States Begin Regulating 1031 Exchanges

In September, California signed a law that became effective on January 1, 2009 regarding companies facilitating 1031 exchanges. The new law holds Qualified Intermediaries (QI) to new requirements on property exchanges taking place in that state. California wasn't the first - Nevada and Idaho had previously approved legislation on the Qualified Intermediary industry. But, California passed legislation that has the intent to protect consumers while minimizing costly and burdensome regulation to 1031 exchange companies that was sure to be passed on to consumers.

The California 1031 law has become a model of consumer protection for other states, such as Colorado, Arizona and Washington, now considering similar legislation. Some of the requirements include requiring 1031 exchange facilitators to maintain bonding and insurance. They require Qualified Intermediary companies to notify clients of any change in the company's control (as in a sale or other controlling change in management). The California law also requires exchange companies to invest exchange client funds in a way that meets “prudent investor standards”. This last point is, perhaps, the most important measure included. No longer will exchange companies be able to loan funds to affiliates or owners to fund other "investments" (bank-owned Qualified Intermediaries are exempt when depositing funds in bank accounts with a parent bank).

This follows on the heels of a recent industry failures that have affected a significant number of 1031 exchange clients. A couple of high profile cases involve 1031 Tax Group and Southwest 1031 Exchange. LandAmerica Financial Corporation's recent bankruptcy filing (due to LandAmerica Exchange's lack of liquid investments) reiterated the point that additional guidance and regulation was necessary. Exchange intermediaries that are found to have not held the funds in a prudent manner - or otherwise fail to meet the "model law" requirements - could be subject to civil and criminal penalties. It also gives some recourse to injured exchange clients to file a claim against the required bonding, cash deposits, or letters of credit.

States that follow are using the California "model law" as a template for sound, practical legislation that doesn't create undue burden on exchange companies while, at the same time, providing protection to consumers. Each state, most likely, will have their own changes to the model. But the California 1031 law is a welcome trend for ethical, prudent exchange companies and the clients that employ them to facilitate their 1031 exchange tax strategy.

The Compounding Effect

The following post is a portion of an article written by Ronald Raitz and appearing in the Sept/Oct edition of Commercial Investment Real Estate, The official magazine of the CCIM.

When Albert Einstein was asked, “What is the most powerful force in the universe?” His reply was, “Compound interest.” People in the financial services industry understand the effects of compounding: For example, whether an investor starts funding an individual retirement account at age 20 or 40 results in a dramatically different retirement balance at age 59½. The simplest of illustrations — the “double the penny” example — further highlights the sometimes surprising benefits of compounding: A penny doubled every day for a month is worth only two cents on day two, but on day 31 it is worth $64 million. Compounding plus time can indeed produce impressive investment growth.

Potentially the most powerful benefit of a 1031 exchange, the compounding effect also is the most overlooked. The key to getting the highest compounding result is keeping all of the money working for the investor — not only now but also into the future. In an exchange, the amount of tax that otherwise would be paid is reinvested. The projected future value of the compounded yield on the deferred tax becomes very substantial over time.

Many real estate investors also add leverage, which significantly amplifies the compounding effect. For example, in 1988, an investor who possessed strong management skills sold a $1 million property that had a $200,000 basis. Without utilizing an exchange, the gain on the sale would have been $800,000 with approximately $200,000 in taxes due. After paying the taxes, there would have been approximately $800,000 after-tax cash to reinvest.

But the investor exchanged the property and bought a $1 million income-producing replacement property that was 85 percent occupied. He put $200,000 down — exactly the same amount he otherwise would not have had without the exchange. Two years later, after making necessary management adjustments, he increased the property’s occupancy to 94 percent and sold it for $1.4 million. The $200,000 that he put down on the property (money that would have been used to pay the recognized gain in 1988) added to the $400,000 he just made equals $600,000.

The investor did another exchange and put the $600,000 in proceeds down on a $2 million income property that had been under-managed and was at 83 percent occupancy. Three years later, after achieving 92 percent occupancy in the property, the investor sold it for $2.6 million. With the $600,000 he had put down plus the $600,000 he made on the sale, after only five years the $200,000 tax that was deferred had grown to $1.2 million. Alternatively, without the exchange strategy the investor would have had no compounding benefit from his investments because the initial $200,000 would have been paid to cover the tax obligation.

Compounding combined with leverage can build wealth very quickly. Over a 12-year period, this investor did five exchanges and turned the money that he otherwise would not have had ($200,000) into $4.8 million.

Many investors have developed exchange strategies that have enabled them to go from a modest net worth to a very high net worth in a 10- to 20-year time frame. Clearly, these real-life examples are achieved more easily when real estate is in an up cycle, but this does not negate the potential benefits of employing a 1031 exchange strategy and holding real estate through the down cycles. Over time, the investors still come out far ahead of where they otherwise would have been if they had sold, paid the tax, and gone into an alternative investment.

