Section 1031 of the Internal Revenue Code states that no gain or loss will be recognized if property held for productive use in trade or business or for investment is exchanged solely for property of a like kind.
Three conditions must be met for a transaction to qualify as a tax-deferred exchange.
A Little History
Tax-deferred exchanges have been around for a long time, almost as long as the 16th Amendment to the Constitution of the United States, which created the constitutional basis for federal income taxes.
In its most basic form, a tax-deferred exchange occurs when two property owners simply trade their respective properties simultaneously with one another. This simple A and B swap, or two-party exchange, is rare because two exchangors rarely own property desired by one another. To overcome this rarity, for decades A would agree to give B his property, and B, either on his own or through an exchange facilitator, would then search for suitable replacement property and when found, B would acquire the replacement property and then simultaneously exchange it with A for A's property.
Many an exchange failed because B was unable to locate suitable replacement property within a reasonable time for simultaneous exchange with A. As a result, a variety of very sophisticated exchange models evolved, some involving as many of six or seven properties. Across the United States, exchange clubs were created in which potential exchangors would meet, often several times each year, looking for someone with like-kind property. When a direct swap could not be arranged, multiple-party exchanges were used, with the design resulting in each exchangor receiving and relinquishing like-kind property. But all of these exchanges had the same core principle–it was the IRS position that the law required that all tax-deferred exchanges be completed simultaneously.
Then, along came the "Starker Exchange!"
The Starker Exchange
The Starker Exchange took its name from a United States Appeals Court case involving T.J. Starker, an Oregon property owner. In April 1967, T.J. Starker and his son and daughter-in-law, Bruce and Elizabeth, entered into a "land-exchange agreement" with Crown Zellerbach Corporation, an Oregon commercial lumber company.
Under the agreement the three Starkers agreed to immediately convey to Crown Zellerbach all their interests in 1,843 acres of timberland in Columbia County, Oregon, and Crown Zellerbach agreed to subsequently acquire and deed over to the Starkers other real property, not yet identified or known to either party, in Washington and Oregon. Crown Zellerbach also agreed that if suitable property could not be located within five years they would pay the Starkers' cash for their timberland.
When the Starkers reported the exchange on their tax returns, the IRS ruled that the transfer did not qualify for deferred tax treatment, finding two flaws in the plan: (i) The transaction was not simultaneous–as mentioned above, the IRS for decades insisted that Section 1031 required simultaneity of transfers; and (ii) The IRS contended that the exchange was not of a like-kind-it was not real estate for real estate, but instead, real estate for a promise.
The Starkers appealed the IRS ruling to the U.S. District Court, where it languished for 12 years. When it finally reached the U.S. Court of Appeals, the Court was asked to decide whether simultaneous transfer of replacement property for relinquished property was required for non-recognition treatment under Section 1031 of the Code.
After careful review of legislative history and judicial precedent, the Court concluded that it was not! The Court said that all the law required was that like-kind property be received for like-kind property transferred–there were no time restrictions in the law. The Court concluded that the IRS theory that a delayed exchange was a transfer of real property for a promise was unreasonable and not what Congress had intended when it enacted Section 1031. The Starkers won, the IRS lost, and a major change in tax law occurred. T.J. Starker v. United States, 602 F.2d 1341 (9th Cir. 1979).
The problem with Starker was that the Court left virtually no time limit constraints on delayed exchanges. In fact, Crown Zellerbach had waited five years to transfer replacement property to the Starkers. Was it now possible to transfer property and wait 10 or 20 years to receive like-kind property? What if someone died–could the receipt of like-kind property by an estate or an heir qualify for the favorable tax treatment? If so, how long after death must the property be received?
