Section 1031 and the same taxpayer requirement

Let's say you and your wife hold an investment piece of real estate in both names with right of survivorship. You both have decided to sell that investment property and transact a Section 1031 tax deferred exchange with the proceeds, which will result in no taxes being paid to either the State or Federal governments at that point in time.

The problem is that both you and your wife have decided to put the replacement property in just the husband's name. Will this still qualify for a tax deferred exchange under Section 1031 of the Internal Revenue Code?

The answer is NO it won't qualify!!! In fact, in a similar example, IRS ruled that when the replacement property is put in just one spouse's name, the non-titled spouse in effect "gifted" its interest to the spouse that now holds full ownership.

This results in the non-titled spouse being forced to report their 50% interest (if that's the percentage the non-titled spouse owned) as a sale on their income tax return--that means they will pay taxes on their profit, which is not necessarily what they had originally intended to do. Remember, the smart investor will always call us and their tax advisor first, before ever signing their contract, so that we can discuss their particular tax consequences.

Can a Cooperative Apartment qualify for a Section 1031 Exchange?

As a national Qualified Intermediary, I have handled Section 1031 exchanges in every state of the Union. As a result, I get asked this question a lot from my taxpayer clients that come from the Northeastern part of the United States, mainly, from the State of New York.

The reason for this is that Cooperatives, a/k/a "Co-ops" are very prevalent in New York. Ownership of a "Co-op" involves the ownership of stock in a cooperative corporation that owns not only the building but also the common areas of that building.

The "tenant" is a stockholder in the "Co-op" and has a proprietary lease on their particular apartment. The issue is whether the ownership of the "Co-op" corporation stock is "like kind" to other types of investment real estate? Normally stock ownership does not qualify for tax deferral treatment under Section 1031 (a). HOWEVER, (notice I emphasized with caps) the answer to the question above is another question: what does IRS and the particular state the investment property is in, hold the ownership of "Co-op" corporation stock to be?

Fortunately, most taxpayers will be happy to read that for tax purposes, both the States and IRS have held the ownership of "Co-op" stock to be the equivalent of owning the real estate and therefore can be exchanged into another type of investment real estate under Section 1031. Of course, all of the additional Section 1031 rules must be complied with. I realize this is a complicated subject, so for a more thorough discussion on these and other Section 1031 rules, visit our website at: www.liberty1031.com.

Time Deadlines and Section 1031

Q. Do I have to know what property I will be purchasing when I start the exchange?

Answer: No. You have 45 days from the sale of your relinquished property to identify your potential replacement properties.

Q. How long do I have to purchase my replacement property?

Answer: You have 180 days from the sale of your relinquished property by which you must close on the purchase of your replacement property/properties.

Q. What happens if my 45th or 180th day falls on a Saturday, Sunday, or holiday? Are there any extensions to these dates?

Answer: As a general principle, there are no extensions for either the 45- or the 180-day rules. However, the President of the United States has the authority to provide an extension to these deadlines. Recent examples of such extensions include the terrorist attacks of September 11, 2001 and recent floods and hurricanes.

Is a Section 1031 Exchange tax-free?

A 1031 exchange defers taxes; it generally does not eliminate them. The replacement property will carry the tax basis of the relinquished property – which means that upon the sale of the replacement property all tax will be due or the taxpayer can enter into another 1031 exchange and defer taxes again. With good estate tax planning, many taxpayers will not pay any estate taxes when they die and their heirs will receive their estate tax free and more importantly, with a stepped up basis.

The Napkin Rule and Section 1031 Exchanges

I continually get asked about the "Napkin Rule" when giving my seminars/speeches on Section 1031.

