can if the original plan becomes unfeasible, he does not hold the property primarily for sale."

All buyers of real estate are customers as the term is used here. The activity "in the ordinary course of business" must be directly related to the sale of that property. In addition, the activity must be "busy." The two "busy" activities usually related to sales or exchanges are

1.sales activities related to the property, and,

2.physical improvements to the property.

Many people, including many IRS agents, misunderstand this activity. To be classified dealer property, there must exist a busy business activity directly related to that property. If you buy a parcel of land, subdivide it, and build houses for sale, there's no question you have dealer property. But if you buy a parcel of land, make no physical improvements, subdivide it by getting it rezoned and meeting other legal requirements, and sell it in the form of an unsolicited offer-you get capital gain treatment. The reason? No business activity related to the property.[iii]

If the property is listed with a licensed real estate broker, the sales activities of the real estate broker are not considered to be the sales activities of the owner.

The Tax Court has held the real estate activities of corporations owned or controlled by an individual cannot be attributed to him even though he may be engaged full-time as an officer of the corporation.

Licensed real estate brokers and salespersons ordinarily are not dealers. In Scheuber v. Com. 371 F2nd 996, it was held properties purchased by a licensed real estate broker (who intended ultimately to sell) and held for realization of appreciation in value over a substantial period of time were capital assets.

If dealer property is sold at a gain, the gain is taxed as ordinary income. If dealer property is sold at a loss, the loss is deductible as an ordinary loss.

Exchange Treatment - Dealer property does not qualify for 1031 like-kind exchange treatment.

Interest paid to acquire dealer property is deductible as business interest against the dealer property activity.

Every sale, exchange and purchase of real estate requires an allocation be made between the various classifications of property. These allocations are required because tax treatment of different classifications is unique. A simple, everyday example is the sale of a rental income property. The buyer of the property must make a cost allocation between the land (non-depreciable) and the building (depreciable). The seller treats the property as a sale of a single property since the land and building is treated as one property. [iv]

Many apartment rental properties require allocation among the building, the land and personal property such as furniture included with the rentals.

Ranch and farm property can require many classification allocations. These allocations include land, single-purpose agriculture buildings, multi-purpose agriculture buildings, fencing, water wells, irrigation systems, animals and poultry, producing trees and vines, and growing crops. Many ranch and farm sales include the farmer’s primary residence. The cost basis and the sales price allocation must be made to the residence and the underlying land related to residential use. This "carved out" sale is treated as the sale of a primary residence and may qualify for §121 exclusion benefits. The sale of a primary residence does not qualify for §1031 treatment since it is classified as real estate held for personal use.

If all or some of the property you want to sell does not qualify for §1031 treatment, a transfer of that property in an exchange transaction will be treated as a sale of that property. For more discussion on this issue, see Topic 3 dealing with treatment of unlike-kind (boot) property.

§1031(a) excludes these assets from nontaxable treatment:

Property you hold for personal use such as your primary residence.

Stock in trade and property held primarily for sale such as inventories and real estate held by dealers.

Stocks, bonds, notes, or other securities or evidences of indebtedness such as accounts receivable.

Partnership interests.

Notes

Choses in action.

Certificates of trust or beneficial interest

âCaution: It doesn’t matter if any of the excluded property items are related to real estate; they are always excluded from §1031 treatment. For example, a note secured by real property can never qualify.

For an exchange to be tax-free, both the Relinquished Property and the Replacement Property must be "qualified." Qualified means held by you either for productive use in a trade or business or for investment.

Examples of property used in a trade or business are farms, ranches, rental income properties, industrial and commercial properties used by the owner in his business. All real estate qualifying for depreciation under Code Section 167 is deemed property used in a trade or business. This property is described in Code Section 1231(b).

An example of real property held for investment is unproductive land. Unproductive real estate held for future use or future realization of the increment in value is held for investment and not primarily for sale.

Two or more qualifying properties can be received in exchange for the transfer of a single property. Likewise, business property may be exchanged for investment property and vice versa. Qualifying newly constructed property can be exchanged for used property.

Properties can be "mixed" and qualify. For example, I exchange my duplex rental property and a lot I have held for investment for your farm. We both may qualify for §1031 treatment. There is no requirement your former property be held for business or investment use by the other party to the exchange. What the other party does with your property will not affect the tax-free status of the exchange for you.

Parallel Point 2-1

You own a 3-plex rental income property that qualifies for exchanging. You exchange for my home high up in the mountains of northern Arizona. To determine if my home-your Replacement Property-qualifies for §1031 treatment depends on your use of the property. If you establish it as rental income property it will qualify. However, if you decide to live there and make it your primary residence, your exchange will fail since the Replacement Property is not qualified.

Looking at it from my viewpoint, I do not qualify for §1031 treatment no matter what you do with my house after you acquire it. My transaction is treated as the sale of my primary residence and may qualify for the exclusion benefits under §121. I will treat the 3-plex as rental property income property if I continue to operate it as a rental.

What happens if I decide to move into one of the four units and occupy it as my primary residence? Tax rules would require me to classify the unit I occupy as the purchase of a primary residence. Basis would be allocated to the 3-units as the purchase of rental income property.

Like-kind is one of the most misused terms in real estate exchanging. Many use it to include the qualifying property requirement. Not so. Be sure not to confuse the term ‘like-kind’ with the term ‘qualified property’. The property must meet both definitions to get §1031 treatment.

The regulations broadly define the term "like-kind."

"As used in Section 1031(a), the words 'like-kind' have reference to the nature or character of the property, and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale."

Real estate located in the 50 United States is of like-kind when exchanged for other real estate located in the 50 United States. The definition of "50 United States" means exactly that. It does not include foreign real estate.

Here are some examples of like-kind:

Improved real estate for unimproved real estate.

A leasehold of a fee with 30 years or more to run for real estate. For this purpose, optional renewal periods may be added to the initial term of the lease. See Sale-Leasebacks as Exchanges in Topic 11.

A fee interest in unimproved land for a fee interest in unimproved property subject to long-term income producing condominium leases.

A perpetual water right treated as real property under local law for a fee interest in land.

Timberlands differing in quality and quantity of timber.

Timberland, with a reservation of timber cutting rights, for timberland.

A remainder interest in farmland for a remainder interest in another parcel of farmland.

Farm land belonging to an incompetent for other farm land, even though the exchange took the form of a cash sale and purchase because it involved an incompetent and local law permitted no exchanges by guardians.[v]

â In LTR 9851039, the Internal Revenue Service ruled the exchange of an agricultural conservation easement for a farm property qualifies as a tax-free exchange under Section 1031(a). The IRS said a parcel of property was of like-kind when exchanged for a remainder interest in a parcel of property. The parties to the exchange were a trust and a corporation. The corporation had one class of stock. The trust owned most of the shares. The adult son of the trustor owned the rest. The corporation owned a parcel of land that it held as income producing rental property. The trust owned a parcel of property also held as income producing property.

The trust proposed to convey to corporation the property on which its headquarters was located in exchange for a vested remainder interest in the property owned by the corporation. After the exchange, the corporation would continue to use the property it gets in the exchange in its business.

The trust would hold its interest in the property it gets for investment. It would hold it as an income producing property when it ripens into a possessory interest at the end of a seven-year period. The IRS said the term "like-kind" refers to the nature or character of the property, not to its grade or quality. Therefore, certain factors, such as whether the property is improved or unimproved, are not relevant. The IRS said the nature and character of properties exchanged by the trust and corporation would constitute like-kind property. Because the nonpossessory interest would become a possessory interest and therefore, a fee interest, the rights vested in the parties were substantial.

Some interests in realty are so dissimilar that an exchange is not treated as like-kind property. Examples include the exchange of leasehold for a fee title unless the lease has 30 years or more to run. It includes the exchange of overriding oil royalties for a fee title. If a mineral interest is exchanged for other property, but the grantor retains a production interest in the minerals, the transaction is considered to be a lease rather that a sale. The property received in the exchange for the mineral interest will be treated as a lease bonus and taxed as ordinary income.[vi]

Real estate is a highly complex asset and exceedingly difficult to classify in many exchanges. In Rev Rul 55-749, the IRS said the exchange of land for perpetual water rights qualified as like-kind where the water rights were treated as real property under state law.

âIn Rev Rul 92-105, the IRS said a taxpayer's interest in an Illinois land trust would qualify as property of like-kind if exchanged in a §1031 exchange transaction. (Under Illinois law, land trusts can hold title to real property located in the state.) The ruling went on to say the same result would apply to similar arrangements under the laws of states having statutorily or judicially sanctioned arrangements similar to the Illinois land trust. These states are California, Florida, Hawaii, Indiana, North Dakota, and Virginia.

A land trust is a legal arrangement where the trustee holds title to real property. The beneficiary has exclusive power to direct or control the trustee in dealing with the title to the property. In addition, the beneficiary has exclusive control of the management of the property and the exclusive right to the earnings of the property.

A land trust arrangement usually includes a deed of trust and a land trust agreement. The deed transfers title to a trustee subject to the provisions of the land trust agreement. The land trust agreement authorizes the trustee to deal with the legal title to the property. The beneficiary keeps exclusive control of operating, buying, renting, and selling the property. Filing tax returns, paying taxes and other liabilities is the duty of the beneficiary.

The IRS said the exchange by the beneficiary of his interest in the land trust is an exchange of the underlying real property. It is not an exchange of beneficial interest or certificate of trust. Since the underlying property and the Replacement Property are like-kind, the exchange falls under the provisions of §1031.

