EUGENE OREGON REAL ESTATE HOMES PRESENTS THE BEST KEPT SECRET IN REAL ESTATE IRC 1031 TAX-DEFERRED EXCHANGES
Rules for an Exchange with Complete Deferral of Tax
THE PLAN: Defer all tax a. Replacement (new) property(ies) must have an acquisition cost equal to or greater than the NET SELLING PRICE of the relinquished (old) property(ies); and b. ALL CASH received from the sale of the relinquished property(ies) must be spent on the purchase of the replacement property(ies). c. Like-debt - is not a requirement.
EXCHANGE TIME LINES a. Must provide written and signed identification of replacement property(ies) on or before 45 days from the sale date; and b. Must purchase identified replacement property(ies) on or before 180* days from the date of sale.
*The earlier of 180 days or the due date (including extensions) of Exchanger's tax return for the tax year in which the transfer of the relinquished property occurs.
IDENTIFICATION RULES a. Three Property Rule b. 200% Rule c. 95% Rule
Identification Rule Diagram
Assumption: Relinquished property gross sale price is $350,000
Rule:
Example
Three Property Rule: The Exchanger may identify up to three properties of any fair market value. The Exchanger is not obligated to purchase all three properties.
Identify: Any property(ies) 1&/or 2 &/or 3
The 200% Rule: The Exchanger may identify more than three properties but their com- bined fair market value cannot exceed 200% (double) the fair market value of the relinquished property.
The 95% Rule: If the Exchanger exceeds the 200% rule, then the Exchanger must purchase at least 95% of the combined fair market value of all the properties identified. It is virtually impossible to purchase 95% of the FMV without buying all the properties identified.
Both the relinquished and replacement properties must be in the United States. The relinquished property must be currently be used by the Exchanger for investment, business or production of income. The replacement property(ies) must be held for investment, business or production of income.
Examples of Qualifying Property
Personal Residence Speculative Home Developed Lots: Held by a Developer as Inventory. Developed Lots: Held by an Investor as an Investment. Residential Rental Commercial Building Bare Land Farm/Ranch w/ Home Water Rights Timber Rights Working or Royalty Interest in Oil and Gas Vacation Home Yes, if held for investment and personal use has been limited. Leasehold Interest Yes, if the remaining lease term with extensions is in excess of 30 years. Time Share Unit Yes, if deeded fee simple interest and it is held for investment
No No No
Yes
Yes Yes Yes Yes Yes Yes Yes Maybe
Maybe
Maybe
REVERSE EXCHANGE STRATEGIES
This is a useful strategy when the Exchanger must purchase the replacement property before selling the relinquished property.
Potential loss of Earnest Money deposits Unable to resolve contingencies on their sale yet Unable to locate a willing and able buyer for the relinquished property Unable to negotiate extension on their closing date Potential loss of favorable financing options Desire to improve property that cannot be completed with 180-day exchange period
Review of Revenue Procedure 2000-37 Safe Harbor for Reverse Exchanges
September, 2000, Rev Proc was issued providing guidance for reverse exchanges.
Requires use of Exchange Accommodation Titleholder (EAT) to park (hold) the property.
Requires use of Qualified Exchange Accommodation Agreement (QEAA) for parking property.
Requires identification of relinquished property within 45 days.
Restricts parking period to 180 days.
Possible ways to avoid a reverse exchange Set up a lease option Negotiate with seller of replacement property to extend the closing Offer incentive equal to the reverse exchange fees to entice the seller
The Qualified Intermediary (QI) will set up a new single purpose entity to act as an Exchange Accommodation Titleholder (EAT.) The EAT will purchase or "park" the replacement property for the Exchanger. The EAT is a single member limited liability company owned by the QI.
The Exchanger will enter into a Real Estate Acquisition and Qualified Exchange Accommodation Agreement (QEAA) with the EAT for the purchase of the replacement property. The QEAA give the Exchanger an option to purchase the property back from the EAT. It will contain a termination date that is 180 days from the date the EAT purchases the property for the Exchanger.
