Converting a principal residence to minimize taxes by combining
IRC §1031 and §121

When the Exchanger’s principal residence is used partially for business purposes, such as a home office or duplex, half of which is rented, then the Exchanger must allocate it between the personal use and business use. The portion allocated to business purposes qualifies for an IRC §1031 exchange and the residence portion may qualify for the exclusion from capital gain for personal residences under IRC §121. Section 121 permits an exclusion from capital gain realized of $250,000 for a single person and $500,000 for a married couple on the sale of a home used as a primary residence for any two of the past five years. If, however, the residence was acquired as a replacement property in a §1031 exchange, the Exchanger must have held the property for a total of five years before it qualifies for the §121 capital gain exclusion on sale. IRC §1031 permits the deferral of capital gain realized by exchanging the property held in a trade or business or for investment for like-kind investment or business use property of equal or greater value. Obviously, the Exchanger’s principal residence will not qualify for a §1031 exchange, but if, for example, the residence is converted for use as a rental for two years, it may qualify both for a §1031 exchange as property used in a trade or business and also for the §121 exclusion when it is sold. On February 4, 2005 the IRS issued Revenue Procedure 2005-14 providing guidance on the concurrent application of IRC §121 and §1031. Naturally, consultation with a tax advisor is important whenever an Exchanger changes how the intend to hold property.

Exchanging with a related party

Exchanges between related parties are allowed but the Exchanger must follow specific rules before the exchange will qualify for tax deferral. Related parties are defined in IRC §267(b) and §707(b)(1) as any person or entity bearing a relationship to the Exchanger, such as certain members of a family (brothers, sisters, spouse, ancestors and lineal descendants); a grantor and fiduciary of any trust; two corporations which are members of the same controlled group; and corporations and partnerships with more than 50% direct or indirect ownership of the stock, capital or profits in these entities. Under IRC §1031(f) it is clear that two related parties, owning separate properties, may “swap” those properties with one another and defer the recognition of gain as long as both parties hold their replacement properties for two years following the exchange. This rule was imposed to prevent taxpayers from using exchanges to shift the tax basis between the properties to avoid paying taxes upon the subsequent sale of one of the properties.

Typically an Exchanger uses a Qualified Intermediary to facilitate an exchange with either a related party buyer who purchases the Exchanger’s relinquished property or a related party seller from whom the Exchanger acquires the replacement property. Exchanges in which the seller of replacement property is the related party are less likely to qualify for tax deferral unless the related party seller also does an exchange. Under Rev. Rul. 2002-83, exchange treatment will be denied to an Exchanger who, through a Qualified Intermediary, acquires replacement property from a related party seller, if the related party seller receives cash or other non-like-kind property, regardless of whether the Exchanger holds the replacement property for the requisite two years. The IRS will generally view this transaction as yielding the same result as if the Exchanger swapped properties with a related party, and then the related party immediately sold the property acquired, violating the two-year holding requirement.

Exceptions to the two-year holding period are allowed only if the subsequent disposition of the property is due to (a) the death of the Exchanger or related person, (b) the compulsory or involuntary conversion of one of the properties under IRC §1033 (if the exchange occurred before the threat of conversion), or (c) the Exchanger can establish that neither the exchange nor the disposition of the property was designed to avoid the payment of federal income tax as one of its principal purposes. In fact, under IRC §1031(f)(4) a related party exchange will be disallowed if it “is part of a transaction (or series of transactions) structured to avoid the purposes of related party provisions.” It is also important to note that under IRC §1031(g) the two-year holding period is “tolled” for the period of time that (a) either party’s risk of loss with respect to their respective property is substantially diminished because either party holds a put right to sell their property, (b) either property is subject to a call right to be purchased by another party, or (c) either party engages in a short sale or any other transaction.

