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1031 Exchanges Capital gains Real Estate tax deferment
Under section 1031 of the Internal Revenue Code, a real property owner can sell his property and then reinvest the proceeds in ownership of like-kind property and defer the capital gains taxes. To qualify as a like-kind exchange, property exchanges must be done in accordance with the rules set forth in the tax code and in the treasury regulations. The 1031 exchange can offer significant tax advantages to real estate buyers. Often overlooked, a 1031 exchange is considered one of the best-kept secrets in the Internal Revenue Code.
Who should consider a 1031 exchange?
If you have real property that will net you a gain upon sale (generally property that has been substantially depreciated for tax purposes and/or has appreciated in fair market value), then you are exactly the person who should consider a 1031 exchange.
There are 5 tax classes of property:
1) Property used in taxpayers trade or business.
2) Property held primarily for sale to customers.
3) Property which is used as your principal residence.
4) Property held for investment.
5) Property used as a vacation home.
Section 1031 applies to the first and fourth categories, and potentially the fifth category. Business use is defined as, "To hold property for productive use in trade or business." Property retired from previous productive use in business can be qualifying property. Investment purpose defined as real estate, even if unproductive, held by a non-dealer for future use or increment in value is held for investment and not primarily for sale. Investment is the passive holding of property, for more than a temporary period, with the expectation that it will appreciate. Property held for sale in the immediate future is not held for investment.
Why should you consider a 1031 exchange?
* Defer paying capital gains taxes.
* A properly structured exchange can provide real estate investors with the opportunity to defer all of their capital gains taxes. By exchanging, the investor essentially receives an interest-free, no-term loan from the government.
* Relief from property management. The lessee takes the responsibility to sublet and maintain the property allowing real estate buyers to avoid most of the day-to-day management headaches.
* Upgrade or consolidate property.
* Diversify. Own multiple properties rather than just one.
* Relocation to a new area.
* Differences in regional growth or income potential.
* Change property types among residential, commercial, retail, etc.
What are the 1031 exchange rules?
The real property you sell and the real property you buy must both be held for productive use in a trade or business or for investment purposes and must be like-kind.
The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.
All the cash proceeds from the original sale must be reinvested in the replacement property - any cash proceeds that you retain will be taxable.
The replacement property must be subject to an equal level or greater level of debt than the relinquished property or the buyer will either have to pay taxes on the amount of the decrease or have to put in additional cash funds to offset the lower level of debt in the replacement property.
Identification Period: Within 45 days of selling the relinquished property you must identify suitable replacement properties. This 45 day rule is very strict and is not extended should the 45th day fall on a Saturday, Sunday, or legal holiday.
Exchange Period: The replacement property must be received by the taxpayer within the "exchange period," which ends within the earlier of... 180 days after the date on which the taxpayer transfers the property relinquished, or... the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs. This 180-day rule is very strict and is not extended if the 180th day should happen to fall on a Saturday, Sunday or legal holiday.
Replacement property identification
3-property rule: You may identify any three properties as possible replacements for your relinquished property. More than 95% of exchanges use the 3-property rule.
200% rule: You may identify any number of properties as possible replacements for your relinquished property as long as the aggregate value of those properties does not exceed 200% of the value of your relinquished property.
95% exemption: You may identify any number of properties as possible replacements for your relinquished property as long as you end up purchasing at least 95% of the aggregate value of all properties identified.
