More On Tax Planningfrom The Advisor's Professional Library
- Taxation of Real Estate Real estate may be used to shelter income and may offer certain tax benefits. However, the type of real estate investment may result in different tax treatment. Learn how to use these investments to help your clients.
- IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
Advisors looking for tax-deferral opportunities for clients might want to consider 1031 exchanges. A 1031 like-kind exchange occurs when a taxpayer sells business property and replaces it with similar or like-kind property without having to pay federal income taxes on the transaction (though when the last exchange property in the chain is sold, tax will be due on the entire gain). The Internal Revenue Service established regulations in 1991 that outline safer guidelines for tax-deferred exchanges under Code Section 1031. Prior to that time, exchanges were more subject to challenge under audit examinations.
The 1991 regulations established use of an intermediary and escrow accounts for holding the "exchange funds." While exchanges can occur without the services of an intermediary, it is wise to structure these exchanges in compliance with IRS guidelines. What are the basic rules for a 1031?
First, the property to be exchanged must be qualified, defined as real estate property held for investment or income-producing purposes or equipment used in a trade or business operation. Non-qualified property includes personal residences, land, inventory, partnership interests, and stocks and bonds.
Also, the replacement property must be transferred into the exact same name as the exchanged property and be "like-kind" in nature. One property may be exchanged for two properties, but a personal residence cannot be exchanged for investment property. Moreover, it is recommended to replace property with one that has equal or greater value. If your client trades down in value and so-called "boot" is exchanged, then tax consequences will result. The term "boot" is defined as the taxable portion of money or other non-qualified property received by the taxpayer. Non-qualified property includes debt reduction "boot" when a taxpayer's debt on replacement property is less than the debt on the exchange property. This happens when the taxpayer is trading down in the exchange.
These are the types of 1031 exchanges:
Simultaneous Exchange. In this most common exchange, the closing of the exchange and replacement properties occurs on the same day, succeeding each other.
Delayed Exchange. This describes an exchange when the replacement property is closed on at a later date than the exchange property. There are strict guidelines established by the IRS for completion of a delayed exchange--the closings must be completed within the 45-day or 180-day rules established by the Code.
Reverse Exchange. This takes place when the replacement property is purchased and closed on before the exchange property is sold. In this case, often referred to as a "title-holding" exchange, an intermediary holds title to the replacement property under an exchange agreement until a buyer is found and closing occurs on the original piece of property.
Improvement (Construction) Exchange. This occurs when a taxpayer acquires a property and arranges for development and enhancements to the property before it can be considered as replacement property. In order to qualify for the 1031 exchange, these improvements cannot take place after the taxpayer has taken title to the property. Therefore, the intermediary must take title until the construction is completed. The IRS does not consider this type of exchange under the provisions of its established regulations and tax reversals could result, should the IRS undertake an examination. Nevertheless, this type of exchange is common.
When a taxpayer is interested in executing a 1031 exchange on his business property, he does not need to advertise his intention to the intended buyer. However, there is generally accommodation language in the contract identifying this intent, and efforts to secure the cooperation of the buyer should stipulate that the purchaser will not incur any additional liability or expense.
When the terms of the contract are satisfied and a closing date is established, then the intermediary is contracted in an exchange agreement with the seller, and that intermediary substitutes as the seller for the actual closing.
The exchange agreement has provisions to assign the seller's contract to the intermediary, who then receives the proceeds due to the seller at closing and places them into an escrow account. The taxpayer has no rights to these funds. The seller must obtain replacement property and enter into a purchase contract within the 45-day or 180-day guidelines. The intermediary is then assigned in contract to purchase the replacement property with the escrow funds.
The first phase of a delayed exchange is to close on or identify the replacement property within 45 days from the date of transfer of the exchanged property. If not, a signed notification from the taxpayer must be delivered to the intermediary identifying that one of the following rules have been followed:
Three-Property Rule. This identifies up to three potential properties for the transaction, regardless of value.
200% Rule. This identifies more than three probable replacement properties, as long as the fair market value of the group does not exceed 200% of the market value of the exchanged property.
