Tom Gustafson

Foreign Property, Virgin Islands and 1031 Exchange

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Foreign Property Virgin Islands and 1031 ExchangeAs is often the case during the cold winter months in North America, questions regarding whether a 1031 exchange is applicable to properties in the Caribbean surface for clarification. As a former Rio Mar resident in Rio Grande, Puerto Rico, the question and picture stirs memories of sand, aqua blue waters, a young family, good friends, deserted beaches, lechon asado, Metropol in barrio Hato Rey, Medalla and warm sea breezes.

Foreign Property

In 1989, Section 1031 was amended with Subsection (h)(1) stating that real property located in the United States is not considered like-kind with real property located outside the United States. Foreign real and personal property used predominantly in a foreign country is eligible for 1031 exchange tax deferral treatment when exchanged for real and personal property located in a foreign country.

Virgin Islands

Section 7701 of the Internal Revenue Code (IRC) defines the borders of the United States as all fifty states and the District of Columbia. The Internal Revenue Service defined the borders of the U.S. to include the U.S. Virgin Islands for 1031 eligibility given the Exchangor is:

(1) A citizen or resident of the United States and

(2) Has income derived from sources within the U.S. Virgin Islands, is effectively connected to the performance of a trade or business in the U.S. Virgin Island or files a joint return with an individual who derives an income or is connected to a trade or business within the U.S. Virgin Islands.

Both requirements must be satisfied to exchange real property in the fifty states and real property located in the U.S. Virgin Islands.

Puerto Rico and Guam

Puerto Rico, though a Commonweath of the U.S. is not eligible for 1031 consideration. Guam is eligible for 1031 tax deferrals. It has been suggested that Sections 932 and 935 of the Internal Revenue Code provide special rules that treat Guam and the U.S. Virgin Islands as part of the U.S. while Puerto Rico is not.

FIRPTA

US citizens and foreigners owning real property outside the US defer federal capital gains taxes with a 1031 exchange when replacing with real property located outside the US. Foreigners selling US located real property must comply with the Foreign Investment in Real Property Act of 1980 (FIRPTA).

A nonresident alien individual, foreign corporation (unless a valid election under Section 897(i) has been made), foreign trust, but not a resident alien individual is considered a foreign person according to Regulation Section 1.4445-2(b)(2)(i)(C).

For more information on FIRPTA or a foreign 1031 exchange call us at 850-496-0090.

Business for Sale – Multi Asset 1031 Exchange

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Multi asset 1031 exchanges apply to sales of apartments, motels, dry cleaners, laundromats, gas stations and variety of franchises including self storage facilities, convenience stores, fast food, automotive and technology service providers. Each has in common real and personal property that can be sold and capital gain and recaptured depreciation taxes deferred when real and personal property are replaced in an Internal Revenue Service (IRS) 1031 tax deferred exchange.

Fast Food Franchise

For example, a Chicken Express franchisee may wish to relocate to a better location or different city. When the sales contract is drafted, it is advisable to assign values to the real and personal property. This allows for an allocation of gain to underlying assets. Real property is matched to real property, while personal property is grouped together. Goodwill or going concern value is excluded. Following the closing, identification of the replacement property must be received preferrably by the Qualified Intermediary.

Incidental Rule

The 1031 identification rule requires that real and personal property are identified by the 45th calendar day post closing of the first property in the exchange. Personal property considered incidental to the larger property is not treated separate given the value does not exceed 15% of the aggregate fair market value of the larger property.

  • For example, a self storage facility may have a fence, gate and personal property perhaps associated with the tenant managing the property. Given the value of the personal property sold does not exceed 15% of the gross sales price, the personal property does not need to be itemized on the identification form.
  • If the value does exceed 15%, then the personal property is grouped into one of thirteen like-kind General Asset Classes or North American Industry Classification System (NAICS) and listed as a group of potential replacement property. If three or more properties are to be identified, it is suggested to use the 200% rule when identifying versus the three property rule.

Identification

Utilizing the two hundred percent rule allows four or more properties to be identified. Property identified should not exceed 200% of the relinquished property value otherwise, 95% of what has been identified must be acquired.

In the case of the fast food franchise, the identification may include up to three locations and a fourth identification of personal property group if the value exceeds 15% of the gross sales price.

