The Rules of Boot in a 1031 Exchange

A Taxpayer Must Not Receive "Boot" from an exchange in order for a Section 1031 exchange to be completely tax free. Any boot received is taxable (to the extent of gain realized on the exchange). This is okay when a seller desires some cash and is willing to pay some taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be tax free.

The term "boot" is not used in the Internal Revenue Code or the Regulations, but is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange. Boot received is the money, debt relief or the fair market value of "other property" received by the taxpayer in an exchange. Money includes all cash equivalents received by the taxpayer. Debt relief is any net debt reduction which occurs as a result of the exchange taking into account the debt on the Relinquished Property and the Replacement Property. "Other property" is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or "non-qualified property." "Other property" also includes such things as a promissory note received from a buyer (Seller Financing).

Boot can be inadvertent and result from a variety of factors. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided. The most common sources of boot include the following:

· Cash boot received during the exchange. This will usually be in the form of "net cash received" at the closing of either the Relinquished Property or the Replacement Property.

· Debt reduction boot which occurs when a taxpayer’s debt on Replacement Property is less than the debt which was on the Relinquished Property. As with cash boot, debt reduction boot can occur when a taxpayer is "trading down" in the exchange.

· Sale proceeds being used to service costs at closing which are not closing expenses. If proceeds of sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to bring cash to the closing of the sale of their Relinquished Property to pay for the following non-transaction costs:

a. Rent prorations.

b. Utility escrow charges.

c. Tenant damage deposits transferred to the buyer.

d. Property tax prorations? Maybe, see explanation below.

e. Any other charges unrelated to the closing.

Tax prorations on the Relinquished Property settlement statement can be considered as service of debt based on PLR 8328011. Under this rationale exchange cash used to service tax prorations should not result in taxable boot. However, taxpayers may want to bring cash to the Relinquished Property closing anyway in order to resolve this issue.

Excess borrowing to acquire Replacement Property. Borrowing more money than is necessary to close on Replacement Property will cause cash being held by an Intermediary to be excessive for the closing. Excess cash held by an Intermediary is distributed to the taxpayer, resulting in cash boot to the taxpayer. Taxpayers must use all cash being held by an Intermediary for Replacement Property. Additional financing must be no more than what is necessary, in addition to the cash, to close on the property.

Loan acquisition costs with respect to the Replacement Property, which are serviced from exchange funds being brought to the closing. Loan acquisition costs include origination fees and other fees related to acquiring the loan. Taxpayers usually take the position that loan acquisition costs are being serviced from the proceeds of the loan. However, the IRS may take a position that these costs are being serviced from Exchange Funds. There is no guidance which is helpful in the form of Treasury Regulations on this issue at the present time.

Non-like-kind property, which is received from the exchange, in addition to like-kind property (real estate). Non-like-kind property could include the following:

· Seller financing, promissory note

· Furniture and fixtures acquired with purchase of real estate

· Sprinkler equipment acquired with farm land

Boot Offset Rules - Only the net boot received by a taxpayer is taxed. In determining the amount of net boot received by the taxpayer, certain offsets are allowed and others are not, as follows:

· Cash boot paid offsets cash boot received (but only at the same closing table).

Cash boot paid at the Replacement Property closing table does not offset cash boot received at the Relinquished Property closing table (Reg. §1.1031(k)-1(j)(3) Example 2). This rule probably also applies to inadvertent boot received at the Relinquished Property closing table because of prorations, etc. (see above).

· Debt incurred on the Replacement Property offsets debt-reduction boot received on the Relinquished Property.

· Cash boot paid offsets debt-reduction boot received.

· Debt boot paid never offsets cash boot received (net cash boot received is always taxable).

· Exchange expenses (transaction and closing costs) paid offset net cash boot received.

Rules of Thumb:

· Always trade "across" or up. Never trade down (the “even or up rule”). Trading down always results in boot received; either cash, debt reduction or both. The boot received is mitigated by exchange expenses paid.

