All States 1031 Top Ten List

"A newsletter devoted to the education of those involved in section 1031 exchanges"

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All States 1031 Top Ten List

Although every 1031 exchange is different, many of our clients, no matter where they are located in the USA, ask very similar questions. The purpose of this newsletter is to provide answers to the ten most popular questions. If you have any additional questions, or want to discuss some of the following answers in more detail, please call Melanie Brienza, Vice President of All States 1031 toll-free at 877-395-1031.

1. How long should a rental house acquired as replacement property be rented before converting it to a primary residence?

This is probably our most popular question, as many exchangers purchase replacement property in a vacation haven, with an eye towards using such property exclusively for their own personal use.  The answer is that there is no hard and fast rule, but a subsequent conversion should not prevent the exchange from satisfying the use requirements provided that the exchanger did not have a concrete intention to convert the property to personal use at the time of the exchange.  Although the preceding sentence is the legally correct answer, most clients want defined time frames.  For the most conservative, we recommend two (2) years, as the IRS has ruled that a two-year minimum rental period was sufficient to meet the qualified use test.  For an aggressive client, we explain the pitfalls of a negligible rental period under the intent

standard, and typically urge such a client to rent the property for at least one season.

2. Can I do an exchange if I use my property partially as a residence and partially as a rental property?

Yes. In such an exchange, allocation of value between the two types of property becomes important. For example, if an exchanger owns a three family house occupying one floor as a personal residence, the allocation may be by the respective square footage, the number of units, the quality of interior improvements, or by appraisal. Any reasonable allocation is permissible.  The gain attributable to the personal residence may be eligible to be excluded under IRC § 121.

3. Must the names on the deeds be the same for both the relinquished property and the replacement property?

Yes, unless a disregarded entity is involved. IRC § 1031 provides that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like-kind which is to be held either for productive use in a trade or business or for investment (a so-called "qualified use").  If the exchanger changes the form of ownership of the property contemporaneously with the exchange, the IRS argues that the exchanger held the property primarily to dispose of it (a nonqualified use) rather than for productive use in a trade or business (a qualified use).

Certain entities with a single owner, such as a single member LLC, are "disregarded" as an entity separate from its owner. The IRS has recently ruled that a transfer of replacement property directly to a single member LLC owned by the exchanger did not disqualify the transaction from the non-recognition rules of IRC §1031 even though title to the relinquished property was held in the name of the Exchanger. The IRS correctly reasoned that because the single member LLC is a disregarded entity, the exchange in question would be viewed as if the exchanger himself had directly received the replacement property, thereby satisfying the requirements of IRC §1031.

For more information on the planning opportunities available through the use of disregarded entities see the topic entitled "Single Member LLC" posted at www.allstates1031.com which contains an article drafted by Thomas J. Moylan, Esq., a principal of All States 1031.

4. Will an exchange increase my chances of an audit?

Not likely.  There is no reported study that a 1031 exchange increases the exchanger's odds of being audited. Furthermore, since tax free exchanges are specifically authorized by statute, an exchanger would have nothing to fear from an audit if the exchange is structured correctly.

5. What happens if I can't acquire the properties I identify?

If an exchanger cannot acquire identified property, the exchange funds will be returned to the exchanger, and the exchanger will recognize the gain realized on the sale of the relinquished property. The timing of the payment of the exchange funds, however, sometimes creates a problem.

The regulations under Section 1031 allow a payment of money to the exchanger upon the earliest to occur of three events: (1) the end of the 180-day exchange period; (2) the end of the 45-day identification period if the exchanger has no remaining unacquired identified replacement properties; or (3) where there are remaining unacquired identified properties at the end of the identification period, then on (a) receipt of all properties that an exchanger is entitled to receive under the exchange agreement, or (b) the occurrence of a "material and substantial contingency that relates to the deferred exchange," that is provided for in writing, and that is beyond the control of the exchanger or any disqualified person.