1031 Benefits

The benefits of an IRS 1031 tax deferred exchange are:

  • indefinite interest free loan of taxable dollars
  • relocation
  • consolidation
  • depreciation
  • diversification
  • replacement of under performing asset.

1031 exchanges provide business owners with the capability to make changes to their overall business structure without the cash outlays for capital gains and recaptured depreciation taxes. The tax obligation is not eliminated, only deferred until the sale of the replacement property.

Conclusion

When exchanging a multi asset property such as a franchise, the personal property does not need to be identified given the 15% incidental rule.

Considering selling your franchise or a business and need to make improvements to the replacement property? An improvement or build to suit exchange is used to make improvements to the parcel.

Tax Implications of Unwinding a 1031 Exchange

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Let’s face it. Times have changed. The tumultuous real estate market, renovations over budget, difficult tenants combined with the challenging job environment have resulted in questions about how to unwind a 1031 exchange. Imagine ten years ago, we survived the Y2K scare and were approaching the tech market bubble burst. Real estate appreciation was gaining traction. Washington was promoting regulations to help those interested in securing a home. Ten years is not a lot of time when you are young. But when you have experienced the depths of job loss, foreclosure and declining retirement portfolio your perspective changes questioning why not sell the rental property and cash out.

Three Reasons Why Unwinding a 1031 Exchange Makes Sense Before 2013

Every market is cyclical, which helps cleanse inefficiencies and to adopt new strategies. Adjusting to change is a maturing process requiring us to take note of the whole and the individual pieces. Three reasons why unwinding a 1031 exchange makes sense includes:

  • Historically low federal capital gains rate of 15% will sunset on December 31, 2012 to 20%. In 2013, federal capital gains will increase 3.8% Medicare tax for those earning over $200,000.
  • If in the ten or fifteen percent income tax bracket, your long term federal capital gains tax rate may be even lower than 15%.
  • Divorce and changing partnership interests: it may make sense to consider cashing out the partner and continue the tax deferral in another 1031 exchange if you want to continue holding real property.

Unwinding a 1031 Exchange

The first place to start is talking with your accountant to understand the tax consequences. If you are selling a replacement property purchased in a prior exchange, is you will have two sets of taxes, one due on the replacement property and a second set due on the original property sold. Questions to consider include:

  • What is your current federal income tax bracket?
  • Were the investment properties itemized on Schedule E?
  • Was depreciation taken on Schedule E of your tax return?

Your accountant will look to determine the adjusted basis of each property to determine the estimated recognized gain or tax due. The tax bill may not be as bad as you think. But not understanding the tax implication could also be quite risky.

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.

Three Easy Steps to Tax Deferred Formula

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Capital gains and recaptured depreciation can be determined in three easy steps.  If you are considering a 1031 exchange, the taxes due represent the value of the 1031 exchange or what the IRS will consider deferred if equal or greater replacement property is acquired. It could be considered an interest free loan because the gain is not paid to the IRS but used towards the replacement property.

Step Number One

The first step is adding three numbers together to determine the adjusted basis.

Original purchase price + capital improvements – depreciation taken = adjusted basis

Step Number Two

Sales price – adj basis – selling expenses = realized gain

Step Number Three

Recaptured depreciation (depreciation taken * 25%) =

Federal capital gain (Realized gain – depreciation) * 15% =

State capital gain (Realized gain – depreciation) * __% if applicable =

Add these numbers together and you have determined the tax due. If you initiate a 1031 exchange, this value is deferred gain until the replacement property is sold. Another 1031 exchange can be used to defer the gain and recaptured on the replacement property, exchanging as many times as needed.  There is no limit to the number of times you can use a 1031 exchange.

Conclusion

Now that the tax triggered by the sale is known, be sure the the net equity and retired debt (if any) on the old or relinquished property will be equal to or greater in the replacement property.  If you want to pull out cash tax free, consider a post exchange refinance once the replacement property closes. If you remove cash at the closing of the old property it will be taxable.

The next step is to confirm your numbers with your accountant and decide to initiate a 1031 exchange.

Deductible and Non Deductible Selling Expenses in a 1031

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Deductible Selling ExpensesWhat selling expenses in a real estate transaction are not taxable if paid from the 1031 exchange proceeds? Specifically, in a 1031 exchange, what selling expenses can be paid from exchange proceeds without triggering a tax?

