1031 exchange rules

1031 Exchange Rules California

Posted on | by Tom Gustafson | Leave a Comment on 1031 Exchange Rules California

Before outlining the specific 1031 exchange rules in California, let’s first introduce the basic concept of a 1031 exchange. In a traditional sale of property, a seller is required to pay capital gains taxes on any gain realized in the sale. One way to avoid paying capital gains taxes is to defer payment by entering into a Section 1031 Exchange. As the name implies, a 1031 Exchange contemplates an “exchange” of like-kind property instead of a traditional sale. If the transaction qualifies, any realized gain is deferred until the replacement property is sold at a later date. One common misconception is that property sold in California must be replaced by property in California, this is not true. The “like-kind” requirement is very general and allows for an Exchangor to acquire property outside of California should they wish to do so. 

The Internal Revenue Service Code sets forth the requirements that must be met in order for a transaction to benefit from 1031 Exchange treatment. In addition to the requirements found in the IRS Code, Qualified Intermediaries must follow additional rules legislated by the State of California for exchanges where the old or relinquished property or the property parked with the Exchange Accommodator Titleholder is located in California.

How does a 1031 exchange work in California? The 1031 exchange rules in California state in general, that anyone who facilitates an exchange for a fee, maintains an office in the state for the purpose of facilitating exchanges, or advertises services as a facilitator in the state, is required to follow the California specific rules.

A Qualified Intermediary operating in California must maintain a bond in the amount of $1 million, deposit an amount of cash or securities or irrevocable letters of credit in an amount not less than $1 million, or deposit all exchange funds in a qualified escrow account or trust account. Anyone who has sustained damages as a result of a facilitator’s violation of the California 1031 exchange rules may make a claim against the bond, account or trust.

In addition, a Qualified Intermediary operating in California must maintain an errors and omissions policy of not less than $250,000 or must deposit cash, securities, or letters of credit in an account designated for the same purpose. Finally, a Qualified Intermediary in California must act as a custodian for all exchange funds and must invest those funds pursuant to a prudent investor standard.

The California Franchise Tax Board also requires a Qualified Intermediary, in most cases, to withhold an amount equal to three and one-third percent of the sales price of any California property as contingency should the exchange not be completed.

Clawback Provision

California has a “clawback” requirement for California property sold in a 1031 exchange and replaced with an out of state replacement property per California FTB Publication 3840. Non-residents are required to file a nonresident income tax return in the year the replacement property is sold in a taxable disposition.

Interested in learning more about when a 1031 exchange makes sense? Click here to download a complimentary eBook on “Ten Reasons Why a 1031 Exchange Makes Sense”.

We strongly recommend conferring with your CPA prior to engaging in a 1031 exchange. It is valuable to have the support and insight of your CPA when making the decision whether or not to proceed with an exchange.

Continue reading →

1031 Exchange Rules: Multiple Owner Insight

Posted on | by Tom Gustafson | Leave a Comment on 1031 Exchange Rules: Multiple Owner Insight

Though 1031 exchange rules provide the requirement for who the Taxpayer is and can be in a 1031 exchange, Section 1031 does not provide the absolute definition. Rather the inference the Taxpayer is the same is found in Section 1033.

1031 Exchange Rules

1031 exchanges can be initiated by a variety of parties. Which party is on title to the relinquished (old) and replacement property is critical. 1031 exchange rules require the Taxpayer who sells is the Taxpayer who buys. The tax return that sells is the tax return that buys. So what happens given:

  • A single or multi member limited liability company;
  • Husband and wife;
  • Taxpayer Death;
  • Corporation.;
  • Grantor Trusts.

Limited Liability Company

The sole member of a single member limited liability company (smllc) can hold the old property in the sole member’s name and the replacement property in the smllc or vice versa. This is provided the state law allows a smllc.

If a multi member limited liability company or partnership is on title to the relinquished or old property, the entity must be on title to the replacement property, not the individual partners. The partnership may change from a general partnership to a limited partnership or limited liability during the exchange without effecting the 1031 exchange.

