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.
As a result of the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), the United States can tax foreign businesses and individuals on the disposal of real property (real estate) located in the United States. The reason for FIRPTA is to ensure the collection of capital gains taxes that it would previously not be able to pursue if the seller was a foreign individual or entity.
When he was asked in a post exchange follow up, “What particular issue did you find difficult and should have been covered with a thorough explanation,” he replied “There were no issues, the process was quick, seamless and efficient.” “There were no problems.”
Section 1.1031 of the Internal Revenue Code provides for the deferral of capital gain taxes. This is granted in exchange of like property that is being held as an investment or for productive use in a trade or business. There are many rules that must be stricly followed including one known as the same taxpayer requirement. The taxpayer or exchangor can be an individual, husband and wife, trust, partnership, corporation, multi or single member limited liability company (SMLLC). The exception is known as a disregarded entity.
Real and personal property held in a trade, business or for investment when sold and replaced with like kind property is provided an exception in Federal Treasury Regulations Section 1.1031. Commonly referred to as a 1031 Exchange, these transactions defer or put off the tax charge associated with gain as the seller essentially trades one property for another that is similar in nature and character. Eventually, the property will be subject to tax when the taxpayer ends up selling the property completely, even if it is sold at a loss given it was depreciated. Consequently, the tax is deferred, postponed, delayed until the property sold is not replaced.
In the general course of business, a taxpayer who sells an asset may be subject to the payment of capital gains taxes on the gain realized from the sale of the property. Section 1031 of the Internal Revenue Code, however, offers another option – an exchange instead of a traditional sale. When a taxpayer successfully utilizes Section 1031, the capital gains tax that would otherwise be due under a traditional sale is deferred. An example of a straightforward 1031 Exchange would be a taxpayer who relinquishes a piece of rental property and then acquires another similar property that will also be used as a rental. A Qualified Intermediary, or QI, must facilitate 1031 Exchange transactions in order for a taxpayer to benefit from the exchange. Some potential exchanges are considerably more complicated than the previous example; however, even these transactions can potentially qualify for Section 1031 Exchange treatment. Certain types of transactions, for instance, may be eligible for the “Like Kind Exchange Program”, or LKE Program.
In a reverse 1031 exchange, Internal Revenue Procedure 2000-37, Section 4.02(3) provides for a five day grace period to enter the Qualified Exchange Accommodation Agreement (QEAA) and ancillary exchange documents following the deeding of the replacement property or transfer of qualified indicia of ownership to the Exchange Accommodator Titleholder (EAT). This can be incredibly important when the taxpayer has already closed on the replacement property to realize that a reverse 1031 exchange must be set up at the time of the closing.
Given all parties are receptive and a lender is not involved, there is hope to resurrect a reverse 1031 exchange without the need to return the Seller’s proceeds to escrow and deed the property back to the Seller. Similar to pushing the proverbial boulder up hill, there is the risk that at the end of the effort, the reverse 1031 exchange may not materialize.
A reverse 1031 exchange allows the taxpayer to acquire the replacement property prior to selling the relinquished or old property. The exchange is a series of interdependent steps orchestrated by a Qualified Intermediary to accommodate the exchange in accordance with the strict rules defined in Rev Proc 2000-37; 2000-4 IRB 308 (September, 15, 2000) and later amended by Rev Proc 2004-51; 2004-30 IRB 294 (July 20, 2004).
A 1031 exchange is the Internal Revenue Service and Treasury Department recognized strategy that as long as the many rules are meticulously followed, the federal and state capital gains and recaptured depreciation tax, triggered at the sale of the old property and potentially totaling upwards of 40 percent of the sale, can be deferred indefinitely or until the replacement property is sold. Then another 1031 exchange can be initiated. The otherwise expended 40 percent is additional, interest free working capital that is used towards the replacement property, including improvements. Cash received or debt not replaced in the replacement property is considered boot and taxable in the year the relinquished or old property is sold.
The EAT is a single member limited liability company created to take title to or park the replacement property. The EAT should not commingle other properties and can be created within the day on line with many State Department of Corporations for a nominal fee – $88 in Indiana, $300 in Texas and $125 in Florida, for example. The sole purpose of the EAT is to temporarily park the relinquished or replacement property title, satisfying the requirement that the EAT has the burden of ownership. Consequently, the EAT should be placed on the parked property insurance to protect against weather and tenant related liabilities.
To use the five business day grace period is dependent upon the warranty deed being conveyed to the EAT, not the Taxpayer. If the EAT is not on title, then the decision whether a reformation or rescission will affect a reverse 1031 exchange is dependent upon whether the Seller is amenable and the Taxpayer is willing to incur the additional legal and additional expense of a second closing. The Seller has no incentive to help; they have their proceeds, the sale commission has been paid and the closing behind them.
What about the deed to the taxpayer? Given the replacement property has been conveyed to the Taxpayer and not recorded, time is of the essence. The Purchase and Sale Agreement (PSA) needs to be assigned to the EAT and a tri-party agreement signed by the EAT, Taxpayer and Seller recognizing that the sales proceeds do not need to be returned and a new warranty deed will convey the property to the EAT for the benefit of the Taxpayer.
Can a warranty deed be retroactive to the date the signed by the Seller to the Taxpayer? My experience, not as an attorney, is no. The deed can be returned to the Seller. Once the new deed is signed and recorded conveying title to the EAT, the QEAA and ancillary exchange documents can be signed before or at the second closing. If the initial warranty deed is recorded conveying the property from the Seller to the taxpayer, then to effectuate a reverse 1031 exchange requires a rescission, unwinding the sale so both the Buyer and the Seller are in their original economic positions prior to the closing.
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