Tag Archives: real estate accounting

What Property Qualifies for a 1031 Exchange? (Part Three)

This is Part Three of our series on what property qualifies for a 1031 exchange.  You can also see Part One and Part Two.

In deciding whether a particular property has been held for productive use in a trade or business or for investment, the IRS looks at how you have characterized that property on your tax returns. If you have historically taken depreciation on or reported rental income on a property, there should not be any problem with that property qualifying for a Section 1031 exchange.

In addition, it is important to note that the IRS has ruled that the Section 1031 requirement that property be “held for productive use in a trade or business or for investment” excludes primary residences, vacation homes (when they are not held for investment), and second homes. When a personal residence is exchanged for other property, the Section 121 exclusion rule applies (providing that up to $250,000 of capital gain, or up to $500,000 for a married couple, is not taxable), not Section 1031.

The burden of establishing that a property is held for productive use in a trade or business or for investment (and not for a non-qualifying use such as inventory for resale) is on the exchanger, not the government.

The “for investment” requirement is somewhat trickier than the requirement that the property be “held for productive use in a trade or business,” since all property could conceivably be considered an investment.

Each property must be evaluated on a case-by-case basis. What the IRS looks at is the intent of the property owner and whether, on balance, the property is held for investment purposes or personal enjoyment.

If you want to do a Section 1031 exchange of property that you now use as your primary residence or as a second or vacation home, you must first turn it into qualifying property that is productively used in a trade or business or for investment. In other words, even property you have used as a primary residence, a second home, or primarily for personal enjoyment as a vacation home, may still qualify for an exchange under Section 1031 – if you re-characterize that property by using it for business purposes for a sufficient period of time.

The date the IRS uses to determine whether property has been held for a qualifying business use is the date of the transaction; any previous use is theoretically irrelevant. There is also no clear rule regarding how long a “holding period” is required in order to re characterize property and qualify for a Section 1031 exchange. Tax advisors recommend a period of one to two years (opinion is split on which time period is sufficient, but in no case less than 12 months) in the new use, and that you are able to report rental income and deduct depreciation and other business expenses regarding the property on your tax returns for that period of time.

It should also be noted that one can also exchange many types of non-real estate property that is held for investment or used in a business. For example, an airline can sell its airplanes as part of a like-kind exchange and avoid recapture of depreciation.

But the “like-kind” requirement is interpreted much more narrowly by the IRS for non-real property than for real property. While any real property held for trade or business use or for investment and located in the United States can be exchanged for any other real property held for trade or business use or for investment use and located in the United States, non-real estate properties exchanged under Section 1031 must be essentially the same type of asset.

Airplanes can be exchanged for airplanes, trucks for trucks, pizza ovens for pizza ovens, oil digging equipment for oil digging equipment; but airplanes cannot be exchanged for trucks, and oil digging equipment cannot be exchanged for pizza ovens. In addition, franchise rights and certain types of licenses can also be exchanged under Section 1031.

The replacement property, like the relinquished property, must meet certain requirements to be eligible for a Section 1031 exchange.

First, the replacement property, like the relinquished property, must be property, not securities or services, and it must be intended for “productive use in a trade or business or for investment.” 

Section 1031 applies only to “the exchange of property…for property.” For this reason, you cannot exchange property for securities or services. As with the relinquished property, this is a matter of the how the exchanger intends to use the property. The use of either property by the other party in the exchange is irrelevant.

Second, the replacement property must be of a “like-kind” to the relinquished property. What does “like-kind” property mean? In a typically obtuse ruling, the IRS has stated that:

“As used in IRC 1031(a), the words like-kind has reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale.”

Got it? Okay, now let’s unpack the “like-kind” requirement in language that makes sense.

As used in Section 1031, “like-kind” property does not mean property that is exactly alike – or even alike at all in any normal sense. Instead, the IRS interprets the “like-kind” requirement very broadly – so broadly that if two or more properties are located in the United States and are held for productive use in a trade or business or for investment, they are considered “like-kind” property under Section 1031.

