Tom Gustafson

Three Sins of a 1031 Exchange Qualified Intermediary

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“Be careful!  I lost my entire life savings in a 1031 exchange.  … Numerous people who had worked their entire lives building equity in a property had everything stolen from them.  1031 exchanges are not regulated by the feds and are only as trustworthy as the people managing them!  Be careful!”  Sam commented on an Atlas 1031 article on LandThink. He understands the tragedy of working with unprofessional 1031 exchange managers, also known as Qualified Intermediaries. Property owners who wish to take advantage of tax deferred exchanges without a risk of losing their equity should be aware of three ways of how to distinguish between a trustworthy and an unreliable Qualified Intermediary.

Why 1031 Exchange?

When selling real and personal property held for investment or use in a business, your CPA, Realtor, Estate Attorney may suggest a 1031 tax deferred exchange to defer federal and state capital gains and recaptured depreciation taxes. These taxes can represent upwards of 40% of the sales price. A 1031 exchange uses those otherwise paid tax dollars towards purchasing replacement property, providing an interest free loan. Foreign nonresidents can also use 1031 exchanges and are subject to the Foreign Investment Real Property Tax Act of 1980 (FIRPTA).

What does a Qualified Intermediary Do?

A 1031 exchange requires a Qualified Intermediary (QI) who creates exchange documents in accordance with Internal Revenue Service Code 1.1031 and holds the net equity from the sale in an escrow account until needed to acquire the replacement property. Until the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the QI industry was not regulated. Eight states (Washington, Oregon, California, Idaho, Nevada, Colorado, Virginia and Maine) have enacted their own requirements to protect their constituents from QIs who may have questionable intent. Some of those requirements include the use of Qualified Escrow Accounts or a $1,000,000 fidelity bond and a minimum $250,000 errors and omission insurance policy or face civil or criminal penalties.

QI Sin Number One

Holding the exchange proceeds in illiquid commingled accounts.

Vs.

Holding the proceeds in segregated, liquid accounts.

By holding the exchange funds in commingled accounts, the QI may be attempting to pool the funds to achieve higher yields. QIs generate revenue by a fee and interest earned on the escrow account. Be sure the funds are liquid and in a segregated escrow account. You want to be able to reach out at anytime and request funds for an earnest money deposit or quick closing. The taxpayer can request the exchange funds be held in alternative investments, but the funds must be liquid and immediately available.

QI Sin Number Two

Using out of date exchange documents.

Vs.

Current exchange documents.

The 1031 regulations are affected by case law from the Supreme Court, Court of Appeals, trial courts, the Tax Court, the district court, and the Court of Federal Claims, regulations prescribed by the Commissioner of the Internal Revenue Service (IRS), revenue procedures, revenue rulings, private letter rulings (PLRs), Technical Advice Memorandums (TAMs), Field Service Advice (FSA) and Field Attorney Advice (FAA). Unassuming and uninformed QIs who advise or use out of date exchange documents are not protecting your interests.

QI Sin Number Three

Escrow accounts are all alike.

Vs.

Use a Qualified Escrow Account or a PIN for security.

Qualified escrow accounts (QEA) require dual signatures to disburse funds representing optimum QI protection. One of those signatures must match the notarized signature of the taxpayer on file. The second signature can be from the QI who the bank knows. As an alternative, a personal identification number is created known only between the taxpayer and the bank. The taxpayer is contacted by the bank after the wire out request is initiated by the QI authorizing the wire out.

How to find a reliable Qualified Intermediary?

Additional suggestions include working with a Certified Exchange Specialist® who pledges to act in accordance to a strict Code of Ethics governed by the Federation of Exchange Accommodators (FEA). The principal QI member that is responsible for moving the exchange funds undergoes an annual criminal background check. If a QI is acquired, the new principal is also subject to a criminal background check.

Trust but verify.

What are your suggestions to safeguard exchange funds?

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Reverse 1031 Exchange: What a Lender Should Know

Posted on | by Tom Gustafson | Leave a Comment on Reverse 1031 Exchange: What a Lender Should Know

The majority of 1031 tax deferred exchanges are forward meaning that the old property is closed on before the new property is purchased. However, sometimes it makes sense to initiate a reverse exchange when the new property is acquired first and the old or relinquished property is sold later. Successful completion of a reverse exchange requires the participation of an Exchange Accommodator Titleholder (EAT) that takes title to either the new or the old property because the Internal Revenue Service does not allow the taxpayer to own both properties at the same time. What happens if a mortgage is required for the new property? What should a lender know before a loan approval process? The answer to that question depends on the type of a 1031 reverse exchange that was initiated.

Reverse First

An EAT is created in the entity form of a single member limited liability company to take title to either the new or the old property. The taxpayer has a secured position in the EAT through a Pledge of Membership Interest from the EAT member to the taxpayer.

