FIVE REASONS TO EXCHANGE: INVESTORS CAN MEET MANY OBJECTIVES UNDER IRC §1031

Section 1031 tax deferred exchanges continue to increase in popularity as more investors nationwide discover the wide range of investment objectives that can be easily met through exchanging.

I. PRESERVATION OF EQUITY

A properly structured exchange provides real estate investors with the opportunity to defer 100% of both Federal and State capital gain taxes. This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash! Often the capital gain taxes are deferred indefinitely because many investors continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with each exchange!

II. LEVERAGE

Many investors exchange from a property where they have a high equity position, or one that is “free and clear”, into a much more valuable property. A larger property produces more cash flow and provides greater depreciation benefits, which therefore increase the investors’ return on their investment.

III. DIVERSIFICATION

Exchangers have a number of opportunities for diversification through exchanges. One option is to diversify into another geographic region, such as exchanging out of one apartment building in Denver, Colorado, for two additional apartments – one in Los Angeles, California, and the other in Dallas, Texas. Another diversification alternative is acquiring a different property type, such as exchanging from several residential units to a small retail strip center.

IV. Management Relief

Some investors accumulate several single family rentals over the years. The on-going maintenance and management of what can be a far-reaching group of properties can be lessened by exchanging these properties for one property better suited to on-site maintenance and management. Exchanging into a single apartment complex with a resident manager is a good example of this strategy.

V. ESTATE PLANNING

Sometimes a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property, which they can either hold or sell.

Call the knowledgeable exchange professionals at Asset Preservation for a complimentary consultation regarding your specific investment objectives.

FARM AND RANCH EXCHANGES: OPPORTUNITIES ABOUND WHEN SELLING RURAL REAL ESTATE

 

 

Section 1031 of the Internal Revenue Code permits real and personal property that is “held for productive use in a trade or business” or “held for investment” to be exchanged for other “like-kind” property while deferring capital gains and recapture taxes that would otherwise result from the sale of a property. In the context of real property, the definition of “like-kind” is so broad that almost any perpetual interest in real property of any type will be treated as like kind to any other perpetual real property interest. Consequently, one is not limited to an exchange of a ranch for another ranch or a farm for another farm. Instead, a farm can be exchanged for a commercial office property, a residential rental property or even raw land. Finally, a sale of a farm or ranch often consists of selling real and personal property. As discussed below, both may qualify for deferral in a 1031 exchange.

REAL PROPERTY

Real property held for productive use in a trade or business or for investment can be exchanged for any like-kind real property to be held for either investment or for productive use in a trade or business. When dealing with the sale of a farm or ranch, the most obvious form of qualifying real property is the actual acreage. However, land used as a farm or ranch can present additional 1031 exchange opportunities. For example:

1. In states where water rights are considered to be real property, many farmers and ranchers are exchanging their rural water rights to acquire income producing real estate, thereby increasing cash flow and reaping tax benefits from depreciation deductions.

2. Mineral rights may provide another 1031 exchange planning opportunity.

3. Some rural property owners are conveying conservation easements on their land to acquire more productive property through an exchange.

4. A 1031 exchange has been extremely useful in the granting of an agricultural easement in exchange for fee simple title in different property.

5. Easements for cell towers can also qualify for a 1031 tax deferral treatment.

6. Mitigation credits for restoring wetland property may be exchanged for other mitigation credits.

A seller of a farm or ranch may be able to take advantage of two different tax code sections to minimize capital gain tax liabilities on the sale of real property. Under IRC §121, for example, farm and ranch sellers can often qualify for a tax exclusion on the primary residence portion of their property, while most or all of the remainder of the property can qualify for tax deferral under IRC §1031. IRC §121 allows a property owner to exclude capital gain taxes if the home was their primary residence for two (2) of the last five (5) years. Couples filing a joint tax return can exclude up to $500,000 of the capital gain on the sale of their principal residence while single filers can exclude up to $250,000.

PERSONAL PROPERTY AND LIVESTOCK

Section 1031 permits personal property held for investment or used in a business to be exchanged for other similar personal property that is in either the same General Asset Class or the same Product Class. Many farm and ranch sales include significant irrigation equipment, farm machinery and tractors. The IRS has established 13 General Asset Classes along with a more detailed description of Product Classes, which are specified in the North American Industry Classification System (NAICS).