· Bring cash to the closing of the Relinquished Property to pay for charges which are not transaction costs (see above).

· Do not receive non-like-kind property (or if you do, pay for it).

· Do not over-finance Replacement Property. Financing should be limited to the amount of money necessary to close on the Replacement Property in addition to exchange funds which will be brought to the Replacement Property closing.

Give us a call at 888-367-1031 or email us at 1031@1031cpas.com if we can help with questions about how a 1031 Exchange can help you. See our Exchange Manual and visit us at http://www.1031cpas.com/ for additional information on how 1031 exchanges can help you save taxes.

Leasehold Interests and 1031 Exchanges Frequently Asked Questions

A leasehold interest with a term of 30 years or more is like-kind to a fee interest in real estate (Reg. §1.1031(a)-1(c)(2)). Renewal options under the lease are counted for purposes of determining if the lease has 30 years or more to run. Accordingly, a 30 year leasehold interest can be exchanged for a fee interest in real estate or vice versa - a fee interest in real estate can be exchanged for a 30 year leasehold interest.

Leasehold interests with less than 30 years remaining under the lease are not like-kind to a fee interest in real estate. But, they can qualify as like-kind to other leasehold interests with either 30 years remaining under the lease or less than 30 years.

What is the difference between a lease and a leasehold interest?

A Leasehold Interest is an interest in real estate which is acquired and possessed by a person who is the lessee of the property under the terms of a lease. The Lessor is the owner of the property. The Leasehold Interest might be bare land or land with improvements. Sometimes the leasehold improvements are in place when the lease is executed and sometimes the improvements are constructed by the lessee after the lease is executed.

A Lease is the legal instrument documenting the terms and number of years of possession by the lessee.

What is the tax basis of a leasehold interest acquired as replacement property in a 1031 Exchange?

Tax basis is the purchase cost of obtaining the lease minus the deferred gain resulting from the exchange. If improvements are constructed on the leasehold, tax basis will include the cost of such construction or improvements.

How is the tax basis of a leasehold interest depreciated?

The tax basis of a leasehold interest is amortized over the number of years the lease has to run, including options for renewal of the lease.

If I exchange bare land for a 30 year lease of a commercial building, I can amortize the tax basis attributable to the bare land over 30 years?

Yes, the tax basis of the leasehold interest is amortized over the life of the lease, including options for lease renewal.

What if the term of the lease is for 30 years plus an option to renew for an additional 30 years (60 years in total)? Am I required to amortize a commercial office building which ordinarily could be depreciated over 39 years over 60 years?

The building can be depreciated over the ;">MACRS recovery period (39 years in this case) if the life of the lease, including renewal options is longer than the MACRS recovery period (Reg. §1.178-1(b)(3)). The cost basis allocable to the land would be amortized over the life of the lease, including renewal options.

What if the term of the lease is for 20 years plus an option to renew for an additional 20 years (40 years in total) and I do not intend to exercise the renewal option?

Amortization of the tax basis of the lease over 20 years is possible if the taxpayer can establish that is “more probable than not” that the lease will not be renewed, extended or continued (Reg. §1.178-1(b)(2).

See our Exchange Manual or give us a call us at 888-367-1031 if we can help with any questions you may have about 1031 Exchanges.

1031 Corporation is Going Green!

Going green is easy with a 1031 exchange. Green as in the Three R's - Reducing, Reusing and Recycling your capital gain tax dollars! The 1031 Exchange option is the perfect “green” way to hold onto your money and reinvest it into another like kind investment. Taxpayers should never have to pay income taxes on the sale of property if they intend to reinvest the proceeds in similar or like-kind property.

Through an IRS tax-deferred exchange, you are able to reduce your tax liability. A 1031 exchange provides the ability to defer the capital gains tax with the purchase of like-kind replacement property that would have been due and payable. For a real estate exchange, like-kind replacement property means any improved or unimproved real estate held for income, investment or business use.

