New Guidance on exchanges of Vacation Homes

Just issued, hot of the press, is a new IRS Revenue Procedure (Rev Proc 2008-16) providing a safe harbor for exchanges of vacation homes held for investment purposes. This has long been an area where guidance, for exchange purposes has been sought. So, this recent Procedure ruling is quite a hot topic around our office.

In order to qualify as a "held for investment" property under the Revenue Procedure safe harbor guidelines, the relinquished (vacation property sold in a 1031 exchange) and replacement property (vacation property purchased in an exchange) must meet three basic guidelines:

The property must be held for at least twenty four months before and after the exchange.

Within this 24 month period, the vacation home properties must meet meet the following requirements:

1) The vacation home must be rented to another person at fair market value for fourteen or more days, and;

2) Personal use must not exceed fourteen days or ten percent of the time the property is rented at fair market value.

To read more about this exciting (okay...we admit, we are easily excited...) IRS Revenue Procedure ruling and obtain a more complete discussion on this topic, please see Safe Harbor for Exchanges of Vacation Homes.

When you visit, be sure to look around for related information on primary and vacation property rules as they relate to 1031 exchanges.

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.

Staging your home for a quick sale

The market is slow, there are a ton of homes available in your neighborhood and you are competing against everyone - or so it seems. How do you get your home to stand out and sell a bit quicker?

A recent phenomenom is staging your home before marketing the property. What is staging? Basically it is making your home appear in top form for sale. Here are some tips to consider that should help your home show well.

FIRST IMPRESSIONS: An inviting exterior, or “curb appeal” invites a view of the interior. In the summer, keep the lawn trimmed and sidewalks edged, flower beds cultivated, bushes and trees pruned. In the winter, make sure snow is removed from walks and driveways and that the yard is free and clear of refuse. Check the gutters and downspouts for debris and make sure there aren't any leaks. Fix, paint, or wash railings, steps, front door and screens.

WALLS AND WINDOWS: Make sure all windows, window coverings, carpets and flooring are clean. Replace dirty or torn window screens. Touch up picture frame pinholes on the walls and clean or repaint kickboard scuff marks. Reduce or remove the number of personal photographs and frames.

FIX AND CLEAN: Make sure all door knobs and hinges work well and fix those sticking drawers and doors. Stop leaking faucets and tighten all fittings and handles. If necessary, replace worn or dated hardware. Clean and change filters on the furnace and air conditioning unit.

STORAGE SPACE: Store all unnecessary items and rearrange or, better yet, remove some furniture to “enlarge” rooms. Keep hallways and stairs free of clutter. Clear out the attic and basement and store off site. Storage and closet spaces don't look as large when they are filled! Having clothes hung neatly, shoes organized and other articles neatly placed will make your closets appear big and inviting.

LIGHTS: Replace all burned out bulbs and repair any faulty or worn out switches. Clean or replace dated and worn light fixtures.

KITCHENS SELL: Keep counter space clear of appliances. Clean and clear the refrigerator, stove and oven. Bake cookies or bread just before showings.

BEDROOMS: Arrange them neatly. Don't forget to safely store jewelry and personal items. Vacumn floors and rugs and make sure the beds are neatly made.

SPARKLING BATHROOMS: Keep countertop(s), sink(s), tub, watercloset and shower clean. Put away personal items - brushes, bottles and prescription medications.

GARAGES: Straighten up the tools and arrange stored goods on the shelves. Clean garage floors of oil spots and stains and make sure there is enough room to park the car.

TAKE ONE LAST LOOK AROUND! Before showing, tidy everything up one last time. Wash any dirty dishes, put clothes away and straighten up loose papers. Open the curtains and turn the lights on to give your home the best lighting.

Use these tidying tips and clutter-busting ideas and you may just find an edge over the competition that will get that home under contract a bit quicker.

Banks as a 1031 Exchange Qualified Intermediary

A couple months ago, we talked about the need to select your Qualified Intermediary (QI) carefully. Highly publicized failures of a couple larger intermediaries further highlight the need to select an exchange facilitator with security in mind. Banks are increasingly becoming involved in providing the services of a 1031 Exchange Qualified Intermediary.

If you think about it, it makes sense since that’s what banks do – hold money on your behalf. Exchanges typically result in sales proceeds being held until replacement property can be purchased and the exchange completed. There is a level of trust that is necessary for an investor to trust his exchange funds. Banks fulfill that needed role.

