Tag Archives: real estate tax

1031 Exchanges Between Related Parties — and Other 1031 Exchange Issues

Special rules govern 1031 exchanges between related parties, and running afoul of them can turn your tax-free exchange into a taxable sale. 

Here is an example:

Brad and Ellis are brothers. Brad lives in Dallas, Texas, where they grew up, and Ellis lives in a suburb of Boston, where he settled after law school. As a result of an inheritance from their grandparents, Brad and Ellis own several houses in Dallas as joint tenants.

They have rented these houses to tenants and divided the expenses and the profits equally between themselves. The largest of these houses is a five bedroom ranch style home sitting on 3.5 acres.

Brad now wants to move into this house, and wants Ellis to sell him his one-half ownership so that Brad can own the house on his own. The house’s fair market value at the time of their inheritance was $600,000. Its current fair market value is $950,000.

Ellis points out to his brother that if he sells his share of the house to Brad, he will be required to pay capital gains taxes of approximately $45,000. Instead, Ellis proposes that they do a Section 1031 exchange, in which he and Brad would swap their portions of ownership of several of the properties that they own together.

Specifically, Ellis proposes that Brad exchange his joint ownership portion of two of their smaller properties with a combined current fair market value of $890,000 for the ranch house property worth $950,000 that Brad wants. Once Ellis has sole ownership of these properties, Ellis plans to remodel and sell them within the next two years.

Does Ellis’ proposal make sense?

What about the $60,000 difference in value between the property that Ellis wants to exchange in return for the ranch house?

Are there any special problems for the brothers to consider, and is there anything that they could do to avoid these problems?

The first point to recall here is that special rules apply to Section 1031 exchanges with anyone who is a “related party” to the taxpayer.

Related parties include family members, such as spouses and lineal descendants (parents and children, brothers, sisters, grandparents and grandchildren), as well as corporations, partnerships, trusts, and estates in which a related person owns more than 50 percent either directly or indirectly.

You can engage in a Section 1031 exchange with these related parties, but only if neither the relinquished property nor the replacement property is sold or otherwise disposed of within two years of the transfer.

The IRS monitors exchanges between related parties by requiring that both parties file a special tax form, Exchange Form 8824, in the year of the exchange and for the next two years.

In this example, Brad and Ellis can exchange properties, but the exchange will be treated as a taxable sale if either the relinquished property or the replacement property is sold or otherwise disposed of within two years of the transfer.

Thus, if either Brad or Ellis sells or otherwise disposes of the property involved in the exchange within two years of the transfer, the IRS will retroactively disqualify the original transaction as a Section 1031 exchange and order that capital gains taxes be paid.

Moreover, if either brother sells or disposes of the property before the two year holding period is over, the other brother will be required to pay capital gains taxes on the transaction even though he was not the party who sold or disposed of the exchanged property.

Here, if Ellis carries out his plans to remodel and sell the property he receives in the exchange within the next two years, the IRS will retroactively declare the exchange to be a taxable sale and both Ellis and Brad will be required to pay capital gains taxes.

Accordingly, Brad should consider doing the exchange only if Ellis agrees, in the written documents controlling the exchange, to a provision specifying that if either party triggers the taxation of gain within the two year holding period, the innocent party will be reimbursed for the adverse tax consequences.

In addition, a transaction to qualify as a Section 1031 exchange, both the relinquished and the replacement properties must be held for use in a trade or business, or for investment. In this example, Brad wants to move into one of the exchanged properties and use it as a personal residence.

If he does so, the property is not held for use in a trade or business, or for investment, and the transaction will not qualify as a Section 1031 exchange. Brad can move into the five bedroom ranch style home only after a prudent holding period of at least two years, during which he uses the property in a trade or business or for investment.

Brad should also be concerned about the $60,000 difference in fair market value between the property he will be giving up and the property he will receive in the exchange.

In order to use Section 1031 to avoid paying any capital gains taxes, the basic rule is to exchange up, never down.

Here, if the exchange were to go forward as Ellis proposes (that is, Brad would receive property with a fair market value of $890,000 in exchange for property with a fair market value of $950,000), then Brad will have a capital gain of $60,000 on which he will required to pay capital gains taxes.

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


When Can — or Should — You Revoke an Identification in a 1031 Exchange?

Sometimes it is necessary to revoke an identification in a 1031 exchange.

For example, Dwight is doing a Section 1031 exchange involving a 300 unit apartment complex he owns in San Antonio, Texas, and has identified three replacement properties under the Three Property Rule. He then learns that one of the properties he has identified is no longer available.

What should he do?

Dwight should revoke his identification of the unavailable property and identify a new replacement property in its place.

