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Basics of a 1031 Exchange

Basics of a 1031 Exchange. The Wisconsin Real Estate Symposium Tues. September 18, 2007 Appleton, Wisconsin. Speaker Profiles. Ken Zacharias, CPA Shareholder, Green Bay Schenck Business Solutions 920-436-8700 Phone 920-436-7808 Fax Ken.Zacharias@schencksolutions.com.

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Basics of a 1031 Exchange

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  1. Basics of a 1031 Exchange The Wisconsin Real Estate Symposium Tues. September 18, 2007 Appleton, Wisconsin

  2. Speaker Profiles • Ken Zacharias, CPA Shareholder, Green Bay Schenck Business Solutions 920-436-8700 Phone 920-436-7808 Fax Ken.Zacharias@schencksolutions.com

  3. Speaker Profiles • Gabrielle Glass, MBA, CES Assistant Vice President, Midwest Region Regional Account Manager Investment Property Exchange Services 866-458-1031 Toll Free Phone 877-776-3128 Toll Free Fax gabrielle.glass@fnf.com

  4. Qualified Intermediary The use of a Qualified Intermediary is essential to completing a valid delayed exchange. The Qualified Intermediary performs several vital functions in an exchange. Acts as a Principal To qualify as an exchange a reciprocal trade or actual exchange must take place in each IRC §1031transaction. This means the Exchanger must enter into a written exchange agreement and assign to a Qualified Intermediary: (1) their interest as seller of the relinquished property and (2) their interest as buyer of the replacement property. By becoming an actual party to the exchange, a reciprocal trade takes place even when there are three or more parties involved in an exchange transaction (i.e. when the Exchanger is purchasing the replacement property from someone other than the buyer of their relinquished property). The Qualified Intermediary cannot be the Exchanger and must be an Independent Party (not DISQUALIFIED) to the transaction. The use of a Qualified Intermediary allows for “DIRECT DEEDING” of the properties involved in the exchange. This is only allowed with the use of a Qualified Intermediary.

  5. Qualified Intermediary (cont’d) • Holds Exchange Proceeds From Constructive Receipt • The Exchanger cannot have the right to receive, pledge, borrow, or otherwise receive the benefits of the exchange proceeds. If the Exchanger actually or constructively receives any of the proceeds from the sale of their relinquished property, those proceeds will be taxable as boot and the entire exchange may be jeopardized. • Prepares Legal Documentation • Several legal documents are necessary in order to properly complete an exchange, including an Exchange Agreement, two Assignment Agreements and Exchange Closing Instructions to each closer. • Provides Quality Service • Although the process is relatively simple, the rules are complicated and filled with potential pitfalls. An experienced Qualified Intermediary is essential to a smooth transaction.

  6. 1031 Exchange Industry Currently Unregulated • $300+ Million of Exchange Funds Stolen Early in 2007 by Shuttered Qualified Intermediaries • Financial Controls at IPX1031 • HR 3420 Introduced August 3. 2007 to Require Federally Insured Intermediaries • FEA Trade Association Petitions FTC for Consumer Protection Requiring Reserves or Letter of Credit, Bonding and Background Checks/Fingerprinting… • Visit www.1031.org

  7. What is a 1031 Exchange? • The regulations define a deferred exchange as: An exchange in which a taxpayer (the “exchanger”) transfers property held for productive use in a trade or business or for investment and later receives property to be held for either of these qualified purposes.

  8. Internal Revenue Code Section 1031 “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” §1031 DEFERS taxes . . . NOT a tax-free transaction. Investors complete tax-deferred exchanges to defer the capital gain tax on the disposition of their investment properties. The motivation to exchange often falls along standard risk-reward or cash flow-appreciation scales. If a seller of investment property plans to purchase and reinvest the funds in another investment property and has a capital gains tax consequence, the purchase contract should include exchange cooperation language.

