EXCHANGE TERMINOLOGY

"UNDERSTANDING COMMON EXCHANGE TERMINOLOGY"

To many real estate investors, the buzz words often used to describe different aspects of a tax deferred exchange can be confusing. For example, doesn't something with two ‘downlegs' and three ‘uplegs' sound a lot more like a lopsided creature than an exchange transaction? Reflected below are brief descriptions of commonly used exchange terminology:

ACTUAL RECEIPT: Physical possession of proceeds.

BOOT: "Non like-kind" property received; "Boot" is taxable to the extent there is a capital gain.

CASH BOOT: Any proceeds actually or constructively received by the Exchanger.

CONSTRUCTIVE RECEIPT: Although an investor does not have actual possession of the proceeds, they are legally entitled to the proceeds in some manner such as having the money held by an entity considered as their agent or by someone having a fiduciary relationship with them. This creates a taxable event.

DIRECT DEEDING: Transfer of title directly from the Exchanger to Buyer and from the Seller to Exchanger after all necessary exchange documents have been executed.

EXCHANGER: Entity or taxpayer performing an exchange.

EXCHANGE AGREEMENT: The written agreement defining the transfer of the relinquished property, the subsequent receipt of the replacement property, and the restrictions on the exchange proceeds during the exchange period.

EXCHANGE PERIOD: The period of time in which replacement property must be received by the Exchanger; Ends on the earlier of 180 calendar days after the relinquished property closing or the due date for the Exchanger's tax return (If the 180th day falls after the due date of the Exchanger's tax return, an extension may be filed to receive the full 180 day exchange period.)

IDENTIFICATION PERIOD: A maximum of 45 calendar days from the relinquished property closing to properly identify potential replacement property(s).

LIKE-KIND PROPERTY: Any property used for productive use in trade or business or held for investment; Both the relinquished and replacement properties must be considered "like-kind" to qualify for tax deferral.

INTRO TO DELAYED EXCHANGES

"THE BENEFITS OF §1031 TAX DEFERRED EXCHANGES "

EXCHANGES ARE A POWERFUL TAX STRATEGY

Tax deferred exchanges have been a part of the tax code since 1921 and are one of the last significant tax advantages remaining for real estate investors. One of the key advantages of a §1031 exchange is the ability to dispose of a property without incurring a capital gain tax liability, thereby allowing the earning power of the deferred taxes to work for the benefit of the investor (called an "Exchanger") instead of the government. In essence, it can be considered an interest-free loan from the IRS. 

BASIC TAX EXCHANGE REQUIREMENTS

The IRS allows up to a maximum of 180 calendar days between the sale of the relinquished property and the purchase of the replacement property. Within the 180 day "exchange period," the investor must also properly identify suitable replacement properties within 45 calendar days of closing on the sale of the relinquished property. There are a number of requirements which need to be met to qualify for tax deferral under the tax code:

Requirement #1: Both the "relinquished" and "replacement" properties must be held for investment or used in a business. The IRS uses the term "like-kind" to describe the type of properties that qualify. Any property held for investment can be exchanged for any other "like-kind" property held for investment. This definition covers a vast variety of developed and undeveloped real estate. Properties which are clearly not like-kind are an investor's primary residence or property "held for sale."

The relinquished and replacement properties need not have identical functions (i.e. both be residential rentals or commercial strip centers). The key issue is that the Exchanger can substantiate that both properties were "held for investment."

Requirement #2:  The IRS requires an investor to identify the replacement property(s) within 45 days from closing on the sale of a relinquished property. The 45 day Identification Period begins on the closing date, and the replacement property(s) must be properly identified in a letter signed by the Exchanger. Exchangers have a number of ways to properly identify properties. They may identify up to three replacement properties without regard to their total fair market value (Three Property Rule).  Alternatively, they can identify an unlimited number of replacement properties, if the total fair market value of all properties is not more than twice the value of the property sold (200% Rule). An Exchanger can not meet either of these rules if they acquire 95%of the aggregate fair market value of all identified replacement properties.

