1031 Exchange - Texas

1031 Exchange INDEPENDENCE TITLE

E D U C A T I O N © 2022 Independence Title Education

1031 Exchange By the Rules

Presented By: Roland Love Vice President – Business Alliances & Field Operations Presented by the Education Team at Independence Title. TREC Approved Continuing Education Provider License# 403.

Agenda o

Introduction to 1031 Exchange

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The 1031 Exchange Rules

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Reverse Exchanges

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Contract Issues

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Refinancing: Before or After

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Opportunity Zones

Introduction

Section 1031 Exchanges are ALL about avoiding taxes...

Or at least deferring them!

Is it Deferred or Eliminated?

UNLESS… 1. You die. Heirs get a step up in basis.

2. You make a charitable contribution.

3. You convert to personal residence and sell under the personal residence gain exclusion rule.

Why Do You Care?

• There are special contract provisions required in any contract involving a 1031 Exchange.

• It will help you understand what your customer is looking for as an exchange property.

• You will know what to look.

• By deferring taxes, these have fallen out of favor due to low long term capital gains taxes.

• Defers recapture on depreciation that may be taxed.

Introduction to the History STARKER EXCHANGES • When Congress wrote Section 1031 in 1917, it was entitled "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 similarly-minded 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 timberland.

• 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 rewrote Section 1031 in 1991 and allowed taxpayers to buy any other type of investment property and imposed the qualified intermediary requirement.

Source: College of Forestry Photographic Collection (P 061)

Introduction to the Law § 1031. Exchange of property held for productive use

or investment.

(a) Non-recognition of gain or loss from exchanges solely in kind.

(1) In general, no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Introduction to the Law (3) Requirement that property be identified, and that exchange be completed not more than 180 days after transfer of exchanged property.

For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if: (A) Such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange.

(B) Such property is received after the earlier of either: (i) The day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange. (ii) The due date (determined with regard to extension) for the transferor’s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.

Introduction to the Law

(2) Exception 7 1 0 2 This subsection shall not apply to any exchange of N I

D E T primarily for sale.

(A) Stock in trade or other property E held L Eor notes.

D (B) Stocks, bonds, S A W (C) Other securities or evidences of indebtedness or interest.

N OInterests in a partnership.

I (D) T C E S (E) Certificates of trust or beneficial interests.

S I TH (F) Choses in action.

You May Hear it Called…

• Starker Exchange • 1031 Exchange • Like Kind Exchange • Tax Deferred Exchange • Tax Free Exchange

Introduction to the Basics • • • • • • •

Sell property Sale proceeds go to exchange agent Cash is NOT received by sellers Identify new property within 45 days Close new purchase within 180 days No taxable gain Tax basis in the old property is carried forward into the new property

Introduction CommontoMisconceptions the Misconceptions • Exchanges = simultaneous property trade between two individuals.

• Residential property does not qualify.

• Exchanged properties must be of equal value.

• Exchanges always involve two properties.

• Exchanges must involve the same category of real property (e.g., land for land, etc.).

• Only the gain must be reinvested.

Tax Deferred Exchange Terminology Tax Deferred Exchange Terminology: • Basis: Method of measuring investment in property for tax purposes. Calculation: Original cost, plus improvements, minus depreciation taken.

• Boot: Fair Market Value of non-qualified (not “like-kind”) property received in an exchange.

(Examples: cash, notes, seller financing, furniture, supplies, reduction in debt obligations.)

• Constructive Receipt: Control of proceeds by an Exchanger (even though funds may not directly be in their possession).

• Exchanger: The property owner(s) seeking to defer capital gain tax by utilizing a Section 1031 exchange. (The Internal Revenue Code uses the term “Taxpayer.”)

Tax Deferred Exchange Terminology • Like Kind Property: This term refers to the nature or character of the property, and not its

grade or quality. Generally, real property is “like kind” as to all other real property, as long as the Exchanger’s intent is to hold the properties as an investment or for productive use in a trade or business. The “like kind” rules for very personal property, however, are very restrictive.