Your Qualified Intermediary must hold and forward net proceeds from the sale of your property to the purchase of the replacement property. If you receive cash or have a trade down in value you may have "Boot". Boot is the money received or the debt reduction received by the taxpayer in an exchange. The rule of thumb for avoiding "boot" is to always replace with property of equal or greater value than the relinquished property.

The tax basis of the old property becomes the new tax basis in the replacement property. If you “bought equal,” the basis in the new property is the same as it was on the old property. In a 1031 exchange, the basis rolls forward from the old property to the new property. If your replacement is a trade up in value you will be able to increase your basis by the amount of the trade up. This trade up allows you to increase the amount available to be depreciated.

Just remember the three R's for going green are Reduce, Reuse, Recycle. 1031 Corporation is ready to assist you in Reducing your tax liability, Reusing your proceeds from the sale of your relinquished property on the purchase of your replacement property and Recycling your ability to depreciate by purchasing up in value on the replacement. Are you ready to go green? Give us a call today at 888-367-1031.

How do you report a 1031 Like-Kind Exchange to the IRS?

We often are asked for assistance from taxpayers and accountants on how to report a like-kind exchange. While we are unable to give tax advice, we do have obvious experience with this somewhat complicated and difficult form to complete. So, we can provide some assistance with YOUR completion of the form.

You must report an exchange to the IRS on Form 8824 and file it with your tax return for the year in which the exchange occurred. For example, if you sold property on November 5, 2008 as part of a 1031 exchange, and you purchased the new property on February 7, 2009, you would need to file Form 8824 with your 2008 tax return. This is a two page form that you submit with your federal tax return to report the details of your 1031 exchange.

Form 8824 asks for:

·Descriptions of the properties exchanged

·Dates that replacement properties were identified and transferred

·Any relationship between the parties to the exchange

·Value of the like-kind and other property received

·Gain or loss on sale of other (non-like-kind) property relinquished

·Cash received or paid; liabilities relieved or assumed

·Adjusted basis of like-kind property relinquished; realized gain

When you complete an exchange with 1031 Corporation you will receive a summary of your 1031 Exchange. Included with this summary is a worksheet to assist you in completing the Form 8824. Our worksheet and the 8824 form are also provided on our website under Accounting Topics.

Of course, we'll also walk you through all the steps of the exchange and make you aware of any obstacles and work with you to hurdle them. Plus, our clients receive pre- and post-consultation at no additional cost. That comes in handy when you are trying to fill out that Form 8824.

Give us a call today at 888-367-1031 with your 1031 exchange needs!

Requirements of a 1031 Exchange

A tax-free real estate exchange is an important financial tool for investors looking to sell a property and reinvest in other real estate. The advantage of a 1031 exchange is that they allow taxpayers to sell income, investment or business property and replace it with like-kind property without having to pay Federal income tax on the transaction. The tax is deferred allowing the investor to reinvest the full proceeds of a sale into new investment(s).

First, the property being exchanged must qualify. Qualifying property is any real or personal property held for investment purposes or used in a taxpayer's trade or business. Any property used exclusively for personal use cannot be exchanged. Also, property acquired with the intent to immediately resell does not qualify.

Second, the replacement property must be like-kind to the relinquished property. In the case of personal property, what is like-kind can be a bit more challenging. The replacement property generally needs to be in the same asset class as the relinquished property. In real property, replacing like-kind property is easier to meet. A single family house can be exchanged for a condominium (or cooperative) unit. Raw land can be swapped for an office building or a farm can be exchanged for commercial or industrial property. A relinquished property in the United States must be replaced with property in the United States. Foreign property is like-kind to foreign property.

Next, a couple of deadlines must be met. The replacement property must be identified within 45 days from the date of sale and must be purchased within 180 days of the sale. The exchange will end if identification is not made within 45 days or if property is not purchased within 180 days.

Finally, the most important requirement of a successful 1031 exchange is that the taxpayer cannot receive (or control) any of the net sales proceeds from the relinquished property. All such proceeds must be held in escrow by a neutral party and must go directly into the purchase of the replacement property. Generally, a Qualified Intermediary is involved in the transaction.

