NOW may be a perfect time to do a reverse exchange...
When the real estate market is a buyer's market, it may be a great time to buy but a lousy time to sell. One of the challenges in a buyer's market is also trying to do a 1031 exchange -- because you have to both buy and sell to accomplish a like-kind exchange -- otherwise you have to pay the capital gains tax. So the very nature of a buyer's market tends to cancel out the positive effects of an exchange -- but not so fast.... There's a type of exchange called a reverse exchange that can be very useful in a buyer's market.
In a reverse exchange, you get to do the exchange backwards: you buy your New Property first -- before you sell your Old property (as opposed to a regular straight or forward exchange where you sell first, and then buy).
With a reverse exchange, you can buy the property you've dreamed about while it's a buyer's market, and sell your old property LATER -- when the price is improved. If done properly, the reverse 1031 exchange will take care of all the capital gains tax issues for you.
But setting up and structuring a reverse 1031 exchange is far more complicated than a regular straight or forward 1031 exchange. It's important that you consult with a good QI to set up the reverse exchange process BEFORE you start scooping up all the great deals to be had in a buyer's market.
Choose a QI that knows all the legal, accounting, and the real estate aspects of the marketplace.
Am I allowed to take an earnest money check when selling my Old Property?
The rule of thumb is that you can't touch the money from the sale of your Old Property; however, you have until the closing of your Old Property to decide whether or not you want to go ahead with an exchange.
So the answer (contrary to what many think) is yes. You can take a check in your name, cash or whatever form you wish. Just make sure that you bring all the earnest money to closing and hand it over to the intermediary for the future purchase of your New Property. Any earnest money not brought to closing will be taxable.
If I follow all the 1031 rules, can the IRS still disallow my exchange...?
This should never happen, although a renegade auditor can do almost anything he wants. But if this were to happen, his superiors should quickly reverse his decision. That's because IRC §1031 is not a loophole, or a procedure that gets around a law. IT IS THE LAW; it is section 1031 in the Internal Revenue Code.
In the upcoming book, Rich Dad's Real Estate Advantages: Tax and Legal Secrets of Successful Real Estate Investors (Warner, Paperback, 288 pages), Gary Gorman writes,
"It's called a '1031' exchange because 1031 is the IRS Code Section that governs this roll over. The fact that it is an IRS Code Section means that it is law and if you follow the rules the IRS has to allow your exchange."
So if you dot your "i"s and cross your "t"s, the IRS has to allow it. It's the law.
IRS changes direction on using exchange funds to build on property you already own.
You may now build or do construction on property you already own – as part of a 1031 Exchange! This is a 180 degree reversal in direction for the IRS: in a recently released Private Letter Ruling (PLR 200251008 - PDF file, 10 pages, 104kb) a taxpayer was allowed to use exchange proceeds from the sale of Property A to construct improvements on Property B, which they already owned.
This ruling signals a total change in philosophy from their landmark Tax Court case, Bloomington Coca Cola vs. Commissioner, which disallowed such an opportunity.
While this latest ruling now allows this construction opportunity, the hoops you will have to jump through will not be easy. The prescribed procedures are complex, but one of our Experts would be glad to walk through them with you.
What is the 200% Rule?
There are many peculiarities to Section 1031, and the 200% Rule is one of them. Basically, this rule means that the sum total of ALL the purchase prices for four or more replacement properties cannot exceed 200% of the selling price of the Old Property. Oddly, there is no limit to the sum of the purchase prices for three or less replacement properties.
For example: If you sell your Old Property for $100,000, you can theoretically identify up to three properties for millions, or even billions of dollars each! BUT-- if you identify a fourth replacement property, then the total value of all the properties on your list combined cannot exceed twice the selling price of your Old Property.
The IRS is very strict about this. If the price of one of your four replacement properties pushes the sum total of the combined purchase prices beyond 200% of the original selling price of the Old Property, even by one dollar, the entire exchange will fail. So keep it simple -- keep your list to only three properties or less.
"I have 45 days to identify replacement property for my exchange. What if I change my identification after the 45 days?"
If you change your identification after the 45th day, you’re in big trouble. If you get caught, your exchange will be disallowed. You’ll also be subject to penalties, which will probably run 100% of the tax. You’ll owe interest on both the tax and the penalties, and you could even end up in jail (yes, people have gone to jail for this).
