Tax-Deferred Section 1031
Real Estate Exchanges
January 27, 2015
The tax-deferred exchange (also called “tax free exchanges” and “1031 exchanges”) remains the most important tool in planning for non-personal real estate transactions.
With the increases in federal tax rates for long-term capital gains from 15% to 20% after 2012 for high-income taxpayers in the American Taxpayer Relief Act of 2012, the 3.8% federal net investment inocme tax for other high-income taxpayers, and increases in state and local tax rates such as the 3% tax increase for high-income California taxpayers in California’s Proposition 30, more taxpayers will be avoiding current taxation of gains from real estate sales by structuring Section 1031 exchanges.
What can be exchanged?
There has been some discussion about curtailing the scope of real estate transactions qualifying for this treatment. For example, a motel would have to be exchanged for a motel; an apartment complex for an apartment complex.
So far, this has not developed. Any type of real estate held for productive use in a trade or business or for investment may be exchanged for any other type. A motel may be exchanged for a dairy pasture.
A little-known exception for depreciable real estate is commercial property acquired after 1980 and before 1987 for which accelerated depreciation was elected under the Accelerated Cost Recovery System. Since this property is Section 1245 recovery property, it is not like-kind with other depreciable real estate, which is Section 1250 recovery property.1 If you have such an exchange, segregate amounts allocable to the exchange of the building from the amounts allocable to the exchange of the land. Most of the gain should be attributable to the land and should qualify for deferral. Exchanges of these properties are very rare, so you probably won’t have to be concerned with this rule.
Note that personal residences and vacation homes (primarily personally used – see below for IRS guidelines) do not qualify for tax-deferred exchanges.
Real estate that is “property held primarily for sale,” such as a home built for sale, also does not qualify for tax-deferred exchange treatment.
Exchanges for partnership interests do not qualify for tax-deferral. If the real estate interest received is converted or contributed to a partnership shortly after the exchange, the transaction may be “collapsed” and the deferral disallowed.
The gain will not be deferred for an exchange involving foreign real estate and U.S. real estate.
If an exchange is made with a “related party,” any sale by the related party or within two years after the exchange will result in the gain or loss being recognized on the date of the sale. This rule does not apply if the sale is made after the death of the related party or taxpayer within the two-year period.
Tenants in common interests or “TICs”
As I stated above, partnership interests don’t qualify for tax-deferred exchanges, even when the sole asset of a partnership is real estate.
This has created a practical problem for many taxpayers. They might simply want to invest in a bigger project or might want to eliminate the management headaches of renting single family homes or duplexes.
An alternative to a partnership interest that can qualify for a tax-deferred exchange is an “undivided interest” or “tenant in common” interest in a piece of real estate. The shares of income and expenses, including fees of a professional management company, can be allocated to the various owners according to their ownership interests.
In some cases, the IRS has attacked tenant in common arrangements and said they were actually partnerships. In a sensitive tax situation such as a tax-free exchange, certainty of the outcome is essential.
The IRS has issued safe harbor guidelines in Revenue Procedure 2002-22, 2002-1 CB 733 for organizers to secure an advance ruling from the IRS that the arrangement qualifies as a tenant in common interest. See a tax advisor for details, or you can look up the Revenue Procedure at the IRS web site, www.irs.gov.
Is an election required?
The tax-deferred exchange section is not elective. If you have an exchange of like-kind property, it automatically applies.
What about losses?
Not only gain, but loss may be deferred from an exchange, even when “boot” is received. Therefore, a transaction that will result in a loss should not be structured as an exchange but an outright sale.
When must a gain be recognized?
When cash or property other than real estate is received as part of an exchange transaction, those are unlike assets, called “boot.” The lesser of the net boot received or the potential gain is recognized as taxable gain. When personal property is received or sold, it should be separately valued (hopefully in the contract) so this computation is made consistently between the buyer and seller.
