ESTABLISHED IN 1976

SECTION 1031 EXCHANGE RISK FACTORS AND SPECIAL CONSIDERATIONS

There are risks and complex tax consequences involved in a 1031 Exchange. For a successful exchange, strict adherence to Section 1031 is imperative. It is important that you understand the risks and rules associated with a 1031 Exchange and seek guidance from your tax advisor, counsel or qualified intermediary. Such risks include the possible failure to qualify for Section 1031 treatment and the subsequent necessity to pay taxes on the exchange.

WHAT TO KNOW ABOUT REAL ESTATE INVESTMENT RISKS

Investors will be subject to all of the risks generally associated with the ownership of real estate, including: the uncertainty of cash flow to meet financial obligations; adverse changes in local and national economic conditions; changes in the investment climate for local real estate, such as declining values or increased supply of residential complexes; changes in interest rates and the availability of permanent mortgage funds; changes in real estate tax rates and other operating expenses, changes in local government rules; and acts of God or other disasters, which may result in uninsured losses brought on by earthquakes, fires, and floods.

REAL ESTATE INVESTMENT INTENT

Both the property sold (Relinquished Property) and the property purchased (Replacement Property) must be held for investment or productive use in a trade or business. None of the properties exchanged can be your personal residence.

1031 TAX EXCHANGE TIME FRAMES

Replacement Property(ies) must be identified within 45 days of the sale of the Relinquished Property and must be purchased within 180 days of the sale of the Relinquished Property.

IDENTIFICATION OF REPLACEMENT PROPERTIES

You can identify up to three Replacement Properties of any value during the Identification Period, or more, subject to certain conditions.

WHAT IS “LIKE-KIND” IN A DST or 1031 EXCHANGE

The Replacement Property must be "Like-Kind" to the Relinquished Property. Any type of real property is Like-Kind to other real property. For example, a shopping center is like-kind to an investment condominium and a warehouse is like-kind to raw land.

COMMON PROPERTY OWNERSHIP

The party selling the Relinquished Property must be the same party purchasing the Replacement Property or a disregarded entity with respect to that party.

REAL ESTATE PROPERTY VALUE

You must purchase a property of equal or greater value to the property sold or pay tax on the difference.

1031 EXCHANGE VALUES

You must use all of the cash proceeds from the sale of your Relinquished Property toward the purchase of Replacement Property or pay tax on the difference. If you offer seller financing on your Relinquished Property, you may be subject to tax as the principal is repaid.

QUALIFIED INTERMEDIARY FOR TAX DEFERRAL

To qualify for safe harbor tax deferral, sale proceeds must be held by a Qualified Intermediary between the sale of the Relinquished Property and the purchase of the Replacement Property.

FAILURE TO CLOSE ON REPLACEMENT PROPERTY

In order to complete a 1031 exchange and close on the replacement property in a subsequent tax year to the year in which the relinquished property is sold, it is absolutely necessary that the taxpayer file a Form 4868 Application for Extension to File Tax Return. Otherwise, the intended exchange will not qualify for tax deferral, but will instead be treated as a taxable sale made on the installment method.

In the event that the taxpayer fails to close within the 180 day deadline, in effect the taxpayer has underreported his income in the year of disposition, and thus would owe interest and penalties. One benefit of the §1031 Regulations is that they provide that if the taxpayer intended in good faith to complete an exchange, the taxpayer is treated as receiving the consideration for the sale of the relinquished property under the installment method (i.e. on the date that the taxpayer received a refund of his money held by the Qualified Intermediary). There may not be automatic interest or penalties imposed if the taxpayer intended the property to be exchanged.

