Tom Gustafson

1031 Exchange: Seller Financing

Posted on | by Tom Gustafson | Leave a Comment on 1031 Exchange: Seller Financing

Given the current tight credit market, taxpayers who want to initiate a 1031 exchange may consider financing or carrying a note for a Buyer to acquire the relinquished property. A 1031 exchange is a strategy to defer the federal and state capital gains and recaptured depreciation tax when selling and replacing property held for productive use in a trade, business or for investment. The tax deferral represents an indefinite, interest free loan that can defer upwards of 40 percent of the sales price. 1031 eligible property includes real property such as timberland, self-storage units, commercial property, single family residential, oil and gas royalty interests as well as personal property including aircraft, precious metals, vintage cars, artwork and collectibles.

Structuring Seller Financing

The Buyer in a typical 1031 exchange acquires the relinquished or old property from the Exchangor with cash, debt or combination of the two. If the Buyer is not able to secure financing, the Exchangor may consider carrying the note. In effect, the note represents an installment loan; however, in a 1031 exchange, the Buyer’s note does not offset debt on the replacement property. The note must be converted into cash by one of the following methods:

  • Assigning the note to the seller of the replacement property as partial payment
  • Selling the note to a third party
  • The Exchangor or related party adding the cash equivalent of the note to the exchange as additional equity

The first two options may not be feasible, leaving the third option dependent upon whether the Exchangor has access to the note’s cash equivalent.

1031 Exchange Carry Back Note Steps

Given the Exchangor has the capital, the carry back note is negotiated between the Exchangor and the Buyer as normal. Prior to the relinquished property closing, the note is made payable by the buyer to the Qualified Intermediary. The relinquished property title is conveyed to the Buyer with a deed of trust and prior to the closing on the replacement property, the Qualified Intermediary sells the note to the Exchangor or a related party. Debt service payments, if any, are paid to the Qualified Intermediary and deposited into an escrow account along with the proceeds of the note sale used to acquire the replacement property. There is no tax when the Exchangor or related party receives principal payments on the note given they will have paid face value to acquire the note. Consequently, all payments other than interest are non-taxable.

One of the benefits of the carry back method described above is, should the replacement property not be acquired, the exchange fails and tax is reported on the installment method in the year the principal and interest payments are received.

Should the note be paid off to the Qualified Intermediary prior to the purchase of the replacement property, the proceeds are used towards the acquisition.

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.

1031 Exchange: Dealer vs. Investor Status

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

1031 Exchange Dealer vs Investor StatusAccording 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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Farmland Auction 1031 Bidder Insights

Posted on | by Tom Gustafson | Leave a Comment on Farmland Auction 1031 Bidder Insights

The bidder’s position in the 1031 exchange cycle is one of the major factors affecting their bids behavior. Timing of the auction in relation to the 45th calendar day post old property closing can influence the bidder’s aggressiveness. Understanding the objective of a 1031 exchange and how it works should lessen the angst of competing bidders if the 1031 bidders are known. Ultimately, the bidding is not about the quantity of 1031 funds available but more importantly the bidder’s value point.

The 1031 Exchange Strategy

The 1031 exchange strategy allows for the deferral of the federal and state capital gains and recaptured depreciation taxes, which can represent 40% of the properties sales price. According to the Internal Revenue Code (IRC) Section 1031 “no gain is recognized when property held for use in a business or investment is exchanged for like kind property held for productive use in a business or investment.” Property refers to both real and personal property. The tax deferral serves as an interest free loan allowing for using those taxable dollars towards the purchase of a replacement property given the new property is equal to or greater than the property sold. The reward is that when the capital gains tax is ultimately paid, the risk of a higher tax rate is compensated for by either annual cash flow, a conservative appreciation or both on the replacement property.

What Affects the Exchangor’s Aggressiveness

Factors affecting the bidder with 1031 money, referred to as the Exchangor include:

  • Is the land adjacent to their existing property?
  • Quality of soil, history of crop production, topography, and water source
  • Has the Exchangor closed or in contract on their property?
  • If their property sold, is the auction before or after the 45th calendar day post old property closing?

