FDIC Insurance on 1031 Exchange Funds

So you are considering a 1031 exchange and you have selected a Qualified Intermediary (QI) to facilitate your exchange. The property you are selling is under contract and the closing is next week. You have begun the search for suitable replacement property but have not yet found anything appropriate. The money from your sale, it appears, is going to be held by the Qualified Intermediary for some time. But what will that QI do with the funds while you await the need for those proceeds in a replacement property purchase? How do you know your funds are secure?

The range of investments a Qualified Intermediary can make with your exchange funds is not currently regulated. Therefore, the funds can be accounted for and placed in many different investment vehicles. Knowing how your exchange funds are protected is vital when selecting a intermediary partner. 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, we haven't discussed the issue of Federal Deposit Insurance as a security vehicle when discussing 1031 exchange funds.

Many larger Qualified Intermediaries co-mingle client funds into one investment account. They do this to maximize the return on investment for the QI firm. From there, the funds may be invested with a brokerage or depository institution. Other QI firms segregate each client's funds into a separate account held at a commercial bank. While many of these brokerage accounts can be just as secure in the instruments they invest, it certainly pays to investigate whether your funds are co-mingled or segregated and exactly where and what the funds are being invested.

Okay, now you've determined that it is in your best interest to use a Qualified Intermediary that is depositing the funds into a segregated account at a commercial bank. But your exchange proceeds are more than $250,000. The amount you receive exceeds the amount of FDIC insurance and you are concerned with the added protection this level of insurance would provide. So, now what?

Some Qualified Intermediaries, including our firm, provide the ability to open multiple exchange accounts to the same client under separate bank charters. What this allows is the ability to increase the overall FDIC insurance coverage to the number of institutions times $250,000 at each charter. For example, 1031 Corporation Exchange Professionals is a subsidiary of FirstBank. With 26 separate charters in Colorado, Arizona and California, 1031 Corporation has the capacity to open multiple accounts and extend the FDIC coverage for any one exchange client up to $6.5 million.

Selecting a Qualified Intermediary that only uses segregated accounts banked at a financially solid, commercial bank (and further - owned by a larger financial parent) are important safety features to consider. Still, having a government-sponsored insurance, like the one the FDIC provides, for the amount of your exchange can certainly add an extra layer of confidence that your funds are secure.

Revoking an Inadvertent Opt-Out from Installment Method in a Failed 1031 Exchange

An interesting private letter ruling was just released that dealt with an installment sale as it relates to a 1031 exchange. In this case, a taxpayer sold real estate property as part of a planned exchange. However, they were unable to find suitable replacement property within the 180 day exchange period, and the exchange was not completed. The exchange was started in one calendar year and the 180 day period expired in the next year. This failed exchange qualified as an installment sale because the taxpayer did not have receipt of any portion of the sales proceeds in the year that the property was sold.

However, a slight problem occurred. Apparently, the taxpayer’s accountant failed to recognize that the transaction qualified as an installment sale and he reported the gain from the property sale on the tax return for the year the exchange started. Declaring the income on the taxpayer’s tax return amounted to an option to opt out of the installment method. Otherwise, the taxpayer would have been permitted to defer the tax payment on the proceeds from this transaction until the return year that the exchange funds were received.

A section of the Treasury regulations provides that an election to opt out of installment sale treatment is irrevocable, and that “An election may be revoked only with the consent of the Internal Revenue Service.”

When the taxpayer learned of the accountant’s error, it applied to the IRS for consent to revoke its "opt-out" election. The IRS was satisfied that the election to pay the taxes in the first year was inadvertent and the result of the accountant’s oversight - rather than hindsight by the taxpayer or some attempt to avoid taxes. Therefore, the taxpayer was permitted to revoke its election out of the installment method and defer the tax payment on the proceeds until the second filing year.

This reflects both the possibility of deferring capital gains tax over a calendar year on an exchange started late in the year as well as the ability to amend or revise taxes for something inadvertently overlooked by an unknowing accounting professional.

There is also another option for investors of failed exchanges called a Structured Sale Transaction. We'll write about that option next so stay tuned.

1031 Exchange Partnership Issues

Investment real estate is commonly owned by multiple owners in a partnership or by multiple owners as tenants in common to an undivided interest in the underlying real property. An exchange of a tenant-in-common interest in real estate poses no problems and is eligible for 1031 Exchange treatment. However, an exchange of an interest in a partnership is not permitted under the Code and Regulations. Careful forward planning is required to ensure a successful 1031 exchange where partnership issues are involved.

If a partnership owns property and desires to sell and exchange it, the partnership is the entity or party to the like kind exchange. Since the partnership will take title to the replacement property, no issues are apparent during the exchange period. However, if the partners wish to split up immediately after the exchange, the "held for" requirement may not be met on the replacement property. The partnership would need to retain ownership of the new property for an unspecified period of time (one year is commonly thought to be sufficient) to meet this qualification. Once sufficient time has passed, the partnership can then dissolve and distribute the property - through deed to individual properties or tenant-in-common ownership - to the former partners.

