1031 Drop and Swap Distributions Receiving New IRS Attention

Partnerships which are selling property often have one or more partners who want to structure a 1031 exchange for their share of the property owned by the partnership (or LLC). Sometimes all of the partners will wish to go separate ways and either sell for cash or do their own 1031 exchange. Sometimes one or two partners of a multi-partner firm will wish to leave the partnership arrangement.

A sale of a partnership interest does not qualify for a 1031 exchange. So, individual partners who want to structure a 1031 exchange for the sale of their interest in the partnership real estate need to position themselves appropriately. They can do so by receiving a deed to their share of the real estate from the partnership. This is done by the partnership conveying a tenancy-in-common interest in the real estate to the individual partner in redemption of his interest in the partnership. This leaves the real estate co-owned by the partnership and the individual member of the partnership who received the deed. Each of the co-owners proceeds to close on the sale of the real estate to the buyer and the individual member proceeds to do a 1031 exchange for the sale of his interest. Of course, the partnership and its remaining members are also positioned to do their own 1031 exchange if they wish to do so. This procedure is known in the industry as a “Drop & Swap.”

The Drop & Swap commonly takes place at the same closing table at which the property is conveyed to the buyer with back-to-back closings. The individual member partner who received a tenancy-in-common deed from the partnership has, technically, only owned his piece of the for sale real estate a few minutes. The first question that comes up is whether a few minutes of ownership is adequate for qualification of the sale for a 1031 exchange. The requirements for a 1031 exchange include the condition that the property being sold has to have been held by the taxpayer for investment or business purposes. This is commonly known as the “held-for requirement.” The Code and Regulations provide no guidance on how long a taxpayer has to have “held” the property for the required purposes.

In the past, the IRS has challenged taxpayers who have done a Drop & Swap with only momentary ownership prior to a sale. However, the courts have been favorable to the taxpayer holding that a distribution of property to a taxpayer is merely continuing the investment in a different form. In recent years, the IRS has not been aggressive in challenging Drop & Swaps.

However, commencing with 2008, Partnership Income Tax Returns include two new questions in Schedule B –

13. Check this box, if during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (including a disregarded entity).

14. At any time during the taxpayer year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?

Based on these new questions - which clearly include Drop & Swaps, it appears that the IRS wants to know how frequently this is being done and is giving it their attention. Will the IRS select partnership returns for audit based on the answers to these questions? We don’t know. At a recent industry conference, an IRS agent indicated it was Treasury and not the IRS that had added these questions. Further, the IRS has offered no explanation for these new questions. Whatever the case, it appears some study is being done on the subject.

Taxpayers involved in a Drop & Swap will have to accept some risk of challenge by the IRS based on these new questions on the Partnership Income Tax Return. Taxpayers should always consult with their tax and law professionals if they are contemplating a Drop & Swap for consultation on this issue as well as other business and tax issues affecting the partnership and its members.

For more answers to your questions regarding partnership interests and 1031 exchanges, please visit our website or give us a call at 888-367-1031.

Strong Ethical Foundations Important in 1031

Michele Falivene recently wrote an article for the banking industry about ethics. In it she states, “I have found there is a great deal of finger pointing going on these days as we grapple with the causes and impacts of the recession. Employees, businesses, government officials and consumers want to know who to blame and how to hold someone accountable for their losses. But it’s that lack of accountability and a very public absence of personal responsibility that has left many people without the answers they’re looking for.”

While we can’t rewrite the past for those 1031 exchange companies who engaged in questionable investment practices and pooled exchange funds, we can certainly revisit the principles that a Qualified Intermediary (QI) should offer - uncompromised integrity and a sound, ethical foundation.

A well-built, ethical foundation should be a vital part of the exchange company that you choose. A principled QI will explain their company’s commitment to best practices and make ethical considerations a primary decision-making factor. Detailed questions should be asked of the 1031 intermediary that you are considering using. Immediate answers for those questions should be forthcoming. You should be left having no lingering doubts.

