Vacation home exchange oversight recommended

A recent report from the Treasury Inspector General for Tax Administration says like-kind Exchanges require greater oversight to ensure taxpayer compliance. One area of particular importance to taxpayers is increased oversight of vacation or second home exchanges.

It is fairly clear that a vacation home used exclusively by the owner or related parties may not be exchanged. When the home is not used exclusively by such persons, or where this is some rental history or attempts to rent, there is no published position by the IRS.

According to the report, this leaves “unrebutted, the sales pitch of like-kind exchange promoters” who may encourage taxpayers to exchange non-qualifying vacation homes. Many of these promoters also advise the taxpayer on exchanging primary residences with gain over the IRC § 121 gain exclusion. It also notes that realtors “who may not be well versed in tax law” may advise amateur real property “flippers”, who are really dealers, that these flips qualify for § 1031. Likewise, taxpayers also claim an exchange despite that they’ve taken possession of the cash proceeds from the sale. Unscrupulous or uninformed promoters are taking advantage of the IRS’s silence on the vacation home issue.

The IRS agrees to act on the Report’s three recommendations. They have agreed to provide additional guidance regarding exchanges of second and vacation homes that were not used exclusively by the owners. It will also caution taxpayers to be wary of individuals promoting improper use of like-kind exchanges.

The Report concludes that the IRS is relying on taxpayers to voluntarily comply, and this has resulted in underreporting of gain. Hence, it states, section 1031 is a “promising target” for additional research to improve reporting compliance.

Mortgage market improvements good news for 2008

According to recent comments from the National Association of Realtors senior economist, Lawrence Yun, 2008 should be a good year for the residential real estate market.

• Conditions are improving for consumers
• Widening credit availability should help release pent up demand
• Mortgage rates are improving
• While sub-prime loans have disappeared, FHA loans see to be the replacement

While sales are off from the peak they hit in 2005, 2007 should go down as one of the fifth highest years in history for existing home sales. With one in sixteen households buying a new home this year, home sales are expected to total nearly 5.8 million in 2007. This number is projected to increase to 6.1 million in 2008.

Commercial Real Estate Broker exemption considered

On November 9th, the National Association of Realtors (NAR) submitted a request to the Securities and Exchange Commission (SEC) on the organization’s exemption from securities broker/dealer registration. Under the requested exemption, a licensed real estate agent or broker that is predominantly engaged in, and has substantial experience in, commercial real estate to provide real estate services and receive compensation from buyers purchasing Tenant-In-Common (TIC) fractional ownership.

Under NAR’s request, a Real Estate Advisory Fee could be paid by the purchaser. It also allows the fee to paid on behalf of the purchaser by a sponsor or issuer of a TIC security that would reduce the commmission or compensation received by a registered broker-dealer involved with the TIC security transaction.

The requested exemption would allow for a potential purchaser of a TIC Security to benefit from the real estate expertise of a commercial real estate professional, while still receiving necessary protections afforded by security laws. It would also limit the role of the commercial real estate professional and real estate firm involved in the transaction. NAR believes this would be consistent with the SEC's mission to protect investors while allowing the public to benefit from a licensed broker's knowledge and experience.

The requested exemption will enter the Federal Register at the end of November. The public then has thirty days to review and comment on the request. After the close of the comment period, the SEC will review the request as well as the public comments and determine the outcome.

This ruling could have a significant impact on the Tenant-In-Common industry. If commercial real estate professionals are not allowed to provide real estate services to, and receive commission from, investors, the exposure to undivided partial ownership interests in real property might be limited.

Farm Bill cloture

I just wanted to provide a quick update to our post last week about the Farm Bill (H.R. 2419). As you may know, this bill carries a number of tax provisions. Included among these is Section 12507, which provides that collectibles, such as artwork and coins, are ineligible for exchange treatment under Section 1031 (what this has to do with farming is beyond me). Under Section 12504, it also amends the standard definition of “like-kind” for certain agricultural properties.

While the House passed the bill back in July, the Senate has not moved on the bill. President Bush has threatened a veto of the bill due to many of the provisions. Before recessing, the Senate, by a vote of 55-42, failed to invoke cloture (which in normal man's speak means to end debate on the issue) on the bill. What does this mean? Failure to invoke cloture is essentially the same effect as killing the bill.

