The
tax topic of the 1031 exchange area is so broad that a real estate
teacher or tax instructor could spend days teaching its details. Most
prelicensing and continuing education teachers, however, want to simply
introduce the topic to their students, a goal that could be fulfilled
adequately in about an hour. This article provides an outline and the
basic concepts that will allow you to do just that.
The purpose of a 1031 exchange is fairly simple: to avoid paying tax on
the gain from the sale of investment property. As long as the taxpayer
continues to do 1031 exchanges on each successive property, the
accumulated tax is postponed, until the taxpayer ultimately decides it'
time to liquidate his or her investments. While the correct technical
terms to describe the properties involved are "relinquished
property" and "replacement property," I always use the terms "Old
Property" and "New Property" in my classes because it takes too long
for each student' brain to translate "relinquished" and "replacement"
and, as a result, they
miss what I say in the moments after I use those terms. "Old" and "New"
are more familiar words to describe the legal, technical terms (and to
be candid, it' hard even for me to keep the terms "relinquished" and
"replacement" straight while I'm in the middle of a lesson).
There are six basic requirements for a 1031 exchange. Teaching your
students these basic requirements will teach them about 95% of
everything they will ever need to know for a working knowledge about
exchanges. Coincidentally, these are the same six issues that the IRS
looks at when it audits an exchange.
Section 1031 is broken into two sets of rules: those dealing with real
estate (i.e., dirt and any thing that is a part of it, such as
buildings, trees, rocks, water, etc.) and personal property (i.e.,
things that move such as jets, boats, trucks, cattle, tables, chairs,
etc.). The rules are very different for the sale of real estate than
they are for personal property. For brevity' sake, let' review the
rules regarding real property only.
RULE #1
BOTH THE OLD PROPERTY AND THE NEW PROPERTY MUST BE HELD FOR INVESTMENT OR USED IN A TRADE OR BUSINESS
The IRS uses the term like-kind exchange to describe the properties
that must be involved in a swap. The IRS previously required that if
you sold a duplex, you had to find someone that also had a duplex, and
restaurants had to be swapped for restaurants. This interpretation of
like-kind was changed during the late 70s and early 80s by a Supreme
Court decision that gave rise to the term Starker Exchange.*
In 1991 Congress rewrote Section 1031 and now a seller can
exchange a duplex for any other type of real estate, such as an office
building, a warehouse, an apartment building or even unimproved land,
so long as it too
will be investment property or used in the taxpayer' trade or business.
Section 1031 rules state that property held for resale does not qualify
for an exchange. This means that developers who " ' flip" properties do
not qualify for exchanges because the intent is resale rather than the
holding for investment. There have been several court cases seeking to
determine the dividing line between held for resale and held for
investment. While intent is a significant factor in determining the
difference, the consensus of the exchange industry is that a holding
period of a year and a day is a minimum time frame distinguishing
between the two. One of the primary reasons for this is that it keeps
taxpayers from turning
short-term capital gains into long-term capital gains by doing an
exchange.
Another important part of this requirement is that taxpayers cannot
sell their Old Properties to, or buy their New Properties from, a
related party. A " party" is defined as parents, grandparents, spouse,
brothers and sisters, kids and grandkids. Thus, Aunt Martha is not
related to the taxpayer for this rule. There are similar rules for
entities (e.g., corporations, partnerships, LLC' etc.) owned by a
related party.
A common question is whether the exchange property can be located
outside of the United States. The answer is that if the Old Property is
inside the U.S., then the New Property must also be inside the U.S. If
the Old Property is outside the U.S., the New Property must be outside
as well. In other words, the taxpayer cannot cross U.S. borders with a
1031 exchange.
RULE #2
45-DAY IDENTIFICATION REQUIREMENT
From the day taxpayers close on the sale of the Old Property, they have
45 days to complete a list of properties they want to buy. Typically
this list will have three or fewer properties. This is because
taxpayers can list up to three properties with no dollar limitations.
For example, if the investors sold their Old Property for $100,000,
they could list three properties for $10,000,000 each (a total of $30
million) because there are no limitations.