If you have questions about additional requirements of your 1031 exchange, please see our Exchange Manual or give us a call at 888-367-1031.

IRS Gives OK to Non-Safe-Harbor Reverse Exchange

In January, the IRS issued a Private Letter Ruling (PLR 200901004) approving a reverse improvement exchange under §1031 that did not comply with Revenue Procedure 2000-37 (the “safe harbor” exchange guidelines issued by the IRS).

There were two unusual features to this exchange –

• It is a “non-safe-harbor” reverse exchange, and
  
  
• The replacement property is an improvement built on property (easements) owned by the taxpayer.

These are issues for which no specific guidance or approval had been previously issued by the IRS. Usually, like-kind replacement real estate has been thought to require ownership of real property as distinguished from an improvement constructed on land already owned by the taxpayer.

As described in the PLR, the taxpayer proposed to exchange “Old Facility” for “New Facility.” Old Facility was to be sold to an unrelated third party. Taxpayer was to hire a contractor (Accommodator) to build New Facility on easements already owned by Taxpayer or acquired by Taxpayer prior to the exchange. The contractor would initially own and finance the construction of the New Facility independently of the Taxpayer. Following completion of New Facility, the contractor would transfer ownership of New Facility to Taxpayer (presumably using the exchange cash to service debts of the contractor).

This is the substance of the proposed exchange described by the PLR. However, there are more complicated relationships in the transaction which can be summarized as follows –

• The contractor was a domestic subsidiary of a foreign corporation which also owned the Taxpayer. However, the contractor is not a related party to Taxpayer because the parent is a foreign corporation which is excluded from the definition of a related party.
  
  
• The contractor had no equity in the project other than funds from its parent foreign corporation.

Unlike the DeCleene Case, the ruling does not examine whether the contractor acting as Accommodator possessed the benefits and burdens of ownership, whether it was acting as Taxpayer’s agent or whether the exchange is a step transaction resulting in the Taxpayer acquiring improvements on its own property. The ruling does imply that an exchange can be structured using an accommodator for property in which the taxpayer has a substantial ownership interest or over which it otherwise exercises control.

As with all PLRs, this opinion was issued as a private letter ruling to the taxpayer requesting a ruling, and therefore it cannot be cited as precedent. The Internal Revenue Service has the right to change its position on this matter without notice. If you have questions about structuring your improvement or reverse exchange, please give us a call at 888-367-1031.

Like Kind vehicles under Section 1031

A new private letter ruling (PLR 200912004) says that vehicles that share characteristics of both cars and light general purpose trucks - including SUVs, minivans, cargo vans and crossovers - are of "like kind" for section 1031 purposes.

The IRS observes that in the past few decades motor vehicles have evolved in a manner which blurs the distinction between cars and light-duty trucks.

The “safe harbor” for determining which vehicles are like-kind to each other has been by reference to the General Asset Classes found in Reg. §1.1031(a)-2(b)(2) or the Product Classes found in Sectors 31, 32 and 33 of the North American Industry Classification System (NAICS). Vehicles which are found in the same Asset Class or Product Class have been deemed to be like-kind.

PLR 200912004 observes that personal property exchanges can be like-kind for a 1031 Exchange even if they are not in the same Asset or Product Class and that no inference is to be drawn from the fact that properties are not in the same Asset or Product Class.

As noted above, the Asset and Product Classes are “safe harbors” and not the exclusive way to determine if personal property is like-kind.

Accordingly, cars, light general purpose trucks and vehicles that share characteristics of both cars and light general purpose trucks (13,000 lbs) (e.g., crossovers, sport utility vehicles, minivans, cargo vans and similar vehicles) are like-kind for 1031 Exchange purposes even though they are in different Asset or Product Classes.

Caveat: This opinion was issued as a private letter ruling, and therefore it cannot be cited as precedent, and the Service has the right to change its position on this matter without notice.