In a 1031 exchange you can exchange any real property for any other real property within the United States or its possessions if said properties are held for productive use in trade or business or for investment purposes. Examples of like-kind property include apartments, commercial, condos, duplexes, raw land and rental homes*. As used in IRC 1031(a), the words "like-kind" mean similar in nature or character, notwithstanding differences in grade or quality. One kind of class of property may not, under that section, be exchanged for property of a different kind or class. Examples of qualified like-kind exchanges:
* apartment building for farm/ranch
* office building for hotel
* raw land for retail space
* unimproved property for commercial property
* airplane for airplane
1031 exchange formats
- Two-party swap
- Alderson exchange
* Delayed exchange (most common)
- Safe Harbor
* Multiple sales/acquisitions
* Reverse exchange
* Improvement exchange
History of 1031 exchange
1918 - First income tax law
1921 - Section 202 of Internal Revenue Code states that gain or loss not recognized on exchanges of like-kind property
1924 - Non like-kind exchanges excluded from Section 202
1928 - Code section changed to Section 112(b)(1)
1954 - Section 1031 enacted
1975 - Starker exchange; Tax court approves delayed exchange
1977 - Tax court reverses prior ruling, invalidating delayed exchanges
1979 - 9th Circuit reverses, reinstating initial ruling and creating delayed exchange
1984 - Congress amends Section 1031; 45 day identification period and 180 day exchange period and partnerships excluded
1991 - Regulations 1.1031 passed
2002 - Revenue Procedure 2002-22 issued by IRS; 15 points to clarify TIC interests
The role of the Qualified Intermediary (QI)
The QI is a person or entity that can legally hold funds to facilitate a 1031 exchange. To be qualified, the intermediary must not be relative or agent of the exchanging party. As an exception, a real estate agent may serve as an intermediary if the current transaction is the only instance in which the agent has represented the exchanging party over the past two years.
The use of a QI is essential to completing a successful 1031 exchange. The QI performs several important functions in the 1031 exchange process including creating the exchange of properties, holding the exchange proceeds and preparing the legal documents.
Five different types of IRS § 1031 Exchanges For Real Estate
Types of Exchanges
There are Five (5) major types of tax-deferred exchanges: Simultaneous, Delayed, Reverse "Build-to-suit", and Personal Property 1031 Tax Deferred Exchanges.
A Simultaneous Exchange occurs when the relinquished (sale) property and the replacement (acquired) property are transferred concurrently. Taxpayers doing such an exchange often think it is acceptable if the two transactions close on the same day, and that this alone will satisfy the requirements of an exchange. Taxpayers who do not employ a Qualified Intermediary may be surprised to discover their transaction does not qualify for tax deferral, as without the Intermediary, the seller may be deemed to have "constructive receipt" of the sale money. The Qualified Intermediary creates the reciprocal trade by receiving the relinquished property and acquiring the replacement property. The Intermediary also provides the paper trail validating the flow and structure of the transaction and ensures the compliance with Treasury Regulations.
A Delayed Exchange is much like the Simultaneous, but allows the taxpayer to close escrow on the replacement property at a later date than the relinquished property sale. There are some important rules which must be followed to effectuate a valid Delayed Exchange:
• The exchange must be set up before the close of escrow on the relinquished (sale) property.
• The taxpayer must identify the replacement (acquired) property within 45 days after the close of the relinquished (sale) property.
• The taxpayer must acquire the replacement property within 180 days from the close of the relinquished property, or by the tax return filing of the relinquished property, whichever comes first.
• The taxpayer must reinvest all net proceeds into the replacement property.
• The taxpayer must obtain a debt of equal or greater amount on the replacement property.
A Reverse Exchange is one in which the replacement property is acquired before the relinquished property is sold. The taxpayer cannot receive title to the replacement property and hold it until the relinquished property is sold and then declare the two transactions to be an exchange. In most reverse exchanges, a facilitator will take title to either the replacement property or the relinquished property. This is known as "parking" the property. In a traditional exchange, there are "safe harbor" regulations to guide and protect the taxpayer, but there are no such regulations for a reverse exchange--or much in the way of favorable court guidance. Thus there is a much higher risk in embarking on a reverse exchange. Reverse exchanges can be complicated, and it is highly recommended that the taxpayer seek professional tax and legal advice.
The newly issued Revenue Procedure (REV. Proc.2000-37) provides a safe harbor for reverse exchanges entered into on or after September 15, 2000 provided the taxpayer does the following:
The safe harbor allows a taxpayer to treat. the Exchange Accommodation Titleholder (E.A.T.) as the beneficial owner of the property for federal income tax purposes. The parked property must be held under a Qualified Exchange Accommodation Agreement. The E.A.T. must hold legal title or similar ownership to the property being parked.