Drop and Swap

What happens if in a two member limited liability company (mmllc) one member wants to go forward in a 1031 exchange and the other wants to cash out? The IRS has become more attentive to the drop and swap of old when partnerships and multi member limited liability companies dropped ownership to the individual members allowing one member to go forward in a 1031 exchange while the other cashes out. On Form 1065, Schedule B, questions 13 and 14, the IRS is now asking whether in the current or prior tax year, did the partnership or mmllc distribute property to another entity or to any partner in a tenancy in common interest.

Though IRS has not provided a specific time frame, a one year hold prior to or post the acquisition is suggested to support the intent of holding for investment.

Husband and Wife

Given husband and wife are on title of the old property, then both should also be on title to the replacement property. If only the wife is on title to the old property, then the new property should also be titled to the wife. Latter, once the exchange is “old and cold” the husband can be added.

Taxpayer Death

If the Taxpayer dies after initiating a 1031 exchange in either a reverse or forward exchange, the Taxpayer’s estate or trustee can complete the exchange.

Corporation

If a corporation and not its shareholders are on title to the relinquished or old property, then the corporation must be on title to the replacement property. If the shareholders are on title to the old property, then they must be on title to the replacement property and not the corporation.

Grantor Trusts

A revocable living trust or “grantor” trust may be on title to the replacement property while the Taxpayer is on title to the old or relinquished property and vice versa. For federal tax purposes revocable living trusts or “grantor” trusts are not considered separate entities from the Taxpayer.

Conclusion

When planning a 1031 exchange, the same Taxpayer requirement must be followed. If considering acquiring the replacement property in a different entity, planning is critical along with a solid understanding of the exceptions.

Is your company selling a commercial building or real property and the acquiring titleholder is different? Do you have a question how this impacts your 1031 exchange?

The Certified Exchange Specialist on staff has been accommodating simple and complex 1031 exchanges for professional advisor’s and their domestic and foreign clients since 2003. If you have any questions regarding multiple owners, call our office at 1-800-227-1031 or start your free consultation above.

Four Key 1031 Exchange Rules

Posted on | by Andy Gustafson | Leave a Comment on Four Key 1031 Exchange Rules

1031 Exchange RulesWhen taxpayers ask what they should know about a 1031 exchange, I suggest reading this brief article to attempt to cover four key target areas that match up with the characteristics of their transaction. Every 1031 exchange is different though they are all either a forward or reverse exchange, meaning that the old property is sold before the new or in a reverse, the new is acquired before the old is sold with both types of exchanges completed within 180 calendar days. They also share the goal of deferring the capital gain though partial 1031 exchanges may be the desired outcome when not all the exchange proceeds or debt retired is replaced. When you think all bases are covered, there are the exceptions to the rules that are reviewed given the taxpayer’s 1031 exchange specifics.

Continue reading →

1031 Exchange Rules in 2014

Posted on | by Andy Gustafson | Leave a Comment on 1031 Exchange Rules in 2014

Smart investors and business owners utilize a 1031 exchange when selling and replacing real and personal property held in the productive use of a business or for investment. The alternative to a 1031 exchange is to pay the federal and state capital gains and depreciation recapture tax, which can represent upwards of 40 percent of the property sales price. A 1031 exchange allows the taxpayer to use those otherwise paid dollars towards the replacement property purchase. If the 1031 exchange rules are not strictly followed, the outcome can be a disqualification, tax payment, interest on the tax not paid, penalty and drama of an IRS audit.

Continue reading →

1031 Exchange and Divorce

Posted on | by Andy Gustafson | Leave a Comment on 1031 Exchange and Divorce

Husband and wife or domestic partner acquire an investment property in a 1031 exchange and in a divorce decree the partner receives the property. Years later, the partner wishes to sell the property. Does a 1031 exchange make sense? It depends upon the tax consequence and whether the partner’s intent is to replace with an investment property.

1031 Exchange

A 1031 exchange allows the titleholder to defer the federal and state capital gain and recaptured depreciation tax when “like-kind” property of equal or greater value is replaced within 180 calendar days post-closing on the old property. There are many rules to follow, with the first to engage a Qualified Intermediary (QI) to accommodate the exchange. The role of the QI is to provide documentation in accordance with Internal Revenue Code (IRC) Section 1031 for the titleholder and buyer to sign. The QI holds the exchange funds in a safe, liquid escrow account under the titleholder’s tax identification number for use towards acquiring the replacement property. If the titleholder accesses or touches the funds, the 1031 exchange is over.

