1031 Tax Deferred Exchange

1031 Tax Deferred Exchange

An exchange, also referred to as a "non-taxable" sale, is simply a method enabling property owners to trade an investment (non-primary residence) property for another investment property (or properties) without paying capital gain taxes on the transaction. In a taxable transaction, the property owner is taxed on any gain realized by the sale of the property. In many states, the combined Federal and State Tax Rate equates to over 1/3 of an investor's capital gain. In an exchange the tax is deferred. This allows the "earning power" of the deferred taxes to work for the benefit of the property owner instead of the government.

To qualify for tax deferral, the exchanger must exchange the 1031 relinquished property for a like-kind 1031 replacement property following the terms of an integrated, interdependent, mutual and reciprocal plan (Exchange Agreement). An agreement to sell and subsequent repurchases does not qualify. The exchanger must enter into an agreement with either (a) the seller of the replacement property, (b) the buyer of the relinquished property or ©a Qualified Exchange Intermediary.

The language of IRC 1031 is straightforward: No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property like-kind which is to be held for productive use in a trade or business or for investment." The basic rules for deferral of the entire capital gain tax is: (1) purchase a property (or properties) with greater or equal net sales price; (2) reinvest all net equity into replacement property (properties); and (3) have equal or greater debt on the replacement property (properties).

There are very specific rules that must be followed or the tax deffered exchange will not be allowed by the IRS. For example, proceeds from the sale of the property to be exchanged must go to the Qualified Exchange Intermediary who must be identified before the closing of the sale (we have a list of 10/31 Qualified Exchange Intermediaries), you then have 45 days to identifiy the property(ies) that will replace the exchanged property, and 180 days to complete the exchange. If all of this seems confusing to you, just give me a call. I can assist you with all your 1031 needs. As a reminder, a 1031 Tax Deferred Exchange can take place between properties located in any state of the union. Sell your rental where you live and buy a rental in Albuquerque, New Mexico. (Thanks to Western American Exchange Corporation for some of the above information.)

Eight facts you should know about 1031 Exchanges:
1. Exchanges can only be used for investment properties or properties owned for use in a business.
2. Exchanges must be made between like kind properties. That does not mean that the properties must have the same use; a rental home can be exchanged for a retail store.
3. To meet Internal Revenue Service guidelines you must identify the replacement property within 45 days of the intitial property transfer date. You may identify three properties of like value or as many properties as necessary to total the fair market value of the property you are exchanging.
4. You must close the replacement property (properties) within 180 days of the initial transfer date of your original property. You can buy the replacement property first in what is called a reverse exchage.
5. If the property exchange is not simultaneous, you must use a qualified intermediary to hold the money until the exchane is complete.
6. If you end up with cash to even out the value of the two exchanged properties, that cash is taxable at current capital-gains rates.
7. All exchanged properties must be within the United States.
8. If you use property from a relative in the exchange and sell the property within two years, the original exchange will not qualify for deferred capital gains.

A common but often misunderstood principle among those familiar with tax deferred exchanges under Internal Revenue Code Section 1031 is the notion that the vesting of the replacement property acquired in the exchange must match the vesting of the property sold by the taxpayer. In other words, if title to the property relinquished in the exchange is in a corporation, then title to the replacement property must be acquired by the same corporation. Although the foregoing statement may be true in many cases, it is merely a guideline for structuring an exchange. What is required to complete an otherwise valid §1031 exchange is that the "tax owner" of the relinquished property must acquire tax ownership of replacement property within the exchange period permitted under §1031.

Fortunately, there are many ways to acquire tax ownership of property that can involve the use of certain business entities or trusts that are disregarded for federal income tax purposes. Through the use of these entities in a tax deferred exchange, a wide variety of structuring opportunities become available, some of which can address an exchange clients other investment goals such as limited liability and succession planning. In these cases, the vesting of the relinquished property may be very different than the vesting of the replacement property, although tax ownership of the replacement property is the same both before and after the exchange.

To make sense of the proposition set forth above, it is necessary to distinguish between: (i) federal tax ownership, (ii) state law ownership, and (iii) vesting. In any given case, all three indicators of ownership might match up, such as an individual who holds title to investment property as "John Smith, an unmarried man". But even in this simple case, Mr. Smith might not actually own the property to which he holds title under state law or federal tax law. For example, many states recognize nominee arrangements under which Mr. Smith might hold title for the benefit of another person who actually owns the property. If there were such a nominee arrangement, Mr. Smith would be the record title holder, but not the tax owner or the state law owner of the property. If Mr. Smith sells property that he holds as nominee for Mr.Saunders, then the gain on the sale would be reported by Mr. Saunders.

