The sale or disposition of real estate or personal property (relinquished property) and the acquisition of like-kind real estate or personal property (replacement property) structured as a tax-deferred, like-kind exchange transaction pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations in order to defer Federal, and in most cases state, capital gain and depreciation recapture taxes.
The involuntary conversion, sale or disposition of real property (relinquished property) and the acquisition of like-kind real estate or personal property (replacement property) structured as a tax-deferred, like-kind exchange transaction pursuant to Section 1033 of the Internal Revenue Code and Section 1.1033(a) of the Treasury Regulations in order to defer Federal, and in most cases state, capital gain and depreciation recapture taxes. The term disposition of the converted property means the destruction, theft, seizure, requisition, or condemnation by power of eminent domain of the converted property, or the sale or exchange of such property under threat of condemnation by power of eminent domain as defined in Amendment 5 of the United States Constitution, often referred to as the Bill of Rights.
An unrelated party in the tax-deferred, like-kind exchange who may facilitate the disposition of the Exchangor’s relinquished property and the acquisition of the Exchangor’s replacement property. The Accommodator has no economic interest in any of the exchanged real properties. The Accommodator may receive compensation (exchange fee). The Accommodator facilitates the exchange as defined in Section 1031 of the Internal Revenue Code. The Accommodator is referred to as the Qualified Intermediary in IRS Publication 544, but is also known as the Facilitator or Intermediary.
In the United States, to be considered an accredited investor, one must have a net worth of at least $1,000,000, excluding the value of one’s primary residence, or have income at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year.
The term “accredited investor” is defined in Rule 501 of Regulation D of the U.S. Securities and Exchange Commission (SEC) as ANY of the following:
The amount you use to determine your capital gain or loss from a sale or disposition of property. To determine the adjusted cost basis for your property, you must start with the original purchase cost. You then add your purchasing expenses, your cost of capital improvements and principal payments of special assessments (sewer and streets) to the property, and then subtract depreciation you have taken or were allowed to take, any casualty losses taken and/or any demolition losses taken.
A balanced exchange ensures that the taxpayer defers 100% of his or her taxes on capital gain and depreciation recapture. To achieve a balanced exchange 1) acquire a replacement property that is equal to or greater than the relinquished property; 2) reinvest all of the net equity from the relinquished property in the replacement property; and 3) assume debt on the replacement property that is equal to or greater than the debt on the replacement property or contribute cash to make up the deficiency. ( See Partial Tax Deferment; Boot and Mortgage Boot/Relief.)
Non-like-kind property (cash or other property) given by one party to another party in a tax-deferred, like-kind exchange that is taxable. For instance, if you trade in a delivery truck on a new model, the cash you pay in addition to your old truck is boot. Boot received may be offset by boot given. (See also Mortgage Boot.)
A tax-deferred, like-kind exchange whereby the Qualified Intermediary and/or Exchange Accommodation Titleholder acquires title and holds title to the replacement property on behalf of the Exchangor, during which time structures or improvements are constructed or installed on or within the replacement property. Also known as an Improvement Exchange.
Tax levied by Federal and state governments on investments that are held for one year or more. Investments may include real estate, stocks, bonds, collectibles and tangible depreciable personal property.
For land or buildings, improvements (also known as capital improvements) are the expenses of permanently upgrading your property rather than maintaining or repairing it. Instead of taking a deduction for the cost of improvements in the year paid, you add the cost of the improvements to the basis of the property. If the property you improved is a building that is being depreciated, you must depreciate the improvements over the same useful life as the building.
The rate of return an investor wants to achieve on real property. The capitalization rate can provide for the return of the investment and the return on the investment (profit). To obtain a property’s capitalization rate, divide the net operating income of a property by its value. To determine a property’s value, divide the property’s net operating income by the desired capitalization rate. In the Income-Capitalization Method of real property appraisal, a capitalization rate is used to appraise a property’s value. The Income-Capitalization Method of appraisal is used to value investment property, such as apartment buildings, commercial office buildings and retail malls. (See Net Operating Income.)