In PLR 200440002 the IRS ruled that §1031(f) would not trigger gain recognition in a series of exchanges involving two related partnerships that used an unrelated Qualified Intermediary since neither related party was cashing out of their investment in real estate and each related party represented that they would hold their replacement property for the required two years following their exchange. In the transaction, Partnership A sold their relinquished property to an unrelated third party buyer and purchased their replacement property from Partnership B, a related party.

Partnership B then completed their exchange by purchasing replacement property from a third party seller. Upon completion of the two exchanges each party owned like-kind property and neither party received cash or other non-like kind property (other than boot received in the exchange) in return for the relinquished property. In the IRS analysis §1031(f)(1) did not apply because the Qualified Intermediary was an unrelated party, and §1031(f)(4) and Rev. Rul. 2002-83 also did not apply because the series of transactions were not set up to avoid the purposes of §1031(f). The IRS reached the same conclusion in PLR 200616005 with similar facts, except that Trust acquired Building 2 from related party S Corporation and planned to acquire additional replacement property from unrelated seller(s), or recognize boot only in the amount of cash received. The IRS permitted exchange treatment as long as Trust held Building 2 and S Corporation held its replacement property in exchange for Building 2 for two years.

The Tax Court confirmed the IRS position in Rev. Rul. 2002-83 that the related party rules of §1031(f) cannot be avoided by interposing an unrelated Qualified Intermediary and that these types of related party transactions are within the recharacterization rule of §1031(f)(4). The Tax Court denied exchange treatment inTeruya Brothers, Ltd., 124 T.C. No. 4 (2005) because it found that a principal purpose of the transaction was avoidance of income taxes, notwithstanding that there was no basis shifting between the related parties. When the related party sold the property it had acquired from the Exchanger within two years of acquisition, it was able to take advantage of not operating losses to offset the gain recognized on sale, resulting in less tax paid than if the Exchanger had sold the property outright.

Conversely, the IRS clarified in PLR 200709036 that there is no basis shifting or tax avoidance when the taxpayer, through an unrelated Qualified Intermediary, transfers relinquished property to a related buyer, but acquires replacement property from an unrelated seller. The exchange will be respected even if the related party voluntarily disposes of the property it acquired from the taxpayer within two years of acquisition. Based upon this indication of the IRS’ thinking, it appears that in a four-party exchange involving the taxpayer, a related buyer of relinquished property, an unrelated seller of replacement property, and an unrelated Qualified Intermediary, that there is no requirement that the related buyer hold the asset received from the Exchanger for two years following the exchange.

The IRS also confirmed in PLR 200706001 and PLR 200712013 that an exchange would be upheld where it could be demonstrated that there was no basis shifting and that avoidance of Federal income tax was not a principal purpose of the transaction, notwithstanding that the taxpayer and related parties exchanged properties, and the related buyer voluntarily disposed of the property it had acquired from the taxpayer shortly after the exchange.

Private letter rulings are directed only to the requesting taxpayers and may not be cited as precedent. However, they are a good indication of the IRS’ interpretation of this complicated section of the tax code.

Tenant-in-common – investor beware

A recent trend with respect to 1031 exchanges is the explosion of the tenant-in-common (“TIC”) ownership opportunities. A tenant-in-common (“TIC”) property is investment real estate whose ownership has been split into a number of undivided fractional shares. Investors who are typically unaffiliated with each combine their exchange proceeds to acquire a large property in which each Investor owns an undivided fee interest in the property equal to his/her proportionate share of the real estate. In addition to his/her equity interest, the Investor may also acquire a proportionate share of the debt secured by the Replacement Property if debt is needed as part of the exchange.

TIC ownership can be used for any type of real estate but most of these types of properties are shopping centers, strip malls, office buildings, apartment buildings, vacant land, or other types of larger commercial real estate. Acquisition of a TIC property affords an Investor with the opportunity to acquire investment grade property, obtain a consistent monthly cash flow, participate in any appreciation, and do away with day-to-day management headaches that often accompany ownership of investment real estate. A TIC property is usually professionally managed. Under this arrangement, management of the property, negotiating leases, payment of taxes and other responsibilities are all performed, for a fee, by the professional property manager. Commonly the only thing the Investor will do in a TIC investment is collect a monthly check for the Investor’s share of the income.

