Lake Amistad Ranch located 25 miles north of Del Rio, Texas is an eligible 1031 exchange property. This 890 acre ranch has water access to the number one Bass lake in the United States, Lake Amistad. Owner has access to fish, swim, canoe or other water activities is available along with hunting for white-tail deer, quail, doves and javelinas.
Andy Gustafson
Deferred Taxes
Deferred taxes is the outcome of Section 1031 of the Internal Revenue Code for taxpayers in certain qualifying situations. The rules on deferred taxes are very strict, but if they are met, the benefits can be substantial. Section 1031 allows a property owner to defer the federal and state capital gains tax that would typically be due at the time of the sale of the property until a point in time in the future if the proceeds and debt retired from the sale are equal to or greater in the replacement property.
Capital Gains Tax
As most taxpayers already know, the sale of a capital asset potentially exposes the seller to a capital gains tax obligation. In order to avoid owing capital gains taxes, a basic understanding of capital assets and gains is in order.
Section 1031
Think about a typical transaction where a property owner sells real or personal property. The taxpayer is taxed at the time of the sale for any capital gain or recaptured depreciation realized on the sale of the property. Section 1031 of the Internal Revenue Code offers an alternative to paying this capital gains tax immediately if a replacement property is purchased of equal or greater value than the net sales price. Section 1031 allows a taxpayer to defer the tax due as a result of a sale to a time in the future, so long as certain rules and guidelines are followed. The reasoning behind Section 1031 exchange is that it is thought that the taxpayer shouldn’t be penalized (taxed) on sales proceeds as long as those proceeds are used to invest in a similar property. In effect the taxpayer’s economic position has not changed nor has she/he received a benefit of cash or reduced indebtedness.
Four 1031 Exchange Rules
Understanding and following 1031 exchange rules is critical when initiating an Internal Revenue Code Section 1031 tax deferred exchange. Seek the services of a Certified Exchange Specialist© whose designation provides the assurance the taxpayer is benefiting from a 1031 expert who is subject to a strict Code of Ethics and Conduct Preamble.
Soft Costs in an Improvement 1031 Exchange
When a taxpayer sells property outright, any gain realized on the sale of the property is potentially subject to the typically high capital gains tax rates. One option for a taxpayer who wishes to avoid incurring a capital gains tax obligation is to enter into a “like-kind” exchange instead of a traditional sale. Under the Internal Revenue Code, Section 1031 allows such an exchange if all relevant conditions are met. In a simple Section 1031 Exchange, a taxpayer must designate a property to be relinquished as well as a replacement property to be exchanged. A Qualified Intermediary, or QI, is then used to facilitate the exchange, which must be completed within 180 days. Additionally, the properties involved in the transaction must be held either for productive use in a trade or business or for investment.
Improvement Exchange
Over the years since Section 1031 was created, like-kind exchanges have taken on many complicated forms that have required the Tax Court to rule on their eligibility. One such evolution is known as the “improvement exchange,” “built-to-suit exchange,” or “construction exchange.” In this type of exchange, improvements are made to the replacement property as part of the exchange. Often, an improvement exchange contemplates improvements made on real property that is already owned by the taxpayer in what is recognized as a Leasehold Improvement Exchange. Because Internal Revenue Service Revenue Procedure 2000-37 prohibits a taxpayer from simultaneously owning both the relinquished property and the replacement property, this type of exchange requires the replacement property to be “parked” with an Exchange Accommodation Titleholder, or EAT, throughout the 180 day period during which the improvements are taking place. One issue that a taxpayer may face when participating in an improvement exchange relates to “soft costs.”
Soft Costs
The overall goal of a Section 1031 Exchange is to avoid receiving any cash or assets directly, thereby avoiding capital gains taxes. If any money or property is received by the taxpayer, either directly, indirectly, or constructively, it is considered “boot” and is taxable. In an improvement exchange, there are a number of costs that could be considered boot. Understanding which of these “soft costs” are tax-deferred and which are considered “boot” is critical for a taxpayer contemplating an improvement exchange.
I.R.S. Private Letter Ruling 200329021 analyzed an improvement exchange where taxpayer was attempting to make improvements to land in which taxpayer had an ownership interest. In that case, taxpayer set up the transaction using both a QI and an EAT to facilitate the transaction, which allowed the replacement property to be “parked” during the improvement stage. The improvements were scheduled to be completed within the 180 day time frame. The ruling allowed the transaction and found that taxpayer would not be in possession of money or property that would subject taxpayer to payment of capital gains taxes, provided that the improvements were completed on time. In the event that improvements were made subsequent to the 180 day period, the value of those improvements would be considered boot and, therefore, be taxable. In addition, “to the extent the estimated cost of the Improvements is less than the qualified funds held by QI, if Taxpayer does not timely identify and acquire additional like-kind replacement property Taxpayer will receive the remaining qualified funds as boot.”
In a footnote, on page three of subject Private Letter Ruling, “soft costs,” including architectural and engineering fees, permit fees, attorney and CPA fees, incurred and paid months in advance of the EAT’s purchase of the replacement property, can be reimbursed to the Taxpayer by the EAT. Planning costs should be capitalized into the replacement property per Internal Revenue Code § 263(a)(1). Finally, improvements must actually be made to the existing structure, meaning that the value of raw materials that are simply delivered to the site and not installed are not tax-deferred.
As with all Section 1031 Exchange transactions, be sure to consult with an expert prior to moving forward to ensure that your transaction will meet the often complicated eligibility requirements.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.