Exercising control over your exchange funds or other property. Control over your exchange funds includes having money or property from the exchange credited to your bank account or property or funds reserved for you. Being in constructive receipt of exchange funds or property may result in the disallowance of the tax-deferred, like-kind exchange transaction, thereby creating a taxable sale.
Language included in the Purchase and Sale Contracts for relinquished and replacement property indicating and disclosing the transaction to be part of an intended tax-deferred, like-kind exchange transaction. The clause requires all parties to cooperate in completing said exchange.
Example:
Relinquished Property – For the seller of the property: Buyer acknowledges that it is the intention of the Seller to complete a tax-deferred exchange under Internal Revenue Code Section 1031. Buyer agrees to cooperate if it does not delay the closing or cause additional expense to the Buyer. Buyer agrees that Seller will assign the rights but not the obligations of this agreement to the Qualified Intermediary of the Seller’s choosing.
Replacement Property – For the buyer of the property: Seller acknowledges that it is the intention of the Buyer to acquire property as part of a tax-deferred exchange under Internal Revenue Code Section 1031. Seller agrees to cooperate if it does not delay the closing or cause additional expense to the Seller. Seller agrees that Buyer will assign the rights but not the obligations of this agreement to the Qualified Intermediary of the Buyer’s choosing.
The sale or disposition of real estate or personal property (relinquished property) and the acquisition of like-kind real estate or personal property (replacement property) structured as a tax-deferred, like-kind exchange transaction pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations in order to defer Federal, and in most cases state, capital gain and depreciation recapture taxes.
A Delaware statutory trust (DST) is a legally recognized trust that is set up for the purpose of business, but not necessarily in the U.S. state of Delaware. It may also be referred to as an Unincorporated Business Trust or UBO.
Delaware statutory trusts are formed as private governing agreements under which either (1) property (real, tangible and intangible) is held, managed, administered, invested and/or operated; or (2) business or professional activities for profit are carried on by one or more trustees for the benefit of the trustor entitled to a beneficial interest in the trust property.
DST Investments are offered as replacement property for accredited investors seeking to defer their capital gains taxes through the use of a 1031 tax deferred exchange and as straight cash investments for those wishing to diversify their real estate holdings. The DST property ownership structure allows the smaller investor to own a fractional interest in large, institutional quality and professionally managed commercial property along with other investors, not as limited partners, but as individual owners within a Trust. Owners receive their percentage share of the cash flow income, tax benefits, and appreciation, if any, of the entire property. DSTs provide the investor the potential for annual appreciation and depreciation (tax shelter), and most have minimum investments as low as $100,000, allowing some investors the benefit of diversification into several properties.
The DST ownership option essentially offers the same benefits and risks that an investor would receive as a single large-scale investment property owner, but without the management responsibility. Each DST property asset is managed by professional investment real estate asset managers and property managers. It used to be that only large institutional investors such as life insurance companies, pension funds, real estate investment trusts (REITS), college endowments and foundations were able to invest in these properties. Now as a viable 1031 exchange replacement property option through a DST, individual investors have the ability to invest in a diversified selection of institutional quality, investment property types that they otherwise could not purchase individually. DST Investments are located throughout the United States. Property types may include multifamily apartment communities, office buildings, industrial properties,
multi-tenant retail, student housing, assisted living, self-storage facilities, medical office, single tenant retail properties and others.
History
The concept for business trusts, especially those that involve the holding of property, dates back to 16th century English Common Law. In Delaware, it was not until 1947 that Common Law began recognizing statutory trusts. No legal recognition of statutory trusts existed until the passage of the Delaware Statutory Trust Act (DSTA), 12 Del. C. 3801 et. Seq., in 1988. Under The Act, developed on the premise of trust law, statutory trusts were now recognized as their own legal entity, separate from their trustee(s), offering freedom from the corporate law template. Within the tradition of trust law, freedom of contract allows the trustee(s) to structure the trust in a way that is most beneficial to the relationship of all parties and their expertise, while offering liability protection similar to that of a Limited liability company or Partnership. Since the year 2000, Delaware statutory trusts have increasingly been used as a form of tax deferral, asset protection, and balance sheet advantages in real estate, securitization, mezzanine financing, real estate investment trusts (REITs), and mutual funds. Massachusetts, another state that has trust law, refers to its legal entity as a Massachusetts business trust. Most states, however, still rely on Common Law to oversee the trusts within their jurisdiction.