In other words, all real property located in the United States is considered “like-kind” to all other real property located in the United States.

Conversely, foreign property such as property located in Canada or Mexico) or in overseas U.S. possessions, such as Guam or Puerto Rico, is not considered “like-kind” to any property located in the United States.

But urban real estate in Los Angeles can be exchanged for a ranch in Utah, a ranch in Utah can be exchanged for a factory in Delaware, a factory in Delaware can be exchanged for a gas station in Las Vegas, and a gas station in Las Vegas can be exchanged for a conservation easement in Seattle. The quality or type of the real property does not matter so long as each real property is located in the United States. Under Section 1031, an apartment building in Chicago can be exchanged for an office building in Los Angeles, an office building in New York can be exchanged for a car wash in Nashville, a car wash in Seattle can be exchanged for a tenancy-in-common ownership in a resort in San Diego, and a tenancy-in-common ownership in a mall in Arizona can be exchanged fortimberland in Oregon, a farm in Wisconsin, a factory in Pennsylvania, or a gas station in Louisiana.

The fact that one property is improved and the other property is unimproved, or that one property is in a run-down part of a city while the other property is located in an upscale neighborhood is irrelevant.  Moreover, even partially completed property can, if properly identified, qualify as “like-kind” property with completed property. The “like-kind” requirement refers to the nature or character of property, not to its grade or quality. As long as a property is located in the United States and is “held for productive use in a trade or business or for investment,” it is “like-kind” to every other property located in the United States that is “held for productive use in a trade or business or for investment.”

See also “What Property Qualifies for a 1031 Exchange?” Part One and Part Two.

To contact Melissa J. Fox for 1031 exchange or other real estate or legal services, send an email to strategicfox@gmail.com

The Role of a Qualified Intermediary (QI) in a 1031 Exchange

Because you are absolutely not allowed to receive (or directly control) any of the proceeds from the transfer of your relinquished property in a 1031 exchange — if you do, you will instantly turn your tax-free Section 1031 exchange into a taxable sale — it is necessary to employ the services of a Qualified Intermediary (also sometimes called a QI or an exchange accomodator) in the 1031 exchange process.

A Qualified Intermediary is the person or business entity that holds the exchange proceeds and acts as a “safe harbor” or barrier between the taxpayer and the proceeds from the transfer of the exchange property, so that these proceeds never come into your actual or constructive possession, but at the same time can be used to obtain new property for you.

The sale proceeds go directly to the Qualified Intermediary, who holds them until they are needed to acquire the replacement property. The Qualified Intermediary then delivers the funds directly to the closing agent.

If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds.

The IRS originally refused to allow deferred exchanges under Section 1031 because the taxpayer received the proceeds from the transfer of the relinquished property before using these proceeds to obtain replacement property.  To the IRS, this receipt of funds in the period between the completion of the exchange made the transactions into a series of sales and purchases rather than a true exchange.

The current law allows the taxpayer a limited period of time after the transfer of relinquished property to identify and obtain title on replacement property, but also reflects the IRS’s concern over the taxpayer’s receipt of the proceeds in the interim by requiring that there be no receipt of cash or other non-qualified property by the taxpayer before both ends of the exchange have been completed.

As a result of this rule, a new professional came into being: the Qualified Intermediary.

Since the taxpayer can not receive the proceeds from the relinquished property until title to the replacement property is obtained, and these same proceeds are used to acquire that replacement property, someone needs to hold on to the funds, acquire the relinquished property from the taxpayer; transfer the relinquished property to another party, acquire the replacement property from another party, and then finally transfer the replacement property to the taxpayer. This is the job of the Qualified Intermediary.