What is the definition of "closed" to meet the 180-Day deadline?
You have to close the purchase of your new property within 180 days of the sale of your old property. So what does "close" mean? Is it enough to have a purchase and sale contract on the property? Or perhaps an option? Can you close in escrow? The best way to answer this question is to ask another question: if the property burned down on the 181st day, who would be out their investment; you, the buyer, or the seller? If your answer is the seller, you have not closed, because in the eyes of the IRS risk of loss has to pass to you, the buyer, in order to meet the requirements of Section 1031.
Tax Court Rules Vacation Home can be Investment Property...
An issue of some concern in areas, such as Colorado, with large numbers of vacation homes, is the question of whether vacation homes qualify for a 1031 exchange. Property held as a personal asset, such as the home where you live, is not investment property and therefore does not qualify for a 1031 exchange. An investment property, such as a rental, on the other hand does qualify for an exchange. So what is a vacation home -- a personal property not qualifying for an exchange, or investment property that does qualify?
In a 1981 Private Letter Ruling, the IRS had ruled that vacation homes qualify for a 1031 exchange provided you can prove at least some investment intent. Now, in a recent tax court case involving the personal use of a vacation home, the court has ruled that the vacation home was investment property (in other words, Section 1031 property) based solely on the testimony of the taxpayer's wife that when they bought the property they had an " that it would increase in value", which it had.
In its opinion, the court stated that the activities of the vacation property were of two different types: a rental (or personal use) activity and an investment activity. In other words, you can have investment intent, without a corresponding rental use of the property. While this is great news for those of us in the 1031 industry that worry about an "investment" attack by the IRS on our client's vacation homes, our firm is still recommending to clients that they take the steps they consider necessary to prove their investment intent.
the specific Tax Court case mentioned, (PDF File): Rivera v. Commissioner, T.C. Summary Opinion 2004-81.
While the intermediary holds the money, can I withdrawal the interest monthly?
The answer is NO. Section 1031 will not allow you to touch the money in between the sale of your old property and the purchase of your new, not even the interest. At the end of the exchange, you may have the interest sent to you in a separate check, or you may include it in proceeds that the intermediary transfers to the purchase of the new property. And yes, it is taxable to you, no matter how it comes to you.
While the intermediary holds the money, can I withdrawal the interest monthly?
The answer is NO. Section 1031 will not allow you to touch the money in between the sale of your old property and the purchase of your new, not even the interest. At the end of the exchange, you may have the interest sent to you in a separate check, or you may include it in proceeds that the intermediary transfers to the purchase of the new property. And yes, it is taxable to you, no matter how it comes to you.
I've heard that can't sell my Old Property to a relative, or buy my New Property from a relative, but what is the definition of relative?"
For 1031 investing purposes, a relative is someone that is directly related to you in a straight line. Think of it this way: Linear = NO; Diagonal = YES. Your parents, grandparents, brothers and sisters, children and grandchildren, and your spouse are related to you horizontally and vertically, so they are not allowed.
Aunt Matilda and your cousin Fred are related to you diagonally. Therefore the IRS does not consider them "related," and you are eligible to buy exchange property from them or sell exchange property to them.
Also, be aware that organizations like companies and trusts can be "related" to you too. If you own a significant portion of an organization, you may not be able to involve the organization in your exchange. Consult the Experts whenever related party issues may be a part of your exchange - we'll help you sort out the rules.
"Can I use exchange funds that are being held by my intermediary for items like earnest money and appraisals prior to the closing of my new property?"
Yes and no. The intermediary may only advance funds from your exchange account (the money being held from your sale) for items that are refunded if the closing never occurred. Earnest money is the most common example of this.
Although items like survey fees and appraisals are clearly associated with the purchase of the new property, they would not be refunded if the deal fell through. Therefore, exchange funds cannot be advanced for these types of expenses. (However, don’t be confused…. if these items are shown on the settlement statement at the time that the property is purchased, exchange funds sent to the closing can be used for these types of costs.)
Can I exchange my real estate contract in a 1031 exchange?
In hot real estate markets around the country, South Florida is one example, more and more buyers are investing in "pre-construction" contracts -- meaning the investor pays a deposit and signs a contract to purchase a property that is not yet erected. Often, the property will not be completed for several months, or even years. Since the property value keeps rising during the construction period, investors can often sell their contract on the property for a good profit before the property is completed, and without ever actually owning the property itself. Does this sale qualify for a 1031? Can you buy such a contract as 1031 property?
