Over the past 17 years, we have had the pleasure of guiding thousands of Exchangors through the 1031 Exchange process. Our Blog draws from that experience and includes content ranging from the basics of an Exchange for first time Exchangors to detailed commentary on complex exchanges for the expert investor. If you do not find the topic or specific question you are looking for, reach out to us via email at info@atlas1031.com or call our office to speak with our team at 1 800 227 1031.
Depreciation can be a confusing and difficult concept to understand. Individuals and businesses need to have a working knowledge of how to use depreciation to maximize their profits. More importantly, they need to understand the tax consequences of recaptured depreciation and how to effectively defer the tax in a 1031 tax deferred exchange.
Internal Revenue Code (IRC) Section 1031 applies to the citizen or resident of the United States (US) or non-resident alien subject to US federal income taxes. When selling real and personal property held for productive use in a trade, business or for investment, a 1031 exchange allows individuals, partnerships, corporations, limited liability companies and trusts to defer the federal capital gain and recaptured depreciation taxes when selling property held for the proper intent, regardless of where the property is located. Property used predominantly in the US is eligible as replacement property held predominantly in the US, while property located outside the US is eligible for 1031 consideration with property held internationally.
Often the titleholder or taxpayer considering a 1031 exchange is a single or multi member limited liability company when selling real or personal property held in the productive use of a trade, business or for investment. For those new to the term “1031 exchange,” the IRS 1031 code allows the taxpayer to defer the federal and state capital gains and recaptured depreciation tax when selling and replacing of equal or greater value, real or personal property held for the proper intent. The 1031 exchange represents an interest free loan that can exceed 40 percent of the asset selling price, which would otherwise be paid to the Treasury Department.
One of the many 1031 exchange rules is the same taxpayer requirement, stating that the taxpayer who sells is the taxpayer who buys. A limited liability company (LLC) is quite often the taxpayer on title. According to the U.S. Small Business Administration ,“a limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.” Owners are known as members. A single member LLC where the taxpayer is the only member is known as a sole or single member LLC. Profits and losses are passed through to the member and reported on the taxpayer’s federal return; consequently for federal income tax purposes the single member LLC is a disregarded entity.
Multi-member LLCs can also be formed where the members are individuals, corporations or other LLCs. Every state has a Limited Liability Company Act providing procedures to form and operate within its statutes. It is wise to consult with either your attorney or CPA when considering establishing a LLC to understand whether the formation of an LLC is to your benefit. Typically each state has a Department of State, Division of Corporations where Articles of Organization are created and annual reports submitted to maintain the LLC in good status. In Florida, www.sunbiz.org allows document searches to determine whether the LLC is active or not, as well as names of the members and address of the Registered Agent. Every state has a different fee to establish the LLC and file an annual report.
How do the following variations impact a 1031 exchange?
· Sole member
o A sole member LLC may sell or acquire the property in the individual’s name and vice versa.
· Husband and Wife
o A sole member LLC may sell and acquire the property as sole member LLC or individual and add spouse on to the replacement property deed as tenants in common.
o If husband and wife are on title selling property and reside in a community property state (Washington, Idaho, California, Nevada, Arizona, New Mexico, Texas, Louisiana and Wisconsin) one LLC can be established with the husband and wife as members to acquire the replacement property.
o If husband and wife are on title selling property and reside in a non-community property state and the intent is to title the replacement property in a LLC, then two LLCs are needed, one for the husband and one for the wife.
· Multi-member
o A two or multi member LLC owns a property and one member wants to cash out while the others want to defer the gain. Either the LLC is dissolved in a drop and swap, prior to entering the Purchase and Sale Agreement, dropping the members to their individual names as tenants in common as titleholders prior to the 1031 exchange or post exchange, or the LLC buys the cash desiring member out, known as “cross purchase,” with post exchange refinancing. The outgoing member is eliminated or reduced to a 1 percent member to maintain the LLC as a tax partnership.
Prior to establishing a LLC or a 1031 exchange, talking with your attorney or CPA is critical. If you own a property in a multi-member LLC, discuss with your partner their intentions to either cash out or to remain as members in the 1031 exchange. The earlier the steps are taken to drop and swap the better. Waiting just before the closing to decide jeopardizes the 1031 exchange given merit to the question whether the property is held for the proper intent by the new titleholders.
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Atlas 1031 has been accommodating all types of exchanges for over 16 years. Should you have any questions regarding 1031 exchange rules and requirements as it pertains to ownership, please contact us through the consultation on this page or call our office at 800-227-1031. We look forward to hearing from you.