Specifically, the Qualified Intermediary:

  • Enters into a written agreement (called an exchange agreement) that documents all important aspects of the exchange.
  • Acquires the relinquished property from the taxpayer.
  • Transfers the relinquished property to another party.
  • Acquires the replacement property from another party.
  • Transfers the replacement property to the taxpayer.

The properties are usually deeded directly between the parties, just as in a normal sale transaction. However, in a Section 1031 exchange, unlike an ordinary sale, the taxpayer’s interests in the property purchase and sale contracts are first assigned to the Qualified Intermediary. The Qualified Intermediary then instructs the property owner to deed the property directly to the appropriate party (for the relinquished property, its buyer; for the replacement property, the taxpayer).

Because the proceeds can never come into your actual or constructive possession before the completion of the exchange, there are limitations on who can serve as a Qualified Intermediary in a Section 1031 exchange.

Anyone who is an agent of the taxpayer at the time of the transaction, or has been an agent of the taxpayer within the past two years, is disqualified from being a Qualified Intermediary of the taxpayer.

This prohibition includes anyone who has been the taxpayer’s employee, attorney, accountant, investment banker or broker, real estate broker or agent within the past two years from the date of the transfer of the first of the relinquished properties.

In practical terms, this prohibition eliminates your present lawyer or accountant from serving as your Qualified Intermediary.

However, assuming there are no other disqualifying activities or relationships, you may use a real estate agent who has previously helped to put together a Section 1031 exchange for you, as well as a business entity or person who has performed routine financial, title insurance, escrow, or trust services for you.

Despite the importance of using a Qualified Intermediary in the Section 1031 exchange process, qualified intermediaries are generally not regulated (the single exception is in Nevada).

Remember that the Qualified Intermediary is an actual principal in the exchange transaction. You must assign to the Qualified Intermediary your interest as seller of the relinquished property and your interest as buyer of the replacement property. The Qualified Intermediary will be responsible for holding the proceeds of the transaction in a separate exchange account until the funds are used to obtain the replacement property.

For these reasons, your Qualified Intermediary must be someone you trust to hold your money or land and who has plenty of fidelity bond insurance in place.

You should also take special note of the Qualified Intermediary’s fund management program, asking in whose name the funds are held and where, and what the requirements are for deposits and withdrawals.

In addition, you should also make sure that your Qualified Intermediary is experienced in the Section 1031 exchange process.

Remember that the rules governing the use of the proceeds of the various transactions in Section 1031 exchanges can be complicated, and that a mistake by your Qualified Intermediary can result in you paying thousands of dollars in taxes that could, and should, be avoided.

Remember, too, that it is not the job of the Qualified Intermediary to provide legal or specific tax advice to the exchanger. On these critical matters, you must have expert and trustworthy advice from other professionals.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

1031 Exchange Q and A: Using a 1031 Exchange to Avoid Recapture of Depreciation — Even If You Have No Capital Gains

Li-Ann owns a shoe factory on Grand Island, New York, that has decreased in fair market value since she inherited it 14 years ago. She was preparing to put the factory on the market when her lawyer suggested that she do a Section 1031 exchange rather than a sale in order to avoid paying capital gains taxes.

Li-Ann told her lawyer that she had no reason to use a Section 1031 exchange, since the property had decreased in fair market value.  She wasn’t going to make a profit on the sale, she said, and therefore wouldn’t be paying any capital gains taxes.  Since she wasn’t making any money on the property, she saw no benefit to a 1031 exchange.

Is Li-Ann correct?

The answer is No.  By focusing exclusively on capital gains, Li-Ann has missed half of the potential benefits of a 1031 exchange.

Li-Ann needs to take recapture of depreciation into account, not just actual profit, when deciding whether she will save money by using a Section 1031 exchange.

In this example, Li-Ann might well be wrong in thinking that because her property has decreased in fair market value, she would not owe any capital gains taxes on a sale.

Because depreciation reduces the adjusted basis in a property, it has the effect of increasing the amount of profit – or, more precisely, the amount of capital gains that the IRS insists that you pay tax on – when you sell the property.