The formation of a Delaware statutory trust is relatively simple and inexpensive, when compared to that of the more complex filings of other entity types. To form a statutory trust, a private trust agreement must be developed by all involved parties to ensure that individual interests are protected. The private trust agreement need not be shown to any official of the State. Once the agreement is completed, a Certificate of Trust can be obtained from the Delaware Division of Corporations and completed. The signatures of the trustee(s) involved are then required, followed by submission of the forms to the Division of Corporations, along with a one-time $500 processing fee. If the statutory trust is, or will become, a registered investment company, it must maintain a registered agent and a registered office within the State of Delaware. If no desire for the statutory trust to be an investment company exists, the only remaining requirement is that it must have at least one trustee who resides in, or has a principal place of business within the State of Delaware.
On August 16, 2004, Internal Revenue Bulletin 2004-33 was published in reference to Rev. Rul. 2004-86. This involved a Delaware Statutory Trust that resulted in the Internal Revenue Service (IRS) and Treasury Department offering a ruling on the following two issues:
These holdings of the federal government offered a clearer notion that Delaware statutory trusts are legal entities, separate from their trustee(s), offering them limited liability. In addition, Delaware statutory trusts were shown to be considered a trust for federal tax purposes, making them a pass through entity that mitigates taxation for their trustee(s). The second holding offers the opinion that real property, being held under a Delaware statutory trust, is eligible to use a 1031 exchange, without the recognition of gain or loss, as long as the following seven restrictions are met:
As an entity that was created within the boundaries of Delaware and is written into the Delaware state charter, Title 12 Chapter 38, there is no question as to where the state stands on the backing of the Delaware statutory trust. Limited liability is offered for DSTs, affording each trustee the benefit of personal asset protection. DSTs can be structured as a pass through entity, so that any income will go straight to each individual trustee’s Form 1040 and state’s tax returns, thus avoiding income tax at the entity level.
Features of a Delaware statutory trust are very attractive to many business entities.
These features include:
Source: Wikipedia.org
If an individual or business taxpayer elects a section 1033 deferral simply by omitting a gain from its return for the year it realizes that gain as a result of an involuntary conversion. However, this method of electing section 1033 deferral (either by showing details on the return or omitting them in a “deemed election”) can and often will subject the taxpayer’s realized gain to remain open until three years after the individual or business notifies the IRS it has or has not replaced the property. Thus, a taxpayer making this section 1033 election creates an indefinite statute of limitations.
Source: Journal of Accountancy, September 1, 2002
The amount of gain resulting from the disposition of property that represents the recovery of depreciation expense that has been previously deducted on the Taxpayer’s (Exchangor’s) income tax returns.
The sale or disposition of real estate or personal property (relinquished property) and the acquisition of like-kind real estate or personal property (replacement property) structured as a tax-deferred, like-kind exchange transaction pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations in order to defer Federal, and in most cases state, capital gain and depreciation recapture taxes.
A written agreement between the Qualified Intermediary and Exchangor setting forth the Exchangor’s intent to exchange relinquished property for replacement property, as well as the terms, conditions and responsibilities of each party pursuant to the tax-deferred, like-kind exchange transaction.
The period of time during which the Exchangor must complete the acquisition of the replacement property(ies) in his or her tax-deferred, like-kind exchange transaction. The exchange period is 180 calendar days from the transfer of the Exchangor’s first relinquished property, or the due date (including extensions) of the Exchangor’s income tax return for the year in which the tax-deferred, like-kind exchange transaction took place, whichever is earlier, and is not extended due to holidays or weekends.
The taxpayer who is completing the tax-deferred, like-kind exchange transaction. An Exchangor may be an individual, partnership, LLC, corporation, institution or business.
The rules for like-kind exchanges do not apply to property held for personal use (such as homes, boats or cars); cash; stock in trade or other property held primarily for sale (such as inventories, raw materials and real estate held by dealers); stocks, bonds, notes or other securities or evidences of indebtedness (such as accounts receivable); partnership interests; certificates of trust or beneficial interest; chooses in action.
