Tax-free (deferred) like-kind exchange

In the following article, Peter A. Karl, III explains in detail The Section 1031 exchange. Also know as the tax-free (deferred) like-kind exchange, the law provides tax payers an opportunity to choose not to pay taxes when disposing of property. The taxes can essentially be deferred when exchanged with investment and rental property than an individual owns. Karl defines how the exchange works, identifies time limits involved, specifiies replacement formalities, qualifying properties and the keys to avoiding taxes through the 1031 exchange.


Section 1031 Exchanges in a Nutshell* By Peter A. Karl, III
*An article published in the August 2002
issue of the Tax Reduction Letter published by
Bradford & Company (1-877-829-9673)
The payment of income taxes on the disposition of real estate is completely voluntary!

The Section 1031 exchange is the most underutilized part of the tax law. That's truly sad as it offers the most significant savings. It could be a name problem-calling it an "exchange." People think exchange during the holidays when they stand in line to return and replace to return and replace the sweater than did not fit. The tax law "exchange" might get a lot more attention if lawmakers called it a "rollover" because that's what you accomplish with Section 1031. You rollover the gain to the new property.

You can continue the rollover of gain and postponement of tax with successive exchanges (stemming from the original property you relinquished), provided a one year holding period exists with the replacement property. The postponement of taxes turns into the cancellation of taxes to the extent that the property get a set-up in basis at date of death.[i]

For example, you buy land for $50,000. It grows in value. You exchange it for land worth $130,000. At the date of your death, the land has grown in value to $300,000. It transfer to your heirs at $300,000 (its stepped-up basis). The increase in value from the original $50,000 through the $130,000 exchange and including the increase to $300,000 its not subject to income taxes under the stepped up basis concept.



How the exchange really works

The Section 1031 exchange is really a sale and then a subsequent reinvestment. The deferred exchange is the most popular form of exchange. It involves four parties:

You as the owner (actually, seller) of the property being relinquished.

The buyer for your property.

The seller of the property you want to acquire.

A qualified intermediary.

The qualified intermediary is an individual or entity with whom you have not had a business relationship of any sort within the last two years.[ii] Therefore, your accountant, lawyer, or real estate sales professional will not qualify as an intermediary.

The intermediary makes the exchange work. Think of exchange money as "radioactive." You may not touch it. Your buddies (like your accountant or lawyer) may not touch it. If you or your buddies touch it, you destroy the exchange and trigger taxes.

The qualified intermediary handles the money and holds the sales proceeds from your property in interest bearing accounts. Then, the intermediary distributes the money as needed to purchase the replacement property.



Strict time limits

Observe the exchange time-limit rules. These dates are set in stone. They are not suggestions. Start date. The strict time limits for the Section 1031 exchange starts with the "initial transfer date." This is the date you close the sale on the property you are selling (the relinquished property).

Forty-five (45) days from the initial date you must formally identify your possible choices of replacement property.[iii]

One hundred eighty (180) days from the initial transfer date, you must have the previously identified replacement property titles in your name. [iv]

Tax law shortens the 180-day period when you tax return is due during the 180-day period. If the exchange occurs after October 17, you need to file an extension to receive the full 180 days.

For example, if your initial transfer date is December 1, you need to file for the automatic extension on or before April 15 to have the benefit of the full 180 day replacement period until May 30.

Planning tip. Postpone the initial transfer date with a lease. For example, you could allow the buyer to occupy the property under a triple net lease until you exercise your option to close the sale.[v]


The replacement formalities

Ideally, within forty-five days, the qualified intermediary uses part of the funds from the relinquished property sale for an earnest money deposit on the replacement property. This provides positive identification. Alternatively, within forty-five days, you can designate the replacement property in a signed document that you hand deliver, mail, fax, or otherwise send to the qualified intermediary.[vi]

The regulations permit you to identify more than one possible replacement property.[vii]

The maximum number of replacement properties that you may identify under the two main rules is three properties of any fair market value, or any number of properties, if the fair market value of properties identified does not exceed 200% of the agregate fair market value of properties relinquished. Look at the beauty of this! When you sell your property, you can be absolutely clueless about where to reinvest. Further, you have complete flexibility as to the type of realty you accept as replacement property. It can be investment or rental property, vacant land, or realty used in a trade or business. About the only types of property that do not qualify are personal use and foreign realty.[viii]


Keys to not pay taxes

You pay no taxes under Section 1031 when you receive no cash, and obtain no debt relief.
Say you use Section 1031 to dispose of your $200,000 building with a $100,000 mortgage for a $250,000 building with a $150,000 mortgage. No taxes here. You exchange your $100,000 equity in the $200,000 building for the same equity in the $250,000 building. You receive no cash. You received no debt relief. In fact, your debt increased from $100,000 to $150,000 because you now own more building and more depreciation deductions.

You can tax advantage of Section 1031 even if you have liability over basis problem that precludes you from giving the property to a relative or charity without recognizing gain. In these cases, you recognize no gain if the replacement cost is equal or greater than the sales proceeds from disposition of the old property.

