HOW DOES ONE IDENTIFY CORNELL BUSINESS SCHOOL STUDENT ASKS: WHO CANNOT ACT AS A QUALIFIED INTERMEDIARY IN A SECTION 1031 EXCHANGE?

The IRS Regulations refer to these types of parties as "disqualified persons."  Well then, who is a "disqualified person?" Disqualified people include:

-The taxpayer's agent at the time of the transaction
-Family members, including ancestors, descendants, and siblings--but interesting  enough-- not in-laws or cousins
-Corporations in which the taxpayer owns more than 10% of the stock of the corporation
-Trusts in which the taxpayer is both the fiduciary and beneficiary or fiduciary and grantor
-Partnerships in which the taxpayer owns more than 10% of the partnership, etc. 

I know you are asking yourself, “OK, what is an agent?”  The IRS Regulations define an agent for disqualification purposes as anyone who may have acted as the taxpayer's employee, attorney, accountant, investment banker, broker or real estate agent within the two year period of the sale of the relinquished property

SECTION 1031 QUESTIONS FROM THE CORNELL SCHOOL OF BUSINESS

I was asked a number of very interesting questions at the end of my lecture at

Cornell

University

.  The next 3 blogs will try to cover some of those questions. 

“What is incidental property, and must you identify it when doing a 1031 transaction?” 

The technical answer is that property whose use is merely incidental to the operation of a more valuable item of property is disregarded for identification purposes.  According to the Regulations, Section 1.1031(k)-1(c0(50(i), incidental property is property that is transferred, together with a larger item of property, and has a fair market value that does not exceed 15 percent of the value of the larger property to which it relates.   

What does this goble-dee-gook definition really mean?  Let me give you an example.  The taxpayer is selling a motel for $1,000,000.  Included in that sale is personal property consisting of 50 beds, 25 tables, 100 chairs, and 100 lamps, with a total value of $78,000.  15% of $1,000,000 is $150,000.   Obviously, the value of the personal property ($78,000) is less than 15% of the sales price and would not have to be separately identified.   This "incidental" rule is only important for figuring out whether proper identification was made pursuant to Section 1031. 

This type of transaction would be a multiple property exchange, because the taxpayer is exchanging real estate (value of $922,000) and also exchanging personal property (value of $78,000). This would require the taxpayer to find replacement real estate property totaling at least $922,000 and replacement personal property totaling at least $78,000.  This was a technical question which, unfortunately for you the reader, required a technical answer

WAYNER QUOTES WAYNER ANSWERING---WHAT WAS THE ORIGINAL PURPOSE OF SECTION 1031?

In an article I wrote a couple of years ago for a major real estate periodical, I was asked, “What are the benefits of Section 1031.”  I answered,   "Section 1031 Exchanges do wonders for the economy: they spur development, generate jobs, create wealth, and allow an individual to increase his or her net worth.  They do not deprive the Treasury of tax revenue; they merely allow investors to defer their capital gains taxes, not avoid them. Of course with appropriate estate planning, estate taxes may be avoided… 

While policymakers and tax experts wrestle with reforming the tax code to make it fairer and simpler, Section 1031 stands as an example of tax policy that really works.  It permits those with modest amounts of capital to transform themselves into financially successful and secure people, with positive ripple effects throughout the economy.”

5 TEASER QUESTIONS ON SECTION 1031

1.   Section 1031, which allows tax deferral of capital gains taxes on investment property or property used in a trade or business has been available to taxpayers since:                                     
a) 1986
b) 1991
c) 1945
d) 1921

ANSWER:  d)  In 1918, income taxes were imposed on the gain or loss of all dispositions of property.  But in 1921, the non-recognition of gain or loss on an exchange was added to the Internal Revenue Code.

2.  The following properties DO NOT qualify for a Section 1031 tax deferred exchange:

a)  stock in trade or property held primarily for sale
b)  stocks, bonds, or notes
c)   interests in a partnership
d)   personal property

ANSWER: a, b, and c do not qualify for a Section 1031 exchange.  Personal property is allowed to be exchanged for “like kind” personal property used in a trade or business under section 1031 (a)(1), but the definition of “like kind” is much more restrictive than for real property exchanges.

3.  Examples of a “like kind” real property section 1031 exchange are:
a) An apartment building for a piece of raw acreage
b) An apartment building for another apartment building
c) An apartment building for a condominium
d) An apartment building for the ownership of a 30 year lease
e) All of the above

ANSWER: The correct answer is (e) All of the above.  All real estate is defined as like kind with all other forms of real estate; so, yes, an apartment building is “like kind” under Section 1031 with raw acreage, another apartment building, a condominium and even a 30 year lease which in every state has been defined as real estate.