For more information on depreciable tangible personal property and like-kind exchanges, please visit our 1031 exchange website, www.1031cpas.com, or give 1031 Corporation a call at 888-367-1031.

Intangibles Can Qualify as Like Kind Property for Section 1031 Exchanges

A new Chief Counsel Advice (CCA 200911006) declares that intangibles such as trademarks, tradenames, mastheads, etc., that can be valued separately and apart from goodwill qualify as like-kind property for a Section 1031 exchange.

This is a policy change from past thinking of the IRS as expressed in PLR 200602034 - issued as a Technical Advice Memorandum - which said that such intangibles could not be of like kind to similar intangibles of any other business because they were closely related to, and part of, the goodwill of the business being sold. Goodwill of a business being sold is not considered to be like kind to the goodwill of any other business being purchased.. The CCA also reverses IRS’s position in FAA 20074401F, which stated that newspaper mastheads and customer-based intangibles were too closely related to goodwill to ever be like-kind.

The CCA declares that the IRS should not follow the position set forth in PLR 200602034. The IRS says that except in rare and unusual situations, intangibles such as trademarks, tradenames, mastheads, etc. can be valued separately from the goodwill of a business and thus are eligible for an exchange for like-kind intangible property.

If you have questions about intangibles and whether they may qualify for a section 1031 exchange, please give us a no obligation, toll free call at 888-367-1031.

Development Rights are Like Kind to Fee Interest in Real Estate

A newly released private letter ruling, PLR 200901020, reaffirms the IRS's view that development rights are a qualifying interest in real estate which can be like kind to a fee and other interests in real estate for purposes of an exchange under IRC Section 1031. PLR 200805012 previously affirmed the same. Accordingly, development rights can be exchanged for a fee interest in real estate and vice versa.

In order for development rights to be like kind to fee interest in real estate under IRC Section 1031, it is necessary for the state the rights are located in to view such rights as a real estate interest and for the rights to be in perpetuity (as distinguished from rights which are short-term or for a limited period of time). Perpetuity is important. Short-term rights may be an interest in real estate under state law but are not like kind to a fee interest in real estate under IRC Section1031. PLR 200901020 makes this clear.

A qualifying interest in real estate which can be like kind to a fee interest in real estate under IRC Section 1031 can include varying types of real estate interests. PLR 200901020 examines such other types of qualifying interests in real estate including –

• Leasehold interests of 30 years or more
• Easements
• Rights-of-ways
• Water rights
• Mineral rights
• Royalty rights
• Mineral leases

All of these types of real estate interests are considered like-kind to each other under IRC Section 1031 and may be exchanged for each other.

While the privage letter ruling can not be cited as precedent, and the IRS has the right to rule differently on subsequent occasions, it is a useful ruling for the purpose of demonstrating the IRS's view for similar situations. To receive a copy of the PLR, give us a call at 888-367-1031 or send us a message at 1031@1031cpas.com.

Mutual Irrigation Ditch, Reservoir or Irrigation Company Stock

With the recent passage of the Food and Energy Security Act of 2007 (commonly referred to as the Farm Bill), mutual irrigation ditch, reservoir or irrigation stock (“ditch stock”) MAY now be considered like-kind to a fee interest in real estate.

Section 1031 clearly spells out that corporate stock, bonds and notes are not eligible for a like kind exchange. However, the recently passed Farm Bill amends section 1031 to exclude mutual irrigation ditch, reservoir or irrigation company stock from “stocks, bonds, or notes”. With this passage, these water rights may now be eligible for a 1031 exchange - depending on state statute and previous court rulings.

Mutual irrigation ditch, reservoir or irrigation stock is generally considered to be a water right which is used on farm land to irrigate crops. Water, as a mineral, is generally considered to be an interest in real estate. As an interest in real estate, it is generally considered to be like-kind to a fee interest in real estate. Farm land which is sold or exchanged sometimes includes ditch stock that has benefits and value to the sale of that land. Particularly in the western United States, these water rights are critical to the ongoing production ability of the property and are typically sold with the real estate.