TIC ownership is not for the casual investor. As with any real estate transaction it is important to perform the necessary due diligence on the property being acquired and the sponsor of the TIC program. Check the strength of the market where the TIC property is located. Thoroughly research the TIC sponsor. Ask for references and information on prior TIC property performance. Confirm the existing leases and the strength of the tenants in the property. Make sure that the leases are of adequate duration to assure long-term cash flow. Analyze the terms of the financing to determine if and when the interest rate is adjustable. Determine if you will be responsible for “capital calls” if the cash flow from the property is not sufficient to pay debt service and expenses. Most importantly, determine if there is an exit strategy should you wish to exchange out of the TIC property at a later date. Remember, that a small fractional ownership interest is not as marketable as owning 100% of a smaller property. In many instances, a TIC sponsor may restrict or limit your ability to sell prior to the decision to sell the entire property. The best advice is to perform the same level of due diligence for a TIC property that you would if purchasing the property individually.

Also, it is of critical importance that the Investor review and analyze the TIC agreement and ownership documents and structure to make sure that the TIC complies with the 1031 exchange regulations. TIC ownership has been around for many years, but its use as a replacement property solution is relatively recent. In recognition of the increased interest in TIC’s, the IRS issued 15 guidelines to assist taxpayers in determining if their TIC ownership will qualify as replacement property in an exchange. These guidelines address items such as: the allowable number of co-owners; the right to transfer or encumber the interest; the proportionate sharing of profits, losses, and debt; and, the ability of the co-owners to enter into a management or brokerage agreement for the property.

Most TIC sponsors have attempted to craft their TIC programs to substantially comply with the IRS guidelines. Any Investor considering the acquisition of a TIC interest to complete a tax deferred exchange should research the various TIC sponsors to select a sponsor whose TIC program either complies with these guidelines and demand that the TIC sponsor provide the Investor with an opinion of competent legal and tax counsel that the structure of the TIC arrangement complies with the requirements of section 1031. In addition, the Investor should consult with their own competent legal and tax counsel to assure that the acquisition of a particular TIC interest as replacement property satisfies the requirements for their exchange.

TIC’s can provide great flexibility and benefits for a 1031 exchange investor. There are plenty of well qualified and reputable TIC sponsors in the marketplace. Just remember, do your homework before you invest.

Refinancing – timing is everything

Often, and Investor will want to take some equity out of a Replacement Property to be utilized for other investments or for personal use.  Section 1031 provides that cash taken by an Investor as part of the exchange and not reinvested into the Replacement Property will be treated as “boot” and subject to tax.  Because of this rule, many real estate investors never consider an exchange because they mistakenly believe their equity must always remain tied up in real estate.  However, it is possible for an Investor to obtain cash through the use of refinancing and use that cash tax free for whatever the investor chooses, whether that is buying more real estate, investing in the stock market or utilizing the cash for personal use.

PRE EXCHANGE REFINANCE OF RELINQUISHED PROPERTY

An Investor should not refinance the Relinquished Property shortly before a sale that is structured as a tax deferred exchange, unless it can be established that the debt incurred prior to the exchange had “independent economic substance.”  If the Exchanger cannot support they had a valid business reason incurring additional debt prior to the sale, the IRS could easily characterize this as a “step transaction” (where they determine the steps leading up to the exchange show the investor’s original intent was merely to obtain the cash in an attempt to avoid the reinvestment rules of IRC §1031).  Therefore, there is a strong possibility that proceeds received by the Investor from a refinance of the Relinquished Property completed shortly before the exchange will be treated as cash boot and subject to tax.

POST EXCHANGE REFINANCING

It is much safer for an Investor to refinance the Replacement Property after completing the exchange transaction in order to receive cash.  Any refinancing should be completed as a separate transaction and not reflected on the closing statement for the Replacement Property.  Proceeds received from a post acquisition refinance of the Replacement Property will not be subject to tax.

