The general rules and guidelines of IRC Section 1031, Like-Kind Exchanges were presented in Part 1, in the August, 2009 edition of FlashPoints. This Part 2 follows the Section numbering and terminology from Part 1.
There are many detailed requirements to accomplish and then retain the benefits of a Section 1031Exchange. Here are some selected tips and traps.
Boot: The Client may have to recognize gain where they received “boot”. The Client may have “boot” created in a variety of different ways, the most common of which are as follows.
Cash Boot: The Client cannot, at any time, have use or control of any of the money from the exchange of a Relinquished property. For example, in the sale of a Relinquished property, if the Client’s agent accepts an earnest money check made payable to the Client or the Client’s broker then gain may be triggered.
Debt Boot: The reduction of debt going from the Relinquished property to the Replacement property is may also trigger a gain. The debt on the Replacement property should be equal or greater than the debt that was on the Relinquished property to avoid Debt Boot.
The Client must plan for deferred 1031 Exchanges and get their team assembled ahead of time. It is critical that the Client map out the deal, step by step including who will hold the earnest money, the amount of debt on the Relinquished property, the amount of debt that will be placed on the Replacement property, whether they will be taking any cash out of the deal, whether they must put cash into the deal, etc. This involves careful coordination between their attorney, tax advisor, lender and real estate broker/agent.
Magic Words in the Contract:
Issue: There is certain legal language that must be in a contract in order for the property to be eligible for a deferred 1031 Exchange and to assure that the other party will cooperate. If this language is not in both real estate contracts (purchase and sale) then the 1031 Exchange may fail.
Discussion: Often, attorneys on real estate transactions are only contacted after there is a fully executed real estate contract. At this point, the attorney must play catch-up to add the necessary language during the “attorney approval” period. Ideally, the language should be inserted before there is a fully executed contract. Further, at this point the clock is ticking on getting a proposed modification out to the other side. Finally, the risk exists that the other side does not agree to the modification.
It would be best if the Client got advice from their attorney before they sign any real estate contract. This is even more important if the Client is planning (or considering) a 1031 Exchange.
- Magic Words For Relinquished Property: Here is sample language that could be inserted into the real estate contract for the sale of the Relinquished property:
“Seller hereunder desires to exchange for other property of like kind and qualifying use within the meaning of Section 1031 of the Internal Revenue Code of 1986, as amended and the Regulations promulgated thereunder, fee title in the Property which is the subject of this Contract. Seller expressly reserves the right to assign its rights, but not its obligations, hereunder to a Qualified Intermediary as provided in IRC Reg. 1.1031 (k)-1(g)(4) on or before the Closing date. Purchaser agrees to cooperate with Seller and the Qualified Intermediary at no additional cost or liability to Purchaser, by executing the documents necessary to complete Seller’s 1031 exchange transaction.”
- Magic Words For Replacement Property: Here is sample language that could be inserted into the real estate contract for the purchase of the Replacement property:
“Purchaser hereunder desires to exchange other property of like kind and qualifying use within the meaning of Section 1031 of the Internal Revenue Code of 1986, as amended and the Regulations promulgated thereunder, for fee title in the Property which is the subject of this Contract. Purchaser expressly reserves the right to assign its rights, but not its obligations, hereunder to a Qualified Intermediary as provided in IRC Reg. 1.1031 (k)-1(g)(4) on or before the Closing date.” Seller agrees to cooperate with Purchaser and the Qualified Intermediary at no additional cost or liability to Seller, by executing the documents necessary to complete Seller’s 1031 exchange transaction.
Changing the Use:
Issue: The use of the property must be qualified at the time of the exchange and thereafter.
Discussion: The recognition of gain might be triggered if the use of the Replacement property changes. For example, the Replacement property is initially rented out but then the Client decides to move in and use it as their residence. At the same time, the 1031 Exchange tax laws combined with the sale of a principal residence tax laws present a unique opportunity. The Client may use the 1031 Exchange laws to defer the gain and then use the sale of the principal residence laws (IRC Section 121) to forever avoid part or all of the gain. Please note that recent changes in the tax laws make this benefit harder to achieve.