Divorce

In a divorce, the adjusted basis of the titleholder is the basis of the transferor’s as stated in IRC Section 1041. For example, while A and B were married they initiated a 1031 exchange, acquiring a vacation rental property. A and B divorce with B receiving the rental property as part of the settlement. B wants to sell the rental property and replace with another rental property in a different state. B should visit with their CPA to understand the tax consequences. In a two property 1031 exchange for a relinquished property with a sale price less than $500,000, the QI fee ranges from $750 to $1,200. If the QI fee is substantially less than the tax due, then most likely B should initiate a 1031 exchange.

So what happens if a couple who recently acquired an investment rental property in a 1031 exchange and one of the two wants to occupy as their primary residence in less than the two year holding period? Given the hold time is outside the “safe harbor” of two years, the courts apply a subjective test as to the taxpayer’s intent at the time the replacement property was acquired.

Tax attorney David Shechtman of Drinker, Biddle & Reath provided the following review.

“In Reesink v. Comm’r, T.C. Memo 2012-118, the Tax Court approved an exchange where the taxpayers converted their replacement property into a personal residence some eight months after acquisition. In that case, the taxpayers demonstrated a clear investment intent at the time of acquisition and that they converted the property to a personal residence only because of unforeseen circumstances (financial setbacks which forced them to sell their more expensive residence and “downsize” into the replacement property). If the husband and wife can demonstrate investment intent and that conversion is occurring because of unforeseen circumstances, they should be okay.

Unforeseen Circumstances

Unforeseen circumstances are when the taxpayer fails to meet the original intent by reason of a change in the location of employment, health, or, to the extent provided in the Regulations. This also applies to a “mixed use” property where the taxpayer utilizes a part of the property as their primary residence and the other portion as an investment property, such as a Bed and Breakfast, farm, or a duplex. The portion used as the primary residence is eligible for the Section 121 exclusion while the portion held as an investment property is eligible for Section 1031 tax deferral. To qualify for the Section 121 exclusion, the taxpayer must hold the principal residence for periods totaling two years or more over a five year period. The exclusion is available once every two years. If the taxpayer fails to meet the two year ownership and use requirements, then a prorated fraction of the exclusion may be taken given the unforeseen circumstances.

Learn more about 1031 exchange steps to consider.

1031 Exchange Rules

Real property can be exchanged for any real property. Examples of real property exchange include a vacation rental property for land, mineral interests for a single family residential rental and a thirty year leasehold interest for a triple net lease or tenant in common property.

The taxpayer who sells is the taxpayer who buys. If a husband and wife are titleholders on the property, then they need to be the titleholders on the replacement property. If a single member limited liability company (SMLLC) is the titleholder, then either the SMLLC or the member can be the replacement property titleholder. If a limited liability company has two members and one wants to cash out while the other member wants to defer the gain, then as soon as possible, the two member limited liability company should be dissolved. A new deed should be recorded reflecting the names of the two members as tenants in common. The Purchase and Sale Agreement should then reflect the names of the two members rather than the limited liability company.

Post-closing on the old property, the replacement property must be identified, preferably to the QI, no later than 11:59 PM on the 45th calendar day. The replacement property must be acquired no later than the 180th calendar day post-closing.

The replacement property must have a sales price equal to or greater than the relinquished property sales price. All the net equity from the sale along with debt equal to the debt retired must be used to acquire the replacement property. Any cash or debt not re-established is considered boot and taxable. Additional cash offsets debt, but additional debt does not offset cash.

To learn “Ten Reasons Why a 1031 Exchange Makes Sense,” click here for a free PDF.

Two Party 1031 Exchange

Posted on | by Andy Gustafson | Leave a Comment on Two Party 1031 Exchange

In a two party 1031 exchange, the taxpayer conveys the relinquished or old property to the buyer and the replacement property is conveyed from the buyer to the taxpayer. These types of exchanges are somewhat rare, given the likelihood that the taxpayer and the buyer want each other’s property. Properties are almost never the same value; consequently the taxpayer may pay tax on that portion of cash or retired debt that is not replaced. Nonetheless, these transactions do qualify as 1031 exchanges and do not require a qualified intermediary to accommodate the two party 1031 exchange.

Continue reading →