1. IRC §1031 Tax Deferred Exchange Strategies Claudia Kiernan, Esq. Certified Exchange Specialist®

2. Course Objectives IRC §1031 Rules-Review Tax Updates Recent changes to IRC §1031 Advanced Issues in IRC §1031

3. Internal Revenue Code Section 1031 “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

4. Tax Update Higher Capital Gains Tax New 3.8% Healthcare Tax Depreciation Recapture Tax State Taxes

5. Higher Capital Gains Tax Single investors exceeding the $400,000 income threshold and married couples exceeding the $450,000 income threshold now pay the new 20% capital gains tax rate.

6. 3.8% Healthcare Tax The Healthcare and Education Reconciliation Act added a new 3.8% Medicare surtax on “net investment income.” Applies to individual earning over $200,000 and married couples earning over $250,000 Net investment income includes: dividends, capital gains, retirement income and income from partnerships.

7. Depreciation Recapture Tax Depreciation is a way to obtain a tax deduction by spreading the cost of the real estate over period of time. As a result, depreciation reduces the properties adjusted cost basis. Upon sale, the part of the gain that is related to depreciation will be taxed at the rate of 25%.

8. State Taxes Certain states, such as California, have a 13.3% top tax rate

9. Run The Numbers §1031 permits deferral of: Capital Gains Taxes of (15%/20% Federal and __% State) Depreciation Recapture (25% Federal) Medicare Surtax (3.8%) Example: Selling $1,000,000 property that has no debt and has been fully depreciated. Using an assumption of a 30% combined taxes between capital gains and depreciation recapture. Purchasing replacement properties with a 75% LTV ratio. SALEVSEXCHANGE NET EQUITY CAPITAL GAIN TAX EQUITY TO REINVEST PROPOSED ACQUISITION 1,000,000 300,000 700,000 2,800,000 1,000,000 0 1,000,000 4,000,000

10. Tax Deferred Exchange terminology may be confusing to those who are unfamiliar with these transactions. The following are some of the typical exchange terms and phrases, with their interpretation. Exchanger: The property owner(s) seeking to defer capital gain tax by utilizing a Section 1031 exchange. (The Internal Revenue Code uses the term “Taxpayer.”) Basis: Original cost plus improvements, minus depreciation taken. Taxable Gain: Selling price minus Basis. Boot: Fair Market Value of non-qualified property (i.e., property that is not of “like- kind”) received in an exchange. (Examples: cash, notes, seller financing, furniture, supplies, reduction in debt obligations) Constructive Receipt: Control of proceeds by an Exchanger (even though funds may not directly be in the Exchanger’s possession). Tax Deferred Exchange Terminology

11. Like Kind Property: This term refers to the nature or character of the property, and not its grade or quality. Generally, real property is “like kind” as to all other real property, as long as the Exchanger’s intent is to hold the properties as an investment or for productive use in a trade or business. The “like kind” rules for personal property, however, are more restrictive. Qualified Intermediary: The entity that facilitates the exchange for the Exchanger. The term “facilitator” or “accommodator” is also commonly used, although the Treasury Regulations specify the term “Qualified Intermediary.” Relinquished Property: The property “sold” by the Exchanger. This is also sometimes referred to as the “exchange” property or the “downleg” property. Replacement Property: The property acquired by the Exchanger. This is sometimes referred to as the “acquisition” property or the “upleg” property. Tax Deferred Exchange Terminology

12. Exchange Myths Exchangers have to find someone with property who will swap property with them. Exchangers have to complete the exchange in one simultaneous transaction. Exchanges are expensive, difficult, and only for large property owners.

13. Exchange Myths Exchangers will be audited if they exchange property instead of selling it. Exchangers who live on part of their property cannot do an exchange. Exchangers do not need to hire an intermediary; they can simply have their attorney hold the exchange funds until the replacement property is purchased.

