The following  memorandum with general information on 1031 Exchanges was provided by Richard Frunzi Consulting in Kahului (808)873-5900:

 

 

RIIICHARD L. FRUNZIII, J.D.

Business and Tax Consulting

Memorandum

Use Of Like Kind Exchanges Under Section 1031

The purpose of Section 1031 is to permit the deferral of income tax on the gain from the

sale of real property used in a trade or business or held for investment purposes. In essence, it

permits a taxpayer to sell one piece of real property to sell their interest in the property and rather

than pay income taxes on the gain earned from such sale, to invest a portion or all of the net sales

proceeds earned from the sale into one or more qualifying properties, thereby deferring the

recognition of the gain, perhaps indefinitely.

To qualify for the tax-free treatment of Code Section 1031, following the sale of an

investment property (or properties) the taxpayer must purchase “like kind” property or properties

with a purchase price equal to or in excess of the net sales price of the property being sold within

the statutory time frame. If such qualifications are met, the gain from the sale of the first property

(or properties) is tax-free; more accurately, the gain from the sale is deferred until the taxpayer sells

the replacement property in a taxable sale. Since the taxpayer’s basis in the new property is the

lower carryover basis of the old property (increased only by additional debt or cash consideration

advanced to purchase replacement properties), the Internal Revenue Service is ultimately guaranteed

its tax when the replacement property is sold at a later date with the lower basis from the first

property (supposedly for a profit).

To understand the benefits and detriments of using a tax-free exchange under Code Section

1031 to defer the tax from a gain in real property, it is important to first understand the mechanics

of how a gain from the sale of real property other than a residence is taxed under the Code. While

some of this information is basic in nature, a brief review at this time may be appropriate.

Deferral of Recognition of Realized Gain. The rules of Code Section 1001 require any

realized gain from the sale of real property to be “recognized” for income tax purposes unless any

of the deferral provisions of the Code permit the gain not to be recognized at the time of the sale.

Stated differently, the Code requires any gain from the sale of a capital asset such as real property to

be subject to immediate taxation unless a specific provision of the Code allows non-recognition.

Realized Gain. The difference between the “net sales price” and the taxpayer’s “adjusted

basis” in the real property that is sold is considered the amount of gain that is “realized” by a

taxpayer upon the disposition of the property.

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Net Sales Price. The definition of “net sales price” is considered to be the amount of

proceeds received in the sale reduced by all of the costs attendant to sell the property (the “closing

costs”) such as realtor’s commissions, escrow fees and recording costs.

Adjusted Basis. The definition of a taxpayer’s “adjusted basis” in real property is the cost

of acquisition of the property increased by the cost of any capital improvements to the property and

reduced by the amount of depreciation taken against the value of the property.

Mathematically expressed, the calculation to determine the amount of gain from the

disposition of real property would be as follows:

GROSS SALES PRICE

– (costs to effectuate sale)

NET SALES PRICE

– (adjusted basis in property)

REALIZED GAIN FROM SALE OF PROPERTY

Non-Recognition of Section 1031. It was the intent of Congress when enacting Code

It was the intent of Congress when enacting Code

Section 1031 to permit an individual to not recognize the realized gain from the sale of one piece of

real property when the taxpayer concurrently purchases a different piece of real property. The

requirements of this Code Section are quite complicated. Of particular importance is that Section

1031 does not permit a taxpayer to take receipt of the cash from the sale of the “original” or

“subject” property and then use such proceeds for the purchase of one or more “replacement

properties.”

The receipt of the proceeds from the sale of the subject property is fatal to qualifying for the

tax-free treatment of an exchange. Court cases have held that even leaving the proceeds from the

sale of the subject property in the first escrow with instructions for the transfer of such proceeds to

a second escrow to complete the exchange fails to qualify as a tax-free exchange under the rules of

Code Section 1031.

In summary, the use of a “1031 exchange” permits an individual to sell a parcel or parcels of

real property for $150,000 with an adjusted basis in the property of $50,000 and not pay income tax

on the $100,000 gain from the property as long as the individual purchases property meeting the

qualifications of Code Section 1031 with a value of at least $150,000, less the closing costs to

effectuate the sale of the subject property.

Note: Section 1031 does not permit the reinvestment of only the profits from the sale ofthe subject real property. In order to make an exchange wholly tax-free under

Code Section 1031, the entire net sales price must be reinvested into a

replacement property or properties.

