With over 100 years of history since the creation of the first 1031 exchange rules in 1921, many real estate investors might conclude that it should now be straightforward to successfully complete an exchange. Although there are many clearly stated rules in the tax code, e.g., the allowed 1031 timelines to complete exchanges, there are also many gray areas that can trap even well-intentioned investors to incur added tax liabilities and penalties.
While many of these areas have been covered in greater depth in previous blogs posted on our website, this blog will present an overview of issues we most often encounter in working with our clients.
Holding Periods
Except for related party transactions (discussed below), there are no specific minimum holding periods that an investor must follow for a 1031 replacement property to qualify for a 1031 tax deferral. Acceptable minimum holding periods are determined on a case-by-case basis and largely based on the investor’s intentions at the time of acquiring the replacement property.
If audited, the investor will bear the burden of proof to show that the acquired property was intended to be “held for investment” and not for other reasons such as a quick flip or to be converted into a personal residence. The length of the holding period is a significant consideration, and, in our experience, most tax advisors would advise their clients to hold a 1031 replacement property for a minimum of 2 tax years before selling it.
However, courts have approved exchanges when the replacement properties were held for as little as 5 days and denied exchanges when the properties were held for as long as 6 years.
Related Parties
Related party 1031 transactions can take place when buying or selling a property from someone related to you. Related parties include immediate family members, such as brothers, sisters, spouses, ancestors, and their offspring. Related parties do not include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces, or ex-spouses.
Selling an investment property to a related party in an exchange transaction may be acceptable provided the related party holds the property for the minimum 24-month related party holding period specified in the tax code. Replacement properties can also be acquired from a related party provided that the related party completes their own 1031 exchange and does not take possession of the sales proceeds.
Since the current 1031 rules are complex, all potential related party investors are encouraged to seek the guidance of their tax and legal counsel.
Changing Entities
In general, IRS rules state that there must be continuity of title between the ownership structure of the relinquished property and newly acquired property in a 1031 exchange. For example, if title of a relinquished property is held by a Limited Liability Company (LLC), title of the new replacement property should be in the name of the same LLC. Another example would be if the sold property was held solely in the name of a wife, the replacement property could not be held in the names of the wife and the husband.
There are several exceptions such as when a property is titled to a single person LLC, the replacement property can be titled in the name of that single person. Investors of properties that are held in fractional ownership structures such as Tenants in Common (TIC) or in a Delaware Statutory Trust (DST) are permitted to own 1031 replacement properties in their own name.
It is also possible to potentially convert entities into other entities that provide greater flexibility of individual investors to make independent investment decisions e.g., LLC into a TIC provided that the investor can demonstrate proper intent in the conversion process.
Exchange Expenses for Relinquished Properties
The IRS allows investors to deduct exchange related expenses from the sales price of their relinquished properties to determine the amount of their potential gain and their net exchange proceeds. Unfortunately, the term “exchange expenses” is not precisely defined in the tax code thereby creating room for interpretation that could, in a worse case, expose investors to added tax liabilities.
In our experience, tax advisors generally allow for the deduction of traditional sales expenses related to a Qualified Intermediary, attorneys, sales commissions, transfer taxes, and closing fees among others.
Sales expenses which are generally not considered to reduce the gains would include real estate taxes, rents, and any prorations or special adjustments.
Exchange Expenses for Replacement Properties
To complete a full 1031 tax deferral, the IRS requires investors to invest all their net exchange proceeds into like-kind investment properties. Generally, most investors conclude that when they purchase a replacement property utilizing all their exchange proceeds, they have satisfied this condition.
What if all the exchange funds did not go into the replacement property but were partially used to pay sales expenses, loan fees, or to fund property reserves? In our experience, tax advisors will generally permit use of net exchange proceeds to be used to pay normal sales expenses e.g., broker commissions. The use of exchange funds to pay loan fees or to fund property reserves falls into a gray area that should be reviewed with a qualified tax advisor.
Cash Out Refinancing
Once an exchange has been completed, investors are generally permitted to receive tax-free equity from a replacement property through obtaining or increasing debt on the property. However, tax advisors will caution their clients not to refinance a rental property “in anticipation” of an exchange unless the investor: 1) uses those proceeds to improve or repair the relinquished property, and 2) has no actual or constructive receipt of such loan proceeds. It generally helps if there is a justifiable and documented business reason for any refinance of a rental property that you plan to sell within acceptable parameters of an exchange transaction. In general, the more time that elapses between the time when the cash out refinancing occurs and when the property subsequently sells, the less the risk will be of a negative tax consequence.
Changing Investment Allocations During a 1031 Exchange
Exchangers can identify multiple properties during the 45-day period that begins upon closing the sale of their relinquished property. During this 45-period period, investors have full freedom to change properties and planned reinvestment amounts. After the 45-period, many Qualified Intermediaries may limit changes in the investment amounts that were designated during the replacement property identification period. A common QI limitation is to allow investors to reduce investment allocations by up to 25% but to not allow any increases. As an example, if an investor identified an investment amount equal to 1% of a DST property, many QIs would not allow any increases above 1% and only up to a decrease of 25% i.e., down to .75%.
Issues can be avoided by completing the acquisition of all desired replacement properties during the 45-day ID period. Investors should also be sure to review the post 45-day re-allocation policy of their Qualified Intermediary if they anticipate making changes.
Conclusion
Since the successful completion of a 1031 exchange can involve considerations of intent and interpretation that can be challenged by tax authorities, we routinely advise clients to seek out assistance from qualified real estate tax advisors that can provide adequate guidance and take on responsibility for judgement calls that may be needed. Clients can be well served by tax advisors who are willing to represent them in an audit or to answer questions from tax authorities.
For more general information on successfully completing exchanges and for referrals to experienced tax professionals, please contact us at https://fgg1031.com/contact/ .
Have you downloaded our ebook?
Your Comments :