• Qualified Intermediary: The entity that facilitates the exchange for the Exchanger. The term “facilitator” or “accommodator” is also commonly used, although the Treasury Regulations specifies the term “Qualified Intermediary.”

• Relinquished Property: The property “sold” by the Exchanger. This is also sometimes referred to as the “exchange” property or the “downleg” property.

• Replacement Property: The property acquired by the Exchanger. This is sometimes referred to as the “acquisition” property or the “uplug” property.

The Six Rules

RULE # 1 • Both the old and the new properties must be held for investment or used in a trade or business.

• Property held for resale or flip does not qualify for a 1031 Exchange.

• Intent is a major factor.

• Property must be held for a year and a day before it can be exchanged.

• Why? It prevents taxpayers from converting short term gains into long term capital gains.

• Cannot sell the property to a “related party” and not realize the tax value.

• “Related parties” includes parents, grandparents, spouses, brothers, and sisters.

• First degree of sanguinity.

• Doesn’t include Aunt Bea or Cousin Matt.

RULE # 2

45-Day Identification Requirement •

From the date of closing the sale of the old property, the taxpayers have 45-days to complete a list of the properties they want to buy or exchange into (includes weekends and holidays).

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Taxpayers can list up to 3 properties without value limitations.

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If seller lists more than three properties, the combined purchase price cannot exceed the aggregate of 200 percent of the sales price. (the “200% Rule”)

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If exceeded, exchange disallowed – unless close on 95% of properties listed.

RULE # 2

45-Day Identification Requirement • List must be delivered to the “qualified intermediary” (often called the “exchange agent”) by the deadline, even if it’s a holiday.

• The list must be prepared in a way that an IRS agent could take it directly to the door of the property.

• Recommend it’s listed by both address and legal description (list must be specific and in writing).

RULE # 2 • As a listing agent, look for a property or group of properties involving a specific value, either individually or in the aggregate.

• You’ll be shopping, not just showing.

• Your target does not have to be the exact same kind of real property, provided it is real property that can be used for investment or income-producing purposes.

• Your target MUST be within the United States or the U.S. Virgin Islands.

• Exception – when your property sold is overseas property, the property bought must also be overseas property.

RULE # 3

180-Day Purchase Requirement • Remember, from the date of closing the sale of the old property, you have 180 days to close the purchase of the new property.

• Time periods run concurrently, so once your 45-day period runs, you have 135 days to close the purchase.

• IRS allows no extensions.

RULE # 4 Qualified Intermediary Requirement • Taxpayers cannot touch the money between the sale of the 1st property and purchase of the 2nd.

• By law, taxpayers must use an independent 3rd party to handle the money.

• This is the “qualified intermediary” or “exchange agent.”

• The qualified intermediary: • Prepares the exchange documents.

• Holds the proceeds from the sale until the purchase of the new property.

• The IRS has disallowed the exchange, and therefore the tax deferral, where the documents have been created incorrectly.

RULE # 4 Qualified Intermediary Requirement • IRS rules do NOT define who can be a qualified intermediary.

• The IRS does list who CANNOT be: • Taxpayer’s CPA • Taxpayer’s attorney • Taxpayer’s real estate professional (YOU!) • Relatives • Employees • Business associates • The IRS is looking for a completely independent party.

• None of the 50 states or the federal government defines or licenses who can be a “qualified intermediary.”

• You might want to be careful who you refer your client to.

• Taxpayers should ask about: • Financial resources.

• Bonding.

• What they’re going to do with the money.

• The bank being used.

• FDIC insurance.

RULE # 5 Title Requirements • The taxpayer who owns the prior property must also buy the new property.

• Cannot change business entities, merge, or dissolve.

• With a partnership or LLC breaking up, you should break it up prior to the exchange to make business owners the direct owners of the property.

• With some corporations, that can create tax issues.

Exchange Vesting Issues Acceptable Variations: 1.

Grantor Trust (e.g. revocable living trust): Trustee takes title to replacement property as an individual and then transfers it later to trust. Trust is disregarded for tax purposes.

