IRS Guidance and 1031 exchanges

Many times in this blog, we refer to different Internal Revenue Service publications that provide guidance on issues involving real estate and 1031 exchanges. The IRS provides a number of publications and written correspondence that provide guidance. These documents are essentially a translation of tax laws that Congress enacts. we often refer to these when consulting clients on 1031 exchanges. I've listed the top 5IRS publications we use - starting at the highest and moving down according to their "rank".

Regulation
Regulations are the highest form of guidance to new legislation. They are are issued by the IRS and Treasury to also address issues that arise with respect to existing Internal Revenue Code sections. Regulations interpret and give directions on complying with the law.

Revenue Ruling
A Revenue Ruling generally states an IRS position. It is an official interpretation of the Regulation Code or statute. It is, basically, how the IRS applies the law.

Revenue Procedure
A Revenue Procedure is an official statement affecting the duties or rights of taxpayers under the Code, statute, and/or regulations. A Revenue Procedure might provide return filing or other instructions concerning an IRS position. It may also provide a "safe harbor" umbrella with which a taxpayer can structure and complete a transaction.

Private Letter Ruling
A Private Letter Ruling, or PLR, is a statement written to a specific taxpayer that interprets/applies tax law to that taxpayer's specific set of facts. It is issued to establish the tax consequences of a particular transaction before the transaction is completed or before the filing of a taxpayer's return. To receive a PLR, a taxpayer must request a written response from the IRS. It is binding to that taxpayer's circumstances only if the taxpayer is fully and accurately describing the proposed transaction in the request and carries it out as described. It should be noted that while a PLR may provide guidance, it can not be relied on as precedent by other taxpayers or IRS personnel.

Technical Advice Memorandum
A Technical Advice Memorandum, or TAM, is guidance furnished by the Office of Chief Counsel in response to technical or procedural questions that develop during a proceeding. A request for a TAM generally comes from an exam of a taxpayer's return or a taxpayer's claim for a refund or credit. TAMs are issued on closed transactions and interpret the application of tax laws, treaties, regulations, Revenue Rulings or other precedents. The advice is deemed a final position of the IRS, but only with respect to the specific issue in the specific case in which the advice is issued.

There are, of course, many other additional publications and pronouncements that provide taxpayer guidance. Robert F. Reilly, CPA, CFA - in a two part article for the AICPA's Practicing CPA, detailed a number of these various publications. Part I covers publications presenting official IRS positions, IRS instructional publications, and announcements, notices, and news releases. While Part II covers advance rulings and determinations as well as new types of IRS pronouncements.

When seeking tax and litigation guidance, tax professionals (CPAs and attorneys) first consider statutory authority. When that is insufficient, they look to these official publications of the IRS as well as judicial precedent (Tax Court rulings)regarding the specific matter.

With respect to 1031 exchanges, your Qualified Intermediary should be monitoring various tax law updates and publications to have the most current weapons to provide you in your arsenal. 1031 Corporation Exchange Professionals has a full time CPA on staff and retains expert tax and real estate attorneys that constantly monitor and update like-kind exchange strategy. While we do not provide tax or legal advice, we can consult with you and your tax professionals and provide guidance as to the proper IRS publications and court case precedent in reviewing your individual exchange facts and circumstances. Further, this consultation is provided as a part of our services and no fee is paid unless an exchange is initiated.

Primary Residence Gain Exemption Rule Changing

Most homeowners are aware of the primary residence exclusion. It is a provision in the tax law that allows a homeowner to sell their primary residence and exempt the gain if certain conditions are met. The gain is available up to $250,000 - if you file your taxes individually - or $500,000 - if you file your taxes if married filing jointly. To be eligible, you must own the home and live in it - as a primary residence - for at least two of the last five years prior to the sale.

The law previously permitted you to convert a vacation, secondary residence or investment property into your principal residence, live in it for two years, sell it and take the full exclusion even though a portion of the gain might have been attributable to periods when the property was used as a vacation, second home or investment property.