  9. 1031 Exchange Tax Rates on Real Estate Sale • Federal Long-Term − Capital gain for individuals15% maximum − Capital gain for corporations 35% maximum − Real estate depreciation recapture 25% − Equipment and pre-1987 Section 1250 accelerated depreciation recapture (ordinary income rates) • Wisconsin − Equipment depreciation (ordinary income rates) − Capital gain and real estate depreciation – 60% exclusion from ordinary rates

  10. $200,000 $ 35,000 $ 58,181 $176,819 Comparing the Tax Consequence: A Sale Versus the Exchange of Investment Property To Estimate the Potential Capital Gain Tax: 1.Calculate the adjusted basis in the property: Original purchase price of the property Plus non-expensed capital improvements Minusdepreciation on improvements (27.5 yr. for 10 years for residential rental) Equals Adjusted Basis

  11. $550,000 $ 31,500 $176,819 $341,681 Comparing the Tax Consequence: A Sale Versus the Exchange of Investment Property(cont’d) 2. Use the adjusted basis to determine the total gain on the sale: Sales price of property Minus transactions costs Minusadjusted basis Equals Total Gain on Sale

  12. $341,681 $9,225 (A) Comparing the Tax Consequence: A Sale Versus the Exchange of Investment Property(cont’d) 3.Calculate the State Capital Gain: Total Gain on Sale Multiply by Wisconsin State capital gain tax rate,if any (assume 6.75%) after applying 60% exclusion

  13. $283,500 $42,525 (B) Comparing the Tax Consequence: A Sale Versus the Exchange of Investment Property(cont’d) • Calculate the Federal Long-Term Capital Gain: Total Gain Less Depreciation Recapture ($341,681 – 58,181 = $283,500) Multiply by Federal capital gain tax rate 15%

  14. $58,181 $14,545 (C) Comparing the Tax Consequence: A Sale Versus the Exchange of Investment Property(cont’d) 5.Calculate the Capital Gain due to Depreciation Taken: Capital Gain From Depreciation Taken Multiply by Federal 25% tax rate

  15. Comparing the Tax Consequence: A Sale Versus the Exchange of Investment Property(cont’d) 6. Total of Taxes A + B + C Equals the Capital Gain Tax Exposure that is Deferred Through a § 1031 Exchange. $66,295 Note: Exchanger may receive some credits at State level for Federal Taxes Paid

  16. Is There Gain or Loss? • Qualified Property • Purpose Requirement • Like-Kind Requirement • Holding Period “No Safe Harbor” • Exchange Requirement • Time Limits Requirements for a Valid 1031 Exchange Extensions Allowed under Rev Proc 2007-56, Section 17 for affected taxpayers in Federally Declared Disaster Areas- check IRS website for updates

  17. 1. Does the Exchanger really want replacement like kind property? 2. Will the tax benefit from using an exchange outweigh the transaction costs? When is an Exchange Appropriate? Before entering into an exchange the Exchanger must consider the following:

  18. Starker Case (1979) • Following Starker vs. U.S., Congress, in 1984, Congress enacted rules which permit non-simultaneous exchanges under certain conditions • Identification (45 days) • Close of Exchange (180 days or tax return due date) • 95% of exchanges are delayed structure

  19. 1. Reinvest all of the net proceeds from the relinquished property. 2. Obtain equal or greater financing on the replacement property than was paid off on the relinquished property (Replacement property debt can be offset with cash put into the exchange.). 3. Receive nothing in the exchange but like kind property. Basic 1031 Rules As a general “rule of thumb,” to obtain a deferral of the entire capital gain tax the Exchanger must: To the extent the Exchanger fails to observe these rules, they will be subject to capital gain taxes. Thumb-nail test for 100% deferral: => in value; => equity.

  20. No Tax is due. Balancing the Exchange Example I. Exchanger goes up in value, across in equity and up in mortgage: Relinquished Replacement $150,000 $225,000 Value Equity Mortgage $ 50,000 $50,000 $100,000 $175,000

  21. Value Equity Mortgage Tax is due on $10,000 of Cash Boot. Balancing the Exchange Example II. Exchanger goes up in value, up in mortgage and keeps $10,000 of net proceeds: Relinquished Replacement $150,000 $225,000 $ 50,000 $40,000 $100,000 $185,000

