1031 exchange

Tax Implications of Unwinding a 1031 Exchange

Posted on | by Tom Gustafson | Leave a Comment on Tax Implications of Unwinding a 1031 Exchange

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.

If you would like to discuss the tax implications of unwinding your 1031 exchange, please contact us at office number 800-227-1031 or ask a question with the links above.

1031 Tax Relief in Disaster Situations

Posted on | by Tom Gustafson | Leave a Comment on 1031 Tax Relief in Disaster Situations

Floods, tornadoes, hurricanes, and other natural disasters can have an impact on the implementation of 1031 tax deferred exchanges. The Internal Revenue Service (IRS) provides written tax relief for disaster situations for taxpayers engaged in 1031 exchanges. If the exchange qualifies, the 45 and 180 calendar day time-lines can be extended. While our office was located in Destin, FL from 2003 – 2009, we had multiple experiences with exchange time-line extensions because of hurricanes including Ivan in 2004, Dennis, Katrina and Wilma in 2005, Humberto in 2007, and Gustav in 2008. It is important to have your accountant interpret the IRS notice to determine whether the exchange qualifies for extra time.

IRS Tax Relief in Disaster Situations

The IRS updates a page on their web site that lists the states and counties affected by the flood, tornadoes, hurricanes, and straight line winds. If you are in an exchange and either you, your qualified intermediary or replacement property are located in an impacted county, check the site to confirm whether you are eligible for an extension.

IRS Experience

A written IRS notice is crucial to utilizing a time-line extension. I witnessed a situation when the 1031 replacement property was in the county impacted by a hurricane. There was a lag in the time between when the notice was posted on the IRS web site and the action required. The action was taken based on the verbal response of the IRS agent stating that the extension would affect the exchange. However, it was not granted because of the absence of the written notice of the IRS.

Enlisting help from the experienced Certified Exchange Specialist® allows the property owner to avoid potential risks during 1031 exchanges and defer the capital gains tax successfully.

If you would like know whether you qualify for a 1031 exchange, download the free white paper below or contact our office.

Qualify for a 1031 Exchange?

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.

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Three Sins of a 1031 Exchange Qualified Intermediary

Posted on | by Tom Gustafson | Leave a Comment on Three Sins of a 1031 Exchange Qualified Intermediary

“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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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.

Consider subscribing to our weekly blog. You will receive timely IRS updates and insight on exchanges of real, tangible and intangible personal property.

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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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