95% Rule. If the market value of the replacement property exceeds the 200% rule, then the taxpayer must purchase 95% of the identified properties.
This identification will extend the final closing date until 180 days from the date of transfer of the original property. If the taxpayer is unable to close on any of the situations acknowledged in the 45-day letter, then the intermediary must disburse all unused funds to the taxpayer, and federal income taxes become due on the sold property.
From Reverses to Relations
A reverse exchange occurs when a taxpayer arranges for the intermediary to hold title to replacement property before the taxpayer locates a buyer for the property. This is common practice when a piece of property is acquired but improvements are necessary before it can be exchanged. Under the Code, a reverse exchange must be completed within 180 days of taking title of the replacement property, and the exchanged properties must be identified within 45 days. Once title of the replacement property has been obtained, the taxpayer and intermediary have five days to sign an exchange agreement.
An intermediary, also known as an exchange facilitator, is required to complete a successful 1031 exchange. The intermediary is essentially an agent of either party of a transaction and must be identified in writing to all parties before the transfer of property is made. There are currently no licensing requirements for a facilitator, but he or she must be a disinterested party to the taxpayer.
There are currently no federal or state regulations to supervise facilitators, but they are generally title companies or law firms that hold large sums of escrow money. An intermediary is compensated by charging a consulting fee or retaining the interest earned on money invested with a brokerage firm. An intermediary should be bonded for at least $2 million for each occurrence, and have an established reputation of consulting on 1031 exchange matters. Verify that the intermediary is a member of a professional organization like the Federation of Exchange Accommodators.
There are special provisions when an exchange occurs between related parties.
The regulations stipulate that related taxpayers who exchange property must hold it for at least two years in order for it to qualify as a proper 1031 exchange. If there is a disqualification, the tax liability occurs on the date of the disposition.
When a taxpayer sells a property to a relative, it is not considered a related party transaction. However, if the taxpayer receives replacement property from a relative, then it is considered a related party transaction. A related party is classified as:
- A direct family member, either a parent, sibling, spouse, child, or grandparent.
- An individual or corporation that is more than 50% owned by that taxpayer.
- A trust fiduciary or corporation more than 50% owned by the grantor of the trust.
- A tax-exempt organization or an individual or family member who controls the charitable organization.
- Two S corporations or partnerships owned by the same individual with 50% or more ownership in each entity.
A multiple-asset exchange occurs when more than one type of asset is exchanged by an individual, investor, small business, or large corporation. Examples would be personal property such as automobiles, furniture, franchises, licenses, copyrights, gold coins, paintings, or other collectible items. Real property refers to any type of real estate that is held for investment or use in a trade or business. The regulations establish "exchange groups" that are separated in like-kind categories for determining value allocations and buy/sell prices. There is generally a separate closing for each asset group. Goodwill does not qualify for a like-kind exchange, and property used within the United States may not be traded for property used outside the U.S. Federal Form 8824, Like-Kind Exchanges, must be filed for each type of asset exchange. If you have any taxable gain from the transactions, it is reported on Federal Form 4797, Sale of Business Property, and Form 1040, Schedule D, Capital Gains and Losses.
Partnership & Co-Ownership
Investment property is normally owned by two or more partners or as tenants in common. Under the regulations, an exchange of a tenant in a 1031 exchange is permitted, though an exchange in percentage of ownership interest is not. Quite often, the individual partners wish to take their share of the proceeds of a sale and replace the qualifying 1031 property in their personal names. This is possible with proper planning, but it is not without risk.
Real estate brokers are often the first to recognize the opportunity of a Section 1031 like-kind exchange for a seller. If a realtor learns that the seller is going to replace one piece of real estate with other real estate, the idea should be suggested. Frequently, a separate limited liability corporation is established for real estate investments. This planning technique provides a tier of protection for the individual investor and clearly identifies the corporation as having a primary business operation in the investment of real estate.
To conclude, a 1031 exchange can be a valuable tool to defer payment of taxes. Just make sure your clients follow the rules.
Ginger Broderick is president of Broderick & Company, CPA PC, an accounting firm in New York that specializes in helping art galleries and other businesses with money management and tax and business planning. She can be reached at email@example.com.