Note that items clearing through escrow, such as the settlement of rent deposits and the payment of property taxes, may represent “cash received” or “cash paid.” For example, if property taxes of $10,000 are paid through escrow, this represents “cash received” applied to property taxes. (The property tax expense will be a deduction that could offset recognized taxable gain.)
The debt relieved for the property sold is compared to the debt incurred for the property received. Any excess of debt relieved over debt incurred is "boot."
John Taxpayer exchanged Blackacre for Whiteacre. His tax basis in Blackacre was $500,000. Whiteacre has a fair market value of $1,000,000. Blackacre was subject to a mortgage of $200,000. Whiteacre is subject to a mortgage of $100,000. John also received net cash of $50,000 for the transaction.
Whiteacre $1,000,000 Debt relieved 200,000 Cash 50,000 Total $1,250,000
Tax Basis Blackacre 500,000 Debt acquired 100,000 Total 600,000
Debt relieved $ 200,000 Debt acquired 100,000 Net debt relieved $ 100,000
Net cash received
Net boot received
Gain recognized (lesser of realized gain or boot)
Tax basis of Whiteacre
Fair market value $1,000,000
Less gain recognized 150,000 Deferred gain 500,000
Allocating basis for acquired properties.
When properties are exchanged, the taxpayer should get an appraisal of the property received allocating the purchase price between land, building, and property improvements, such as driveways and swimming pools, in order to construct the depreciation schedule for the property.
See the section on cost segregation and like-kind exchanges below.
Thanks to the Starker decision, Congress and the IRS have defined certain situations where an exchange may be made on a non-simultaneous basis.2
In order to qualify for a non-simultaneous (deferred) exchange, replacement property must be identified within 45 days after the transfer of the relinquished property (identification period) and the replacement property must be received within the earlier of 180 days after the transfer of the relinquished property or the due date, including extensions, of the seller’s income tax returns (exchange period). If the sale is made close to the end of the year, the seller will usually need to extend the due date of his or her income tax returns.
In structuring these transactions, the net proceeds from the “sale” leg of the transaction are deposited with an intermediary called a “qualified intermediary” or “QI.” In other words, the seller may not have control of the funds during the intervening period. A person who has had an agency relationship with the person making the exchange during the two-year period ending on the date of transfer of the first of the relinquished properties can’t be a qualified intermediary for the transaction. Disqualified agency relationships include acting as that person’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker.3
Be careful when selecting an intermediary. One of my clients had his exchange funds embezzled!
During May, 2007, one of the largest qualified intermediaries in the country, 1031 Tax Group, LLC of Richmond, Virginia filed for bankruptcy. The company was holding millions of dollars for clients who weren’t able to complete their exchanges. The company listed about $160 million of debts owed creditors.
Another big qualified intermediary, Southwest Exchange, was also forced into liquidation during 2007, owing customers about $100 million.
When the exchange can’t be completed within the 180-day period, the seller who has deposited funds with the qualified intermediary must report the sale as paid at the expiration of that period. The sale is usually reported as an installment sale. (See the section on installment sale reporting for like-kind exchanges, below.)
The seller might be able to claim an offsetting loss for any funds that can’t be recovered. When the transaction relates to a sale of business or rental property, the loss should be an “above the line” deduction. The loss might not be deductible in the same year that the gain from the failed exchange has to be reported. In order to deduct the loss, you have to be able to determine an amount that can’t be recovered under an “all events test.” If the qualified intermediary has filed for reorganization under Bankruptcy Code Chapter 13, you might not be able to establish the amount of the loss until a plan of reorganization is completed.
If you find yourself in this situation, get help from a qualified tax advisor.
The most important thing you can do to protect yourself is to know your qualified intermediary. You could request a bond, but this requirement will disqualify all but the largest QIs. Another approach is to arrange a letter of credit. A friend of mine who is a qualified intermediary has set up a two-signature requirement to make payments from the account where the funds are deposited. The second signature is from a person who is independent from the person making the exchange.
