Unlock Your Understanding of 1031 Tax-Free Exchanges ©M.DeRepentigny 2005

Warning!  This course is not designed to substitute for the use of a Certified Public Accountant (CPA) or an Attorney specializing in Tax Matters!  Your role, as a real estate agent, is as presenter of concepts to be verified by your client’s tax professional  Do not hold yourself out as being a 1031-expert, tax consultant, or estate planner

©M.DeRepentigny 2005 Key Terms in an Exchange  Property your client wants to sell is called the old property or the relinquished property  Property your clients wants to purchase (exchange for) is called the new property, or the relinquished property  When executing a 1031 exchange, sale refers to the marketing of the replacement property; purchase refers to the acquisition of the replacement property

©M.DeRepentigny 2005 Income Taxes  Taxes on ordinary/earned income  Taxes on unearned income –Interest –Dividends –Rental –Capital gains/losses

©M.DeRepentigny 2005 Long-Term Capital Gains  A gain on the sale of an investment held “more than one year” is treated as long-term capital gain  As of 2003, maximum tax rate for long-term capital gains is 15% (5% for people in the two lowest tax brackets); this applies to “property taken into account” after May 5, 2003 and before 2009

©M.DeRepentigny 2005 Depreciation  The Modified Accelerated cost Recovery System (MACRS) extends depreciation over 27.5 years for residential real estate and 39 years for commercial real estate.

©M.DeRepentigny 2005  Taxpayer may only use straight-line depreciation.  Land is not depreciable.

©M.DeRepentigny 2005 Capital Gains Taxes  Capital gains result form the sale of assets  If you acquire an asset and then sell the asset, you may have either a capital gain or a capital loss

©M.DeRepentigny Steps To Determining Capital Gains  1st: Determining the Cost Basis of Property  2nd: Determining the Adjusted Sale Price  3rd: Computing Capital Gain

©M.DeRepentigny 2005 Step 1  Determine the Cost Basis of property Original Cost Basis (Purchase Price) +Cost to Purchase +Capital Improvements -Depreciation Taken (if any) ____________________________ =Adjusted Cost Basis

©M.DeRepentigny 2005 Step Two  Determine the Adjusted Sales Price Sales Price -Cost to Sell ___________________________ =Adjusted Sales Price

©M.DeRepentigny 2005 Step Three  Computing Capital Gain Adjusted Sales Price -Adjusted Cost Basis _____________________ =Capital Gain

Adjusted Cost Basis OWNER- OCCUPANT INVESTOR Purchase Price $100,000 Depreciation -0-$25,000 Adjusted Cost Basis $100,000$75,000

©M.DeRepentigny 2005 Installment Sales  Installment sale takes place when the seller (through a real estate listing agent) offers to sell the property by taking back owner financing.  Can be structured in many ways

©M.DeRepentigny 2005 Pros of the Installment Sale  To the buyer  Low closing costs  Fast closing  To the seller  Fast closing  Creation of annuity  Future property taxes paid by buyer  Buyer purchases homeowner insurance policy showing seller as first mortgagee  Buyer responsible for maintenance  Seller collects negotiated interest rate  Spreads capital gains tax over the term of payments

©M.DeRepentigny 2005 Cons of the Installment Sale  Buyer may default or file Bankruptcy  Prepayment may be costly to seller

©M.DeRepentigny 2005 What is Tax-Free Exchange?  It is a method of selling a capital asset, like real estate, according to certain prescribed rules and procedures in such a manner that all or most of the capital gains taxes will be deferred to the future.

©M.DeRepentigny 2005 The taxpayer is not selling a capital asset, but reorganizing!

What advantage does an exchange offer my client?