The answer is yes, but this kind of exchange comes with some risk. The majority of legal authorities say that yes, an option or agreement to buy real estate is real property interest, and therefore eligible in a 1031 exchange. But there isn't a lot of authority on this specific subject, and none of it is overwhelmingly conclusive. So it's not clear if IRS would or would not challenge this kind of exchange.
Aside from whether contracts qualify to begin with, remember that you still have to meet the same qualifications for a 1031 exchange as with any other real estate. And with option contracts there are some particular tricky issues to deal with, like:
When does the "transfer" of the property occur to start the exchange?
What is the value of the contract?
Was the contract "held for investment"?
Who Tracks My Deadlines...?
Three principles from a real estate investment company interviewed their local Qualified Intermediary, who was with a prominent title company, about handling their 1031 exchanges. While the QI was showing them his file drawer of clients, he mumbled, “Hmm. Gotta clean this out. This one’s dead… this one’s dead… this one’s expired…” and so on. One by one, he pitched folders in the trash. True story! Names changed to protect the guilty.
These three reps were shocked to see that about 80% of his exchanges were failing because he never bothered to inform his clients about their deadlines! Now it was too late, and nothing could be done about it. “Not my job” he shrugged. “That’s THEIR responsibility.”
We at 1031 Exchange Experts don't agree. We know that missing important deadlines in a 1031 exchange will kill a transaction dead. As a full-service QI, we believe it’s important to cradle your 1031 exchange from beginning to end. That’s what we get paid to do.
This other QI could afford to take the more cavalier attitude toward deadlines because tax-deferred exchanges weren’t his main line of business. He was actually very good at his niche, but 1031s were just his sideline. Therefore, it didn’t matter to him if his client’s exchanges failed or not.
Needless to say, those three real estate investors didn’t use this title company for their exchanges. After researching 1031 companies for a few months, they flew in from another state to meet with us. They finally chose 1031 Exchange Experts, LLC, as their 1031 Qualified Intermediary.
So if you're going to do a 1031 exchange, don't settle for a taco stand that also does 1031 exchanges on the side. Go with a 1031 company that is FULL-service, FULL-time.
Where does the term "boot" come from...?
Boot is the term used by the IRS and tax professionals when they talk about the taxable portion of a 1031 exchange. But where does it come from?--it's not defined anywhere in the internal revenue code, or in any court cases.
There are several theories, but the one that we think is probably correct goes back to the beginning of this country when people commonly traded things like horses and cattle. If the two parties determined that one horse, for example, was worth more than the other, the person that received the more valuable horse had to pay something to the other (money, tobacco, sugar, etc.) to even the score, and the additional item went into the recipients boot--hence the term.
I heard I can use §1031 for estate planning, but how?
Selling your old property and buying several new properties can be a very useful tool for estate planning. Here's how it can work: You can sell a large old property and buy three smaller properties -- one for each of your three children to 'manage.' The children can even be involved in making the decisions about which properties to buy. After your death, each of the three children would inherit the property they are managing.
Tailoring the property to your children's situation could be beneficial to them in other ways. For example: Your teacher child may select a "fixer upper" -- property where he or she can invest "sweat equity" during the summer. Your doctor child, on the other hand, may benefit from bare land -- property that appreciates, but avoids rental income that would be highly taxed.
Can you spot a fraudulent intermediary...?
You've sold your purple duplex and you want to do a 1031 exchange. When it's time to pick your intermediary, how do you know if the intermediary has previously been convicted of fraud? At least one has! Can you tell if the intermediary is day trading with their client's money? Several have! Could the intermediary get on an airplane with your money and disappear? Several have!
The answer is no -- you cannot tell from talking to them, or meeting them in person. And there is no agency that is dedicated to protecting you.
The only thing that you can do is make sure that your money is parked in a separate account where you can see it -- online or otherwise. And that you watch it the entire time the intermediary has it.
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If I buy more than one new property, how do I allocate my tax basis between them?”
