1031 Exchange Information

What is a Tax Deferred Exchange?

Section 1031 of the Internal Revenue code lays the guidelines for what is known in the commercial real estate world as a Tax Deferred Exchange. Basically, it allows you to avoid a taxable financial gain on the sale of commercial real estate if you receive “like kind” property rather than cash for the transaction. Though we’ll be discussing the uses of Tax Deferred Exchange in terms of real estate, the principle applies to other types of property as well.

Section 1031 sanctioned property exchanges can be beneficial to any company, large or small, but they must be carried out according to all IRS regulations, which can be fairly complicated. Also, Tax Deferred Exchanges do not apply to every real estate investment, especially if you’re selling property at a loss.

How Tax Deferred Exchanges Function

1031 real estate exchanges are a lot like conventional transactions.
A key difference is the involvement of a Qualified Intermediary, a third party selected to carry out the sale of the property. The Qualified Intermediary accepts the agreed-upon sum and deposits it into a special interest-bearing bank account. This is a critical step because IRS rules do not allow the seller or the seller’s representatives to accept the payment for the sale of the property at any time.

The Intermediary uses the money generated by the initial sale to buy “like kind” real estate, selected to serve as a replacement for the property you sold and transfers ownership back to you.

These processes must happen within an official timetable. The replacement real estate must be located within 45 days after the initial sale and the final transaction must be completed within 180 days. The IRS requires the complete Tax Deferred Exchange to be carried out within 180 days of the initial sale or by the date on which your tax return for that year must be filed –whichever of the two options comes first. There are no exceptions.

Executing a Tax Deferred Exchange

Any real estate involved in a 1031 Tax Deferred Exchange must be used for purely commercial purposes, and the replacement property must be used in the same way as the property sold. Before making a real estate investment via a Tax Deferred Exchange, we highly recommend that you consult with a lawyer and a tax accountant to be sure such a transaction makes sense.

Your sale contract should contain language requiring the buyer to recognize the seller’s choice to execute a Tax Deferred Exchange, allow the seller to assign his or her rights to the Qualified Intermediary, and cooperate with the Intermediary to finalize the transaction.

For taxes to be deferred, the price of the replacement property must be equal to or greater than the price of the property sold all net gains from the initial sale must be used in the purchase. Any monies left over from the transaction are taxable.

Up to three prospective replacement properties may be selected. They must be indentified in writing within 45 days of the initial sale. If you would like to indentify more potential replacements, you may do so as long as the collected value of all potential replacements is not more than 200 percent of the collected value of all properties sold.

All replacement property or properties must be purchased within a maximum of 180 days from the initial sale. Be sure you realize that the 45-day search period is included in the 180-day delineation.

When appropriate, a 1031 real estate exchange can be an excellent money-saving method of real estate investment. If you choose to purchase commercial real estate via such an exchange, be absolutely sure carry out the transaction in accordance to IRS requirements. Failing to do so can be very costly.

News Update.

CALCULATING SPECIAL FIRST-YEAR DEPRECIATION ALLOWANCE ON QUALIFIED PROPERTY ACQUIRED VIA LIKE-KIND EXCHANGE OR INVOLUNTARY CONVERSION

IRS has not yet definitively answered how the special first-year depreciation allowance under Code Sec. 168(k) is calculated when property that qualifies for it is acquired by way of a like-kind exchange or involuntary conversion. This Practice Alert explores the alternatives.

Exchanges and involuntary conversions. No gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment. In general, the basis of property received in the exchange is the adjusted basis of the property traded away plus any money paid to acquire the replacement property. (Code Sec. 1031(d); Reg § 1.1031(d)-1(a)) Where the taxpayer’s property is involuntarily converted into money, and, within the prescribed replacement period, he buys other property similar or related in service or use to the converted property, and elects not to recognize any part of the gain, the basis of the replacement property is its cost, reduced by the amount of gain that isn’t recognized. (Code Sec. 1033(b)(2))

Special first-year depreciation allowance. Unless the taxpayer “elects out,” property qualifying for the special depreciation allowance automatically gets a 30% first-year depreciation deduction, plus regular depreciation on adjusted basis (after a reduction to reflect the 30% first-year depreciation allowance). (Code Sec. 168(k)(1)) In general, an asset is qualified property if it is tangible personal property with a MACRS or ADS recovery period of 20 years or less, certain software, and a new category called qualified leasehold improvement property. The property’s original use must commence with the taxpayer after Sept. 10, 2001, and, in general, it must be acquired by the taxpayer after Sept. 10, 2001 and before Sept. 11, 2004, and placed in service before 2005. (Code Sec. 168(k)(2))

