In this issue we recap the Cases and Rulings in 2014 that touched on 1031 Exchanges.
Improvements on Property Owned by a Related Party
A not infrequent scenario is the Taxpayer selling real estate and wanting to construct improvements on property they already own. This is not permitted under the regulations. However, in February we saw the third ruling allowing, as replacement property, construction of leasehold improvements on property owned by a related party. PLR 201408019 (2/21/2014)
The IRS allowed multiple potential Exchangers to enter into parking transactions for the same replacement property. PLR 201416006 (4/18/2014)
There were two cases that, while not 1031 related, touch on an issue that frequently comes up in 1031 discussions – whether land is investment (1031 eligible) or inventory (not 1031 eligible). A sale of land generated ordinary income instead of capital gain income due the level of development activities relative to the land. Boree v. Commissioner, TC Memo 2014-85 (5/12/2014) A civil engineer was held taxable at ordinary income rates on the sale of land he tried to develop for 12 years. Allen v. USA (USDC ND CA) (May 28, 2014)
Son as 1031 Intermediary
The exchange was disallowed in which the Taxpayer used his son, an attorney, as his intermediary. As a related party Son is a disqualified partyand may not provide accommodation services for Dad. His license to practice law did not create an exception. Frank J. Blangiardo v. Commissioner, TC Memo, 2014-110 (6/9/2014)
Son as Tenant
Son resided in the replacement property without paying rent. A Minnesota state tax court disallowed the exchange. Johnson vs. C.I.R., 2014 WL 2965410 (MN Tax Ct., 6/20/14) In the last few years we have seen similar cases where the courts have determined that the property is being held forpersonal use purposes rather than investment purposes. Revenue Procedure 2008-16 provides guidance regarding rental income and personal use of dwelling units.
Qualified Intermediary Negligence
A title company affiliated exchange company was found negligent for failing to use a reasonable standard of care in structuring a regular delayed exchange when an improvement exchange was necessary. Kreisers Inc. et al. v. First Dakota Title Limited Partnership et al., 2014 S.D. 56 (S.D. 2014). This case illustrates the truth that exchanges are not just fill-in-the-blanks paperwork. Working with a company that takes time to structure is critical to the success of an exchange.
Agent Negligent Misrepresentation
Utilizing the services of Agent, Taxpayer acquired a property in 2000 in a 1031 exchange. In 2010 using Agent to sell the property, Taxpayer asked Agent whether they could avoid the capital gain tax. Agent advised that this was not possible due to the previous exchange. After getting a $75k tax bill Taxpayer sued Agent. The court dismissed most claims against Agent but let stand a claim of “negligent misrepresentation.” The court stated that where an agent, experienced in a specific type of transaction, makes a representation to the taxpayer, the taxpayer is not unreasonable in relying upon the representation. Coon v. Wood, 2014 WL 4647713 (USDC DC) (Sept. 18, 2014)
ANNOUNCING – Beutler Exchange Group, LLC now documents Reverse and Improvement Exchanges!
Besides reverse and improvement exchange questions there are many other commonly asked 1031 questions. What follows is a sampling of those questions and a brief version of some very complicated answers. (This is tax law. There are no simple answers.)
DROP AND SWAP EXCHANGE
Q – The sale of our medical building is closing in two weeks. My partner wants his sale proceeds and will pay tax. Can I do an exchange with my share.
A – No. The Caller owns a partnership interest and, by definition, 1031 prohibits the exchange of partnership interests and LLC membership interests. The partnership can do an exchange but not the individual partner.
Follow-up Q – But people used to do it all the time.
A – Yes, but… Before the real estate bubble burst interests in partnerships were routinely dropped right at the closing table and then exchange documents were signed, aka a “drop and swap.” And tax authorities paid little attention. However, beginning with the 2008 partnership return the IRS added questions to detect these exchanges. This heightened attention has curtailed the use of drop and swap.
Follow-up to the Follow-up Q – What can I do?
A – Most tax and legal advisors would recommend dropping out of the partnership/LLC in a tax year prior to selling so that there is some seasoning before the exchange.
ADDING A SPOUSE
Q – Can I add my husband to the title of the Replacement Property?
A – The answer is more complicated than you might imagine. A basic requirement of 1031 is that the Taxpayer that owned the old property be the Taxpayer to own the new property. Not uncommonly the financials of a spouse are necessary to obtain financing for the new property. A couple of ways to bring them in: 1) Add them to the title of the old property before it is sold so they participate throughout the exchange, or 2) Have them pay a pro-rata share of the down payment and take title as a tenant-in-common with the Exchanger. Consultation with the tax advisor and Beutler Exchange Group, LLC is essential.