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If, on the other hand, our taxpayer above did not qualify for the tax-free treatment afforded

under ode Section 1031, the gain of $100,000 would be subject to immediate taxation for both

federal and state income tax purposes. At the highest federal income tax rates, there could be as

much as $15,000 if the property has been held for the more than one year period required for long

term capital gains treatment and at the highest State of Hawaii income tax rate, there could be as

much as $7,250 in income taxes due as a result of the gain from this sale.

The requirements of Code Section 1031 are straightforward:

1. Like Kind. The property which is purchased as a replacement for the property

exchanged must be “like kind” to the property sold. The definition of “like kind” is a fairly broad

classification. Under current law, all real property, improved or unimproved, commercial or

residential, is considered “like kind.” Treasury Regulations 1031(a)-1(b).

Watch Out for Fee Simple/Leasehold Problems. It is important to note that fee

simple real property is not “like kind” to leasehold property which has less than thirty (30) years

remaining in the lease. Fee simple real property is considered “like kind” to leasehold property with

thirty or more years remaining in the lease term. Treasury Regulations 1031(a)-1(c).

Note Regarding Proposed Tax Changes That Never Materialized. Under a tax

proposal introduced a ways back in the late 1980’s, the House Ways and Means Committee

proposed that the “like kind” standard currently in use for tax-free exchanges under Code Section

1031 be replaced with the more strict “similar use” standard (currently in use for involuntary

conversions under Code Section 1033). This standard is much stricter than the “like kind” standard

which would permit the exchange of, for example, a parcel of raw undeveloped land for a

condominium. Under the “similar use” standard, the replacement of such raw undeveloped land for

a condominium would not qualify for the tax-free treatment afforded under Code Section 1031.

This proposal was rejected by Congress prior to its adjournment at the time. The final

regulations have not adopted the similar use standard. Unfortunately, however, one can never

predict what Congress may do in the future.

2. Investment Versus Speculation. Under the terms of Code Section 1031, an

exchange is only permitted for:

• property held in use for a trade or business; or

• property held for investment.

Property held for speculation specifically is not permitted to reap the benefits of the tax- free

treatment accorded to investors under Code Section 1031. Neither are dealers in real property

accorded the tax-free treatment afforded under this Code section. Its benefits are only available to

persons or entities who hold such real property for investment purposes.

What is the Necessary Time Period an Individual Must Hold Real Property

for it to Be Investment Property? Under the current provisions of the Code and the Treasury

Under the current provisions of the Code and the Treasury

Regulations, the necessary holding period to qualify property as “held for investment” is still not

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entirely clear. Note that each subject property “sold” and the replacement property “bought” must

meet the holding period requirements.

Service’s Position. It is the position of the Internal Revenue Service that as long as

the taxpayer holds title to the subject property for at least two (2) years, the property will be

qualified as “held for investment.”

Court Cases. It has been held by one court that a taxpayer who had only held the

subject property for approximately six (6) months had held the property for speculative purposes

and not as an investment.

What Does This All Mean? If you hold your subject property for at least two

years, no problem. If less than six months, you probably won’t qualify for tax-free treatment under

Code Section 1031.

What About the Middle? There is no authority for what the qualification status is

for taxpayers holding property between six months and two years.

Less Than One Year. It is generally held that a taxpayer who has held his or her

property for less than one year (but more than six months) is taking quite a risk with regard to

qualification under Code Section 1031. The chance of obtaining the tax-free treatment for such a

transaction under these conditions depends on the case law at the time of audit and the chances of

audit in each particular case.

More Than One Year. It is also generally held that a taxpayer who has held his or

her property for more than one year but less than two years is probably (but by no means

absolutely) safe in effectuating a 1031 Exchange under these rules.

As noted above, speculation on the replacement property by the sale or exchange of such

property too soon after its acquisition may invalidate the tax-free nature of the first exchange.

3. Boot. The receipt of cash in an exchange under Code Section 1031 or the release of

indebtedness on the subject property, which debt is not transferred to any of the replacement

properties, is referred to as “boot” and is taxable.

What Happens if I Receive Some of the Proceeds From the Sale of My Subject

Property? Under the provisions of Code Section 1031, the receipt of cash proceeds from the sale

Under the provisions of Code Section 1031, the receipt of cash proceeds from the sale

of the subject property does not, per se, invalidate the qualification of the rest of the exchange.

To illustrate, if the taxpayer in the example above were to purchase a replacement property

for $145,000 and were to take the remaining $5,000 from escrow, the amount of cash (or relief of

indebtedness) received by the selling taxpayer is called “boot” and would be subject to immediate

taxation. Stated in other words, if any cash is received by the selling taxpayer or the selling taxpayer

is relieved of any debt obligation which is not exceeded in the replacement property, the amount of

such boot (cash received or debt not transferred to the replacement property) will be taxable under

the rules of Code Section 1001 as if a sale took place.