The taxpayer must have the intent to park with E.A.T. either the relinquished or the replacement property as part of a 1031 tax deferred exchange. No later than five (5) business days after the transfer of ownership of the property to the E.A.T., the taxpayer and E.A.T. must enter into a written agreement indicating that this is an exchange and that the accommodating party will be treated as the owner of the property for tax purposes.
Within 45 days after the transfer of ownership of the replacement property to the E.A.T., the taxpayer must identify the property to be relinquished.
No later than 180 days after the transfer of ownership of the property (replacement or relinquished) to the E.A.T., the replacement property must be transferred to the taxpayer or the relinquished property to the ultimate to buyer.
An E.A.T. that satisfies the requirements of a Qualified Intermediary under the regulations, may also enter into an exchange agreement with the taxpayer to serve as the Qualified Intermediary in a simultaneous or deferred exchange. The taxpayer can guarantee some or all of the obligations of the E.A.T., including secured or unsecured debt incurred to acquire the replacement property. The taxpayer can also loan or advance funds to the E.A.T. The parked property can be leases by the E.A.T. to the taxpayer or enter into a property management agreement with the taxpayer.
Build-to Suit: The taxpayer can choose to make repairs or build a structure as part of the replacement property. These types of exchanges can be complicated and very time consuming for everyone involved. The taxpayer must first identify the improvements to be made during the identification period, but the Qualified Intermediary must take title to the land in which the improvement will be built, and must contract for the repairs or construction. There are restrictions on how the sale funds can be handled, and the time periods for completion of the work and conveyance of the improved real property must be done prior to the expiration of the 180 day exchange limit.
A Personal Property Exchange allows the taxpayer to exchange planes, business, boats, etc. and other personal property held for investment purposes or the productive use for trade or business, but the definition of "Like Kind" is more specific than that of real property. Please call us for more details regarding the Personal Property Exchange.
IDENTIFICATION OF REPLACEMENT PROPERTY
The taxpayer has 45 days from the close of the relinquished property in which to identify Replacement Property. When identifying replacement property, you have a choice between two rules.
1st Rule: The first rule is known as the three-property rule.
The taxpayer may identify a maximum of three (3) replacement properties without regard to fair market value.
2nd Rule: This rule is known as the 200% rule.
When identifying more than three (3) properties, the total aggregate value of all properties identified cannot exceed 200% of the relinquished property value (or twice the amount of sale price).
Example: Relinquished property sold for $200,000.00 2 x $200,000 = $400,000.00
(The Taxpayer can identify a maximum of $400,000 in Replacement Properties)
1) 123 Main Street, Anytown, TX Value: $75,000.00
2) 1031 USA Avenue, Anytown,WA Value: $135,000.00
3) 555 Exchange Lane, Anytown, NY Value: $65,000.00
4) 1212 Tax Alley, Anytown, CA Value: $125,000.00
TOTAL VALUE LISTED $395,000.00
REPLACEMENT PROPERTY: Once the taxpayer has located a "like-kind" replacement property, ERI will be assigned into the Contract/Escrow Instructions as the Buyer. When this transaction is ready to close, funds held by ERI will be deposited into to escrow to fund the closing. Should escrow require additional funds to close, the taxpayer can deposit funds directly into escrow. The replacement property must be acquired on or before the following dates: 1) 180 days from the date of the transfer of the relinquished property, or 2) the date the tax return is due for the tax year in which the replacement property is transferred (the taxpayer has the right to request an extension).
How Do Most Exchanges Come Into Being?
As a practical matter, many people list their property for sale, and at the time an offer is submitted, they inform the broker that they want to do a tax-deferred exchange. This is usually accomplished by the broker inserting a few words in the Purchase and Sale Agreement to the effect the "Seller" wants to do a tax-deferred exchange. (See cooperation clause below).