14. Cashflow: Sell vacant land; acquire improved property to generate cash flow. Depreciation: Exchange from fully depreciated property to a higher value property – the additional value can be depreciated. Appreciation: Dispose of property in a slow market area and acquire property in a hot market area. Conversion: Acquire property suitable for future conversion to primary residence or vacation home. Joint Ownership Problems: Acquire separate properties so that co-owners can separate interests. Reduce Management Burdens: Acquire management-free property. Estate Planning: Dispose of one property and acquire several properties (example: distribute one replacement property to each family member). Use in Profession: For example, a doctor sells a rental house and acquires a medical building to support the practice. Exchange Motives

15. Why do a 1031? No. 1 Diversification SELL BUY 1031 Sell One Buy Multiple

16. SELL BUY 1031 Multiple properties One larger property that is easier to manage or no management Apartment complex, commercial strip center, DST T.I.C., DST, etc.. No. 2 Consolidation

17. No. 3 Move Markets SELL BUY 1031 Sell in California Buy in FL

18. SELL BUY 1031 Heir #2 Heir #1 Heir #3 No. 4 Estate Planning

19. Delayed Exchange Time Limits 1.45-Day Rule: The Exchanger must identify the potential replacement property or properties within the first 45 days of the 180 day Exchange period. 2.180-Day Rule: The Exchanger must acquire the replacement property or properties within 180 days, or the date the Exchanger must file a tax return (including extensions) for the year of the transfer of the relinquished property, whichever occurs first. 3.There are no extensions for Saturdays, Sundays, or holidays. 4.The time limits begin to run on the date the Exchanger transfers the relinquished property to the buyer. 5.The “date of transfer” will be the date of recording or transfer of the benefits and burdens of ownership, whichever occurs first.

20. Disaster Extensions Since September 11, 2001, Congress has permitted 120 day extensions for taxpayers affected within federal disaster areas by presidential order. The rules are complicated, but generally the Exchanger receives the extension if one of the following is within the affected area: Exchange Properties Exchanger’s Principle Residence Exchanger’s Tax Preparer Qualified Intermediary

21. Exchange Identification Rules 1.Three Property Rule: The Exchanger may identify up to three properties of any value. 2.200% Rule: The Exchanger may identify more than three properties if the total fair market value of what is identified does not exceed 200% of the fair market value of the relinquished property. 3.95% Exception: If the Exchanger identifies properties in excess of both Rule 1 and Rule 2, then the Exchanger must acquire 95% of the value of all properties identified.

22. Procedures for Property Identification 2. It must be in writing and signed by the Exchanger. 4. It must be delivered, mailed, faxed, or “otherwise sent” within the 45 days. 1. The property identification must be delivered to a party to the exchange that is not a disqualified party (e.g., the Qualified Intermediary). 3. It must be “unambiguous” (site specific). 5. An identification can be revoked within the 45 days, but the revocation must also follow steps 1 through 4.

23. Safe Harbor Restrictions To qualify as a Safe Harbor against actual or constructive receipt of the exchange funds, the Exchange Agreement must limit the Exchanger’s right to receive, pledge, borrow, or otherwise receive the benefit of money or other property except: 1. After the end of the 45-day Identification Period, if Exchanger has not identified any replacement property; OR 2. If Exchanger has identified replacement property; then upon or after receipt by Exchanger of all replacement property to which Exchanger is entitled under the Exchange Agreement; OR 3. If Exchanger has identified replacement property; then upon or after the occurrence, after the end of the Identification Period, of a material and substantial contingency that: (a) relates to the exchange, (b) is provided for in writing and (c) is beyond the control of Exchanger and of any disqualified party, other than the party obligated to transfer replacement property to Exchanger; OR 4. After the end of the 180-day Exchange Period.

24. In an I.R.C. §1031 real property exchange, you can exchange real property for any other real property in the United States or its possessions, if said property is held for productive use in a trade or business or for investment purposes. What is Like-Kind Property? 1031 Property CondosRaw Land Apartments Single Family Industrial Property Commercial % Interest as a TIC Retail

25. 1. “Like-kind” refers to the nature or character of the property, and not its grade or quality. 2. Generally, all real property is “like-kind” to all other real property. 3. Real property can be improved or unimproved, because this only relates to the grade or quality – not to its kind or class. 4. The Exchanger’s intent must be to hold the replacement property as an investment, or for productive use in a trade or business. Like-Kind Property (cont’d)