1031 Corporation has built it’s foundation on these standards. As Henry Kravis said, “If you build that foundation - the moral and the ethical foundation as well as the business foundation and the experience foundation - the building won’t crumble.” In light of recent failures or “crumbling” in the 1031 exchange industry, 1031 Corporation is still standing strong. You can count on 1031 Corporation to provide our clients uncompromised integrity from a sound ethical foundation. For your 1031 exchange needs, please give us a call today at 888-367-1031.

Hold Open Title Policy Can Benefit your 1031 Exchange

What is a Hold Open?
A Hold Open is a title insurance term used for real estate transactions where the title company that insures the initial sale agrees to insure another sale of the same property within 24 months of the original sale. They are used in reverse 1031 exchanges to avoid the cost of two separate policies. Investors might also use them in a "flip" transaction.

There are three parties involved in a completed Hold Open transaction: the original seller, the middle buyer (the person requesting the Hold Open or, in the case of a reverse exchange, your Exchange Accommodation Titleholder or EAT), and the final purchaser (the exchanging client. Hold Opens are often associated with reverse 1031 exchanges and fixer-upper properties, but this is not a requirement for a buyer to request a Hold Open. Investment properties can be held open from one sale to the next and Hold Opens are also available for short-term owners who simply know they will be selling the property within two years.

Benefits of a Hold Open
A Hold Open ultimately saves money for the buyer in a 1031 exchange. Since the buyer knows that the purchased property will be resold within two years, the title company can hold the file open for the resale at a fraction of the cost the buyer would have paid — even with a discounted reissue rate — in title insurance premiums.

The process works like this: The original seller pays the applicable title insurance premium for the initial sale to insure the middle buyer. The middle buyer then pays only a small percentage (depending on the underwriter) of the full basic premium charge in order for the title company to keep the file open, and no title insurance policy is issued at this time. In the case of a reverse exchange, the client pays all closing costs associated with the initial purchase so they ultimately save title cost on the subsequent exchange.

When the middle buyer (EAT) sells the property (back to the exchanging client), they pay the difference in premiums between their purchase price and the selling price on the second half of the Hold Open. A title policy is issued only to the final purchaser.

For example, a Denver residential property purchased for $250,000 would have a full premium of $1,265. The buyer (via the EAT) would pay an additional Hold Open fee of $126 to keep the file open. Upon the sale of the relinquished property in the exchange, the EAT sells the house back to the taxpayer for the same price. While this second sale would normally trigger the need for new title insurance (costing another $771 at the standard 50% reissue rate), the up-front, 10% payment of the Hold Open policy would result in no additional title insurance premium.

In the case of a fix and flip, hopefully, the property was sold for more. Let's say it was subsequently cleaned up and sold for $300,000. In this case, the seller would pay the difference in premiums, which would be $92. His total title charge would be $218 ($126 for the Hold Open and $92 for the increased coverage over the original $250,000 purchase), saving $553 over the $771 he would have paid if he had simply used a standard 50% reissue rate.

Conditions for a Hold Open
A property is eligible for Hold Open status only if the following conditions are met:

• A commitment to insure the final purchaser is issued after recording the initial conveyance to the middle buyer. This is in lieu of a policy of title insurance to the middle buyer, or EAT. Any adverse matters that are recorded or become known to the title company must be satisfied before the policy is issued.

• There must be a single resale transaction of the exact property as reflected on both the original commitment to the middle buyer (EAT) and the final policy to the final purchaser (the exchanging party). For example, the purchase of a duplex must be sold as a duplex, not sold as two separate units in the final conveyance.

• The middle buyer (the exchanging party's EAT) must sign an affidavit acknowledging that he is aware the property must be sold within two years or the Hold Open charge will be forfeited and the policy issued to the middle buyer.

• Both transactions must be insured through the same title company. The final purchase for the transaction initially held at one title company cannot be insured by another title company.

Property Value Increases
The Hold Open charge is based upon full value of the real estate or interest at time of the initial conveyance, with an additional charge of 10–25% (depending on the underwriter) of the basic premium based on the full value of the real estate or interest.

