Closing costs deductions on 1031 Exchange

We are often asked this question. Or perhaps it is asked, “Do I have to replace the net sales price or full sales price of the property I am selling to fully defer my tax?” Unfortunately, very little guidance (and it is fairly dated) has been provided in determining the deduction of transactional costs from any realized and recognized gain. Internal Revenue Service Form 8824 provides for transactional costs that are referred to as “exchange expenses” that can be deducted. But what are transactional costs?

Exchange expenses are those expenses which result solely as a result of the sale or acquisition of property and other costs directly related to the sale or acquisition of real estate or in connection with the 1031 Exchange (transaction expenses). These may include: real estate commissions, closing or escrow fees, title insurance premiums, legal fees, transfer taxes as well as such items as notary fees, recording fees and even the fee paid to your Qualified Intermediary.

One thing is clear. Costs related to obtaining financing should not be deducted from the proceeds to determine the "net sale price." Other transactional items typically found on a closing statement are not exchange expenses and probably do not reduce the amount realized or recognized and are not added to the basis of the replacement property. Items such as property taxes, utility escrow deposits or charges, homeowners' association fees, hazard insurance premiums, tenant security deposits and prepaid rents are items to look for on a closing statement.

When completing your tax return and determining how to report closing cost deductions, it will be extremely helpful to have your settlement statement as well as a form such as 1031 Corporation's Form 8824 worksheet. Of course, a taxpayer should review their individual transaction and closing costs with their tax and/or legal advisors to determine whether costs related to the closing are exchange expenses or not.

Where Does Your Intermediary Put Your Exchange Funds?

We've spoke before of the need to fully investigate the Qualified Intermediary (QI) you, as an investor or a referring agent, choose. Some high profile cases have identified the need to deal with a QI you know and trust. Even that is sometimes not enough and you should really investigate the safety and security of the company you use.

As we've said before, the range of investments a Qualified Intermediary can make with your exchange funds is not currently regulated. Your QI can place your exchange funds in many different investment vehicles. Knowing how your exchange funds are protected is vital when selecting an intermediary partner. Most, but not all, QIs place your 1031 exchange proceeds in financial institution. Others choose to pool the funds and place them with an investment firm that offers short term liquidity such as overnight borrowing vehicles.

While we've previously explored the security features of bonding and making sure you deal with a firm that is financially stable and uses segregated accounts. However, we haven't discussed knowing the financial strength of the institution with which the Qualified Intermediary banks your funds. With recent news of bank capital calls, troubled financial institutions and even failures like Indy Mac, you should ask the question of where your funds are held.

Some of the questions you should ask include:

Are your exchange proceeds placed in a segregated account or are they pooled with other exchange client funds?

How well capitalized is the bank or financial firm your Qualified Intermediary uses?

Can you find information of the bank or investment firm?

Has there been any recent news about trouble such as capital calls, bad loans or subprime lending participation with the financial institution?

Does the bank or investment firm provide independent depositor insurance such as FDIC coverage?

Does your Qualified Intermediary offer the ability to split your exchange funds into multiple accounts to provide deposit insurance protection?

Our firm has always segregated funds and held them in a bank account. We are a subsidiary of FirstBank. They hold more than $9.2 billion in assets, have a low loan-to-deposit ratio of around 42% and are extremely well capitalized. Further, they are profitable today having a very low percentage of problem loans and have never participated in subprime mortgage lending. In fact, the health of the bank was just highlighted in both a Rocky Mountain News article and a Denver Post article. We also have the ability to split accounts into 26 separately chartered banks of the bank. This provides our clients with up to $6.5 million in FDIC insurance.

You should expect the same level of security and safety in your 1031 exchange funds. After all, it's your money they are holding. If your Qualified Intermediary can not answer these simple questions of where the money is held, or the answers aren't sufficient to provide you peace of mind, it's time to look for a new QI.

Oil, Gas and Mineral Interest 1031 Exchanges

It would seem to make sense that you could exchange a working or royalty interest for another working or royalty interest as part of a 1031 Exchange. But, did you know that you can also exchange a working or royalty interest for other real estate? For example, if you sell a working interest, you could replace it with another working interest, a royalty interest, or ownership in an office building, apartment building, or other real estate.

However, oil, gas and mineral interest exchanges are tricky. For example, if you sell a working interest and retain the royalty interests or surface rights, the IRS may disallow your exchange. This is because production payments do not qualify for a 1031 Exchange.

The sale of working interests often involves the sale of related equipment. Keep in mind that transfers of equipment require the equipment to be treated as a separate personal property exchange. Personal property exchanges are a different animal than real estate exchanges.

Also note that any costs incurred to drill and develop the gas or mineral site must be recaptured to the extent that you do not re-acquire qualified natural resource property. In other words, if you sell a working interest in a gas well and buy an office building, you would have to "recapture" the Intangible Drilling Costs (IDC) costs you had previously deducted.

If you have questions about Oil, Gas or Mineral interests and how they relate to 1031 exchanges, please contact 1031 Corporation Exchange Professionals at 888-367-1031.

