berniecmps
01-08-2008, 12:29 AM
Pitfalls to Avoid in 1031 Exchanges
Pitfalls to Avoid in 1031 Exchanges
Section 1031 of the Internal Revenue Code allows investors to defer the capital gain tax due on the sale of investment or business property by exchanging into other like kind investment or business property. This code section is extremely beneficial to investors because it allows them to reinvest all their net equity into another investment property without paying capital gain taxes. However, there are many pitfalls to avoid under Section 1031. Investors can find themselves facing a hefty tax bill if their exchange is not structured properly.
Pitfall 1 Investors don’t understand the need for a Qualified Intermediary
One of the most basic requirements under Section 1031 of the Code is that you must have an “exchange” of properties, a reciprocal trade. The IRS established the concept of a Qualified Intermediary (QI) in 1991 to simplify the process. The QI trades properties with the investor by acquiring the relinquished property from the investor and transferring it to a buyer for cash, and then acquiring the replacement property with the cash from a different seller and transferring it to the investor. The QI typically produces the necessary documentation that must meet some very specific requirements under the Tax Code and IRS Regulations. Additionally, it is imperative that the Qualified Intermediary holds the cash or controls the cash. A QI is necessary even for simultaneous exchanges wherein the investor is closing on their relinquished and replacement properties at the same time because the investor must still create a trade of properties between two parties.
Investors should be careful in their selection of a QI. Not all QI’s are alike. QI’s can vary greatly in their level of expertise and security (or lack thereof) of exchange funds. Unlike most service providers in the real estate community, QI’s are completely unregulated. The IRS only prohibits agents (real estate agents, accountants, attorneys, etc) and parties that are related to the taxpayer from acting as a Qualified Intermediary. There is no requirement for QI’s to have a license, a bond, insurance, conservative banking/investment procedures or any continuing education or training. Investors should inquire into the level of expertise and security offered. Unfortunately, there have been several recent incidents wherein Qualified Intermediaries lost significant sums of exchange clients’ funds.
Pitfall 2 Support Professionals may not be of any help.
I am always surprised at that number of calls I get from people that have already completed a sale of an investment property, are not aware of the benefits of a 1031 exchange and call us 1 week to months later. If your accountant is not aware of your intent to sell he cannot advise you. However, in many cases as people want to get out of the property management side of their investments, may not know of a 1031 TIC and may sell a property when many investments are professionally managed, you defer the taxes and may earn a nice return on your sizeable investment.
Pitfall 3 Failure to properly identify replacement property.
There are many ways an identification can be done improperly. The id requirements are actually quite simple, most Qualified Intermediaries provide an identification form to use. The investor needs to complete the form by unambiguously describing the potential properties to be acquired.
Some common mistakes made by investors are: putting down the wrong street address; leaving off the city and state; failing to note they are buying only a percentage interest; failing to include improvements that will be constructed on the property before it will be acquired; etc. Unfortunately, what would appear to be a minor procedural requirement has major implications for the exchange. After midnight of the 45th day there is no way to correct these errors. Taxpayers can be charged with tax fraud for backdating identification statements or otherwise trying to make it appear as if they properly identified their properties in a timely manner.
Pitfall 3 Investors believe that an exchange is an “all-or-nothing” tax benefit.
Assume an investor is selling a rental house for $200,000 and has found another property valued at $175,000. Sometimes “partial” exchanges can be beneficial. This can be a partially tax deferred exchange. They will owe capital gain taxes on the $25,000 differential. Depending on the gain realized from the transfer of the relinquished property, there may still be some tax-deferral from the reinvestment. (Please note, that using the above figures, there may be no taxable gain if there were commission involved that totaled $25,000 in buying and then selling the 2 properties, or the tax may be very small if less than $25,000.)
Pitfall 4 Investors don’t hold their properties for investment or business use.
Although all real property is like kind with all other real property, the properties in the exchange must be held either for investment or business use; excluding properties held primarily for sale or personal use. If an investor sells a rental house, buys a condo in Palm Springs and quickly begins to use the condo for personal use the IRS might disallow the exchange for failure to have the appropriate “investment” intent. With proper planning, however, an investor can initially hold the Palm Springs condo for investment purposes by renting it out for a period of at least one to two years, and then later “convert” the condo to a property used for personal purposes. If you are intending to “upgraded” the new rental you may want until you get on or near the 1 year anniversary. If you rent it out for 12 months, and then take 3-4 months of self renovating, and then rent it out just 1 last time maybe 30 days later to a close friend or family member, (of course rent paid will be reflected on the tax returns) you can then make it your vacation or 2nd home within guidelines.
Pitfall 5 Failure to obtain “replacement” debt.
Most investors understand they need to reinvest the net proceeds realized from the sale of their relinquished property into like-kind replacement property. Many fail to realize that they must also replace the debt they were relieved of when the relinquished property was sold. For example, if an investor sells a property for $100,000 with debt in the amount of $75,000, they must not only reinvest the $25,000 of equity; they must also acquire replacement property with at least $75,000 of debt. They can take on more debt if necessary to acquire a higher value property as long as all of the equity is reinvested. Additionally, an investor can always add cash out of pocket towards the purchase of replacement property. On the other hand, if an investor only reinvests the net equity without replacing their debt, the IRS will tax them on their “debt relief”.
In conclusion, there are many ways an investor can get tripped up in the tangles of complicated IRS rules and regulations and the tax code requirements of a 1031 exchange. With careful planning and an experienced team of professionals a tax deferred exchange can be properly structured and successfully closed.
I KNOW A LITTLE ABOUT THIS, BUT AS ALWAYS PLEASE CHECK WITH YOUR CPA, AND OR LAWYER...