Q – Can I exchange a food cart for a commercial building to house my new restaurant?
A – No. Real property is like-kind with real property. While the use of the food cart and restaurant are essentially like-kind, the food cart (personal property) is not like-kind with the real property. Likewise, if the Exchanger sells a rental house to buy an operating farm, that comes with farm equipment, the farm equipment will not be like-kind with the rental house. The house is like-kind with the farm but the equipment would be “boot” and receipt by the Exchanger would be taxable.
Q – I get 18 months to reinvest, right?
A – Sadly, no. From the time the sale of the old property closes the Exchanger has 180 days or the date their tax return is due, whichever comes first, to close on the new property. And even more challenging, the Exchanger has only the first 45 days of the 180 to identify the new property.
Follow-up Q – Surely there is a way to get an extension!
A – In fact, there is a way. If the Exchanger is “lucky” enough to be affected by a federally-declared disaster (hurricane, flood, tornado, etc.) they will be eligible for extensions of 120 days on the 45-day deadline and 120 days on the 180-day deadline.
These examples are meant to be illustrative, only. Before proceeding with any 1031 exchange, consultation with tax and legal advisors and Beutler Exchange Group is essential.
Contact Toija Beutler and Karen Inabnit at
phone: 503.748.1031 toll-free: 844.414.1031
In this issue – Toija’s Q and A
There are many commonly asked 1031 questions. What follows is a sampling of those questions and a brief version of some very complicated answers. (This is tax law. There are no simple answers.)
Q – Inventories are so limited right now. I found a perfect Replacement Property. Can I close on it before closing the sale of my old?
A – Yes, but…. This is a Reverse Exchange and while the rules do permit them the Exchanger cannot own the old and the new properties at the same time. A reverse exchange will require the ownership of one or the other to be parked with an Exchange Accommodation Titleholder (EAT). There will be additional fees and expenses for this parking arrangement – double closing costs, EAT fees, etc. – and a certain amount of hassle-factor. And the EAT can only own the property for 180 days.
Q – The new property has deferred maintenance and needs $130,000 in repairs. Can I use funds from my exchange account to do the work?
A – Yes, but…. While exchange rules do contemplate Improvement Exchanges what they don’t allow is the Exchanger to be the owner of the new property while the work is taking place. There are various ways to structure an improvement exchange. In its most full blown version the property would be parked with an EAT incurring the expense, hassle-factor and 180-day time limitation. (See above.)
Q – I need $30,000 for a trip down the Rhine. Can I take that cash and just have a “partial” exchange?
A – Yes. To get the best tax deferral the Exchanger would reinvest all sale proceeds into the new property and they would obtain debt on the new property that is equal to, or greater than, the debt on the old property. However, there are countless reasons why Exchangers might want to take some cash out or take on less debt. The Exchanger will owe tax on the cash they pull out or the “debt relief” but this can still be a nice exchange.
To complicate this answer a bit…one exception to the requirement for equal debt…cash added in by the Exchanger will offset the requirement for replacement debt. For example, the Exchanger pays off a $30,000 mortgage on the old property. If they bring additional funds of $30,000 to the purchase of the new property they will not be taxable on the debt relief.
It is important to understand that some partial exchanges can be so partial that they don’t benefit the Exchanger. Consultation with the tax advisor and Beutler Exchange Group, LLC is essential.
Q – Can I exchange out of my second home in Phoenix for a second home in Hawaii?
A – No. While seemingly “like-kind,” 1031 is not available for personal use properties (second homes) or inventory properties (new construction, newly created lots and flips). 1031’s are for investment properties (rentals and commercial buildings) and trade or business properties (farms and ranches).
If the Exchanger is willing to be patient the Phoenix house can be converted into a rental (24 month rental period and very limited personal use) then they can exchange into a rental in Hawaii (24 month rental period and very limited personal use).
These examples are meant to be illustrative. Before proceeding with any 1031 exchange, consultation with tax and legal advisors and Beutler Exchange Group is essential.
Washington Realtors EdCon 2014, October 7, Hilton Seatac
RMLS Trade Show, October 9, Florence Events Center
WFG National Commercial Services Luncheon, October 16, Portland Golf Club – Registration email@example.com
Contact Toija and Karen at
phone: 503.748.1031 toll-free: 844.414.1031