Livestock held for investment may also be exchanged, although livestock held primarily for sale would not qualify. Furthermore, IRC §1031 states that livestock of different sexes are not like-kind property. Most tax advisors believe breeding livestock that are not held primarily for sale can be exchanged. Although a bright line standard regarding exchangeable livestock does not currently exist, some tax advisors are of the opinion that a purebred registered beef cow may be like-kind to a grade beef cow because they differ only in quality or grade. On the other hand, a dairy cow might not be considered like-kind to a beef cow because they represent two different types of livestock. As always, review all aspects of any proposed farm or ranch exchange with a competent tax and/or legal advisor along with a reputable leading national exchange qualified intermediary, Asset Preservation, Inc.

EXCHANGE ENTITIES: CONSIDER THESE VESTING ISSUES PRIOR TO A §1031 EXCHANGE

Generally in a §1031 tax deferred exchange, an Exchanger should take title to the replacement property in the same manner they held title on the relinquished property. In most cases, the entity initiating the exchange must be the same entity concluding the exchange. Some examples are reflected below:

· If a wife relinquishes, then the wife acquires;

· Smith LLC relinquishes, Smith LLC acquires;

· Gemco Corp. relinquishes, Gemco Corp. acquires;

· Durst Partnership relinquishes, Durst Partnership acquires.

Some Exceptions to the General Rule

Partnerships and Limited Liability Companies (LLC’s): An Exchanger who elects taxation as a sole proprietorship can hold the relinquished property as an individual but acquire the replacement property as a single-member, single-asset LLC.  This provides the benefit of liability protection and also can help satisfy the ‘single asset entity’ requirements that many lenders impose on replacement property purchases.  The IRS has also ruled that a limited liability company with two members will be considered a single member limited liability company if the sole role of one of the members is to prevent the other member from placing the LLC into bankruptcy and that the limited role member had no interest in LLC profits or losses nor any management rights other than the limited right regarding bankruptcy.

Grantor Trusts: An Exchanger can acquire a replacement property in a revocable living trust or “grantor” trust for estate planning purposes.

Death of an Exchanger: If the Exchanger dies during the exchange, the deceased Exchanger’s estate may complete the exchange.

BUSINESS CONSIDERATION/LENDER REQUIREMENTS

Sometimes a business consideration, lender requirement or the Exchanger’s liability issues can make it difficult to keep the vesting entity the same throughout the exchange. For this reason, it is important that Exchangers review the entire exchange transaction with their legal and/or tax advisors before closing on the sale of the relinquished property. Some problem areas:

If a wife, as the only Exchanger, is relying on the husband’s income to qualify for replacement property financing, the lender may require that the husband appear on the deed. This could have an impact on the wife’s exchange.

Most lenders are wary about lending to trustees. An Exchanger who relinquishes property in a trust but needs to obtain conventional financing for the purchase may have difficulty obtaining a loan because lenders prefer loaning to an individual.

Sometimes an Exchanger may relinquish a property in one entity such as multi-member LLC, corporation or partnership but want to acquire a replacement property in a different entity. This would disqualify the exchange.

Commercial Real Estate Returns for the Past 10 Years -- 117 Percent Combined Operating Profits and Property Value Change in a Decade

The National Council of Real Estate Investment Fiduciaries (NCREIF) http://www.ncreif.org/about.aspx  is a non-profit  trade association for pension funds and other tax-exempt investors in real estate created to aggregate and report accurate, unbiased real estate return data. 

One of the many data series they provide is the NCREIF Property Returns Index reporting quarterly performance in both property value and operating income for  more than 6,800 commercial properties having a combined value in excess of $283 billion.  A description of the index and the quarterly can be found http://www.ncreif.org/property-index-returns.aspx  This series is perhaps the best proxy for U.S. commercial real estate performance.

In the past 10 years, average annual return of the index was 7.73 percent, with a combined 13.56 percent total return (property value change and operating income) in 2011.  While some of the properties are leveraged using debt, the index is calculated as if all properties were unlevered. 

Commercial real estate was one of the top investment performers in 2011.  In the past decade, the total return was more than 117 percent—a more than doubling of the original investment.  

For a look at all of the NCREIF data series (including timberland) click  http://www.ncreif.org/data.aspx

Good News about Real Estate Market

Good news from Dr. Ted Jones:

The National Association of Realtors® reported February 2012 homes sales of 4.59 million on a seasonally-adjusted annualized rate—a gain of 8.8 percent when compared to February 2011.  That’s really good news for the housing market since home prices typically follow the trajectory of sales numbers, although lagging 18 to 24 months.   

To remove the seasonality noise from the data, the following table shows a 12-month moving average of existing home sales.  Focus on the rising sales numbers in the red circle and realize that the market indeed is recovering.  Existing home sales on a 12-month moving average basis have now increased in six of the past seven months. 