"Buyer hereby acknowledges it is the intent of the Seller to effect an IRC Section 1031 tax deferred exchange which will not delay the closing or cause additional expense to the Buyer. The Seller's rights under this agreement may be assigned to a Qualified Intermediary for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and a Qualified Intermeadiary in a manner necessary to complete the exchange."
When a tax-deferred exchange is the ultimate aim of the taxpayer, it is necessary that the taxpayer be restricted from any access or use of the proceeds from the disposition of his property. The essence of an exchange is the transfer of property between owners, while that of a sale is the receipt of cash for property - whether that receipt is actual or constructive if the taxpayer has--or could get--control of the cash.
For more information please contact me.
Capital Gains & Losses Investment Basics
Capital Gains & Losses
Buy low, sell high. Do that and you'll be a successful investor. You'll also have capital gains. This informational flyer will deal with the basics of the tax treatment of capital gains — and capital losses —
Investors receive two types of income: ordinary income and capital gains. Ordinary income includes dividends and interest you receive. You have a capital gain when you sell a capital asset for a profit. Any asset you hold as an investment (stocks, bonds, real estate, for example) is a capital asset. Note: Capital assets do not include supplies (such as paper and pens) or inventory
(anything you regularly sell to customers in your business). Investment assets such as stocks and bonds are not considered inventory — even if you regularly sell them — unless you're a securities dealer. Of course you can also lose money when you sell a capital asset: a capital loss.
Advantages of Capital Gains
Capital gains are better than ordinary income for two reasons. First, you don't pay tax on a capital gain until you sell the asset.
Normally you can choose whether to sell sooner or later, so you control the timing of your gain or loss. For example, you can decide to sell late in December or early in January, depending on which year you want to report your gain or loss. Generally speaking, you don't have that kind of choice with ordinary income, such as interest and dividends. Capital gains have another big advantage over ordinary income: they're taxed at special rates. To qualify for these rates you must have long-term capital gains.
Short-term capital gain is taxed at the same rates as ordinary income.
Special Rates for Long-Term Capital Gain
A capital gain or loss is long-term if you held the asset more than one year (at least a year and a day) before you sold it. At that point you're entitled to a special capital gain rate. In most cases the rate will be 20% (10% if the gain falls within the 15%
bracket). There are exceptions for certain types of assets. The 20% (or 10%) rate should always produce some savings. If your tax bracket for ordinary income is 10% or 15%, the rate on this category of capital gain is 10%; if your ordinary tax bracket is 28% or higher, the rate on this category of capital gain is 20%.
Measuring Capital Gain Your capital gain from a sale is measured by the difference between the amount realized in the sale and your basis in the asset
you sold. Roughly speaking, the amount realized is what you received on the sale — usually measured by the sale price minus the brokerage commission. Your basis is based on your cost (usually the purchase price plus the brokerage commission) but may be adjusted as a result of various events. For example, if your stock splits while you own it, the basis splits, too.
Example: You buy 100 shares of XYZ at $35, paying $3,500 plus a brokerage commission of $40. Your basis is $3,540. Later, you sell when the stock is at $39. You receive $3,900 minus a brokerage commission of $40, so your
amount realized is $3,860. Your capital gain is $3,860 minus $3,540, or $320. If your basis is greater than the amount realized, you have a capital loss.
What About Capital Losses?
Capital losses are used first to offset capital gains. If there are no capital gains, or if the capital losses are larger than the capital gains, you can deduct the capital loss against your other income — up to a limit of $3,000 in one year. If your overall capital loss is more than $3,000, the excess carries over to the next year. In other words, you treat the extra portion as if it were an additional capital loss in the following year.
Example: In 1999 Ted had a $4,000 capital gain, and a capital loss of $11,400. He used $4,000 of the capital loss to offset the capital gain: that left a net capital loss of $7,400. He claimed $3,000 of the loss on his 1999 return. The effect was to reduce his taxable income by $3,000. Ted was in the 31%
Please be aware thereare several new tax laws relating to losses from Hurricane Katrina and Wilma that have come into effect as of the beginning of 2006. Please consult your tax professional.
We work with a number of tax professionals that can assist you with all of your tax related needs.