Upon closing of the resale within two years, the owner’s title policy will be issued to the final purchaser without additional cost. If there is an increase in the liability between the initial conveyance and the ultimate sale, a charge will be made based on the difference between the two liabilities calculated at the applicable schedule of rates.

Additional stipulations
The Hold Open is available only one time per transaction. If the resale to the final purchase is not recorded within 24 months of the date of the original sale, the policy of title insurance will be issued insuring the purchaser in the initial
sale in the amount originally committed. The Hold Open charge will be forfeited.

A potential drawback of the Hold Open procedure is that the middle buyer is not insured for any warranties of title that may be given in the deed to the final purchaser, since no owner’s policy is issued to the middle buyer.

Kyle Snyder of Land Title Guarantee Company has graciously provided much of the above information. If you have questions about Hold Open title policies, give Kyle a call at 303-393-4945. For your reverse exchange needs, please contact us at 888-367-1031.

FirstBank at the Colorado Rockies Season Opener

1031 Corporation is a wholly-owned subsidiary of FirstBank. While we try to highlight the safety and soundness of our parent company, the bank recently made an aerial effort to highlight its long-standing belief that fiscal responsibility starts with the way a company you do business with spends its money. This banner flew over LoDo Denver above Coors Field on the Colorado Rockies 2009 opening day last Friday.



In case you can't read the banner, it says: "This is the closest thing we have to a private jet"....with the FirstBank logo.



Oh, by the way, 1031 Corporation does aircraft exchanges...in case you are considering exchanging a single prop, like the one in the photo, for that private jet.

Have a great weekend!

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.

1031 Exchange Classes and Continuing Education

1031 Corporation Exchange Professionals provides continuing education classes for Realtors, CPAs and Attorneys. We work with broker offices, title companies and real estate, accounting and legal trade associations to provide Continuing Education credit for 1031 exchange classes in Colorado (and very soon, Arizona and California). In conjunction with a couple self-directed IRA providers, we also provide a broader, tax deferred real estate investing class.

While many states now have a prescribed minimum requirements list that includes ethics and other "core" classes, a class involving 1031 exchange options, rules and procedures is a great way to add an interesting twist to your class offerings. It allows participants to hear something about a topic with which they may not be as familiar. It attracts agents, business associates or investor clients that might not normally attend a class offering and gives something of value to the agency or firm sponsors the course.

Carol Croft, Larry Jensen and I combine to offer our expertise and real life experiences to provide valuable insights into new strategies to defer capital gains. Carol has over fourteen years experience and she is a Certified Exchange Specialist. She's performed thousands of exchanges on behalf of our clients and has a number of real life examples that provide practical knowledge about how one goes about completing an exchange. Larry, as a Certified Public Accountant, is extremely knowledgeable about the technical and legal basis for many exchange strategies and concepts. While he is a former accounting firm partner and has more than 30 years accounting experience, he provides much more than a dry scholarly approach. Pretty interesting stories too...oh....me? I am just a former banker of seventeen years that really likes mixing real estate, financial concepts and saving money on taxes! All three of us love thinking "outside the box" and coming up with possible solutions to the most complex of 1031 exchange scenearios.

Our most popular class, a course titled Everything Your Ever Wanted to Know About 1031 Exchanges (I know, pretty lofty title, LOL) provides the basics of a like kind exchange in a format that allows interaction - all while informing in a very easy to follow, two hour format. We typically even work with a sponsor that partners by providing the facility or perhaps lunch. No better way to bring in a crowd than with free food! In these economic times, inexpensive, one-on-one marketing opportunities are effective. They provide the ability to converse face-to-face with those individuals that are actively positioning themselves to benefit during the next recovery cycle.

If you have questions about 1031 exchange classes or partnering with 1031 Corporation Exchange Professionals on education opportunities, please call us toll free at 1-888-367-1031.