Many qualified intermediaries take the position that the exchange funds can never be returned prior to the 45-day identification period, and after 45-days only if the exchanger provides the qualified intermediary with a letter stating from a third party (e.g. an attorney or engineer) that the identified property cannot be purchased due to a material and substantial contingency. All States 1031 looks at each situation on a case-by-case basis.

6. Can I perform an exchange if I recently refinanced the relinquished property, and how long must I be in title to the replacement property before I can refinance it?

It is the position of the IRS that the effect of refinancing relinquished property shortly before an exchange allows an exchanger to receive cash which should be treated like boot (i.e. taxable). The logic behind the IRS' position is questionable.  It is well established that an exchanger can encumber property without tax consequences.  Furthermore, if property is encumbered and then transferred as part of a like‑kind exchange, the Regulations are clear that the transferor will recognize gain unless an equal or greater amount of debt encumbers the replacement property received in the exchange. Thus, from a before‑and‑after perspective the exchanger's liabilities will not be reduced as a result of a like‑kind exchange.

There appears to be no reason why an exchanger cannot encumber property after the exchange, and there is no valid reason why the exchanger should wait before encumbering the same. The receipt of debt proceeds from a refinancing does not give rise to taxable income, and the fact that the debt proceeds are from replacement property obtained in a like‑kind exchange should not alter this result. Accordingly, the exchanger can defer the recognition of gains tax on the exchange, and immediately thereafter tap into the equity in the replacement property placing cash in his pocket.

For more information on refinancing before, after or simultaneously with a 1031 exchange see article entitled "Financing Issues" posted at www.allstates1031.com.

7. Does All States 1031 provide the earnest money deposit with respect to the replacement property?

All States 1031 should provide the earnest money deposit, but only after the purchase and sale agreement for the replacement property is assigned to All States 1031. Furthermore, the agreement should provide that if it is cancelled, the deposit will be returned to All States 1031.  If the exchanger advances the deposit, the exchanger will not be reimbursed by All States 1031 until after the exchanger has received the replacement property in order to avoid a violation of the Regulations.

8. What costs on the settlement statement can be deducted from the exchange proceeds?

With regard to selling expenses, the IRS has ruled that cash received by an exchanger is offset by commissions paid. It is the opinion of the American Bar Association ("ABA") that the principles contained in the IRS' ruling concerning commissions should be extended to all selling expenses typically deducted by a seller in a taxable sale under Section 1001, or capitalized by a buyer and added to the basis of the property acquired under Section 1012.  Such expenses typically include commissions, finder's fees, inspection and testing fees, recording fees and legal fees.

Loan fees, points, loan application fees, mortgage insurance, lender's title insurance, and other costs related to the acquisition of a loan for the replacement property are typically not treated as selling expenses because these costs generally are treated as part of the cost of obtaining a loan rather than the cost of obtaining the property, and do not increase the basis of the replacement property.  Therefore, if loan related expenses are paid out of the exchange balance, they should constitute taxable boot in the form of cash received by the exchanger.

9. What options are available if I currently own an interest in a partnership?

Exchanges of partnership interests generally do not qualify for non-recognition treatment under IRC § 1031. Therefore, when partners want to end their relationship, they cannot each exchange out of their partnership interests into another partnership interest or real property under IRC § 1031.

Such transactions can be structured as exchanges, however, by converting the partnership interest into a real property interest. The various structures include partnership split-ups, split-offs, buy-outs and formations. All such structuring is not without tax risk, and requires the advice of an experienced tax professional.

10. In an improvement exchange, does the construction have to be completed within 180 days?

Maybe.  With real property, partially completed improvements are like-kind to the relinquished property. With personal property, however, the improvements must be fully completed when received by the exchanger. A related issue is whether all the exchange proceeds must be exhausted for a valid exchange. 

Improvements constructed after the exchanger has acquired the replacement property do not qualify as like-kind property. The improvements, therefore, must be completed by a third party prior to the date that the exchanger receives the replacement property.  If the exchange value of relinquished property, however, is less than the completed value of the replacement property, the replacement property may be conveyed to the exchanger when enough construction has occurred to cover the relinquished property exchange value.