How Long Do I have to Hold My Property In Order to Qualify For A Section 1031 Exchange?

Section 1031 contains no fixed amount of time needed to qualify a transaction for tax-deferred status.  Instead, Section 1031 requires that the taxpayer have the intent to hold the property for either an investment purpose or a business purpose at the time of the exchange in order to avoid a taxable exchange.   

The case law on Section 1031 follows a line of precedence where courts will attempt to determine what the taxpayer's original intent was at the time he sold his relinquished property and purchased his replacement property.  The court applies a “facts and circumstances” test to objectively measure whether the taxpayer had a bonafide intention to hold each property as investment or business property at the time of the exchange. The taxpayer’s actions, written and oral communications, and tax filings, constitute evidence for examination if the Internal Revenue Service challenges the tax-deferred status of the exchange.  For a more thorough discussion on this subject go to our website:  bayview1031.com and look up the resources section for recent articles and information written on this subject.

The Napkin Rule Explained

I now have had two blog readers request a definition of the Napkin Rule. 

The Napkin rule is a rule that was written on a cocktail napkin, a number of years ago by some of my fellow brethren in the 1031 industry.  It describes four "givens" that are used when trying to decide whether a 1031 transaction will be 100% valid.  So here goes--the description of the famous -- NAPKIN RULE:

Rule #1--The taxpayer must purchase (exchange) a property of equal or greater value to the property sold, in order to completely defer the applicable capital gains tax.  If the taxpayer purchases a property of lesser value, the taxpayer will be taxed on the difference. 

Rule #2--The taxpayer must use all of the cash proceeds from the sale of the taxpayer's property toward the purchase of the replacement property in order to completely defer the applicable capital gains taxes.  If the taxpayer does not use all of the proceeds towards the purchase of the replacement property, those proceeds not used will be taxed. 

Rule #3--The taxpayer selling the relinquished property must be the same taxpayer who purchases the replacement property. 

Rule #4-- In order to have safe harbor protection, the taxpayer must use an independent qualified intermediary.  WHAT DOES ALL OF THIS MEAN?   The long and short of this rule is that the taxpayer must purchase property of equal or greater value than the property sold. They must use all of the proceeds received at sale towards the purchase of the replacement property. The taxpayer must be the same on the purchase as was on the sale. 

So, for example, you can't add your child to the title of the purchase of the replacement property because your child was never on title when you sold your relinquished property. And, finally, make sure you hire a completely independent Qualified Intermediary, not anyone who was or is your agent.  Any variation of the above rule might cause some or all of the proceeds to be taxed. 

You now have my permission to transact a tax deferred exchange as set out in Section 1031 of the Internal Revenue Code--I find that a lot of my bloggers go back and look at some of our previous published blogs--that is a very good idea, because we have covered numerous important subjects.

HOW DO YOU REPORT SECTION 1031 LIKE-KIND EXCHANGES TO THE IRS?

Most CPA’s are aware that you must report a Section 1031 exchange to the IRS on Form 8824.  You should file this form with your tax return for the year in which the exchange occurred. The information on Form 8824 asked for is:

·    Descriptions of the properties exchanged
·    Dates that properties were identified and transferred
·    Any relationship between the parties to the exchange
·    Value of the like-kind and other property received
·    Gain or loss on sale of other (non-like-kind) property given up
·    Cash received or paid; liabilities relieved or assumed
·    Adjusted basis of like-kind property given up; realized gain

For our clients at Bayview1031, we provide a computer questionnaire to help fill out Form 8824.  The client and/or their CPA must still fill out this complicated Form 8824.   This is just another example of how we continue to try help our clients.

ARE THERE RESTRICTIONS FOR DEFERRED AND REVERSE EXCHANGES?

On March 5, 2008 , IRS issued again another Fact Sheet relating to Section 1031.  If you have been reading our blog for the past couple of years you will note that the issues discussed in today's blog were covered in previous blogs. 

I thought it was interesting to show you how IRS discusses these issues.  So here is IRS's response to the questions relating to restrictions on Section 1031 exchanges:  "It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable.  If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property. one way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete. You can not act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) can not act as your facilitator. Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections."  