The price at which property would change hands between a buyer and a seller, neither having to buy or sell, and both having reasonable knowledge of all necessary facts.
An undivided fractional interest or partial interest in property.
The period of time during which the Exchangor must identify potential replacement properties in his or her tax-deferred, like-kind exchange. The period is 45 calendar days from the transfer of the Exchangor’s relinquished property and is not extended due to holidays or weekends.
A tax-deferred, like-kind exchange whereby the Qualified Intermediary and/or Exchange Accommodation Titleholder acquires title and holds title to the replacement property on behalf of Exchangor, during which time new or additional structures or improvements are constructed or installed on or within the replacement property. Also known as a Build-To-Suit Exchange.
For land or buildings, improvements (also known as capital improvements) are the expenses of permanently upgrading your property rather than maintaining or repairing it. Instead of taking a deduction for the cost of improvements in the year paid, you add the cost of the improvements to the basis of the property. If the property you improved is a building that is being depreciated, you must depreciate the improvements over the same useful life as the building.
An unrelated party who participates in the tax-deferred, like-kind exchange to facilitate the disposition of the Exchangor’s relinquished property and the acquisition of the Exchangor’s replacement property. The Intermediary has no economic interest except for compensation (exchange fee) it may receive for acting as an Intermediary in facilitating the exchange as defined in Section 1031 of the Internal Revenue Code. The Intermediary is technically referred to as the Qualified Intermediary, but is also known as the Accommodator or the Facilitator.
Section 1031 of the Internal Revenue Code allows an Exchangor to defer his or her capital gain tax and depreciation recapture tax when he or she exchanges relinquished property for like-kind or like-class replacement property.
Section 1033(a)(2)(A) generally provides that if property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat thereof) is compulsorily or involuntarily converted into money or property, then at the election of the taxpayer the gain (if any) shall be recognized except to the extent the taxpayer, during the period specified in § 1033(a)(2)(B), for the purpose of replacing the converted property, purchases other property similar or related in service or use to the property so converted.
The sale or disposition of real estate or personal property (relinquished property) and the acquisition of like-kind real estate or personal property (replacement property) structured as a tax-deferred, like-kind exchange transaction pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations in order to defer Federal, and in most cases state, capital gain and depreciation recapture taxes.
Property that is exchangeable with another property. Refers to the nature or character of the property and not to its grade or quality.
Members of Limited Liability Companies enjoy the limited liability offered by corporations and the minimum requirements of an S corporation. Limited Liability Companies typically contain two or more members and must file articles of organization with the secretary of state, although single-member LLCs are allowed in certain states.
An exchange that contains different types of properties, such as depreciable tangible personal property, real property, and intangible personal property. In a Mixed Property Exchange, relinquished properties are segmented in like-kind groups and matched with corresponding like-kind groups of replacement properties.
The depreciation method generally used since 1986 for writing off the value of depreciable property, other than real estate, over time. MACRS allows you to write off the cost of assets faster than the straight-line depreciation method.
When you assume debt on your replacement property that is less than the debt on your relinquished property, you receive mortgage boot or mortgage relief. Generally speaking, mortgage boot received triggers the recognition of gain and is taxable, unless offset by cash boot added or given up in the exchange. (See Boot.)
Disposition and/or acquisition of more than one property in a Section 1031 Exchange.
An exchange that entails receiving cash, excluded property and/or non-like-kind property and/or any net reduction in debt (mortgage relief) on the replacement property, as well as an exchange of qualified, like-kind property. In the case of a partial exchange, tax liability would be incurred on the non-qualifying portion and capital gain deferred on the qualifying portion under Internal Revenue Code Section 1031.
An association of two or more persons who engage in a business for profit. A partnership is created by an agreement, which does not have to be in writing. However, for the partnership to hold title in a partnership name, the partnership agreement must be signed, acknowledged and recorded. Tenancy in partnership allows any number of partners to have equal or unequal interest in property in relation to their interests in the partnership. Profits and liabilities are passed through to the members. In a limited partnership, each limited partner’s liability is limited to the amount of his or her investment. A limited partner only contributes money and is not actively involved in the business. A limited partnership must have one general partner who is personally liable for all debts. Partnership entities can complete exchanges. Partnership interests are not exchangeable. Difficulties sometimes occur in 1031 Exchanges when some partners want to enter into an exchange while others want to sell.