DEPRECIATION RECAPTURE RULES AND TAX RATES

DISPOSITION OF CODE SECTION 1250 PROPERTY

Non-residential real property is 27.5 year depreciable property that has been depreciated using the straight-line method of depreciation since 1986. When 1250 property that has been in service for over one year is disposed of, there are three (3) possible tax rates:

1. ORDINARY INCOME RATES FOR EXCESS DEPRECIATION RECAPTURE

Ordinary income rates (up to 37%) apply for excess depreciation recaptured. Excess depreciation is that portion of depreciation that exceeds straight-line depreciation. In many cases, since 1250 property has been required to be depreciated in accordance with straight-line depreciation since 1986, there will be no excess depreciation over straight-line depreciation. However, even during the post-1986 time period, certain structures and improvements to property, such as sidewalks, driveways, fencing, park-ing, and landscaping, have been depreciable over 15 years, using 150% declining balance method. This treatment will cause excess depreciation recapture on the disposition of 1250 property on these improvements.

2. 25% TAX RATE ON SECTION 1250 UNRECAPTURED GAIN

Section 1250 depreciation, which is deducted over 27.5 years using the straight-line method, will generate accumulated depreciation over the years. This accumulated 1250 depreciation is taxed at a flat rate of 25% upon disposition, up to a maximum of the amount of the recognized gain.

3. 0%, 15% OR 20% CAPITAL GAINS TAX RATE

For individuals, estates, and trusts, a number of different tax rates can apply to net capital gains for regular income tax and alternative minimum tax (AMT) purposes. For tax years beginning in 2018, net capital gains and qualified dividends are taxed as follows:

0 percent if taxable income is less than $77,200 ($78,750 for 2019) if married filing jointly or surviving spouse, less than $51,700 ($52,750 for 2019) if head of household, less than $38,600 ($39,375 for 2019) if single or married filing separately, and $2,600 ($2,650 for 2019) for an estates or trust;
15 percent if taxable income is less than $479,000 ($488,850 for 2019) if married filing jointly or surviving spouse, less than $452,400 ($461,700 for 2019) if head of household, less than $425,800 ($434,550 for 2019) if single, less than $239,500 ($244,425 for 2019) if married filing separately, and less than $12,700 ($12,950 for 2019) for an estate or trust;
20 percent if taxable income is at least $479,000 ($488,850 for 2019) if married filing jointly or surviving spouse, at least $452,400 ($461,700 for 2019) if head of household, at least $425,800 ($434,550 for 2019) if single, at least $239,500 $244,425 for 2019) if married filing separately, and at least $12,700 ($12,950 for 2019) for an estate or trust.

These graduated capital gains tax rates apply to taxable gain, after first applying the ordinary income recapture rate on excess depreciation, and then the regular Section 1250 depreciation gain at 25%. Any untaxed gain left is then taxed at one of these capital gains rates.

RECAPTURE IN 1031 REAL ESTATE TRANSACTIONS

The foregoing tax rates apply to boot received in a §1031 transaction, to the extent that there is gain to be recognized. The order of taxation of boot runs consecutive from items one to three (i.e. taxable gain from the transaction starts with excess recapture, then the 25% rate is applied to 1250 depreciation, and finally one of the capital gains rates is applied to any taxable boot that is left).

EXCHANGE FOR NON-DEPRECIABLE PROPERTY

When depreciable section 1250 property is exchanged for non-depreciable real property, such as raw land, then excess depreciation and 1250 unrecaptured gain is recaptured and is taxable at the time of the exchange, even though no taxable boot is received in the exchange. This is a tax trap that few taxpayers are aware of.

1031 TAX EXCHANGE TIMELINE - 45 DAYS

You have 45 days from the sale of your Relinquished Property to identify your potential Replacement Properties. You can generally identify up to 3 properties or more, subject to the Rules of Identification. You do not have to have the identified property or properties under contract in order to identify them.

REAL ESTATE PROPERTY HOLDING PERIODS - GENERAL RULES

HOLDING PERIOD

The words "held for" are a key element of the definition of property qualifying for exchange under §1031. Property acquired for an exchange is not "held for" the prescribed purpose and cannot be exchanged tax free. How long one must "hold" property before an exchange is uncertain.