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Since your tax basis rolls over from the old property to the new, you would allocate your basis between
multiple properties on a pro-rata basis. |
For example, if you sell your Old Property for $100,00, which has a basis of $50,000, and you buy two new properties; one for $60,000 and one for $40,000; your $50,000 basis would transfer pro-rata. This means that the basis of the $60,000 property will be $30,000 and the basis of the $40,000 property will be $20,000.
| If I buy more than one new property, how do I allocate my tax basis between them?” |
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Since your tax basis rolls over from the old property to the new, you would allocate your basis between
multiple properties on a pro-rata basis. |
For example, if you sell your Old Property for $100,00, which has a basis of $50,000, and you buy two new properties; one for $60,000 and one for $40,000; your $50,000 basis would transfer pro-rata. This means that the basis of the $60,000 property will be $30,000 and the basis of the $40,000 property will be $20,000.
Can I sell my investment property and then buy a house that I would like to live in? In order to properly do a 1031 exchange, both your Old Property and your New Property have to be held for investment. This means that in most situations you would have to hold the New Property as investment property for at least a year and a day. Once this period has expired, you may do with it as you wish, including moving into it as your personal residence.
What if the lender for the new property is insisting that the loan include my spouse’s name, and that my spouse must also be on the deed? Is this a problem?
The taxpayer (name that appears on the deed) for the sale of the old property must be the same taxpayer on the deed for the new property.
For example: If you sell as John C. Investor, you must buy as John C. Investor.
Sometimes, for credit and underwriting reasons, the lender will require that both husband and wife appear on the loan. To secure the loan, the lender will also require that both names appear on the deed. Depending on the particular situation, this may be no problem. Carefully review the following examples for the various scenarios.
For example: If you sell the old property for $100,000, and you are buying the new property for $200,000, you only need to acquire $100,000 of the new property (in this case 50%) to satisfy your exchange. You and your spouse could be equal owners of the new property.
Continuing our example: If the new property will cost you $150,000, you will need to acquire two-thirds ($100,000/$150,000 = 2/3) to satisfy your exchange. Your spouse can acquire the other one-third. Your lender may or may not accept the fact that your spouse is on title for less than 50%. You might try having the deed show that you and your wife are joint tenants, without specifying a percentage. This will make the lender happy, and the actual percentage that you each own can be shown on the exchange documents and settlement statement.
Final example: If the new property will only cost you $100,000, you have a problem. You must acquire 100% of the property to satisfy your exchange. In this case, there is no room for your spouse to be included on thetitle. Adding your spouse will definitely jeopardize your exchange. You can help build your case for the IRS by getting a letter from the lender that states their requirement to have your spouse on title. Therefore, if you get audited, you can give an solid explanation about why your spouse is on the title. Hope for an understanding auditor.
Exchange from Real Estate into a REIT...
Tee-Shot #20 stated that you absolutely CANNOT exchange out of real estate and into a REIT. This is still true, except in the following limited situation:
Many real estate investors find themselves in a position whereby they want to sell their investment property (or perhaps have already done so) and then cannot find a suitable replacement property to exchange into and thereby defer their capital gains taxes. Some investors simply no longer want the responsibilities of being a landlord or the hassles of property maintenance. And still others wisely want to diversify their real estate portfolio.
Is it possible to sell your relinquished or Old Property and do a Section 1031 exchange and buy into something other than real estate...? What about alternative investments, such as stocks, bonds, mutual funds, and the like? The answer is a resounding NO, and in fact, securities are expressly forbidden under Section 1031 of the Code. Well, what about a mutual fund that invests solely in real estate, such as a REIT (Real Estate Investment Trust)? Again, the answer is NO.
Having said that, there is an exception of sorts -- a special type of REIT, called an UPREIT or Umbrella Partnership REIT. But it's not as simple as selling your Old Property and using the proceeds to buy REIT shares off of one of the major stock exchanges. UPREITs allow investors to purchase Partnership Units in the REIT, which are similar to, but not the same as, Equity Shares (such as you'd buy off of a stock exchange). This strategy is done by combining two different, complex sections of the Internal Revenue Code: 1031 and 721. The REIT must be an UPREIT, youare still just deferring the capital gains, the Partnership Units liquidity is limited, and this exit strategy a one-way ticket! With traditional real estate investments you can always sell or do another 1031 exchange with your property -- but with UPREITs, once your 'in', you cannot then sell or exchange your Units and go 'back out' and buy actual real estate.
Make sure that you use a Qualified Intermediary that is very knowledgeable about this unusual real estate strategy.
"The old property that I sold was in the name of my revocable living trust. The lender on my new property won't make a loan to the trust. Is this a problem?"
