CAN I STILL DO AN EXCHANGE, IF I HAVE ALREADY CLOSED ON THE SALE?

NOPE!!  Well that's the short answer.   

If the taxpayer has actually or constructively received the proceeds from the sale, then the taxpayer has in fact had a closing and generally it is not possible to then proceed with a Section 1031 exchange(but see possible exception below).  This is better explained through the following example:  Taxpayer Tom held an investment property for 5 years and paid taxes on the rental income he received each year.  He sells his investment property and two days after closing,  realizes he should have done a tax deferred exchange.   He goes back to his attorney/closing agent and says: " let me give you back the money I received and start all over again, because I want to do a Section 1031 exchange".  The attorney/closing agent correctly explains to Taxpayer Tom that it is too late.   What if Taxpayer Tom did in fact have a closing, gave a deed to his purchaser, but never received the funds---additionally, the warranty deed had not been recorded at the Clerk's office?   Well in that situation, you might have a very good chance of "rescinding the sale",  because the funds had not been delivered to Taxpayer Tom or his agent and of course the deed had not been recorded. 

I and many other experts in the 1031 industry will probably take the position that there never was a final closing (no  delivery of funds and no deed recorded), and therefore a Section 1031 exchange can still be transacted.   Finally, what if the taxpayer had a closing, received  all closing funds and the deed was recorded, is there any possibility of still saving a 1031 transaction?   Stretching the envelope a little bit, some authorities take the position that you could rescind the transaction. 

Here's how that would work:  The parties would have all proceeds returned to the purchaser.  The deed would be re-recorded back into the taxpayer's name and the entire transaction would start all over again.  I know what you are thinking-- is this really practical--and I would have to answer you--not really--- especially if the new purchaser has moved into the property or had obtained financing to purchase the taxpayer's property, because I don't know of many lenders that are going to retract or rescind their loan, after funds have been disbursed--and if they do, they are certainly going to charge additional fees for the rescinding and new refunding.  There also could be the individual State Transfer Tax Fees that would have to be paid again--So  this would be a costly and time consuming task--which would have to have all of the parties cooperate, Taxpayer, its purchaser, its lender, its real estate agents, its mortgage broker, its closing agent(s),---all with the hopes that IRS allows the transaction, should there by an IRS audit.

HOW LONG IS LONG ENOUGH? OR HOW LONG DOES A TAXPAYER HAVE TO HOLD ITS PROPERTY BEFORE THEY CAN EXCHANGE IT?

This is an interesting issue, because the Internal Revenue Services has not given a definitive answer to that question.  Some authors state a "reasonable time"--but of course that begs the question, because  you then have to determine what is a "reasonable time".    IRS has taken the position in numerous cases,  that a 2 year holding period is satisfactory.   

A number of authorities believe  a property that has been held as an investment property for more than 1 year, should qualify for Section 1031 treatment.  What if the taxpayer had purchased the property recently (within the past 6 months) and wants to do a Section 1031 exchange?  IRS takes the position that the taxpayer had acquired the property for "resale" and not for investment purposes--so in that case, the taxpayer would not qualify for a Section 1031 exchange---- and to add insult to injury-- the taxpayer will also not qualify for long term capital gains treatment, as the taxpayer did not own the property for more than 1 year--this results in the profit being taxed as ordinary income, which is at a much higher tax  rate. 

Finally, what if the taxpayer had owned their relinquished property for 2 or more years, does an exchange and purchases a replacement property, and then resells the replacement property immediately.  Will that still qualify for a Section 1031 exchange?  IRS takes the position that the replacement property was not held for "investment purposes" and therefore would void the Section 1031 exchange.  Some courts however have been more lenient on how long an investor had to hold the replacement property for it to still qualify as an investment---suffice it to say, I believe this last issue is a "grey area".

ZERO CAPITAL GAINS TAXES?---WELL FOR SOME PEOPLE

Are you in the 25% tax bracket or below?  FYI--IRS has established your tax rate as follows for the 2008-2010 taxable years:  income of $32,550 for singles and marrieds filing separately; $65,100 for marrieds filing jointly; and $43,650 for head of households are in the 25% tax bracket.  What does this mean? 

Let me give an example.  Mr. and Mrs. Taxpayer are a married couple who file jointly and have taxable income in the year 2008 of $75,000, comprised of $40,000 ordinary income and $35,000 of capital gains.  Since their ordinary income is below $65,100 ( they received $40,000), they have $25,100 of their capital gains that will be eligible for taxes at 0%.  The balance of their capital gains ($35,000-$25,100= $9,900) will be taxed at capital gains rates of 15%.