The story goes that some of my fellow brethren were in a bar and were writing down some additional rules they thought were important when transacting a Section 1031 exchange. They ended up writing this information on a cocktail napkin and as a result the rule is now known as "the Napkin Rule". Here it is: You must buy a Replacement Property of equal or greater value to the Relinquished Property in order to completely defer the applicable capital gains tax. If you purchase a property of lesser value, you will be responsible for any tax on the difference. You must also use all the cash proceeds from the sale on your purchase in order to completely defer the applicable capital gains tax. If you do not use all your proceeds on the purchase, you will be responsible for any tax on the difference. The Taxpayer selling the relinquished property must be the same taxpayer who is purchasing the replacement property.

Finally, the taxpayer must place all of their funds with someone who is completely independent, which in today's economy, will be an independent Qualified Intermediary. FYI--Your attorney, CPA, Financial Advisor and Realtor are generally found under Section 1031 not to be "independent".

IRS "LIGHTENS THE RULES" ON SECTION 1031 EXCHANGES OF AUTO'S FOR LIGHT DUTY TRUCKS

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he Internal Revenue Service(IRS) in a recently released Private Letter Ruling (PLR 200912004), is going to allow taxpayers to exchange light general purpose trucks (for example: crossovers, sport utility vehicles, mini-vans, cargo vans and similar types of vehicles) for vehicles that share the characteristics of both cars and light general purpose trucks.

What does this mean? Remember, when it comes to personal property exchanges, IRS has taken the position that in order for a piece of personal property to be exchanged, it must be exchanged for another piece of personal property that is the same (IRS's definition of "like kind") and qualifies under there same Asset Class or Product Class as defined in the North American Industry Classification System (NAICS). Using that system has made it almost impossible to exchange for example, a female cow for a male cow. Male and female cows are in different Asset and/or Product Classes according to the NAICS.

The reason for the change in position when it comes to the vehicles mentioned above is that IRS has observed that over the past few years, various motor vehicles have evolved in such a manner that there is a blur when trying to distinguish between these types of cars and light-duty trucks.

I agree with IRS on this point, as my wife's SUV is built on the same chassis as a light truck--the main difference is that the "cab" on my wife's SUV is a lot more luxurious than a normal light-duty truck. Unfortunately, the opinion given by IRS was a private letter ruling, which means that it cannot be cited as precedent, as IRS has the right to change its position on this issue without notice. But most of us in the 1031 industry believe it is a good step forward.

A BIG QUESTION IN SECTION 1031 EXCHANGES: ARE YOU A DEALER OR AN INVESTOR?

One of my fellow attorneys mentioned to me at lunch the other day that he felt his first obligation to his real estate investor clients is to protect the client’s assets from judgments.  I countered, that when I was practicing law as a “dirt” (real estate) lawyer, I too emphasized asset protection, but I felt it was just as important to examine, for IRS purposes, whether the client would be found to be a “dealer” rather than an “investor”. 

 As you are about to discover, there are major negative tax consequences when IRS determines the taxpayer to be a “dealer” rather than an “investor”. 

Let’s start with an example:  Flip (short for Flipper) Investor, because of the slumping real estate market, has decided this is a terrific time to purchase a number of homes, at very reduced prices.  He further intends to resell (flip) the properties quickly (in less than a year).   His thought process is that he would be taxed short term capital gains taxes on the profit.   Flip Investor’s thought process unfortunately needs some tender loving care and help due to Treasury Regulation Section 1.402(a)-4, which defines Flip as a “dealer”.   IRS has determined that Flip Investor is a “dealer” because he is engaged in the business of buying and selling real estate to customers with the “intent” of making a profit from these transactions.   “Intent” as mentioned in previous blogs is a big word.  In IRS cases, the taxpayer has the burden to prove they are an “investor” and not a “dealer” rather than the other way around.  

This burden of proof is very hard to overcome when it comes to “dealer” vs. “investor”.  More importantly, poor Flip will be the recipient of a number of negative tax consequences as a result of being classified a “dealer”.  He will NOT be allowed to do a Section 1031 tax deferred exchange because he was not an “investor” –instead he was found to be a dealer”; he will NOT be able to defer income recognition on installment sales of the property, again because he was a “dealer”; he will NOT have the ability to claim depreciation on these pieces of real estate, as IRS says the properties are inventory, not investments;  and finally, Mr. Flip Investor WILL have all income earned on these properties taxed as earned income, which subjects him to a possible 15.3% self-employment tax. 