But what if you have an existing relationship with the bank? Does this disqualify your bank from being your Exchange Facilitator? According to a couple recent IRS rulings the answer is, no, they are NOT disqualified. In fact, your bank may be the safest and most prudent choice as your Qualified Intermediary.

Two recently released, nearly identical IRS Private Letter Rulings (200803003 and 200803014) involved exchange companies that were wholly-subsidiaries of a bank group. In these two cases, the banks provided investment advisory brokerage, private planning, insurance, trust, and retail banking services. In some instances, these subsidiaries would provide banking services to customers who also use the exchange services of the bank-owned Qualified Intermediary.

The IRS ruled that the provision of these types of services would not result in the Exchange Facilitator, or QI, being deemed a disqualified person under section 1031 of the Internal Revenue Code. Applying the factors put forth in a Supreme Court case (National Carbide Corp. v. Commissioner), the IRS held that insurance services did not create an agency relationship between the bank subsidiary and the exchanger.

Trust services - including principal and income accounting, fiduciary income tax services, distribution and valuation services, charitable trust services, bill payment, probate related services, and discretionary investment and asset management services - by an affiliate of the QI did not create an agency relationship. These were considered routine trust services that are not taken into account when determining whether the Qualified Intermediary is a disqualified person.

The IRS also ruled that routine banking services such as: consumer and small business lending, home financing, retirement and custodial services, check writing, direct deposit, online bill payment, and fee-refunded ATM transactions by an affiliate or by the QI itself, did not create an agency relationship. These services are considered routine financial services that are not taken into account when determining whether the QI is a disqualified person.

So can your bank also serve as your Qualified Intermediary? Based on these two Private Letter Rulings, it is pretty clear that, in most every case, your bank can accommodate your exchange. Given the increased safety and security they provide, the strict regulatory oversight they are under and the financial strength they possess, it seems prudent that a bank-owned Qualified Intermediary is a good place to start your 1031 exchange.

1031 Corporation Exchange Professionals is a subsidiary of FirstBank Holding Company - an $8.6 billion dollar bank with more than 120 retail locations in Colorado, Arizona and California. 1031 Corporation has been in business since 1990 and is a member of the Federation of Exchange Accommodators and the Denver Better Business Bureau.

More Related Party Exchange Guidance

Who are related parties? Related parties include –

• Members of a family (including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal descendants).
• An individual and a corporation, partnership or LLC when the individual owns, directly or indirectly with family members, more than 50% of the ownership of each corporation, partnership or LLC.
• Two corporations, partnerships or LLCs when the same person or owners own, directly or indirectly with family members, more than 50% of the ownership of each corporation, partnership or LLC.

If a related party is used in this fashion, it is preferable to use a party or entity which already exists that is not just a shell entity set up to do this transaction (with the entity disappearing after the relinquished property is sold). The related party should bear the benefits and burdens of ownership of the relinquished property and not be merely acting as the taxpayer’s agent. The purchase price of the relinquished property should be fair market value.

When the property is resold by the related party, the gain or loss may be short term if the property has been held for less than 12 months by the related party. So, care should be taken to price the sale to the related party at the expected property sales price.

Potential ordinary income from sale to a related party. Sale of depreciable property to a related party. Under IRC §1239(a) any gain from the sale of depreciable property to a related party is ordinary income rather than capital gain. In the context of a 1031 Exchange, if there is any boot to be reported by the taxpayer from a sale of the relinquished property to a related party, the boot will be taxed as ordinary income.

Sale of property to a corporation by a shareholder. Under case law, if a shareholder sells his property to a related party corporation (51% or more of ownership) and if a subsequent resale by the corporation would be treated as ordinary income by the corporation, the gain on the sale by the shareholder to his corporation will also be ordinary income (and not capital gain). However, even if the related party is a corporation, only boot received by the taxpayer will be taxed as ordinary income. Just to be on the safe side, it is better for the related party or entity to be a person, LLC or partnership and not a corporation.

If you would like further information about 1031 exchanges between related parties, further guidance is available on our website at our Related Party Rules section.