Exchange Process

There are two types of exchanges, a forward and a reverse. In a forward exchange, which is the most common type, the old property is sold before the new property is purchased. In a reverse 1031 exchange, the new property is purchased before the old property is sold. A reverse is a bit more complex and expensive. The opportunity to defer the tax in the exchange can be lost if the old property does not sell within 180 calendar days. In addition, the farmer now owns two properties, and a Qualified Intermediary fee has been paid. The only reason the Exchangor may risk a reverse 1031 exchange is they have a buyer for their old property and a closing date scheduled. More importantly, they want to get the new property off the market now because it is undervalued or the Exchangor really wants the land.

Given today’s economy, many landowners would not favor taking a risk, and would prefer using a forward exchange. Consequently, they have two polar milestones:

  • Formally identify the replacement property to the Qualified Intermediary by the 45th calendar day post closing on the sale of their old or relinquished property
  • Close on the replacement property by the 180th calendar day post closing on the sale of their old property.

Knowing when the Exchangor closed on their old property and the sales price can provide valuable insights into their actions.

Sales Price of Exchangor’s Old Property

To determine the sales price, it is recommended to check with the Realtor, newspaper postings or County Clerk of Court web site. This will help to identify what the Exchangor needs to spend to defer their capital gains tax.

Closing Date of Exchangor’s Old Property

What was the date when the old property was sold? Once known, add 45 calendar days to understand where the Exchangor is in the identification milestone. If the auction date is before the 45th day, the Exchangor may be less aggressive bidding higher than their old property sales price because he may have time to locate other properties. If the auction date is after the 45th calendar day, the Exchangor has formally identified this property as one of potentially three properties (if using the three property rule) and will most likely be more aggressive.

Solution

The 1031 code defers the capital gains tax when property of equal or greater dollar value is acquired. If the Exchangor does not use all the exchange funds and debt retired on their old property, a tax is triggered on the difference. For example, a farmer sells land for $850,000. He will be looking to bid upwards of $850,000 for the new property. If the farmer spends $700,000, he will pay tax on the net difference less selling and purchase costs. If the competing bidders know the price and date the Exchangor’s old property was sold, they will be less likely to be frustrated at the price paid.

For those landowners who have 1031 funds to reinvest, there is no recourse but to hold the property for productive use in a business or investment. That implies but not limited to using the land for development, hunting, conservation and farming. If it is determined the property is used primarily for personal enjoyment, the IRS could question the 1031 exchange and potentially disallow the tax deferral resulting in an audit, penalty and taxes due.

Article featured on Agriculture.com.

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Three Issues to Consider When Selling Farmland

Posted on | by Tom Gustafson | Leave a Comment on Three Issues to Consider When Selling Farmland

Farmland is in high demand in many areas around the United States. Higher commodity prices, increased farm incomes and a reported 30% reduction in the supply of farmland for sale from historical numbers are driving farmland prices up. Although much of the demand comes from farmers, investors are also looking to farmland to diversify their holdings as return on farmland almost equals Standard & Poor’s 500-benchmark index’s return. Due to higher prices and increased demand, landowners are selling their assets and using profits to acquire more farmland or other cash generating real property. With a tax deferrment tool known as 1031 exchange, they can use taxable dollars as interest free loans for new acquisitions.

Three Issues to Consider When Selling Farmland

Over the years, Atlas 1031 has accommodated 1031 exchanges for many families and partnerships owning farmland. Some elect to purchase more farmland while others decide to sell and reinvest into a vacation property held for investment with minimal personal use. Arriving at the decision to sell can be and often is a difficult task. Securing the guidance of your CPA and estate attorney is important to achieving family and financial goals. Issues to consider when selling include:

  1. How can farmland be sold and provide a cash flow for the retiring farmer?
  2. If the goal is to sell and purchase additional land, how can taxes be minimized and new land purchased?
  3. What are the tax implications of passing on the farmland to your beneficiaries?
  4. Do you have a multi generational C corporation and the generation offspring do not want to continue the farm or ranch? Seek the input of an attorney to determine options. Added on December 8, 2011.

1031 Exchange

A 1031 exchange is a tax deferment tool that allows the landowner to sell and replace with any real property given the Internal Revenue exchange rules are followed. The tax obligation does not go away, but is deferred until the replacement property is sold. Those taxable dollars rather than being paid can be used towards the acquisition of the replacement property interest free. Farmland can be sold and exchanged for an investment property that generates cash flow, such as triple net lease, single tenant Tire Warehouse or CVS Pharmacy leased property.