Deductible Selling Expenses

Selling expenses that are not taxable typically include:

  • Commissions
  • Finder’s fees
  • Title charges
  • Title search fees
  • Title examination
  • Notary fees
  • Title insurance
  • Document Prep
  • Courier fees
  • Escrow fees
  • Tax certification
  • Pest inspection
  • Testing fees
  • Survey
  • Gov’t recording
  • Home warranty
  • Legal and 1031 fees
  •  QI fees

Minor repairs required for the sale can be paid from exchange proceeds directly to the contractor.

Non Deductible Selling Expenses

Selling expenses that should be taxable as ordinary income include:

  • proration of rents;
  • property taxes;
  • property insurance premiums debited against the Exchangor;
  • reserves deposited with the lender and utilities;
  • any items payable in connection with a loan are considered taxable.

Reimbursement for major repairs, capital improvements and earnest money deposits are considered taxable. The Service views the first dollar paid out as taxable. In a 1031 exchange if you need to pull these funds out, a post exchange refinance is an alternative. After the replacement property has closed, secure a line of credit on the property. You can then pull out cash without triggering a tax.

Another alternative is to do a partial exchange, recognizing that any cash received is taxable. There is a point when the equity pulled approaches 50% that it does not make sense to initiate a 1031 exchange. Always seek the counsel of your accountant for tax planning strategies like 1031 exchanges.

 

What a Lender Should Know About a 1031 Exchange

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Recently I spoke with a mortgage office about 1031 exchange basics and the circumstances where they would typically see one. Here’s a quick read for those new and old to the mortgage industry.

1031 Exchange Basics

Who: Individuals, trusts, partnerships, corporations both domestic and foreign are eligible for the tax deferral.

What: Real and personal property held for an investment or for use in a business are eligible for 1031 consideration. Property is sold and replaced. Real property can be replaced with any kind of real property while personal property must be replaced with like-kind personal property. U.S. for U.S. based property while international is replaced with international property.

Why: A 1031 exchange enables the titleholder to defer federal and state capital gains and recaptured depreciation taxes representing upwards of 40% upon sale of the old property.

When: The tax deferred exchange must be signed prior to or at the closing of the first property. The Exchangor must complete their tax deferred within 180 calendar days post the first closing.

How: The use of a qualified intermediary is required to effect a 1031 exchange, except in a two party or “pure” exchange. Given the moderate intermediary fee, it is well worth an accommodator facilitate the exchange.

Forward and Reverse 1031 Exchange

There are two types of exchanges a forward and a reverse. Forward exchanges are when the old or relinquished property is sold first followed by the acquisition of the replacement property. In a reverse, the replacement property is purchased first, with 180 calendar days to sell the old property.

Here’s where you come into the transaction. The Exchangor needs to acquire the replacement property first. In a reverse 1031 exchange, the Exchangor is not allowed to own both the new and the old at the same time. The qualified intermediary creates an Exchange Accommodator Titleholder (EAT) in the form of a single member limited liability company to take title to either the new or the old property for the duration of the 1031 exchange.

If the EAT takes title to the new property that the Exchangor is financing with you, the EAT signs a non recourse note, guaranteed by the Exchangor. Payments continue as normal with the EAT temporarily on title. The Exchangor signs a triple net lease with the EAT to cover insurance, taxes and expenses of renting the property. Once the old property is sold, title for the new property is transferred to the Exchangor.

If the EAT takes title to the old property, the new property financing continues as normal. With the EAT on title to the old property, mortgage payments continue to be paid by the Exchangor. The property is marketed and sold with the Exchangor signing the settlement statement under “Read and Approved” while the EAT signs as the Seller. The 1099 bears the name and address of the Exchangor.

If the old property fails to sell, the property parked with the EAT is conveyed to the Exchangor by the 180th calendar day.

Many of my referrals come from mortgage brokers seeking a seasoned qualified intermediary to accommodate reverse 1031 exchanges. If you have a question, call us at 800-227-1031 or if you would like a tri fold semi glossy brochure with Atlas 1031 business cards for your office, send me a note and thirty will be sent including the plastic brochure holder.

Experience matters.