Home values may have finally stabilized, after declining almost 27 percent from the peak in July 2006.  This now makes three months that prices (on a 12 month moving average) have remained static.  I am calling a bottom to the housing market at this time.

While home sales and prices are far off of the 2002 levels (which I consider normal given that period was following the 2001 recession and prior to the stupidity of subprime lending which caused the bubble), sales numbers are finally increasing and prices have stabilized.  I truly believe that housing has turned the corner to recovery—and that is great news.

To read the entire NAR press release, click: http://www.realtor.org/press_room/news_releases/2012/03/ehs_feb

Ted C. Jones, Ph.D.
Senior Vice President-Chief Economist, Stewart Title Guaranty Company
Director of Investor Relations, Stewart Information Services Corporation NYSE-STC

DEPOSITS IN AN EXCHANGE: HANDLING EARNEST MONEY DEPOSITS IN AN EXCHANGE

Most offers to purchase real estate are accompanied by the Buyer’s delivery of a check to the Seller generally referred to as an “Earnest Money Deposit”.  Depending on the terms of the purchase agreement, the earnest money deposit may be refundable or non-refundable.  In most cases, the delivery of the earnest money deposit is refundable and merely serves as evidence of the Buyer’s intent to purchase a property.

In a tax deferred exchange under Internal Revenue Code Section 1031, however, the Seller (Exchanger) is generally prohibited from receiving the proceeds from the sale of the relinquished property.  An Exchanger receives sale proceeds if “. . . the taxpayer actually receives the money or property or receives the economic benefit of the money or property.  The taxpayer is in constructive receipt of money or property at the time the money or property is credited to the taxpayer's account, set apart for the taxpayer, or otherwise  made available so that the taxpayer may draw upon it at any time or so that the taxpayer can draw upon it if notice of intention to draw is given.”

As a result of the foregoing rules, Exchangers are rightfully concerned about the tax consequences resulting from their receipt of an earnest money deposit or the payment of an earnest money deposit to a Seller in connection with the acquisition of replacement property. Some of the typical questions that Asset Preservation receives are discussed below:

If a Seller of an investment property is planning to engage in a §1031 tax deferred exchange, can  the Seller accept an earnest money deposit and still obtain full tax deferral?  The answer is usually, yes.  First, the question of whether the Exchanger is in receipt of the sale proceeds is determined at the time ownership is transferred from the seller to the buyer (usually referred to as the “closing”).  Thus, if the Exchanger enters into a qualified exchange agreement before the closing as required when engaging in a tax deferred exchange, and thereafter deposits the earnest money funds with the Qualified Intermediary or the Closing Agent before the closing occurs, the receipt of the earnest money deposit should not be treated as the receipt of the sale proceeds.  On the other hand, if the Exchanger keeps the earnest money deposit through the closing, he or she would be in receipt of proceeds from the sale. In this case, the deposit would constitute boot in the exchange, thus would be taxable to the extent there is a capital gain.

Can an Exchanger pay an earnest money deposit to a Seller of replacement property?  Yes. There are two ways to accomplish this within a tax deferred exchange. If the Qualified Intermediary is holding exchange funds from the sale of the Exchanger’s relinquished property, the deposit can be wire transferred directly to the Closing Agent or Seller for the Exchanger after the replacement property exchange agreement has been fully executed by the Exchanger. Alternatively, the Exchanger can pay the earnest money directly to the Closing Agent or Seller from their own funds and get reimbursed their deposit at the closing without creating a taxable event.  The Exchanger may enter into contract on the replacement property before entering into contract on their relinquished property, but it is important to close on the relinquished property prior to purchasing the replacement property in order to avoid a "Reverse Exchange" situation. 

Can an Exchanger get reimbursed for their earnest money deposit paid for the replacement property?  Yes. Assuming that the Exchanger has paid the earnest money deposit from their own funds, the Qualified Intermediary may direct the closing agent to include an item on the closing statement evidencing the return of earnest money funds to the buyer such as “Refund of Earnest Money to Buyer”. The Qualified Intermediary would then transfer funds to the closing agent in an amount sufficient to reimburse the Exchanger.

Rents are Rising

"[A] large and growing pool of renters is spurring investors to purchase distressed inventory in order to convert it to rental inventory," Between January 2011 and January 2012, median rents increased by 3 percent.

Median rent increased from $1,182 in January 2011 to $1,218 in January 2012. Rents are up in 69.2 percent of the metropolitan areas tracked by Zillow, which bases its numbers on rent estimates from 84.9 million properties.