In order to qualify for a non-simultaneous exchange, the replacement properties must be identified in writing by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period. This step should be carefully documented. There are various persons who could be notified, but the best choice is the intermediary.
The taxpayer may identify more than one replacement property. There can be any number of relinquished properties for a deferred exchange. For the replacement properties, the choices are (a) up to three properties without regard to the fair market values of the properties (three property rule) or (b) any number of properties provided the aggregate fair market value at the end of the identification period doesn’t exceed 200% of the aggregate fair market value of all the relinquished properties as of the date they were transferred by the taxpayer (200% rule.)4
From a practical standpoint, almost everyone follows the three-property rule, because it’s much easier to implement.
If too many properties are identified at the end of the identification period, then the taxpayer is treated as if no replacement property had been identified. There are two exceptions to this rule: (1) Replacement property received before the end of the identification period “counts”; (2) Replacement property identified before the end of the identification period and received before the end of the exchange period provided 95% of the aggregate fair market value of all identified properties are received (95% rule).
The replacement property must be received no later than the earlier of (a) 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (b) the due date (including extensions) for the transferor's tax return for the taxable year when the property was relinquished. (You should usually extend the due date of the tax return for the year of the exchange when the sale happens late in the year.)
For example: John Taxpayer has a non-simultaneous exchange of Blackacre on December 31, 20X2. He must designate a replacement property in writing no later than February 14, 20X3. The purchase of the replacement property must be completed no later than June 29, 20X3, provided John filed for an extension. If he did not, the purchase of the replacement property must be completed no later than April 15, 20X3.
These deferred exchanges can be very suspenseful. It seems Murphy’s Law reigns – if anything can go wrong, it will. 45 days is a very short window for identifying replacement property, so it’s better to identify it before the sale “leg” closes. The seller of the replacement property has a very effective negotiation “hammer” against the buyer, who might have to pay a big tax bill if the purchase “leg” falls through.
What if the exchange “falls apart” and isn’t completed? If the cash isn’t distributed until the year after the year of sale, the sale can be reported using the installment method. (See the section on installment sale reporting for like-kind exchanges below.) The reason is the amounts held by the qualified intermediary are not considered to have been received by the seller. The qualified intermediary is required to distribute the funds after the 180-day “exchange period.” Remember that the sale proceeds applied to pay off the debt on the sold property will be considered received when the sale closed. Therefore, part of the gain may be taxable for the year of the sale and the balance in the year the replacement period expires.
Exchanges can be structured so the replacement property is acquired before relinquished property is sold. The taxpayer loans funds or guarantees a loan to the intermediary who then purchases the replacement property to hold and uses the proceeds from the relinquished property to pay off the loan. The relinquished property must be sold and the exchange closed within 180 days after the replacement property is purchased. The IRS has issued safe-harbor guidelines for reverse exchanges in Revenue Procedure 2000-37.
Reverse exchanges are sensitive transactions that should only be done under the guidance of qualified tax advisors. Putting together the financing is very complex.
Sale of a principal residence acquired as part of a tax-deferred exchange
The tax law was changed effective for sales or exchanges after October 22, 2004 so that a principal residence acquired in a tax-deferred exchange won’t qualify for the exclusion for the sale of a principal residence unless the property has been held more than five years. This situation could happen when a taxpayer exchanges rental real estate for another home that is rented for a period of time, but is later converted from a rental home to a principal residence. A side effect of this rule is the principal residence evidently won’t qualify for the a partial exclusion if the residence is sold early due to a hardship or unforeseen circumstances.
Installment sale reporting for like-kind exchanges
When you have taxable income because there is “boot” received for a like-kind exchange and part of the boot is a note payable to the seller, you are eligible for installment sale reporting for the taxable income.
