1031 Exchanges

In today’s distressed real estate market – especially in resort areas – there are many good bargains!   For someone wanting to also do a 1031 tax-deferred exchange, there is a handy strategy called a Reverse Exchange:

     

  • 1. The purchase and closing of the ‘new’ replacement property occurs BEFORE the closing of the sale of the (yet-to-be) relinquished property (hence the name “Reverse” exchange)
  • 2. The client cannot take title to the ‘new’ replacement property – because if they did they could not do an exchange between the replacement and relinquished properties, because the client is on title to both at the same time
  • 3. So…the Qualified Intermediary (QI) or Accommodator – IPX 1031® Exchange – must close and take title to the ‘new’ replacement property.   Essentially, the QI parks title under Revenue Procedure 2000-37– using an IRS-required special purpose entity called an EAT (Exchange Accommodation Titleholder)
  • 4. This purchase of the replacement property by the QI-EAT-IPX must be paid for by the client: either they (1) Have cash to lend to the EAT (secured with a promissory note), or (2) They can use a lender’s funds (which can be secured with the replacement property, and perhaps even cross-collateralized with the relinquished property; and the lender can also request personal guarantees and be secured by mortgage or deed-of-trust as well).
  • 5. After the purchase of the replacement property by the EAT, the client then goes on with their life and business, and will eventually sell their ‘old’ relinquished property – this is closing #2…
  • 6. After the closing of the sale of the relinquished property, there needs to be a third closing whereby title is transferred from the QI-EAT to the client on the ‘new’ replacement property.   This completes the Reverse Exchange.
  • 7. If all of this is accomplished within 180 days from the date of the sale of their relinquished property, then this is a Safe Harbor Reverse Exchange…which essentially provides the client with an “Audit Pass” of sorts from the IRS.
  • 8. If the reverse exchange takes longer – or is originally anticipated to take longer – than 180 days, then that type of reverse exchange falls outside of the Safe Harbor under Rev Proc 2000-37 and is called a Traditional or non-Safe Harbor Reverse Exchange.   It is still allowed by the IRS, but the client as lost their “audit pass”…   This type of reverse exchange, if properly structured and documented, is OK with the IRS, but the QI needs to know in advance if this is where the client wants to go.
  • 9. The following links from our website (www.ipx1031.com) explain in more detail a Reverse Exchange: (1) http://www.ipx1031.com/pdf/IPXBriefExchangePDFs/ReverseExchange.pdf and (2) http://www.ipx1031.com/pdf/IPXBriefExchangePDFs/HowToInitateReverseExchange.pdf

When a client is contemplating a 1031 exchange one of the potential stumbling blocks is that exchanges are just a tax-deferred strategy – not a tax free strategy… Guess what!? There actually is a way for a client to make their exchange essentially tax-FREE…! With careful planning, a little life-style change, and utilizing Revenue Procedure 2005-14, as modified in 2008 by the Housing & Economic Recovery Act, the client can ultimately take out their capital gain tax FREE with certain limits. Here’s how:

  • 1. First, exchange into qualified investment property that is residential in nature. Usually a client has wide latitude with their replacement property: the concept of “Like-Kind” where the replacement property must be the same type as the relinquished property is somewhat of a misnomer. In a 1031 exchange as long as you exchange into any other type of real property in the U.S.(other than your personal primary residence), the exchange should be ok. But for this strategy to work, the replacement property must be something that the client can eventually live in – therefore it must be residential in nature.
  • 2.Treat it as investment property for at least one-year-and-one-day (but see #3 below)
  • 3.Depending on your accountant’s advice, you may want to treat the property as an investment for two full years so as to qualify for Safe Harbor treatment under Rev Proc 2008-16
  • 4.After the qualifying investment period above, you can safely move into the property – without invalidating your recent 1031 exchange into it… And if you live in the property for at least 24 months (the time does not have to be contiguous) treating it as the client’s personal primary residence; and…
  • 5. You must own the property for at least (a minimum of) five years; and…
  • 6. If you do sell it after Year 5, you’ll be able to use your personal primary home exclusion (IRC Sec 121) for a maximum tax FREE exclusion of gain up to either $250K if your single or $500K if your married.
  • 7. The more years you live in it, the more of your exclusion you’ll be able to utilize. The IRS calculates the amount of your qualifying use as a fraction: the numerator being the number of years you live in it, and the denominator being the number of years you own it. For example, if you live in it for three years, and have owned it for five years (remember, for at least the first year you treated it as an investment), then when you sell it you’ll be able to use 3/5 of $500K for a maximum exclusion of $300K of gain.
  • 8. You’ve turned a deferred taxable gain into tax free dollars…!
  • 9. Note: the gain due to recapture of depreciation (Section 1250 Gain) is not able to be deferred. And the gain that is recognized and reported on your income for State tax purposes may also be taxable. Always consult with your tax advisor!

Q: Can a client exchange into – or out of – a vacation home or a second home?

A: A vacation home or a second home is essentially investment property that also has some personal use by the client. And perhaps the vacation/2nd home has never been rented, but has only been used by the client or family members – does the vacation/2nd home qualify for a possible 1031 exchange? Is this property now ‘tainted’ because of the client’s personal use? In other words, when it comes time for the client/owner to sell the property, can the client still utilize IRC Section 1031 to do a tax-deferred exchange? The answer is “YES!” but with some qualifications, and there are new rules to provide the client with a Safe Harbor – which simply means that if the client stays within the below guidelines their exchange will be valid with the IRS:

  • 1. The client must own the vacation home for at least two full years (24 contiguous months) – either before selling it and then doing an exchange, or, after they’ve bought it by exchanging into it. After this two-year tolling period the IRS would not necessarily care about the property’s usage in terms of a 1031 exchange.
  • 2. For each 12-months of the two-year tolling period the client must limit their personal use of the property to no more than 14 days.
  • 3. For each 12-months of the two-year tolling period the client must make the property available for rent for at least 14 days or 10% of the amount of time that it was available for rent.
  • 4. Notice that there is some wiggle-room: if the client makes the property available for rent (and they must do so at fair market value, and any security deposits must also be reasonable and at fair market value) for the entire year (365 days), then 10% of that availability, or 36 days, now becomes the client’s allowed personal use…
  • 5. Client is also allowed Maintenance Days – which don’t count against their personal usage days – but the client should keep all invoices, records, and documents verifying usage versus maintenance. And that is true of course for the rental days – or the time it was advertised for rent but not actually rented out. Please note that the maintenance days should be reasonable: if you report that you had 4 months of maintenance (December through March) during prime ski-season, then you had better be able to back up that assertion…!
  • 6. Even if the client “violates” these rules (say, perhaps their personal use is greater than the maximum 14 days per year for the first two years) – then they may still be able to complete a 1031 exchange! By consulting with their accountant or tax advisor, and showing enough expense items on Schedule E of their tax return (and not on their Schedule A), then it demonstrates that the property was utilized more so as an investment than just for personal use… At the very least they may defer some of their gain but perhaps not all of it (that portion that is personal use won’t be deferred). So, for example, if you have a mortgage on the vacation property and you’re taking the interest deduction on your personal tax return on Schedule A, don’t… Instead, show it as an expense on Schedule E. The same goes for property taxes, and other expense including depreciation taken.