As with all exchange issues, we recommend that every Investor consult with their personal tax advisor to review their specific situation with respect to structuring a cash out refinance.

Single Member LLC’S

Any natural or legal person (individual, corporation, partnership, LLC, trust, etc.) may elect to complete a 1031 exchange on the sale of property held for investment or property utilized in a trade or business.   The general rule is that an Investor must acquire title to the Replacement Property in the same natural or legal person that sold the Relinquished Property (generally as determined by the status of legal title).  For example, if John Doe is the seller of the Relinquished Property, the Joe Doe must acquire the Replacement Property.  Also, if ABC Corporation sells the Relinquished Property, then ABC Corporation must acquire the Replacement Property.

EXCEPTION TO RULE / DISREGARDED ENTITIES

An exception to the general rule above is that if the transferor of the Relinquished Property or the transferee of then Replacement Property is a “disregarded entity” or the “owner” of a disregarded entity, then the entity is treated as if it does not exist and the owner and the entity are, in effect, interchangeable.

LIMITED LIABILITY COMPANIES (LLCs)

Limited liability companies (“LLC”) may be considered as a disregarded entity in the following cases where the LLC has not made an election to be treated for tax purposes as a corporation:

• 100% of the interests are owned by a single legal or natural person.
• 100% of the interests are owned by husband and wife as community property in a community property state.

Additionally, the IRS has ruled that a two-member LLC formed under Delaware law was disregarded for §1031 exchange purposes where all economic interests were held by one member and the function of the second member was solely to prevent a bankruptcy filing or other violation of the LLC’s covenants with lenders.  The IRS has also ruled that the acquisition of all the ownership interests held by 2 different owners by a single buyer in a single transaction constituted an acquisition of the underlying assets owned by the LLC.
Use of disregarded entities provides flexibility in exchange planning.  For example, an individual who sells a Relinquished Property in his or her individual name may acquire the Replacement Property in a single member limited liability company.  This provides additional liability protection for the Investor.

Conversion to personal use – 5 year holding period required

A fairly common strategy of Investors is to convert investment property acquired as part of a 1031 exchange to personal use and then dispose of the property under the provisions relating to the sale of a principal residence.  Section 121 of the Internal Revenue Code provides that a taxpayer may exclude up to $250,000 ($500,000 for a married couple) of the gain recognized from the sale of a principal residence if the property was utilized as the taxpayers principal residence for two of the previous five years.

On October 22, 2004, President Bush signed into law corporate and foreign tax legislation that also contained a provision affecting IRC §1031. Under this provision, an Investor who performs an IRC §1031 tax deferred exchange into a Replacement Property that is later converted to the Investor’s principal residence is not allowed to exclude gain under the principal residence exclusion rules of IRC §121 unless the sale occurs at least five years after the closing date of the Replacement Property purchase.  The actual provision reads as follows:

Sec. 840. Recognition of gain from the sale of a principal residence acquired in a like-kind exchange within 5 years of sale. (10) PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE — If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property.

The change to IRC §121 is effective for principal residence sales occurring on or after October 22, 2004 and all investors who previously acquired their current residence through a §1031 exchange within the past three years will now have to wait at least two more years before selling their residence to exclude the gain. This assumes they meet the two out of five year principal residence test.

Although Section 1031 does not impose a specific holding period for Replacement Property prior to converting to personal use, a safe rule of thumb is that Replacement Property acquired as part of a 1031 exchange should be kept as investment property for a minimum of two years prior to converting the property to the Investor’s principal residence. EXAMPLE An Investor completes a 1031 exchange for a rental home that is held for investment and rents the property out for the suggested two years. Investor then moves into the property as Investor’s principal residence. Under the new law, the Investor will have to wait for at least three more years before selling the principal residence and excluding gain under IRC §121.  If the Investor had elected to rent the property out for three years prior to converting the property to Investor’s principal residence, Investor would only be required to wait two years before selling and excluding gain under IRC §121.