Requirement #3: Close on the replacement property by the earliest of either: 180 calendar days after closing on the sale of the relinquished property or the due date for filing the tax return for the year in which the relinquished property was sold (unless an automatic filing-extension has been obtained). Example: If an Exchanger closes on the relinquished property on December 27, the exchange period will end on April 15 (assuming this is the due date for their tax return). In this case, they would have to close on the replacement property (or file the appropriate extension) by April 15. Exchangers may choose to close both transactions within a shorter period of time, thereby avoiding the potential hardship of the 45/180 day time limits.

Requirement #4: The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved middleman called a "Qualified Intermediary." The Qualified Intermediary documents the exchange by preparing the necessary paperwork (Exchange Agreement and other documents), holding proceeds on behalf of the Exchanger, and structuring the sale of the relinquished property and purchase of the replacement property.

Note: To defer all capital gain taxes, an Exchanger must buy a property or properties of equal or greater value (net of closing costs), reinvesting all net proceeds from the sale of the relinquished property. Any funds not reinvested, or any reduction in debt liabilities not made up for with additional cash from the Exchanger, is considered "boot" and is taxable. Example: Stewart sells his duplex, which he held for investment, for $160,000. A hundred calendar days later he closes on a different duplex, which he will hold for investment, for $110,000.  Stewart receives the $50,000 in excess funds for his child's education.  Stewart must pay capital gain taxes on $50,000. (In this example, Stewart chose to take some money out of his exchange and pay the capital gain taxes.)

WHEN ARE CAPITAL GAIN TAXES PAID?

Maybe never. Many investors mistakenly believe they will "have to pay the taxes sometime" so they might as well just sell. Quite often, this is a bad investment decision. The tax on an exchange is deferred into the future and is only recognized when an investor actually sells the property for cash instead of performing an exchange. Investors can continue to exchange properties as often and for as long as they wish, thus moving up to better investments and putting off the taxes for many years.

To learn more:

1. Call Asset Preservation toll-free at 800-282-1031

2. Visit API's website at http://www.apiexchange.com/.

CALCULATING CAPITAL GAIN

"ANALYZE THE BENEFITS OF AN EXCHANGE
BEFORE YOUR SELL"

This is a highly simplified way of figuring capital gain and capital gain tax liability. In 2007-2008 there have been changes that make calculating capital gain more complex. The model below is a simplified form for getting a ballpark figure on capital gain and the tax liability. The taxpayer's accountant/CPA is critical in determining the ACTUAL tax liability.

Capital Gain Tax Calculator

Gross Equity x 4 =

__________

EXCHANGE BASICS

"AN OVERVIEW OF SEVERAL REQUIREMENTS 
FOR TAX DEFERRAL"

WHAT IS IRC SECTION 1031?

Section 1031 of the Internal Revenue Code allows an owner of investment property to exchange property and defer paying federal and state capital gain taxes (15%+ applicable state taxes) if they purchase a like-kind property following the rules and regulations of the Internal Revenue Code. This allows investors to use all of their proceeds from their sale to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate into one property.

WHAT IS LIKE-KIND PROPERTY?

There is some confusion regarding what type of property qualifies for a §1031 tax deferred exchange. The Internal Revenue Code Section 1031 states that "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." Like-Kind property can include, but is not limited to, any of the following, provided it is held for investment:

- Single Family Rental
- Duplex
- Apartment
- Commercial Property
- Raw Land

For example, a single family rental can be exchanged for raw land, or apartments or a commercial building. In addition, properties can be exchanged anywhere within the United States.

DOES AN EXCHANGE NEED TO BE SIMULTANEOUS?

No, contrary to what most owners envision, a §1031 tax deferred exchange is rarely a two-party swap. Most exchanges are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of their replacement property. They must identify the potential replacement property(s) within 45 days from closing on their relinquished property.

WHEN IS A §1031 EXCHANGE APPLICABLE?

It is applicable whenever a property owner intends to SELL any property that is not their primary residence (and falls under the definition of like-kind) and plans to BUY another like-kind property within 180 calendar days following the closing of their relinquished property. Paramount to any exchange is a competent and experienced Intermediary. Asset Preservation is the entity which structures, consults, guides and documents the exchange transaction from beginning to end.