â Tax Case - Exchange of Water Rights for Farmland Not Like-Kind Exchange. A U.S. district court granted the government's cross-motion for summary judgment after deciding that the exchange of water rights for farmland is not a like-kind exchange under section 1031.

Donald, Gary, and Deborah Wiechen were partners in a partnership, Wiechens Properties Limited Partnership, that owned land in an irrigation district. The partnership obtained the right to receive Colorado River water to irrigate its land and it was permitted to sell the water rights to the government without selling the land. The partnership retained the land but exchanged its water rights for an interest in farmland. The partners didn't report any income from the transaction, believing that it qualified for nonrecognition treatment under section 1031. The IRS made assessments against the partners for their 1993 taxes. The partners filed suit for a refund in district court. The parties filed motions for summary judgment. The partners argue that their water rights are an interest in real property, that the properties exchanged were of like-kind, and the exchange qualifies for nonrecognition treatment.

U.S. District Judge Stephen M. McNamee agreed with the partners that the water rights were an interest in real property. However, the parties disputed the duration of the water rights. The partners asserted that the water rights were perpetual, that they originated from the Supreme Court decision in State of Arizona v. State of California, 373 U.S. 546 (1963), and that the water rights were established by a Department of Interior water allocation notice, 48 Fed. Reg. 12446 (Mar. 24, 1983). Sustaining the government, the court dismissed the partners' reliance on the opinion and concluded that under a 1984 subcontract the partners were entitled to water rights for a 50-year period. Thus, the court concluded that the water rights are limited in quantity, priority, and to a 50-year duration.

Judge McNamee was persuaded by the government's argument and followed Rev. Rul. 55-749, 1955-2 C.B. 295, which discussed the exchange of water rights for a fee simple interest in land and advised that water rights of a limited amount or duration aren't sufficiently similar under §1031 to a fee simple interest in land. Thus, the court held that an exchange of nonperpetual water rights for a fee simple interest in land does not satisfy §1031. Judge McNamee denied the partners' motion for partial summary judgment and granted government's cross-motion for summary judgment.[vii]

â Here's an exchange that warmed the hearts of all exchangers and farm brokers throughout the land: Dave owned a farm. One day a state agency called, wanting to buy an agricultural conservation easement on his farm. The easement was treated under state law as an interest in land and defined as the right to prevent the use of the land for any purpose other than farming. Dave said OK but instead of selling and paying capital gains tax, he wanted to exchange for a fee simple interest in another farm. However, the state could not enter into an exchange agreement. So Dave signed an exchange agreement with a Qualified Intermediary. Under the exchange agreement, the intermediary acquired the farm Dave wanted and exchanged it with Dave for the easement. The intermediary sold the easement to the state and used the proceeds to buy the replacement farm conveyed to Dave. Cash boot paid and received by Dave was subject to the regular boot rules under §1031.

All requirements of the Qualified Intermediary safe harbor rules (Reg 1.1031(k)-1) were met and the property was of like-kind. Dave qualified for §1031 treatment, and got a deferred exchange. âSee IRS Letter Ruling 9232030.

Options to buy or sell real property must be considered in §1031 tax planning. Depending on the classification of the underlying real property, an option may qualify for §1031 treatment.

An option contract may be

a binding agreement by the owner of real estate giving another the right to buy the property at a fixed or determinable price within a specified time, or,

it may be a binding agreement by the owner of property and another giving the owner the right to sell the property to the other person at a fixed or determinable price within a specified time.

A right of first refusal is not an option. Nor is executory contract to sell land in the future.

Gain or loss on the sale or exchange of an option takes on the same character as the underlying property; it is considered gain or loss from the sale or exchange of property. The option contract takes on the same classification as the property (to which it relates) would have if acquired by the optionee buyer.

A taxpayer granted another party an option to purchase property. The property qualified for like-kind treatment in the hands of the taxpayer. The other person exercised the option by transferring like-kind property to the taxpayer. IRS said it was a good like-kind exchange because both the Relinquished Property and Replacement Property were used in the taxpayer’s business. The transaction did not qualify as a like-kind exchange for the other party. The property he transferred to the taxpayer was acquired solely for the purpose of making the exchange and not held for use in a trade or business or held for investment.[viii]

An option is an agreement between a seller (optionor) and a buyer (optionee) to keep open, over a set period of time, an offer to sell property. It's a unilateral agreement imposing an obligation only on the seller. He must sell if the buyer exercises the option. But the buyer is not obligated to buy the property if he chooses not to.

People use options because they offer advantages to both buyer and seller. They give the buyer time to decide if he really wants to buy the property and arrange financing. They give the seller compensation for taking the property off the market during the option period.

The option must be supported by its own consideration, separate and independent of the purchase price of the property. It creates a contractual right and does not give the buyer any estate in the property. When the buyer acquires an option to buy real estate, he gets the right to buy the property at any time within a specified time period at the price specified in the option. What he pays for the option depends on the circumstances, but it will be small compared with the selling price of the property. If the buyer fails to exercise the option, he loses the amount he paid for it.

Options involve tax consequences for both parties. Two issues are involved: when is tax imposed and is the gain a capital gain or ordinary. Tax may also be incurred if the option is sold or exchanged.

Reminder: Gain or loss from the sale or exchange of an option contract is considered gain or loss from the sale or exchange of property. The option contract takes on the same classification as the property (to which it relates) would have if acquired by the optionee buyer.

Business Property (§1231)-If the underlying property would have been business property in the hands of the optionee, the gain or loss is subject to §1231 treatment. To qualify, the option must have been held for more than one year. Under Section 1231, gain is treated as long-term capital gain. Loss is treated as ordinary loss.

If the holding period of the option is one year or less, gain is treated as ordinary income. Loss is treated as ordinary loss.

Investment Property (§1221)-If the underlying property would have been investment property in the hands of the optionee, capital gain or loss is realized. If the option was "held" for more than one year, the capital loss is long-term. If one year or less, short-term.

Personal Use Property-If the underlying property would have been real estate held for personal use in the hands of the optionee, gain is treated as capital gain. If a loss is suffered, it is personal and not deductible.

Parallel Point 2-2

You are considering buying a new house for your residence and acquire an option to buy a certain house at a fixed price. Although the property goes up in value, you decide you do not want the house for your residence. You sell the option for more than you paid for it. Your gain is a capital gain since the house, if acquired, would have been a capital asset in your hands .If you suffered a loss on the sale, the loss is treated as a loss from an asset held not for profit. The loss would not be deductible.

Dealer Property-If the underlying property would have been real estate held as property for sale to customers in the ordinary course of his trade or business by the optionee, any gain is treated as ordinary income. Any loss is treated as a deductible ordinary loss.

If one of the properties in an exchange is held primarily for sale, the exchange of that property does not qualify for §1031 treatment. Held primarily for sale is not limited to dealers. Property was deemed held primarily for sale and not for investment where it was sold under a "prearranged plan" shortly after it was acquired in an exchange.

Property acquired in an exchange and leased with option to buy is not held for use in business or for investment.

Your intention to eventually give away property you receive in an exchange will not defeat the exchange if the exchange is not a part of the gift transaction. In one case, the gift of a ranch received in an exchange was made to the taxpayer's children 9 months after the exchange. His general desire at the time of exchange was to eventually transfer it to his children and was not, in the court's view, inconsistent with his intent at that time to hold the ranch for productive use in business or for investment. He had no concrete plans to do so at the time of exchange.

We know both the Relinquished Property and the Replacement Property must be held for use in a trade or business or for investment. The big question that comes up more than any other is, "Yes, but for how long?" It’s a tough one to answer because the statute is silent on this issue. Therefore, it must be examined on individual facts and circumstances. There is no safe holding period for property to automatically qualify.

IRS has ruled that property transferred to a controlled corporation immediately following the exchange did not qualify.[ix] However, a general intention to make a future transfer is probably OK. In one case, the taxpayer gifted the Replacement Property to his children nine months after the exchange. The court said the exchange was OK because even though the taxpayer contemplated eventually gifting the property to his children, he had no concrete plans to do so at the time of the exchange.[x]

Many time period holding problems created by taxpayers are linked to rental income property and the personal residence. How long must I operate the Replacement Property as a rental before I move in and occupy it as my primary residence? Again, it’s a matter of facts and circumstances. For example, at the time of the exchange, you have no intention of converting it to your primary residence. But an unforeseen event, not related to the exchange, takes place-perhaps the death of a spouse. Or the rental turns out to be an unbearable negative cash flow situation. In such cases, you should have no problem supporting the like-kind exchange.

Here is a general rule-of-thumb I have used for many years with success. To be on the safe side, you should hold the Replacement Property for at least two yeas. In my opinion, this is the magic number. In a private letter ruling, the IRS told one taxpayer one year was not long enough to hold several rental houses being acquired as Replacement Property before they were sold. But the IRS did say two years would meet the intent of the statute and the properties could qualify if sold after the two-year holding period.

The two-year holding period pops up in many places. That’s the minimum holding period applying to the exchange with a relative rule. (See discussion in Chapter Eleven) It’s the same for the installment sale rules between related parties. And it’s also the minimum time period a taxpayer must live in their primary residence to qualify for the §121 exclusion benefits on the sale of the residence.

If you have any doubts or questions about the classification of either your Relinquished Property or Replacement Property, be sure to discuss it with both your tax professional and your real estate agent.