There are many types of trusts, and each type is handled differently by Section 1031. Probably the most common type of trust is the revocable living trust. You can tell if this is the type of trust that you are dealing with if it does not file a tax return. Luckily, revocable living trusts are disregarded for 1031 exchange purposes. This means that whomever (?) owns the trust is treated as having sold the old property and is treated as the buyer of the new property. If that
is you, your lender may make the loan to you and you may take title to the property in your own name.
Can I buy a share of the new property then immediately transfer my share?
I know I cannot sell the old property in my name, and then turn around and buy a share of a partnership. But, can I buy a share of the new property in my name, and then immediately transfer my share of the land to the partnership?
No. Section 1031 requires that you sell real estate and buy real estate. If you buy a partnership interest, that is not considered real estate. If you buy real estate, and then transfer your share of the real estate to a partnership, the IRS may connect the two transactions together. Therefore, arguing that you, in effect, bought the partnership interest which would disallow the exchange. Your best bet is to wait a year and a day before you transfer the real estate to the partnership
| If I buy more than one new property, are there rules on how I have to split the cash and the debt?" |
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No, as long as you buy equal or up, and reinvest all the cash, you can split the cash and the debt however you wish. For example, if you sold your Old Property for $100,000 and $60,000 went to your qualified intermediary (after paying the mortgage and closing costs of $40,000), in order to avoid paying tax you would have to buy properties totaling at least $100,000 and you would have to spend the $60,000.
If, for example, you were buying two replacement properties for $50,000 each, you could purchase the first one for cash, and could purchase the second one using the remaining $10,000 that the intermediary is holding and getting a loan for the $40,000 balance.
Can I buy REIT shares as my replacement property?”
I often hear about qualified intermediaries saying you can, but what does the IRS say?
Absolutely not! The IRS has ruled that REIT shares do not qualify as replacement property in a 1031 exchange. A REIT, or Real Estate Investment Trust, is like a mutual fund that owns real estate. It is a security, however, not real estate.
Note: There is a new development allowing an exception to this in very specialized circumstances.
| My attorney says that he can be my intermediary. He'll have one of his partners handle my exchange. Is this okay?" |
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No. Section 1031 prohibits an attorney, or their firm, who has had a client relationship with you in the past two years from acting as your qualified intermediary.
"The intermediary I use is an attorney/CPA/title company. They tell me that the bond from their other business covers their intermediary work. Is this correct?"
It might, but probably not. Ask for a copy of their bond; they should be more than happy to give it to you. Once you get the copy, review what it covers and look for wording about a 1031 exchange, or qualified intermediary, or exchange services, etc.
My intermediary holds my exchange funds in a commingled account.
Should I be worried about this?
Yes. A commingled account means that your intermediary is putting every client's exchange funds into one account.
This creates a couple of potential problems for you. First of all, if your intermediary goes bankrupt, your funds will be used to pay other creditors of the intermediary. Even after you have received your exchange funds, you could be required to send all the money back to the creditors of the intermediary. Separate accounts (called segregated accounts) protect you from this.
Can I use my IRA along with my 1031 proceeds to buy my replacement property...?
Yes you can, but it has to be done just right, and there are some limitations on how you use your property. Any property purchased by your IRA must be used for investment purposes only--so your replacement property cannot be a vacation home for you to use personally and it cannot become your personal residence in the future. In fact you cannot rent your property out to any disqualified person, which is your business or any immediate family member except siblings.
In order to get the full benefit of your 1031 exchange, you must buy and take title to a property equal or greater in value than the one you sold. In addition, if you use your IRA in your purchase it will need to take title to the property for the percentage it is buying. Specifically, that portion bought with IRA money must be titled in the IRA's trust name.
So how do you make both these requirements work? First, the exchange portion must at least equal what you sold for. For example, if you sold for $300K and buy for $400K, you must take title to at least $300K of your new property as the replacement part of your exchange; the IRA can take title to the remaining $100K. Keep in mind that your proceeds from your old property may not be enough to cover your $300K purchase so you will need to make up the difference with a loan or with your own cash, but either way, your IRA can only buy the excess part of the property. In other words, the most IRA proceeds you could use in our example would be the $100K.
And an important thing to remember when thinking about using your self directed IRA to help purchase your replacement 1031 property is to talk to your IRA custodian; it could be that your plan does not even allow for real estate purchases.
