Year-end Tax Planning with Section 1031

If you are selling property before the end of the calendar year, you have a potential opportunity to plan for taxes in 2010 by utilizing Internal Revenue Code section 1031 as a tool. Whether a 1031 exchange is ultimately completed or not, there may be an opportunity to choose whether the tax will be paid in 2009 or 2010. This is because, under exchange rules, your right to receive the proceeds from the sale of the property are held by a third party Qualified Intermediary. If you are unable to identify or close on a sale, and subsequently, the exchange fails, your first right to the proceeds doesn't occur until 2010. How is that? It has to do with the time of year we have entered.

Under 1031 exchange rules, a person exchanging property may receive the sale proceeds (a) after the expiration of the 45 day identification period (if the taxpayer did not identify any replacement property); or, (b) the date upon which the taxpayer acquires all replacement property identified by the taxpayer in the exchange, or (c) at the end of the 180 day exchange period. So if you sell a property on December 15th, your 45 day period would not occur until January 29th.

Section 1031 says that if your exchange fails in a different tax year than the year you sold it, the IRS's installment sale rules kick in. So, the taxes that would be due in 2009 could be deferred until 2010. I say COULD be because the installment sale rules also allow you to elect out of them.

If the Obama administration and Congress decide to raise capital gains rates before the Bush tax cut is set to expire at the end of 2010, a taxpayer whose exchange failed could elect out of the installment reporting rules. This also might help if you determine, before filing your tax return, that it would be better to go ahead and recognize the gain in 2009. This stategy, setting up an exchange now, would allow you to plan and recognize the gain in the year of greater tax benefit for you.

Of course, you should have a legitimate intent to complete an exchange and not simply look at this as a tax deferral strategy. However, if you are selling real estate and MIGHT reinvest the proceeds in replacement property, it could certainly make sense to setting up an exchange - just in case. If you are considering this option, you should also consult with your tax accountant or attorney regarding your specific tax situation. For more information on this option, visit our 1031 exchange professionals website or give us a call at 888-367-1031.

Swap and Drop Exchange Upheld by Oregon

As we've previously indicated, there are situations where a partnership may split up or liquidate but one or more partners may want to defer capital gains through the benefits of a 1031 exchange. Perhaps the partners have different goals or they simply no longer want to stay in business together. Partners often want to go in different directions with their share of the proceeds. Some may want to reinvest in real estate and can defer their taxable gain through use of a 1031 Drop and Swap.

The opposite can also happen where an investor exchanges a property and wants to enter into partnership with other investors. This is known as a "Swap and Drop". This investment would take the form of a tenancy-in-common interest in the property. It has been previously thought by many tax professionals that this undivided fractional real estate interest should be maintained for a sufficient period of time in order to satisfy the 1031 "held for investment purposes" requirement.

However, a recent court case in Oregon puts some doubt into whether this is really necessary. In the case of the Oregon Department of Revenue v. Marks taxpayers had acquired a tenancy-in-common interest as replacement property for their exchange. They then immediately contributed the replacement property to a partnership (a "swap and drop"). The Oregon Department of Revenue (affectionately referred to hereafter as ODOR) challenged the exchange based on the partnership "drop". The original court ruled that the taxpayers had indeed met the guidelines of a 1031 exchange and it was permissible to exchange and then immediately contribute the property to a partnership. ODOR appealed that decision but the Tax Court upheld the original ruling.

Within the appeal ruling the Tax Court referenced the 9th Circuit court case of Magneson v. Commissioner. In that case, the 9th Circuit held that the transfer did not impair investment intent and that the transfer to the partnership changed the form of ownwership but not the substance of real property ownership. The Tax Court determined that the taxpayers' continuity of interest and lack of cashing out override the ODOR's concerns about the short holding period of the replacement property.

This is significant in that Magneson preceded adoption of a subsection of IRC 1031 ((a)(2)(D))that excludes partnership interests from property that can be exchanged. It appears from the reference that the court continues to affirm the view that the partnership is an aggregate of its partners (in contrast with a corporate entity status being seaparate from its shareholders.

It should also be highlighted that the Oregon court case only applies to Oregon STATE tax and not to Federal tax. The assertive Franchise Tax Board in the state of California is reportedly pursuing a case contesting the "Swap and Drop" tax strategy. It appears that case involves similar arguments that the immediate transfer demostrates the taxpayer lacked investment intent at the time of acquisition.

Neither the statute, the Revenue Code, the IRS, nor the courts have provided complete certainty in this area. The 2008 Partnership Tax Form 1065 was revised to include questions regarding "Drop and Swaps" and "Swap and Drops". This change was made to "enable the IRS to focus compliance resources on returns and issues that warrant examination. What, if any, resources is unclear. But it does appears that the IRS has some interest in continuing to fight court cases involving "Drop and Swaps" and "Swap and Drops". If you are contemplating such an exchange, you should consult with your tax professional(s) and speak to your 1031 exchange professional early in the sale process to attempt to understand and mitigate your financial risk. Of course, if you have any questions about 1031 exchanges, you can give us a call free of charge at 888-367-1031.

1031 Regulation Part of CFPA Bill

Representative Michael Michaud (D-ME2) successfully added an amendment to the the "Wall Street Reform and Consumer Protection Act of 2009". HR 4173 would establish the Consumer Financial Protection Agency as the primary regulatory body over 1031 Exchange Qualified Intermediaries.

