SECTION 1031 EXCHANGES AND THE NAPKIN RULE

A number of our readers have asked about the Napkin Rule.  We answer that question and many others in the resources section of our company's website, www.liberty1031.com.  My suggestion to of all our bloggers is to go to that site for all of your 1031 information questions.  Below is an excerpt from the resource section, on the subject of the Napkin Rule.

Q. Do I have to acquire a property of equal or greater value?

Yes, you do in order to completely defer the applicable capital gains tax. To the extent that you purchase a property of lesser value, you will be taxed on the difference.

Q. Do I have to use all the cash proceeds from my sale on my purchase?
Yes, you must use all cash proceeds from the transaction in order to completely defer the applicable capital gains tax. To the extent you do not use all your proceeds on the purchase, you will be responsible for any tax on the difference.

Q. Do I have to obtain a mortgage on my replacement property in the same amount or same percentage of debt as I had on my relinquished property?

No. Just follow the above rules.

Q. Does Seller Financing jeopardize my exchange?

Seller Financing is considered boot, which means it is taxable in the year(s) that it is paid (considered an ‘installment sale’). There is a possibility that the Seller Financing (Note) can be placed into the exchange without paying taxes, but the note would have to be paid off or sold before the purchase of the replacement property.

FYI: These rules are often referred to as the Napkin Rule, because they were allegedly originally written on a cocktail napkin by the drafters of the rule.

WHAT IS THE DIFFERENCE BETWEEN A FACILITATOR, AN ACCOMMODATOR, AND A QUALIFIED INTERMEDIARY IN A SECTION 1031 EXCHANGE?

Nothing!!!   I could, of course, end this discourse with that one word—nothing, but I won't do that to you.  They all mean the same thing.  In fact, the governing organization for Qualified Intermediaries is called the Federation of Exchange Accommodators (FEA)--not Federation of Qualified Intermediaries.  Since most of the financial world knows us as Qualified Intermediaries maybe our governing organization should change the name to Federation of Qualified Intermediaries.  I am on the Board of Directors of the FEA, and I might just suggest that. 

So then what is a Qualified Intermediary? In order to have a "safe harbor" transaction, a transaction that IRS recognizes as valid for a Section 1031 tax deferred exchange, the taxpayer should use an independent Qualified Intermediary (QI).   The QI's role in the transaction is not that of a legal or tax advisor.  The QI should remain completely independent.  Their job is to prepare the necessary exchange documentation, not the closing documents, the exchange documents. The QI receives the proceeds from the sale and then disburses the proceeds when the taxpayer closes on the purchase of the replacement property.  By accomplishing those and other tasks, the QI is able to convert the taxpayer's sale and purchase into a tax deferred exchange.  We (the QI) do a lot of work, for a small sum of money. But it's a lot of fun, especially, since our clients are happy because at closing they don't have to pay any taxes.   Is this a good job or what!!!

SHOULD TITLE BE TAKEN IN THE NAME OF THE QUALIFIED INTERMEDIARY IN A SECTION 1031 EXCHANGE?

In most cases, the answer is NO. 

I think a brief Section 1031 history lesson would be appropriate right now.  When the original laws were written into the Internal Revenue Code on exchanging, they required that the title to the property being sold (the relinquished property) be transferred to the Qualified Intermediary (QI) who would then transfer the property and all of its contract rights to the purchaser.  So in the "old" days (prior to 1991), the owner/taxpayer would transfer ownership of its property to the QI, who would take title and then subsequently transfer title to the purchaser.  

On a section 1031 tax deferred exchange, we describe the sale of the relinquished property as Phase 1 of the exchange.  Phase 2 involves the taxpayer purchasing a property (the Replacement Property).  In the old days on the Phase 2 portion of the exchange, title would be delivered to the QI at closing and then the QI would subsequently transfer title to the taxpayer.  That was a lot of work and in MANY cases, resulted in double taxation and that my friends is not a good result. 

Let me explain. 