Exclusion from capital gain tax on the sale of principal residence of $250,000 for individual taxpayers and $500,000 for couples, filing jointly, under Internal Revenue Code Section 121. Property must have been the principal residence of the taxpayer(s) 24 months out of the last 60 months. In the case of a dual-use property, such as a ranch, retail store, duplex or triplex, the taxpayer can defer taxes on the portion of the property used for business or investment under Internal Revenue Code Section 1031 and exclude capital gain on the portion used as the primary residence under Section 121.
An escrow account, wherein the Escrow Agent (Diversified Title Insurance Company) is not the Exchangor or a disqualified person and that limits the Exchangor’s rights to receive, pledge, borrow or otherwise obtain the benefits of the tax-deferred, like-kind exchange cash balance and/or other assets from the sale of the relinquished property in compliance with the Treasury Regulations. The Qualified Escrow Account also ensures that the Exchangor’s exchange funds and/or assets are held as fiduciary funds and are therefore protected against claims from potential creditors of the Qualified Intermediary.
The actual contract or agreement between the Exchangor and the Exchange Accommodator Titleholder that outlines the terms for parking property pursuant to Revenue Procedure 2000-37.
An unrelated party who participates in the tax-deferred, like-kind exchange to facilitate the disposition of the Exchangor’s relinquished property and the acquisition of the Exchangor’s replacement property. The Qualified Intermediary has no economic interest except for compensation (exchange fee) it may receive for facilitating the exchange as defined in Section 1031 of the Internal Revenue Code. The Qualified Intermediary is the correct technical reference pursuant to Treasury Regulations, but the Qualified Intermediary can be known as the Accommodator, Facilitator or Intermediary.
Land and buildings (improvements), including but not limited to homes, apartment buildings, shopping centers, commercial buildings, factories, condominiums, leases of 30-years or more, quarries and oil fields. All types of real property are exchangeable for all other types of real property. In general, state law determines what constitutes Real Property.
A trust that invests primarily in real estate and mortgages while passing income, losses and other tax items to its investors. REITs are typically offered as shares or units (security derivatives) and are not eligible as replacement property in a 1031 Exchange.
The sale or disposition of real estate (relinquished property) and the acquisition of like-kind real estate (replacement property) structured as a tax-deferred, like-kind exchange transaction pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of Treasury Regulations in order to defer Federal, and in most cases state, capital gain and depreciation recapture taxes.
individuals and/or business entities determined by Section 267(b) of the Internal Revenue Code as having a special connection to the taxpayer/exchanger. A transaction between a related party and an exchanger may be restricted or prohibited in a 1031 exchange. Related parties include family members (spouses, children, siblings, parents or grandparents, but not aunts, uncles, cousins or ex-spouses) and a corporation in which you have more than a 50% ownership; or a partnership or two partnerships in which you directly or indirectly own more than a 50% share of the capital or profits.
The property to be sold or disposed of by the Exchangor in the tax-deferred, like-kind exchange transaction.
The like-kind property to be acquired or received by the Exchangor in the tax-deferred, like-kind exchange transaction.
A tax-deferred, like-kind exchange transaction whereby the replacement property is acquired first and the disposition of the relinquished property occurs at a later date.
Treasury Regulations provide certain Safe Harbors that assist Qualified Intermediaries and Exchangors in structuring tax-deferred, like-kind exchange transactions so they can be assured that no constructive receipt issues will be encountered during the exchange cycle.
When the buyer of a property gives the seller of the property a note, secured by a deed of trust or mortgage. In a Section 1031 Exchange, seller carry-back financing is treated as boot, unless it is sold at a discount on the secondary market or assigned to the seller as a down payment on the replacement property.
A tax-deferred, like-kind exchange transaction whereby the disposition of the relinquished property and the acquisition of the replacement property close or transfer at the same time. A Simultaneous Exchange is also referred to as a Concurrent Exchange.