©M.DeRepentigny 2005  Allowed by IRS on: –Property held for the productive use in trade or business –Investment property  Not allowed by IRS on: –Principal residences, second homes, and time- shares purchased for personal use –Inventory property

©M.DeRepentigny 2005 Types of Exchanges  The Simultaneous Exchange  Starter Deferred Exchange  Reverse Intermediary Exchange (aka Reverse Starker Exchange)

©M.DeRepentigny 2005 Simultaneous Exchange  Also known as straight exchange or simple exchange  Exchanges are based on equity  Boot is taxable to the recipient; may be partially offset by deductible closing costs  All mortgages have to be factored into the equation

©M.DeRepentigny 2005 Example of Simultaneous Exchange Property AProperty B Value$100,000$120,000 Mortgage balance $ -50,000$ -80,000 Equity$ 50,000$ 40,000 Cash boot$ 10,000

©M.DeRepentigny 2005 OWNER A Relieved of mortgage $50,000 Assumes/Creates mortgage $80,000 ($30,000) This figure will factor into the cost basis of new property B. Boot received $10,000 $10,000 Capital Gain Income Pay taxes in the year of the exchange

©M.DeRepentigny 2005 OWNER B Relieved of mortgage $80,000 Assumes/Creates mortgage $50,000 +$30,000 Paid Boot Cash -$10,000 Net Boot $20,000 Will report $20,000 in Boot Capital Gain Pay tax in year of exchange.

©M.DeRepentigny Percent Tax-Free Exchange  Buy up,  Mortgage up, and  Spend all the money

©M.DeRepentigny 2005 Starter Deferred Exchange aka The Starker Exchange  Establishment of deferred exchange  Three-party exchange Starker’s role versus the IRS

©M.DeRepentigny 2005 Reverse Starker Exchange  Initially, the IRS chose to do nothing  In September 2000, IRS guidelines approve Reverse Starker Exchanges and outline rules for them  IRS has also established specific requirements to execute an exchange and gave a new definition of “like kind”

©M.DeRepentigny 2005 “No gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.”

©M.DeRepentigny 2005 “Held”  Law not specific  Assumption of one year  In case of “related exchange”, two years  Always consult with tax professional

©M.DeRepentigny 2005 “Like Kind”  1990 rewrite of Section 1031 redefined like kind, allowing tax-free exchange of any real estate for any real estate as long as it is “property used in the productive use in trade or business or investment property”  New rules do not allow an exchange of a principal residence, second home, a time share, or inventory property

©M.DeRepentigny 2005 Can Leased Property Qualify For An Exchange?  Leases for more than 30 years qualify as real estate for 1031 exchange purposes  20-year lease with two 10-year options would quality Yes!

©M.DeRepentigny 2005 Can An Exchange be “Dis-allowed”? Yes!  IRS will not allow the deferral of tax liability afforded under Section 1031  Taxpayer will have to pay the taxes, interest, and penalty  Taxpayer may not have the cash to pay, if all proceeds were used to purchase additional property

©M.DeRepentigny 2005 Tax-Free Exchange Identification Rule:  Replacement property must be closed OR identified within 45 days –Taxpayer can gain additional time by “identifying” the subject properties for a total of 180 days –Changes in identified property must be accomplished within the 45-day time period –After 45 days, taxpayer may not change list of identified properties and must purchase some or all of the identified properties

©M.DeRepentigny 2005 Time’s A Wasting…  The day the relinquished (old) property closes, an imaginary clock starts to tick.  The replacement (new) property must be closed OR identified within 45 days of the closing of the relinquished property. This is the 45-day clock.

More Rules also known as Alternatives! Three Property Rule 200 Percent Rule 95 Percent Rule

©M.DeRepentigny 2005 Three Property Rule  If no more than three properties are identified, the replacement properties may be of any value, individually or collectively.  Of importance if taxpayer has already closed on one or two replacement properties but runs out of time  Properties acquired during the 45-day period count toward the three-property rule.

©M.DeRepentigny Percent Rule  If taxpayer identifies more properties than allowed by the three-property rule, the total value of all purchased replacement properties may not exceed 200 percent of the total sales price of all relinquished properties.  Properties acquired during the 45-day period count toward the 200 percent rule requirement.

©M.DeRepentigny Percent Rule  If taxpayer identifies more properties than allowed by the three-property rule, and the 200 percent rule has been exceeded, the taxpayer must purchase, by the end of the exchange period, enough replacement properties to equal at least 95 percent of the fair market value of the identified replacement properties.

180-Day Rule ► Once the taxpayer identifies, additional time is allowed to close the purchases of the replacement property.  For closings January 1 – June 30, 180- day rule simple  For closings after July 1, the tax- deadline of April 15 requires careful planning

©M.DeRepentigny 2005 Boot  Any money resulting from the sale of the relinquished property not invested in the replacement property will go to the taxpayer, called boot.  Boot is taxable in year received.