THIS INFORMATION IS PROVIDED FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY. TAXPAYERS ARE STRONGLY RECOMMENDED TO SEEK THE ADVICE OF THEIR INDIVIDUAL TAX/LEGAL ADVISORS REGARDING THEIR SPECIFIC CIRCUMSTANCES. 

FIVE REASONS TO EXCHANGE

"INVESTORS CAN MEET MANY
OBJECTIVES UNDER IRC §1031"

Section 1031 tax deferred exchanges continue to increase in popularity as more investors nationwide discover the wide range of investment objectives that can be easily met through exchanging.

I. PRESERVATION OF EQUITY

A properly structured exchange provides real estate investors with the opportunity to defer 100% of both Federal and State capital gain taxes. This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash! Most often, the capital gain taxes are deferred indefinitely because many investors continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with each exchange!

II. LEVERAGE

Many investors exchange from a property where they have a high equity position or one that is "free and clear" into a much more valuable property. A larger property produces more cash flow and provides greater depreciation benefits, which therefore increase an investor's return on their investment.

III. DIVERSIFICATION

Exchangers have a number of opportunities for diversification through exchanges. One option is to diversify into another geographic region such as exchanging of one apartment building in Denver, Colorado for two additional apartments - one in Los Angeles, California and the other in Dallas, Texas. Another diversification alternative is acquiring a different property type such as exchanging from several residential units to a small retail strip center.

IV. MANAGEMENT RELIEF

Many investors accumulate several single family rentals over the years. The on-going maintenance and management of what can be a far-reaching group of properties can be lessened by exchanging these properties for one property better suited to on-site maintenance and management. Exchanging into a single apartment complex with a resident manager is a good example of this strategy.

V. ESTATE PLANNING

Often a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property which they can either hold or sell. Call the knowledgeable exchange professionals at Asset Preservation for a complimentary consultation regarding your specific investment objectives.

THIS INFORMATION IS PROVIDED FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY. IT IS NOT TAX/LEGAL ADVICE. TAXPAYERS ARE STRONGLY RECOMMENDED TO SEEK THE GUIDANCE OF THEIR INDIVIDUAL TAX/LEGAL ADVISORS REGARDING THE SPECIFIC CIRCUMSTANCES OF THEIR TRANSACTION.

A SALE VS. AN EXCHANGE

"ANALYZE THE BENEFITS BEFORE SELLING"

The benefits of IRC Section 1031 exchanges can be tremendous! Investors are often able to defer thousands of dollars in capital gain taxes, both at federal and state levels. If the requirements of a valid §1031 exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it. This essentially results in a long-term, interest-free loan from the IRS.

AN EXAMPLE

An investment property owner sells a rental property for $400,000. The owner originally purchased the property for $200,000. There is $200,000 of debt and the property has been fully depreciated.  The capital gain is approximately $350,000 (assuming 75% of the property is depreciable). If the investor does not do an exchange, federal capital gain taxes would be:

The state taxes owed (where applicable) would need to be added to the federal taxes due. Assuming the property owner sold in California, the following additional taxes would need to be paid:

The next comparison analyzes the value of the new property that could be acquired in a sale versus an exchange. The comparison assumes an investor makes a 25% down payment and finances 75% of the property (75% loan-to-value ratio).

SALE VS. AN EXCHANGE

This example illustrates that the real power of a tax deferred exchange is not just the tax savings - it is the increase in purchasing power generated by this tax savings!

ADVANTAGES OF AN EXCHANGE

1. Preservation of equity

2. Maximize return on investment

3. Increased cash flow from larger properties

WHAT AGENTS NEED TO KNOW

"WHAT RESIDENTIAL REAL ESTATE AGENTS
NEED TO KNOW"

§1031 tax deferred exchanges provide real estate agents a tremendous opportunity to increase commissions! Conversely, by not understanding a few key exchange concepts, real estate agents often can unknowingly incur increased liability. We have provided answers to questions frequently asked by residential real estate agents.

Q: WHEN SHOULD THE INTERMEDIARY BE CONTACTED?

A: As soon as the contract is signed. Asset Preservation, a leading national Qualified Intermediary, does not charge a cancellation fee if the transaction does not close.

Q: WHAT LANGUAGE SHOULD BE ADDED TO THE PURCHASE AND SALE AGREEMENT?