Some commentators have believed that the taxpayer should hold each exchange property for at least two (2) years. In such case, the relinquished property should have been held as an investment or for business purposes prior to the exchange, and the replacement property should likewise remain as investment or business use property for two years following its acquisition. The Internal Revenue Service has granted a private letter ruling (PLR 8429039) that permitted an exchange to qualify under Section 1031 where the taxpayer held the replacement property for a minimum holding period of two (2) years. Private letter rulings only apply to the taxpayer who applies for them, but many tax practitioners believe that private letter rulings often represent the Internal Revenue Service's interpretation of a particular issue. Under Code Section 1221, the holding period for a taxpayer receiving capital gains treatment on a sale of real property is one (1) year. Section 1031 does not currently have a set minimum holding period; however in 1989 the House of Representatives passed a Bill (Section 1106 of HR Rep No 3150, 100th Cong, 1st Session) that would have required a one (1) year holding period for both the replacement property and the relinquished property. Fortunately for taxpayers, the final 1989 Omnibus Budget Reconciliation Act omitted the House Bill.

RELINQUISHED PROPERTY HOLDING PERIOD

In Rev. Rul. 84-121, the Internal Revenue Service asserted its position that relinquished property acquired and exchanged soon after its acquisition will not qualify for a Section 1031 exchange, because the taxpayer is deemed to have acquired the property with the intent to dispose of it, rather than to hold it for investment or business purposes. Some of the courts, especially those in the Western States have construed Section 1031 much more liberally. In Bolker v. Commissioner, 760 F.2d 1039 (9TH Cir. 1985), the court per-mitted a holding period of only three (3) months to qualify for a 1031 exchange. The court opined that the taxpayer satisfied the holding and intention requirements by owning the property without the intent to liquidate the investment or to use it for personal pursuits.

REPLACEMENT PROPERTY HOLDING PERIOD

The courts have not been so liberal when examining a quick disposal of replacement property, or a speedy conversion of replacement property to the taxpayer's personal use. Treasury Regulation 01.1002-1(c) states that the Internal Revenue Service may consider subsequent dispositions of replacement property by the taxpayer to be evidence that the replacement property was not acquired to be "held" for business or investment purposes. In Click v. Commissioner, 78 T.C. 225 (1982) the taxpayer exchanged a farm for two (2) residences, allowing her children to live in them for seven (7) months, and then made a gift of the residences to her children. The U.S. Tax Court ruled and the Fourth Circuit Court of Appeals affirmed) that the taxpayer would not qualify for Section 1031 treatment on the exchange of the farm, because she did not intend for the residences to be held for investment or business use.

SPECIAL FIVE (5) YEAR HOLDING PERIOD

Recently enacted subsection (d)(10) of Code Section 121 does not allow the exclusion of gain if the principal residence was acquired in a Section 1031 like-kind exchange in which any gain was not recognized within the previous five years. This means that the holding period for realizing the $500,000 exclusion of gain on replacement property is a minimum of five (5) years following the date that the taxpayer received the new property from the 1031 Exchange.

IS BOOT TAXABLE IN A 1031?

Property the taxpayer receives in the exchange which does not qualify as "like-kind property". Cash proceeds are the most common form of boot. Boot is subject to taxation.

WHAT IS THE 1031 EXCHANGE NAPKIN RULE

You must buy a Replacement Property of equal or greater value to the Relinquished Property in order to completely defer the applicable capital gains tax. If you purchase a property of lesser value, you will be responsible for any tax on the difference. You must also use all the cash proceeds from the sale on your purchase in order to completely defer the applicable capital gains tax. If you do not use all your proceeds on the purchase, you will be responsible for any tax on the difference.

ORIGINAL BASIS

The purchase price of a property. It is used to calculate capital gains or losses for tax purposes.

THREE REAL ESTATE PROPERTY RULE

The Exchanger may identify up to three properties, without regard to their value.

200% PERCENT RULE IN 1031 EXCHANGES

The Exchanger may identify more than three properties, provided their combined fair market value does not exceed 200% of value of the Relinquished Property.

95% PERCENT RULE

The Exchanger may identify any number of properties, without regard to their value, provided the Exchanger acquires 95% of the fair market value of the properties identified.