Private Annuity Trusts As Alternative To A IRS § 1031 Exchange
Tenant In Common
Have you ever driven down the road and noticed a large busy shopping center or a class “A” commercial building and said to your self that you wish you had enough money to buy that property? Do you own a highly appreciated income property that you would like to sell and not pay capital gains taxes or recapture of depreciation but can not identify a quality replacement property for a IRS § 1031 exchange ? Or are tired o dealing with ”Tenants, Toilets and Property Taxes and other property management issues”?
A Tenant In Common Property may be your solution.
Large retail companies with multiple locations or other corporations often choose not to tie up their working capital in real estate so they lease properties on a long term basis. Some of these leases can be 10, 25 or 50 years or more. They lease the property and on a Triple net or NNN basis.
Very often these properties are owned by a group of investors called Tenants In Common.
What is Tenants-in-Common (TIC)?
A TIC is a form of real estate asset ownership in which two or more persons have an undivided, fractional interest in the asset, where ownership shares are not required to be equal, and where ownership interests can be inherited. Each co-owner receives an individual deed at closing for his or her undivided percentage interest in the entire property. Through TIC ownership, the average person is able to enjoy ownership in an institutional-type property with a minimum investment.
NNN PLUS Lease
The NNN PLUS lease is a triple-net lease in which the lessee completely leases the replacement property under an escalating rental payment plan. The lessee takes on the responsibility to sublet the property. In addition to rent, a tax, insurance and maintenance, the lessee also pays the debt-carrying expenses.
TIC interests combined with a NNN PLUS lease provide the real estate buyer with the advantages of ownership in a larger property with appreciation, revenue and annual depreciation benefits without many of the management problems associated with individually-owned rental property.
The triple-net lease ends whenever the Tenants-in-Common (TIC) vote to terminate it or, in any event, when the TIC owners sell the entire property. The lessee is a real estate ownership and management company with an established history of 1031 experience.
What are the benefits of TIC ownership?
The TIC structure has various features that make it attractive to the real estate buyer.
Access to Higher Grade Properties - The typical entrance in whole commercial building begins at $1 million, but through TIC ownership, the average person is able to enjoy ownership in an institutional-type property with a minimum purchase. Besides reliable income and growth potential, these properties are able to attract tenants with greater financial strength and stability than possible for the individual landlord.
Combined Real Estate Experience - As an alternative to sole ownership of real estate, a 1031 buyer can take ownership in a large commercial property along with other unrelated buyers, not as limited partners, but as individual owners. Each of the TIC owners brings their previous real estate knowledge to the group. Thus, each decision of the TIC ownership will be backed by many years of real estate experience.
Lessee with an established history of 1031 experience in Real Estate - Most of the day-to-day property operations are handled by the NNN PLUS lessee. The lessee has extensive experience in real estate. Thus, situations that arise in day-to-day operations will be addressed quickly and efficiently, and the TIC owner will enjoy the freedom from property management.
Simple Management - The TIC owner avoids the time and frustration of dealing with multiple tenants. You no longer deal with "toilets, tenants and trash," and simply receive your monthly rental income from your mailbox. Enjoy "tennis, travel and time with family."
Exact Dollar Matching - In a TIC property, you can purchase any amount above the minimum. For example, if you have $152,479 of equity from the sale of a previous property you can purchase $152,479 of equity in a TIC property.
Low Minimums - Revenue Procedure 2002-22 issued by the IRS allows up to 35 TIC owners in any one property. Minimum purchase requirements are structured to meet this limitation and can range as low as $150,000 equity.
Non-recourse Financing - The mortgages on most of the TIC properties offered by FOR 1031 are non-recourse. The TIC debt structure generally allows for the debt financing to assumed. Assumption usually occurs without the need for qualification or loan assumption fees.
Diversification - Due to the low minimums in TIC properties, the buyer can decrease risk by diversifying into different properties in various different marketplaces.