To curtail this "open-endedness" which prevailed in the aftermath of Starker, Congress added Section 1031(a)(3) to the Internal Revenue Code, imposing the following strict time limits on delayed exchanges:
The IRS regulations implementing Section 1031 have added some interesting twists to exchanges, but have generally been helpful in clarifying the rules and eliminating some of the pitfalls previously facing taxpayers. Most importantly, the regulations established “safe harbors” which, if used, would per se, qualify a transaction for tax-deferred treatment. Under the regulations, replacement property must be designated within the 45-day identification period in a written document signed by the exchangor and hand delivered, mailed, FAXED or otherwise sent before the end of the identification period, to a person
involved in the exchange other than the exchangor or a related party. Replacement property must be unambiguously described in the written document or agreement - this generally means by legal description or street address.
In implementing Section 1031(a)(3), the IRS felt compelled to limit and exchangor’s degree of discretion in selecting replacement property, apparently theorizing that the greater the exchangor's discretion to vary designations of property to be received in exchange, the more the transaction appeared to be a sale rather than an exchange. To restrict this discretion, the IRS placed strict (and rather silly) rules on the number of replacement properties which can be designated in an exchange. The maximum number of replacement properties which may be designated by the exchangor in any given exchange transaction is (i) three of any fair market value, or (ii) any number so long as the aggregate fair market value of all the designated properties as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties.
With certain exceptions, if, as of the end of the identification period, more properties than permitted have been designated, the exchange fails! If the exchangor identifies more than one property as replacement property, the receipt rules are applied separately to each replacement property, but all replacement properties must be received within the 180-day replacement period.
Where a replacement property is not in existence or is being produced or constructed at the time the identification is made, the replacement property must be received within the replacement period–no allowances are made for construction delays or similar matters. Finally, recent changes to IRS regulations allow for a so -called “reverse Starker,” where the exchangor is permitted to identify replacement property before closing on the relinquished property. This is a complicated and difficult procedure, and should only be used where absolutely necessary.
Possession or Control of Funds Prohibited
A transaction will not be recognized as a tax-deferred exchange and capital gain will be subject to immediate taxation if the exchangor actually or constructively receives money or anything other than like-kind property as part of the exchange. Also, if the exchangor has control over or constructive possession of any funds paid for the relinquished property in the transaction, it will be deemed a sale and not an exchange, even though the exchangor may not actually receive cash and ultimately receives only like-kind replacement property. Finally, if the exchangor receives "boot," which is something other than like-kind property, such as personal property, gain is taxed up to the amount of the boot.
If the exchangor trades mortgaged property, the mortgage released is treated as boot unless it is matched by a mortgage on the replacement property. If the exchangor relinquishes property with a larger mortgage than placed on the replacement property, the difference is considered "mortgage boot" and the exchangor is taxed on this net difference. The rule of thumb to follow to assure tax-deferred treatment of an entire exchange transaction is to assure that the cost of, and mortgages on, all replacement properties received in the same transaction, equal or exceed the transfer price of, and mortgages on, all relinquished properties in that transaction.
The basis concept of an exchange, even after Starker and with all the changes Section 1031 and in the IRS implementing regulations, remains unchanged–Property A gets swapped for Property B. The IRS “safe harbors” have created certain "legal fictions" which allow this simple concept to be twisted a bit to more practically fit the reality of modern commercial transactions. Still, however, these legal fictions follow the Starker Exchange model fairly closely: Party A transfers Relinquished Property to Party B, Party B is then obligated to procure Replacement Property and transfer it to Party A–just exactly what Crown Zellerbach did for Bruce and Elizabeth Starker.
The safe harbors then are designed to keep the basic concept of a Starker Exchange largely in tact, with modifications to avoid misuse and rules regarding time limits to preclude "open-endedness."
As with most legal fictions, "a rose may not look like a rose" and in the realm of tax-exchanges, an exchange often looks more like a sale and purchase than like an exchange. Nevertheless, if the safe harbor rules are followed strictly, a transaction will be deemed an exchange and receive the favorable tax-deferred treatment.
There are four IRS save harbors. Two address security of funds being held while replacement property is found to convey to the exchangor, one covers rules for use of a third-party intermediary to facilitate the exchange and one controls the growth of exchange funds held in an exchange transaction.