26. Personal Property Exchanges The “like kind” requirement for personal property exchanges is more restrictive than real property exchanges. The relinquished and replacement assets must be either “like-kind” or “like class”. “Like-kind” refers to assets that are the same, such as an airplane for an airplane or a backhoe exchanged for a backhoe. “Like-class” refers to tangible, depreciable personal property that falls within the same General Asset Class or within the same Product Class (sharing North American Industry Classification System (NAICS) codes)

27. IRC §1031 shall not apply to any exchange of: Stock in trade or other property held primarily for sale (i.e. property held by a developer, “flipper” or other dealer) Securities or other evidences of indebtedness or interest Stocks, bonds, or notes Certificates of trust or beneficial interests Interests in a partnership Choses in action (rights to receive money or other property by judicial proceeding) Foreign property (real or personal) for U.S. based property Goodwill of one business for goodwill of another business

28. Qualified Purpose Test 1. Not Held for Sale Inventory Other instances of “Held for Sale” “Held for use in Trade or Business or for Investment” 2. Not Held for Personal Use Residences Second Homes 3. Test is at time of Exchange 4. Holding period

29. How long do I need to own something before I can do a 1031 Exchange? 1989-U.S. House of Representatives passed a one-year holding requirement before and after exchanging a property. This did not reach the final version of the Revenue Reconciliation Act of 1989. Nonetheless, prudent to hold a property in use for at least one year (long term gain). A taxpayer might note that Congress did include in the Act a two-year holding period of any property received in a “related party” exchange. The more conservative professionals and commentators speculate that this two-year hold might be a more appropriate holding period.

30. Vacation and Second Homes In Moore v. Commissioner, T.C. memo 2007-134, the Tax Court held that properties held for personal use with the mere hope or expectation of gain did not establish investment intent. Effective for all exchanges on or after March 10, 2008, Revenue Procedure 2008-16 creates a safe harbor (meaning the IRS will not challenge the exchange) for “dwelling units” that meet the following criteria:

31. Vacation and Second Homes The relinquished property: 1) was owned by the taxpayer for 24 months prior to the exchange and 2) was rented for 14 days or more in each of the two 12 month periods preceding the exchange and 3) the Taxpayer’s personal use in each of those years did not exceed the greater of 14 days or 10 percent of the number of days the property was rented at fair rental rates. The replacement property must meet the same criteria. The exchange must meet all the other Section 1031 requirements. It is unknown how the IRS will view properties that do not fall within this safe harbor.

32. Combining IRC Sections 1031 and 121 IRC §121 permits an exclusion from capital gain realized of $250,000 for a single person and $500,000 for a married couple on the sale of a home used as a primary residence for any two of the past five years. If, however, the residence was acquired as a replacement property in a §1031 exchange, the Exchanger must have held the property for a total of FIVE years before it qualifies for the §121 exclusion when it is sold. (HR 4520 October 22,2004)

33. Combining IRC Sections 1031 and 121 Effective January 1, 2009, the §121 exclusion will not apply to gain from the sale of a residence that is allocable to periods of “nonqualified use”. (Housing Assistance Act of 2008) If a primary residence is converted for use as rental, it may qualify for both a §1031 exchange as property used in a trade or business and also for the §121 exclusion when it is sold (Revenue Procedure 2005-14)

34. Housing Assistance Tax Act of 2008 Amends §121 to further restrict its exclusion benefits $250,000/$500,000 no longer applies to periods of “Non-qualified” use. Non-qualified use: “Any use other than primary residential” by the taxpayer. Thus no exclusion allowed for portion of ownership that was either: –Rental (Investment) or Personal Use (Second or Vacation Home). Effective January 1, 2009 the exclusion will not apply to gain from the sale of the residence that is allocable to periods of “nonqualified use.” §121 Exclusion is now allocated based on ratio of qualified use period to ownership period. Non-qualified use prior to January 1, 2009 is not taken into account for the non- qualified use period (but is considered for the ownership period).

35. Exchange Contract Cooperation Clauses To provide the other party to the transaction with notice of the exchange the Exchanger should have an exchange cooperation clause in the purchase and sale agreement for both the relinquished and replacement properties: Relinquished Property Buyer hereby acknowledges that it is the intent of the Seller to complete a tax deferred exchange under IRC Section 1031 which will not delay the close of the purchase transaction or cause additional expense to the Buyer. The Seller’s rights under the purchase and sale agreement may be assigned to a Qualified Intermediary of the Seller’s choice for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and the Qualified Intermediary in a manner necessary to complete the exchange.