When a taxpayer sells real or personal property held in a business, trade or for investment and a gain is realized on the sale, the taxpayer typically incurs a capital gains tax obligation on the sale. One way a taxpayer can defer the payment of capital gains taxes is to enter into a Section 1031 Exchange instead of a traditional sale. As the name implies, the concept behind a 1031 Exchange is that the taxpayer relinquishes one property and replaces it with another one of “like-kind”. There are a number of other guidelines that must be followed for a transaction to qualify for Section 1031 Exchange treatment including the requirement that the entire transaction be completed within 180 days and that a Qualified Intermediary, or QI, be used to facilitate the exchange. One responsibility of the QI is to hold onto any funds used or acquired during the exchange. Upon occasion a taxpayer may wish the return of his or her funds prior to the expiration of the 180 day exchange period; however, a QI cannot simply return funds upon the request of the taxpayer. In fact, a QI may only return funds under specific circumstances according to the Section 1031 Exchange rules.
Taxpayers seeking to defer federal and state capital gain taxes in a 1031 exchange when selling their vacation home must determine whether the sale qualifies for tax deferral treatment. Often times, the taxpayer wishes to engage a Qualified Intermediary, or QI, to accommodate the exchange, only to discover their vacation property has not been held as an investment property. The tax consequence, depending upon the realized gain, may be as high as 40 percent of the sales price.
In a 1031 exchange, a qualified intermediary (QI), accommodator or facilitator is engaged to provide exchange documentation and hold the exchange proceeds in an escrow account under the taxpayer’s tax identification number. Advice is provided to qualify the transaction as a 1031 exchange. For those accommodators who are not CPAs or attorneys, care must be given not to provide specific tax advice which subjects the accommodator to Circular 230 enrolled as agents who practice before the Internal Revenue Service. The QI is similar to a flagman warning a taxpayer driving along at 70 mph before a curve that the bridge not in view is out. Determining how to navigate the bridge is up to the taxpayer’s tax counsel, including their CPA and or tax attorney.
When a 1031 exchange is audited and disallowed, the penalty standards include the income tax related to the sale of the relinquished property and the penalty and interest imposed on the underpayment of taxes, which is equal to the federal short term rate plus three percent. The accuracy related penalty is equal to 20 percent of the substantial understatement of the tax. A substantial understatement is defined as the greater of $5,000 or ten percent of the recognized gain.
Should the taxpayer have substantial authority for the disposition taken, the penalty can be avoided. Substantial authority is defined in Regulation Section 1.6662-4(d)(3)(iii) and based on the following:
(i) The Internal Revenue Code and other statutory provisions
(ii) Proposed, Temporary and final Regulations construing such statutes
(iii) Revenue Rulings and Revenue Procedures
(iv) Tax treaties and regulations thereunder and Treasury Department and other official explanations of such treaties
(v) Court cases
(vi) Congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports and floor statements made prior to enactment by one of a bill’s managers
(vii) General Explanations of tax legislation prepared by the Joint Committee on Taxation
(viii) Private Letter Rulings and Technical Advice Memoranda issued after October 31, 1976
(ix) Actions on Decisions and General Counsel Memoranda issued after March 12, 1981 (as well as General Counsel Memoranda published in pre-1955 volumes of the Cumulative Bulletin)
(x) Internal Revenue Service information or press releases
(xi) Notices, Announcement and other administrative pronouncements published by the Service in the Internal Revenue Bulletin.
The penalty can be avoided if the relevant facts are adequately disclosed on the tax return and there is a reasonable basis for the position per Regulation Section 1.6662-4. In addition, the penalty can be assessed if there is negligence or disregard of regulations or rules per I.R.C. Section 6662(b). The taxpayer must maintain sufficient records to support their positions.
A fraud penalty is imposed of 75 percent of the underpayment if determined that taxpayer’s intent was to willfully evade the tax or to mislead.
I.R.C. Section 6701 levies penalties on persons who assist in the preparation of any portion of the taxpayer’s return knowing that such portion may result in an understatement of the tax liability. A $1,000 penalty is imposed; however, should a corporation tax return be subject to penalties, a $10,000 fine is assessed.
From a QI’s perspective who is not subject to Circular 230, knowing and acting within the boundaries of exchange advice is critically important. Telling the client they cannot provide tax advice protects the client and themselves. Taxpayers need to know the difference of what to expect and what not to ask. Ignorance is no excuse.
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