2.

Death of Exchanger: If Exchanger dies, Exchanger’s estate can complete exchange.

3.

Single Asset Entities: Exchanger who relinquished as an individual can acquire replacement property in a single-owner LLC. This entity is disregarded for tax purposes under the “check the box” rules.

Areas of Concern: •

Lender may not want to loan to a trust and may require individual as borrower.

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Lender may require spouse to be on loan and deed but there may only be one Exchanger..

RULE # 6 Boot Issues In 1031 Exchanges, “boot” is the IRS term for money in the transaction which becomes taxable to the taxpayer. Your goal is usually to avoid boot.

In order to defer all tax gains, the taxpayer must buy a property that is equal to or higher in value than the one they sold.

• 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. This “buy down” 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.

RULE # 6 Boot Issues

• In order to defer all tax gains, the taxpayer must buy a property that is equal or higher in value than the one they sold.

• Example #2 - same facts as before, 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.

RULE # 6 Boot Issues So, you must think about both: • The price of the property you sold compared to the price of the property you’re buying.

• The amount of equity you are putting in compared to the amount you netted out of the sale.

In other words: In order to pay zero tax, taxpayers must do two things.

1.

2.

They have to buy a property equal to or higher in value than the one they sold.

They have to reinvest all of their cash profits.

Reverse Exchanges

Reverse Exchanges A “Reverse Exchange” is when the property the taxpayer is exchanging into is acquired first, before the sale of the property the taxpayer is selling.

Quite simply, the qualified intermediary acquires the property first, and then the taxpayer exchanges into upon sale.

Property owner cannot “buy” and the “sell” properties simultaneously. One property, usually the replacement property, must be ‘parked’ with the qualified intermediary.

Reverse Exchanges Parking Issues Often, an experienced qualified intermediary will not want the liability of holding the property during the exchange period.

This often requires the creation of a limited liability company (LLC) to own the property until the exchange goes through. The LLC must be owned by the qualified intermediary until the exchange goes through.

Taxpayer does not get the tax advantages of ownership while the qualified intermediary owns it.

Reverse Exchanges Parking Issues Think about the cost of parking issues.

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Forming a business entity.

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Attorney’s fees for corporation.

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If time period is to go past the end of the year, accounting and filing a tax return for the business entity.

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Owner must finance the acquisition of the replacement property before selling the relinquished.

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This often creates property issues because the lender does not like the debt ratio of the taxpayer.

Reverse Exchanges Time Reversal •

Revenue Procedure 2000-37 outlines a safe harbor for Reverse Exchanges.

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Although not mandatory, it sets 45 days from acquisition of the replacement property to identify the relinquished property.

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180 days from acquisition of the replacement property to complete the exchange.

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The revenue procedure also gives 5 days after the acquisition of the replacement property to complete signature of the exchange agreement.

But… Must be titled with the exchange agent when acquired!

Reverse Exchanges Some of the situations that occur that can turn an anticipated 1031 exchange into a Reverse Exchange: • Owner finds a unique opportunity to buy another property before he gets his sold.

• Sale of the relinquished property falls apart, and purchase of the new property cannot be delayed.

• Property owner is overly concerned about the time deadlines and wants everything resolved before he sells.

• Remodeling or construction needs to be done to increase the value of the replacement property.

Like-Kind Property for Real Property The like-kind requirement for real property can be easily satisfied: •

All properties in the exchange must be considered real property under applicable state law.

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All properties in the exchange must be “held for productive use in a trade or business, or for investment.”

Contract Issues

Contract Issues TREC will not allow a Realtor to add contract terms outside of the form except for factual issues.

To make the needed additions to the contract required for a 1031 Exchange, an attorney draft the changes.

Generally, a contract needs language added: If your client is the seller and they wish to do a 1031 Exchange out of the property: • “Seller intends to perform an IRC Section 1031 tax deferred exchange. Buyer agrees to cooperate with Seller in such an exchange. Buyer agrees to an assignment of the contract to a Qualified Intermediary (Exchange Agent) to be chosen by Seller.”