The additional first year depreciation deduction is equal to 30% of the adjusted basis of the qualifying property. Adjusted basis generally is its cost or other basis multiplied by the business/investment use percentage, reduced by amounts expensed under Code Sec. 179, and adjusted to the extent provided by other rules (e.g., reduced by the amount of the Code Sec. 44(d)(7) disabled access credit). (Rev Proc 2002-33, Sec. 2.02, 2002-20 IRB)

Regular depreciation rule for like-kind swaps and involuntary conversions. MACRS property that is placed in service after Jan. 2, 2000, and acquired (1) in exchange for MACRS property in a like-kind property exchange to which Code Sec. 1031 applies or (2) in replacement of involuntarily converted MACRS property in an involuntary conversion to which Code Sec. 1033 applies, is depreciated in the same way as the exchanged or involuntarily converted MACRS property. The acquired MACRS property is depreciated over the remaining recovery period of the exchanged or converted MACRS property, using the same depreciation method and convention as that of the exchanged or converted MACRS property. However, any excess of the basis in the acquired MACRS property over the adjusted basis in the exchanged or converted MACRS property is treated as newly purchased MACRS property. (Notice 2000-4, 2000-3 IRB 313)

Swapping temporary water rights for land is a taxable event.

A farming partnership was entitled to receive a share of the water from a nearby river for 50 years. The firm exchanged the water rights for some additional farm acreage through an unrelated intermediary.

The transfer is not a like-kind exchange, a district court says.

Although for state law purposes, the water rights are an interest in land, the farmland and the water allocation are different types of real estate because the water rights are not permanent. Thus, any gain on the sale of the allotment is taxed to the partnership (Wiechens, D.C., Ariz.).

Using an LCC in an IRC section 1031 Avoids Transfer Taxes.

In LTR 200118023, the Internal Revenue Service ruled that the acquisition of the sole interest in an LLC that owns real property will be treated as the acquisition of qualifying like-kind replacement property under IRC section 1031. To avoid incurring a liability for local real estate transfer fees, a taxpayer proposes to have a Single Member LLC (SMLLC) (that has not elected to be classified as an association) act as an exchange vehicle by acquiring real property owned by its sole member. Then the taxpayer will acquire the SMLLC from its sole member. The IRS noted that non-recognition of gain under IRC section 1031 only applies to the extent that the property held by the SMLLC at the time it is transferred to the taxpayer is property of a like kind to the property being transferred. Any property that is not like-kind property held by the SMLLC or any property transferred to the taxpayer incident to the exchange will be taxable to the taxpayer as boot. In this respect, all real property should arguably be held in SMLLC's to help avoid local transfer taxes (except in jurisdictions such as the District of Columbia or New York City where these real property transfers would still be subject to such taxes).

Terrorist Attack Tax Relief.

Immediately following the September 11 terrorist attacks, the IRS announced a variety of tax relief measures. The President declared the following areas to be disaster areas: Bronx, Kings (Brooklyn), New York (Manhattan), Queens, and Richmond (Staten Island) counties in New York and Arlington county in Virginia. Disaster-area relief is available not only to taxpayers in these counties but also to other affected taxpayers, regardless of where they reside. These "other affected taxpayers" include: victims of the crash (on board or on the ground), all workers assisting in the relief activities in the disaster areas and in Pennsylvania, and taxpayers whose place of employment is located within the disaster area.

The IRS has granted relief for Section 1031 like-kind exchanges as follows:

If the property transferor is an affected taxpayer, the last day of the identification period of the exchange period for deferred like-kind exchanges, or a deadline relating to a qualified exchange accommodation arrangement, is postponed by 120 days if the relinquished property was transferred before September 11, and the identification or exchange period would end after September 10, 2001 and before December 1, 2001.

Similar relief applies to those who are not "affected taxpayers" who have difficulty meeting like-kind exchange deadlines due to the terrorist attack because of a variety of stated reasons, including the relinquished to replacement property’s being located in a disaster area; or the principal place of business of any other party to the transaction (including transferee, intermediary, settlement attorney, lender, or title insurance company) being in a disaster area; or documents or records being destroyed, damaged, or lost as a result of the attack.

Assets acquired in like-kind swaps can get faster depreciation. Generally, like-kind property that's received in a tax-deferred exchange has the same income tax basis for depreciation as the traded property. But there has been confusion over how to write off replacement assets.

Acquired property is depreciated over remaining life of old asset, IRS says ... takes over the depreciation schedule of the traded property. To the extent the new property has a higher basis because seller paid cash in the exchange, that amount is depreciated like a newly acquired asset. Total depreciation allowed is still greater than if the entire tax cost of replacement property had to be written off over its full useful life.

The relief applies to assets placed in use after January 2, 2000.

But the easing can also be retroactive in most circumstances. For all details, see IRS Notice 2000-4 in the January 18 IRS Bulletin.