If the investor's list has more than three properties, then the
combined purchase price of all of the properties on the list cannot
exceed twice the selling price of the Old Property. This is called the
200% rule. If investors put more than three properties on their list
(it does not matter if the list has four or 400 properties), then the
combined purchase price of all the properties cannot exceed $200,000
(i.e. twice the Old Property selling price of $100,000). If taxpayers
exceed the 200% limit, their whole exchange is disallowed. The common
sense rule here is for investors to keep the list to three or fewer
properties. The list is given
to the qualified intermediary whose job it is to receive the list on
behalf of the IRS. See upcoming Rule #4.
The 45 days are calendar days. That means that if the 45th day falls on
a Saturday or Sunday, or a holiday such as the Fourth of July, or New
Year' Day— is the final day: taxpayers must have their list to
their intermediary by midnight on that day. There are no exceptions or
extensions! If the IRS can prove that a taxpayer changed a list after
the 45th day, the taxpayers and their qualified intermediaries could go
to prison.
The list must be prepared in a way that an IRS agent could take it
directly to the door of the property. You want to list a property as "
Main Street, Anywhere, USA." An identification such as " three-bedroom
house on Main Street" won' work. In other words, the 45-day list must
be specific and in writing.
RULE #3
180-DAY PURCHASE REQUIREMENT
This rule is pretty simple: again from the day of closing, taxpayers
have 180 days to close the purchase of what they say they are going to
buy, and what they buy has to be on their 45-day list. The 45- and
180-day requirements run concurrently, which means that when the 45
days are up, the taxpayer only has 135 days remaining to close. As with
the 45- day identification requirement, there are no extensions.
Closed means that risk of loss must pass to the taxpayer. In other
words, title has to pass to the taxpayer before the 180th day.
RULE #4
QUALIFIED INTERMEDIARY REQUIREMENT
Taxpayers cannot touch the money in between the sale of their Old
Property and the purchase of the New Property. By law, taxpayers have
to use an independent third party (or intermediary) to handle the
exchange.
The function of the intermediary is to prepare the documents required
by the IRS both at the time of the sale of the Old Property and at the
time of the purchase of the New Property and to hold the proceeds from
the sale until the purchase of the New Property.
If the documents are prepared incorrectly, the IRS will disallow the
exchange. Yes, the IRS disallows 1031 exchanges for improper documents.
Remember, the IRS loses tax revenue to Section 1031, so documents have
to be perfectly correct.
Section 1031 rules do not define who can be a qualified intermediary.
It defines who cannot be an intermediary (in other words— is
disqualified). Included on the list of disqualified persons: the
taxpayer' attorney and CPA, their real estate professional, any
relative, any employee, and any business associate. This means that the
intermediary needs to be a completely independent party.
None of the 50 states nor the federal government regulates qualified
intermediaries. This means that a convicted felon could be an
intermediary and hold clients' money. For this reason it is prudent to
use caution in selecting an intermediary. First of all, taxpayers will
want to make sure that their intermediaries are bonded. There are
approximately 2,000 intermediaries in the U.S. Of this number, only 39
are bonded, meaning that only a very small number have bothered with
the hassles of background checks. Taxpayers should make sure they
receive a copy of the bond.
RULE #5
TITLE REQUIREMENT
Any entity, such as corporations, trusts, partnerships, LLC' etc. may
do an exchange. They all have the same rule: the tax return that holds
title to the Old Property must be the same tax return that takes title
to the New Property. For example, if Fred and Sue are married (i.e., a
joint return) and they sell the Old Property, then husband Fred may not
buy a replacement property in his name only. Sue has to be on the title
also. On the other hand, if Fred and Sue are brother and sister, then
two taxpayers own the Old Property and Fred may buy any New Property he
wishes in his name only (the IRS looks only to his tax return to see if
he met
the title requirement).
Similarly, if a partnership, or LLC, owns the Old Property, then only
one tax return (i.e., the partnership' owns the property even though
the partnership has many partners. If the partnership sells the
property, then only the partnership— not the partners— do
an exchange. In these situations it comes down to " or none" when the
partnership is considering an exchange.