A: The language below is satisfactory in establishing the Exchanger's intent to perform a tax deferred exchange and releases the other parties from costs or liabilities as a result the exchange:

"Buyer is aware that Seller intends to perform an IRC Section 1031 tax deferred exchange. Seller requests Buyer's cooperation in such an exchange and agrees to hold Buyer harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Buyer agrees to an assignment of this contract to Asset Preservation, Inc. by the Seller."

Q: WHO SHOULD I CONTACT TO SET UP AN EXCHANGE?

A: You can call either National Headquarters toll-free (800) 282-1031 or your local Division Manager.

Q: WHAT SHOULD BE DONE SO I DO NOT INCUR A POTENTIAL ADDITIONAL LIABILITY?

A: Every time you list any property that may have been held for investment (i.e. rental house, second or vacation home, duplex, land, etc.), recommend that your client talk to their legal and/or tax advisors about the benefits of a §1031 exchange. You can also suggest that your client call an experienced Qualified Intermediary. Exchanges have been a part of the tax code since 1921. As a licensed professional, a real estate agent can't afford to say "I don't know anything about exchanges because I specialize in residential."

Q: CAN EXCHANGES BE SET UP AT THE LAST MINUTE?

A: Yes, as long as the transaction has not closed. Asset Preservation can successfully convert a sale into an exchange. Documents can be prepared and faxed to the title company within a matter of hours.

Q: IF MY CLIENTS HAVE MORE QUESTIONS, WHERE CAN THEY GO FOR MORE INFORMATION?

A: Call Asset Preservation's toll-free number or visit our Internet site: http://www.apiexchange.com/.

VACATION HOME EXCHANGES
"BARRY E. MOORE V. COMM., T.C. MEMO. 2007-134"

Many sellers who own vacation homes want to explore the potential of performing an Internal Revenue Code (IRC) Section 1031 tax deferred exchange. See Asset Preservation's handout entitled, "Vacation Home Exchanges - Basics", for an introduction to issues involved in these types of exchanges. One Tax Court decision, Barry E. Moore v. Commissioner, T.C. Memo. 2007-134, provides a significant case concerning whether a vacation home would be considered "held for investment." The court's analysis also indicates certain tax planning strategies investors may wish to use when considering exchanging a vacation home held for investment.

LAKEFRONT PROPERTY EXCHANGED FOR LAKEFRONT PROPERTY

In Moore v. Comm., the taxpayers exchanged a lakefront vacation property with a mobile home in Lincoln County, Georgia (the Clark Hill property) for a lakefront property with a larger five bedroom and 4.5 bath house on 1.2 acres in Forsyth County, Georgia (the Lake Lanier property). The taxpayers in this case argued that both of these properties were held for investment, specifically for long-term appreciation purposes, and thus qualified for tax deferral under IRC §1031. However, based upon the taxpayer's significant personal use of the property, the court concluded that both the relinquished Clark Hill property and the replacement Lake Lanier property should be viewed as held primarily for the taxpayer's personal use and enjoyment. In reaching this conclusion, the court considered the following: (i) the taxpayers never rented or attempted to rent the property to others; (ii) the taxpayers deducted mortgage interest as a "home mortgage interest" expense rather than investment interest expense; (iii) the taxpayers did not take (and probably did not qualify for) depreciation or other tax benefits associated with an investment property under the Internal Revenue Code, including deductions for maintenance expenses.

The court accepted the taxpayer's argument that both the relinquished and replacement properties were held for appreciation but concluded that "...the mere hope or expectation that the property may be sold at a gain cannot establish investment intent if the taxpayer uses the property as a residence. The proposition that holding a primary or secondary (e.g. vacation) residence motivated in part by an expectation that the property will appreciate in value is insufficient to justify the classification of that property as property ‘held for investment' under Section 212(2) and, by analogy, Section 1031. There is no convincing evidence that the properties were held for the production of income, and there is convincing evidence that petitioners and their families used the properties as vacation retreats. The evidence overwhelmingly demonstrates that petitioners' primary purpose in acquiring both the Clark Hill and Lake Lanier properties was to enjoy the use of those properties as vacation homes, i.e. as secondary personal residences."