Similarly, if title to property is held in the ABC limited liability company (ABC LLC), we know what vesting should look like and that the state law ownership rests in the limited liability company, but who is the tax owner? The answer depends on how ABC LLC is characterized for federal income tax purposes. If the company has elected to be taxed as a corporation, then tax ownership would be in the company. If the limited liability company has more than one member and has not elected to be treated as a corporation for tax purposes, then it is treated as a partnership for federal income tax purposes and, again, the company is the tax owner of the property. If, however, Mr. Smith is the sole member of ABC LLC and the company has not elected to be treated as a corporation for federal tax purposes, then Mr. Smith is the owner of the property for federal income tax purposes. Under federal tax law, a single member limited liability company is a "disregarded entity" and its assets are treated as owned by the sole member of the company. Thus, if Mr. Smith sells property in a § 1031 deferred exchange (property that was titled in his name), he could acquire property in ABC LLC provided that he is the sole member and the company is a disregarded entity. The same result would follow where ABC LLC sells relinquished property and Mr. Smith acquired replacement property in his individual name.

Revocable trusts are another area where tax ownership, state ownership and vesting may diverge. During the lifetime of the person who forms a revocable trust (a Grantor) and during the time he or she retains the right to revoke the trust, federal law treats the Grantor as the tax owner of assets held in the trust. So, as the Grantor, Mr. Smith is the tax owner of assets held is his revocable trust, but the trust is treated as an entity under state law and for purposes of vesting and ownership of trust property. Thus, Mr. Smith might sell property owned by his revocable trust as part of a tax deferred exchange and acquire replacement property in his own name. Alternatively, if Mr. Smith sells property owned by his trust, he could also acquire replacement property in a disregarded limited liability company in which he was the sole member, or, he could acquire replacement property in a disregarded limited liability company owned solely by Mr. Smith’s revocable trust.

In most of the foregoing examples, a valid exchange can be accomplished in circumstances where the vesting of the relinquished property does not match the vesting of the replacement property, so the notion that vesting of the relinquished property and the replacement property must be the same is not a hard and fast rule. What matters is that the tax owner of the relinquished property acquires tax ownership of replacement property. The determination of tax ownership is not always a simple matter, especially for those not steeped in federal tax law, but accountants and tax attorneys can assist in structuring an exchange transaction to maximize the taxpayer’s advantage. In the last example in the proceeding paragraph in which Mr. Smith relinquishes property owned in his revocable trust and acquires replacement property in a disregarded limited liability company owned solely by Mr. Smith’s revocable trust, Mr. Smith not only obtained tax deferral under §1031, he obtained limited liability under state law that would protect the trust and himself from liabilities that might arise out of his ownership and operation of the property, and ensured that the property was properly held in his trust to be disposed of in accordance with his overall estate plan.

DETERMINING THE VALUE OF A PROPERTY "CAP RATE, GRM AND CASH-ON-CASH DEMYSTIFIED"

Investors nationwide use commonly accepted formulas to analyze new purchases and arrive at appropriate prices for the sale and purchase of investment properties. A few commonly used methods to determine the value of an investment property are the Income Capitalization Rate (Cap Rate), the Gross Rent Multiplier (GRM) approach and the cash-on-cash rate of return.

CAPITALIZATION RATE (CAP RATE): The cap rate is the ratio between the first year Net Operating Income (NOI) and the purchase price of the property. The cap rate formula below can be used to arrive at the value of an investment property, when the cap rate and the net operating income are known. Another variation of the cap rate formula is to determine the cap rate of an investment property when the NOI is known and the price is fixed.

NOI Cap Rate= Investment Value NOI Purchase Price= Cap Rate

Once the NOI for an investment property has been determined, the following assumptions can be made: the lower the cap rate, the higher the sales price; the higher the cap rate, the lower the sales price; sellers want buyers to accept the lowest possible cap rate; from the buyer’s point of view, the higher the cap rate, the more advantageous the purchase. Pros: The main advantage of using a cap rate is its simplicity. It also accounts for vacancy and operating expenses. Cons: The reliability of using a cap rate is limited because it only looks at a one year forecast and does not take into consideration any financing or tax implications.

GROSS RENT MULTIPLIER (GRM): The value of an investment property is calculated using the Gross Scheduled Income (GSI = the maximum amount of annual rent received if the property was 100% occupied) for year one, multiplied by the GRM.

First Year GSI x GRM = Investment Value

If an investor wants to calculate the GRM for a potential investment, divide the asking price by the first year GSI. The higher the asking price, the higher the GRM. Sellers generally try to sell their properties at the highest possible GRM. Buyers typically try to purchase investment properties at the lowest possible GRM. The lower the GRM, the more attractive the investment becomes to the buyer. Pros: The GRM is a convenient tool because of its simplicity. Cons: The usefulness of the GRM is limited by the fact that it does not take into account vacancy and uncollected rent, operating expenses, debt service, tax impact or income past the first year.

CASH-ON-CASH: Another measurement of investment performance is called the cash-on-cash rate of return. This involves comparing an investor’s initial investment to the potential before-tax cash flow that the investment property is likely to produce.

Before-Tax Cash Initial Investment= % Return

Pros: Cash-on-cash takes into consideration vacancy and uncollected rent, operating expenses, and debt service. Cons: Cash-on-cash does not take into consideration anything past a first year forecast and does not take into account tax considerations.