The location of properties being exchanged is important. For purposes of the nonrecognition rules of §1031, real property located outside the United States does not qualify as like-kind property if exchanged for real property located in the United States. United States real property means property located within the fifty states and the District of Columbia. Property located in Guam, Puerto Rico, and U.S. possessions are treated as foreign real estate and do not qualify.

When this amendment was added, The Conference Committee Report stated no inference was intended to override or otherwise modify Section 932 involving the tax treatment of U.S. and Virgin Islands residents. Accordingly, real estate located in the U.S. Virgin Islands may qualify for §1031 treatment when traded for U.S. real estate.

Partnership interests are specifically excluded from like-kind exchange treatment. A partner's exchange of an interest in one partnership for another partner's interest in a different partnership cannot qualify for §1031 treatment. This rule does not apply to exchanges of interests in the same partnership.

A partnership as a business entity can qualify to exchange real estate it owns for other real estate.

âIn LTR 9807013, the IRS said a limited partnership would be treated as having received replacement properties through single-owner entities and qualifies for §1031 treatment.
 
The limited partnership owned land and an office building leased under a long-term lease. The limited partnership wanted to dispose of the land and building and acquire several parcels of real estate. It located someone interested in buying the land and building. The limited partnership proposed to transfer title directly to a Qualified Intermediary and then form separate entities to take title from the QI for each of the replacement properties. The limited partnership would be the sole owner of each "replacement entity." These entities would then either elect to be disregarded as an entity or would rely on the default classification for single-owner entities.
 
For discussion of strategy using §1031 to Split Up Partners and Investors in Real Estate see Topic 11.

Many exchanges involve multiple properties. For example, you exchange a rental property and two investment parcels for a larger apartment complex. Or you exchange one property for three others. Or you exchange two properties for two others. These transactions follow the same rules as a one-for-one §1031 deferred exchange with addition requirements for allocating "sales price" and "substituted basis" to the assorted properties.

Detailed coverage of this important subject is reported in  Exchanges of Multiple Properties.

An exchange of assets of a business for the assets of a similar business cannot be treated as exchange of one property for another property. An analysis of each asset involved in the exchange determines if you are engaged in a like-kind exchange for some or all of the assets.

The IRS issued AdvRevRul 89-121 to clarify an older ruling (Rev Rul 85-135) dealing with the transfer of multiple properties in a §1031 exchange. The advance ruling limits the application of §1031 provisions in an exchange of several assets of one business for a single asset of another.

Reg 1.1031(j)-1 explains rules dealing with exchanges of multiple assets.

 

Topic 3 - Figuring Boot and Taxable Gain

Before your exchange transaction is triggered, you need to figure how boot and taxable gain (if any) works. This topic explains how to identify and figure the amount of boot in a deferred exchange. It deals with boot problems related to mortgage relief inside the exchange. It also provides special in-depth coverage of how to treat installment sale notes inside the exchange period.


If you receive boot in an exchange, the fair market value of the boot is recognized as taxable gain. However, this gain cannot exceed the amount of gain you would have recognized if the property had been sold in a taxable transaction.

Parallel Point 3-1

You exchange real estate with an adjusted basis of $30,000 for other real estate with a fair market value of $100,000. In addition, you receive $35,000 boot.

Total consideration received $ 135,000

Less-Adjusted basis $ 30,000

Total realized gain is $ 105,000

Total boot received $  35,000

Your gain is the smaller of the two $  35,000

Value of real estate received $100,000 plus $35,000 cash.

Reg 1.1031(b)-1 explains rules dealing with receipt of money or other property.

The character of taxable gain is determined by the property sold-not the character of the consideration received. It's determined by the real estate involved in the exchange-not by boot. Think of it this way: In a cash sale, all "boot" received is cash but that does not make all the taxable gain ordinary income. If the relinquished real estate traded is capital gain real estate, any gain recognized from boot received by you will be capital gain. However, if the property is subject to depreciation recapture, the ordinary income from recapture will be recognized before the capital gain.

The depreciation recapture provisions of §1250 (real property) and §1245 (personal property) apply to exchanges as well as sales. These provisions require certain depreciation to be recaptured as ordinary income (instead of long-term capital gain) when the property is sold or exchanged and a gain is recognized.

If you exchange property subject to recapture, and no gain is recognized, the "recapture potential" of the Relinquished Property carries over to the Replacement Property.

If you exchange property subject to recapture, and gain is recognized because of boot taken, the ordinary income portion of the recognized gain is limited to the depreciation that would be recaptured as ordinary income if the property had been sold.

Parallel Point 3-2

You exchange real estate with an adjusted basis of $50,000 for other real estate with a fair market value of $125,000. In addition, you receive $25,000 boot. At the time of sale, your excess depreciation subject to recapture as ordinary income under §1250 was $20,000.

Gain taxable on exchange is $ 25,000

Deduct amount taxable as ordinary income 20,000

Balance – taxable as capital gain $  5,000

If you exchange property subject to depreciation recapture, and gain recognized because boot taken is less than depreciation that would be recaptured as ordinary income if the property had been sold, all the recognized gain will be taxed as ordinary income. The balance "recapture potential" carries over to the property acquired in the exchange.

Parallel Point 3-3

You exchange rental property subject to recapture of depreciation under §1250. As part of the exchange, you receive boot totaling $30,000. The boot is taxable and you recognize gain in that amount. If you had sold the property, your ordinary income from recapture of additional depreciation would have been $65,000.

The entire $30,000 is taxed as ordinary income and the "recapture potential" of $35,000 carries over to the Replacement Property.

 Tax Trap - It's possible, in a §1031 exchange, to recognize gain even if not one cent of boot is received! There’s a little-known rule that can cause you to trigger the entire recapture as ordinary income even if you do not recognize gain figured under the regular exchange rules. Recapture income will be recognized if the fair market value of the depreciable property you receive in the exchange is less than the income subject to recapture. The amount of gain recognized is limited to the difference between the depreciation subject to recapture and the value of the depreciable property.

Parallel Point 3-4

You exchange a large apartment complex for undeveloped investment land. You receive no boot. If you had sold the apartment complex, $122,000 of additional depreciation would have been taxed as ordinary income under §1250. Since the fair market value of §1250 depreciable property received by you (none) is less than the income subject to recapture ($122,000), the entire $122,000 is recognized as ordinary income at the time of exchange.

If there was a rental building on the land with a value of $75,000, only $47,000 of recapture income would be taxed (the difference between the value of the depreciable property ($75,000) and the total subject to recapture ($122,000).

Money and unlike property received in the exchange is boot and is taxable. The amount of boot received is:

the amount of money received plus

the fair market value of unlike property received.

Parallel Point 3-5

You exchange real estate for other real estate plus you receive $10,000 cash and securities with a fair market value of $25,000. Total boot received by you is $35,000.

Other examples of unlike property received in real estate exchanges are gold, silver, foreign currency, airplanes, motor homes, precious stones and real estate to be used as your personal residence.

In a real estate exchange, the assumption of a liability by the other party (or transfer of your property subject to a liability) is treated as boot received by you. It's called mortgage relief. In figuring your net mortgage relief, you may offset against it your assumption of a liability (or transfer of property subject to a liability).

The assumption of a liability or the transfer of a property subject to a liability is treated as boot.

If the other party assumes your liability-or your property transferred subject to the liability-you have received boot. You will be treated as if you received cash in the amount of the liability. The party assuming the liability, or acquiring the property subject to the liability, gives boot.

Parallel Point 3-6

You exchange real estate with an adjusted basis of $30,000 for other real estate with a fair market value of $100,000. In addition, you receive
$35,000 cash and the other party assumes your mortgage of $25,000.

Step 1 – Total Gain Realized

Fair market value of like-kind property received $ 100,000

plus cash received 35,000

plus mortgage assumed by other party 25,000

Total Consideration Received $ 165,000

minus Adjusted Basis of property given up 30,000

Total Gain Realized is $130,000

Step 2 – Total Boot Received by You

Mortgage assumed by the other party $  25,000

plus cash received 35,000

Total Boot Received is $  60,000

Step 3 – Taxable Gain

Smaller of Total Gain or Boot Received $  60,000

 

Reg 1.1031(d)-2 explains rules dealing with treatment of assumed liabilities.

Exchange transactions become more complicated when both properties are mortgaged. If each of you assumes the liability of the other, the liabilities of one are offset against the liabilities of the other. Only the excess is treated as net boot given or received. In other words, the mortgages are netted. You deduct the mortgage you assume from the mortgage on the property given up.

If you do not assume the mortgage on mortgaged property received in an exchange, you are taking the property subject to the mortgage. You are treated as if you assumed the mortgage.

If the mortgage you assume is less than the mortgage on the property given up, the net liability-called mortgage relief is counted as boot received by you.

If the mortgage you assume is more than the mortgage on the property given up, the excess is counted as boot paid by you.

If you transfer unencumbered real estate in exchange for mortgaged real estate, you have paid boot equal to the amount of the mortgage. The payment of mortgage boot does not result in recognition of gain or loss to the person paying it.

âTax Case[xi]: In computing "boot" on three-cornered realty exchange, transferor's receipt of cash to satisfy mortgage on property she transferred was offset by larger mortgage on property she received in exchange. Fact that cash was paid into escrow and mortgage was paid off before transfer was completed didn't bar "netting" of liability discharged against liability assumed. In effect, transferor was merely conduit for funds.