A Less than Favorable Exchange….. Sales Price of old property:$200,000 Sales Price of new property$180,000 Boot$ 20,000 Client gets “the boot” and pays taxes on a gain of $20,000!

©M.DeRepentigny 2005 Qualified Intermediaries or Safe Harbor  Taxpayer may not be in either actual or constructive receipt of the money  Prior to the closing of the relinquished property, the taxpayer must enter into an “exchange agreement” with a qualified intermediary/safe harbor  Four safe harbors: –Security or guarantee arrangements –Qualified escrow accounts and qualified trusts –Qualified intermediaries –Interest and growth factors

©M.DeRepentigny 2005 Who Qualifies as an Intermediary?  Any CPA, an attorney, or any trust department of a bank, as long as the professional or bank has not performed any work for the taxpayer for the past two years  Companies established to act as 3 rd party intermediaries, such as Investors Title Exchange Corporation and Kring Financial Services.

©M.DeRepentigny 2005 Duties of an Intermediary  “Hold” the proceeds of sale in a reliable account  Pay interest on the funds if agreed upon in the “exchange agreement”  Disburse these funds to close the purchase of the replacement properties at the direction of the taxpayer or the taxpayer’s representative  Account to the taxpayer for the funds

©M.DeRepentigny 2005 Case Study

©M.DeRepentigny 2005 And a few more things…. ► If an interest-bearing account is utilized, taxpayer receives 1099 when account is closed and owes taxes on the interest. ► Cost basis is carried over to the replacement property. ► Depreciation on replacement property is recomputed by tax professional—no start over

©M.DeRepentigny 2005 By the way….  All properties and replacement property must be in the United States, Washington DC, or U.S. territories  The client can purchase a lot and hire a builder to construct improvements, but if improvements cannot be completed by the 180 th day& close the purchase; IRS will count only the cost of the lot and the finished improvements as of the day of the closing for the 1031 purpose

©M.DeRepentigny 2005 Legitimately Lower Future Liability

©M.DeRepentigny 2005 Replacement Properties Needing Rehab…  Unfortunately, rules about using funds from the sale of a relinquished property to improve the replacement property that needs work or that is vacant are not clear; your client’s CPA should advise on this VERY gray issue!

©M.DeRepentigny 2005 Forms Required for 1031 Exchange  IRS Form 8824: Like Kind Exchange  The Exchange Agreement  Any Exhibits to the Exchange Agreement  Relinquished Property Assignment  Replacement Property Assignment  Addendum to Closing Statement

©M.DeRepentigny 2005 Suggested language for contracts:  Buyer: In purchasing the Property, Buyer may elect to utilize an I.R.C. Section 1031 tax deferred exchange by trading Property with a qualified intermediary. In such event, Seller agrees to cooperate with and assist Buyer in connection with Buyer’s like/kind exchange and execute an assignment of this Agreement to the qualified intermediary, provided that Seller shall not be obligated to incur any additional expense or liability in connection with the Buyer’s exchange of property. In the event Buyer so elects to utilize I.R.C. Section 1031, Seller shall convey the property to the qualified intermediary designated by Buyer.

©M.DeRepentigny 2005 Suggested language for contracts:  Seller: In purchasing the Property, Seller may elect to utilize an I.R.C. Section 1031 tax deferred exchange where the proceeds from the sell of the Property are used by a qualified intermediary to purchase like/kind property; and the Property may be: 1) conveyed by the Seller directly to the buyer, or 2)conveyed by the Seller to a qualified intermediary who shall then transfer the Property to the Buyer. In such event, Buyer agrees to cooperate with and assist Seller in connection with Seller’s like/kind exchange and execute an assignment of this Agreement to the qualified intermediary, provided that Seller shall not be obligated to incur any additional expense or liability in connection with the Buyer’s exchange of property.

©M.DeRepentigny 2005 Warning!  This course is not designed to substitute for the use of a Certified Public Accountant (CPA) or an Attorney specializing in Tax Matters!  Your role, as a real estate agent, is as presenter of concepts to be verified by your client’s tax professional  Do not hold yourself out as being a 1031-expert, tax consultant, or estate planner