Moreover, the government assumes that you have taken all scheduled depreciation deductions, regardless of whether you have actually taken the depreciation deductions or not, and will insist that this allowable depreciation be recaptured when the property is sold.

The longer you’ve owned a particular property, the more depreciation has been taken, and the lower your adjusted basis.

Thus, the longer you own a particular property, the more depreciation will increase the amount of taxable capital gain, even without any cash profit due to appreciation.

In fact, if you sell a property that you have owned for a long time, you are likely to have a sizable taxable capital gain (and be required to pay sizable capital gains taxes), even though you have no cash profit whatsoever.

On the other hand, if you exchange property that is subject to recapture and no gain is recognized, the recapture potential of the relinquished property is not paid by you but carries over to the replacement property.

This recapture potential can be deferred endlessly if you continue to transfer the property through Section 1031 exchanges.

Li-Ann should therefore consider using a Section 1031 exchange in order to avoid paying capital gains taxes on a potentially substantial “profit” that exists in the account books of the IRS, even though her property has not appreciated in value.

For more information on depreciation and 1031 exchanges, see our previous post Why Do a 1031 Exchange in a Down Real Estate Market?

For everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

1031 Exchange Q and A: Can You Exchange a Vacation Home in Taos for a Casa in Mexico?

Sabina and Jeremy live in Houston, Texas, and own a vacation home in Taos, New Mexico, where they have enjoyed vacations. When they bought the vacation home six years ago, they thought that they would rent it to other vacationers when they weren’t using it and allocate the rental money they received to pay the mortgage on the property.

After two seasons as landlords, Sabina and Jeremy decided that they didn’t need the extra headaches that seemed unavoidable in renting the house and dealing with tenant demands, complaints, and damage to their property. For the past four years, they have kept the property solely for their own use, except for occasional uses by close friends and relatives.

Now Sabina and Jeremy think that this would be a good time to cash in on the rise in property values in Taos over the last six years. When they bought the house, they paid $125,000. In today’s market, it’s worth $725,000. Jeremy knows someone who owns a dream house on the beach in Mexico and who would be willing to do a Section 1031 exchange for their vacation property in Taos.

Jeremy thinks that a Section 1031 exchange would be a great way to legally avoid paying capital gains taxes of about $90,000 that they would owe the government if they let go of the vacation home through a sale.

Is Jeremy overlooking anything important?

What should Jeremy and Sabina do?

Jeremy has indeed overlooked some very important limitations on the kinds of property that qualify for a Section 1031 exchange.

For property to qualify for a Section 1031 exchange, the property must be “held for productive use in a trade or business or for investment.” In the past, the IRS had ruled that this requirement excluded vacation homes from 1031 exchanges.

Recently, however, the IRS has declared that that property that is rented to others but also occasionally used by the owners for personal purposes (such as vacation homes) may be exchanged under Section 1031 when (1) the property has been owned by the taxpayer for at least 24 months immediately before the exchange, and (2) the period of the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10 percent of the number of days that the dwelling is rented at fair market value.

Sabina and Jeremy’s vacation home in Taos meets the first requirement — that is, they have owned it for at least 24 months — but does not meet the second requirement — because their personal use of the property exceeds the greater of 14 days or 10 percent of the number of days that it is rented at fair market value.

In order for Sabina and Jeremy to do a Section 1031 exchange with their Taos vacation property, they would first need to recharacterize the property for taxes purposes as property “held for productive use in a trade or business or for investment.”

They could do this by again renting it to vacationers. The date the IRS uses to determine whether property has been held for a qualifying business use is the date of the transaction; any previous use is theoretically irrelevant.

But while there is no clear rule regarding a “holding period” in order to recharacterize property as held for productive use in a trade or business or for investment, most tax advisors recommend a period of one to two years (in no case less than 12 months) in the new use, to be able to report rental income and deduct depreciation and other business expenses regarding the property on your tax returns for that period of time.