The majority of the states have a transfer tax every time a piece of real estate is sold.  So if we followed the "old" method of handling a Section 1031 exchange, we would have double transfer fees on the each phase of the same transaction.  Transfer fee #1--Taxpayer transfers property to QI;  Transfer fee #2--QI transfers property to the purchaser--and that's on the relinquished side of the transaction.  Additionally, as you probably surmised, there could also be double taxation on the purchase of the replacement property.   Transfer Fee #3--Title to replacement property delivered to QI;  Transfer Fee #4--Title transferred from QI to taxpayer.  So in the "old" days there was a very good possibility of double taxation on both sides of the tax deferred exchange.  But in 1991, the I.R.S. Regulations (they interpret the I.R.S. Code) were amended to allow the taxpayer to transfer the relinquished property directly its purchaser and to have title to the replacement property directly deeded to the taxpayer.   One very important point:  all of the proceeds from the sale of the relinquished property still had to be delivered to the QI and not to the taxpayer's agent.  The QI of course would then use those Phase 1 proceeds to purchase the replacement property (Phase 2).  By allowing this change,  there would only be one (1) transfer of title on each phase and therefore no double taxation. 

Whew--that was a long and important discussion.  When a taxpayer decides to do a reverse exchange--that's where the taxpayer purchases the replacement property before closing on the sale of the relinquished property--title to the relinquished property is generally put in the name of the QI and in some cases there could be double transfer fees to be paid--but that's an extremely complicated discussion for another day.  For more information on these and other Section 1031 subjects go to the "Resource Section" on our website at:  www.liberty1031.com.

IS YOUR PROPERTY TAX TOO HIGH?

The following are excerpts from an article that appeared in Parade magazine.  Most of my bloggers are aware that a couple of times a year I include a consumer oriented article having nothing to do with Section 1031 tax deferred exchanges--and since home values have plunged over the past 18 months, it is important to make sure that the assessed value on your home is assessed at the new lower value. 

"Nationwide, we have properties that may be overassessed by as much as 60%, says Pete Sepp of the National Taxpayers Union, a watchdog group in Washington,D.C....Many localities are still charging taxes based on the housing-boom values of a few years ago...While you can cut back on spending to lower your sales-tax burden or pay less income tax if your salary is cut or you lose your job, property taxes are not designed to respond immediately to economic pressures...Although most municipalities calculate the value of homes every three to five years, there are no national standards for how often reassessments should take place.  The good news is that, unlike sales and income taxes, property taxes can be appealed---and many homeowners are doing just that.  Some 50,000 appeals were filed this spring in Atlanta alone--10 times more than in 2008...In the past, about 40% of all appeals nationwide have been successful.  But that may not be the case this time.  Local governments often depend on property axes as their primary source of income, and most schools are funded via property taxes.  With budgets already stretched thin, property taxes represent a source of revenue that local governments may not be willing to give up."

MUST YOU TELL YOUR BUYER OR SELLER THAT YOU ARE DOING A SECTION 1031 EXCHANGE?

There  is no requirement in the IRS Code or Regulations that the contract for sale of either the relinquished or replacement properties specify that the properties are going to be exchanged.  In fact, the taxpayer in many cases has not even decided when they sign their contract of sale that they are in fact going to do an exchange. 

My office, LIBERTY 1031 Exchange Services encounters numerous taxpayers that decide just before the closing, sometimes they decide right at the closing table, that they want to do a Section 1031 exchange.  In our case (LIBERTY 1031), we have the ability to prepare documents on a standard deferred exchange and have them delivered within minutes--that's of course a part of our great service.   Hopefully the taxpayer (exchanger) and the party on the other side will agree to sign our necessary paperwork--that of course makes the transaction a lot simpler.   It always suggested that you have a cooperation clause inserted in your contract, when you are selling and when you are purchasing.  For a well written cooperation clause, go to www.cooperationclause.com.

EASEMENTS, SECTION 1031 AND THE ICE CREAM STORE

One of our clients owns an ice cream store.  They were approached by a sign company to sell to the sign company a perpetual easement on the ice cream store property, for a billboard sign.   Can the proceeds received by the property owner from the sale of perpetual easement be deferred by using IRS Code Section 1031?

The answer in my humble opinion is YES it can qualify.  Remember, in a Section 1031 exchange the properties exchanged must be "like kind".    It has been determined that an easement is a right in real property.  In one of the leading cases in the "1031 industry", the court talked about a "bundle of rights".  The giving of a perpetual easement is the giving up of a part of that "bundle of rights". 

So in the case of the ice cream store, the owner of the property can sell a perpetual easement, giving up a right in that real estate, and use those funds to do an exchange for another type of real estate.  For that matter, they could exchange, using those funds, for a shopping center or an office building if they wanted to.  Remember, any type of real estate can be exchanged for any other type of real estate.  Gosh I love that part of the IRS Code.