In order to qualify, the new law clearly indicates that such ditch stock has to be recognized as real property, or an interest in real property, in the state in which the corporation is located. Recognition can be by the highest court of the state or by applicable state statute. Mutual irrigation ditch companies are organized under separate sections of state statutes and ditch stock has been recognized as an interest in real property by the District Court of Colorado and other court cases. However, ditch stock in other states may or may not qualify.

Exchange clients should be familiar of the state laws and court rulings in the state their exchange property is located. Of course, they should also discuss their circumstances with a knowledgeable real estate attorney or qualified tax professional before embarking on an exchange of water rights. A Qualified Intermediary that is familiar with the special closing and exchange-related issues involving ditch and water stock should also be consulted and engaged to ensure the exchange is completed properly. To learn more about this topic, please consult our 1031 Exchange Manual or give 1031 Corporation Exchange Professionals a call at 888-367-1031.

Transferable Development Rights are 1031 Like Kind to Real Estate

Transferable Development Rights (TDRs) are a relatively modern land use planning tool that are encountered in many jurisdictions. Where they are authorized, governments can grant TDRs in order to limit or to entirely prevent development in special zoning districts. When properly structured, governments can accomplish these land use goals without having to pay for what might otherwise constitute costly partial – or even total – condemnations. TDR programs can also be used to reduce political and legal opposition to a restrictive zoning plan. In a TDR program, a governmental entity grants owners of property in the special use zone TDRs in exchange for either voluntary or compulsory new restrictions on the development of property within the zone. These TDRs can be sold on the open market to owners of other real property in a receiving zone, permitting development of the property in the receiving zone beyond what would otherwise have been permitted.

In a recent IRS Letter Ruling (2008-05012), a taxpayer proposed to sell a fee interest in relinquished property and use the proceeds to acquire TDRs. Those TDRs would be used to enhance construction on property the taxpayer already owned within a designated receiving zone. The taxpayer sought a ruling that the TDRs were like-kind to a fee interest in real property.

The IRS ruled that the TDRs could be like-kind to a fee interest under section 1031, despite the fact that the taxpayer intended to use the them to enhance real property it already owned, as long as the TDRs were acquired in an arm’s length transaction. They cited a prior Revenue Ruling from 1968 that said a leasehold with more than 30 years left to run on the property the taxpayer already owned was like-kind to a fee interest under section 1031 as long as the taxpayer acquired the leasehold in an arm’s length transaction.

Next, relying almost entirely on their classification under state and local law, the ruling held that the TDRs are like-kind to a fee interest in real property. While TDRs may not be treated identically to real property for all purposes, they are treated like real property in a number of important ways including: a) the fact that their grant is not discretionary; b) they appear to be permanent; c) they are transferred in a manner similar to the transfer of a deed or an easement; and d) they are recorded and indexed against the granting and receiving sites. Further, the state where the taxpayer was located had a tax statute and transfer tax provisions that seemed to define TDRs as real estate.

Because TDR programs vary considerably from one state to another, it is by no means certain that the laws of a particular jurisdiction will comply sufficiently with the standards presented in this letter ruling. As is always the case with private letter rulings, the ruling itself cannot be cited as precedent, and the IRS has the right to rule differently on subsequent occasions. However, the ruling is useful for the purpose of demonstrating the current thinking on this important subject. To receive a copy of the PLR involving TDRs, give us a call at 888-367-1031 or send us a message at 1031@1031cpas.com.

Conservation Credits and Development Rights are Like-Kind to Real Estate

Recent Private Letter Rulings have ruled that conservation easement credits and tranferable development rights are like kind to a fee interest in real estate.

PLR 200649028 regarding Conservation Easement Credits dealt with the question of whether future development restrictions conveyed by a taxpayer under a state conservation program would qualify as being like kind to a fee interest in real estate. In this case, a county issued "credits" to a taxpayer for a conservation easement. The credits were sold to a buyer and the taxpayer used the money to purchase replacement real estate - all with the assistance of a Qualified Intermediary. The IRS ruled that the credits represented an interest in real estate for both the seller and the buyer.