--The Experts
One of the basic requirements
of a 1031 exchange is that you have to hold both the old property and the new property for investment. So what is the definition of “investment”?
Investment property is a very broad category. In fact, it generally includes any real property that is not your personal residence.
Examples of investment property include rental houses and condominiums, bare land, commercial office or warehouse space, apartments and farm land.
When evaluating 1031 exchanges, the IRS will most often look to the exchanger's intent for owning the property. Two common ways to establish investment intent are to establish rental income for the property or to establish a strong case for holding the property for a time while it appreciates in value.
In IRC Section 1031, the IRS also outlines that property held for productive use in a trade or business qualifies for 1031 exchanges. For example, the land and building for a restaurant are held for business use or land used by a rancher for grazing cattle.
Can I sell two properties, and then only buy one new property to complete my 1031 exchange?
Yes, you can. In fact, this is a good strategy for reducing your management hassles by consolidating your investments. This may also make sense if you want to sell a few smaller properties in order to finance one more expensive property.
Likewise, you can sell one property and buy multiple new properties. This strategy is good for diversifying your investment risk either geographically or by property type. For example, you can sell your old property, and then buy 3 separate properties -- a rental house in Florida, bare land in Colorado and a commercial condo in New York. Diversification can also improve your leverage and cash flow potential.
Does my New Property need to be in the same State as the one I sold?
You may buy your new property anywhere in the United States. You do not have to buy your new property near where you sold the old. This could allow you to move your rental property with you when you move to another part of the country. You may also want to buy a rental property near where your elderly parents or perhaps your grandchildren live.
"Does §1031 require that I only buy Like-Kind replacement property?"
The "Like-Kind rule" mainly applies to personal property, i.e.: "things you can move;" like supplies, transportation, machinery, equipment, inventory, etc. This means if you sell a pizza oven in an exchange, the new property must be another pizza oven.
But with real estate, i.e.: "things attached to the ground," you can buy any type of investment real estate to complete your exchange. If you sell a rental house, you could buy an office building, a commercial property, or even bare land. And of course you could always buy another rental house
How do I get an extension to my 45-day deadline?
The short answer: you don't. Except in VERY EXTREMELY RARE CIRCUMSTANCES, there is no such thing as an "extension" to the 45 day identification deadline. The 45 day requirement is a part of the code section. Legally, that makes it "statutory," meaning that the only way that the deadline can be changed is through an act of Congress -- literally! The deadline ends at midnight on the 45th day.
Why is there a 45-Day and 180-Day Rule for 1031 Exchanges?
Time for some 1031 Trivia!!
As you know, when performing a Section 1031 Like-Kind Exchange, you have 45 days to identify your New Property (calculated from the date of closing on the sale of your Old Property), and 180 days to close on the purchase of your New Property.
But, why did Congress choose these particular time deadlines? Unfortunately, the answer to this question is a bit esoteric. But, here are the answers -- for what they're worth!
The 180-day rule was Congress' response to the second Starker case (Starker v. U.S., 602 F.2d 1341 (9th Cir. 1979)). Starker is the seminal court case decided in 1979, which first allowed deferred, as compared to simultaneous, exchanges that we primarily see today. Starker upheld a five-year time period between selling the Old Property and buying the New Property! However, Congress decided that five years was way too long. The primary reason they originally passed Section 1031 -- the fact that the taxpayer's money is still tied up in the same type of investment -- was not served by the second Starker ruling. In addition, open-ended exchanges lasting for several years would create numerous administrative problems - How does the taxpayer report the exchange every year? How does the IRS track each open exchange? It's more likely that the exchanger dies during the exchange, etc. Therefore, Congress decided that 180-days were plenty long enough for a taxpayer to decide whether to continue his or her investment.
There is much less rationale given in the legislative history for the 45-day rule. In fact, there is virtually no rationale given whatsoever! We could venture some guesses, but our opinion is that the rule is likely arbitrary -- perhaps the result of Congressional negotiation.
Nevertheless, the 45- and 180-day rules are here to stay. So, follow them well, because while their reason for existence may be esoteric--and possibly even arbitrary--their effect is not. They are hard deadlines with no chance for an extension short of, literally, an Act of Congress!
Other QI's have told me I could do an exchange on my personal residence if I keep it quiet. Is this risky?