What Happens if the Purchaser of a Property to Be Used by the Seller in a

Like-Kind Exchange Demands That the Seller Take Back Seller-Financing in the Form of a

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Promissory Note and Mortgage? Where the seller of a property is required to take back “seller

financing” in the form of a promissory note and mortgage, the seller contemplating using the

property to be sold as an exchange property has three options:

a. Pay the Tax. The seller may take the promissory note as “boot” and

will be liable to pay income tax on any gain from such sale, which gain will usually be reported

under the installment sales method.

b. Use Note in Exchange. If the promissory note and mortgage are

paid to the facilitator, it may be possible to “sell” the promissory note and mortgage to the seller of

the replacement property. If the seller/owner of the replacement property is willing to take the note

and mortgage as partial consideration for the purchase of such replacement property, the fact that

“seller financing” was required will not affect the qualification of the proceeds from being used to

effectuate the exchange. In our experience, the chance of convincing any seller of a replacement

property to take the promissory note (and mortgage) from the sale of the subject property as partial

consideration for the purchase of the replacement property is minimal.

c. Purchase Note From Facilitator. The last option would be for the

taxpayer desiring to do an exchange (or any other party) to purchase the promissory note from the

facilitator, thereby providing the facilitator with the cash funds which are usually necessary to

complete the exchange. To do so, the taxpayer or other purchaser would transfer cash to the

facilitator and the facilitator would assign the promissory note and mortgage to the taxpayer or

other purchaser who would then collect the debt owed by the maker of the note.

4. Deferred Exchanges Under the Code. Like kind exchanges need not be

simultaneous. The provisions of the Code also apply to deferred like kind exchanges if the

replacement property meets the identification requirement and the acquisition of any replacement

property (and therefore, the exchange) is completed within certain statutory time limits.

Under the Deficit Reduction Act of 1984, Congress enacted limitations to the rules which

permit deferred exchanges. A taxpayer is not treated as receiving like kind property unless both of

the following requirements are met:

a. Identification Period. The property to replace the subject property must be

identified as property to be received in the exchange on or before the day that is 45 days after the

date on which the taxpayer transferred the subject property; and

b. Closing Period. Title to the replacement property must be received (closed)

by the exchanging taxpayer on or before the earlier of:

• 180 days after the taxpayer transfers (sells) the property relinquished

in the exchange, or

• the due date (including extensions) for taxpayer’s tax return for the

taxable year in which the transfer of the relinquished property occurs.

Note: This may require an extension of a taxpayer’s individual income tax

return if its normal filing date is prior to the time that the taxpayer may close

on the purchase of the replacement property. Since the 180-day period will

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pass April 15 for all exchanges after October 18 (2004 is a leap year), it is

recommended that the exchanger’s tax preparer be put on notice that it may

be necessary to extend the filing of the taxpayer’s income tax returns if the

replacement property or properties are not transferred to the exchanger

before such due date.

Requirements Relating to Identification of Replacement Properties. The Treasury

regulations provide that property is treated as “identified” before the end of the 45-day

identification period only if it is designated as replacement property in a written document signed by

the taxpayer and hand-delivered, mailed, telecopied, or otherwise sent before the end of the period

to a person involved in the exchange (other than the taxpayer or a related party). The identification

may also be made in the written exchange agreement signed by all the parties, regardless of whether

the agreement is “sent” to a person involved in the exchange. Any replacement property received

by the taxpayer before the end of the identification period is treated as identified before the end of

the identification period.

This means that an exchanger should deliver the designation of the replacement properties

to the facilitator with a way to verify the date of delivery (i.e., the date stamp of the facilitator or on

a fax). Delivery of a separate copy of the designation to the taxpayer’s tax counsel should also be

made to assure satisfaction of the deadline requirements.

Multiple Properties Exchanged. The proposed regulations provide that if as part of the

same deferred exchange the taxpayer transfers more than one property and the relinquished

properties are transferred on different dates, the identification and exchange periods are determined

by reference to the earliest date on which any of the properties was transferred.

This means that if the exchange is of two or more properties, it is advisable to do so in

separate exchange documents so that the date on which the 45-day identification and 180-closing

periods occur do not run from the closing of the sale of the first property to close.