This strategy was used for 1031 exchange investors to exempt up to $500,000 of deferred gain in an investment property. In 2004, the Jobs Creation Act made an additional requirement that if a 1031 exchange was involved, you had to own the property for a minimum of five years. thus you could rent a home out for three years, move in it for two and exempt the exclusionary gain.

The Housing Assistance Tax Act of 2008 changes all that. While many provisions within the new law assist struggling homeowners, a provision added takes away from the primary residence exemption rules.

Beginning on January 1, 2009, homeowners will now be required to pay tax on gains made from the sale of a second home, vacation or investment property the portion of time after that date that the home was not used as a primary residence. The amount taxed will be based on the portion of time that the house was not used as a primary residence. The rest of the gain remains eligible for the "up to $500,000" exclusion as long as the two out of five year usage and ownership tests are met. The new law thus reduces the exclusion to the ratio of time used as a principal residence to the total time of ownership.

For example, suppose a married couple filing a joint tax return purchases an investment property after January 1, 2009 and rents it for seven years. They then convert it into a primary residence for three years before selling it. In this situation, only 30% (3/10 years) of the gain would be eligible for the $500,000 exclusion and 70% 7/10 years) of the gain would be subject to tax. Quite a difference.

There is some good news. It is not retroactive. The period of investment use before 2009 is ignored. So is the period of time it is rented after you move out of the residence. Only periods of time it is rented before you made it your residence (after January 1, 2009) count. So, if you've owned an investment property for the past twenty years, move into it before January 1, 2009, and live in it for two years before you sell it, the entire gain remains eligible for the tax exclusion. So, too, is the primary residence that you lived in on January 1, 2009 but later rent out for two years before selling it. The entire gain is eligible for the exclusion.

The Act complicates deferred gains on 1031 exchanges and changes investor strategy for moving into an investment property. 1031 Corporation Exchange Professionals can provide guidance on the issue and, of course, you should speak with your tax advisor to ensure you fully understand your options.

Land Banking & 1031 Exchange

Land banking is not a new concept. It is described as the process of separating real estate activities by forming different business entities that perform investment functions while others complete development activities.

Let's say an investment group forms an LLC and purchases a tract of land for a long-term investment. Over the years, development moves closer to the land and the land increases in value. Perhaps the property is annexed into a municipality, the zoning is changed and a new four lane highway appears. The group decides that, rather than sell it "as is", they would further profit by taking the land through development of the parcel. But wait, they've held it for a long time and they realize that if they develop it, they will get taxed at ordinary tax rates instead of the long term capital gain rate - which is significantly lower. But what if they form a new entity to develop the property? Ah....land banking!

Thanks to a series of favorable court rulings over the past couple decades, owners can sell a property to a separate corporation they control. This corporation then develops the horizontal (and perhaps vertical) improvements and markets the land. By doing so, the former entity - in our example, the LLC - can potentially save significant tax liability on the appreciated value of the land when it is sold to the related corporation by classifying the investment as a long-term capital gain! Jim Walker, the senior tax partner of at the firm Rothgerber Johnson & Lyons LLP explains this process more fully in his article "Land Banking:" A Structured Approach to Capital Gains Planning.

So what would happen if the owners of the LLC decide ahead of the sale that they'd like to reinvest the proceeds of the land sale, to the related corporation, via a 1031 exchange rather than pay the 15% Fed cap gains tax (plus any applicable state or local tax) in order to fully defer the tax?

There is a special rule for exchanges between related parties which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years following the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs. Under this thinking, the development corporation would be compelled to hold the land purchased from the LLC for two years before reselling it.

Tax and exchange professionals have historically advised their clients to comply with the two year rule. However, three Private Letter Rulings (PLRs) released in 2007 say that the two year rule did not apply to a related party who purchased the relinquished property from the taxpayer. The legislative history of Section 1031 identifies several situations intended to qualify under this provision. It includes a non-tax avoidance exception that applies to transactions not involving the shifting of basis between properties.

