1031
Tax-Deferred Exchanges
Real estate investing is similar to
playing Monopoly. Winning at either takes savvy and the skill to negotiate the
exchange of less desirable properties for more valuable ones. Texas property
owners intent on winning should understand the many benefits of Internal Revenue
Code section 1031 tax-deferred exchanges.
Tax-deferred exchanges have been in the tax code since 1921
and are among the significant tax advantages for real estate investors. The key
advantage of a 1031 exchange is that it allows an investor to dispose of a
property without incurring a capital gain tax liability. This allows the earning
power of the deferred taxes to work for the benefit of the investor instead of
the government.
Creative Exchange Strategies
As tax code rules and cases have evolved overwhelmingly in
favor of taxpayers - especially with regard to real estate - exchanges have
become easier. A seller hires a 1031 qualified intermediary (QI) to document the
sale of a property as an exchange. The QI holds the proceeds to prevent the
seller from being in a taxable situation. Potential replacement property is
identified within 45 days after closing, and some or all of those properties are
acquired within 180 total days after the sale. For real estate exchanges, the
properties just need to be used in the exchanger's business or held as an
investment. This format is called the delayed exchange.
Although the delayed exchange variation is the most common,
many exchangers employ more creative strategies, such as reverse exchanges.
A 1031 reverse exchange is called for when the replacement property must be
acquired before closing on the relinquished property (if for example, a prime
property is listed in a hot market, investors would have to write a contract
quickly to compete with other prospective buyers).
Previously, reverse exchanges were used infrequently because
the IRS offered no guidance on the topic. Reverse exchanges were considered a
gray area, and taxpayers either proceeded with caution or chose to avoid them.
'Parking' Properties
In the past, there were three basic approaches to reverse
exchanges: the "pure" reverse approach, the exchange-first
(relinquished property parked) approach and the exchange-last
(replacement property parked) approach. The first was dismissed by most QIs
because the exchanger cannot own the relinquished property and the replacement
property at the same time.
The goal was to create an arms-length transaction in which
the QI (or an entity created by the QI) acquired either the relinquished
property or the replacement property for the taxpayer and created an exchange,
which should otherwise fall within the rules and regulations relating to
deferred exchanges. The exchange-first and exchange-last approaches became known
as parking arrangements because the QI "parks" one of the properties
in the QI's name to prevent the exchanger from owning both properties
simultaneously.
The problem of constructive ownership arose in these
transactions. Although the QI held title to the property, all the benefits and
burdens of ownership were transferred to the exchanger.
Questions regarding management of the parked property, loan
arrangements, taxpayer advances to fund the acquisition, exit strategy, fixed
price versus fair market value and who was to receive the tax benefits of
ownership while the property was parked were common. If the taxpayer retained
all the burdens and benefits of ownership while mere legal title was parked, it
was feared the taxpayer would be treated as actually owning both the
relinquished and the replacement properties at the same time.
New Rules for Reverse,
Improvement Exchanges
After years of deliberation, the IRS has validated the
parking arrangements described previously, as long as the exchange is completed
within 180 days. Revenue Procedure 2000-37, enacted Sept. 15, 2000, creates a
"safe harbor" for exchanges in which a third party called the
"exchange accommodation titleholder" (EAT) enters into a parking
arrangement and acquires title to either the relinquished or replacement
property. This applies to reverse and improvement exchanges. More on improvement
exchanges follows.
The EAT is the entity that parks the property. The EAT and QI
can be the same, but preferably the EAT is a separate entity formed by the QI
specifically for an exchange. Strategically applied, the new rules offer
investors enhanced investment alternatives.
Seize a Buying Opportunity. Investors can now immediately
acquire a desirable replacement property before selling the relinquished
property. Many commercial investors are using this strategy, particularly in
markets where inventory of properties is low or turns over quickly. Investors
can purchase their next investment property as soon as a good buy is available.
Guarantee Exchange's Buying End. The new rules can reduce the
pressure associated with finding a replacement property within the 45-day
identification period. Thousands of commercial transactions fail to close each
year because investors are unable to locate suitable investments within the
45-day identification period constraints. A replacement property can now be
purchased before selling the relinquished property. This transfers the time
crunch from the purchasing phase to the selling phase.
Create an Investment. Investors can build their investment
properties from the ground up or improve an existing property (as long as the
property is in the EAT's name) to create an investment that meets their exact
needs. Many Texas investors are using tax-deferred dollars to build new
warehouses or office buildings that meet their particular requirements rather
than being limited to properties available on the market. This type of exchange
provides tremendous flexibility because a certificate of occupancy is not
required within the 180-day exchange period to meet the requirements for full
tax deferral. The taxpayer can count improvements built and paid for during the
180-day exchange period, whether the project is complete or not.
More investors are combining a reverse exchange with an
improvement exchange by purchasing a new property and making improvements to the
property before the relinquished property is sold.
Converting Rental to Residence
Investors can combine the tax deferral benefits of an
exchange with the tax exclusion advantages available under the primary residence
tax rules (Internal Revenue Code 121). Exchanging into a replacement property
that is initially held for investment and later converted from rental property
into a primary residence enables a property owner to obtain tax-free funds.
Under the primary residence tax rules, anyone living in a
property as their primary residence for 24 months out of a 60-month period can
exclude from taxable income $250,000 (if filing single) or $500,000 (if married
filing jointly) of the gain from the sale of their home. This exclusion is
available once every two years.
Vacation Homes and
Tenants-in-Common
Real estate located in resort or vacation areas may qualify
for an exchange if owners can establish that their intent was to hold the
property for investment. Property owners in many resort destinations nationwide
are deferring 100 percent of their capital gain taxes and exchanging for more
desirable properties.
IRS rules have long allowed an owner to sell a whole property
and purchase an undivided interest in another property, becoming a "tenant
in common" (TIC) with other owners of the real estate.
Increasingly, owners of shopping centers anchored by national
tenants like supermarkets are selling fractional ownership interests in such
centers. These are called TIC/NNN programs because tenant-in-common interests
are sold in centers managed largely by the tenants through triple-net leases.
Investors participate in the benefits of larger commercial
projects that often result in a relatively passive investment generating a
predictable monthly cash flow. However, each such investment must be closely
examined for economic and legal viability.
Real estate cannot be exchanged for personal property, such
as a partnership interest or REIT stock. Therefore, a taxpayer must be satisfied
that the substance of the transaction, and not just the form, is still a real
estate purchase. On March 19, 2002, the IRS issued Revenue Procedure 2002-22,
specifying the conditions under which the IRS will consider a request for a
ruling that an undivided interest in rental real estate will be considered an
interest in real estate and not an interest in a partnership or "business
entity." While this procedure does not constitute a safe-harbor that
automatically validates any program, the advance-ruling requirements are likely
to become a litmus test for many sponsors of TIC programs.
Unlike Monopoly players, real estate investors do not have to
depend on a roll of the dice to pass go and collect more money. Savvy Texas
property owners are using tax-deferred exchanges to acquire desirable Boardwalk
and Park Place properties and win the investment game.
This information is not intended to replace qualified legal
or tax advisors. Taxpayers should review their specific transactions with their
own legal or tax counsel.
Lehrmann (greg@apiexchange.com)
is an attorney board certified in commercial and residential real estate law by
the Texas Board of Legal Specialization. He is Texas Division Manager for Asset
Preservation, Inc., a 1031 Qualified Intermediary.
By Greg Lehrmann
Reprint from Volume 9, No. 3 - July 2002, TIERRA GRANDE