ISSUES TO CONSIDER WHEN CONTEMPLATING
A VACATION HOME EXCHANGE

Has the property been shown on one or more tax returns as an investment property or property used in a trade or business, including the characterization of mortgage interest as deductible investment interest expense or business expense? Is the improved property eligible for depreciation? Is the property used substantially as a personal vacation or second home? The characterization of residential property as held primarily for investment or for use in a trade or business is often unclear and must be made with reference to the taxpayer's use of the potential exchange property. Based on recent IRS announcements, we expect to see greater scrutiny of reported tax deferred exchanges under Section 1031. Accordingly, consult your legal or tax advisor before engaging in a tax deferred exchange.

THIS INFORMATION IS PROVIDED FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY. THIS DOES NOT CONSTITUTE TAX/LEGAL ADVICE. TAXPAYERS ARE STRONGLY RECOMMENDED TO SEEK ADVICE FROM THEIR INDIVIDUAL TAX/LEGAL ADVISORS REGARDING THE SPECIFIC CIRCUMSTANCES OF THEIR EXCHANGE.

VACATION HOME GUIDANCE
"REVENUE PROCEDURE 2008-16 CREATES SAFE HARBOR"

Revenue Procedure 2008-16 (the "Procedure") creates a safe harbor definition of investment property applicable to exchange transactions closing after March 10, 2008 that involve the transfer of property consisting of a dwelling unit (defined below) and/or the acquisition of a dwelling unit as replacement property. In short, the IRS will not challenge whether a residential property or vacation home property is held for productive use in a trade or business or for investment if certain specified ownership and use requirements are met. This safe harbor Procedure provides useful guidance on the characterization of vacation property and may also be useful for planning purposes such as the conversion of a principal residence into a qualifying relinquished property.

REQUIREMENTS OF REVENUE PROCEDURE 2008-16

A dwelling unit is defined as any real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including a sleeping space, bathroom and cooking facilities (e.g., a residential property).

The IRS will not challenge whether a dwelling unit qualifies as §1031 exchange property held for productive use in a trade or business or for investment if: (1) the relinquished property is owned by the taxpayer for at least 24 months immediately prior to the exchange and a replacement property is owned for at least 24 months immediately after the exchange (the "qualifying use period") and (2) within each of the two 12 month periods constituting the qualifying use period, the taxpayer must:

(a) Rent the property to another person or persons at a fair rental for 14 or more days; and

(b) The taxpayer's personal use of the dwelling unit cannot exceed the greater of 14 days or 10 percent of the number of days during the 12 month period the dwelling unit is rented at a fair rental.

Under the Procedure, personal use of a dwelling unit occurs on any day in which the taxpayer is deemed to use the property for personal purposes under §280A(d)(2) (taking into account §280A(d)(3) but not §280A(d)(4)). Thus, personal use includes:

(1) use by the taxpayer or any other person who has an interest in the property or by a family member; (2) use by any individual who uses the unit under an arrangement which enables the taxpayer to use some other dwelling unit (whether or not a rental is charged for the use of such other unit) ; or (3) use by any other individual if rented for less than fair market value. A taxpayer can rent the property to a family member if the family member uses the property as a primary residence and the family member pays fair market rent.  Whether a dwelling unit is rented at a fair rental is determined based on all the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the parties to the rental agreement are taken into account.

SAFE HARBOR BUT NOT A "BRIGHTLINE" TEST

The Procedure provides a safe harbor for purposes of characterizing investment property for purposes of Internal Revenue Code §1031. Property that does not meet the terms of the safe harbor may nevertheless constitute qualifying relinquished or replacement property under current law. Of course, any exchange must meet all other applicable legal requirements. Every taxpayer should consult with their legal and tax advisor before engaging in any §1031 exchange.

THIS INFORMATION IS PROVIDED FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY. THIS DOES NOT CONSTITUTE TAX/LEGAL ADVICE. TAXPAYERS ARE STRONGLY RECOMMENDED TO SEEK ADVICE FROM THEIR INDIVIDUAL TAX/LEGAL ADVISORS REGARDING THE SPECIFIC CIRCUMSTANCES OF THEIR EXCHANGE.