Or, under the new IRS ruling on 1031 exchanges and vacation homes, Sabina and Jeremy could discontinue their own use of the propery entirely — so that their personal use is less than the greater of 14 days or 10 percent of the number of days that the dwelling is rented at fair market value.

In addition, Jeremy has overlooked the geographic limitation on property that qualifies for a Section 1031 exchange.

While the IRS interprets the “like-kind” requirement under Section 1031 very broadly (all real property located in the United States is considered “like-kind” to all other real property located in the United States), the property must be located in the United States.

Foreign property (for example, the property in Mexico that Jeremy is interested in obtaining), or even in overseas U.S. possessions such as Guam and Puerto Rico, is not considered “like-kind” to any property located in the United States and is not qualified for exchange under Section 1031.

While Sabina and Jeremy can, under certain circumstances, do a 1031 exchange with their Taos vacation home, they can not trade it for una casa en la playa en México.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

House Swapping with Section 1031?

ABC News recently ran a piece about the emerging trend of house swapping, where home owners trade properties as a way of circumventing the tough market in home sales.

The expert interviewed was Wendy Bounds of the Wall St. Journal and Good Morning America. Bounds said that one of the possible benefits of a house swap was the deferral of capital gains taxes, presumably under Section 1031.

She failed to note, however, that 1031 exchanges are limited to property held for “productive use in a trade or business or for investment,” and do not include personal residences.

Home owners who are considering a trade should learn more about 1031 exchanges before counting on deferring their capital gains taxes.

Why Use a 1031 Exchange?

There are many things you can do with your real property – from keeping it to selling it to giving it away to family members or charity.

Each of these choices has predictable financial, legal, and other consequences, and wise real property transactions are made with a full awareness of, and appreciation for, all of these consequences – especially the tax consequences.

The sale of real estate is a taxable event, and all profit from the sale of real estate is taxed as capital gains in the year of the sale. If you sell a property that has appreciated in value, you will be required, in general, to pay capital gains taxes on the difference between what the property cost you and what you get for it now, plus recapture of any depreciation you have previously taken. If your property has substantially appreciated in market value, you will be required to pay a substantial amount of money as capital gains taxes and depreciation recapture to the government.

A Section 1031 exchange allows you to legally avoid paying these taxes.

Section 1031 (a)(1) of the Internal Revenue Code states that “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.”

What this section means is that Section 1031 exchanges – if done properly – have the special benefit, unlike other forms of real property transactions, of allowing the complete legal avoidance of capital gains taxes and recapture of depreciation.

Technically, a Section 1031 exchange is a tax deferral rather than a tax elimination technique. The new replacement property purchased with the proceeds from the sale of old relinquished property has the same tax basis as the old property, and when the new property is later sold, the deferred capital gain, plus any additional gain realized since the purchase of the new property, is subject to taxation.

But since you can continue to exchange the new properties you obtain through Section 1031 exchanges again and again, you can continue indefinitely to legally defer taxes.

In other words, by taking advantage of the full benefits of the Section 1031 exchange process, you never have to pay taxes on the transfer of real property. Upon death, the basis of property gets “stepped-up” to its fair market value and the accumulated capital gain is never taxed. Even those who inherit the property can sell it at its fair market value at the date of death and not pay tax on that gain.

As Section 1031 exchangers like to say, you can “swap ’till you drop.”

You don’t have to be a financial genius to recognize that avoiding tax liability is always a good investment practice. If you can defer payment of taxes to some indefinite date in the future, you will have more money to invest today.

By putting the money that you save in taxes today to work for you now in sound real estate investments, you will have more equity in the future. By properly using the tax avoidance strategy of Section 1031 exchanges, with the money you save by legally avoiding capital gains taxes and depreciation recapture, you are able to continually step up your real estate portfolio and build substantial wealth from your original investment.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com