PLR 200805012 held that Transferable Development Rights ("TDR"s) are a qualifying interest in real estate which is like kind to a fee interest in real estate if they are considered real estate under state law. In this case, the taxpayer proposed to sell (exchange) real estate and replace with the purchase of TDRs. Another interesting aspect of this ruling is that the TDRs were to be used to construct improvements on a property already owned by the taxpayer. The IRS ruled that the TDRs were like kind to a fee interest real estate. It is unclear whether the IRS condoned the use of the proceeds for improvements on property the taxpayer already owned as replacement property.

These rulings are useful for purposes of demonstrating the current thinking of the IRS on these issues. However, taxpayer beware! Private Letter Rulings are specific to that taxpayer's question. The IRS has the right to rule differently on subsequent occasions. Also, conservation programs can vary significantly from state to state. The assistance of a tax professional, real estate attorney and qualified intermediary is essential when determining how best to structure your conservation easement or development rights exchange.

Proposed Farm Bill would limit agricultural exchanges

The United States Senate has unveiled the “Food and Energy Security Act of 2007”, otherwise known as the “Farm Bill,” which combines agricultural program proposals with tax proposals formerly included in the “4-H Bill.” The Farm Bill is currently under consideration by the full Senate. The proposed bill, as currently crafted, has a potentially negative impact for farmers and ranchers with respect to 1031 exchanges. It will limit their options to do a tax-deferred exchange out of farmland and into other real estate investment property.

As part of the bill, the Senate is proposing to change the 'like-kind' standard to provide that “unimproved agricultural real property” is not like-kind to “improved real property”. “Unimproved agricultural real property” is defined as agricultural land that is enrolled in certain farm subsidy programs, unless the agricultural land is permanently retired from the farm subsidy programs prior to the date of an exchange transaction. Much of America's agricultural land is subject to these subsidy programs.

What does this mean for exchanges of agricultural properties? It prevents farmers, ranchers and owners of agricultural property from exchanging out of improved agricultural property (livestock facilities, grain elevators, machine sheds, fence, tile etc.) and into the subsidized agricultural land. It also prevents farmers and ranchers from exchanging the subsidized agricultural land for any improved real property, including commercial, residential and tenancy-in-common (TIC) properties. Finally, it prevents owners of commercial and residential investment properties from exchanging into the subsidized agricultural land.

Most likely, these provisions will result in agricultural land owners having limited choices in exchanging their farm or ranch land. If they decide they'd like to reinvest their land sale proceeds into an improved investment property they will be forced to pay the tax or exchange and lose the land's future ability to qualify for subsidies (thus potential reducing the value in the land). As you can see, this provision will have a significant impact on those that work with agricultural land and on those communites that are located in agricultural-based areas.

We believe this is a bad provision. If you agree, please let your Senator know that you oppose Section 12504 too.

Section 1031 Exchange defined

A 1031 Exchange, also sometimes called a Like Kind Exchange or a Starker Exchange, is a way of structuring the sale of property so that the seller’s taxable profit or gain is deferred. If the property that is sold is replaced with another “like kind” property and if the transaction is properly structured, the seller’s profit or gain may be deferred out to the date the replacement property is sold (or perhaps longer if the replacement property is subsequently exchanged).

The logic behind a 1031 Exchange is that since the taxpayer is simply exchanging property for another "like kind" property, thetaxpayer has received nothing to pay taxes. All gain is in still being held in the form of property, so no gain or loss should be recognized or for income tax purposes.

Let's take a look at the actual section of the code where this benefit originates for a definition of what this means. Section 1031 of the Internal Revenue Code:

"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."

