Two banked owned 1031 eligible single family lots located at 1720-1722 George Street in Chicago, Illinois. The lots are east of the Kennedy Expressway and west of North Lake Shore Drive in Lakeview, north of Bucktown and DePaul.
Andy Gustafson
Leasehold Improvement
A leasehold improvement exchange is the application of a leasehold interest with a 1031 tax deferred exchange. A couple of examples includes building on land already owned or exchanging out of leasehold improvements made into another leasehold interest to be improved. Each requires planning, but the first example requires that the property to be improved is owned by a related party at least six months prior to initiating the exchange.
Bowling Center, Bar, and Restaurant – 1031 Eligible
This fine business and 1031 eligible property comes with twenty five acres as well as rental property. Total income is up $40,000 in 2011! Beautiful area for hiking, camping, skiing, hunting, or just enjoying the great outdoors.
Bowling Alley, Bar, Restaurant and Arcade – 1031 Eligible
Price Reduced: This 1031 eligible large center built in late 1990’s, building in good shape, large acreage very little competition. Safe place to live, located around many area businesses and comes with Real-estate. Updated pro shop, cosmic bowling, nice bar seats 120, with full service restaurant and Arcade games. Business comes from well-established league play, including senior and youth leagues.
1031 Exchange Fees
1031 exchange fees represent payment to a Qualified Intermediary (QI) to accommodate a 1031 tax deferred exchange. A 1031 exchange is a tax deferral strategy federal and state taxpayers utilize to postpone the payment of capital gains and recaptured depreciation taxes when selling and replacing real property held in a trade, business or for investment. Both foreign and resident individuals, trusts, partnerships and corporations use this section of the Internal Revenue Code (IRC) to defer gain on farms, timberland, apartments, shopping centers, single family rentals, and more. In 2012, the Joint Committee on Taxation estimates that $3.2 billion in taxes were deferred with $1.2 billion to be initiated by individuals.
1031 Exchange Process
In a 1031 exchange, the QI prepares documentation created in accordance with the IRC supporting the taxpayer’s intent to initiate a 1031 and holds the exchange proceeds, typically in a bank under the taxpayer’s tax identification number. The bank account may or may not earn interest. FDIC insurance insures those proceeds of $250,000 or less. When the taxpayer is ready to acquire the replacement property, the QI initiates a wire out for the closing.
There are different types of 1031 exchanges including:
- Forward
- Reverse
- Deferred improvement
- Simultaneous
- International
The QI is compensated by a fee and potentially interest earned on the escrow account. The 1031 exchange fee is dependent upon the type of exchange, complexity and the QI involvement to accommodate the exchange. International exchanges may require the set-up of an escrow account in a foreign country to avoid converting foreign currency to US dollars. It takes time and research to establish foreign escrow accounts.
1031 Industry
Currently, the 1031 exchange industry is not regulated. The Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 created the Bureau of Consumer Financial Protection within the Federal Reserve. The law requires the Bureau to conduct a study and propose legislation to protect consumers engaging QIs accommodating 1031 tax deferred exchanges. The proposed recommendations are to be completed one year after the law takes effect and implement regulations within two years of the Bureau’s report.
Eight states including Washington, Oregon, California, Idaho, Colorado, Nevada, Virginia and Maine have enacted laws to protect their constituents requiring that exchange funds are held in a qualified escrow account with dual signatures authorizing disbursements or that the 1031 intermediary maintain a fidelity bond of at least $1,000,000 and a minimum $250,000 error and omissions insurance policy. Each state has a variation of the law and respective criminal and civil penalties.
Disqualified Persons
A disqualified person cannot act as a 1031 intermediary or an Exchange Accommodator Titleholder in a reverse 1031 exchange. In general, a disqualified person is a person or entity that is related to the taxpayer or is the agent of the taxpayer at the time of the transaction. An agent includes:
- Taxpayer’s employee
- Attorney
- Accountant
- Investment banker
- Real Estate agent or broker
Exceptions allow for those above who have provided 1031 accommodation, routine financial, title insurance, or trust services for the taxpayer by a financial institution, title insurance company, or escrow company not to be deemed disqualified. A firm and their associates who have provided additional services to the taxpayer are considered disqualified from acting as a 1031 intermediary.
An attorney and accountant may not act as the taxpayer’s 1031 intermediary if the attorney or accountant has performed legal or accounting services for the taxpayer within two years prior to the exchange.
Are you considering a 1031 exchange? Do want to understand when a 1031 exchange makes sense? Download a complimentary eBook answering that question by clicking here.
1031 Exchange Reinvestment Rules
To defer 100 percent of the realized gain, the 1031 exchange reinvestment rules requires that the net equity from the sale plus the debt retired must be reinvested into the replacement property. The common misconception is that only the net equity needs to be reinvested. This is true if no debt on the property sold exists, but if there is debt and it is not replaced with equal or greater debt, then a tax (mortgage boot) is triggered.
1031 Exchange Code
The Internal Revenue Code Section 1.1031 states “no gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like-kind which is to be held for productive use in trade or business, or for investment.” No gain or loss shall be recognized implies that the capital gains tax is deferred, postponed given the property is held for the proper intent and supported by facts such as the replacement property is like-kind and held for the proper intent. The tax is deferred indefinitely or until the replacement property is sold. There is no limitation to the number of 1031 exchanges a taxpayer can initiate.
The Internal Revenue Service categorizes property into four classes:
- Investment property
- Property held for the productive use in trade or business
- Inventory held primarily for sale
- Primary residence including second homes and time-shares not rented out to others.
Property held for productive use in a trade, business, or for investment qualifies for the 1031 tax deferral. Like-kind real property may be exchanged for any real property given the state where the property is located recognizes the property as real rather than personal.
What is not eligible for a 1031 exchange includes:
- Personal residence
- Inventory
- Property held for fix and flips
- Stocks, bonds and securities
- Partnership interests
- Indebtedness
Boot
When a capital asset is sold, two calculations are determined. Federal and state capital gains and recaptured depreciation taxes due are the outcome of the first review while the settlement statement determines the net equity or cash due seller by itemizing the sales price, less the selling expenses, less the debt retired. The first calculation does not consider whether or not there is debt.
In a 1031 exchange, the economic position of the taxpayer does not change given the replacement property acquired has a net price that is equal to or greater than the old or relinquished property. When the taxpayer receives cash or does not replace the debt on the property sold, the Internal Revenue Service considers this a taxable benefit. Equity boot is when cash is received in a 1031 exchange, while mortgage boot is when debt is not replaced. Selling expenses such as sales commissions, title insurance, government recording charges, transfer taxes, pest inspections, home warranty, survey and qualified intermediary fees can be paid from the exchange proceeds.
What needs to be reinvested in the replacement property is the net equity plus any debt retired at the old property closing. Otherwise, a tax is triggered. Partial exchanges make sense where not all the net equity or debt is reinvested. Seek the counsel of your accountant to understand whether a partial exchange provides the intended tax deferral benefits.
Download the complimentary eBook on “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking here.