Why rents are rising as home values fall

http://www.theatlanticcities.com/housing/2012/03/why-rents-are-rising-home-values-fall/1479/

CREATIVE EXCHANGE PROPERTY: EXPLORE A NEW UNIVERSE OF 1031 EXCHANGE OPPORTUNITIES

Sometimes we miss opportunities because we see what we expect to see. An investor that owns an apartment complex is likely to consider selling only if there is another investment property with better cash flow -- usually another apartment complex. A little imagination, however, can open up a whole new world of opportunities. As Willy Wonka noted in Charlie and the Chocolate Factory, “invention, my dear friends, is 93% perspiration, 6% electricity, 4% evaporation, and 2% butterscotch ripple.” Is there room for such creativity in the world of real estate investment?

Yes indeed. With the slow down in real estate sales activity across the United States over the last few years, some investors are utilizing creative investment strategies to generate current income, diversify their real estate portfolios and utilize Internal Revenue Code §1031 to defer capital gain taxes. While traditional sales activity has certainly declined, other real estate investment activity has remained stable or increased. Examples include the purchase and sale of timber rights, agricultural land, mineral rights, oil and gas investments, water rights, conservation easements and renewable wind and solar energy projects. Each of the foregoing investment classes have a common denominator in that they are, more or less, investments in real property and may be sold as relinquished property or purchased as replacement property to complete a §1031 tax deferred exchange. In many instances, these interests can be exchanged for a fee simple interest in other improved or unimproved real estate to be held for investment or used in a trade or business. The IRS has held that many separate interests that are included in the bundle of rights that constitute “real property” under state law, are like-kind to a fee interest in improved or unimproved real property, including:

· A perpetual easement for a fee simple interest in improved or unimproved real property (PLR 9601046);

· A conservation easement in farm property for a fee simple interest in other real property (PLR 9232030, 9621012);

· An agricultural use easement in farm property for a fee simple interest in other farm property (PLR 9851039);

· Mitigation credits for other mitigation credits (PLR 9612009);

· Timber rights for fee simple interest in other real property (TAM 9525002);

· Transferable development rights (rights used to construct improvements on a property)(PLR 200805012);

· Water rights for fee simple interest in other real property (Rev. Rul. 55-749. PLR 200404044).

Thus, the foregoing interests in real property in many cases can be exchanged under Section 1031 for all of the rights constituting a fee interest in real property, or acquired as replacement property following the sale of a fee simple interest. If you look, you will be surprised at the wide range of real property interests that qualify for tax deferral under Section 1031.

Fractional ownership interests in real property provide yet another investment opportunity. An investment as a tenant-in-common (“TIC”) in income-producing property or similar ownership structures created by sponsors using a Delaware Statutory Trust (“DST”) offer investors the opportunity to acquire a slice of a much larger replacement property that is often managed by a third party property manager. In some high density areas, such as New York City, property owners are exchanging their “co-op” investment properties for a fee interest in other investment property. A simple change in the use of property from a non-qualifying use to a qualifying use presents another opportunity that is sometimes not considered. With proper planning, a real property asset that was held for personal use and enjoyment rather than for investment, such as a vacation home or former residence, can be converted into an investment property that can be exchanged for other like-kind property. (See e.g., Rev. Proc. 2005-14). Some exchanges don’t involve any equity at all. In what is sometimes referred to as a ‘no equity exchange’ transaction, a taxpayer who is forced to give a property back to a lender can defer capital gain taxes by acquiring a replacement property and investing the funds that would otherwise be needed to pay capital gain taxes into an income producing property. Finally, many types of personal property held primarily for investment can also be exchanged for like-kind property, including aircraft, collectible cars, artwork and collectible coins.

According to scientists at the Institute of Food Research, researchers may have developed a way to realize Wonka’s plan to combine three meals in a single stick of chewing gum. Apparently, advances in nano-technology now permit several distinct flavors to be packed into food structures (called colloidosomes) that break down over time with chewing. As Wonka surmised, one stick of gum may be able to deliver “tomato soup, roast beef, baked potato and blueberry pie.” A §1031 exchange of a routine investment property can produce a green energy property, a perpetual easement and mineral rights. Now, chew on that.

CONVERTING A RESIDENCE TO A RENTAL: “REVENUE PROCEDURE 2005-14: APPLYING §1031 AND §121 TO A SALE”

REVENUE PROCEDURE 2005-14

The IRS recently gave guidance on Revenue Procedure 2005-14 on how to report exchanges of property used as a principal residence and for business/investment use in the last five years. A property owner can convert a principal residence to a rental property and later sell it and benefit from both IRC §121 (principal residence tax exclusion rules) and IRC §1031 (investment property tax deferred exchange rules). Property owners must comply with all the rules in both sections to qualify.