Impounded funds used to pay closing costs do not count as cash receipts to you. The regulations state that use of money held by a qualified intermediary to pay specified transactional items will not result in actual or constructive receipt by the exchangor of the remaining funds. This rule apples to


Costs that relate to the disposition of the relinquished property or to the acquisition of the replacement property; and
Expenses listed as the responsibility of a buyer or seller in the typical closing statement under local standards.
Examples of these expenditures include commissions, recording or transfer taxes, and title company fees. Also, the selling price of the property relinquished does not include reimbursements to you to cover monies you received, like advance rents, or expenses you already paid, like property taxes.


More property flexibility than you think

There is no requirement that the exchange be a "one for one" transaction. In other words, you can divest yourself of one property and replace it with two properties or vice versa.

In fact, you might want to consider a "build to suit" (a/k/a construction exchange) where you identify replacement vacant land along with the details of a structure you want built during the 180-day reinvestment period. The qualified intermediary disburses impounded funds to the contractor(s) on a "pay as completed" basis.

Alternatively, you might buy a "fixer-upper" and have the qualified intermediary rehab it using impounded funds. The result: You improve your replacement property using pre-tax dollars. Similarly, you can identify less expensive property that needs some capital improvements (like a new roof) to gobble proceeds from the property relinquished.

This is not an "all or nothing" proposition. To the extent the qualified intermediary has money remaining at the end of the exchange period, the law taxes it as "boot" (cash received by you). That's the bad news.

The good news is that the law taxes you only on the boot received part. The receipt of boot does not ruin the entire exchange.[ix] It simply triggers taxes on the amount you receive as boot.


Owner takebacks in a 1031 exchange

Most of the normal options for selling your property apply to an exchange. For example, you (actually, your intermediary) could finance the sale of your property with an owner takeback (purchase money mortgage). With the owner takeback, you:[x]

reduce the total contract price by the like-kind property received, and

reduce the gross profit by that part that applies to the exchange.

Alternatively, you may want to avoid taxes altogether on the owner takeback. Your qualified intermediary may accomplish this for you by:

discounting the takeback mortgage to cash and then using the net proceeds for the replacement property, or

assigning the takeback mortgage in the acquistion of the replacement property.

With the assignment, the seller accepts the takeback at its face value. The seller likes this deal because he secures the takeback mortgage with two properties:

the property you sold (relinquished) in the exchange, and

the property you bought from the seller (target property).

Reverse exchanges

Section 1031 is flexible. Recently, the IRS established a safe harbor for "reverse exchanges." [xi] You have to love these. The "reverse" comes in handy when you do not yet have a buyer for the property you want to relinquish and you are afraid of losing the property you wish to acquire.

To help with reverse exchanges, the IRS issued a recent Revenue Procedure that established the notion of an Exchange Accommodation Title-holder (EAT) (really, another name for a qualified intermediary). The EAT buys the replacement property using money that you advanced. He then "parks" the property for you. You have the 180-day replacement period to "get your act together" and find a buyer for the property that you wish to relinquish.

The "paper-trail" for the reverse exchange should begin immediately with the original agreements. You could include a clause like this:

The seller reversed the option to convert the subject transaction to qualify under Section 1031 of the Internal Revenue Code with the purchaser agreeing to cooperate in the execution of any of the required documentation (including, but not limited to a Four-Party Deferred Exchange Agreement and a Qualified Intermediary Agreement) provided purchaser shall incur no addition cost or liability.


Properties that qualify

The tax-deferred exchange rules of Section 1031 apply to business and investment real estate. The rules do not apply to your personal home. Also, you may not use the favorable exchange rules for vacation homes that have substantial personal use.[xii]

Planning tips. You may use the favorable exchange rules if you convert you home to a bonafide rental property for a minimum of one year, the long term capital gain holding period.[xiii]

If you have an operating business, Section 1031 applies separately to both the realty and personal property (a "mixed property exchange"). The personal property parts, like computers, desks, and vehicles are more difficult to configure. IRS regulations that apply to Section 1031 define like-kind personal property with terms such as "like class" and "like use."[xiv]

The terms "like class" and "like use" deny exchanges of office equipment for cars. Similarly, the rules deny exchanges of an operating business intangible personalty, like goodwill, even if similar in nature (e.g. two restaurants).

Planning tips. The rules make it easy for you to use Section 1031 to defer taxes on real estate. Stay with the "easy" (real estate) for maximum return on minimum effort.


Avoiding taxes without 1031 exchange

What happens if you want to stop investing in real estate? Is there anything you can do? Yes! In an upcoming issue, we will examine tax avoidance alternatives if you are no longer interested in reinvesting in real property. We will look at property owned by a multi-member partnership or limited liability company where some want to cash out and the others want to reinvest under Section 1031.


Summary

Remember, the law gives you a choice to pay or not pay taxes when you dispose of property. You can defer taxes when you exchange investment and rental real estate that you own individually. Also, your trust or closely-held corporation may use the exchange rules to defer taxes on its investment and rental realty.