The bold section I believe is very important, that is why I am so pleased to be working for Bayview Financial Exchange Services, a/k/a Bayview1031.  We just wrote an article in the March/April issue of Commercial Investment Real Estate Magazine on how "investors can evaluate qualified intermediaries" ---go get a copy, it is the Magazine of the CCIM Institute--The thumbnail version---security of funds, service, experience and price are the keys to hiring a valid qualified intermediary, with security of the funds being the most important issue.

WHAT ARE THE TIME LIMITS TO COMPLETE A SECTION 1031 DEFERRED LIKE-KIND EXCHANGE?

Recently we had a client, who thought he understood the time limits involved in a 1031 exchange.  So for his sake and yours here is a portion from the new IRS tax gap series answering the question:  What are the time limits to complete a Section 1031 Deferred Like-Kind Exchange?   

"While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.  The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.   Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.  The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above. " 

For more information on this subject please go to our website (www.bayview1031.com) and checkout the educational resource center.

What Property Qualifies For A Like-Kind Exchange?

Last week IRS came out with their 21st Fact Sheet in their Tax Gap Series.  One of the important questions they discussed was: What property qualifies for a Like-Kind Exchange?
"Both the relinquished property you sell and the replacement property you buy must meet certain requirements.  Both properties must be held for use in a trade or business or for investment.

Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.  Both properties must be similar enough to qualify as "like-kind." Like-kind property is property of the same nature, character or class. Quality or grade does not matter.

Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land. 

Real property and personal property can both qualify as exchange properties under Section 1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.  Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of:
·    Inventory or stock in trade
·    Stocks, bonds, or notes   
·    Other securities or debt
·    Partnership interests
·    Certificates of trust"

MR. SANDMAN BRING ME A........

"Mr. Sandman, bring me a dream, bring me a......"  I still love that old Rosemary Clooney song.  What refreshed my memory of that song is a Section 1031 transaction that we are handling in the office, with a "Mr. Sandman".    

Before I give you the factual pattern, let me tell you what the law is pertaining to "inventory and stock in trade".  Property that is "inventory or stock in trade" is excluded from being able to be exchanged under tax deferral Section 1031. 

So if I own a factory and have machinery that makes "widgets" I cannot exchange(sell) the "widgets" and claim no tax is due under Section 1031 of the Internal Revenue Code.  The equipment that makes the "widgets" can be exchanged for other "like kind" equipment without paying any tax because it is" property used in a trade or business";  but the "widgets", which are the products I sell to the public CANNOT be exchanged without the immediate payment of taxes being due. 

So now comes my client, "Mr. Sandman".  The client, believe it or not is in the business of manufacturing sand--that's why I call him "Mr. Sandman".  He purchases small mountains, makes sand from the mountains, which he then sells to others.   When the sand is depleted, he sells the land and purchases another small mountain. 

We know from the above example, that the sand obviously is his product, his inventory, and therefore will not qualify for a Section 1031 tax deferred exchange.  But what about the land?  Can the land qualify for a Section 1031 exchange?  I believe it can, as it is similar to the equipment, that is used in the "trade or business".   I thought our exchange of the race horse was interesting, but the consensus in the office is that  "Mr. Sandman" beats the race horse, by a furlong.

NNN--WHAT IS A TRIPLE NET LEASE AND WHY SHOULD I WANT ONE?

One of our clients asked about a NNN lease and whether it would be a good investment for them.  NNN stands for triple net lease. 

A Triple net lease requires the tenant not only to pay the rent each month, but further to pay all of the taxes, insurance and maintenance expenses that are associated with the property being leased.  Generally, the owner of the property receives its rent (cash flow) without the hassles of property management. 

The perfect taxpayer/owner on this type of transaction is the person who wants a set cash flow each month, without having to worry about paying any of the normal bills associated with the property or the maintenance of the property.  The rates of return (cash flow) are usually lower than the return an investor would receive if they were managing the property themselves. 

Typical tenants would be large chain operations, such as Walgreens, Best Buy, Dunkin Donuts, and Home Depot, etc.   It's up to the investor to decide, if they want a set cash flow from usually a national tenant, with no or little management responsibility, but with the probability of a lower return.  If they do like this type of arrangement, then a NNN lease might be the correct avenue for them to pursue.