If a partnership wishes to exchange property but one or more of the partners want to "cash-out" or go their separate way(s), it is common for the partnership to split out the ownership before the sale. The partnership distributes tenancy-in-common title to the individual partners who wish to proceed in separate directions. The partnership (and its remaining partners) would then proceed with an exchange of the remaining ownership in the name of the partnership.

Frequently, individual partners desire to end the partnership relationship when the owned property sells. They would prefer to take their share of the partnership sale proceeds and buy qualifying 1031 replacement property in their own names. Far too frequently, the partnership gives each individual their undivided tenant-in-common interest in the old property just days or hours before closing. The plan is for each partner to take ownership in his or her name and individually complete a 1031 exchange. This lack of planning presents problems. The entire exchange could fail since the partnership could be seen as the selling entity that did not take title to qualifying replacement property. The individual owners have not met the "held for" requirement as they only owned the property in their individual names for a short period of time.

If partners wish to discontinue the partnership, sell the property and go their separate ways - with either the cash or a 1031 Exchange - it is necessary for the individual partners to receive deed to the property from the partnership in advance of the sale of the property. This is done through a distribution of property from the partnership to its individual partners. The partners are then generally required to hold the property as tenants in common for an unspecified period of time (decent interval of time) in order to comply with the "held-for" requirement of a 1031 Exchange that requires a taxpayer to have "held" qualifying property for business or investment purposes prior to the exchange.

The services of a tax professional are essential for tax planning purposes. An experienced Qualified Intermediary is also needed to ensure a successful exchange structure where partnership and co-ownership real estate interests are involved. To view more on partnership issues or other issues related to 1031 exchanges, take a look at this 1031 Exchange Manual or give us a call at 888-367-1031.

Tired of Being a Landlord Yet You Don’t Want a Big Tax Bill?

Anyone who has owned investment real estate, whether a student rental, a small apartment building, an office building or a strip retail center, knows that two of the most demanding aspects of being a landlord is dealing with tenants and maintaining property. For many, being a real estate investor appears a Catch-22: you want out, but to get out you must give away all or most of what you have worked for. One of the best strategies for freeing yourself of landlord hassles while deferring taxes is 1031 Exchanging into an Absolute-Net-Leased property in which the tenant maintains the building.

1031 Exchange. The IRS Code allows you to exchange one real estate investment asset for another while deferring the gain and depreciation recapture on the sale of the first property. With 15% federal capital gains tax, state taxes and the recapture of depreciation, the potential for deferring taxes is huge...particularly if you have held the property for many years. On the sale of an investment property that has been held long enough to generate significant appreciation while a significant amount of depreciation has been taken, it is not unusual for 30% to 40% of the proceeds from the sale to be paid in taxes if the seller does not 1031 exchange into another property.

The IRS Code says properties eligible for a tax-deferred exchange must be like-kind. For real estate held for investment, that gives you a lot of latitude. An apartment building you own in California can be exchanged for an office building in Colorado. Raw land can be exchanged for a fully-developed building. Your 100% ownership in the building you are selling can be divided into two or three properties to create diversification. As long as the exchange is done properly the options for tax-deferred investments are limitless.

Replacement Property. Locating and securing your 1031 replacement property must be done swiftly, skillfully and knowledgeably. The replacement property must be identified in writing within 45 days of the sale of your relinquished property. Then, the closing on the purchase of the second property must occur within 180 days of the sale of the relinquished property. The process of selecting your replacement property should begin as soon as you know you have a solid buyer for your replacement property. You do not want to wait until day 44 to begin looking, or you are likely to come up empty handed.

If you are looking to let go of the hassles associated with being a landlord, then you should focus search on Absolute Net-Leased properties. Such properties can be purchased as fractional interests (also known as Tenant-In-Common, or TIC, interests) or as ‘whole’ properties. TIC interests are available in large retail centers, multi-family housing, luxury private student housing and office buildings. Generally, you will need a minimum of $150,000 in cash and meet certain accreditation requirements in order to buy into a TIC.

‘Whole’ Absolute Net-Leased properties are often the separately-owned pad sites of larger retail centers. It could be the real estate for a Jack-in-the-Box, a Big-O Tire Store, Blockbuster Video or a Starbucks. One of the classic Absolute-Net-Leased properties for the larger buyer is the real estate for a Walgreens Pharmacy. In general, you will need $500,000 or more in cash to purchase a quality ‘whole’ Absolute-Net-Leased property.

Where to find Expertise. The 1031 Exchange is the ideal tool to move from a management-intensive property into an Absolute Net-Leased property. While you do not personally need to have all the answers, you need to know where to find them. Two essential members of your team are: (1) an investment real estate broker who can provide you with and help you evaluate various TIC and ‘whole’ replacement property options, and (2) a top-notch Exchange Qualified Intermediary, QI for short. With the right expertise, you can preserve your hard-earned equity, establish a predictable and reliable cash flow, and free yourself from getting the call when the toilet is not working.

The above article was graciously provided by Mark Casey. Mark is president of Casey Partners, Ltd. a real estate brokerage and consulting firm headquartered in Boulder. Mark holds a Master of Business Administration (MBA) from the University of Virginia. and is a member of Commercial Brokers of Boulder and the Denver Metro Commercial Association of Realtors (DMCAR). Casey Partners can be reached by calling 303-665-6000 or email info@caseypartners.com.