In a reverse first, the old property is parked with the EAT. Prior to the closing on the new property, a deed is created conveying title from the taxpayer to the EAT. If a mortgage exists on the old property, the taxpayer continues to make payments. The taxpayer is responsible for taxes, insurance and expenses on the old property throughout the time owned by the EAT. The old property is marketed and sold to the buyer as normal. At the closing, the property is conveyed from the EAT to the buyer. Net proceeds from the sale are wired to the taxpayer.

Reverse Last

In a reverse last, the new property is acquired by the EAT on behalf of the taxpayer. If a mortgage is required for the new property, the EAT will sign a non recourse note with the lender. It is important to know before the loan application gets to the loan committee that the transaction is part of a reverse 1031 exchange. Once the loan is approved, it can be a challenge to re-do the loan approval process given the EAT will temporarily be on title.

Once the old property is sold, the title for the new property is conveyed to the taxpayer. This can be done through a warranty deed. If the state assesses a transfer tax, the EAT can also be conveyed to the taxpayer, consequently the title does not change, just the member of the EAT.

What the Lender Should Know

Which property will be parked or titled to the EAT? If the new property is parked, then be sure to involve the EAT in the loan approval process. If the old property is parked with the EAT, the existing lender will not be aware of the temporary title change given there is no interruption of mortgage payments.

Do you have a question? Contact our office of complete a few questions for a response be clicking on the free consultation request.

1031 Tax Relief for Victims of Hurricane Irene

Posted on | by Tom Gustafson | Leave a Comment on 1031 Tax Relief for Victims of Hurricane Irene

Natural disasters can disrupt the normal course of business and prevent taxpayers from meeting crucial deadlines to file returns, pay taxes and implement tax deferral strategies such as 1031 exchanges. In order to assist taxpayers affected by Hurricane Irene in Vermont, North Carolina, New Jersey, New York State and Puerto Rico, the Internal Revenue Service (IRS) has recently issued a written tax relief confirmation for disaster-impacted counties. Additional states may be included in a later revision of the relief.

The notice posted on the IRS web site page allows taxpayers who live in the covered disaster area and businesses that provide time-sensitive acts in those locations, to postpone the time to file returns, pay taxes and to meet deadlines in 1031 exchanges. Taxpayers who do not live in the specified counties but whose records necessary to meet a deadline listed in Treasury Regulation § 301.7508A-1(c) in the covered disaster area qualify for the tax relief. Additionally, any individual visiting the eligible disaster area who was injured as a result of the disaster qualifies for tax relief.

Special Rules for Section 1031 Like Kind Exchanges

Revenue Procedure 2007-56 Section 17 defines special rules for 1031 like kind exchanges including:

  • Last day of the 45-day identification, 180-day exchange period and the last day of a reverse exchange that fall on or after a Presidentially declared disaster are postponed 120 days or the last day of the extension period authorized by the IRS official announcement.
  • Lender and title insurance company who do not fund or provide required title policy to close a real estate transaction due to the disaster.

If you or your Qualified Intermediary qualifies for disaster relief, contact your CPA to confirm that you are entitled to the extension. Rely only on the official written notice issued by the IRS.

In the past, clients of Atlas 1031 Exchange have been entitled to the extension marking in red “Hurricane Tax Relief” on the first page of their federal tax return. It is important to understand the requirements that you need to meet to qualify and how the extension affects your 1031 exchange time-sensitive dates. Continue to check the IRS web site for updates and revisions.

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1031 Exchange: Dealer vs. Investor Status

Posted on | by Tom Gustafson | Leave a Comment on 1031 Exchange: Dealer vs. Investor Status

According to Section 1031 (a)(2) of the Internal Revenue Code “property held primarily for resale to customers in the ordinary course of the taxpayer’s business” is considered inventory or stock and ineligible for a 1031 exchange. To qualify for the tax deferral treatment, the property should be held in productive use in business or investment. Distinguishing between the dealer and investor status of the property is crucial for determining 1031 exchange eligibility for the transaction.

Dealer vs. Investor Intent

Dealers hold inventory for resale. The sale of inventory results not in a capital gain tax but in ordinary income tax. Realtors and developers who own and sell real estate can be considered a dealer depending upon the facts that support their intent.

An investor purchases real and personal property and holds the asset for typically more than one year allowing the acquisition or investment to season. When the investor sells, a capital gains and recaptured depreciation tax is triggered . The intent or initial motivation of the investor is to hold versus a quick sale as in a flip where the seller’s intent is for resale.

Dealer vs. Investor Questions

Nine questions provide the criteria used by the courts to determine whether the taxpayer fact pattern represents a dealer or investor.

  1. The purpose for which the property was initially acquired
  2. The purpose for which the property was subsequently held
  3. The extent to which improvements, if any, were made to the property by the taxpayer
  4. The frequency, number and continuity of sales by the taxpayer
  5. The extent and nature of the transactions involved
  6. The ordinary business of the taxpayer
  7. The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property
  8. The listing of the property with brokers, and
  9. The purpose for which the property was held at the time of sale

There is no one determining factor, however the court looks to the frequency and substantiality of the transactions.