Yes it is risky -- AND it's an unnecessary risk at that. You don't need to do a Section 1031 exchange on your primary residence to defer or eliminate taxes. If you've lived in your house for two out of the last five years, you can claim the exemption (under Section 121 IRC) on capital gains up to $250,000 for single tax filers and up to $500,000 for joint returns. And, you can take this exemption every two years!
If your gains are over these limits, you might be able to do a §1031 exchange if you've treated the property as investment or for business use forat least the last year and a day. In this case, you can sell the property, use the exemption under Section 121, and for the rest of the gain defer it using Section 1031. This needs to be carefully done and documented, so use a Qualified Intermediary that has both legal and accounting skill sets and experience.
If you've lived in the house for less than two years, you still might be able to take what is called a partial exemption or a Reduced Maximum Exclusion. But this is not a Section 1031 exchange. Check with your tax advisor (or click here and scroll down to page 14: http://www.irs.gov/pub/irs-pdf/p523.pdf).
What if I just don't do an exchange?
A common question we get from prospective clients is how they determine what their tax consequenses would be if they didn't do an exchange. Here is a simple way to calculate it.
Depreciation Tax - First, you will be taxed at a maximum rate of 25% for all of the depreciation you've taken (or could have taken) on the property up to the amount of gains realized.
Federal Capital Gain Taxes - If you've held the property for over a year (long term), your tax rate will be 15% on the amount of gain in excess of the "depreciation tax" discussed above. If you've held it for less than a year (short term), you'll be taxed on the gain at your marginal tax rate. You CAN offset this amount on your tax return with capital losses from other sources.
State Capital Gain Taxes - You'll be taxed on the total gain by the state in which you live. If the property is in a state different from the one you live in, you'll probably owe tax in that state as well.
Example:
Let's say you originally bought the property for $200,000 and sold it for $300,000, leaving a gross capital gain of $100,000. And, let's say you took $60,000 in depreciation. Assuming 6% ($18,000) in broker's commissions and $2,000 in other costs associated with the sale, here's what you'll owe. I've used 5% for the state's tax rate in this example.
Net Cap Gain: $100,000-$18,000-$2,000 = $80,000
To this, add $60,000 for depreciation recapture to give $140,000 in taxable gain
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Depreciation Tax |
$15,000 ($60K x 25%) |
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Federal Long Term Cap Gains Tax |
$12,000 ($80K x 15%) |
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State Long Term Cap Gains Tax |
$ 7,000 ($140K x 5%) |
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Amount you'd owe |
$34,000 |
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Since every situation is different, you should consult your CPA or tax attorney for the actual tax in your situation. YOU MAY WANT TO FORWARD THIS TO YOUR ATTORNEY...
A 1031 QI (Qualified Intermediary) serves many functions: an officially sanctioned entity to hold the proceeds of a 1031 exchange; a 'trail guide' to help you through the process; an advocate if the IRS challenges your exchange; a guardian to protect your funds while being held for the exchange.
But there is another useful function a QI can serve that most people don't think about: Expert Witness. If an attorney needs someone to testify in tax court regarding the intricacies of a 1031 exchange, a QI as an expert witness-for-hire can help clarify things and help move the case along.
Not all QIs have the capacity to serve as an expert witness. If you need an expert witness in a 1031 exchange being challenged by the IRS, be sure you're getting a real expert with verifiable qualifications, expert service, a record of honesty and a good reputation.
Can I trust my QI...?
One of the things I used to tell my clients when I had my CPA practice is you never get ripped off by people you DON’T trust. What I mean is, after a high profile fraud case, you never hear the victims say, “I just KNEW he was going to rip me off!” Instead, the victim usually says something like “I can’t believe this happened," or, "I never saw it coming...."
Likeability is a good reason to do business with someone, but it’s not a good reason to trust them. Several high profile cases have made news across the country about Qualified Intermediaries (or “QIs”) either filing for bankruptcy, mismanaging client’s funds, or even disappearing all together (along with the exchanger’s money).
So, if you can’t trust the people you don’t trust, and you can’t trust the people you do, who do you trust? The answer, when it comes to your money, is simply: yourself. For years I’ve preached that you have to make sure that your 1031 intermediary places your money in a segregated account (and “segregated” means that only your money is in that account).
Can I fire my Qualified Intermediary...?
Recently, there has been a spate of high-profile Qualified Intermediaries, or 'QIs,' facing financial problems, including bankruptcies, lawsuits and possible federal actions.