Description of Identified Property or Properties. To be treated as identified, it is now

required that the replacement property be unambiguously described. Real property is

unambiguously described if it is described by a legal description or street address. Personal property

generally is unambiguously described if it is described by a specific description of the particular type

of property (e.g., a truck should be described by its specific make, model, and year).

This means that for Hawaii property, the tax map key, actual legal description or address of

the property will be sufficient to meet the requirements proposed in the regulations.

Identification of Multiple Properties. As a general rule, the proposed regulations permit

taxpayers to identify more than one property as replacement property. However, the maximum

number of replacement properties that may be identified is:

(1) three properties without regard to their fair market values; or

(2) any number of properties so long as the total fair market value at the end of the

identification period does not exceed 200% of the total fair market value of the

properties relinquished.

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Subject to one exception, if more than the permitted number of properties are identified by

the end of the identification period, the taxpayer is treated as if no properties were identified. An

identification of property may be revoked before the end of the period if the revocation is made in a

written document signed by the taxpayer and sent before the end of the period to the person to

whom the identification of the property was sent.

Even if more than the permitted number of properties are identified by a taxpayer at the

time the identification period expires, the taxpayer’s designation of replacement properties will not

fail if the taxpayer actually acquires 95% of the properties which were identified.

In summary, identifying more than the allowed number of properties invalidates all of the

selections of replacement properties unless the 95% purchase exception is met. This means that if

the taxpayer desires to identify more than three properties as replacement properties, the total fair

market value of the identified properties should not exceed 200% of the value of the property

exchanged by the taxpayer unless he fully intends to purchase all of the property.

5. Debt. The rules regarding debt are quite complicated. Since the rules are too

complicated for explanation here, a simple summary of the rules can be defined as follows:

• Any cash received in an exchange must be rolled over as cash.

• Any mortgage relieved in an exchange must be rolled over into the new

property as cash or mortgage or as a combination thereof.

6. Mechanics of an Exchange. There are two types of exchanges, a three-party

exchange and a four-party exchange.

Three-Party Exchange. Under a three-party exchange:

a. the taxpayer transfers his subject property (or properties) to the buyer;

b. the buyer, rather than remit the proceeds to the taxpayer-seller, holds them

until the taxpayer selects one or more replacement properties;

c. the buyer uses the “proceeds” in his possession to purchase taxpayer’s

replacement property or properties;

d. the buyer transfers (in exchange for the taxpayer’s transfer of the property to

the buyer in (a) above) the replacement property to the taxpayer.

The problem with a three-way exchange is that the buyer who is holding the funds may go

bankrupt, be sued, get divorced, die, or otherwise tie up the taxpayer’s money held in the exchange.

Four-Party Exchange. Under a four-party exchange:

a. the taxpayer transfers his subject property (or properties) to a facilitator who

is independent of the buyer;

b. the facilitator sells the property to the buyer for cash or otherwise;

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c. the facilitator, rather than remit the proceeds to the taxpayer-seller, holds

them until the taxpayer selects one or more replacement property or

properties;

d. the facilitator uses the “proceeds” in his possession to purchase the

replacement property or properties; and

e. the facilitator transfers (in exchange for the taxpayer’s transfer of the property

to the facilitator in (a) above) the replacement property to the taxpayer.

Under a four-party exchange, the funds, if held due to a delay between the close on the sale

of the subject property and the repurchase of the replacement property, are held by an independent

bonded entity, thereby making the exchange easier and safer for the taxpayer contemplating an

exchange.

Direct Deeding. In a direct deeding situation, title passes either directly to or from the

taxpayer without passing through the hands of the facilitator or other accommodator.

Direct Deed of the Replacement Property. The Treasury Department released a

Revenue Ruling which provides that during the acquisition of the replacement property (but, not the

sale of the subject property), the property can pass directly from the seller to the exchanger without

passing from the seller to the facilitator and then from the facilitator to the taxpayer-exchanger in a

second conveyance. This “direct deeding” avoids the need for a second conveyance by way of a

limited warranty deed and assignment of warranties and, in addition, avoids the necessity of having

to pay a second conveyance tax. Once again (hopefully stated in a more readable way), the new rule

(Revenue Ruling 90-34) specifically requires that the sale of the initial property being exchanged

must be transferred through the facilitator, but that the replacement property may be acquired by

way of a direct deed.

Direct Deed of the Subject Property. The Treasury Regulations appear to permit

direct deeding even of the subject property to the purchaser. While this may be necessary in certain

circumstances, the use of direct deeding on the first leg is not recommended.