4. In order for there to be a valid Section 1031 Tax Deferred Exchange, the following must occur:
a) Both the Seller and Buyer must want each other’s property
b) Both of the taxpayers must exchange on their respective properties simultaneously.
c) Both the Seller and Buyer must be related to each other
d) The taxpayer that is exchanging must exchange for “like kind” property

ANSWER:  d)  The beauty of Section 1031 is that the taxpayer does not have to purchase the replacement property immediately. In fact, the taxpayer has up to 180 days to close on the replacement property from the date of his sale and does not have to purchase that property from his Buyer or a relative.  But the taxpayer must purchase property that is “like kind” to the property he relinquished.

5.  Which of the following will qualify for “like kind” status under Section 1031?
a)  a piece of raw acreage exchanged for a motel
b)  a farm for a tractor and trailer
c)  a bus for a SUV
d)  a typewriter for a computer

ANSWER:  a and d are like kind.  Any type of real estate for any type of real estate has been determined as “like kind” under Section 1031.  A typewriter, which was the precursor to the computer, has been classified as “like kind” to the computer, but a bus is not classified as like kind with a SUV.  Remember, personal property exchanges, are very restrictive.

SECTION 1031 EXCHANGES AND THE NAPKIN RULE

A number of our readers have asked about the Napkin Rule.  We answer that question and many others in the resources section of our company's website, www.liberty1031.com.  My suggestion to of all our bloggers is to go to that site for all of your 1031 information questions.  Below is an excerpt from the resource section, on the subject of the Napkin Rule.

Q. Do I have to acquire a property of equal or greater value?

Yes, you do in order to completely defer the applicable capital gains tax. To the extent that you purchase a property of lesser value, you will be taxed on the difference.

Q. Do I have to use all the cash proceeds from my sale on my purchase?
Yes, you must use all cash proceeds from the transaction in order to completely defer the applicable capital gains tax. To the extent you do not use all your proceeds on the purchase, you will be responsible for any tax on the difference.

Q. Do I have to obtain a mortgage on my replacement property in the same amount or same percentage of debt as I had on my relinquished property?

No. Just follow the above rules.

Q. Does Seller Financing jeopardize my exchange?

Seller Financing is considered boot, which means it is taxable in the year(s) that it is paid (considered an ‘installment sale’). There is a possibility that the Seller Financing (Note) can be placed into the exchange without paying taxes, but the note would have to be paid off or sold before the purchase of the replacement property.

FYI: These rules are often referred to as the Napkin Rule, because they were allegedly originally written on a cocktail napkin by the drafters of the rule.

WHAT IS THE DIFFERENCE BETWEEN A FACILITATOR, AN ACCOMMODATOR, AND A QUALIFIED INTERMEDIARY IN A SECTION 1031 EXCHANGE?

Nothing!!!   I could, of course, end this discourse with that one word—nothing, but I won't do that to you.  They all mean the same thing.  In fact, the governing organization for Qualified Intermediaries is called the Federation of Exchange Accommodators (FEA)--not Federation of Qualified Intermediaries.  Since most of the financial world knows us as Qualified Intermediaries maybe our governing organization should change the name to Federation of Qualified Intermediaries.  I am on the Board of Directors of the FEA, and I might just suggest that. 

So then what is a Qualified Intermediary? In order to have a "safe harbor" transaction, a transaction that IRS recognizes as valid for a Section 1031 tax deferred exchange, the taxpayer should use an independent Qualified Intermediary (QI).   The QI's role in the transaction is not that of a legal or tax advisor.  The QI should remain completely independent.  Their job is to prepare the necessary exchange documentation, not the closing documents, the exchange documents. The QI receives the proceeds from the sale and then disburses the proceeds when the taxpayer closes on the purchase of the replacement property.  By accomplishing those and other tasks, the QI is able to convert the taxpayer's sale and purchase into a tax deferred exchange.  We (the QI) do a lot of work, for a small sum of money. But it's a lot of fun, especially, since our clients are happy because at closing they don't have to pay any taxes.   Is this a good job or what!!!

SHOULD TITLE BE TAKEN IN THE NAME OF THE QUALIFIED INTERMEDIARY IN A SECTION 1031 EXCHANGE?

In most cases, the answer is NO. 