The Four Safe Harbors
To qualify under the safe harbors, an exchange must be carefully structured to strictly fall within the harbors boundaries–and clearly restrict the exchangor's access to exchange funds, while assuring adequate protection of funds passing through the exchange. For this reason, considerable emphasis is contained in the regulations on the security of exchange funds. The first safe harbor follows the Starker model and addresses the security of exchange funds. It permits the obligation of the exchangor's transferee to acquire
and transfer replacement property to the exchangor to be secured or guaranteed by --
Under the second safe harbor, the obligation of the exchangor's transferee to acquire and transfer the replacement property may be secured by cash or a cash equivalent if the cash or cash equivalent is held in a qualified escrow account or a qualified trust.
In order for an escrow account or trust to be "qualified," the escrow holder or trustee must not be the exchangor or a related party, and the exchangor's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in escrow or trust must be confined to certain extremely limited and specific circumstances.
Under the third safe harbor (the one most often used), exchanges may be facilitated by a qualified intermediary, provided the exchangor's rights to receive money or other property are strictly limited.
A qualified intermediary is a person who is not the exchangor or a related party who, for a fee, acts to facilitate a deferred exchange. The intermediary must enter into an agreement with the exchangor to exchange properties, to acquire the relinquished property from the exchangor (either on its own behalf or as the agent of any party to the transaction), to acquire the replacement property (either on its own behalf or as the agent of any party to the transaction), and to transfer the replacement property to the exchangor.
The qualified intermediary is considered to have acquired property so long as such acquisition is subject to a binding commitment to re-transfer the property to the exchangor. This is usually done as part of the contract for acquiring the replacement property. The transfer of property in a deferred exchange that is facilitated by using a qualified intermediary may occur via a "direct deed" of legal title from the current owner of the property to its ultimate owner, the exchangor, but must follow other guidelines issued by the IRS.
Under the fourth safe harbor, the exchangor is permitted to receive interest or a growth factor on funds held as part of a deferred exchange, provided the exchangor's rights to receive such interest or growth factor are limited to certain specified circumstances. The exchangor must treat the interest or growth factor as interest income for tax purpose, whether it is paid in cash or in property.
Non-simultaneous exchanges of real estate require careful attention to the details of contact drafting, intermediary rules, and closing procedures. In any real estate exchange, several issues must be considered at the outset to assure that exchange treatment is preserved. Care must be exercised in securing adequate guidance in properly structured a transaction. This is an area where "self help" could lead to failing of the exchange, and result in unfavorable tax treatment. Finally, state and local taxes must be taken into account. An exchange which is tax-free for federal tax purposes may still produce state and local taxes (e.g., "tax-free exchange" of properties in some states could be subject to substantial real property transfer and state gains-tax liabilities).
Short Selling? You Should Still Exchange!*
Why would a taxpayer need or want to do an exchange if they are short selling a property? There are two major reasons: capital gains and recapture of depreciation.
First, let us understand how a Short Sale works. In a short sale, the unpaid balance on a property owner’s note is greater than the value of the property. The property owner coordinates with the lender and the lender agrees to take less than the balance due (a shortage) to release the note.
For example, in the year 2000 a taxpayer purchased an investment property with cash for $1M, which by 2006, the was worth $2.5M. The taxpayer refinanced the property and took out $2M. By 2010, the property value had decreased, but in 2015 its value rebounded and the taxpayer decides to sell the property for $2M.
In this situation, the taxpayer has no equity and will not receive any proceeds at the closing. Unfortunately, many individuals in this situation believe that since they are not receiving any funds at closing, they do not need to do a §1031 exchange; i.e. “no equity, means no tax”. This thought process is incorrect. Just because a taxpayer has no equity in a property does not mean there is no gain or tax liability. In the scenario above, our taxpayer purchased the property for $1M and sold it for $2M. They have a gross profit of $1M. Also, over the 15 or so years our taxpayer owned the property, the taxpayer been depreciating the property. So, in addition to the $1M gain, our taxpayer will likely be liable to pay tax on “Recapture of Depreciation” at a tax rate of 25%. This taxpayer has a large tax liability even though there is "no equity" at the time of sale.
