Property Loss From Exchanges example essay topic

Final Paper "1031 Exchanges - Insight for the real estate investor " This paper is written to provide a reasonably comprehensive overview of Section 1031 of the IRC as it pertains to real estate transactions, and to offer some thoughts on the wealth-creation advantages that 1031 Exchanges offer. For the greater part of the last decade, we in the United States have been witness to a consistently appreciating real estate market. Sometimes it seems that almost anyone who has purchased a house, piece of property, or other real estate type investment has done very well. I personally can point to a few examples where friends of mine have made several hundred times their first home equity investment. In sales of primary homes there is a tax advantage that the IRS permits, as long as the proceeds are invested into another home, the capital gains on your existing home sale are exempt from taxation. However, if the property in question is an investment, a capital gain tax is assessed every time there is a sale that includes a gain.

A tax strategy that investors can employ in such situations is to transfer their investment property for another investment of "like-kind", this is a Section 1031 Exchange. Under Section 1031, if all its guidelines are met, the exchange is not a taxable event. Also, similar to tax rules regarding reorganizations - in a 1031 Exchange there is no taxable event and therefore no step-up in basis. The wealth-creation advantage of a 1031 Exchange can be viewed in the chart below. The example depicts two sales of real estate, the initial assumption is that the property has been completely depreciated and the entire $100 K of initial equity is a capital gain. Event 1 Event 2 Typical Sale 1031 Exchange Investment experiences 20% appreciation Typical Sale 1031 Exchange Equity 100,000 100,000 160,000 200,000 Tax 20,000 0 16,000 0 Net Equity to Invest 80,000 100,000 144,000 200,000 New Investment (20% Down payment) 400,000 500,000 720,000 1,000,000 By the end of event two, the investor who utilizes 1031 Exchanges is able to invest in a property that is 39% greater in value than the investor who sells his (her) real estate investments in a typical manner.

Section 1031 of the IRS tax code can be viewed in Exhibit 1 at the end of this paper, for practical reasons I would like to offer a basic example in which an investor (s) can benefit from the tax advantages of Section 1031. John and Jane own and rent out a duplex in Atlanta. They are getting older now and are planning to retire and to move to Miami. John and Jane would like to sell the Atlanta Duplex and purchase a small commercial building next to the lovely condo they bought on the beach. The main issue is John and Jane can only afford to buy this building if they are able to capture all of the existing equity in their Atlanta duplex.

To avoid (defer) a taxable event when they sell their duplex John and Jane can utilize Section 1031 of the IRC. There are, however, a few hoops that John and Jane must jump through to qualify. First, the properties being exchanged must be "like-kind"", this criteria is defined by its use, not its characteristics. For example, land may be exchanged for rental property such as a house, condo, or commercial real estate". In addition to "like-kind" both properties must be located within the United States.

It is important to identify the investment because once the initial property is sold, the investor has 45 days in which the acquisition property must be identified, failure to due so and the capital gains tax will apply to the sale of the initial investment. The investor now has 180 days, from initial sale to purchase the target real estate investment. There is some flexibility in the 45-day replacement property rule, namely two options the investor has when identifying his (or her) replacement property. 1. The three-property rule will allow the investor the flexibility of identifying up to three properties they are interested in exchanging for, the fair market value of the properties identified is not considered here. 2.

A 200% rule will the allow the investor to identify any number of properties as long as the market value of the individual identified properties does not exceed 200% of the market value of the property being exchanged. A 1031 Exchange must pass through an intermediary, in theory you are exchanging assets, it is necessary to have a third party to the transaction "to maintain the fiction that you aren't buying and selling". Of course the investor can simply trade (exchange) properties with the owner of the target property, however, it is unlikely that the other investor wishes to exchange and extremely unlikely that both properties will be equal in value. If the properties are mismatched in value the addition of "boot" in an exchange will expose an investor to the capital gains tax - at least equal to the boot portion of the sale.

These situations, and for situations in which the two parties do not wish to trade property at all, an intermediary is a requirement to execute a 1031 Exchange. "The duties of the qualified intermediary are to act as a principal for the exchanger in relinquishing property, to hold exchange proceeds, and to disburse these proceeds to the seller of the replacement property". The intermediary can be an accountant, an attorney, a broker, or an investment banker. However, the intermediary is limited to only performing 1031 services to that client.