Good Supporting Facts for Realtor and Developer

How the realtor and developer account for the property’s income and expenses is one set of facts that supports an investor status. Realtors and developers who in their normal course of business sell real estate, can own investment properties under another titleholder or entity and maintain a separate set of books. Making improvements to land begin to take on dealer status when roads and utilities are installed. Homes can be built for resale as a dealer while other houses may be held in a rental pool qualifying for nonrecognition under Section 1031.

Each exchange has an intent when the property is initially acquired and a set of facts supporting it. The intent and factor pattern help to determine ultimately whether the taxpayer is either a dealer or investor subject to ordinary income or capital gains tax respectively.

Ask the Certified Exchange Specialist on staff a question and receive the answer within twelve hours or less.

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IRS Section 721 Exchange and UPREITs

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In a recent speaking engagement, I was asked about the relationship between Section 721 and 1031 of the Internal Revenue Code. The answer starts with Real Estate Investment Trusts (REITs) which can be publicly traded companies. REITs buy, sell and hold real estate portfolios consisting of a variety of different commercial properties ranging from shopping malls, apartments, office buildings, hotels, medical facilities and warehouses. Owning shares in a REIT is one way to own real estate.

UPREIT

An Umbrella Partnership Real Estate Trust (UPREIT) is an ownership structure consisting of an operating partnership with a REIT as the general partner and real estate investors as limited partners. Property owners can contribute their property to the operating partnership and receive an interest in the partnership called operating units. The tax free (or tax deferred) contribution of property for partnership interest is known as a 721 exchange or Section 721 of the Internal Revenue Code.

UPREITs represent an exit strategy for property owners of institutional grade property who rather than exchanging for another real property in a 1031 exchange, prefer the benefits of owning an interest in an UPREIT’s operating partnership. These operating units benefit from the REITs capital appreciation and distributions of operating income. At a time determined by the taxpayer, the operating partnership units can be exchanged for shares in the associated REIT. This conversion has tax consequences.

Taxpayers owning commercial property that is not institutional grade, can sell and replace through a 1031 exchange into a tenancy in common (TIC) property investment or acquire UPREIT grade property. Given the UPREIT wants to acquire the property and after holding the property for twelve to eighteen months, the TIC or property can be contributed to the UPREIT in exchange for operating partnership units through the 721 exchange.

Conclusion

Section 721 of the Internal Revenue Code provides an alternative strategy to a Section 1031 exchange allowing the property owner to convert their property into shares of a REIT. Owning shares in a REIT provides the benefit of a diversified real estate holding portfolio, professional management and liquidity.

Securing the counsel of a tax advisor familiar with 721 exchanges and subsequent converting of operating units to shares in the associated REIT is an important step to understanding the tax consequences.

For those who have used 721 exchanges, what do you suggest for those considering the exchanging for operating units rather than using the traditional 1031 exchange for replacement property?

Three 1031 Exchange Myths

Posted on | by Tom Gustafson | Leave a Comment on Three 1031 Exchange Myths

Over the years while speaking at seminars and in phone consults, three common 1031 exchange myths appear. Prior to getting to the three myths, let’s cover “what is a 1031 exchange?”

1031 Exchange

A 1031 exchange allows the seller of a rental property to sell and defer the capital gains and recaptured depreciation taxes as long as any type of real property such as land, oil and gas royalties, or commercial property are acquired of equal or greater value. Tangible and intangible personal property such as livestock, aircraft and patents are also eligible for 1031 tax deferral treatment.

The tax obligation does not evaporate, but rather delayed, postponed until the replacement property is sold. The tax can represents up to 40% of the old property’s sale price. Why not use those dollars towards purchasing the replacement property?

1031 Exchange Myths

The top three exchange myths are:

  • land must be exchange for land or rental for rental property.

As with all 1031 exchanges, consideration must be given to the nature and character of conveyed rights of the 1031 exchange properties to determine whether they are essentially alike. This includes the likeness of physical properties, character of title conveyed, rights of the parties and period or duration of interests. Real property can be exchanged for any real property.

  • Earnest money deposit can be returned at propert closing tax free.

The IRS views the first dollar out as taxable. Yes, that means being taxed twice.

  • Replacing retired debt from first closing is not required.

Many assume only the net equity from the sale needs to be reinvested. If the old property has debt, then that debt must be replaced in the replacement property, unless additional cash takes its place. Cash offsets debt, but debt does not offset cash. If the debt is not replaced, a tax is triggered called mortgage boot or a benefit of no longer having the debt.

Conclusion

There are many 1031 exchange rules. Engage a qualified intermediary that will ask the appropriate questions to help make sure you are aware of your responsibilities.

Do you have a question regarding a 1031 exchange? I always suggest to engage the qualified intermediary when you are considering placing the property up for sale. Experience matters.