The QI will prepare an Assignment that will transfer all the Exchanger's rights and interests in the sale agreement for the replacement property to the EAT.
The Exchanger will lend the EAT funds to cover the down payment and closing costs as outlined in the sale agreement. The EAT will give the Exchanger a Note for this loan. However, the Note will be non-recourse to the EAT. The Exchanger will receive monthly interest only payments on this loan.
The Exchanger will make the necessary arrangements for a third-party lender to fund the balance of the purchase price. This Note will be non-recourse to the EAT and it may be fully guaranteed by the Exchanger. Payments on this loan should be interest only.
At the time of closing, the EAT will lease the parked property back to the Exchanger for a monthly lease payment that will cover the monthly debt service due the third-party lender and the Exchanger (as mentioned above.)
The Exchanger will to need to provide insurance for the property naming the EAT as an additional insured. The lease will require the insurance, as well as providing the Exchanger with the ability to insure the property.
Once the relinquished property sells and closes, an escrow will be opened for the sale of the parked property to the Exchanger. This sale will close in accordance with the terms of the QEAA. Please note that title insurance will not be provided by the EAT on this purchase. If the Exchanger desires title insurance, the Exchanger may purchase a policy at their expense.
The Qualified Intermediary (QI) will set up a new single purpose entity to act as an Exchange Accommodation Titleholder (EAT.) The EAT will purchase or "park" the replacement property for the Exchanger. The EAT is a single member limited liability company owned by the QI.
The Exchanger will enter into a Real Estate Acquisition and Qualified Exchange Accommodation Agreement (QEAA) with the EAT for the purchase of the relinquished property. The QEAA give the Exchanger an option to purchase the property back from the EAT. It will contain a termination date that is 180 days from the date the EAT purchases the property for the Exchanger.
The EAT will prepare a purchase and sale agreement between the Exchanger and EAT for the purchase of the relinquished property.
The QI will prepare an Exchange Agreement that will set the 1031 exchange in place between the Exchanger and the QI.
The QI will prepare an Assignment that will transfer all the Exchanger's rights and interests in the purchase and sale agreement for the relinquished property to the EAT.
The EAT will purchase the relinquished property subject to the existing debt against the property, if any in favor of a third party lender. This will not be a formal assumption. Caution: most loans have a due on sale clause and this sale to the EAT could trigger the "due on sale"
The Exchanger will lend the funds to cover the balance of the purchase of the property and closing costs. The EAT will give the Exchanger a Note for this loan. However, the Note will be a non-recourse to the EAT. The Exchanger will receive monthly interest only payments on this loan.
At the time of closing, the EAT will lease the parked property back to the Exchanger for a monthly lease payment that will cover the monthly debt service due the third-party lender and the Exchanger (as mentioned above.)
The Exchanger will need to add the EAT as an additional insured on the existing insurance policy on the property.
The net proceeds from the sale will be transferred to the QI for the benefit of the Exchanger and will be spent on the purchase of the replacement property.
Exchanger will close on the replacement property thereby completing the exchange.
When a "real" buyer materializes for the parked property, the Eat will sell the property to them. Upon receipt of the net proceeds from the sale, the EAT will satisfy its loan with the Exchanger.
Construction Exchange Strategies
This is an effective strategy when you want to use exchange proceeds to: a. make improvements to an existing property b. build a new replacement property
Construction Exchange
Typically, the Exchanger wants to do improvements to property that is going to be purchased as replacement property. Here is how to proceed:
Exchanger sells the relinquished property and exchange funds go to the Qualified Intermediary (QI.)
The QI will set up a new single purpose entity to act as an Exchange Accommodation Titleholder (EAT.) The EAT will purchase or "park" the replacement property for the Exchanger. The EAT is a single member limited liability company that is owned by the QI.
The EAT enters into a construction contract with builder/contractor for improvements to be done and the Exchanger guarantees the contract.