Since there are no restrictions on the number of exchanges a taxpayer can complete, this strategy can be used during the taxpayer’s entire lifetime. Although some investors eventually sell property that is acquired via an exchange and pay the tax, it is very common to never cash out and carry investments into the taxpayer’s estate. At that point, the estate receives a stepped-up basis and the tax consequence disappears.

Section 721 Exchange into an UPREIT

A REIT is a Real Estate Investment Trust whose stock is publically traded. An UPREIT is a real estate investment operating partnership in which the REIT is the general partner and real estate investors are limited partners. A Section 721 Exchange is the method by which real estate investors can transfer a real estate investment into an UPREIT tax-free (or tax-deferred). Internal Revenue Code Section 721 deals with contributions of real estate to an operating partnership in exchange for an interest in the partnership.

UPREITs use IRC §721 to acquire property from investors who want to exchange out of their real estate investment into an investment which is managed by professionals. Subsequently, at a point in time which is suitable for the investor, UPREIT partnership ownership units are exchanged for shares for publically traded stock in the REIT which are then sold on the securities market. The exchange of units of the UPREIT operating partnership for stock shares in the REIT is a taxable event. But this is done at the same time that the REIT stock shares are sold so at this time the investor is cashing out of all or part of his investment at capital gains rates. This arrangement provides professional management and liquidity to the real estate investor.

In order to contribute an investment property to an UPREIT, the property must meet the REIT's investment criteria which generally include a requirement for institutional-grade property. If the real estate investor's real estate is not institutional-grade, he can convert his real estate to institutional-grade real estate with a sale and exchange through IRC §1031 and replacement with an investment in a syndicated tenancy-in-common (TIC) investment. Then, the TIC investment can be contributed to the UPREIT in exchange for ownership units in the operating partnership of the UPREIT.

Insist your QI Hold Funds in a Segregated Exchange Account

Qualified Intermediaries (“QIs”) use a variety of ways to bank and invest funds they hold in escrow or trust for their 1031 Exchange clients. QIs have a fiduciary responsibility to hold client funds in a safe and liquid manner. At the present time there is no industry standard for how funds should be held by QIs or how funds should be invested. The most common ways are as follows -

Segregated Accounts – Many QIs, like 1031 Corporation, open separate bank accounts for each 1031 file that they open. The accounts are usually money market accounts which are under FDIC protection and are opened in the name of the QI as escrow holder for the client and include the client’s federal identification number. The accounts usually bear interest which is reported on year end Form 1099 to the client.

Pooled Accounts – Many QIs pool all of their client 1031 funds into one bank account or investment. This is the common way large QIs manage money they hold for their clients. Many smaller QIs also use this method of holding 1031 funds.

Several recent scandals and failures in the 1031 Exchange industry have occurred with QIs using pooled accounts. In some instances, the pooled accounts were invested in other companies owned by the owner of the Qualified Intermediary company. In other instances, the pooled accounts were reinvested in securitized investments which have lost value in the current financial “melt down.”

Land America is apparently the latest casualty of the Pooled Account type of QI. They are reported to be holding $290 million of client exchange funds invested in securitized investments called Auction Rate Securities. The securities have become illiquid and Land America is attempting to meet client obligations from other operating accounts.

Our recommendation is to always insist that your QI hold your 1031 funds in a segregated account subject to FDIC protection.

Acquiring a Leasehold Interest as Replacement Property

Section 1031 defines a leasehold interest with a term of 30 years or more as "like kind" to a fee interest in real estate. Renewal options under the lease are counted for purposes of determining if the lease has 30 years or more to run. Accordingly, a 30 year leasehold interest can be exchanged for a fee interest in real estate or vice versa, a fee interest in real estate can be exchanged for a 30 year leasehold interest.

Usually when a leasehold interest is sold or exchanged, the lease is an existing lease and there is significant value in the lease because of leasehold improvements which are present on the leasehold. When a leasehold interest is purchased as replacement property for an exchange, the value of the leasehold would normally be attributed to the value of the improvements which are on the leasehold. For income tax reporting, the taxpayer-lessee would continue paying rents after acquiring the leasehold including improvements. The purchase cost (or tax basis in an exchange) of the lease would be amortized over the period of the lease.

What if the lease is a newly created lease into which the taxpayer is entering? A taxpayer can transfer a fee interest for the receipt of a newly created 30 year lease. But in this case, it is important that the purchase price appear to be for the acquisition of a leasehold and related improvements and not merely as an advance payment of rent over the term of the lease. If the newly created lease was perceived to be an advance payment of rent 1031 exchange treatment has been denied under case law for the seller of the lease. But there have been exceptions under IRS Rulings.

If the IRS viewed the purchase of the lease to be an advance payment of rent to the lessor (and the rental agreements required rents of more than $250,000), the Internal Revenue Code would require that the lessor and lessee both treat the payment as rent income and rent expense over the period of the lease and this would not be viewed as a “purchase” by the lessor. Accordingly, the possible application of this provision is an issue that taxpayers entering into a purchase of a newly-created lease should be concerned about in drafting the terms of the purchase.