This is one reason that many professions either specialize in 1031 services or avoid them altogether. Section 1031, in one from or another, has been a part of the IRC for over 70 years. Recently the section has been expanded to 'loosen' the requirements for exchanges that involve Tenants in Common (TIC). Here is a brief timeline of Section 1031's history: 1918 - First income tax law 1921 - Section 202 of Internal Revenue Code states that gain or loss not recognized on exchanges of like-kind property 1924 - Non like-kind exchanges excluded from Section 2021928 - Code section changed to Section 112 (b) (1) 1954 - Section 1031 enacted 1975 - Starker exchange; Tax court approves delayed exchange 1977 - Tax court reverses prior ruling, invalidating delayed exchanges 1979 - 9th Circuit reverses, reinstating initial ruling and creating delayed exchange 1984 - Congress amends Section 1031; 45 day identification period and 180 day exchange period and partnerships excluded 1991 - Regulations 1.1031 passed 2002 - Revenue Procedure 2002-22 issued by IRS; 15 points to clarify TIC interests " Procedure 2002-22 significantly expands the ability of real estate to engage in transactions involving TIC properties, and makes this opportunity available to smaller investors as well as large institutional shareholders".

This is an important development in the way we are able to view our real estate investments. Larger properties now enter the realm of potential investments for investors who would not be capable of producing the necessary capital on their own. Groups of investors can form a TIC relationship and utilize 1031 Exchanges to acquire larger more substantial real estate properties. People who once could only consider owning a rental house now have the possibility of owning a piece of a large office building or retail mall. But, as you might expect, the IRS has added a few more hoops for investors to jump through, to be exact fifteen hoops. 1.

The property must be held TIC. 2. The number of co-owners is limited to 35.3. The co-ownership cannot be an entity that files a tax return.

4. The co-owners may enter into a limited agreement, it is important that this agreement does not resemble a partnership agreement. 5. The co-owners must retain the right approve the hiring of manager, the sale, and like responsibilities regarding the investment property. 6. He co-owner must retain the right to transfer / partition their interest in the investment.

7. The co-owners must share the proceeds and liabilities on the sale of property. 8. There must be proportionate sharing of profits and losses. 9.

Proportionate sharing of debt among co-owners. 10. A co-owner may issue a call option to purchase the co-owner's interest provided that the exercise price reflects the fair market value of the asset. 11. No business activities, co-owners activities must be limited to maintenance and repair. 12.

The co-owners may enter management agreements as long as the agreement is not with a lessee and is renewed at least annually. 13. All leasing agreements must be bona fide leases. 14.

The lender cannot be related to any co-owner. 15. Payments to the Sponsor must be fair market value for services and cannot depend on the investment's profitability. These fifteen 'hoops' as cumbersome as they may be, are designed to ensure that each co-owner has a direct interest and liability in the investment. The involvement of several investors can complicate the timing issue associated with executing Section 1031 TIC transactions, however, they should not (and do not) discourage this type of transaction.

In fact the popularity of Section 1031 TIC transactions is expected to increase substantially over the next decade. A reason for the expected increase some advantages offered by larger real estate investments. These include: o Utilizing economies of scale and hiring a management company to oversee day-to-day operations. o An increased pool of potential investments. o Ability to trade up to commercial properties with Triple Net Leases. o Increased diversity of the investor's portfolio. So if we take this back to the original example of John and Jane, the couple can now consider exchanging their Atlanta duplex for a share in say, a large strip mall. An investment that would most likely employ a property manager and require less of John and Jane's time than the small commercial property they were considering. The job of the intermediary is also more complex in a Section 1031 TIC Exchange.

At the moment there is a growing industry sprouting up to service investor's needs in this area. It is important to note that when you as an investor are entering into a 1031 Exchange there many guidelines that must be met, failure to do so will result in capital gains taxes, the more complicated the transaction the more prudent the investor should become when seeking tax advice and services. Tax Considerations in a 1031 Exchange o The tax basis is carried over from the old property to the new property, effectively reducing the depreciable amount of the asset. Conversely, if there has been a drop in value of the property sold, the investor may retain high levels of depreciation deductions for the new property. o You as the investor are controlling the timing of when taxes are paid.