If you represent the buyer, you should add something like…

• “Seller agrees that Buyer will incur no cost or delay in connection with Seller’s desire to conduct a 1031 Exchange.”

Contract Issues • If your client is buying in connection with a 1031 Exchange: • “Buyer’s purchase is in connection with an IRC Section 1031 tax deferred exchange. Seller agrees to cooperate with Buyer in such an exchange. Seller agrees buyer MAY assign the contract to a Qualified Intermediary (Exchange Agent) to be chosen by Buyer.”

• If you represent the seller, you should add something like…

• “Buyer agrees that seller will incur no cost or delay in connection with Buyer’s desire to conduct a 1031 Exchange.”

EXCHANGE CONTRACT COOPERATION CLAUSE

To provide the other party to the transaction with notice of the exchange, the Exchanger should have an exchange cooperation clause in the purchase and sale agreement for both the relinquished and replacement properties:

Relinquished Property Buyer hereby acknowledges that it is the intent of the Seller to complete a tax deferred exchange under IRC Section 1031 which will not delay the close of the purchase transaction or cause additional expense to the Buyer. The Seller’s rights under the purchase and sale agreement may be assigned to a Qualified Intermediary of the Seller’s choice for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and the Qualified Intermediary in a manner necessary to complete the exchange.

Refinancing

Refinancing Before or After the Exchange What is the Danger?

• Although refinancing is not a taxable transaction if done too close in time to the beginning of an exchange, it may result in a taxable transaction under the “Step Transaction Doctrine.”

• The IRS can argue that a cash-back refinancing immediately before the exchange is completed is just one step in the many steps of an exchange transaction and, therefore, the refinance loan proceeds should be taxable as boot in the exchange.

Refinancing Before or After the Exchange • If the IRS believes that there was no independent business purpose for the refinance loan, then the result may be unfortunate for the Taxpayer.

• The threshold question is “was the purpose of the loan nothing more than the Exchanger’s desire to take cash out of the equity of either the relinquished or replacement properties without paying the capital gains tax?”

• The refinance loan should not appear to be solely for the purpose of “pulling out equity.”

• As a rule of thumb, the refinance transaction should be separated from the exchange sale or purchase by at least six months.

• At least complete the refinancing transaction prior to listing the relinquished property for sale.

• Document the refinance loan and the sale or purchase as separate transactions to avoid any “Interdependence.”

• The refinance loan should be commercially reasonable and reflect as “independent business purpose.”

Section 121 Exclusion Capital gains tax on principal residences: • First $500,000 of gain for married couples filing a joint return is not subject to tax.* • First $250,000 of gain for single taxpayers is not subject to tax (if a principal residence for two of the prior five years).

• Gain in excess of the exclusion is subject to tax.

• For second homes, every dollar of gain is taxable.

• Section 121 Exclusion can be taken no more often than once every two years.

• If property was subject to a 1031 Exchange, you must live in it FIVE years to qualify for Section 121 Deduction.

Opportunity Zones

OPPORTUNITY ZONES – AN OPTION ?

• Not really a real estate play – it is an investment of capital gains in a qualified fund to defer or avoid capital gain taxes • Advantages • The sale of any type of property qualifies • No like kind requirement ( but Fund must invest in property in a Qualified Zone) • 180 days to invest • Only required to invest capital gain • Disadvantages • No Step Up in basis upon death, but some step up if held > 10 years • Limited flexibility after investment made • Ability to defer gain expires when Fund is sold or December 31, 2026 • Related Party transactions must fall under 20% ownership threshold

QUALIFIED OPPORTUNITY ZONE vs. 1031 Caveat: Uncle Sam can change the law anytime he wants.

It is possible to get into long-term tax planning and have the government change the rules.

Roland’s thoughts…

An experienced investor or business owner dealing with real estate will have a longer timeline and more flexibility with a 1031 Exchange.

He/she will also be better able to preserve gross equity and maybe do some estate planning.

A QOF is a great tool for tax planning and handling capital gains from a sale of non-real estate assets

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