36. Tax Court Decision Confirms Need for Qualified Intermediary Crandall vs. Commissioner of Internal Revenue No QI No Exchange Agreement Court held that the taxpayers had constructive receipt of the proceeds and were required to pay not only capital gains taxes on the sale of the property but also a hefty accuracy-related penalty. “it is well established that a taxpayer’s intention to take advantage of tax laws does not determine the tax consequences of his transactions…Congress enacted strict provisions under section 1031 with which taxpayers must comply.”

37. Qualified Intermediary The use of a Qualified Intermediary is essential to completing a valid delayed exchange. The Qualified Intermediary performs several vital functions in an exchange. Acts as a Principal The IRS stipulates that a reciprocal trade or actual exchange must take place in each IRC §1031 transaction. This means the Exchangers must assign to a Qualified Intermediary (1) their interest as seller of the relinquished property and (2) their interest as buyer of the replacement property. The Qualified Intermediary should be an Independent Party (not DISQUALIFIED) to the transaction. The use of a Qualified Intermediary allows for “DIRECT DEEDING” of the properties involved in the exchange. This is only allowed with the use of a Qualified Intermediary.

38. Holds Exchange Proceeds If the Exchanger actually or constructively receives any of the proceeds from the sale of the relinquished property, those proceeds will be taxable as boot. Prepares Legal Documentation Several legal documents are necessary in order to properly complete an exchange. The Qualified Intermediary will prepare an Exchange Agreement, two Assignment Agreements, and Exchange closing instructions for each closer. Provides Quality Service Although the process is relatively simple, the rules are complicated and filled with potential pitfalls. Qualified Intermediary (cont’d)

39. Balancing Act How to Measure the Exchange

40. Balancing the Exchange In order to obtain a deferral of the entire capital gain tax the Exchanger must: 1.Purchase property of equal or greater value. 2.Reinvest all of the net proceeds from the relinquished property. 3.Obtain equal or greater financing on the replacement property than was paid off on the relinquished property. Replacement property debt can be offset with cash put into the exchange. 4.Receive nothing in the exchange but like-kind property. To the extent the Exchanger fails to observe these rules they will be subject to capital gain tax

41. Balancing the Exchange Value Mortgage Equity Relinquished Replacement Exchanger goes up in value, across in equity and up in mortgage: $150,000 $ 50,000 $100,000 $225,000 $50,000 $175,000 Example I. No Tax is due.

42. Balancing the Exchange Value Mortgage Equity Relinquished Replacement Exchanger goes up in value, up in mortgage and keeps $10,000 of net proceeds: $150,000 $ 50,000 $100,000 $225,000 $ 40,000 $185,000 Example II. Tax is due on $10,000 of Cash Boot.

43. Balancing the Exchange Value Mortgage Equity Relinquished Replacement Exchanger goes down in value, across in equity and down in mortgage: $150,000 $ 50,000 $100,000 $125,000 $ 50,000 $ 75,000 Example III. Tax is due on the $25,000 of Mortgage Boot.

44. Refinancing Issues Refinancing prior to the relinquished property sale Refinancing after the purchase of replacement property – Better but should have a time break/separate transaction. To avoid the pitfalls of the “step transaction doctrine”: The refinance should not appear to be solely for the purpose of “pulling out equity”, refinance prior to listing relinquished for sale, document as separate transactions.

45. Examples: Exchange Vesting Issues With few exceptions in an exchange, title to the Replacement property must be held in the same manner as title was held on the Relinquished property. Partnership ABE Acquires ACME, Inc. Acquires Individual Acquires Individual Relinquishes Partnership ABE Relinquishes ACME, Inc. Relinquishes Except in limited circumstances, the same tax identification number should be used on both the relinquished and replacement phases of the transaction.