As one can see, it is important that the purchase appear to be in the nature of the purchase of real estate vs. an advance payment of rent. For more information on Leasehold Interests as Replacement Property, please visit our website or call 1031 Corporation Exchange Professionals at 888-367-1031.

Banking your 1031 exchange in uncertain markets

There has been a great deal of turmoil in the financial markets and banking industry as several large and well known financial institutions have stumbled. With so much unease in the marketplace, and wondering who will be next in the news, I wanted to take a moment to talk about 1031 escrowed funds. During the exchange, the Qualified Intermediary you select has control of the funds. While they make accept your "input" into where the deposit is placed, it is ultimately up to them to determine where to place the money. It is important to know where the money is being banked. I wanted to spend a bit of time to discuss what is important and how 1031 Corporation - as a subsidiary of FirstBank deposits the funds.

Each account is segregated from all other exchange accounts. That means, the exchange we facilitate for you will have an account number that can be viewed 24/7 on FirstBank's website. You know exactly where the money is and when you awake to the sound of CNN talking about turmoil in the Asian stock exchange causing fears at 2 a.m., you can get online and view your account. Segregation is very important if there are issues with your Qualified Intermediary.

But what if there is an issue with the bank that your QI places the funds? It is worth checking to find out the stability, strength and customer service the bank provides - particularly in times of uncertainty. 1031 Corporation, as a subsidiary of FirstBank, deposits all client escrow accounts at FirstBank.

Here are some highlights of this respected institution.

Solid History FirstBank was founded in Lakewood, Colorado in 1963. It is employee owned with a long term focus. Over 100 officers and nearly 600 employees have more than 10 years of service with FirstBank.

Strong Financial Position FirstBank is viewed as "well capitalized" under regulatory guidelines. With assets totaling $9.2 billion and deposits of $7.8 billion, FirstBank continues to experience solid growth.

Record EarningsWhile others are reporting large losses, FistBank's net income was up to over $67 million thru the first half of 2008. This represents a 41% increase over the comparable period last year.

Unique FDIC Insurance Options While most banks can only insure up to $250,000 of your exchange funds, FirstBank's 26 separate bank charters make it possible to be insured for up to $6.5 million. No longer is there a need to "spread the risk" around by opening multiple accounts at various financial institutions.

No Subprime Involvement FirstBank does not originate, hold or purchase subprime mortgage loans or security. Continued focus on credit quality enables them to succeed in all ecomnomic cycles.

Open For Business With 126 branch location in three states (Colorado, Arizona and California) FirstBank serves more than 60,000 customers. Along with internet banking and 24 hour customer service, you can always speak to someone about your exchange account.

You should speak with your Qualified Intermediary and determine where your exchange funds are held. It is extremely important in these times of uncertainty!

Aircraft Exchanges

If you have used an aircraft for trade or business purposes, a 1031 exchange of aircraft could save you thousands of dollars on the sale and replacement. Chances are you have depreciated the aircraft, perhaps even completely. The aircraft may be worth more today than when you purchased it. If you sell it without doing a 1031 Exchange, you may be taxed not only on any gain from the sale, but also on the depreciation recapture. Section 1031 of the Internal Revenue Code provides for the deferral of gain, provided certain requirements are met.

Things You Need to Know About 1031 Exchanges of Aircraft:

1. Both the old and new aircraft must be used for trade, business or investment. The old and new aircraft must both be used for trade, business or investment activities to qualify for a 1031 exchange. Personal use aircraft do not qualify.

2. The aircraft exchanged must be like kind. Aircraft are generally like kind to any other aircraft under the General Asset Classes or the Standard Industrial Classification (SIC) guidelines. In general, all aircraft and helicopters (except those used in commercial or contract carrying of passengers or freight) are treated as like kind. Commercial or charter aircraft and helicopters used for transporting passengers and cargo in scheduled air transportation, are similarly treated as like-kind to one another.

3. You have 45 days from the date of closing on the old aircraft to identify a list of aircraft from which you will purchase the new aircraft. From the date of closing, you have 180 days to close on one or more of the aircraft from your 45-day list.

4. You cannot have actual or constructive control of any of the proceeds received from the sale of the old aircraft. By law, all money is held by a Qualified Intermediary (also referred to as an Accommodator or Facilitator). You cannot have an associate or employee, your attorney, broker or CPA hold the proceeds, nor can you leave the proceeds in escrow until the new aircraft is purchased.

5. The titleholder on the old aircraft must be the same titleholder on the new aircraft. One aircraft can be exchanged for two or more replacement aircraft or vice versa.

6. The replacement aircraft must be equal or greater in value to the relinquished aircraft to avoid taxable boot, and all exchange cash must be reinvested in the replacement aircraft.

Aircraft owners can realize the benefits available through the 1031 Exchange process. A team of professional consultants is critical to ensure the necessary steps to complete your exchange properly are followed and comply with current Section 1031 tax law.

Selecting a knowledgeable and experienced Qualified Intermediary that is familiar with aircraft exchanges is of particular importance given the complexities of the exchange.