Speed and Simplicity - Speed and simplicity are achieved due to the efforts of the FOR 1031 team. The negotiation process is complete, and survey, rent rolls, etc. are already completed and available for your review. After your review of all the due diligence used to acquire your property, and upon your approval, you are ready to close. The closing can be completed in days, not months.
No Closing Costs - Absent seller default or other items outside the control of FOR 1031, closings are met within the agreed upon time frame. FOR 1031 does not charge the TIC owners any closing costs.
Deeded Interest - The TIC owners buy the property and receive a deeded interest. You can transfer this interest by gift, sale, inheritance, assignment, etc. Such transfer does not need to coincide with the transfer of all TIC interests in the property. DBSI Housing, if requested to do so by the TIC owner, will assist in the marketing of any TIC interest.
No Special Allocations - All the TIC owners receive monthly rental payments, sale proceeds and the depreciation tax benefits in proportion to their percentage ownership in the property.
Impasse Resolution Procedure - On a decision requiring unanimous vote, such as a sale decision, a 60% - 75% (depending on your TIC agreement) vote by the TIC owners will be sufficient to initiate the impasse resolution procedure. This procedure allows the TIC owners with 60% - 75% (depending on your TIC agreement) or more of the property to make an offer to buyout the dissenting owner with 25% or less of the property. The dissenting TIC owners can either: (1) accept this offer, (2) buy out the 60% - 75% (depending on your TIC agreement) TIC owners at the same price per percentage ownership, or (3) change their dissenting vote to a consenting vote.
Disclaimer: The above brief description is not to be construed as legal or tax advice and is qualified in its entirety by the actual closing documents. In case of any discrepancy, the actual closing documents will control.
We have relationships with the companies that purchase and manage these first class properties and sell Tenant In Common ownership and would be pleased to provide more information to you regarding these opportunities.
Question: In a nutshell, what is TIC ownership? Answer: TIC ownership combined with NNN leases provide the real estate buyer with the advantages of ownership in a larger property, revenue and annual depreciation benefits without many of the day-to-day management problems associated with individually-owned rental property.
Question: What purchase amounts are ordinarily required for TIC ownership? Answer: Revenue Procedure 2002-22 issued by the IRS allows up to 35 TIC owners in any one property. Minimum purchase requirements are structured to meet this limitation and can range as low as $150,000 equity. The typical entrance in whole commercial building begins at $1 million, but through TIC ownership, the average person is able to enjoy ownership in an institutional-type property with a minimum purchase. Besides reliable income and growth potential, these properties are able to attract tenants with greater financial strength and stability than possible for the individual landlord.
Question: What happens if fail to close on my 1031 exchange? Answer: You will have to pay your capital gains taxes. Failure to close is the top reason clients reveal as to why they pay capital gains. By identifying a TIC property, you can reduce your potential tax risk, and avoid a failed closing. If you fail to close on other identified properties, you are able to move all your proceeds into the TIC property you identified.
Question: Is there any liability exposure associated with TIC ownership? Answer: The mortgages on most of the TIC properties offered by FOR 1031 are non-recourse. The TIC debt structure generally allows for the debt financing to assumed. Assumption usually occurs without the need for qualification or loan assumption fees.
Question: What if I want to sell my TIC ownership? Answer: On a decision requiring unanimous vote, such as a sale decision, a 60% - 75% (depending on your TIC agreement) vote by the TIC owners will be sufficient to initiate the impasse resolution procedure. This procedure allows the TIC owners with 60% - 75% (depending on your TIC agreement) or more of the property to make an offer to buyout the dissenting owner with 25% or less of the property. The dissenting TIC owners can either: (1) accept this offer, (2) buy out the 75% TIC owners at the same price per percentage ownership, or (3) change their dissenting vote to a consenting vote.
Question: What happens to my TIC ownership if I die? Answer. Your ownership interest will pass to your heirs pursuant to your will just like any other asset. Currently, the estate tax code provides that they will also receive a stepped-up tax basis to fair-market value, but you should check with your CPA or tax adviser because not all circumstances are alike. The income taxes which were deferred because of your 1031 exchange are potentially forgiven forever.