Rather than selling, farmland can be passed on to the beneficiaries and estate taxes paid. The beneficiaries could elect then to sell at a stepped up basis without capital gains taxes. If sold later, they should consider the tax implications deciding whether to initiate a 1031 exchange or sell and pay federal and possible state capital gains taxes.

Finally, there is merit to paying the federal and state capital gains taxes given the federal rate is at a historical low rather than the likelihood of paying higher taxes in the future. However, if the intent is to minimize capital gains taxes, a 1031 exchange is an alternative that uses those taxable dollars towards purchasing replacement property that generates cash flow for tomorrow’s needs. It is recommended to discuss these options with your estate attorney and CPA.

Once the decision to sell is made and you want to learn more about a 1031 exchange, contact us for a free consultation.

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.

Realtors Should Know Three 1031 Exchange Keys

Posted on | by Tom Gustafson | Leave a Comment on Realtors Should Know Three 1031 Exchange Keys

Realtors are usually one of the first to determine that a 1031 exchange should be considered when an individual, husband and wife or company is selling real estate. “Usually” is the operative word given the seller may not share their intent to replace with another property. Nonetheless, whenever the seller is selling a property that is not their primary residence, the question, “Does a 1031 exchange make sense?” should be asked. Be sure to have a couple of qualified intermediaries to refer who can readily answer questions. As a qualified intermediary (QI), I receive calls from sellers and Realtors who just closed or closed the selling transaction a couple of weeks ago to ask “Is it too late?” Yes, once the seller has access to the net proceeds, the exchange cannot take place unless the transaction is unwound and restarted.

1031 Exchange

A 1031 exchange allows the seller to defer federal and state capital gain and depreciation recapture taxes when selling and replacing with like-kind property. To avoid discussing taxes, the suggestion is for the seller to visit with their CPA to determine the tax consequences of the sale. If the result is not to enter into a 1031 exchange, at least the Realtor has provided the guidance for the seller to determine with the financial counsel whether a 1031 makes sense.

A 1031 exchange is either a forward or a reverse. In a forward, the relinquished or old property is closed on before the replacement property is acquired. In a reverse, the replacement property is acquired before the relinquished property is closed. Improvements to replacement property can be funded from the exchange funds.

Like-kind property means real, tangible or intangible personal property must be replaced with real, tangible or intangible personal property. Real property held in the US, such as a single family residential property held for rent and not primarily for personal use, can be exchanged for any real property in the US. Eligible replacement property includes land, commercial property and oil and gas royalties.

Assignment Language

One of the many Internal Revenue Code 1031 requirements is that the rights, not the obligations of the purchase and sale agreement (PSA) are assigned to the QI. In the relinquished property PSA, the Seller can assign the rights without the written permission of the Buyer unless otherwise stated in the contract to the QI. When the exchangor is buying, the assignment language must be included in the PSA. Many state Realtor Association PSAs have 1031 language already embedded.

Multiple Commission Potential

Once the seller initiates a 1031 exchange and closes on the first leg (commission number one), the 180 calendar day clock begins. The seller must acquire a replacement property or multiple replacement properties or the exchange fails. Given the replacement property is within the market the Realtor serves, the Realtor is in position to sell the replacement property (commission number two) to the client. I have facilitated many 1031 exchanges where multiple properties were sold and multiple replacement properties were acquired with the same Realtor.

A 1031 exchange may appear confusing to the uninformed, but is really where a property is sold and replaced with a property of equal or greater value to the relinquished net sales price. Partial 1031 exchanges are also acceptable. There are many rules and exceptions to apply, but put that burden on the QI to qualify. Realtors are serving and separating themselves from their competition by understanding the value in suggesting to their clients “You should ask your CPA the tax consequences of the sale and whether a 1031 exchange makes sense.” To learn more about what a Realtor should know about a 1031 exchange, click here to receive a free, six page 1031 Exchange Guide for Realtors.

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.

IRS Section 721 Exchange and UPREITs

Posted on | by Tom Gustafson | Leave a Comment on IRS Section 721 Exchange and UPREITs

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?