Mortgages on property given up by you are counted as boot received. However, you are permitted to offset mortgages assumed by you against this boot. This is called "netting the liabilities." If the mortgage balance assumed by you on the Replacement Property is less than the mortgage balance on the Relinquished Property, your net boot from mortgage relief is the difference.

Parallel Point 3-7

You exchange a property with a mortgage balance of $25,000. You assume a mortgage of $12,000 on the Replacement Property you receive in the exchange. Your mortgage relief is $13,000-the difference between the mortgage you assume ($12,000) and the mortgage on the property you transferred ($25,000). This amount-your net mortgage relief-counts as boot received by you.

Mortgage you gave up was $25,000

less mortgage you assumed was $12,000

Your net mortgage relief is $13,000

 

âImportant: Liabilities are always netted before other boot considerations are accounted for.

Figuring your net mortgage relief becomes more complicated when the mortgage you assume in the exchange is more than the mortgage on the property given up. The excess is treated as boot paid but is subject to this special offset rule:

Mortgage boot paid offsets mortgage boot received but does not offset cash or unlike property boot received.

Parallel Point 3-8

You exchange land with a mortgage of $10,000 for land with a mortgage of $15,000. In addition, you receive cash boot of $6,000 to balance the equities. After offsetting the mortgages, you figure you have paid $5,000 mortgage boot. However, you are not allowed to offset this mortgage boot paid from the cash boot received. Your taxable boot received is $6,000.

 

Mortgage given up by you was $10,000

Mortgage assumed by you was $5,000

Net mortgage relief (not less than zero) None

Add - cash boot received $6,000

Total boot received was $ 6,000

Negative mortgage relief counts as boot paid and adds to the basis of Replacement Property. Knowing how this treatment could affect your exchange is essential in your tax planning. Here is another example:

Parallel Point 3-9

You enter into a §1031 exchange. The terms of your exchange include:

·         You assume a mortgage of $34,000 on the property you acquire in the exchange.

·         The mortgage on the property given up was $20,000.

·         You receive cash boot in the amount of $35,000.

Taxable boot received is $35,000-here's how you figure it:

Mortgage on property transferred $ 20,000

Deduct mortgage on property assumed by you 34,000

Difference - may not be less than zero zero

Other boot received by you $ 35,000

Taxable boot received $ 35,000

The mortgage you assumed was $34,000-$14,000 more than your mortgage given up. Following the rules of offset, you were only permitted to reduce your taxable boot received by the amount of your mortgage given up-$20,000. (The difference may not be less than zero. What happens to the $14,000?

The $14,000 is called negative mortgage relief and counts as boot paid. You are not permitted to offset negative mortgage relief against other boot received. Later you will learn how boot paid adds to the basis of property received in an exchange.

Tax Idea - Experienced real estate exchangers are quick to recognize transactions where negative boot relief can result in more gain being recognized from net boot received. The amount in Parallel Point 4-9 is small but add a zero or two zeros to the amount and we are talking about some real money. For example, it the negative mortgage relief was $140,000 or $1,400,000, a good exchanger would seriously consider some financing moves outside the exchange to reduce the negative boot relief to zero if possible. Even though equities would not change, the amount of taxable boot could be substantially reduced. This can be accomplished but only with very careful and knowledgeable planning. You don’t want any financing moves treated by the IRS as part of the exchange transaction.

A very sticky problem faced by many exchangers is anticipatory mortgaging. What happens if you refinance the Relinquished Property prior to the exchange to get cash and raise the mortgage to be assumed or paid off by the buyer?

This could be a great advantage in the exchange:

Borrowing money on your property is not a taxable event.

The higher mortgage increases the amount of mortgage boot received that qualifies for offsetting against mortgage boot paid.

 

Here is an example: Jones wants to exchange Sunshine Apartments for Brentwood Apartments owned by Allen. The terms of his exchange include:

·        Jones assumes a mortgage of $274,000 on the property he acquires in the exchange.

·        Jones has a mortgage on Sunshine of  $100,000 that will be assumed by Allen.

  • Based on the market values of the properties, Jones receives cash boot in the amount $200,000 to balance the equities.

When the exchange is closed, Jones receives taxable boot in the amount of $200,000 making him very unhappy. Here’s how his taxable boot is figured following the offset rules of 1031:

  • Mortgage on Sunshine Property relinquished was $100,000 (mortgage boot received)
  • Deduct mortgage on Brentwood assumed by Jones - $274,000 (mortgage boot paid)
  • This results in a negative offset - $174,000

However, under the rules, mortgage offset cannot be less than zero. Jones gets no boot offset from the difference of $174,000 to offset his cash boot received of $200,000. The result is Jones gets hammered for a $200,000 taxable gain.

Experienced real estate exchangers are quick to recognize transactions where negative boot relief can result in more gain being recognized from net boot received. In our example, Jones should consider borrowing on his Relinquished Property (Sunshine) prior to and outside the exchange transaction. If he refinanced and took out $175,000 cash (non-taxable), his boot would be figured like this:

·        Jones assumes a mortgage of $274,000 on the property he acquires in the exchange.

·        Jones has a mortgage on Sunshine of  $275,000 that will be assumed by
Allen.

·        To balance the equities, Jones receives cash boot in the amount $25,000.

When the exchange is closed, Jones receives taxable boot in the amount of only $26,000 making him very happy. Here’s how the taxable boot for this exchange is figured following the offset rules of 1031:

  • Mortgage on Sunshine Property relinquished was $275,000
  • Deduct mortgage on Brentwood assumed by Jones - $274,000

    Difference – Mortgage relief boot received by Jones is $1,000

    • Add Cash boot received of $25,000
    • Total boot received by Jones is $26,000

    By refinancing outside the exchange, Jones reduces his gain $200,000 to only $26,000.

     

    Tip: Selling expenses paid by Jones are treated as cash boot paid and may be offset against the $26,000 net boot received. In this example, Jones would probably end up with no taxable gain from boot.

    In these kinds of cases, exchangers should seriously consider some financing moves outside the exchange to reduce the negative boot relief to zero if possible. Even though equities would not change, the amount of taxable boot could be substantially reduced. This can be accomplished but only with very careful and knowledgeable planning. You don’t want any financing moves treated by the IRS as part of the exchange transaction.

    If the refinancing can be demonstrated to be unrelated to the exchange of the Relinquished Property, the proceeds of the refinancing will not be characterized as boot.[xii] 

    Some time ago, the IRS issued a Proposed Regulation making such mortgage proceeds taxable but it was not adopted. The IRS commented, "Commentators demonstrated the proposed rule could create substantial uncertainty in the tax results of exchange transactions involving liabilities on both Relinquished Properties and Replacement Properties." The final Regulations did not include this proposed amendment. Ref: Reg 1.1031(b). 

    Replacement Property may be refinanced after the exchange is closed and the proceeds used by the owner for any purpose. This is a non-taxable event. However, to qualify, the refinancing must not be connected to the exchange transaction such as a contingency for the exchange to close. The exchange agreement and closing statements should be silent regarding the refinancing.

    The Tax Court has ruled the payment of the mortgage on the taxpayer’s Relinquished Property is not treated as cash received in figuring the netting of the boot if the payment is contemporaneous with the exchange. The parties involved must require payment of the mortgage and the taxpayer cannot receive or have any right to receive the payment.[xiii]

    Many real estate agents and investors when working out the numbers for their real estate exchange often overlook selling expenses as an offset against boot received. Factoring in this offset is critical when the exchange is originated and in the planning stages. Selling expenses paid in connection with a §1031 exchange are treated as cash boot paid and offsets any boot received. Selling expenses include brokerage commissions and other closing costs such as title policy fees, escrow fees, and recording fees. 

    Parallel Point 3-10

    You own property with an adjusted basis of $30,000 and exchange it for like-kind property with a fair market value of $100,000. In addition, you receive $35,000 cash. You pay a $9,000 commission to your real estate broker. Your taxable gain is limited to the net boot received by you-$26,000.

     

    If you receive no cash or property boot in the exchange, but you have net mortgage relief, you may offset sales expenses paid against your net mortgage relief. If the offset creates a "loss", the Code bars any deduction.

    Parallel Point 3-11

    You complete an exchange in which you receive $5,000 cash. You pay selling expenses of $9,000. The $4,000 difference or "loss" is not deductible.

    If you receive cash or unlike property in addition to the like-kind property received and realize a gain on the exchange, subtract the expenses from the cash or fair market value of the unlike property. Then use the net amount to figure recognized gain.

    âCaution: Selling expenses cannot be deducted twice against cash boot paid. For example, if you get a down payment of $125,000 on the sale of your Relinquished Property, and you pay $30,000 selling expenses out of the closing escrow, the net proceeds of $95,000 is paid into your QI Trust Account. Since the $30,000 selling expenses have already been deducted from your cash boot received of $125,000, your net boot received is $95,000. You cannot deduct or offset the sales expenses of $30,000 again against your netted proceeds of $95,000.

    In the final accounting, selling expenses are recorded on the closing or escrow statements and other supporting documents. Be careful not to include items that must be treated elsewhere on the tax return. For example, rental income adjustments, security deposits, prepaid rents, insurance, realty taxes, points, and interest are not selling expenses and must be treated in the appropriate tax form. Personal items such as payment of liens, personal judgments, and back income taxes are all personal and not selling expenses.

    Sometimes you may find it necessary to pay boot in a form other than cash. For example, you may give up precious stones to complete the exchange agreement. In these cases, caution is the byword-you are selling the boot.