The purpose of the rule is to prevent related parties from shifting basis from a high basis asset to a low basis asset in anticipation of the sale of the low basis asset that would reduce gain recognition. However, the exchanges in the three PLRs treated the exchanges as valid even though the related buyer voluntarily disposed the property it acquired within two years of the purchase. The rationale used in the 2007 Private Letter Rulings was that the exchanging taxpayer was the only entity that owned property before the exchange. The development corporation did not own property prior to the exchange. Thus, the subsequent disposal did not result in "basis shift" or "cashing out".

So is it possible to land bank a property separating the investment and development activities between entities and then subsequently have the investment entity exchange property? It would appear so - based on recent rulings. Clearly, one need get their legal and tax professional included early on in this process to ensure that you've structured a case that will stand up to potential audit. You also should use the services of a Qualified Intermediary that understands related party issues and knows how to properly process the exchange.

Closing costs deductions on 1031 Exchange

We are often asked this question. Or perhaps it is asked, “Do I have to replace the net sales price or full sales price of the property I am selling to fully defer my tax?” Unfortunately, very little guidance (and it is fairly dated) has been provided in determining the deduction of transactional costs from any realized and recognized gain. Internal Revenue Service Form 8824 provides for transactional costs that are referred to as “exchange expenses” that can be deducted. But what are transactional costs?

Exchange expenses are those expenses which result solely as a result of the sale or acquisition of property and other costs directly related to the sale or acquisition of real estate or in connection with the 1031 Exchange (transaction expenses). These may include: real estate commissions, closing or escrow fees, title insurance premiums, legal fees, transfer taxes as well as such items as notary fees, recording fees and even the fee paid to your Qualified Intermediary.

One thing is clear. Costs related to obtaining financing should not be deducted from the proceeds to determine the "net sale price." Other transactional items typically found on a closing statement are not exchange expenses and probably do not reduce the amount realized or recognized and are not added to the basis of the replacement property. Items such as property taxes, utility escrow deposits or charges, homeowners' association fees, hazard insurance premiums, tenant security deposits and prepaid rents are items to look for on a closing statement.

When completing your tax return and determining how to report closing cost deductions, it will be extremely helpful to have your settlement statement as well as a form such as 1031 Corporation's Form 8824 worksheet. Of course, a taxpayer should review their individual transaction and closing costs with their tax and/or legal advisors to determine whether costs related to the closing are exchange expenses or not.

Where Does Your Intermediary Put Your Exchange Funds?

We've spoke before of the need to fully investigate the Qualified Intermediary (QI) you, as an investor or a referring agent, choose. Some high profile cases have identified the need to deal with a QI you know and trust. Even that is sometimes not enough and you should really investigate the safety and security of the company you use.

As we've said before, the range of investments a Qualified Intermediary can make with your exchange funds is not currently regulated. Your QI can place your exchange funds in many different investment vehicles. Knowing how your exchange funds are protected is vital when selecting an intermediary partner. Most, but not all, QIs place your 1031 exchange proceeds in financial institution. Others choose to pool the funds and place them with an investment firm that offers short term liquidity such as overnight borrowing vehicles.

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. However, we haven't discussed knowing the financial strength of the institution with which the Qualified Intermediary banks your funds. With recent news of bank capital calls, troubled financial institutions and even failures like Indy Mac, you should ask the question of where your funds are held.

Some of the questions you should ask include:

Are your exchange proceeds placed in a segregated account or are they pooled with other exchange client funds?

How well capitalized is the bank or financial firm your Qualified Intermediary uses?

Can you find information of the bank or investment firm?

Has there been any recent news about trouble such as capital calls, bad loans or subprime lending participation with the financial institution?

Does the bank or investment firm provide independent depositor insurance such as FDIC coverage?

Does your Qualified Intermediary offer the ability to split your exchange funds into multiple accounts to provide deposit insurance protection?