It is the taxpayer’s decision to do or not do a §1031 exchange on this transaction. If the taxpayer decides to exchange, all of their tax liabilities may be carried into newly acquired replacement property. Unfortunately, the exchange account will not have any funds, so the taxpayer must come out of pocket to acquire the new property. Although there are no funds to hold, a Qualified Intermediary should still be used to prepare the necessary documentation and coordinate the transaction.
This situation may not meet every taxpayer’s needs, but if you or someone you know is in a similar circumstance, talk with a tax professional to see if this type of exchange will work for you. Should you have specific questions, please feel free to contact your local First American Exchange office. We would welcome the opportunity to speak with you about this topic or any other §1031 related needs you may have.
*Adapted from "The Exchange Update" by First American Exchange Company, April 2013, Converting Investment Property to Your Primary Residence**
Exclusion of Gain from Sale of Residence
Many people are aware that they can sell their primary residence and not pay taxes on a significant amount of gain. Under Section 121 of the Internal Revenue Code, you will not owe capital gains taxes on up to $250,000 of gain, or $500,000 of gain if you are married and filing jointly, when you sell a home that you used as your primary residence for at least two of the previous five years. Taxpayers can take advantage of this exclusion once every two years.
Property Converted from Investment to Primary Residence
Taxpayers used to be able to trade into a rental, rent the home for a while, move into it and then exclude all or some of the gain under Section 121. Provided they lived in the home as their primary residence for at least two years, they could sell it and exclude the gain under Section 121 up to the maximum level of $250,000/$500,000. In recent years Congress enacted two amendments to Section 121 in order to limit the benefits of Section 121 when the property has been used as a rental.
First, if you acquire property in a 1031 exchange and then convert it to your primary residence, you must own it at least five years before being eligible for the Section 121 exclusion.
Second, the amount of gain that you can exclude will be reduced to the extent that the house was used for something other than a primary residence during the period of ownership. The exclusion is reduced pro rata by comparing the number of years the property is used for non-primary residence purposes to the total number of years the property is owned by the taxpayer.
For example, a married couple uses a tax deferred exchange under Section 1031 to acquire a house as investment property. The couple rents the house for three years, and then moves into it and uses it as their primary residence for the next three years. The couple sells the property at the end of year 6, netting a total gain of $800,000. Instead of being able to exclude $500,000, the couple will not be able to exclude some of the gain based on how many years they rented the house. Since they rented it for three years out of six, 50% of the gain, or $400,000, will not be able to be excluded. Because of this new limitation, the couple will be able to exclude $400,000 of the gain rather than $500,000.
There are a couple of exceptions to this restriction. If the house was used as a rental prior to January 1, 2009, the exclusion is not affected. Using the example provided above, if the three year rental period occurred prior to January 1, 2009, the exclusion would not be reduced and the couple would be able to exclude the full $500,000.
Another important exception is that property that is first used as a primary residence and later converted to investment property is not affected by these restrictions on excluding gain. For example, if you own and live in a house for 18 years and then you move out and rent the house for two years before selling it, you can receive the full amount of the exclusion. Because your investment use occurred after the last day of use as a primary residence, all of the gain accumulated over your 20 year ownership of the property can be excluded, up to $250,000, or $500,000 for married couples.
Combining Exclusion with 1031 Exchange
Fortunately, the rules are favorable to taxpayers who have more than $250,000/$500,000 of gain and are looking to combine Section 1031 with Section 121 to both exclude and defer tax. When the property starts out as a primary residence and then is converted into an investment property, you can exclude gain under Section 121, and then defer tax on the remaining gain, provided you comply with the requirements of both Section 1031 and Section 121.
The Internal Revenue Code still provides investors with favorable options for exclusion of gain and tax deferral. The rules can be complicated, but with the right planning taxpayers can still make the most of their real estate investments. For additional information about the 1031 exchange process or to open an exchange contact us at First American Exchange.
**From "The Exchange Update" by First American Exchange Company, February 2012, References: Internal Revenue Code Section 121, Housing Assistance Act of 2008 (HR 3221).
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