    âThis is so important, it needs repeating: Any boot you give (payment in part consideration of the Replacement Property) is treated as a straight sale of the boot. The tax-free provisions of §1031 do not apply to boot you transfer in the exchange. If you give money, no gain or loss to you is recognized on the money you give. However, if you give boot in property other than money, a gain or loss will be recognized. The transaction is treated as a sale of the unlike property and the regular gain and loss tax rules apply. The gain or loss is the difference between your adjusted basis in the property and your amount realized. The fair market value is considered to be your amount realized.

    For example, as part of an exchange you give unlike property with a cost of $1,000. The fair market value of the property at the time of the exchange is $1,500. You will recognize a $500 gain.

    If the personal property was business property (§1245), the gain would be treated as ordinary income to the extent of depreciation taken, and might be taxed as ordinary income.

    If the sale of the personal property had resulted in a loss, the loss would be deductible as an ordinary loss since the nonrecognition of gain or loss provision of §1031 does not apply to unlike property.

    If you exchange real estate held for business use or investment, you can qualify under §1031 for a nontaxable like-kind exchange. The property you receive in a like-kind exchange is treated as if it were a continuation of the property you gave up.

    In a like-kind exchange, you do not recognize gain from the property you receive. But you will recognize gain if you also receive money or other property. Money and other property received is called boot. The fair market value of boot received is recognized gain. However, there's a happy exception if you receive, as part of an exchange, an installment obligation.

    Even though the fair market value of the installment note received is boot and recognized as gain under the like-kind exchange rules, the gain may be reported using the installment method of tax accounting. For full coverage see Chapter Eight-Exchanges Involving Installment Sale Notes.

    Topic 4 - Time Restrictions for Deferred Exchange Transactions

    This topic explains how the identification and exchange time restrictions work once you have sold your Relinquished Property. And how to identify the Replacement Property so it qualifies for §1031 exchange treatment. The rules even permit you to exchange for property to be constructed to your plans. Great stuff here for tax planning.

    The Tax Reform Act of 1984 imposed two time limitations on §1031 exchanges. One limitation requires Replacement Property to be identified within a certain time. The other requires Replacement Property to be received by the exchanger within a certain time period. To successfully qualify for §1031 treatment, your exchange must satisfy both tests.

    In a deferred exchange, any Replacement Property you receive will be treated as property which is not like-kind to the Relinquished Property if

    the Replacement Property is not "identified" before the end of the "identification period", or,

    the identified Replacement Property is not received before the end of the "exchange period."

    The identification period begins on the date you transfer the Relinquished Property and ends 45 days after.

    The exchange period begins on the date you transfer the Relinquished Property and ends on the earlier of 180 days after or the due date (including extensions) for your tax return for the taxable year in which the transfer of the Relinquished Property occurs.

    Parallel Point 4-1

    You file your federal income tax return on a calendar year basis. You and Cullinan enter into an agreement for an exchange of property requiring you to transfer Whiteoak to Cullinan. Under the agreement, you are required to identify like-kind Replacement Property which Garland is required to purchase and transfer to you. You transfer Whiteoak to Garland on November 17, 2000.

    The identification period ends on January 1, 2001, the day that is 45 days after the date you transfer Whiteoak, even though it is New Year's Day. The exchange period ends on April 15, 2001, the due date for your federal income tax return for the taxable year (2000) in which you transferred Whiteoak. However, if you are allowed the automatic four-month extension for filing your tax return, the exchange period ends on May 16, 2001, the day that is 180 days after the date you transferred Whiteoak.

    Sometimes in a deferred exchange transaction, you transfer more than one Relinquished Property and they are transferred on different dates. If this happens, the identification period and the exchange period are measured from the earliest date on which any of the properties are transferred.

    One of the most frequently asked questions we get relates to backdating documents to satisfy the identification and exchange time periods. Here is an example:

    I recently sold my condo that was used as a rental property for many years with the intention of a 1031 exchange.  The 45-day identification period is running out fast, and I have not yet found any properties to identify.

     I was told by several people that this 45-day period can be "back dated" and what is really important is the 180-day close of escrow.  Is this correct?  Can I find a property after the 45 day period (but before the end of the 180-day period) and write a letter to my real estate agent dated within the 45 day period identifying the  property and the exchange still qualify as 1031 legal?

     

    For the record, this is the answer we sent:

    Backdating tax documents is fraud and the IRS does not look kindly on this. The penalties are severe and if you or any of the other parties are audited, this backdating is sure to be discovered. This is a matter to discuss with your attorney right now.

    â Tax Case: Here is a case right on point where the taxpayers got slammed with a fraud penalty. David Dobrich, et ux. v. Commissioner, 84 AFTR2d

    The Ninth Circuit has affirmed a Tax Court decision holding a couple did not timely identify replacement property under Section 1031 and they fraudulently backdated documents alleging timely compliance with the identification requirement.

    In 1988, real estate investors David and Naomi Dobrich executed an option to sell a portion of their real property for $4 million, which was exercised in August 1989. Clack Brothers Inc., hired by the Dobriches to act as intermediary on the sale, transferred $3.9 million of the proceeds to a trust account to be used to purchase replacement property to qualify under Section 1031. The 45-day identification period for replacement property was to expire in October 1989.

    Although the Dobriches had begun looking for replacement property in 1988, they did not make offers to purchase such property until January 1990. The couple did not discuss purchasing this property with Clack, any of their real estate agents, or the properties' prior owners during the 45-day identification period. In January 1990 David asked two real estate agents to prepare false letters indicating that he and his wife had identified the purchased property in September 1989.

    The Dobriches transmitted the false documents to their accountant, who prepared their 1990 return indicating that the sale of their property qualified as a section 1031 exchange. The IRS determined that the sale did not qualify because the couple did not timely identify the replacement property. The IRS also determined fraud penalties under Section 6663. The Tax Court held the Dobriches did not timely identify replacement property for Section 1031 purposes.

    The Dobriches appealed.

    Affirming, the Ninth Circuit concluded that the Dobriches' sale did not qualify for nonrecognition treatment under Section 1031 because they did not express intent to acquire the replacement property within the identification period. The appeals court rejected the Dobriches' argument that they were not familiar with the 45-day identification requirement, noting that the couple repeatedly discussed the requirement with their advisors.

    The appeals court also upheld the fraud penalties, concluding the Dobriches fraudulently attempted to circumvent section 1031(a)'s identification requirement by backdating documents.

    The Replacement Property is considered identified before the end of the identification period only if the following requirements are satisfied. However, any Replacement Property you receive before the end of the identification period will in all events be treated as identified before the end of the identification period.

    Replacement Property is identified only if it is designated as Replacement Property in a written document signed by you. This document must be hand delivered, mailed, telecopied or otherwise sent before the end of the identification period to a person (other than yourself or a related party) involved in the exchange.

    An identification of Replacement Property made in a written agreement for the exchange of properties signed by all parties thereto before the end of the identification period will be treated as satisfying the requirements. It's not necessary for the agreement to be "sent" to a person involved in the exchange.

    Replacement Property is identified only if it is unambiguously described in the written document or agreement. Real estate is unambiguously described if it is described by its legal description or street address.

    There are limitations on how many replacement properties you may identify in the same deferred exchange, no matter how many relinquished properties you transfer.

    You may identify more than one property as Replacement Property subject to two rules: the 3-property rule and the 200% rule. You only have to satisfy one of these rules-not both.

    The maximum number of replacement properties you may identify is three properties without regard to fair market value of the properties.

    You may identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all Relinquished Properties.

    You figure fair market value of Replacement Property as of the end of the identification period. You figure fair market value of Relinquished Properties as of the date you transfer them. If, as of the end of the identification period, you have identified more properties as replacement properties than permitted, you are treated as if no Replacement Property has been identified. However, there are two important exceptions to this rule:

    It does not apply to any Replacement Property received by you before the end of the identification period, and

    it does not apply to any Replacement Property identified before the end of the identification period and received before the end of the exchange period. However, to qualify for this exception you must receive identified Replacement Property constituting at least 95 percent of the aggregate fair market value of all identified Replacement Properties before the end of the exchange period.

    Parallel Point 4-2

    You are a calendar year taxpayer. You and Garland agree to enter into a deferred exchange. Under the agreement, you transfer Whiteoak to Garland on May 17, 1991. Whiteoak, which has been held by you for investment, is unencumbered and has a fair market value on May 17, 1991, of $100,000.

    On or before July 1, 1991 (the end of the identification period), you are required to identify like-kind Replacement Property. On or before November 13, 1991 (the end of the exchange period), Garland is required to purchase the property identified by you and transfer it to you. To the extent the fair market value of the Replacement Property transferred to you is greater or less than the fair market value of Whiteoak, either you or Garland will make up the difference by paying cash to the other party after the date the Replacement Property is received by you.

    In the exchange agreement, you identify real properties, J, K, and L as replacement properties. They satisfy the identification of Replacement Property rules, are of like-kind to Whiteoak and you intend to hold them as investment properties. The agreement provides that by July 25, 1991, you will orally inform Garland which of the properties she is to transfer to you.

    As of July 1, 1991, the fair market values of real properties J, K, and L are $75,000, $100,000, and $125,000, respectively. On July 26, 1991, you instruct Garland to acquire real property K. On October 31, 1991, Garland purchases it for $100,000 and transfers it to you.

    Because real property K was identified before the end of the identification period and was received by you before the end of the exchange period, the identification and receipt requirements are satisfied for real property K.