Transfers Or Changes To The Like-Kind Nature of The Property:
Issue: The Replacement property received must remain qualified.
Discussion: Once the Client defers a gain through a 1031 Exchange, they need to be careful about nearly everything relating to the property. For example, if a property held for productive use in a trade or business, or for investment is gifted, sold, or the nature is changed the gain could be triggered.
The Amount of The Gain:
Issue: It is often difficult to determine the gain on the original exchange. It is even more complex where a Client has “rolled” the gain from property to property.
Discussion: The Client should consult with an attorney or tax advisor that understands these rules to properly determine the amount of the deferred gain. Ideally, this would be done before any contracts are signed since the amount and nature of the gain may affect the Client’s decision as to whether they even want to do a 1031 Exchange.
The Nature of the Gain:
Issue: The tax on the gain is not necessarily based upon one tax rate.
Discussion: Clients have various options for depreciating real estate for income tax purposes. Further, the available depreciation rules have changed over time. The tax laws require that certain portions of the gain be “recaptured” and taxed at ordinary income rates. The Client should consult with an attorney or tax advisor that understands these rules to properly determine the nature of the deferred gain, not just the total amount. This could significantly affect the tax considerations that a Client will use in determining whether to enter into a deferred 1031 Exchange.
Issue: Deferred 1031 Exchanges are very technical and must be meticulously mapped and executed. Even if someone has the misguided belief that any attorney can “do a Closing” not all attorneys, not even all good real estate attorneys, know the deferred 1031 Exchanges rules.
Discussion: The Client should make sure that their attorney is experienced in deferred 1031 Exchanges before they are engaged. From the attorney’s point of view, the attorney should never take on a job that they are not qualified to do.
Fees and Costs:
Issue: Many real estate attorneys agree to represent Clients on modest fixed fee rate per transaction. However, additional requirements, time, risks and out-of-pocket costs are involved in deferred 1031 Exchanges.
Discussion: A low fixed fee may be an indication that the attorney does not fully understand all of the extra work that must be done. The attorney should be very specific, in their written engagement letter, as to who is responsible for what. They should also address the out-of-pockets costs associated with 1031 Exchanges.
The Qualified Intermediary:
Issue: The Qualified Intermediary is a critical team member of the deferred 1031 Exchange process.
Discussion: The Qualified Intermediary must follow the proper steps and their forms must be compliant with the then current tax laws. Of course, they must be completely safe and trustworthy since they will be holding large sums of the Clients’ money and/or title to the Client’s property.
Often, attorneys will use their own forms and/or select a Qualified Intermediary based upon their fee alone. It is recommended that only respected Qualified Intermediaries that regularly handle deferred 1031 Exchanges be utilized. No attorney should rely upon any forms unless they are confident that the forms are current. The money saved by using the “cheapest” Qualified Intermediary or the old forms that the attorney pulls out from their word processor could be dwarfed by the pain suffered if things go bad.
Related Party Transactions:
Issue: There are additional requirements imposed where the Client exchanges with a related party.
Discussion: Additional care must be taken whenever related parties are involved in a transaction. This is true whether or not a 1031 Exchange is involved. The definition of a “related party” for purposes of 1031 Exchanges is a combination of IRC Section 267(b) and IRC Section 707(b). For example, if the Client exchanges with a related party, both parties must hold their properties for at least 2 years after the exchange. Separately, losses from transactions between related parties are generally not deductible. Sometimes, 1031 Exchange between related parties can present beneficial estate planning opportunities.
Issue: While a Client may successfully achieve a 1031 Exchange the Client must still report the transactions to the IRS.
Discussion: A 1031 Exchange is reported by individual taxpayers on IRS Form 8824. Form 8824 is part questionnaire and part computation. Clients must keep track of certain tax amounts and attributes relating to their exchanged properties.
Deferred like-kind exchanges provide both wonderful opportunities and the chance for unhappy surprises. To get the benefits (and avoid the problems) every aspect of the transactions must be mapped out, step by step and diligently executed.
Copyright ©, Keith B. Baker – 2009
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