§1031 BROCHURE

This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.

Internal Revenue Code §1031 allows the tax deferred exchange of investment real estate. [The tax deferred exchange is also known as a "Starker," named after the first tax case on this topic.]

Unlike §1034 which applies to the tax deferred roll over of profit for the sale of a primary residence, §1031 is a highly complicated and technical Tax Code Section. It must be handled correctly from the beginning, and expert legal advice is needed. The real estate agent should advise (in writing) his client to obtain proper legal advice before signing anything.

OVERVIEW

ALL U.S. INVESTMENT REAL ESTATE IS "LIKE KIND."

The replacement property must be identified within 45 days & acquired within 180 days of the sale of the old property.

The Seller must not have the right to receive the sales proceeds.

1) QUALIFIED PROPERTY: LIKE KIND

Several years ago, Congress proposed limiting the definition of like kind, but the restriction was NOT passed.

Foreign property is NOT eligible to be traded for US property, but US territories are uncertain.

§1031 does NOT apply to a personal residence or to a vacation home.

§1031 does NOT apply to a Partnership (or LLC) Interest. If a Partnership owns real estate, the Partnership may enter a §1031 exchange; individual partners may not trade a share of one Partnership for another, or for real estate.

FICTIONAL TRADE

Reality: Tom owns First Street; he wants to sell it and buy Second Street. Bob wants to buy First Street from Tom; Sam wants to sell Second Street to Tom.

Structure: Tom hires an accommodator, Xchange Inc. Tom gives Xchange a deed for First Street. Xchange sells First Street to Bob. Xchange uses the sales proceeds from First Street to buy Second Street from Sam. Xchange gives Tom Second Street to complete the trade.

The tax consequence is that Tom has traded First Street for Second Street with Xchange.

The reality is that Tom sold First Street and bought Second Street; Xchange's participation is only a manipulation to make the facts fit the law, BUT IT WORKS AND IS NECESSARY.

Transaction

They calculate Tom's potentially taxable profit on an outright sale. [This is his sales price (less commissions and costs of sale) less his tax "basis" (generally, cost plus capital improvements less depreciation).]

10 years ago First Street cost Tom $100,000. He put a new roof, deck, and driveway in, at a cost of $25,000. He took $45,000 of depreciation. Tom's tax basis is $80,000.

[Not necessarily! If Tom inherited all or a portion of the property, he gets a "step up in basis" to the date of death fair market value.]

Tom can sell First Street for $150,000, after commission and costs of sale.

Tom's profit is $70,000.

Note: IGNORE MORTGAGES in calculating profit. Tom may net very little after payment of the mortgage, but that does not count in computing profit.

After meeting with his lawyer, Tom signs a listing to sell First Street. His agent markets the property and finds a buyer.

The offer states that "Buyer will co-operate in a §1031 exchange, at no cost to Buyer." Tom's lawyer gives his OK before Tom accepts the offer.

An accommodator is hired to facilitate the trade; Tom signs papers approved by his lawyer to transfer First Street to accommodator; accommodator signs the property over to Sam; commissions are paid; net proceeds are held by accommodator.

Tom then finds a new property. He makes an offer (after his lawyer reviews it) which includes "Seller will co-operate in a §1031 exchange, at no cost to Seller."

The accommodator buys the new property for Tom with the net proceeds from First Street.

2) ACTUAL OR CONSTRUCTIVE RECEIPT

In order to avoid constructive receipt, the Seller is forced to have an unrelated third party (an "accommodator," "facilitator," or "exchangor") hold the funds until the replacement property is found and purchased.

The Seller's biggest concern is protection from theft. If an accommodator embezzles the funds, the Seller loses not only his money, but must pay tax on the profit on the sale of the old property since the trade was never completed.

One protection for the Seller is to have a simultaneous exchange. Both transactions close in the same escrow. The Seller's risk is almost eliminated. But, how often can deals be planned to close that perfectly? With a delayed close of escrow, it can happen, if the other parties are flexible.

Other protections

Interest

3) IDENTIFICATION WITHIN 45 DAYS

How to identify: A written document signed by the Seller, delivered, mailed, faxed, or sent to any other (non-related) person involved in the transaction is sufficient.

Specificity of identification: The street address or legal description of the proposed replacement property is required.

Alternate identification of replacement properties is allowed, IF (1) no more than 3 alternate properties are described (eg. 1 First Street, 2 Second Street, or 3 Third Street as alternate replacement properties), or (2) up to twice the value of the old property is identified as the target properties (eg. any of the following 6 properties, the total value of which is not more than 200% of the value of the old property).

What happens if you find a new property after the 45 day identification period passes? It is too late. If, for any reason, you do not close on one of the identified properties within the 180 day period, tax is owed on the sale of the old property.

Multiple new properties may be purchased.

4) BOOT

There are several kinds of boot. First is cash. The exchange of property 1 for property 2 plus $5,000 results in tax on profit up to the amount of boot. Here, boot is the $5,000 received.

The complicated kind of boot is net debt relief.

Property 1 is worth $100,000; it is subject to a mortgage of $75,000. Property 2 is worth $90,000, subject to a $65,000 mortgage. Although the equities are equal, the trade results in a $10,000 net relief of debt, which is potentially taxable boot.

5) HOLDING PERIOD

You may trade properties repeatedly, and frequently. [However, §1031 is not available for real estate developers, or if the real estate is inventory of a real estate professional.]

More frequent is this situation:

I have a rental. I want to §1031 into a new property. I eventually may want to reside in the new property. How long must I hold the new property as a rental before I later decide to convert it to personal use?

The determinative factor is intent at the time of the exchange. The acquired property must be investment property at the time of acquisition, without a present intent to convert it to personal use at a later time. However, mental intent is difficult to prove. The true test is your objective manifestation of that mental intent.

If you trade into your new rental, hire an agent to find a tenant, and that same day your personal residence burns down, you have a legitimate reason to alter the character of your new rental into a personal residence without tainting your intent at the time of the exchange. However, such an external event is rare, and the better rule of thumb is that a year should pass before altering the new rental to a personal residence. Even that is inadequate if your intent at the time of the trade was to acquire a new personal residence after waiting long enough to get away with it.

Reverse Exchange Update

SUMMARY

1031

The 10/2004 Tax Law changed the rules for sale of a personal residence acquired in a 1031 exchange.  The primary residence cannot be sold (tax free) for 5 years after its acquisition.  New Section 121(g).