A leasehold improvement exchange is the application of a leasehold interest with a 1031 tax deferred exchange. A couple of examples includes building on land already owned or exchanging out of leasehold improvements made into another leasehold interest to be improved. Each requires planning, but the first example requires that the property to be improved is owned by a related party at least six months prior to initiating the exchange.
1031 exchange fees represent payment to a Qualified Intermediary (QI) to accommodate a 1031 tax deferred exchange. A 1031 exchange is a tax deferral strategy federal and state taxpayers utilize to postpone the payment of capital gains and recaptured depreciation taxes when selling and replacing real property held in a trade, business or for investment. Both foreign and resident individuals, trusts, partnerships and corporations use this section of the Internal Revenue Code (IRC) to defer gain on farms, timberland, apartments, shopping centers, single family rentals, and more. In 2012, the Joint Committee on Taxation estimates that $3.2 billion in taxes were deferred with $1.2 billion to be initiated by individuals.
In a 1031 exchange, the QI prepares documentation created in accordance with the IRC supporting the taxpayer’s intent to initiate a 1031 and holds the exchange proceeds, typically in a bank under the taxpayer’s tax identification number. The bank account may or may not earn interest. FDIC insurance insures those proceeds of $250,000 or less. When the taxpayer is ready to acquire the replacement property, the QI initiates a wire out for the closing.
There are different types of 1031 exchanges including:
The QI is compensated by a fee and potentially interest earned on the escrow account. The 1031 exchange fee is dependent upon the type of exchange, complexity and the QI involvement to accommodate the exchange. International exchanges may require the set-up of an escrow account in a foreign country to avoid converting foreign currency to US dollars. It takes time and research to establish foreign escrow accounts.
Currently, the 1031 exchange industry is not regulated. The Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 created the Bureau of Consumer Financial Protection within the Federal Reserve. The law requires the Bureau to conduct a study and propose legislation to protect consumers engaging QIs accommodating 1031 tax deferred exchanges. The proposed recommendations are to be completed one year after the law takes effect and implement regulations within two years of the Bureau’s report.
Eight states including Washington, Oregon, California, Idaho, Colorado, Nevada, Virginia and Maine have enacted laws to protect their constituents requiring that exchange funds are held in a qualified escrow account with dual signatures authorizing disbursements or that the 1031 intermediary maintain a fidelity bond of at least $1,000,000 and a minimum $250,000 error and omissions insurance policy. Each state has a variation of the law and respective criminal and civil penalties.
A disqualified person cannot act as a 1031 intermediary or an Exchange Accommodator Titleholder in a reverse 1031 exchange. In general, a disqualified person is a person or entity that is related to the taxpayer or is the agent of the taxpayer at the time of the transaction. An agent includes:
Exceptions allow for those above who have provided 1031 accommodation, routine financial, title insurance, or trust services for the taxpayer by a financial institution, title insurance company, or escrow company not to be deemed disqualified. A firm and their associates who have provided additional services to the taxpayer are considered disqualified from acting as a 1031 intermediary.
An attorney and accountant may not act as the taxpayer’s 1031 intermediary if the attorney or accountant has performed legal or accounting services for the taxpayer within two years prior to the exchange.
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When a taxpayer plans to include improvements to be constructed in a 1031 exchange, the role of the Qualified Intermediary (QI) is extremely important. The Exchange Accommodator Titleholder (EAT) will hold the title to the property while the QI holds the cash included in the transaction while improvements are being made. The QI will then pay the vendors and contractors, and prior to the 180th calendar day post-closing on the old or new property, the EAT will convey title to the taxpayer.
A 6,800 square foot Advance Auto Parts in Ridgeland, South Carolina is a 1031 eligible investment replacement property featuring new construction to be completed in October, 2012 and a 15 year net lease. Price is $1,317,057 with a capitalization rate of 7.0%.
In a 1031 tax deferred exchange, what amount of personal use is acceptable? If a vacation rental property is held for investment, how many days can the titleholder use for their family? A 1031 exchange is a well-documented tax deferral strategy recognized by the Internal Revenue Code (IRC) Section 1.1031. The theory is when a taxpayer, either domestic or foreign, sells real or personal property held in a trade, business or for investment and reinvests the sales proceeds and debt retired, their economic position has not changed. The taxpayer has not received the realized gain in the form of cash or reduced debt; consequently it would be unfair for a capital gain and recaptured depreciation tax to be paid. The gain is deferred when the replacement property is sold. When sold (and another 1031 exchange is not initiated), the original deferred gain plus any additional gain realized since the purchase of the replacement property is subject to tax.