46. Exchange Vesting Issues Grantor Trust (e.g. revocable living trust): Trustee takes title to replacement property as an individual and then transfers it later to trust. Trust is disregarded for tax purposes. Death of Exchanger If Exchanger dies, Exchanger’s estate can complete exchange. Single Asset Entities: Exchanger who relinquished as an individual can acquire replacement property in a single-member LLC. This entity is disregarded for tax purposes under “check the box” rules. (Rev. Proc. 2002-69 Husband and Wife in community property state – can choose disregarded treatment.) A corporation merges out of existence in a tax-free reorganization after disposition of relinquished property, may complete the exchange and acquire the replacement property as the new corporate entity.

47. Exchange Structures with A Qualified Intermediary Delayed/Simultaneous Reverse Build-to Suit Reverse Build-to-Suit

48. What is Reverse Exchange? A Taxpayer needs to close on the acquisition of the replacement property before the relinquished can close. Because IRC 1031 requires an “exchange” the taxpayer cannot own both the relinquished and the replacement properties at the same time. Typically, the reverse exchange involves a third-party “parking” title until the taxpayer can complete the exchange.

49. Intermediary holds title to Exchanger’s Replacement Property until the Relinquished is sold Parking Title to the Replacement Property & Assignment Exchange Agreement Seller Cash Replacement Property Phase One Loan from Exchanger for Downpayment or Entire Purchase Price Loan from Exchanger for Downpayment or Entire Purchase Price Cash Qualified Intermediary EXCHANGER

50. Parking Title to the Replacement Property Exchanger & Assignment Exchange Agreement Replacement Property Cash Used to Repay Exchanger’s Loan for Replacement Property Relinquished Property Direct Deed Qualified Intermediary Buyer Phase Two

51. Build-to-Suit Exchange & Assignment Exchange Agreement Cash Relinquished Property Direct Deed Step 1 Qualified Intermediary Buyer Exchanger

52. Step 2 Cash from Exchange Account Replacement Property to be Improved Intermediary holds title to the Replacement Property while it is being improved with Exchange Funds Qualified Intermediary Seller

53. Step 3 Completed Replacement Property There can be no more than 180 days between steps 1 and 3 in order to remain within the safe harbor Qualified Intermediary Exchanger Build to Suit on Tax Payer Owned Property (Rev Proc 2004-51)

54. Related Party Issues IRC §1031(f) is designed to prevent basis-shifting & avoidance of payment of federal income tax. Through exchange of high basis property for low basis property, in anticipation of the sale of the low basis property. If a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect ‘cashed out’ of the investment, and the original exchange should not be accorded non-recognition treatment.” H.R. Rep. No. 247, 101 st Congress 1 st Sess. 1340 (1989)

55. Related Party Buyer Related Party Buyer must hold the Relinquished Property received from Exchanger for 2 years. IRC §1031(f)(C)(i) Unless Related Party Buyer is not actually “trading” any Related Party Buyer owned property with Exchanger. If Related Party Buyer starts out with cash, not property, and it simply a purchaser of Exchanger’s property, ending up with 100% basis in the purchased property, then the Related Party Buyer may dispose at will. PLRs 200709036 & 200712013-There is some dispute as to whether this will hold up for others.

56. Related Party Seller Exchanger must hold Replacement Property received from Related Party for 2 years. IRC §1031(f)(C)(ii) Related Party Seller of Replacement Property must also do an exchange. Related Party Seller may not receive cash or non like-kind property. If Related Party Seller does not do an exchange, IRS views this as “cashing out” and transaction will be taxable (Revenue Ruling 2002-83).

57. Combining Seller Financing With An Exchange If the Exchanger carries back financing for the buyer, the Exchanger can: 1.Treat the seller financing as an installment sale under IRC §453. The capital gain taxes are due when Exchanger receives principal payments on the note. 2.Exchanger can act as a “third-party lender” and loan the buyer the equivalent amount of Exchanger’s own funds at the close of the relinquished property. The note and security instrument is in the Exchanger’s name. All exchange funds are transferred to Qualified Intermediary for use in the exchange. When buyer pays off the note the proceeds are not taxable to the Exchanger.

58. Combining Seller Financing With An Exchange 3. Include the note and security instrument as part of the exchange by specifying the Qualified Intermediary as the payee of the note. The Exchanger then can have the Qualified Intermediary use the note in several ways: A. Assign the note to the seller of the Replacement Property. B. Sell the note to a third party for cash and then use the cash to purchase the replacement property. C. Sell the note for cash to the Exchanger and use the cash to purchase the replacement property. If none of the options is utilized, the note will be reassigned to the Exchanger at the termination of the exchange.