The readjustment of the value of an appreciated asset for tax purposes upon inheritance. The higher market value of the asset at the time of inheritance is considered for tax purposes. When an asset is passed on to a beneficiary, its value is typically more than it was when the original owner acquired it. The asset receives a step-up in basis so that the beneficiary’s capital gains tax is minimized. A step-up in basis is applied to the cost basis of the property transferred at death.
Another common name for the tax-deferred, like-kind exchange transaction based on a court decision that was handed down (Starker vs. Commissioner) in 1979. The Ninth Circuit Court of Appeals eventually agreed with Starker that its delayed tax-deferred, like-kind exchange transaction did in fact constitute a valid exchange pursuant to Section 1031 of the Internal Revenue Code. This ruling set the precedent for our current day delayed exchange structures.
The postponement of taxes to a later year, usually by recognizing income or a gain at a later time. Tax-deferred, like-kind exchange transactions are a common method of deferring capital gain and depreciation recapture taxes.
The sale or disposition of real estate or personal property (relinquished property) and the acquisition of like-kind real estate or personal property (replacement property) structured as a tax-deferred, like-kind exchange transaction pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of Treasury Regulations in order to defer Federal, and in most cases state, capital gain and depreciation recapture taxes.
A separate, undivided fractional interest in property. A tenancy-in-common interest is made up of two or more individuals, who have equal rights of possession. Co-tenants’ interests may be equal or unequal and may be created at different times and through the use of different conveyances. Each co-tenant has the right to dispose of or encumber his or her interest without the agreement of the other co-tenants. He or she cannot, however, encumber the entire property without the consent of all of the co-tenants. In an Internal Revenue Code Section 1031 Exchange, an Exchangor may acquire a tenancy-in-common interest with one or more other investors, as his or her like-kind replacement property. For purposes of Internal Revenue Code Section 1031 Exchanges, a co-tenancy must only engage in investment activities, including supporting services that would typically accompany the investment. Co-tenants that are engaging in separate business activities are treated as partnerships by the I.R.S.
The entity that owns/holds title to property. In an Internal Revenue Code Section 1031 Exchange, the titleholder of the relinquished property must generally be the same as the titleholder of the replacement property. If a taxpayer dies prior to the acquisition of the replacement property, his or her estate may complete the exchange. When the acquisition and disposition entities bear the same taxpayer identification numbers, such as disregarded entities (single-member LLCs and Revocable Living Trusts), the exchange usually qualifies.
A triple net lease (NNN) is a lease agreement on a property whereby the tenant or lessee promises to pay all the expenses of the property including real estate taxes, building insurance and maintenance. These payments are in addition to the fees for rent and utilities, and all payments are typically the responsibility of the landlord in the absence of a triple, double, or single net lease.
A legal entity created by an individual in which one person or institution holds the right to manage property or assets for the benefit of someone else.
An individual or institution appointed to administer a trust for its beneficiaries.
Ensure Your Exchange Facilitator is Fully Qualified
Depreciation is an essential concept for understanding the true benefits of a 1031 exchange.
Depreciation is the percentage of the cost of an investment property that is written off every year, recognizing the effects of wear and tear. When a property is sold, capital gains taxes are calculated based on the property’s net-adjusted basis, which reflects the property’s original purchase price, plus capital improvements minus depreciation.
If a property sells for more than its depreciated value, you may have to recapture the depreciation. That means the amount of depreciation will be included in your taxable income from the sale of the property.
Since the size of the depreciation recaptured increases with time, you may be motivated to engage in a 1031 exchange to avoid the large increase in taxable income that depreciation recapture would cause later on. Depreciation recapture will be a factor to account for when calculating the value of any 1031 exchange transaction—it is only a matter of degree.
Some landlords don’t want to take the risk associated with legislation recently passed regarding a neighborhood where they may have had rental property. There are 47 bills prepared to be filed in the January 2021 session of the Texas House of Representatives. Each bill addresses a state’s right to hold a landlord accountable.
On the docket are bills that will impact:
Depending on the location of the rental property, some landlords are selling “high risk” properties and exchanging for more conservative properties with more stable cash flow.