IN A SECTION 1031 EXCHANGE, CAN A TAXPAYER REVOKE A PROPERTY THEY HAVE ALREADY IDENTIFIED?

In order to do a Section 1031 exchange, the taxpayer must sell an investment property or property used in a trade or business for a like kind property.   When the taxpayer sells its relinquished property, they then have 45 days from the closing date to "identify" what they might like to buy as a replacement property.  

What happens if they taxpayer identifies a property they no longer are interested in, that is the question.  The answer is:  the taxpayer may revoke the property identified at any time prior to the end of the identification period (the 45 days mentioned above).  This revocation must be in writing and signed by the taxpayer and finally should be sent to the party to whom the taxpayer originally identified the property they wish to revoke. 

The delivery of the revocation can be by hand delivery, mail, or telecopy--but again must be sent before the expiration of the 45 days.  For more information on identification and related subjects go to www.liberty1031.com and look up the resources section.  By the way, any of our Exchange Coordinators at Liberty 1031 Exchange Services can also get your the answers to these types of issues.

IN A SECTION 1031 EXCHANGE CAN A TAXPAYER ADD AN ADDITIONAL PARTY TO THE PURCHASE OF THE REPLACEMENT PROPERTY?

The head of our E-Marketing Dept. sent me a copy of an e-mail requesting information on the following issue:  Can an individual  taxpayer use the proceeds from the sale of its investment property(relinquished property), to purchase along with others, a replacement property?   

The answer is a firm YES THEY CAN.  For Example:  a taxpayer could sell a piece of investment RE(the relinquished property) for $1 million and purchase a $2 million replacement property, owning a 50% interest in the $2 million property, as a tenant in common with another party(ies).  In this example, both the taxpayer and their other co-owner (legally described as tenant in common) each would put up the same sum of money, $1 million each.

This leads to another question:  Could the other co-owner put a mortgage on the property in order to fund its $1 million contribution toward the purchase?  They could, but that would create another problem for the taxpayer, as that loan would become a lien on the entire property, which would allow IRS to take the position that the taxpayer who did an exchange really only put up $500,000 ,  not the full million.  I know this is a little complicated, that is why you need to make sure you are using a competent Qualified Intermediary.  You know where to find Liberty 1031.  Enough advertising--but I think you can agree that it is an interesting issue.

IDENTIFICATIONS ON A SECTION 1031 EXCHANGE

One of our prospective clients asked a provoking question.  After he closes on the sale of his relinquished property in a Section 1031 exchange,  he understands that he only has 45 days to identify what he would like to purchase as his replacement property(ies).   He read in our blog, that the 45 day identification period has no extensions (there are extensions, but only when given by the President of the United States, generally for those affected by disasters).  What he wanted to know  was could he fudge the date, in other words, could he give us an identification statement after the 45 days period had expired, but date it prior to the 45 day deadline?

The answer is NO HE CAN'T !!  He would be committing criminal tax fraud.  Liberty1031 and most other reputable Qualified Intermediaries will not be part of criminal fraud.  Additionally, that type of fraudulent act would open up the QI to losing its Qualified Intermediary status with IRS.  For the protection of all of our clients, identification statements are time stamped.  This protects our clients, should there be an audit by IRS. 

IS IT DIFFICULT TO DO A 1031 EXCHANGE?

That's a question Liberty 1031 gets asked at least 10 to 15 times a week. 

The answer is YES and NO.  It can be difficult if you have someone advising or working with you that really does not have the experience in handling 1031 exchanges.  It can be an easy experience, if you use an independent Qualified Intermediary(QI) who is knowledgeable and experienced in handling 1031 exchanges.  One of the first questions you might want to ask your independent QI, is whether they have a CES  (Certified Exchange Specialist) working for them.   .FYI—in order to obtain the CES designation, a QI must have been in the full time business of handling 1031 exchanges for at least 3 years and pass a very rigorous examination

That's one of the wonderful things about working at Liberty1031.  We prepare 8 documents when you sell your relinquished property and prepare 7 documents when you purchase your replacement property.  We have it down to a science.   With our Exchange Coordinators(EC), all of whom had to be real estate paralegals for at least 5 years, before we would hire them for training as EC's, we are able to literally have the documentation PDF'ed to the closing agent within 20 minutes of receiving all  the necessary information. It makes my life as the "Boss" a lot simpler.   Go back and look at our blog on how to select a QI or go to our website at: www.liberty1031.com for the information on how to select a QI.