  22. Tax is due on the $25,000 of Mortgage Boot Balancing the Exchange Example III. Exchanger goes down in value, across in equity and down in mortgage: Relinquished Replacement $150,000 $125,000 Value Equity Mortgage $ 50,000 $ 50,000 $100,000 $ 75,000

  23. Tax is due on Mortgage Boot if TIC is a lower d/e ratio than asset exchanger traded Balancing the Exchange Example IV. Exchanger goes down in value, across in equity and down in mortgage: Relinquished Replacement $800,000 $ ? Value Equity Mortgage $200,000 $ 200,000 $600,000 75% d/e $ ? 55% d/e

  24. Vacation Homes and 1031 Exchanges • Can you sell your “second” home and do a 1031 exchange? • Favorable 2005 Tax Court Case Rivera v. Commissioner (not a 1031 ruling) • Unfavorable Tax Court Memorandum 2007-134 Moore v. Commissioner-course of conduct personal use (never rented) so prospect for appreciation on resale was not primary intent for Georgia residents • How to prove investment intent? • Rental Activity • Personal-Use/Dormant (avoid wear and tear) • Depreciation Schedule

  25. 1. Transfer due to death or involuntary conversion. 2. Transfer where it is established to the satisfaction of the IRS that there is no tax avoidance intent. Related Party Issues Related parties can complete an exchange if both parties hold onto the property they received for 2 years. If either related party disposes of their property prior to the 2-year holding period, the entire transaction will be taxable to both parties in the year of disposition. The 2 year period is tolled during the term of any “puts” or “calls” on the property. IRC Section 1031 (f). Exceptions to the 2-Year Holding Period: Note: Exchanges structured to avoid these rules will not qualify for tax deferral.

  26. 1. Exchangers spouse, siblings, descendents or ancestors 2. Two corporations that are members of same controlled group 3. A grantor, fiduciary or beneficiary of any trust 4. Related C corporation, S corporation or partnership in which there is more than a 50% ownership or controlling interest [IRC Sections 267 (b) and 707 (b) (1)] Related Party Issues (cont’d) Related parties include: Note: Exchanges structured to avoid these rules will not qualifyfor tax deferral.

  27. Buyer of Relinquished Property is the Related Party — Will be recognized, with the only limitation being that the Taxpayer completes the purchase of Replacement Property. We now have guidance that the Related Party Buyer does not need to his or her own exchange and has no two year holding requirement. PLR 200709036, PLR 200712013, PLR 200616005. Related Party Exchange Scenarios

  28. Seller of Replacement Property is Related Party — Will not qualify, even if Exchanger uses an Intermediary. IRS will restructure as a three party exchange: Exchanger and related party seller first exchange properties, then related party seller immediately sells relinquished property to buyer for cash without holding property for 2 years. However, if related party seller reinvests in a tandem 1031 (rather than cashing out), the Exchanger’s 1031 exchange will be respected. • PLR 9748006 The Mommy TAM;PLR 200126007 • 3. Rev Rul 2002-83; PLR 2004-40002; PLR 2006-16005 Related Party Exchange Scenarios

  29. 1. Is a “Related Party” to the Exchanger; OR 2. Is related to the Exchanger by substituting 10% for 50% (IRC Sections 267 (b) and 707 (b) for related corporations, partnerships or trusts); OR Disqualified Parties A disqualified party is a person or entity who:

  30. Disqualified Parties (cont’d) 3. Within the 2 years preceding the transfer of the relinquished property, the person acted as the Exchanger’s: • Employee • Real Estate Broker or Agent • Attorney • Investment Bank or Broker • Accountant Exceptions - if the person or entity only provides the Exchanger with: A. Routine financial, trust, title insurance or escrow services; or B. Services solely with respect to the exchange of property. Note: To obtain the Safe Harbor protection against constructive receipt of the exchange funds a disqualified person or entity may not act as an intermediary for the exchange.

  31. Bill Introduced to Double Exchange Deadlines • Rep. Adrian Smith of Nebraska (R) Introduced HR 3039 Jul 12, 2007 Farmland Relief Act of 2007 90 days to Identify and 360 Days to Reinvest

  32. 1031 Exchanges • Question and Answer Period

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