    Continuing the illustration: Instead of identifying real properties J, K, and L as replacement properties, you identify Blackacre as Replacement Property. Blackacre consists of 2 acres of unimproved land and has a fair market value of $250,000. As of October 3, 1991, Blackacre remains unimproved and has a fair market value of $250,000. On that date, at your direction, Garland purchases 1.5 acres of Blackacre for $187,500 and transfers it to you. You pay $87,500 to Garland.

    The fair market value of the portion of Blackacre you received ($187,500) is 75 percent of the fair market value of Blackacre as of the date of receipt. You are considered to have received substantially the same property as identified.

    For purposes of applying the 3-property rule and the 200-percent rule, all identifications of property as Replacement Property are taken into account. But don't count identifications of property that have been revoked.

    Parallel Point 4-3

    You transfer Whiteoak with a fair market value of $100,000 to Cullinan. You receive Blackacre with a fair market value of $50,000 before the end of the identification period. Blackacre is treated as identified because you received it before the end of the identification period. Under the rules, you may identify either two additional replacement properties of any fair market value or any number of additional replacement properties as long as the aggregate fair market value of the additional replacement properties is not more than $150,000. (200% of Whiteoak is $200,000 less $50,000 Blackacre equals $150,000.)

    Property incidental to a larger item of property is not treated as property that is separate from the larger item of property. Property is incidental to a larger item of property if in standard commercial transactions, the property is

    typically transferred together with the larger item of property, and

    the aggregate fair market value of all "incidental" property is not more than 15% of the aggregate fair market value of the larger item of property.

    Parallel Point 4-5

    You are exchanging for an apartment house worth $1,000,000. The furniture, laundry machines, and other miscellaneous items of personal property will not be treated as separate property if their total fair market value is not more than $150,000. (15% of $1,000,000.) For purposes of the 3-property rule, the apartment building, furniture, laundry machines, and other personal property are treated as one property.

    For description purposes, the apartment building, furniture, laundry machines, and other personal property are all unambiguously described if the legal description or street address of the apartment building is specified, even if no reference is made to the furniture, laundry machines, and other personal property.

    An identification of property as Replacement Property may be revoked at any time before the end of the identification period. The identification is treated as revoked only if the revocation is made in a written document signed by you. This document must be hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to the person to whom the identification of the Replacement Property was sent.

    If the identification was made in a written agreement for the exchange of properties, it is treated as revoked only if the revocation is made in a written amendment to such agreement or in a written document signed by you. The agreement or document must be hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to all of the parties to the agreement.

    Under the identification rules, all identifications of Replacement Properties are taken into account. But you don't count identifications that have been revoked! And an identification of Replacement Property may be revoked at any time before the end of the identification period.

    Let's say you identify three Replacement Properties and two of them fall through in the first week. Following the revocation rules, you revoke both identifications. Now you have only one identification in place and more than four weeks left in the identification time period. Since you are allowed up to three at any given point in time, you have the opportunity to identify two more and still qualify. And so on for the entire identification time period. 

    It's sad how many people lose or give up their exchange because they don't understand how all this identification stuff really works.

    The identified Replacement Property is treated as received before the end of the exchange period if

    you receive the Replacement Property before the end of the exchange period, and

    the Replacement Property received is substantially the same property as identified.

    One of the greatest stipulations in the final deferred exchange regulation permits you to exchange for real estate that has not been built yet. Exchangers are still smacking their lips over this one.

    A transfer of Relinquished Property in a deferred exchange will not fail to qualify for nonrecognition of gain or loss under §1031 merely because the Replacement Property is not in existence or is being produced at the time the property is identified as Replacement Property.

    Replacement Property to be produced must be identified. For example, your identified Replacement Property consists of improved real property where the improvements are to be constructed. The description of the Replacement Property will satisfy the requirements if a legal description is provided for the underlying land and as much detail as is practicable at the time the identification is made is provided for construction of the improvements. Two examples of identification of the property to be produced are blueprints and the contract with the builder.

    For the 200-percent and incidental property rules, the fair market value of the Replacement Property to be produced is its estimated fair market value as of the date you expect to receive it.

    For property to be produced, variations due to usual or typical production changes are not taken into account. However, if substantial changes are made in the property to be produced, the Replacement Property received will not be considered to be substantially the same property as identified.

    If identified Replacement Property is real property to be constructed and the construction is not completed on or before the date you receive the property, the property received will be considered to be substantially the same property as identified only if it is real property, and it would have been considered to be substantially the same property as identified had construction been completed on or before the date you received it.

    The value of the Replacement Property must be figured on the day of transfer. Construction work completed after the day of transfer will not be treated as part of the exchange.

    IRS Letter Ruling 9149018 is an excellent guide for planning and "building" a §1031 exchange involving construction and packaging of Replacement Property by the "buyer" of your client's property. Here's what happened:

    Needing additional office space, Taxpayer was looking for new property. To avoid taxable gain, he wanted to exchange his old property instead of selling it. He found land owned by LM that was perfect for his new building. LM leased the land to Buyer. The lease was a 30-year lease and gave Buyer the right to build on the property. In addition, Buyer and successors were given an option to buy the land from LM.

    Taxpayer and Buyer agreed that Buyer would build a building on the land. Buyer approved the plans, the costs of construction, and the architect, contractors, and other parties involved in the construction. The taxpayer provided the construction financing in the form of a nonrecourse mortgage.

    After completion of the building, Taxpayer would exchange his old property for Buyer's leasehold interest in the land and new building. At the closing, a portion of the mortgage would not be repaid to balance the equities.

    The IRS said the exchange of Taxpayer's old property for the long-term lease plus the new buildings were interdependent parts of an overall plan resulting in a like-kind exchange. It qualified for §1031 non-recognition of gain treatment. It was not a transfer of the old property for cash followed by a separate and unrelated purchase of the new property. IRS noted Buyer bore risks of ownership before the exchange and had the obligation to build the building. In addition, Buyer was obligated under the lease with LM.

     Reminder: A lease on real estate with 30 years or more to run qualifies as like-kind when exchanged for qualified like-kind real estate. See Chapter 3.

    An interesting aside is the IRS ruling permitted Taxpayer to assist in financing the exchange property with a mortgage loan.

    âCaution: Be very careful not to get caught in an exchange for services trap. The transfer of Relinquished Property won't qualify for §1031 treatment if it's transferred in exchange for services. This includes production services.

    Any additional production or construction occurring with respect to the Replacement Property after you receive the property will not be treated as the receipt of like-kind property.

    Topic 5 - Safe Harbors For Deferred Exchangers

    How the safe harbors work is critical to planning a successful exchange. In general terms, a safe harbor is an area of protection. The IRS has spelled out certain standards and procedures for taxpayers to meet in real estate exchanges. As long as the exchanger meets these criteria, he will be in a "safe harbor" and not subject to attack by the IRS.

    The deferred exchange regulations make explicit four safe harbors you may use to avoid constructive receipt of money or boot. If you use safe-harbor specifications, their use will not be considered in testing to see if you have constructive receipt. That’s why they are called safe harbors. Since the safe harbor rules require the exchanger to use the services of a Qualified Intermediary, a wrong choice can doom your exchange.

    The four safe harbors are covered, plus related party exchanges, and example of direct deeding and how to chose the right Qualified Intermediary for your transaction.

    It’s OK for your transferee to be your agent, but only if the transferee is a Qualified Intermediary. A Qualified Intermediary is a person (or company) who, for a fee, acts to facilitate the deferred exchange by entering into an agreement with you for the exchange of properties.

    To clarify what an intermediary must do to acquire property, the regulations describe limited circumstances under which an intermediary is treated as acquiring and transferring property regardless of whether, under general tax principles, the intermediary actually acquires and transfers the property.

    An intermediary is treated as acquiring and transferring property if

    The intermediary acquires and transfers legal title to that property.

    The intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than the exchanger for the transfer of the Relinquished Property to that person. Under the agreement, the intermediary transfers the Relinquished Property to that person.

    The intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with the owner of the Replacement Property for the transfer of that property. Under the agreement, the intermediary transfers the Replacement Property to the exchanger. Solely for these purposes, the intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property.

    The exchanger or a disqualified person cannot qualify as qualified intermediaries for their own exchange. A person is a disqualified person if:

    The person is an agent of the exchanger at the time of the transaction.

    The person and the exchanger bear a relationship described in Section 267(b) or Section 707(b). However, you must substitute "10 percent" for "50 percent" each time it appears in those Sections.

    The person and a person who is an agent of the Exchanger at the time of the transaction bear a relationship described in (2) above.

    These people are treated as agents of the exchanger: A person who has acted as the exchanger’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties. However, the regulation disregards certain services for purposes of determining if an agency relationship exists. Performance of services with respect to exchanges of real estate intended to qualify under §1031 is not taken into account.

    Furthermore, performance of routine financial, title insurance, escrow, trust services by a financial institution, title insurance company, or escrow company is not taken into account.

    Here are some examples to illustrate the disqualified person definition. In all examples, Exchanger enters into an exchange agreement with Jones to retain Jones to facilitate an exchange of real property Happy Acres.

    Jones is Exchanger’s accountant and has rendered accounting services other than with respect to §1031 exchanges of property to Exchanger within the 2-year period ending on May 17, 1991. Jones is a disqualified person. If Jones had not acted as Exchanger’s accountant within the 2-year period ending May 17, 1991 or if Jones had acted as Exchanger’s accountant within that period only with respect to Section 1031 exchanges, Jones would not be a disqualified person.