So, choose not to pay taxes! Do this with the "rollover" benefits of Section 1031 that allow you to defer the tax on property you sell by rolling the profits into replacement property. To make this happen, you need only an intermediary to sell your property and buy the replacement. What could be easier?

Housing Counsel: Protecting Your Child's Inheritance Takes Careful Planning

Question: My first wife passed away in June of 2000. After she died, I sold the home I bought with her for $300,000, which I wanted to leave to our children when I died. I have now remarried. We have a home in another State, which I will leave to my current wife. Recently, we bought a home in Maryland and both of us were on the property deed. I stated in my Will that the house was to go to my children when I died, but subsequently discovered that the Will has no effect since title was held as tenants by the entirety. My new wife has executed a Quit Claim deed relinquishing her interests in the property to me and the deed was recorded in land records in the county where the property is located.

Does this satisfy my desire to leave the property to my children or is there something else I must or should do?

Answer: The first thing you should do is have your financial and legal advisors review your Will and any estate planning arrangements you have made. You want to leave your current house to your children, so you have to make sure that your Will reflects current law and is specific enough to accomplish your desires.

Many states, including Maryland, allow a spouse to elect against the Will. For example, Maryland law specifically states that "instead of property left to him by will the surviving spouse may elect to take a one-third share of the net estate if there is also a surviving issue, or a one-half share of the net estate if there is no surviving issue."

This means that your current wife could elect to assert her spousal rights and possibly defeat your intentions to protect your children. You and your current wife should discuss this immediately. Your attorney can assist you in preparing a renunciation or similar agreement which your wife can sign -- but she must have independent legal counsel to advise her regarding this matter. If she relies only on your attorney's advice, she can subsequently argue that she was not properly represented and did not really know what she was signing. Additionally, she could claim that your attorney had a conflict of interest.

You have advised me that you have several children. How old are they? If they are not of the age of majority (usually 18 years of age) you do not want to leave your house to a minor. You should make sure that you specifically name a trustee in your Will who will hold title to your under-age children until they get older. You have the right to designate the age; some parents believe that their children will be fully mature and competent at age 18 -- while others would prefer to wait a longer period of time. The determination is yours and must be spelled out carefully in your Will.

Are any of your children married? What happens if one of them should die before you do? Do you want their spouse to inherit their share of the family home or should their share be redistributed to their children or your remaining surviving children?

Originally, you held title with your wife as tenants by the entirety. There are several ways in which title can be held with another person:


Tenants in Common: Here, each owner owns a percentage interest in the property. If is usually held on a 50-50 basis, but that is not mandatory. I have seen property held in any percentage. What is important, however, is that on the death of one tenant in common, his or her interest does not go to the survivor. Rather, that interest must be distributed in accordance with the Will of the deceased, or if there is no Will, in accordance with the laws of inheritance of the jurisdiction in which the person died.
And the deceased person's estate must be probated. The property interest of the deceased person is administered by the Personal Representative (PR). In some cases, the PR may have to sell the property to pay estate expenses or creditor claims against the decedent. This could result in your children not receiving the home -- or the full value of the home -- when you die.

It should be noted that in most jurisdictions throughout this Country, if a deed is conveyed to two persons without a description of how title is to be held, the Courts will consider that the property is titled as "tenants in common."


Joint Tenants: Here, the parties own an undivided interest in the property. In most states, the interest must be equal, although some states have enacted laws to permit an unequal ownership in a joint tenancy. On the death of one owner, his/her interest will automatically go to the surviving joint tenant, and probate will not be necessary.
It should be noted that some state laws require specific language in the deed to make sure that the title is really held as joint tenants. Thus, if you really want to avoid probate, it is important that the deed contains these magic words: "joint tenants with rights of survivorship".

It should also be noted that while both joint tenants are alive, creditors may be able to attach the interests of one of the joint tenants, thereby forcing the sale of the property. The other joint tenant who does not owe any money to the creditor will receive half of the sales proceeds, but obviously may not be able to keep the property.

Additionally, since there is nothing sacred about a joint tenancy, either joint tenant can sever that tenancy by conveying his or her interest to a third party. If that should occur, that third person would end up owning the property as tenants in common with the non-conveying owner.


Tenancy by the Entireties: This form of ownership is reserved exclusively for husbands and wives. Under a tenancy by the entirety (T by E) arrangement, both husband and wife own an undivided interest in the property. Unless both parties owe money to a creditor, the house cannot be attached. On the death of one party, the entire property will be owned by the survivor, and no probate will be necessary.
Thus, in order to protect your children's inheritance, you took the proper first step by arranging for your wife to convey her interests in the family home into your name as sole owner.

But that is not the only step you must take. Although you have a Will, it may be out-of-date. There are many questions involved, and you must make sure that your Will meets all of your needs and desires. The law favors Wills and wants to make sure that the Will-makers intentions are fully carried out. But your Will must be specific and carefully crafted.

by Benny L. Kass