59. Partnership Issues COMMON SCENARIOS: 1.A partnership owns property and wishes to sell it. Some of the partners want to engage in a 1031 tax deferred exchange upon the sale and some do not. 2.A partnership owns property and wishes to sell it. All of the partners would like to participate in a 1031 tax deferred exchange, but the partners do not want to purchase the new property together

60. Possible Solutions IF MOST OF THE PARTNERS IN THE PARTNERSHIP WISH TO COMPLETE THE 1031 EXCHANGE TOGETHER: Distributing an undivided interest. Purchase of the interest of the retiring partner. The partnership could sell the relinquished property, distribute a portion of the proceeds to the partners who wish to cash out and use the remaining proceeds to purchase the new property.  ISSUE: The partners that are cashing out would receive a special allocation of the gain from the sale of the property. This gain maybe greater for the partners that cashed out.

61. What if the partners do not wish to purchase the new property together? The partnership can be liquidated and terminated and the relinquished property distributed to the partners as tenants in common. This should be done as far in advance of the sale as possible. If a distribution or dissolution occurs shortly prior to the sale, the key issue is whether the relinquished property was “held for productive use in a trade or business or for investment purposes.” Possible Solutions

62. Exchange Strategies A foreclosure or short sale may result in taxes on gain that must be recognized. Taxpayers can take advantage of creative exchange strategies to use the funds that would otherwise be needed to pay capital gain taxes for the purchase of a better performing replacement property.

63. Why is Tax Basis Important? Pay taxes on the difference between the sales price and the tax basis not the difference between sale price and the equity Can owe taxes even if there is no (or even negative) equity!

64. The 1031 Exchange Solution Structure the short sale as an exchange Acquire replacement property By doing so, you can avoid recognizing capital gains taxes Unfortunately, COD income cannot be avoided

65. Audit Issues Verify the Exchange Agreement was executed prior to the closing of the relinquished property. IRS looks for “as of” dates. Exchange Agreement must contain the “(g)(6)” restrictions from the Treasury Regulations regarding the limitations on the Taxpayer’s access to exchange funds. Qualified Intermediary cannot be a disqualified party. Was the 45 day identification timely done…lot of issues here… Did the Exchanger buy or sell to a related party?

66. Millions of Taxpayer 1031 Funds have been lost over the last five years HOW DID THIS HAPPEN? 1.Qualified Intermediaries are not regulated or monitored by the Federal Government, but a few states have recently enacted legislation. 2.Treasury Reg §1.1031(k)-1(f) Taxpayers must not have actual or constructive receipt of the sale proceeds from their relinquished property until the replacement property has been purchased and the exchange has terminated. Security of 1031 Funds

67. Who owns the Qualified Intermediary? How financially stable are its owners? Is it a publicly traded corporation? Will the Qualified Intermediary provide you with its financial statements? What is the package of security that the Qualified Intermediary is offering your client? Fidelity Bond Corporate Guarantee Errors and Omissions Insurance Does the Qualified Intermediary have trained professionals (Attorney or CPA) on staff? Questions To Ask Regarding The QI

68. What criteria does QI use to pick its bank or will it use any bank? Does the bank send bank statements to taxpayer? Questions To Regarding The Banks The QI Uses

69. Questions To Ask Regarding The Account Structure The QI Uses Does the 1031 Intermediary deposit 1031 funds in segregated accounts under the exchanger’s name and Taxpayer Identification Number? Are funds commingled? Does the 1031 documentation state exactly what type of an account structure is being used? Does the QI require written authorization to disburse funds?

70. Security Features You Should Look For In A QI Performance Guaranty issued on each exchange Fidelity Bond Errors and Omissions Insurance Transparency about entire organization Exchange funds deposited into segregated, interest bearing bank accounts that are separately identified to each Exchanger. Disbursement of exchange funds requiring written authorization of the Exchanger Exchange funds deposited into highly rated financial institutions.

71. Investment Property Exchange Services, Inc. Contact Information: CLAUDIA KIERNAN, ESQ., CES Vice President 877-494-1031 904-826-7140 claudia.kiernan@ipx1031.com