The QI (and Exchanger, if necessary) loans funds to the EAT to purchase the property and build the improvements.
When the improvements are complete (or constructed to a value enough to complete the exchange,) the EAT will transfer the improved property to the Exchanger completing the exchange. The improvements will be a part of the exchange value of the replacement property.
Problems with construction exchanges Must identify the improvements to be constructed on identification form Main question: Can enough value be built by the 180-day exchange line?
REVERSE CONSTRUCTION EXCHANGE
Sometimes, the Exchanger wants to begin the improvements to the replacement property before the relinquished property sells. We combine the reverse and construction strategies:
The QI will set up a new single purpose entity to act as an Exchange Accommodation Titleholder (EAT.) The EAT will purchase or "park" the replacement property for the Exchanger. The EAT is a single member limited liability company that is owned by the QI.
The Exchanger will enter into a Real Estate Acquisition and Qualified Exchange Accommodation Agreement (QEAA) with the EAT for the purchase of the relinquished property. The QEAA give the Exchanger an option to purchase the property back from the EAT. It will contain a termination date that is 180 days from the date the EAT purchases the property for the Exchanger.
The QI will prepare an Assignment that will transfer all the Exchanger's rights and interests in the sale agreement for the replacement property to the EAT.
The Exchanger will lend the EAT funds to cover the down payment and closing costs as outlined in the sale agreement. The EAT will give the Exchanger a Note for this loan. However, the Note will be non-recourse to the EAT. The Exchanger will receive monthly interest only payments on this loan.
The Exchanger will make the necessary arrangements for a third-party lender to fund the balance of the purchase price. This Note will be non-recourse to the EAT and it may be fully guaranteed by the Exchanger. Payments on this loan should be interest only.
The EAT enters into a construction contract with builder/contractor for improvements to be done and the Exchanger guarantees the contract.
The Exchanger or third party lender loans funds to the EAT to purchase the property and build the improvements.
At the time of closing, the EAT will lease the parked property back to the Exchanger for a monthly lease payment that will cover the monthly debt service due the third-party lender and the Exchanger (as mentioned above.)
The Exchanger will to need to provide insurance for the property naming the EAT as an additional insured. The lease will require the insurance, as well as providing the Exchanger with the ability to insure the property.
Once the relinquished property closes, and the value of the improvements is sufficient to complete the exchange, an escrow will be opened for the sale of the parked property to the Exchanger. This sale will close in accordance with the terms of the QEAA. Please note that title insurance will not be provided by the EAT on this purchase. If the Exchanger desires title insurance, the Exchanger may purchase a policy at their expense.
COMMON EXCHANGE PROBLEMS
Financing Issues a. Seller carry backs b. Refinancing
carry backs carry backs Issue CarryIssueCarry back Carry back Carryback on the Relinquished Property
1. Exclude the Note from the exchange altogether. Exchanger will pay taxes on the principal, as it is receive each year.
2. Include the Note in the exchange and the Note will be payable to the Qualified Intermediary. QI will hold the Note and collect all payments (and hold those payments received.) Exchanger must cash out Note without QI before purchasing replacement property. QI will endorse the Note and assign the Trust Deed over to the Exchanger. QI will have all cash to to wards apply towards your new purchase.
3. Include the Note in the exchange and the Note will be payable to the Qualified Intermediary. QI will hold the Note and collect all payments (and hold received negotiates negotiates receivednegotiates Exchanger negoitates with Seller of replacement property to accept Note as partial payment for the property. QI endorses the Note over and assigns the Trust Deed to the Seller of replacement property.
4. Include the Note in the exchange and the Note will be payable to the Qualified Intermediary. QI will hold the Note and collect all payments (and hold those payments received.) Exchanger finds a buyer for the Note. Note Buyer gives QI the cash for the Note (usually includes a discount.) Discount may be treated as a boot. QI will endorse the Note over and assigns the Trust Deed to the Note Buyer.