NEW TAX COURT DECISION ON VACATION HOME EXCHANGES

Taxpayers use Internal Revenue Code (IRC) §1031 tax deferred exchanges to defer paying capital gain taxes. Frequently, a taxpayer may consider exchanging out of or into property held for investment in a vacation or resort area. Many tax and legal advisors believe it is possible to perform an exchange on a vacation property that is held for investment purposes, provided the personal use is incidental (generally less than 14 days a year or less than 10% of the time rented) and the taxpayer can substantiate that the primary purpose was to hold the property for investment, not personal use. A recent Tax Court decision, Barry E. Moore v. Commissioner, T.C. Memo 2007-134, provides a significant case concerning whether a vacation home would be considered “held for investment.” The court’s analysis also indicates certain tax planning strategies that taxpayers may wish to utilize when considering exchanging a vacation home.

LAKEFRONT PROPERTY EXCHANGED FOR LAKEFRONT PROPERTY

In Moore v. Comm., the taxpayers exchanged a lakefront vacation property with a mobile home in Lincoln County, Georgia (the Clark Hill property) for a lakefront property with a larger five bedroom and 4.5 bath house on 1.2 acres in Forsyth County, Georgia (the Lake Lanier property). The taxpayers in this case argued that both of these properties were held for investment, specifically for long-term appreciation purposes, and thus qualified for tax deferral under IRC §1031. However, based upon the taxpayers’ significant personal use of the property, the tax court concluded that both the relinquished Clark Hill property and the replacement Lake Lanier property should be viewed as “held primarily for the taxpayers’ personal use and enjoyment.” In reaching this conclusion, the court considered the following: (i) the taxpayers never rented or attempted to rent the property to others; (ii) the taxpayers deducted mortgage interest as a “home mortgage interest” expense rather than investment interest expense; (iii) the taxpayers did not take (and probably did not qualify for) depreciation or other tax benefits associated with an investment property under the Internal Revenue Code, including deductions for maintenance expenses.

The court accepted the taxpayers’ argument that both the relinquished and replacement properties were held for appreciation but concluded that “...the mere hope or expectation that the property may be sold at a gain cannot establish investment intent if the taxpayer uses the property as a residence. The proposition that holding a primary or secondary (e.g. vacation) residence motivated in part by an expectation that the property will appreciate in value is insufficient to justify the classification of that property as property ‘held for investment’ under Section 212(2) and, by analogy, Section 1031. There is no convincing evidence that the properties were held for the production of income, and there is convincing evidence that petitioners and their families used the properties as vacation retreats. The evidence overwhelmingly demonstrates that petitioners’ primary purpose in acquiring both the Clark Hill and Lake Lanier properties was to enjoy the use of those properties as vacation homes, i.e. as secondary personal residences.”

ADDITIONAL LEGAL PERSPECTIVES IN VACATION HOME EXCHANGES

In the tax court case, Rivera v. Commissioner (2004), the tax court noted that, “...the term ‘income’ is not confined to recurring income but may also apply to gains from the disposition of property.” In this case, the court found the owners held the property for investment purposes because they had purchased it with that the expectation it would increase in value. The court referenced Section 1.183-2(b) of the Income Tax Regulations that outlines nine factors indicating whether or not a taxpayer is involved in a venture that is intended to produce a profit. Although §1031 exchanges are not discussed directly, this section does define income and expense deductions for a vacation property and the intent to hold property as an investment.

Another reference for tax guidance on vacation home exchanges comes from Private Letter Ruling (PLR) 8103117 which states “... the house and lot you acquire in this trade will be held for the same purposes as the properties exchanged: to provide for personal enjoyment and to make a sound real estate investment.” Although a PLR only applies to the facts and circumstances in a specific situation, in this instance, some limited personal enjoyment of a property did not prevent a taxpayer from benefiting from a §1031 exchange. In this PLR, however, it is important to note that the personal use was minimal on the relinquished property in the years before the owners sold this property and initiated a §1031 exchange.

PLANNING STRATEGIES FOR A POSSIBLE VACATION HOME EXCHANGE

Despite the court’s conclusion in the Moore case, a taxpayer should be able to substantiate investment intent with proper planning, even with some limited personal use and enjoyment of the property (see T.C. Memo. 1997-401; Frazier v. Comm., T.C. Memo., 1985-61). The reporting of rental income, attempts to rent the property or the outright conversion of the property from a vacation property to a rental property before a sale of such property could be helpful in establishing investment intent. It also appears that a taxpayer would have a stronger argument if the property has been treated as an investment property on the tax return over a period of time. Obviously, there are tradeoffs in taking this position on the tax return in that eligibility for depreciation and other tax benefits associated with income and/or investment property may restrict the amount of personal use the taxpayer may make of the property. Most importantly, taxpayers should consult with their tax or legal advisors regarding any vacation home exchange.

Asset Preservation, Inc. encourages clients to obtain competent tax and legal advice in structuring an exchange transaction. As an experienced qualified intermediary, we have seen a broad array of transactions that qualify as tax deferred exchanges under IRC §1031. However, because of the non-tax considerations surrounding the structure of an exchange transaction (such as limited liability, liability protection and succession planning), many exchange clients would benefit by consulting their personal tax or legal advisors before engaging in an exchange transaction.

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