About 1031 Exchanges
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On March 19, the Internal Revenue Service released Revenue Procedure 2002-22, which addresses the use of real property fractional ownership interests as replacement property in Internal Revenue Code Section 1031 tax-deferred exchanges. Commercial real estate professionals commonly refer to these fractional ownership opportunities as tenancy-in-common interests.
The potential advantages of using fractional ownership interests to complete a 1031 exchange are significant for both investors and their advisers. Tenancy-in-common interests offer increased opportunities to identify a replacement property within 45 days, the option to buy into institutional-grade product for less money, and the potential to diversify into multiple properties with fewer dollars.
Like-Kind Exchange Primer Under Section 1031, property owners may defer gain recognition on a sale by exchanging for like-kind property; however, they must meet numerous requirements to complete a successful exchange.
In order to achieve 100 percent tax deferral, the cost of the replacement property must be equal to or greater than the net sales price of the property being sold, and all the proceeds must be used. Further, the seller must identify a suitable replacement property within 45 days of the relinquished property sale. Finally, the seller must take title to the property he ultimately buys in the same manner in which he gives title to the property he sells.
In the past, tax professionals and other investment advisers were wary of recommending fractional interests as replacement properties because the IRS often considered the investor’s interest in the new property to be a partnership, thereby invalidating the exchange. Along with partnerships, Section 1031 prohibits owners from exchanging out of real estate and into a corporation or limited liability company.
This concern often prevented investors from buying shares of larger and potentially more attractive properties. In response to the need for high-quality replacement property in a range of prices, a niche group of companies began offering tenancy-in-common interests to complete 1031 exchanges. To meet the title requirements, investors receive a deed for a portion of the property, rather than a share of a partnership. To encourage referrals, many tenancy-in-common program sponsors offer referral fees ranging from 1 percent to 6 percent of the equity value placed in the product.
Fundamentals of the New Guidelines Rev. Proc. 2002-22 provides guidance on the use of fractional interests as replacement properties in 1031 exchanges. Although the IRS did not provide the ultimate safe harbor blessing for these investments, it outlined 15 minimum standards tenancy-in-common interests must meet to be considered as potential replacement property. A few of the key criteria are:
- the number of tenants-in-common cannot exceed 35;
- the sponsor of the interests may own the property (or an interest therein) for only six months before 100 percent of the interests are sold;
- any decision that has material or economic impact on the property or its owners must be approved unanimously by the owners; and
- the management agreement must be renewable annually and must provide for market rate compensation.
For the complete listing of requirements, visit the IRS Web site at http://www.irs.gov/. Investors should seek private-letter rulings on specific offerings for more concrete assurance that their fractional interest meets the specified qualifications.
Some investment advisers have found that recommending properly structured tenancy-in-common programs can result in a win-win situation for all parties. For example, one of your clients owns a small apartment building that requires an inordinate amount of time to manage. As he nears retirement, your client receives a $750,000 offer on the building and wants to exchange into an institutional-grade investment. With the amount he will be able to invest from the sale, your client doesn’t think he can afford a high-quality investment offering a strong yield and greater appreciation potential. However, in this scenario, your client should consider a tenancy-in-common program that complies with the recent IRS ruling. With his sale proceeds, your client feasibly could exchange into a 15 percent interest in a class A office building worth $5 million.
The new guidelines also open the door for investors who want to structure fractional interests in a desirable replacement property on their own. For instance, Jennifer Reed owns a high-quality rental property in suburban Atlanta worth $500,000. She notices a small strip shopping center for sale in the area and, after some due diligence, discovers the center can be purchased for $1.5 million. Though individually she cannot afford the center, she has two friends who would like to invest a portion of their portfolio in real estate. The three decide to purchase the property together. When Jennifer sells the rental property, she exchanges all of the debt and equity from the sale for a one-third interest in the shopping center as a tenant-in-common. The other two investors provide the balance of the funds necessary to close the deal.