I think a brief Section 1031 history lesson would be appropriate right now.  When the original laws were written into the Internal Revenue Code on exchanging, they required that the title to the property being sold (the relinquished property) be transferred to the Qualified Intermediary (QI) who would then transfer the property and all of its contract rights to the purchaser.  So in the "old" days (prior to 1991), the owner/taxpayer would transfer ownership of its property to the QI, who would take title and then subsequently transfer title to the purchaser.  

On a section 1031 tax deferred exchange, we describe the sale of the relinquished property as Phase 1 of the exchange.  Phase 2 involves the taxpayer purchasing a property (the Replacement Property).  In the old days on the Phase 2 portion of the exchange, title would be delivered to the QI at closing and then the QI would subsequently transfer title to the taxpayer.  That was a lot of work and in MANY cases, resulted in double taxation and that my friends is not a good result. 

Let me explain. 

The majority of the states have a transfer tax every time a piece of real estate is sold.  So if we followed the "old" method of handling a Section 1031 exchange, we would have double transfer fees on the each phase of the same transaction.  Transfer fee #1--Taxpayer transfers property to QI;  Transfer fee #2--QI transfers property to the purchaser--and that's on the relinquished side of the transaction.  Additionally, as you probably surmised, there could also be double taxation on the purchase of the replacement property.   Transfer Fee #3--Title to replacement property delivered to QI;  Transfer Fee #4--Title transferred from QI to taxpayer.  So in the "old" days there was a very good possibility of double taxation on both sides of the tax deferred exchange.  But in 1991, the I.R.S. Regulations (they interpret the I.R.S. Code) were amended to allow the taxpayer to transfer the relinquished property directly its purchaser and to have title to the replacement property directly deeded to the taxpayer.   One very important point:  all of the proceeds from the sale of the relinquished property still had to be delivered to the QI and not to the taxpayer's agent.  The QI of course would then use those Phase 1 proceeds to purchase the replacement property (Phase 2).  By allowing this change,  there would only be one (1) transfer of title on each phase and therefore no double taxation. 

Whew--that was a long and important discussion.  When a taxpayer decides to do a reverse exchange--that's where the taxpayer purchases the replacement property before closing on the sale of the relinquished property--title to the relinquished property is generally put in the name of the QI and in some cases there could be double transfer fees to be paid--but that's an extremely complicated discussion for another day.  For more information on these and other Section 1031 subjects go to the "Resource Section" on our website at:  www.liberty1031.com.

IS YOUR PROPERTY TAX TOO HIGH?

The following are excerpts from an article that appeared in Parade magazine.  Most of my bloggers are aware that a couple of times a year I include a consumer oriented article having nothing to do with Section 1031 tax deferred exchanges--and since home values have plunged over the past 18 months, it is important to make sure that the assessed value on your home is assessed at the new lower value. 

"Nationwide, we have properties that may be overassessed by as much as 60%, says Pete Sepp of the National Taxpayers Union, a watchdog group in Washington,D.C....Many localities are still charging taxes based on the housing-boom values of a few years ago...While you can cut back on spending to lower your sales-tax burden or pay less income tax if your salary is cut or you lose your job, property taxes are not designed to respond immediately to economic pressures...Although most municipalities calculate the value of homes every three to five years, there are no national standards for how often reassessments should take place.  The good news is that, unlike sales and income taxes, property taxes can be appealed---and many homeowners are doing just that.  Some 50,000 appeals were filed this spring in Atlanta alone--10 times more than in 2008...In the past, about 40% of all appeals nationwide have been successful.  But that may not be the case this time.  Local governments often depend on property axes as their primary source of income, and most schools are funded via property taxes.  With budgets already stretched thin, property taxes represent a source of revenue that local governments may not be willing to give up."

MUST YOU TELL YOUR BUYER OR SELLER THAT YOU ARE DOING A SECTION 1031 EXCHANGE?

There  is no requirement in the IRS Code or Regulations that the contract for sale of either the relinquished or replacement properties specify that the properties are going to be exchanged.  In fact, the taxpayer in many cases has not even decided when they sign their contract of sale that they are in fact going to do an exchange. 

My office, LIBERTY 1031 Exchange Services encounters numerous taxpayers that decide just before the closing, sometimes they decide right at the closing table, that they want to do a Section 1031 exchange.  In our case (LIBERTY 1031), we have the ability to prepare documents on a standard deferred exchange and have them delivered within minutes--that's of course a part of our great service.   Hopefully the taxpayer (exchanger) and the party on the other side will agree to sign our necessary paperwork--that of course makes the transaction a lot simpler.   It always suggested that you have a cooperation clause inserted in your contract, when you are selling and when you are purchasing.  For a well written cooperation clause, go to www.cooperationclause.com.