5. Include the Note in the exchange and the Note will be payable to the Qualified Intermediary. Note pays off before the end of the 180-day exchange period and funds are placed in exchange account with net proceeds from the sale. All funds are used to acquire the replacement property.
Refinancing
Issue: Refinancing Before or After an Exchange
Refinancing before an exchange Deemed risky Intent: to receive cash out of the exchange? Could be challenged in an audit and classed as boot
Refinancing after an exchange Deemed to be okay
REMEMBER: Exchange cannot access funds at all during the exchange.
Related Party Issues
Who is a "Related Party?" Family members(siblings, spouse, ancestors, descendants) . Does not include uncles,aunts, in-laws, or "step" entitles entitles controlled entitlies in which Exchanger owns more than 50%.
Basis Shifting Shift high basis property to low basis property and sell without tax ramifications. . Allowed up to 1989 (IRC Section 1031(f))
2-year Holding Rule became effective in 1989 Exchanger and related party generally must hold like-kind property for 2-years. Begins on the date of the last transfer that was part of the related party exchange. Temporarily substituting non-related party does not work (i.e.QI). 2-year period extended if either party enters into a contract for sale or option that substantially diminishes risk of loss.
Exceptions to 2 year-rule of either party. Involuntary conversion (1033). "If established by the Secretary that the disposition did not have as one of its principal purposes the avoidance of federal income tax."
Revenue ruling 2002-83: IRS denies 1031 treatment if the following 3 occur: Replacement property is purchased from related party; Related party receives cash (or non like-kind property); and The related party pays less tax because of the exchange.
IRS Form 8824 All related party exchanges disclosed by checking the box. Beginning in 2003, if replacement property is bought from a related party, the Exchanger is required to disclose why one of its principal purposes was not the avoidance of income tax.
Can the related party rules be avoided? If the related party also does an exchange - it will qualify (related party MUST complete their exchange AND all to hold their properties ro 2 years). Enter into an exchange with in-laws rather than a related party.
Partnership Issues
Partnership Interests CANNOT be exchanged Partnerships CAN be the Exchanger
What can be done if partners want to go separate ways? >>>Pre-plan with tax advisors well in advance if listing and selling property<<<
Option1: Drop and swap Distribute property from partnership to individuals. Dissolve partnership and cease all partnership activities. Individuals enter onto listing and sale agreements. Individuals may exchange their interests. Risk: Holding period
Option 2: Swap and drop Partnership sells property through an exchange. Partnership purchases various properties that the indvidual partners want. Partnership holds new properties for a period of time to satisfy holding period requirements. Dissolve partnership and distribute properties to individual partners Risk: None unless the replacement properties are not held long before distribution. Requires all partners' cooperation.
Vacation Homes
To exchange or not to exchange? That is the question...
Section 1031 does not prohibit exhanging vacation homes. Eligibility is base on use of property. Primarily for business use or investment - qualifies Determining eligibility is complicated. Tax advisors should be involved in decision process.
Use of Relinquished Property Exchange Possibility
Consistently occupied as a vacation rental Strong Personal use is occasional or never
Personal use is occasional or never Primarily used for corporate retreats Strong
Exchanger never used the home or has not used it for a significant time. Strong
Exchanger visits the home a small portion of the year; mainly to take care of maintenance. Likely
Exchanger was at the property for a few months while overseeing a renovation. Personal use is limited: occasional or never in the past few years. Likely
Exchanger frequently used the vacation home personally in the last year. Weak
Closing Thoughts
How can 1031 exchanges help real estate professionals grow their business?
Some people won't sell because they don't want to pay taxes on the gain. 1031 exchanges opens this door.
No need to save for capital gains tax. Spend more money on new property.
Allows you to help your client with two properties instead of one. Relinquished AND replacement. Maybe they need to sell or buy more than one property, too.
Educate your clients about 1031 exchanges. You will earn their trust and respect for being knowledgeable. They will pass your name along because of how you helped them.
Align yourself with partners so you can devote your time to your business.
All this information was provided by "1031 Asset Exchange "