Interest Earned Goes to Taxpayer. Under the new Regulations, taxpayers are permitted

to receive interest or a growth factor in connection with a deferred exchange provided the

taxpayer’s right to receive the interest is limited to certain specified circumstances. This means that

the taxpayer-exchanger can get the interest earned on the exchange funds while held by the

facilitator prior to the acquisition of the replacement property or properties. The interest itself is

taxable income that is not sheltered by the exchange.

Construction Difficulties. As noted above, the purchase price of the replacement property

generally must equal or exceed the sales price of the subject property or the exchanging taxpayer will

have a taxable gain. The complication in such case is that the new property needs a building

constructed to bring the value up to the sales price of the subject properties. This will require that

the facilitator purchase the property and contract with a builder to construct a building using the

proceeds of the exchange to build the structure and then effect a transfer of the real property (with

a completed building) to the taxpayer within the 180-day period. The intent is that the property

transferred to the taxpayer (with the building) will have the proper exchange value. However, it gets

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very complicated, and your facilitator is required to place himself (or itself) at some risk to

accomplish the construction. Assuming that a facilitator can be retained to accomplish this task, it

can be done.

The mechanics of the facilitator constructing the building are essentially the same as for any

other party that would contract for such services. The facilitator must directly contract with the

builder and must pay for the services. It is strongly recommended that the facilitator receive a

“non-recourse” contract with the builder (meaning that the facilitator has no independent liability

for the contract) prior to commencing construction. We also would strongly suggest that the

taxpayer not personally sign any of the construction documents or personally commit or guaranty

the documents directly. Remember, the taxpayer’s part in the exchange is merely to exchange a

deed or deeds to the facilitator and, in return, receive back a replacement property within the

180-day deadline. If the taxpayer is deemed merely to have purchased the land with a construction

contract, the cost of the contract will not receive tax-deferred treatment under Section 1031. A

contract for services to be rendered is not like-kind with real property.

Reverse Exchanges. Regulations issued by the Internal Revenue Service specifically

authorize the use of reverse exchanges. The IRS agreed that where a qualified intermediary holds

title to property specifically acquired for the specific purpose of funding the replacement of an

exchange for a taxpayer, the transaction will not be disqualified for such reason.

Use of a Facilitator. There are a number of facilitators who are willing to act in the

capacity of holding title to the “replacement property” until the taxpayer can close on the sale of

their subject property. It is not inexpensive for the facilitator to hold title to the replacement

property while waiting for the sale of the subject property.

Facilitator’s Costs. The facilitator’s costs are changed in two different areas:

1. Higher Fees. Most, if not all, facilitators charge significantly more to

Most, if not all, facilitators charge significantly more to

effectuate a reverse exchange.

2. Obtaining Non-Recourse Lending to Facilitator; Costs. The

facilitator must obtain the proceeds to purchase the taxpayer’s replacement property. Since the

facilitator is not willing to use its own credit to purchase the property, all financing for the purchase

price of the replacement property must originate with the taxpayer.

In some instances, the taxpayer has the cash position to lend the facilitator the necessary

funds to acquire the property for cash. In other instances, outside financing is necessary.

Regardless of whether it is a financial institution or the taxpayer who lends the funds to the

facilitator, usually the facilitator is not willing to use its own credit to purchase the property or

execute any financing documents unless the documents are “non-recourse to the facilitator.” “Nonrecourse

to the facilitator” means that the facilitator has no personal liability to the lender of the

funds. If the loan is in default, the facilitator merely turns over the property. Under non-recourse

lending, there can be no type of deficiency judgment against the facilitator to obtain payment of any

shortfall that occurs from the resale of the property in order to satisfy the loan obligation.

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In order to negotiate non-recourse loan documentation, the taxpayer should expect extra

costs on behalf of the facilitator to review the additional documentation in a reverse exchange and

on behalf of the taxpayer’s legal counsel to negotiate and review the loans and documentation.

Section 1031, although an effective tax-deferral Code Section, is a complicated process to

accomplish. In addition, although exchanges with construction have been accomplished

successfully on a tax-deferred basis under Section 1031, there is no guaranty that the Service will not

review and attempt to invalidate the exchange for a technical violation of the statute.

In closing, we wish to confirm that this memorandum has been provided to you for

informational purposes only. All of the information and statements made in this memo are general

in nature. Accordingly, we can assume no responsibility for the success or failure of any exchange if

such exchange is conducted without our continued assistance. If you have any further questions,

please feel free to give our office a call.

Please let me know if and when you would like to discuss these in greater detail