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.

Family Limited Partnerships

In managing federal estate taxes, the use of Family Limited Partnerships (FLPs) has proven to be a beneficial planning technique. During the last two decades, FLPs gained popularity. They also attracted the attention of the Internal Revenue Service (IRS).

Due to the FLPs extraordinary tax benefits, the IRS has audited many FLPs. But this IRS challenge should not be viewed as their demise. Rather, IRS audits reveal proper FLP use and maintenance.

Benefits of the FLP
An FLP is a powerful estate planning tool that can help reduce future taxes. This tool may be very handy as estate taxes may soon be at an all time historic high. For those who pass away after 2010, the tax law would impose a steep estate tax or "death tax" burden of up to 55% of ranch value!

Using an FLP can help ease this tax burden. Through an FLP, a senior family member can reduce the estate tax and keep control of the family operation.

An FLP is often formed by a member of the senior generation who transfers family assets to the partnership in exchange for both general and limited partnership interests. Some or all of the limited partnership interests are then gifted to the junior generation. The general partner need not own a majority of the partnership interests. In fact, the general partner can own only 1 or 2% of the partnership, with the remaining interests owned by the limited partners.

This structure produces several advantages:

The senior family member can gift limited partnership interests to junior family members at less than the full fair market value of the underlying assets.

The use of the partnership entity allows a senior family member to shift some of the form and ranch income and future appreciation to other members of the family.

The senior family member retains management and control while transferring away limited ownership interests.

The senior family member can also place restrictions within the partnership agreement that ensure continuous family ownership.

At death, the senior family member's estate tax bill may be reduced since only the value of the decedent's partnership interest will be taxed.

IRS Scrutiny: Potential Concerns with the FLP
The IRS has taken a more aggressive stance regarding FLPs. Over the past several years, the IRS has had success in attacking FLPs with the most common problems being:

Failure to Follow Formalities. FLPs are required to have Partnership Agreements that must be followed. Although FLPs have far fewer formalities than corporations, the partners should have regular meetings, take minutes, and treat the entity with the formality expected of a non-family business.

Inadequate Valuation Reports. The IRS is often critical of both the quality and content of the family's valuation appraisals. To avoid the IRS attention, the family should retain accredited appraisers experienced with the requirements of estate tax appraisals.

Non-business Assets or Activities. FLPs are business entities and are not meant for personal use. The family homestead should not be placed into an FLP, nor should normal family expenses (utilities, clothing, educational expenses, etc.) be paid from the FLP.

Other "red flags" include commingling FLP and personal income, preparing FLP financial records after death and forming "deathbed" FLPs.

FLPs need annual care and regular maintenance. With this care, FLPs can achieve substantial federal estate and gift tax savings. For farm and ranch families with large illiquid estates, FLPs can be a very beneficial tax savings tool.

Denise Hoffman is a senior associate with the law firm Rothgerber Johnson and Lyons LLP. If you or your family has questions concerning Family Limited Partnerships, please call Denise at 303-628-9523 or contact her by e-mail at dhoffman@rothgerber.com.

Depreciation using Cost Segregation

The following information was graciously provided by Jeff Pinkerton of U.S. Cost Segregation.

You may be able to easily take cash out of the investment properties you currently own. It's actually quite easy.

You're probably depreciating those properties at 27.5 years (if residential) or 39 years (if commercial). There is a section of the IRS code that allows you to depreciate certain assets within that building at 15 or 7 or even 5 years. That faster depreciation means more of a tax writeoff which means less taxes. You can even go back in time and recapture this 'lost' depreciation that you haven't been taking.

The technique is called cost segregation analysis and has been a part of the tax law for the past decade. This analysis needs to be performed by a qualified engineering firm, which identifies and "costs out" those assets which qualify for faster depreciation. For example, carpet, electrical for computer equipment and decorative elements can be depreciated over 5 years. Site utilities, paving and landscaping can be depreciated over 15 years.

Imagine you purchased a 15 year old four-plex five years ago and paid $500,000 for it. Assume 20% of that went to land, that means you are depreciating $400,000 over 27.5 years (that's 3.6% per year). But of that $400,000 you paid for the building itself, how much went to the carpet? To the plumbing and kitchen fixtures? To the interior non-load bearing walls?

The answer, of course, is "I don't know". Cost segregation analysis answers those questions and provides data your CPA can use to apply the deductions you've been missing. Extra deductions means less taxes. In fact, it's common that 25% of the assets in an apartment can be depreciated more rapidly. Compare that with the 3.6% you're depreciating now and you can see how this technique can benefit you.

Further, leasehold improvements have even a more profound impact. Typically about 50% of those assets are amenable to accelerated depreciation. This means that you can write off the cost of the original carpet that came with the building, as well as the new carpet you installed. Similarly the new cabinets, the new bathroom and the new electrical wiring and so forth.

This is a time-tested and IRS-accepted method of helping improve your cash flow.

For more information, contact Jeff at 303.694.3924 or visit their website at U.S. Cost Segregation Services.