Proceed With Caution As tenancy-in-common programs are in their infancy, commercial real estate professionals should review them carefully before advising clients to consider them as viable replacement property options. Because all programs are not created equal and may have been structured prior to the release of Rev. Proc. 2002-22, careful due diligence is essential. As more sponsors modify their programs to seek and receive private-letter rulings certifying compliance, less due diligence will be necessary.
Whether for groups sponsoring fractional interests or creative investors looking to pool resources into a larger property, the new IRS guidelines are good news for the commercial real estate industry. For investment advisers, this guidance provides exciting new options for clients who don’t want to forego the benefits of a Section 1031 tax-deferred exchange.
Consult a tax professional for further information on individual cases.
Like-Kind Exchanges – Real Estate Tax Tips
Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.
Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.
Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Note: This page contains one or more references to the Internal Revenue Code (IRC), Treasury Regulations, court cases, or other official tax guidance. References to these legal authorities are included for the convenience of those who would like to read the technical reference material. To access the applicable IRC sections, Treasury Regulations, or other official tax guidance, visit the Tax Code, Regulations, and Official Guidance page. To access any Tax Court case opinions issued after September 24, 1995, visit the Opinions Search page of the United States Tax Court.
1031 Exchange Explained
<:figure>A 1031 exchange helps defer gains taxes on the sale of a property.
For real estate speculators and families who live in areas with an expensive real estate market, capital gains can pose a significant tax burden, particularly if real estate was held for a long time or through a volatile time in the market. Although it’s impossible to completely avoid capital gains assessments, a 1031 like-kind exchange allows property owners to sell one property and purchase another with the proceeds, and, if handled correctly, shields investors from immediate gains taxes.
The Internal Revenue Service allows investors to liquidate one property and exchange it for one of a similar kind — all domestic real estate qualifies as like-kind — and postpone gains taxes from the original sale. To qualify for a 1031 exchange, taxpayers may not take possession of the money generated by the sale of the property. To do this, investors must simultaneously sell the old property and purchase the new one, or route their funds to a qualified intermediary so they don’t take possession of the money, even if it’s reinvested in the new property. Any personal acquisition of the funds, even if it’s momentary, incurs gains taxes.
A 1031 exchange is only valid if the property owner’s equity in the new property is equal to or greater than that of the old property. Because of this, investors may not cash in equity on their old property during the exchange, though they can invest more into the new property.
If property owners don’t simultaneously sell and purchase the properties involved in the 1031 exchange, a qualified intermediary — a real estate broker — must serve as a go-between for the sale and purchase of the properties. Money gained through the sale of the original property is placed into an exchange account managed by the intermediary, so taxpayers never come in direct contact with the funds.
Property owners must identify one to three potential properties to purchase within 45 days of the original sale if a qualifying intermediary holds the funds. The exchange must be completed, with a new property purchased, within 180 days of the sale of the original property or by the date the taxpayer’s taxes must be filed.
In the case that a taxpayer purchases a replacement property before the original one is sold, a reverse exchange may be engineered. Amendments to 1031 rules were introduced in 2000 to allow a safe harbor for reverse exchanges in this situation.
Tax Basis and Gains
A successfully executed 1031 exchange allows a taxpayer to avoid paying gains on the sale of the original property, but those gains are only deferred to a later date. When a property purchased as part of a 1031 exchange is sold, its tax basis is calculated as the gains between the original property and the final one’s sale price. For example, an investor purchases a property for $100,000, and sells it as part of a 1031 exchange for $150,000, and purchases another property for $200,000. When that property is sold for $220,000, the investor’s tax basis is the difference between the purchase price of the original property and the sale of the second one. This investor faces gains taxes on $120,000 ($220,000 – $100,000) in this situation.
Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including “TV Guide” and “The Dallas Observer.” Schnotz holds a Bachelor of Arts in journalism from Colorado State University.