If a non-simultaneous exchange doesn’t work out and the sale proceeds are received after the year of sale, the gain may be reported as an installment sale. Since the “payment” applied to pay off the debt on the property is received on the closing date, the gain attributable to that payment is taxable (on the installment sale form) in the year of the sale. Cash held by the intermediary is taxable when the 180 day period for completing the installment sale is over, even if the funds aren’t received from the intermediary.
Some intermediaries have failed to distribute funds for the purchase of properties or to sellers for failed exchanges. They have gone bankrupt or had funds embezzled. Be careful who you are doing business with. The seller could be stuck with a loss for a non-business bad debt (capital loss) or a theft loss that may not match with the income reported for the installment sale – not a happy situation.
Cost segregation and like-kind exchanges
One of the hottest services for the real estate industry is cost segregation studies.
The purpose of a cost segregation study is to break down the purchase price or tax basis of real estate to get faster depreciation. The depreciable life for a commercial building is 39 years and for a residential building is 27.5 years. The depreciable life for land improvements is 15 years and for some electrical wiring associated with computer equipment is 5 years.
A side effect of cost segregation is to make like-kind exchanges more complex and harder to qualify. It’s easier to make an exchange of a building that is simply being depreciated as such. Electrical wiring being depreciated over 5 years does not qualify as like kind property to a commercial building. Electrical wiring in a replacement building used for the same purpose can qualify as like-kind to electrical wiring in a surrendered building.
Since depreciable land improvements are Section 1245 property, they are not like-kind to land and buildings.
The longer term you expect to keep the real estate, the more favorable a cost-segregation study is. If you expect to exchange the property in a fairly short time (guess less than eleven years), you are probably better off not going through the cost segregation exercise.
Related party exchanges
If a taxpayer has a tax-deferred exchange property with a related person and within two years of the last transfer of the exchange, the related person disposes of the property relinquished or the taxpayer disposes of the property received, the previously untaxed gain will become taxable for the year of disposition.5
Related persons include (1) corporations, S corporations and partnerships that are controlled, directly or indirectly by the seller; (2) a seller and a trust for with the seller or his or her spouse is a beneficiary; and (3) a selling estate and a beneficiary of the estate, unless the sale is in satisfaction of a pecuniary bequest.
There are three exceptions to this income acceleration rule: (1) a disposition after the death of either person; (2) a disposition in a compulsory or involuntary conversion, or a threat of one; (3) if the IRS is satisfied the exchange didn’t have as one of its principal purposes the avoidance of federal income tax.
For the last exception, the taxpayer will have to apply for a ruling from the IRS. In evaluating whether income tax avoidance applies, the IRS is mostly looking for “basis shifting.” The IRS surprised the tax consulting community with surprisingly liberal rulings, approving two sales by related parties within the two-year period on the same day.6
The two-year period is extended when (a) there is an option to purchase the property; (b) another person has a right to purchase the property (contract of sale); or (c) there is a short sale arrangement for the property (contract for a future sale).
Like-kind exchanges of foreign and U.S. property
Both real estate and personal property held in the United States are not like kind to real estate and personal property held outside the United States.7
Vacation rental homes
The general rule for vacation homes that are used by a taxpayer as a second home for vacations is these are personal use assets that don’t qualify for inclusion in a tax-free exchange, even though investment may be a significant purpose of holding the property.8
The IRS recently issued guidelines permitting vacation homes that are principally rented to unrelated persons to qualify for tax-free exchanges. In order to qualify for the relinquished property, (a) the home must have been owned by the taxpayer for at least 24 months before the exchange; (b) for the two 12-month periods immediately before the exchange (i) the taxpayer must have rented the home to another person or persons at a fair rental for at least 14 days or more, and (ii) the period of the taxpayer’s personal use of the home may not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the home is rented at a fair rental.9
For the replacement property, the home must be owned by the taxpayer for at least 24 months immediately after the exchange. During the 24 months immediately after the exchange, the taxpayer must meet the same use requirements as for the relinquished property, above.