A 1031 exchange is a deferment of taxes and the only true way to avoid the eventual capital gains tax is death. So it is important to keep in mind that with each transaction your tax basis remains the same and is being depreciated more each year. After several transactions and many years a 0 basis is possible. o A major advantage of a 1031 exchange is the investor will have larger amount of equity 'available' from property sales. This will allow the investor, in the absence of a tax 'bite', to purchase more expensive properties and participate in there - we hope - appreciation. This ability to defer taxes will have a multiplying effect on the asset value over time, assuming that real estate investments continue to appreciate and the investor is accurate in identifying new opportunities for profitable exchanges. Exhibit 1 SS 1036.

Stock for stock of same corporation Release date: 2003-05-15 (a) General rule No gain or loss shall be recognized if common stock in a corporation is exchanged solely for common stock in the same corporation, or if preferred stock in a corporation is exchanged solely for preferred stock in the same corporation. (b) Non qualified preferred stock not treated as stock For purposes of this section, non qualified preferred stock (as defined in section 351 (g) (2) ) shall be treated as property other than stock. (c) Cross references (1) For rules relating to recognition of gain or loss where an exchange is not solely in kind, see subsections (b) and (c) of section 1031. (2) For rules relating to the basis of property acquired in an exchange described in subsection (a), see subsection (d) of section 1031. For purposes of this section, an interest in a partnership which has in effect a valid election under section 761 (a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership. (3) Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if- (A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (B) such property is received after the earlier of- (i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date (determined with regard to extension) for the transferor's return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs. (b) Gain from exchanges not solely in kind If an exchange would be within the provisions of subsection (a), of section 1035 (a), of section 1036 (a), or of section 1037 (a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property. (c) Loss from exchanges not solely in kind If an exchange would be within the provisions of subsection (a), of section 1035 (a), of section 1036 (a), or of section 1037 (a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized. (d) Basis If property was acquired on an exchange described in this section, section 1035 (a), section 1036 (a), or section 1037 (a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035 (a), section 1036 (a), or section 1037 (a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035 (a), and section 1036 (a), where as part of the consideration to the taxpayer another party to the exchange assumed (as determined under section 357 (d) ) a liability of the taxpayer, such assumption shall be considered as money received by the taxpayer on the exchange. (e) Exchanges of livestock of different sexes For purposes of this section, livestock of different sexes are not property of a like kind. (f) Special rules for exchanges between related persons (1) In general If- (A) a taxpayer exchanges property with a related person, (B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and (C) before the date 2 years after the date of the last transfer which was part of such exchange- (i) the related person disposes of such property, or (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.

(2) Certain dispositions not taken into account For purposes of paragraph (1) (C), there shall not be taken into account any disposition- (A) after the earlier of the death of the taxpayer or the death of the related person, (B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or (C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax. (3) Related person For purposes of this subsection, the term "related person" means any person bearing a relationship to the taxpayer described in section 267 (b) or 707 (b) (1). (4) Treatment of certain transactions This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. (g) Special rule where substantial diminution of risk (1) In general If paragraph (2) applies to any property for any period, the running of the period set forth in subsection (f) (1) (C) with respect to such property shall be suspended during such period. (2) Property to which subsection applies This paragraph shall apply to any property for any period during which the holder's risk of loss with respect to the property is substantially diminished by- (A) the holding of a put with respect to such property, (B) the holding by another person of a right to acquire such property, or (C) a short sale or any other transaction. (h) Special rules for foreign real and personal property For purposes of this section- (1) Real property Real property located in the United States and real property located outside the United States are not property of a like kind. (2) Personal property (A) In general Personal property used predominantly within the United States and personal property used predominantly outside the United States are not property of a like kind.

(B) Predominant use Except as provided in subparagraph [1] (C) and (D), the predominant use of any property shall be determined based on- (i) in the case of the property relinquished in the exchange, the 2-year period ending on the date of such relinquishment, and (ii) in the case of the property acquired in the exchange, the 2-year period beginning on the date of such acquisition. (C) Property held for less than 2 years Except in the case of an exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection- (i) only the periods the property was held by the person relinquishing the property (or any related person) shall be taken into account under subparagraph (B) (i), and (ii) only the periods the property was held by the person acquiring the property (or any related person) shall be taken into account under subparagraph (B) (ii). (D) Special rule for certain property Property described in any subparagraph of section 168 (g) (4) shall be treated as used predominantly in the United States.