APPLICATION OF §121 AND §1031

If a property owner has owned and lived in a principal  residence for at least 2 out of the last 5 years preceding the sale of the principal residence, $250,000 if filing as a single ($500,000 on a joint return) of the gain from the sale, except for any depreciation taken on the property since May 6, 1997, can be excluded. IRC §121 does not require the owner to live in the property at the time of the closing to qualify for the gain exclusion.  A principal residence does not qualify if it was purchased in a §1031 exchange within the previous five years.

In essence, the Treasury has declared that if an owner lives in the residence long enough to meet the principal residence requirements, they may then convert the house into a property “held for investment” which can qualify for a §1031 exchange. (Note: Although there is no defined “holding period” to be considered “held for investment,” many tax/legal advisors believe 1-2 years is sufficient barring any factors which contradict an investment intent.) The property owner can perform an IRC §1031 exchange and still be eligible for gain exclusion under IRC §121, even if it is presently being used as a rental.

When the owner sells the home as an investment property, they must still meet all the necessary requirements for a §1031 exchange. This includes hiring a Qualified Intermediary prior to closing on the relinquished property and adhering to all the time requirements of an exchange, such as identifying the replacement property within 45 calendar days from the sale date and purchasing all replacement properties within 180 days, or the owner’s tax filing date, whichever is  earlier. 

DEPRECIATION

The property owner can exclude gain up to $250,000 (filing as a single) or $500,000 (filing jointly) under IRC §121 except for any depreciation taken on the property after May 6, 1997. Realized gain is first excluded under IRC §121 and then is eligible for deferral under IRC §1031.

The revenue procedure provides six examples that include illustrations of the treatment of depreciation and boot in which both the benefit of §121 exclusion and §1031 deferral could be used. Please visit the “Tax Code/Legal References” section at apiexchange.com to read the full text of Revenue Procedure 2005-14.

CONVERTING A RENTAL TO A RESIDENCE: “MANY TAXPAYERS CAN TAKE ADVANTAGE OF TWO TAX CODE SECTIONS”

Some taxpayers take advantage of exchanges and the tax deferral available under IRC §1031 and later convert their former rental house to a principal residence to qualify for the tax exclusion available under IRC §121.

HOW LONG TO RENT THE §1031 PROPERTY?

Section 1031 of the tax code does not provide a defined “holding period” for investment properties. The time period the property is held is only one factor the IRS may look at to determine the taxpayer’s intent to hold for investment. The IRS can examine all the other facts and circumstances that may or may not support the intent to hold for investment.

Some legal and tax advisors recommend that a taxpayer hold a §1031 exchange property for a minimum of at least twelve months. The reason for this is that a holding period of 12 or more months results in the taxpayer reflecting the property as an investment property in two tax filing years. Another perspective is holding the §1031 exchange property for at least two years. In one Private Letter Ruling (PLR 8429039), the IRS stated that a minimum holding period of two years was sufficient. Many legal and tax advisors who believe two years is a conservative holding period, provided no other significant factors to contradict the investment intent.

IRC §121 - PRINCIPAL RESIDENCE EXCLUSION

Exclusion of up to $250,000 of the capital gain on a principal residence for a single taxpayer and $500,000 for a married couple filing jointly. The taxpayer must own and use the home as a principal residence 2 of the 5 years prior to the sale.

HOUSING ASSISTANCE ACT OF 2008

As a result of the Housing Assistance Act of 2008, beginning January 1, 2009, the Section 121 exclusion must be allocated between the period the principal residence was used as an investment property and the period of time the residence was used as a principal residence. Any portion of the exclusion amount that is allocable to the period the property is not used as a principal residence is eliminated.

In general, the allocation rules only apply to time periods prior to the conversion into a principal residence and not to time periods after the conversion out of principal residence use. Accordingly, if a single taxpayer converts a principal residence into a rental property and never moves back in, and otherwise meets the two out of five year relinquished under §121, the taxpayer is eligible for the full $250,000 exclusion when the rental property is sold. This rule only applies to non-qualified use periods within the 5 year lookback period of §121 after the last date the property was used as a principal residence. Therefore, if the taxpayer used the property as a principal residence in year one and year two, then rented the property for years three and four, and then used it as a principal residence in year five, the allocation rules would apply and only three-fifths (3 out of 5 years) of the gain would be eligible for the exclusion under §121. Every taxpayer is urged to seek the advice of a tax advisor to review their specific situation and application of the tax rules.