I think we all can agree that  most of these problems could have been avoided if Flip had hired good tax and legal advisors, as well as a knowledgeable Qualified Intermediary, if a 1031 tax deferred exchange was being contemplated.

What happens when the taxpayer receives funds at the closing in a Section 1031 exchange?

This is the fifth and final segment in our 5 part series on problems and their solutions when financing is involved in a Section 1031 exchange.

5.    What if at closing, the taxpayer receives funds?   Taxpayers directly receiving funds will have a taxable consequence on the receipt of those funds.  Let’s go one step further, what if on the purchase of the replacement property, the taxpayer obtains a new loan and has excess proceeds.  These excess funds of course, belong to the taxpayer and therefore are then delivered to the taxpayer.  When the taxpayer receives those funds, there will be a taxable consequence, which is not what most taxpayers want to obtain as a result.  And the Solution is?  That situation can be remedied by instructing the new lender to reduce the original amount of the new loan by the amount of these excess proceeds.  In that manner, the taxpayer never received the funds and a valid Section 1031 exchange on the entire transaction will be accomplished.
My final admonition:  PLAN AHEAD.   That is what many of the tax advisors that send us 1031 exchange transactions are smart enough to do.  They give us the factual situation and we discuss the possible tax issues and possible solutions.

 If you haven't read the other 4 parts of this series, go to our blog:  www.blog1031.com to review same.  If you have any questions, just give us a call at our toll free number:  866-903-1031.

In a Section 1031 Exchange, when can the Taxpayer take money out from the property they are selling (the Relinquished Property)?

This is the fourth segment in our 5 part series on problems and their solutions when financing is involved in a Section 1031 exchange.

4.    When can you take money out of your Relinquished Property?   It is never suggested that the exchanger refinance their relinquished property just prior to their exchange because IRS can again can take the position that you planned to take this money out "in order to avoid paying taxes".  IRS will then deny your Section 1031 tax deferred exchange.  Of course, if you could prove that the funds were used to improve the property in order to get the sale, then you will have a much better chance to win that argument with IRS.  Some pundits suggest that refinancing the relinquished property more than 6 months prior to the sale or contract of sale of the relinquished property is satisfactory. 

Our next and final segment on the issue of financing and Section 1031 exchanges will cover what happens when the taxpayer receives funds at the closing.

Section 1031 and Refinancing the Replacement Property

This is the third segment in our 5 part series on problems and their solutions when financing is involved in a Section 1031 exchange.

3.    When to Refinance the Replacement Property:  This issue alone should be an entire article, but I will endeavor to make this a brief explanation, rather than a 5 page article on the subject.  Let's assume the client was told by an “advisor” that they could refinance the replacement property a “nanosecond” after they obtained title to their replacement property.   The client was very happy with this advice because they wanted to refinance their new replacement property in order to purchase a beautiful new red Porsche they had always desired.  I'd be very careful in this situation.   Amazingly there are a lot of articles written on this subject.  Suffice it to say, that it is not recommended by IRS to refinance immediately after closing on the replacement property, because IRS might take the position that you “intended” to refinance immediately when you did your exchange and that this was done as a plan "to avoid paying taxes" on your profit.  IRS might claim "fraud" and come after you if that is what they believe to be the factual pattern.  So how long should you wait before you can refinance your replacement property?  Is there a solution to this problem?  Yes there is---I suggest waiting to refinance for at least three months, because everyone is aware that the business environment can change in a very short time period such as 3 months, but in most cases the business environment does not normally change in 1 day or a nanosecond. 

Our next segment will cover when the taxpayer can take money out of the property they are selling (the relinquished property).