    Jones is engaged in the business of acting as an intermediary to facilitate deferred exchanges. Jones is a wholly owned subsidiary of an escrow company that has performed routine escrow services for Exchanger in the past. Jones has previously been retained by Exchanger to act as an intermediary in prior §1031 exchanges. Jones is not a disqualified person notwithstanding the intermediary services previously provided by Jones to Exchanger and notwithstanding the combination of Jones’s relationship to the escrow company and the escrow services previously provided by the escrow company to Exchanger.

    Jones, Inc. is a corporation only engaged in the business of acting as an intermediary to facilitate deferred exchanges. Each of 10 law firms own 10 percent of the outstanding stock of Jones, Inc. One of the 10 law firms that own 10 percent of Jones, Inc. is Mason and Mason. Eileen is the managing partner of Mason and Mason and is the president of Jones, Inc. Eileen, in her capacity as a partner in Mason and Mason, has also rendered legal advice to Exchanger within the 2-year period ending on May 17, 1991, on matters other than §1031 exchanges.

    Eileen and Mason and Mason are disqualified persons. Jones, Inc., however, is not a disqualified person because neither Eileen or Mason and Mason own, directly or indirectly, more than 10 percent of the stock of Jones, Inc. Eileen’s participation in the management of Jones, Inc. does not make her a disqualified person.

    Here’s a transaction where everything went wrong. It’s an excellent example of why an exchanger should retain the services of a good Qualified Intermediary and tax advisor before entering into a §1031 exchange. Especially one involving related taxpayers.

    In FSA (Field Service Advice) 200048021, the IRS said a father who sold his property to his children couldn’t qualify for nonrecognition of gain under §1031(a) on the exchange of his property for an interest in another property.

    Here’s what happened-the father wanted to sell his property to his four children. They drew up an exchange agreement for a like-kind exchange, but failed to identify the property being exchanged. The father then deeded the property to the children, and the children executed a promissory note designating their father as the lender and another individual as the escrow agent. The children did not own any replacement property, so the father located it for them. Only then did the father then contacted a Qualified Intermediary for the exchange.

    In the meantime however, the father actually received the deed to the property directly from the owner. The children later sold small portions of the property they received from their father to unrelated third parties. The IRS said the father was not entitled to the benefits of §1031.

    First, the escrow agent didn't satisfy the definition of a Qualified Intermediary. Second, the father failed to unambiguously identify the replacement property. Third, the father was in constructive receipt of the proceeds from the sale of his relinquished property before receiving his replacement property. This violated the constructive receipt rules since the father never did use the safe harbor rules available from a Qualified Intermediary.

    The IRS said the father's transfer to his children did not even qualify as a §1031 exchange at all, even as an exchange between related persons because the father did not exchange property with his children, but rather sold property to them.

    Up until 1990, when the IRS finally issued the long needed definitive guidelines, exchanging real estate was confusing and many times fatal. Thousands of deferred exchanges were disallowed when challenged by the IRS. The new regulation-1.1031(k)-1-changed all that. For the first time we had a bulletproof plan to follow in structuring "IRS safe" deferred real estate exchanges.

    The biggest, most important change was the creation by IRS of the Qualified Intermediary function necessary to make deferred exchanges work within the restrictions and definitions of the Internal Revenue Code. That’s why the role of the Qualified Intermediary has become crucial to successful deferred §1031 exchanges.

    The importance of this central position cannot be over emphasized-it is vital. An inexperienced or incompetent Qualified Intermediary can sink your exchange faster than the Titanic went down. You must choose a Qualified Intermediary that gives you fast, accurate and reliable service with an up front schedule of fees charged.

    To help you choose your Qualified Intermediary, here are some guidelines and a checklist to guide you.

    Track Record – How long has the company been in the qualified intermediary business? If they are in their tenth year or more, they have been there from the start. That’s good. You should insist they have the ability to exchange properties anywhere in the United States and the U.S. Virgin Islands. And national experience in making these exchanges is a must.

    Real Estate Background – Exchanging is a series of real estate transactions subject to strict time limits and other requirements. Some transactions can get very sticky and mess you up. When this happens, you need the experience and know-how of a QI with a solid background in real estate brokerage to help guide and problem-solve you through. If your exchange gets in trouble, you want-no, you need-a QI who can jump in and help you. Not some inexperienced QI who has not been there and done that. You need a lot more than a QI with only financing or title business experience.

    One easy way to check on real estate experience: Find out if the owners hold professional designations earned by study and experience through national real estate organizations. Examples are Accredited Land Consultant (ALC) awarded by the Realtors Land Institute, Graduate, Realtors Institute (GRI), and Certified Residential Specialist (CRS), awarded by the National Association of Realtors. It takes a lot of time and experience to earn these and other designations-the kind of experience you need in your QI.

    Support and Help – How much support can you get when you need it? Can you deal directly with the Qualified Intermediary company owners, not hired staff, clerks, or branch offices? This assures you of quick, on the spot reliable answers when you need them. I learned of a case where a client called the local office of a large Qualified Intermediary company to set up an exchange transaction. It took almost a month to get all the details worked out to get the transaction in motion. Then one day, the client needed an answer on one of the issues and called the QI. The person answering the phone was not familiar with the transaction and the client spent considerable time bringing her up to date. The staff person at the QI told the client that the exchange as described could not qualify for §1031 treatment. By now the client is in orbit. It turns out the phone call to his QI was rolled over to another office in another city. So much for high tech.

    Security – Insist on a complete up-front disclosure of how your funds are secured. Your sales proceeds can run into hundreds of thousands of dollars-your dollars-and its safety is critical.

    Fees – Fees can be a real sticky wicket. It’s a must to get an honest disclosure of fees up front. No low-balling or hidden charges that pop up at the closing. Beware of QIs who quote a flat fee only to add on all kinds of extra charges at the closing. Insist on a fee schedule in writing before you commit.

    References – Be sure to check out the Qualified Intermediary’s bank and attorney references. These two are a must. And look for other references such as memberships in professional organizations such as the National Association of Realtors® and the Federation of Exchange Accommodators.

    A Word for Real Estate Agents – One of the most difficult areas of your real estate practice is the art of recommending other professionals to your clients. For example, you have listed a property for sale by your client seeking a §1031 deferred exchange. As part of this transaction, your client will need the services of other professionals such as a Qualified Intermediary, title companies, lenders, and the like. In your client counseling session, you should establish the identity of the client’s attorney, banker, etc. These people have a current relationship with the client and this relationship should never be endangered by you recommending or directing them to someone else. If the client has a genuine need for the services of another professional, your recommendation should be the very best you know of to serve your client’s transaction requirements, and not based on friendships or reciprocal agreements with others.


    A Word for Principals Making the Exchange -     The safe harbors of deferred exchanges specifically permit the Qualified Intermediary to be your agent, answerable only to you-absolutely no one else. Real or perceived. Be careful of "steering." Steering is the act by real estate agents and others referring business to friends or related parties. In our opinion, your QI should have no relationship or business connections to other parties you are dealing with in your deferred exchange transaction.

    It’s OK for the obligation requiring the transfer of Replacement Property to you to be secured or guaranteed by one or more of the following:

    ·        a mortgage, deed of trust, or other security interest in property (other than cash or a cash equivalent),

    ·        a standby letter of credit which does not allow you to draw on the standby letter of credit except upon a default of your transferee’s obligation to transfer like-kind Replacement Property to you, and

    ·        a guarantee of a third party. The letter of credit must also satisfy all of the requirements of 15A.453-1(b)(3)(iii) dealing with installment sales.[xviii]

    It’s OK for the obligation requiring the transfer of Replacement Property to you to be secured by cash or a cash equivalent if the cash or cash equivalent is held in a qualified escrow account or in a qualified trust.

    A qualified escrow account is an escrow account where you are not the escrow holder or the escrow holder is not a related party. In addition, your rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account are limited.

    You must not have the right to receive money or other property until

    after you have successfully completed the exchange, or

    you fail the identification or exchange period requirements.

    If you do, you will lose your safe harbor protection to the extent you have the ability or unrestricted right to receive money or other property before you actually receive like-kind Replacement Property. This safe harbor applies only until you have such an ability or unrestricted right.

    A qualified trust is a trust where you are not the trustee or the trustee is not a related party. In addition, your rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the trust account are limited the same as qualified escrow accounts.

    Funds held in a qualified escrow account or qualified trust, or held by a qualified intermediary, may be needed to pay closing costs for the Exchanger. Even though the Exchanger will be in constructive receipt of funds used to pay these costs, the use of this money to pay certain specified items will not result in actual or constructive receipt of the remaining funds.

    The certain specified items are transactional items that

    ·        relate to the disposition of the Relinquished Property or to the acquisition of the Replacement Property, and

    ·        are listed as the responsibility of a buyer or seller in the typical closing statement under local standards.

    Examples of these transactional items include commissions, prorated taxes, recording or transfer taxes, and title company fees. In addition, an Exchanger’s rights to receive items (such as prorated rents) a seller may receive as a consequence of the disposition of property and are not included in the amount realized from the disposition of property are disregarded.

    Under the regulations, the Exchanger may receive money or other property directly from another party to the transaction, but not from a qualified escrow account, a qualified trust, or a qualified intermediary, without affecting the application of a safe harbor.

    Your Qualified Intermediary must manage the cash proceeds from the sale of your Relinquished Property following strict IRS rules and regulations. Here are some frequently asked questions reported by Jim Maxwell in his role as President of Realty Exchangers Incorporated.