1031 property "Held for" investment purpose

Many times, people will ask, "How long do I need to hold a property to be considered investment property under 1031 rules?

In order to qualify for a 1031 Exchange, both the relinquished and the replacement properties must have been acquired and “held for investment or for use in a trade or business." The amount of time is not specified in the Code or Regulations. In a private letter ruling (Ltr Rul 84-20939), the IRS ruled that two years was an adequate holding period. But, they did not go as far as saying two years is mandatory. Tax and exchange professionals generally consider a minimum of one year to qualify as "held for" investment purposes. This seems to fit with the long-term capital gains requirement.

If a taxpayer acquires a property immediately before an exchange, or if he buys a replacement property and immediately disposes of it following an exchange, it was probably not going to meet the “held for” requirement. But what about the owner that purchases a property for investment and changes his or her mind three, six or eight months after owning the property?

In short, there is no safe harbor holding period for complying with the “held for” requirement. Compliance is based on the taxpayer’s intent demonstrated by facts and circumstances surrounding the taxpayer’s property acquisition. It most likely comes down to what the taxpayer does with the property and how much evidence he or she has to support that original intent.

Here are a few transaction examples having potential for an IRS finding that the “held for” requirement has not been met:

• The taxpayer purchases a property, spends three months remodeling it and immediately proceeds to sell and exchange it.


• The taxpayer acquires replacement property and immediately lists the newly acquired property for sale. In this case, clearly the intent was not to acquire the property for investment purposes.


• The taxpayer acquires replacement property and immediately converts the property to a personal residence or vacation home.


• The taxpayer receives a deed from a partnership and immediately sells it or acquires replacement property and immediately transfers the property to an LLC, partnership or corporation.

While no time is outlined in the regulation, a significant period of time between purchase and sale is desirable to reduce the risk of possible “held for” issues in an exchange. How long? It's not clear. If there is any doubt, sound tax professional advice should be considered. In an audit, the burden of proof is on the taxpayer to support his compliance with the “held for investment or productive use in a trade or business” requirement.

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.

Basic types of 1031 exchanges

A Simultaneous Exchange is an exchange in which the closing of the relinquished property and the replacement property occur on the same day. Ideally, these closings are scheduled back-to-back so there is essentially no time interval between sale and purchase. This type of exchange is covered under the safe harbor regulations established by the IRS in 1991.

A Delayed Exchange is an exchange where the replacement property is closed at a date after the closing of the relinquished property. The exchange is not simultaneous or on the same day. This type of exchange is sometimes referred to as a "Starker Exchange" after the well known Supreme Court case that is the grandfather of a delayed exchange. In 1991, section 1031 of the Internal Revenue Code provided guidelines and strict time frames for completion of a delayed exchange.

A Reverse Exchange (Title-Holding Exchange) is an exchange in which the replacement property is purchased before the relinquished property is sold. Usually the Intermediary takes title to the replacement property and holds title until the taxpayer can find a buyer for his relinquished property. Subsequent to the closing of the relinquished property (or simultaneous with this closing), the Intermediary conveys title to the replacement property to the taxpayer.

An Improvement Exchange (Title-Holding Exchange) is an exchange in which a taxpayer desires to acquire a property and arrange for construction of improvements on the property before it is received as replacement property. The improvements are usually a building on an unimproved lot but could also include enhancements made to an already improved property. This type of exchange is completed in order to create adequate value to close on the exchange so that a trade down in value does not occur. The Code and Regulations do not permit a taxpayer to construct improvements on a property as part of a 1031 Exchange after he has taken title to property as exchange replacement property. Therefore, it is necessary for the Qualified Intermediary to close on, take title, and hold title to the property until the improvements are constructed. Once sufficient value has been added, the QI conveys title to the taxpayer as replacement property. Improvement Exchanges may be done in combination with either a delayed exchange and reverse exchange, depending on the circumstances. In 2000, the IRS issued safe harbor guidance on Reverse Exchanges (including title-holding exchanges for construction or improvement).