The CFPA bill was quickly introduced on December 8th and passed the House late last Friday by a vote of 223 to 202. It now moves to the Senate. If passed there and signed into law, the bill would usher in, what CNN describes as, “the most sweeping set of changes to the banking regulatory system since the New Deal.”

Michaud's amendment requires that the Director of the CFPA conduct a review of Federal laws and regulations relating to the protection of individuals that utilize exchange facilitators , submit to Congress recommendations on the steps necessary to ensure appropriate protection of such persons and establish and carry out a program, utilizing the authority of the CFPA, to protect individuals that utilize exchange facilitators.

Calls for reform, in light of the previously covered Okun 1031 Tax Group and LandAmerica Exchange fraud and failure, have come from consumers as well as many within the QI industry. A few states, including Colorado, have established their right to regulate 1031 exchanges within their borders. However, the federal bill and the Michaud amendment makes no mention of what protections should be established. Instead it puts the power to decide solely in the hands of the CFPA Director.

Some in the QI industry, that appear to have pushed for the bill amendment without industry association support, have suggested regulatory requirements that Qualified Intermediaries have specific prohibitions against illiquid investment vehicles and require the exchange facilitator to hold funds in a segregated bank account. They have also called for audits of Qualified Intermediaries.

While not in disagreement with these sound financial business principles, the wild card in any government intervention into the financial markets is what the CFPA Director decides to recommend. Many within the financial industry are concerned the legislation creates sweeping new powers for the federal government and may have unintended consequences that reduce access to credit and financial services while increasing the costs. One thing seems logical...such a "superagency" regulator, would further increase costs of running the federal government and increase costs to those within the financial industry - costs that will undoubtedly get passed on to consumers.

First Signs of Life for CMBS Reincarnation

Two successive commercial mortgage bond offerings have many hopeful that the CMBS market may be showing signs of recovery while others question just how quickly this initial sign of life may jump start a dead market.

In late November, a real estate investment trust (REIT), Developers Diversified Realty Corp., broke the market with the assistance of the Federal Reserve's Term Asset-backed Securities Loan Facility (TALF). The $400 million deal was met with strong investor demand as evidenced by the significant subscription activity and the resulting Treasury price premium reduction. The offering was the first true CMBS transaction to reach the market since June 2008.

As further evidence that the CMBS market may be showing early signs of life, Bank of America followed by pricing a $460 million offering for Flagler Development (backed by Fortress Investment). That issue was secured by office buildings and industrial investment property in Florida and was brought to market without any TALF support. A third offering, a $500 million retail investment property deal for Inland Western Retail Real Estate Trust Inc., is scheduled to come to market from JP Morgan. It, too, is said to be free of any TALF backing.

Goldman Sachs, Bank of America and JP Morgan have all publicly announced that their door is now, or will shortly be, open for new securitization activity. Reports indicate that Deutsche Bank and Royal Bank of Scotland are also firing up their conduit lending programs. So far, the deals announced have been limited to single-borrower transactions that were reportedly "conservatively underwritten and well-structured". Many industry experts have commented that they believe this niche may spark a welcome revival to thawing the lifeless private-label CMBS market.

Most would agree that this is a welcome sign. The deals brought to the market thus far seem to have transparency, low leverage and, thus, have been positively acknowledged. Only time will tell whether these initial CMBS offerings will return the market to pre-2008 levels of credit availability for commercial real estate. Of course, the wild card may turn out to be how open Congress will allow the markets to be.

But, if investors continue to respond positively to these low-leverage deals, it should prove to be something of a positive catalyst for the commercial real estate sector and may stem the tsunami of billions of maturing securitization dollars that are scheduled to mature in the next couple years. Just how distressed the commercial market gets remains to be seen. Much of that will depend on the state of the economy and the substantive, yet sensible, reincarnation of the capital markets.

Section 1245 Property Issues in 1031 Exchange

Many taxpayers don’t immediately recognize that the sale of Section 1245 property is subject to depreciation recapture at ordinary income tax rates. This can be a startling discover when their tax bill is calculated. Section 1245 property is subject to tax at ordinary rates to the extent of any gain on the sale and to the extent depreciation is recognized on the property since acquisition.

Section 1245 Property is generally depreciable personal property whether tangible (such as machinery, equipment, furniture and fixtures) or intangible (such as patents, copyrights, and subscription lists). However, real property can sometimes include Section 1245 Property subject to the same depreciation recapture rules. Some examples of real property which is also Section 1245 Property include –

• Cost segregated real property that includes components which are depreciated as personal property.
• Oil and gas storage tanks, grain storage bins, silos.
• Certain commercial real estate acquired between 1981 and 1986 which was depreciated using an accelerated method.

Section 1245 property that is a part of the sale of real estate, attributable to the realized gain and depreciation taken on Section 1245 property, will be taxed at ordinary income tax rates instead of the preferred capital gains tax rates (subject to previously non-recaptured section 1231 losses).

In a 1031 exchange of real estate, realized gains are deferred if qualifying replacement property is acquired and if there is no taxable “boot” received. However, if the real estate exchanged contained any Section 1245 Property, there will be a Section 1245 depreciation recapture unless the replacement real estate also includes Section 1245 Property of equal or greater value. Any “trade-down” in the Section 1245 Property will result in Section 1245 depreciation recapture taxed at ordinary income tax rates.

Taxpayers with Section 1245 property embedded in their real property should consult with their qualified legal and tax professionals on the potential recapture occurring when contemplating either a sale or exchange. If you’ve questions on the 1031 exchange of Section 1245 property, 1031 Corporation would be happy to consult with you and your tax professional. Give us a call at 888-367-1031.