One dollar is worth fifteen

The following except was provided in a recent newsletter from John Temple, President of 1031 Property Watch. I felt the content was important and wanted to include it in our blog. He graciously agreed to allow us to repost it. John writes,

I just returned from a strategic planning meeting with the Tenant-in-Common Association (TICA) Board of Directors. It should come as no real surprise that the effects of the credit crisis that started in the second quarter of 2006 are being felt throughout the industry. Arguably, this real estate correction will take some time to work itself out. In the past 60 days prices have softened to the point where the average cap rate has risen 60 basis points, from 6.20% to 6.80%. This is good news for real estate buyers; however finding value will still require a sharp pencil and an experienced eye as prices continue to correct.

The market is also getting back to real estate basics. Properties are no longer being valued based upon speculative assumptions, but rather through predictable increases in net operating income (NOI). Solid increases in NOI will keep real estate performing over the next few years. I believe it will not only bridge this market correction, but is how a disciplined investor should invest over the long term.

Let me give you an example of how increasing the NOI can add value over time. Let’s say that a given property has an annual rent increase of 2%, for a total of 20% over ten years. Given a cap rate of 6.67%, a $1 dollar increase in net operating income will increase the value of the property by approximately $15. So if your property has an NOI of $100,000 and a rent increase of 2%, in ten years the value of your property would raise from $1.5 million to $1.8 million. In this example, a $20,000 increase in NOI moves the price up $300,000 dollars. This explains why experienced investors look for properties that can sustain long-term occupancy and support small steady increases in net operating income.

NOI / Cap Rate = Sales Price

If you would like a more detailed article on how NOI growth works or if you want more information on how this could affect your property, please give John a call at 877-337-1031. He can also be reached at john@1031propertywatch.com.

Related Party Alternative to a Reverse Exchange

Can a taxpayer set up an exchange, sell his relinquished property to a related party to hold for resale and complete his exchange by taking title to his replacement property? This scenario would make it unnecessary for an Exchange Accommodation Titleholder (“EAT”) to take temporary title to the replacement property and hold it while the taxpayer is searching for a buyer for his relinquished property.

In the usual Reverse Exchange, the taxpayer engages an EAT (usually a subsidiary of the QI) to take temporary title to a property. The property will subsequently be deeded to the taxpayer as replacement property in a § 1031 exchange. This is usually done because the taxpayer has to close on the purchase of a replacement property before the sale of a relinquished property. Under the “safe-harbor” provisions of Revenue Procedure 2000-37 the EAT can hold the property for no longer than 180 days. During this time, the taxpayer must find a buyer for his relinquished property, close on the sale and complete his 1031 exchange by taking title to the parked replacement property.

An alternative which is attracting interest lately is for the taxpayer to sell his relinquished property to a related party (corporation, LLC or partnership which is owned by him and/or related family members)> The taxpayer then takes title to the replacement property and complete the exchange immediately. The related party can then hold the relinquished property while listing for sale to an unrelated third party with no exchange time limitations or holding requirements.

When property is exchanged between related parties, each related party is compelled by the Regulations to hold the property it received for two years. A disposition by either related party would disqualify the exchange and each related party would be required to amend their returns and report the exchange as a taxable sale. A sale to a related party and replacement from an unrelated party has been thought to be subject to this rule as well. It has been the thinking that a related party had to hold the property for at least two years before the property could be resold. However, three private letter rulings issued by the IRS in 2007 say this is not so and that the two-year holding period does not apply (PLRs 200706001, 200712013 and 200728008).

The related party can acquire the relinquished property from the taxpayer at the same time that the taxpayer is taking title to the replacement property. Subsequently, the related party can hold the property for sale to a third party with no 180 day time limit and not be subject to the two-year holding period. The related party has a tax basis equal to the purchase price. So, when the property is resold, there should be little or no taxable gain on the sale. The taxpayer’s exchange is completed and everyone is happy.

A variation on this theme is for the taxpayer to engage the services of an EAT to initially take title to the replacement property. The EAT holds the property for up to 180 days hoping that a buyer can be found for the relinquished property in time to complete the exchange. If a buyer is not found, the taxpayer then sells the relinquished property to a related party and takes title to the replacement property from the EAT. His exchange is complete and is under the protection of the safe harbor provisions of Rev. Proc. 2000-37. This arrangement may be more compatible with the taxpayer's circumstances at the time of the replacement property closing.