Our firm has always segregated funds and held them in a bank account. We are a subsidiary of FirstBank. They hold more than $9.2 billion in assets, have a low loan-to-deposit ratio of around 42% and are extremely well capitalized. Further, they are profitable today having a very low percentage of problem loans and have never participated in subprime mortgage lending. In fact, the health of the bank was just highlighted in both a Rocky Mountain News article and a Denver Post article. We also have the ability to split accounts into 26 separately chartered banks of the bank. This provides our clients with up to $6.5 million in FDIC insurance.

You should expect the same level of security and safety in your 1031 exchange funds. After all, it's your money they are holding. If your Qualified Intermediary can not answer these simple questions of where the money is held, or the answers aren't sufficient to provide you peace of mind, it's time to look for a new QI.

Oil, Gas and Mineral Interest 1031 Exchanges

It would seem to make sense that you could exchange a working or royalty interest for another working or royalty interest as part of a 1031 Exchange. But, did you know that you can also exchange a working or royalty interest for other real estate? For example, if you sell a working interest, you could replace it with another working interest, a royalty interest, or ownership in an office building, apartment building, or other real estate.

However, oil, gas and mineral interest exchanges are tricky. For example, if you sell a working interest and retain the royalty interests or surface rights, the IRS may disallow your exchange. This is because production payments do not qualify for a 1031 Exchange.

The sale of working interests often involves the sale of related equipment. Keep in mind that transfers of equipment require the equipment to be treated as a separate personal property exchange. Personal property exchanges are a different animal than real estate exchanges.

Also note that any costs incurred to drill and develop the gas or mineral site must be recaptured to the extent that you do not re-acquire qualified natural resource property. In other words, if you sell a working interest in a gas well and buy an office building, you would have to "recapture" the Intangible Drilling Costs (IDC) costs you had previously deducted.

If you have questions about Oil, Gas or Mineral interests and how they relate to 1031 exchanges, please contact 1031 Corporation Exchange Professionals at 888-367-1031.

Mutual Irrigation Ditch, Reservoir or Irrigation Company Stock

With the recent passage of the Food and Energy Security Act of 2007 (commonly referred to as the Farm Bill), mutual irrigation ditch, reservoir or irrigation stock (“ditch stock”) MAY now be considered like-kind to a fee interest in real estate.

Section 1031 clearly spells out that corporate stock, bonds and notes are not eligible for a like kind exchange. However, the recently passed Farm Bill amends section 1031 to exclude mutual irrigation ditch, reservoir or irrigation company stock from “stocks, bonds, or notes”. With this passage, these water rights may now be eligible for a 1031 exchange - depending on state statute and previous court rulings.

Mutual irrigation ditch, reservoir or irrigation stock is generally considered to be a water right which is used on farm land to irrigate crops. Water, as a mineral, is generally considered to be an interest in real estate. As an interest in real estate, it is generally considered to be like-kind to a fee interest in real estate. Farm land which is sold or exchanged sometimes includes ditch stock that has benefits and value to the sale of that land. Particularly in the western United States, these water rights are critical to the ongoing production ability of the property and are typically sold with the real estate.

In order to qualify, the new law clearly indicates that such ditch stock has to be recognized as real property, or an interest in real property, in the state in which the corporation is located. Recognition can be by the highest court of the state or by applicable state statute. Mutual irrigation ditch companies are organized under separate sections of state statutes and ditch stock has been recognized as an interest in real property by the District Court of Colorado and other court cases. However, ditch stock in other states may or may not qualify.

Exchange clients should be familiar of the state laws and court rulings in the state their exchange property is located. Of course, they should also discuss their circumstances with a knowledgeable real estate attorney or qualified tax professional before embarking on an exchange of water rights. A Qualified Intermediary that is familiar with the special closing and exchange-related issues involving ditch and water stock should also be consulted and engaged to ensure the exchange is completed properly. To learn more about this topic, please consult our 1031 Exchange Manual or give 1031 Corporation Exchange Professionals a call at 888-367-1031.