Seller financing – Alternatives to avoiding “boot” on carry back

A promissory note received as consideration for the sale of Relinquished Property will be treated as “boot” and may be subject to tax.  If a promissory note is received by the Investor at the closing on the Relinquished Property, the note will be subject to tax but may be reported under the installment method (Internal Revenue Code Section 453).  The installment method allows Investor to defer payment of capital gains tax relating to the Note over the period of time that the note is outstanding.

Once the note is paid to IES, the Investor has four different alternatives for attempting to use the note as part of the tax deferred exchange.

OPTION 1 – INVESTOR PURCHASES NOTE FROM IES FOR CASH

This is the most common and practical alternative.  Essentially, the note is replaced with cash paid by Investor to IES in the full amount of the Note.  IES adds the amount paid for the Note to the Exchange Proceeds being held by IES.  The Exchange Proceeds will be applied towards the acquisition of the Replacement Property.  The Investor will receive the Note from IES.  Investor’s basis in the note will be the face amount paid.  As such, the only tax liability that Investor will have upon receipt of payments under the Note from the buyer of the Relinquished Property will be any amounts attributable to interest charged under the Note.

OPTION 2 – THE PAYER ON THE NOTE PAYS OFF THE NOTE PRIOR TO CLOSING ON THE REPLACEMENT PROPERTY

The note is actually paid off during the 180-day exchange period and prior to Investor’s acquisition of the Replacement Property. This works only on short-term notes due within the 180 day exchange period. The payer under the note pays off the note directly to IES.  This amount is added to the Exchange Proceeds and transferred in connection with Investor’s acquisition of the Replacement Property.

OPTION 3 – SELLING THE ON THE SECONDARY MARKET

Rather than selling the note to Investor as outlined under Option 1 above, IES sells the note to a third party investor. The cash proceeds received from the sale of the note are added to the Exchange Proceeds and utilized by IES for purchasing the Replacement Property. Typically the note will need to be sold at a discount, often anywhere from 15% – 40%. If the Note is discounted, the discounted amount MAY be considered a selling expense.   Usually the discount charged by a third party purchaser will offset any tax savings.  As such, this alternative is rarely utilized.

OPTION 4 – USE THE NOTE TOWARDS THE DOWN PAYMENT ON THE REPLACEMENT PROPERTY

The Seller of the replacement property accepts the note as partial payment towards the purchase price. In this scenario, the Note is assigned to the Seller by IES and delivered to the Seller at closing.  This option is rarely feasible as it is difficult to find a Seller who will accept a third party note as part consideration for the sale of the Replacement Property.  This is largely due to the fact that the Seller will be unable to take installment treatment with respect to the third party note.

FAILURE OF ANY OF THE FOUR OPTIONS

If the Investor elects to have the note payable to IES at closing and then is unsuccessful with any of the four alternatives shown above, IES simply assigns the note back to Investor at completion of the exchange. The Investor retains all the tax benefits of the installment method under Section 453 of the Internal Revenue Code that Investor would have had if the note would have been payable to Investor at the closing on the Relinquished Property.

Calculating Gain

Often the first step in determining whether a 1031 exchange is right for you is to calculate the amount of taxable gain generated by the sale of investment property.

Taxable gain on the sale of investment property is calculated in accordance with the following formula:

Sales Price less
Exchange Expenses less
Adjusted Basis equals
Taxable Gain

Exchange Expenses includes those transactional costs deductible in connection with the Exchange that should generally include costs that are:

• A direct cost of selling real property, which typically include:
  • Real estate commissions
  • Title insurance premiums
  • Closing or escrow fees
  • Legal fees
  • Transfer taxes and Notary fees
  • Recording fees