    Question – What should I do with the Earnest Money deposit on the sale of my Relinquished Property?

    Answer - When selling relinquished property in a 1031 exchange, you must avoid actual or constructive receipt of the earnest money deposit. The earnest money should never be deposited in your own account. It should be deposited in an escrow account, or real estate brokers trust account, or with your QI. The earnest money receipt should state that the funds are to be assigned to the QI, and that you have no control or right to direct how these funds are to be used.

    Question - How do I handle the earnest money deposit for the purchase of my Replacement Property?

    Answer - The best and safest way is to make the deposit from your personal funds. Any unused funds brought into the replacement property transaction, other than the exchange proceeds being held by your QI can be reimbursed at the time of closing. Exchange proceeds can only be used for earnest money if the purchase and sale agreement has been assigned in writing to your QI And even then they are not true earnest money as the funds can only be released to the seller at the time of closing. If the transaction fails to close the funds will be returned to your QI.

    Question - Do I have to spend all of the proceeds from my relinquished property on replacement property?

    Answer - No you don’t. However, any amount you don’t spend will be treated as boot received and taken into account when figuring your net boot received.

    Question - If I don’t spend all of my proceeds when can I receive the unused amount?

    Answer - You can receive unused proceeds anytime after you have acquired all of the properties identified in your 45-day identification time period. If you do not acquire all of the properties identified in the 45-day identification, then the unused proceeds cannot be released until the earlier of the due date of your tax return including extensions, or 180 days after the closing of the sale of the Relinquished Property.

    Question - If I decide not to go through with my exchange when can I get my money back?

    Answer - We can return your proceeds at any time you decide to abandon your exchange, or in the event you are unable to find Replacement Property to identify by the end of the 45-day period. There is no charge for the return of proceeds.

    Question - Many old timers in exchanging talk about the "napkin test." I know it has something to do with the cash proceeds from sale of the Relinquished Property-if you don’t spend all the proceeds or more on the new property then you get taxed on the difference. Please explain.

    Answer - The term "napkin test" was coined by one of the old time gurus in exchanging to describe the basic rule that all cash proceeds from the sale of the Relinquished Property must be "reinvested" in the Replacement Property to avoid recognized taxable gain from the exchange. If you trade up, and all the cash is "reinvested", no taxable boot. But if you trade down, and all the cash is not "reinvested", the net cash back to you is treated as cash boot received and recognized as taxable gain.

    However, there is an adjustment to cash boot received not realized by many when the exchange is originated and in the planning stages. Selling expenses paid in connection with a §1031 exchange are treated as cash boot paid and offsets any boot received. Selling expenses include brokerage commissions and other closing costs such as title policy fees, escrow fees, and recording fees. This means you can trade down by the amount of your selling expenses paid and still have no recognized gain. Here is an example of this vital tax-planning tool.

    You sell your Relinquished Property and the cash proceeds total $135,000. Your selling expenses total $32,000 of which you paid $10,000 outside of escrow. The balance of the selling expenses or $22,000 was paid through escrow and the net proceeds of $113,000 are paid into your QI’s trust account. At this point, your net cash boot received is $103,000 and this is the amount you need to "reinvest" to avoid net boot received and taxable income.

    Caution: Selling Expenses are all expenses directly related to the sale of the Relinquished Property and is the amount used by IRS to deduct from the Selling Price to figure the Adjusted Sales Price. Selling expenses do not include interest, points, taxes, fixing up expenses, repairs, insurance, operating expenses of the property, personal bills or impound account adjustments. Occasionally selling expenses are paid outside of escrow. For example, a consulting fee paid in connection with the transaction may qualify as a selling expense. Be sure to check with your tax professional if you have any questions regarding your particular selling expenses. See Chapter Four for more discussion of this important topic.

    It’s OK to earn interest on money being held in the deferred exchange. You are treated as being entitled to receive interest or a growth factor if the amount of money or property you are entitled to receive depends upon the length of time elapsed between transfer of the Relinquished Property and receipt of the Replacement Property.

    If you receive interest or a growth factor, the interest or growth factor will be treated as interest, regardless of whether it is paid to you in cash or in property (including property of like-kind). You must report the interest or growth factor in your income according to your method of accounting.

    There’s an interesting aside regarding the use of the term "growth factor" that I believe to be one of the ultimate tax puns. In the famous Starker case there was a separate issue related to the 6% to be added to the unpaid exchange price to Starker. Under the Land Exchange Agreement, this 6% amount accrued over the two years it took to close the account. IRS said it was interest and taxed as ordinary income. Starker argued it was a "growth factor" because the timberland Starker transferred had growing timber on it and the timber would be "worth more" after two years. Therefore, Starker claimed, it should be treated as like-kind property and qualify for §1031 treatment.

    The court answered with a big, resounding NO! We can’t help chuckling over the fact that Starker claimed the annual timber growth rate just happened to be the same as the interest rate in effect at that time.

    Under the deferred exchange regulations, direct transfer of the Relinquished Property and the Replacement Property is permitted.

    On May 1, 1991, Exchanger enters into an agreement to sell White Acre to Davis for $100,000.  However, Davis is unwilling to participate in a like-kind exchange. Exchanger enters into an exchange agreement with Arnold whereby Exchanger retains Arnold to facilitate an exchange of White Acre. Arnold is not a disqualified person. In the exchange agreement between Exchanger and Arnold, Exchanger assigns to Arnold all of Exchanger’s rights in his agreement with Davis.

    The exchange agreement expressly limits Exchanger’s rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property held by Arnold.

    On May 17, 1991, Exchanger notifies Davis in writing of the assignment and executes and delivers to Davis a deed conveying White Acre to Davis. Davis pays $10,000 to Exchanger and $90,000 to Arnold. On June 1, 1991, Exchanger identifies Black Acre as Replacement Property.

    On July 5, 1991, Exchanger enters into an agreement to purchase Black Acre from Williams for $90,000, assigns his rights in that agreement to Arnold, and notifies Williams in writing of the assignment. On August 9, 1991, Arnold pays $90,000 to Williams and Williams executes and delivers to Exchanger a deed conveying Black Acre to Exchanger.

    Because Exchanger’s rights in his agreements with Davis and Williams were assigned to Arnold, and Davis and Williams were notified in writing of the assignment on or before the transfer of White Acre and Black Acre, Arnold (the Qualified Intermediary) is treated as entering into those agreements. Arnold is treated as acquiring and transferring White Acre. Similarly, Arnold is treated as acquiring and transferring Black Acre.

    Because Exchanger did not have the immediate ability or unrestricted right to receive money or other property held by Arnold before Exchanger received Black Acre, he is not in actual or constructive receipt of the $90,000 held by Arnold before receipt of Black Acre. The transfer of White Acre by Exchanger and Exchanger’s acquisition of Black Acre qualify as an exchange under §1031.

    For purposes of deferred exchange rules only, a person is a related party to you if:

    ·        Such person and you bear a relationship described in either section 267(b) or section 707(b) determined by substituting "10 percent" for "50 percent" each place it appears.

    ·        Such person acts as your agent (including for example, by performing services as the taxpayer’s employee, attorney, or broker), or

    ·        Such person and a person described in (2) above bear a relationship described in (1) above.

    In determining whether a person acts as your agent, solely for purposes of this paragraph, the following are not taken into account:

    ·        The performance of services for you with respect to exchanges for property intended to qualify for nonrecognition of gain or loss under Section §1031, and

    ·        the performance by a financial institution of routine financial services for you.


     

    A reverse exchange is a transaction in which the Replacement Property is acquired before the Relinquished Property is sold. This powerful tax planning procedure permits you to acquire the Replacement Property currently under favorable circumstances before you are able to sell the Relinquished Property.

    If the Relinquished Property is sold before the Replacement Property is acquired, you follow the safe harbor rules of Reg 1.1031(k)-1 and transact a normal or forward exchange. However, if you are unable to dispose of your Relinquished Property first, it is still possible to qualify for the desired tax treatment of §1031 by following the safe harbor rules of Rev. Proc. 2000-37.

    There are many situations where the reverse exchange can solve exchange dilemmas. These are especially important in depressed real estate markets. Here are three examples:

    You must close on the Replacement Property or lose your earnest money deposit.

    You have not found a buyer for the Relinquished Property.

    Your financing commitment at good rates will expire if you don't buy the Replacement Property before you can close on the sale of the Relinquished Property.

    Real estate exchanges under §1031 deferred exchange rules generally do not permit you to buy the Replacement Property until after you have sold your Relinquished Property. But many times you find it necessary or desirable to acquire the Replacement Property first. Since buying the Replacement Property first requires a "parking arrangement", Revenue Procedure 2000-37 actually deals with "parking transactions." The "parking" can take place with either the Relinquished Property or the Replacement Property.

    The biggest difference in the rules for reverse exchanges involves the time restrictions. Under the normal or forward exchange rules, the Identification Time Period and Exchange Time Period both start on the day the Relinquished Property is surrendered. Not so with a reverse exchange.

    The reverse exchange rules require the entire reverse exchange to be completed within 180 days of the date your Qualified Intermediary acquires the Replacement Property for you.

    âCaution: Reverse exchanges are very complicated and usually incur considerable costs including legal and additional Qualified Intermediary fees. A careful analysis of the exchange and the amount of income tax saved should be made and compared to the total costs. Many times the tax saved is not enough to justify the added costs.