A solution that most attorneys devise to the problem of partners who
want to go in different directions is to liquidate the partnership or
LLC and give each of the partners a tenant-in-common interest in lieu
of their partnership interest. The problem with this solution is the
holding period requirement of one year and a day in Rule #1. In other
words, if the partnership is dissolved today and the sale of the
property closes next week, each of the '' owners now has a one week
holding period for their interest: meaning that they held it for resale
and not for investment, which will result in the exchange being
disallowed.
Can any of the partners sell their partnership interest and do a 1031
exchange? No— they are not selling real estate, they are selling
a partnership interest and the IRS does not allow exchanges of
partnership interests.
RULE #6
REINVESTMENT TARGETS
To defer all of the capital gains tax, taxpayers must buy a property of
equal or higher value than the one they sold, and they must reinvest
all of the cash proceeds from the sale. It sounds complicated, but it'
not. Let' assume the following set of facts:
Sale price of Old Property $100,000
Debts paid at closing 40,000
Cash to Intermediary 60,000
Example #1: Fred and
Sue sell their Old Property for $100,000. The mortgage on the property
is paid off at closing and the balance of $60,000 is transferred to the
intermediary. If they buy their New Property for $90,000, they' bought
down by $10,000. The buydown does not kill their exchange, but the
difference (between the Old sales price and the New purchase price) of
$10,000 is taxable. The IRS calls this taxable amount boot.
Example #2: Same facts as above, but instead of buying the New Property
for $90,000, Fred and Sue decide to buy a New Property for $150,000 for
which they obtain a loan for $100,000. This means that they will only
use $50,000 of the $60,000 proceeds that the intermediary is holding.
The $10,000 excess is also boot and is taxable.
In both of the examples above, the entire $10,000 is taxable. In a 1031
exchange, the gain is taxed first. Where you have a boot situation, the
boot is taxable to the extent of the lesser of the boot or the entire
gain on the transaction.
So let me restate this rule: In order to pay zero tax, taxpayers must
do two things: they have to buy a property equal to or higher in value
than the one they sold, and they have to reinvest all of their cash
profits.
Notice that taxpayers do not have to have debt on the New Property
equal to or greater than the debt that was paid off on the Old
Property. There are teachers providing 1031 classes that say this is
so, but they' wrong; purchasers simply have to buy equal or up to and
reinvest all their cash.
Real estate teachers shouldn' have any problems taking their students
through the six rules above. You can cover these six rules in 15 to 20
minutes if you keep it really simple, or you can expand the class to a
one-and-a-half or two hours by adding some more examples to each
requirement.
If you want to make sure that your examples are correct, you may call
our national headquarters (toll free: 866-694-0204) and speak to one of
our CPAs or attorneys free of charge.
In addition, our firm has many technical articles covering more advanced 1031 topics on our website at www.expert1031.com that you may incorporate into your class.
* When Congress wrote Section 1031
in 1917, it was titled " Exchanges." Partly because of the title,
taxpayers believed that to do an exchange, you had to swap the deed for
your purple duplex with the deed of a purple duplex held by a
similarlyminded taxpayer. In the mid-70s, T.J. Starker challenged that
view by selling some timber property, and instead of simultaneously
swapping with another timber property owner, Starker took cash from the
closing and then bought replacement timber land. The IRS sued Starker
for not paying capital gains tax on the cash Starker took from the
sale. This case went all the way to
the Supreme Court, and surprisingly, Starker won. Taxpayers throughout
the rest of the country immediately began doing " Exchanges" (i.e.
selling their property, taking cash proceeds, and then buying the new
property). The IRS argued that only Starker could do a Starker
Exchange. At the same time, the Supreme Court let it be known that they
would rule in the taxpayers' favor if any more Starker cases came their
way. Congress re-wrote Section 1031 in 1991 and allowed taxpayers to
buy any other type of investment property, and imposed the qualified
intermediary requirement.
|