  – or-

• Costs specifically related to the fact the transaction is an exchange such as the Qualified Intermediary fees.Costs related to obtaining the loan on the Replacement Property are not considered Exchange Expenses and should not be deducted from the Exchange Proceeds. Other non-exchange expenses include:
  • Mortgage points and assumption fees
  • Credit reports
  • Lender’s title insurance
  • Prorated mortgage insurance
  • Loan fees and loan application fees
  • Property taxes
  • Utility charges
  • Association fees
  • Hazard insurance
  • Credits for lease deposits
  • Prepaid rents and security deposits

In order to avoid “boot” on this non-exchange expenses, an Investor should consider paying for these items outside of closing or investing additional cash equity into the Replacement Property to offset these amounts.

The Adjusted Basis of the property is calculated by taking the acquisition cost of the property (less any deferred gain from prior 1031 exchanges), adding the cost of any capital improvements made to the property, and subjecting the amount of depreciation deductions taken.

Once Taxable Gain is determined, you can estimate your tax liability by multiplying the Taxable Gain by the applicable tax rate.  Investment property held for a year or less will be taxed as ordinary income at the Investor’s individual tax rate.  Investment property held for over one year is taxed at the long-term capital gains rate of 15% (lower if the Investor is in a lower federal tax bracket).  Additionally, many states impose an additional state tax on top of the federal tax.  Investors should check the tax rates in effect for the state in which the Relinquished Property is located.

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The analysis set forth above provides an overly simplistic view of the complicated tax rules and regulations governing property taxation, basis determination, and gain calculation.  Consultation with your CPA or personal tax advisor is strongly encouraged.

Do vacation and second homes qualify for IRC §1031 treatment?

Vacation and second homes that are held by the Exchanger primarily for personal use do not qualify for tax deferred exchange treatment under IRC §1031. When vacation homes are used both for personal purposes and business purposes, the allocation between the uses becomes important. Obviously the greater the personal use, the less likely the second home will qualify for an exchange. IRC §280A provides that the personal use of a second home for more than 14 days a year characterizes it as a residence. Given the lack of guidance in this area, this 14-day rule has been applied as the standard of allowable personal use of property eligible for a §1031 exchange.

While an argument may be made that vacation homes should qualify as investment property, the argument is unlikely to prevail when the Exchanger’s intent is to use the property solely for personal use. However, when the Exchanger’s primary intent in purchasing a vacation home is investment, the fact that there is personal use does not exclusively recharacterize the Exchanger’s intent. Sedar v. C.I.R., T.C. memo 1986-504, (1986).

Taxpayers that use a vacation home for significant personal use may wish to qualify the home for a §1031 exchange based on the fact that their primary acquisition intent was for investment. For §1031, property is held for investment purposes if losses from the sale or exchange of such property are deductible.Starker v. U.S., 602 F.2nd 1341, 1350-1351 (9^th Cir. 1979). Where an Exchanger established that his primary intent in acquiring the second home was to make a profit, the court allowed a business expense deduction under IRC §212 for an 11-month rental period despite personal use for the remaining month, allocated the deduction between investment and personal use. Rivera v. C.I.R., T.C. Summ. Op 2004-81(2004). However, Rivera may not be cited as legal precedent and there is no direct legal authority that either property used for significant personal use will qualify for a §1031 exchange because deductions were allowed under either IRC §208A or §212. Exchangers taking the position that a second home, or portion of a second home, qualifies for exchange treatment despite personal use because it was purchased predominantly for investment have a heavy burden of proof and should consult their tax advisor

An Exchanger may utilize a §1031 exchange to avoid paying capital gains tax on the sale of a vacation home by converting it to valid exchange property and establishing this intent by renting the property and holding it for the requisite period. See Rev. Rul. 57-244, 1957-1 CB.247. Revenue Procedure 2005-14 provides examples illustrating that if an Exchanger rented a primary residence for two years and claimed depreciation deductions, the house would qualify for exchange treatment. In each of the examples, it was assumed that the property had been used in the Exchanger’s trade or business or held for investment within the meaning of §1031.