Pitfalls to Avoid in 1031 Exchanges
Section 1031 of the Internal Revenue Code allows investors to defer the capital gain tax due on the sale of investment or business property by exchanging into other like kind investment or business property. This code section is extremely beneficial to investors because it allows them to reinvest all their net equity into another investment property without paying capital gain taxes. However, there are many pitfalls to avoid under Section 1031. Investors can find themselves facing a hefty tax bill if their exchange is not structured properly.
Pitfall 1 Investors don’t understand the need for a Qualified Intermediary
One of the most basic requirements under Section 1031 of the Code is that you must have an “exchange” of properties, a reciprocal trade. The IRS established the concept of a Qualified Intermediary (QI) in 1991 to simplify the process. The QI trades properties with the investor by acquiring the relinquished property from the investor and transferring it to a buyer for cash, and then acquiring the replacement property with the cash from a different seller and transferring it to the investor. The QI typically produces the necessary documentation that must meet some very specific requirements under the Tax Code and IRS Regulations. Additionally, it is imperative that the Qualified Intermediary holds the cash or controls the cash. A QI is necessary even for simultaneous exchanges wherein the investor is closing on their relinquished and replacement properties at the same time because the investor must still create a trade of properties between two parties.
Investors should be careful in their selection of a QI. Not all QI’s are alike. QI’s can vary greatly in their level of expertise and security (or lack thereof) of exchange funds. Unlike most service providers in the real estate community, QI’s are completely unregulated. The IRS only prohibits agents (real estate agents, accountants, attorneys, etc) and parties that are related to the taxpayer from acting as a Qualified Intermediary. There is no requirement for QI’s to have a license, a bond, insurance, conservative banking/investment procedures or any continuing education or training. Investors should inquire into the level of expertise and security offered. Unfortunately, there have been several recent incidents wherein Qualified Intermediaries lost significant sums of exchange clients’ funds.
Pitfall 2 Support Professionals may not be of any help.
I am always surprised at that number of calls I get from people that have already completed a sale of an investment property, are not aware of the benefits of a 1031 exchange and call us 1 week to months later. If your accountant is not aware of your intent to sell he cannot advise you. However, in many cases as people want to get out of the property management side of their investments, may not know of a 1031 TIC and may sell a property when many investments are professionally managed, you defer the taxes and may earn a nice return on your sizeable investment.
Pitfall 3 Failure to properly identify replacement property.
There are many ways an identification can be done improperly. The id requirements are actually quite simple, most Qualified Intermediaries provide an identification form to use. The investor needs to complete the form by unambiguously describing the potential properties to be acquired.
Some common mistakes made by investors are: putting down the wrong street address; leaving off the city and state; failing to note they are buying only a percentage interest; failing to include improvements that will be constructed on the property before it will be acquired; etc. Unfortunately, what would appear to be a minor procedural requirement has major implications for the exchange. After midnight of the 45th day there is no way to correct these errors. Taxpayers can be charged with tax fraud for backdating identification statements or otherwise trying to make it appear as if they properly identified their properties in a timely manner.
Pitfall 3 Investors believe that an exchange is an “all-or-nothing” tax benefit.
Assume an investor is selling a rental house for $200,000 and has found another property valued at $175,000. Sometimes “partial” exchanges can be beneficial. This can be a partially tax deferred exchange. They will owe capital gain taxes on the $25,000 differential. Depending on the gain realized from the transfer of the relinquished property, there may still be some tax-deferral from the reinvestment. (Please note, that using the above figures, there may be no taxable gain if there were commission involved that totaled $25,000 in buying and then selling the 2 properties, or the tax may be very small if less than $25,000.)
Pitfall 4 Investors don’t hold their properties for investment or business use.
Although all real property is like kind with all other real property, the properties in the exchange must be held either for investment or business use; excluding properties held primarily for sale or personal use. If an investor sells a rental house, buys a condo in Palm Springs and quickly begins to use the condo for personal use the IRS might disallow the exchange for failure to have the appropriate “investment” intent. With proper planning, however, an investor can initially hold the Palm Springs condo for investment purposes by renting it out for a period of at least one to two years, and then later “convert” the condo to a property used for personal purposes. If you are intending to “upgraded” the new rental you may want until you get on or near the 1 year anniversary. If you rent it out for 12 months, and then take 3-4 months of self renovating, and then rent it out just 1 last time maybe 30 days later to a close friend or family member, (of course rent paid will be reflected on the tax returns) you can then make it your vacation or 2nd home within guidelines.
Pitfall 5 Failure to obtain “replacement” debt.
Most investors understand they need to reinvest the net proceeds realized from the sale of their relinquished property into like-kind replacement property. Many fail to realize that they must also replace the debt they were relieved of when the relinquished property was sold. For example, if an investor sells a property for $100,000 with debt in the amount of $75,000, they must not only reinvest the $25,000 of equity; they must also acquire replacement property with at least $75,000 of debt. They can take on more debt if necessary to acquire a higher value property as long as all of the equity is reinvested. Additionally, an investor can always add cash out of pocket towards the purchase of replacement property. On the other hand, if an investor only reinvests the net equity without replacing their debt, the IRS will tax them on their “debt relief”.
In conclusion, there are many ways an investor can get tripped up in the tangles of complicated IRS rules and regulations and the tax code requirements of a 1031 exchange. With careful planning and an experienced team of professionals a tax deferred exchange can be properly structured and successfully closed.
I KNOW A LITTLE ABOUT THIS, BUT AS ALWAYS PLEASE CHECK WITH YOUR CPA, AND OR LAWYER...