Things a Lender's Counsel Thinks about in a Real Estate Transaction - Part 2

Last Friday, we covered the first six of the top things a Lender’s counsel thinks about regarding a commercial loan transaction. This weeks conclusion of that article provides the final items. This list is courtesy of Michael Fogel of the Florida law firm of Fogel and Pekale LLP.

7. Show me where the dead bodies are buried

Except for a condominium, it is almost the rule that some form of environmental questionnaire, analysis, study, or report will be required by the lender. If you think buyers don’t like surprises, then you’ll not be surprised to learn that lenders dislike them even more. You should know that there are very few exceptions to the lender’s requirement that this pre-closing condition meet the lender counsel’s satisfaction. Quite simply, the lender will not fund the loan without it. While an environmental questionnaire is relatively quick to prepare, an environmental study (i.e., a Phase 1 Report) frequently is not. If any further analysis is required, that WILL take time. Therefore the best advice is, when the contract is fully executed and if the lender requires an environmental analysis, don’t delay. Order it today!

8. How’d they do that?

Ah...the appraisal. One of life’s great mysteries. Some how, some way, the property is given a value by those all-knowing, all-powerful prognosticators of worth: the appraisers. This may be one of the toughest jobs in the real estate industry. It takes experience and study and is critical to the loan process. Which means that the appraiser (like the surveyor) must meet the lender’s qualifications and the bank will (or will not) make its loan based upon the value the approved appraiser gives the subject property. The lender’s counsel will have this item as a high priority item on its Closing Checklist as the loan itself will not be done without the appraisal meeting the lender’s criteria.

9. The Kitchen Sink

Each commercial real estate transaction is unique and there are times when there are other important facts, terms, or conditions that are critical to disclose to the lender and its counsel very early in the process. The list is endless - virtually a kitchen sink of scenarios. For example, franchises and gas stations have very specific agreements that affect the use of the subject property and, therefore, are subject to the Lender’s review and approval. Other commercial properties may have tenants of all different sizes and leases of varied terms. There may be cross-access easements, deed or other use restrictions, property owner associations, zoning or code violation matters, like kind exchange documents. All of these are important to lender’s counsel and must be addressed in the initial pre-closing phases of the transaction. A delay in getting lender’s counsel information on any of these items may result in a delay of the closing, or perhaps closing will not happen at all, frustrating the buyer’s and the broker’s objectives and creating unwanted consequences.

10. I’ve got you covered

If you have lived in Florida for 5 minutes you know that property insurance is a very hot topic now and likely will be for some time to come. It one of the essential ingredients in “baking the closing cake”. It is extremely unlikely that buyer’s lender will close without the buyer obtaining insurance coverage acceptable to the lender. It is, therefore, important to have the buyer determine what the lender’s insurance requirements are as soon as possible then diligently pursue satisfying them. Insurance will most certainly be a pre-closing item on the lender counsel’s closing checklist. Get evidence of insurance coverage - paid in advance by the buyer - to the lender’s counsel. As we have all seen, the insurance market changes like the weather. Do not wait until the last minute on this matter.

10 (again). Show me the Money (Again)

While all of the pre-closing conditions are getting satisfied, keep your eye on
one of the last requirements - the buyer’s closing funds. Generally, the buyer shall be required to come to the closing with funds sufficient to close the transaction. Funds are usually in the form of a bank or cashier’s check, an attorney’s trust account check or are sent by wire transfer. It is not uncommon for buyers/borrowers to lose track of this requirement. They then have to scramble to come up with sufficient closing funds, thereby causing a myriad of issues on the eve or day of the closing!

While this article is written from the perspective of a lender’s counsel, you may notice that several of the top items are very important, even critical, to the buyer and its counsel. Accordingly, make sure that these items are delivered to such parties concurrently with the delivery thereof to lender and its counsel. If the broker can provide this information thoroughly and quickly, it can and most often does make the pre-closing part of the transaction proceed more quickly and efficiently. And getting the closing to occur, as we all know, is the main objective.

We'd like to thank Mr Fogel for granting us permission to use his insights. Please contact Mitchell at (561) 393-9707 with any questions or comments.