It is a common misunderstanding that the relinquished property sale, and the replacement property acquisition have to be simultaneous. However, the majority of exchanges that have occurred over the past twenty five years are not simultaneous. This was the result of the 1984 Starker tax court case (and, hence, the name Starker Exchange). In 1991, the IRS issued the present day section 1031 rules.

For a non-simultaneous exchange, the taxpayer must use a Qualified Intermediary (also sometimes ccalled an Exchange Accommodator or Facilitator), follow IRS guidelines, and use the proceeds of the sale to buy qualifying, like-kind, investment or business property. The IRS rules require specific time clocks to be followed. The replacement property must be “identified” within 45 days after the sale of the old property and the acquisition of the replacement property must be completed within 180 days of the sale of the old property.

Section 1031 is most often used in connection with the sale of real property. For real property exchanges under Section 1031, any property that is considered "real property" under the law of the state where the property is located will be considered "like-kind" so long as both the old and the new property are held by the owner for investment, or for active use in a trade or business, or for the production of income.

Some exchanges of personal property can qualify under Section 1031, however, the classifications of what is "like kind" become a lot more specific and limiting. Shares of corporate stock in different companies will not qualify. Exchanges of partnership interests in different partnerships and exchanges of livestock of different sexes do not qualify.

In order to obtain full benefit, the replacement property must be of equal or greater value and all of the proceeds from the relinquished property must be used to acquire the replacement property. The taxpayer cannot receive the sales proceeds of the old property. Exchanges are typically structured so that the taxpayer's interest in the relinquished property is assigned to a Qualified Intermediary prior to the close of the sale. That way, the taxpayer does not have access to or control over the funds when the sale of the old property closes.

At the time the relinquished property is sold, the proceeds are sent directly to the Qualified Intermediary. The proceeds from the sale of the relinquished property are deposited by the QI and held until the purchase the replacement property. After the acquisition of the replacement property closes, the QI delivers the property to the taxpayer and the exchange is complete.

Introduction to 1031 Like Kind Exchanges

A 1031 Exchange (Tax-Deferred Exchange) Is One Of The Most Powerful Tax Deferral Strategies Remaining Available For Taxpayers. Anyone involved with advising or counseling real estate investors should know about tax-deferred exchanges, including Realtors, lawyers, accountants, financial planners, tax advisors, escrow and closing agents, and lenders. Taxpayers should never have to pay income taxes on the sale of property if they intend to reinvest the proceeds in similar or like-kind property.

The Advantage of a 1031 Exchange is the ability of a taxpayer to sell income, investment or business property and replace with like-kind replacement property without having to pay federal income taxes on the transaction. A sale of property and subsequent purchase of a replacement property doesn't work, there must be an Exchange. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges. The IRS issued "safe harbor" Regulations in 1991 which established approved procedures for exchanges under Code Section 1031. Prior to the issuance of these Regulations, exchanges were subject to challenge under examination on a variety of issues. With the issuance of the 1991 Regulations, tax-deferred exchanges became easier, affordable and safer than ever before.

The Disadvantages of a Section 1031 Exchange include a reduced basis for depreciation in the replacement property. The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain which was deferred on the sale of the relinquished property as a result of the exchange. The replacement property thus includes a deferred gain that will be taxed in the future if the taxpayer cashes out of his investment.

Exchange Techniques. There is more than one way to structure a tax-deferred exchange" under Section 1031 of the Internal Revenue Code. However, the 1991 "safe harbor" Regulations established procedures which include the use of an Intermediary, direct deeding, the use of qualified escrow accounts for temporary holding of "exchange funds" and other procedures which now have the official blessing of the IRS. Therefore, it is desirable to structure exchanges so that they can be in harmony with the 1991 Regulations. As a result, exchanges commonly employ the services of an Intermediary with direct deeding.

Exchanges can also occur without the services of an Intermediary when parties to an exchange are willing to exchange deeds or if they are willing to enter into an Exchange Agreement with each other. However, two-party exchanges are rare since in the typical Section 1031 transaction, the seller of the replacement property is not the buyer of the taxpayer's relinquished property.