If a taxpayer believes the replacement property will meet the use requirements when preparing the tax return for the year of exchange, he or she should report it as an exchange on the original return. If the property later fails the use tests, the tax return for the year of exchange should be amended to eliminate the tax-free exchange treatment and report the taxable income for the exchange.
The new procedure for vacation home rental homes is effective for exchanges on or after March 10, 2008.
Reporting like-kind exchanges
The IRS form for reporting like-kind exchanges is Form 8824. You can get a copy at the IRS web site, www.irs.gov.
California long-term reporting requirement
California has adopted a reporting requirement for exchanges of California real estate for real estate located outside of California, effective for taxable years beginning after January 1, 2014. The Franchise Tax Board has issued Form 3840 to fulfil this requirement. You can get a copy at www.ftb.ca.gov.
The form is required to be filed every year until the replacement property is sold or the taxpayer who exchanged the property is deceased. If the replacement property is exchanged for other real estate located outside California, the reporting requirement will apply to the "new" replacement property.
If the taxpayer isn't otherwise required to file a California income tax return, Form 3840 should be filed by itself to the Franchise Tax Board. The due date is the due date for the taxpayer's California income tax return. For most individuals, that is April 15 of the year following the taxable year. The taxpayer can apply for an extension of time to file, for individuals up to October 15 of the year following the taxable year.
The reason California adopted this rule is California has a "clawback" rule that treats the deferred gain from the California sale as California source, and subject to California income tax when replacement property is eventually sold in a taxable transaction.
If the form isn't filed, California will accelerate the taxation of the deferred gain and charge penalties and interest. This will be a likely error when taxpayers prepare their own income tax returns or change tax return preparers.
Could the gain from an exchange be subject to income tax in two states?
States with income taxes typically allow a state tax credit when income is subject to tax in another state. If a state doesn't have a "clawback" rule subjecting the deferred gain for out-of-state replacement property to income tax (like California does), it probably won't allow a state tax credit for the other state that imposes a tax when the replacement property is sold.
In addition, if the state does have a "clawback" rule but the gain is taxable in different years, such as when a taxpayer fails to file Form 3840 in California and the tax is accelerated, a state tax credit won't be allowed.
(California residents are subject to income tax on their worldwide income. The gain from a taxable sale is taxable for the state where the property is located, if it has an income tax. See your tax advisor for details.)
The reporting requirement for California property exchanged for property located in another state and the exposure to a potential double state tax are big disincentives for making a Section 1031 exchange of California real estate for real estate located in another state. Anyone considering making an exchange of property for property located in another state should consider consulting with tax advisors in both states or consult with a tax advisor who researches the rules in both states for this issue.
Conclusion - Get Help!!
This is a simplified explanation of some of the issues relating to tax-deferred exchanges. These are sensitive transactions, usually with high-stakes results. We highly recommend that you get professional help beyond the real estate agent to put a deal together. An investment in fees for legal and tax consulting help can pay off in avoiding unpleasant surprises later.
If you need support with one of these transactions, call Mike Gray at (408) 918-3161.
For more information about like-kind exchanges, see IRS Publication 544, Sales and Other Dispositions of Assets, starting at page 10. You can get a copy at www.irs.gov.
1 IRC Section 1245(a)(5), before repeal by the Tax Reform Act of 1986 return
2 Treasury Regulations § 1.1031(k)-1 return
3 Treasury Regulations § 1.1031(k)-1(k) return
4 Treasury regulations § 1.1031(k)-1(c)(4) return
5 IRC § 1031(f) return
6Letter Rulings 200820017 and 200820025, both issued February 7, 2008 return
7RC § 1031(h) return
8Moore v. Commissioner, T.C. Memo. 2007-134, May 30, 2007 return
9Revenue Procedure 2008-16, 2008-10 I.R.B. 547 return