HOW DO YOU REPORT TO IRS THAT YOU ARE DOING AN EXCHANGE

IRS states:  "You must report an exchange to the IRS on  Form 8824, Like-Kind Exchanges and  file it with your tax return for the year in which the exchange occurred.

Form 8824 asks for:

• 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

If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions. "   FYI--For our clients and their financial advisors, Bayview1031 has a computer program to help you fill out this difficult extra form.

CAN YOU ACT AS YOUR OWN QUALIFIED INTERMEDIARY (QI)?

IRS reiterated the answer in their recent fact sheet.  They said:  "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."  This paragraph is very important--that is the reason why Bayview1031 is one the few QI's that is bonded and insured (by a Lloyds of London insurance company)  for up to $20 million per occurrence.

CAN THE TAXPAYER TAKE CONTROL OR USE THE PROCEEDS AFTER THE SALE BUT BEFORE THE PURCHASE OF THE REPLACEMENT PROPERTY?

Most of my bloggers know the answer to this question, but now IRS has put out Fact Sheet--FS 2008-18 to further explain.  "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.

WHAT HAPPENS WHEN YOU FAIL TO CLOSE ON YOUR PURCHASE OF THE REPLACEMENT PROPERTY?

I am copying my response to that question, which is one of the many subjects covered in the resource section above.  "In order to complete a 1031 exchange and close on the replacement property in a subsequent tax year to the year in which the relinquished property is sold, it is absolutely necessary that the taxpayer file a Form 4868 Application for Extension to File Tax Return. Otherwise, the intended exchange will not qualify for tax deferral, but will instead be treated as a taxable sale made on the installment method.   

In the event that the taxpayer fails to close within the 180 deadline, in effect the taxpayer has under reported his income in the year of disposition, and thus would owe interest and penalties. One benefit of the §1031 Regulations is that they provide that if the taxpayer intended in good faith to complete an exchange, the taxpayer is treated as receiving the consideration for the sale of the relinquished property under the installment method (i.e. on the date that the taxpayer received a refund of his money held by the Qualified Intermediary). There are no automatic interest or penalties imposed if the taxpayer intended the property to be exchanged. "

CAN THE PURCHASE OF AN ENTIRE PARTNERSHIP QUALIFY AS A PURCHASE OF REPLACEMENT PROPERTY?

This is a technical question, but an excellent topic because it requires me to explain a different aspect of partnership interests and Section 1031. 

A couple of weeks ago I expounded in a 5 part series of blogs about the issue of whether someone could sell a partnership interest and do an exchange with the proceeds.  The simple answer to that issue is that you cannot sell an individual partnership interest and do an exchange, but the partnership can sell the property.   

We talked about other avenues to pursue when one or more of the  partners wants to sell and the other(s) want to do a Section 1031 tax deferred exchange.  Then one of you wonderful bloggers called me up at the office and asked could you purchase the partnership, which just happens to own the property you want, as a replacement property, and still qualify for a Section 1031 exchange?   

I am happy to say that IRS, recently ruled, in LTR 200807005 that a taxpayer purchasing all of the interests of a partnership is the equivalent of purchasing the replacement property owned by the partnership. 

Why would a taxpayer want to purchase the partnership rather than just the replacement property which is owned by the partnership?    Some experts propound that there would  be no change of title in the public records.  So no one would know that a transfer of the property occurred--this could result in lower real estate taxes, little or no transfer fees, and lower evaluations for future tax increases.   Plus the public records would not show the new owner's name.   This results is in a terrific asset protection technique and hides the ownership from public disclosure which results in better privacy for the taxpayer.   

But the issue that still surfaces is:  How can taxpayer "A" purchase an entire partnership and have it qualify as a replacement property for Section 1031 purposes?  A partnership is taxed as a "disregarded entity"--which means that it is taxed directly to the owners of the partnership, without having to have a separate additional tax, levied on the partnership.  For those of my bloggers who have been reading this blog for years,  you can recall me explaining one of the sections of the "Napkin Rule" which states that the taxpayer of the relinquished property must be the same as the taxpayer of the replacement property.   

So if taxpayer "A" sells its relinquished property and now purchases the entire partnership---- and title remains in the name of the partnership, isn't that a violation of the "Napkin Rule"?   I am happy to state that IRS affirms that  this is not a violation of Section 1031, because a partnership, for tax purposes, is a "disregarded entity",--- which means the owner of the "disregarded entity" is taxed, not the entity and IRS considers the ownership of the "disregarded entity" the same as if the property had been put in the taxpayer's individual name(s).  What a great result.