An identification of replacement property can be revoked at any time before the end of the identification period

If Dwight did nothing, he would be left with only two replacement properties, and if those properties did not close he would be unable to complete a Section 1031 exchange.

If, however, Dwight timely revokes the identification of the property that is no longer available — or appropriate — for whatever reason — then he can add a new property to his identification list.

For maximum security when using the Three Property rule, the goal is to end the identification period having named three qualified and suitable replacement properties, any of which can be used as a replacement property in the exchange.

This strategy also applies to other 1031 exchange identification rules (the 200 Percent Rule and the 95 Percent Rule).

Remember, too, that the revocation of identification must, like the earlier initial identification, be made in a written document signed by you that unambiguously describes the property whose identification you have chosen to revoke.

And as with the earlier identification, a revocation of identification must be hand delivered, mailed, telecopied, or otherwise sent to either the person obligated to transfer the replacement property to the exchanger, or any other person involved in the exchange other than the taxpayer or a disqualified person.

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

Why Do a 1031 Exchange in a Down Real Estate Market?

Should you consider a 1031 exchange in a down real estate market?

In the booming real estate market of a few years ago, property owners saw their real estate assets increase dramatically in value.  As a result, if they sold their property they would have significant capital gains and therefore owe significant capital gains taxes that could be deferred or eliminated by a 1031 exchange.

Such dramatic increases in value are much less common in our current real estate market.  In fact, many properties have decreased in value, and would not lead to significant capital gains taxes if sold.

The question then is: if your property has not significantly appreciated in value, and you will not have a significant capital gain if the property is sold, is there still a reason to do a 1031 exchange?

The answer is yes.

Most people think of 1031 exchanges only in regard to avoiding capital gains taxes.  That’s only half the story.

In almost all real estate transactions, capital gains taxation has two components – taxes on actual gain and recapture of depreciation. The depreciation recapture provisions of Section 1250 (real property) and Section 1245 (personal property) apply to Section 1031 exchanges as well as sales. These provisions require depreciation to be recaptured at the higher ordinary income rate (instead of the long-term capital gain rate) when the property is sold or exchanged and a gain is recognized.

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 instead, carries over to the replacement property.

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

Thus, from a dollar perspective, avoiding the recapture of depreciation is just as important – and often more important – than avoiding taxes on actual capital gain since the monetary amount demanded by the government as recapture of depreciation is often larger than the taxes on actual capital gain.

In order to properly understand how recapture of depreciation works, you must first understand depreciation, and especially how the government looks at depreciation.

Simply stated, depreciation is loss of value. Over time all property except unimproved land depreciates, in the sense that over time all property except unimproved land undergoes wear and tear, becomes obsolete, and loses some of its physical integrity as foundations settle, damage is caused by long term exposure to air, water, and insects, and materials such as wood, metal, and concrete deteriorate.

The tax code properly recognizes this natural loss of value over time and allows property owners to deduct a prorated portion of this natural and inevitable loss of value each year from the owner’s basis in the property.

Deductions based on depreciation are taken according to schedules established by the IRS. For residential real estate and improvements, depreciation is taken over 27 years (known as the recovery period). For all other real property, including nonresidential investment property, depreciation is taken over a recovery period of 31 years.

While different kinds of assets are depreciated by different methods, all real properties, including buildings and permanent improvements, are currently depreciated using the straight-line depreciation method. Under the straight-line depreciation method, an identical proportional amount is deducted from your taxes as depreciation each year over the entire recovery period.

Crucially, because depreciation reduces your 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.

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.

For example, let’s say that you purchased a property 20 years ago for $400,000 and sell it today for exactly the same amount. You have absolutely no profit due to appreciation. But because of the depreciation allowable over the 20 years that you have owned the property, you will still have a taxable capital gain of approximately $300,000, even though you will have no cash profit whatsoever.

Even more significantly, even though you have no cash profit, you would still owe the government capital gains taxes of approximately $45,000!

Using a Section 1031 exchange allows you to legally avoid paying this tax, and instead, legally keep the money that you have deducted from your taxes as depreciation over the time that you’ve owned the property.

It is also important to note that the scheduled deductions for depreciation (and the resulting decrease in your property’s basis) are built into the tax code and are not at the discretion of the taxpayer. In other words, you cannot choose whether to depreciate your property and, hence, decrease your basis.

Even more significantly, you cannot claim an exemption from the recapture of depreciation because you did not, in fact, take the deductions due to depreciation that you were entitled to.

The government simply and absolutely 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.

So the answer to the question “Should I consider a 1031 exchange in a down real estate market?” depends not only on your actual capital gains, but also whether you want to avoid paying the government the amount of depreciation that the property has been entitled to during the time you have owned it.

In many cases, the answer will be yes.

For more information on this topic, and 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

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.