As a result, other QIs who are reputable and have safeguards in place to protect client funds (like 1031 Exchange Experts) have been receiving calls from clients of other QIs seeking to move their funds and switch 1031 exchange companies.
So, the question arises . . . can you do this legally? Unfortunately, the answer is probably not. But keep reading; maybe you can....
First, there is no provision in the Tax Code or Regulations for switching QIs mid-stream. Going outside the rules is risky in any exchange. Second, and perhaps more important, there are strong arguments that if you (The Exchanger) direct your first QI to send your funds to a second QI, this constitutes you exercising "control" over your proceeds . . . and this is fatal to your 1031 exchange.
On the other hand, Reverse 1031 Exchanges (where you buy your New Property before selling your Old Property) are governed by different rules, and in many cases you CAN switch QIs. As you may be aware, in a Reverse Exchange, your QI holds your New Property on your behalf because you can't hold title to both your Old and New Properties at the same time. Therefore, it is possible to switch QIs in these cases by simply transferring title (or membership interest in the holding company for the property) to the new QI.
IRS Challenges a State's Definition of "Real Estate"
A recent Tax Court case could dramatically impact the exchange of 1) pre-construction contracts, and 2) purchase and sale contracts. In the past, it was common for taxpayers to do a 1031 exchange on a contract if their state defined that type of contract as "real estate."
For example, Fred enters into a pre-construction contract to buy a unit in a beachfront development in Florida. Two years later, construction on the building is almost complete. Fred has a buyer who would like to purchase the unit for $100,000 more than he is under contract to pay. If Fred takes title to the unit, he has to wait another year-and-a-day beforehe can sell it and do a 1031 exchange.
Alternatively, before taking title to the unit, Fred could sell the contract to the buyer and roll his gain into another property in a 1031 exchange. This is because he was under contract for more than a year-and-a-day, and because Florida defines these type of contracts as 'real estate.' That is, until now.
In a recent Tax Court case, the IRS challenged the long-held standard that something defined as "real estate" in one state can be 1031 exchanged for other conventional real estate. Even more disturbing, the court agreed that federal law (meaning what the IRS thinks) trumps state law in these matters
New Vacation Home Ruling...
While vacation or second homes [see: 1031 vacation home update: May 2007] have generally been treated as investment property, a Tax Court case released last month is a text book case on how to have your vacation home exchange disallowed.
This taxpayer had two major problems:
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1) |
They did absolutely nothing to indicate their investment intent for their property, and, in fact, almost everything they did seemed to prove that they had NO investment intent. And, |
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2) |
They got no help from either their intermediary or their attorney to help build their case that the properties were held for investment. |
We’ve always encouraged our clients to document the investment intent of their vacation home ownership. We also handle, for free, the audits of any of our client’s exchanges, so, had they used us, we would have helped them build their case. The truly unfortunate aspect of this case is that now there is a court case that disallows vacation homes for lack of investment intent.
I know what I want to buy, but I'm not sure where. Does that satisfy the IRS's Identification Rule?
Identification must be clear enough for your average IRS agent to go from your 45-Day Identification form to the property you have identified. Street addresses are fine. An identification of the main address of a 50 condominium tower without a unit number, however, does not do this. You must identify it as "Unit 203, Imperial Condominium Tower, 1027 Main Street, Smithtown, Texas."
Legal descriptions are necessary when the property involves bare land that does not have a legal address. We’ve had clients identify property as "40 acres on the northeast corner of Highway 71 and Interstate 100, Smith County, Texas."
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Real Property
45 Day Identification Period. You have 45 days from the closing of your sale to list the properties you may want to buy. There are no exceptions to the deadline.
180 Day Exchange Period. From the sale closing date, you have 180 days to close on the purchase of one or more properties from the 45-day list. Again, there are no exceptions to this deadline.
Qualified Intermediary (QI). The IRS mandates that you use a QI to prepare the legal documents for your exchange. Because the QI must be independent, it cannot be your friend, employee, broker, or even your accountant or attorney. The QI also holds your money, so that you do not have access to it.
Proper title holding. You must purchase and take title to your new property exactly as you held title to your old property.
Reinvestment Requirement. To defer all of your capital gain tax, you must buy a property equal or higher in value than the one you sold. Also, you must reinvest all of the cash proceeds from your sale.