This article is a three-part series explaining the basics of the tax-deferred 1031 exchange, the different types available, the mechanics of how they work, and the benefits to be reaped by a client who decides to partake in such an exchange.

Tax-deferred 1031 Exchange: What It Is and What’s Involved

The tax-deferred 1031 exchange refers to a situation where taxpayers exchanges like kind property for like kind property as opposed to a sale and reinvestment of sale proceeds. In short, property is sold or given up, also referred to "relinquished property," in exchange for property being purchased that replaces the relinquished property, also referred to as "replacement property."

Only certain types of property, however, can be used for the tax-deferred 1031 exchange. First of all, both the relinquished and replacement properties must be for productive use of investment or for business purposes.

Secondly, the properties cannot fall under any of the following categories, as they do not qualify for tax-deferred 1031 exchange treatment under the law:

1. personal property (i.e. the taxpayer's principal residence or that portion of the home used as such);
2. primary residence and the second home of taxpayer (however, that a two-family home can qualify for the "like kind" exchange with respect to the rental portion of said premises);
3. property held primarily for sale (i.e., inventory);
4. partnership interests; and
5. shares of corporate stock.
   

Real estate not used as a residence by a taxpayer as either a primary or secondary home, but rather is used for investment or business purposes, does qualify as the type of property that can be exchanged and have tax deferral pursuant to Internal Revenue Code § 1031. Therefore, this kind of property can be exchanged. Furthermore, the properties can be within different geographic locations (i.e., New York, New Jersey). However, when a real estate attorney contemplates how this tax-deferred 1031 exchange should be executed for business or investment real properly, he or she must consider whether ·the exchange will be “forward” or “reverse.”

Aforward IRC. § 1031 tax-deferred exchange (hereinafter "forward exchange") is a tax-deferred 1031 exchange in which the taxpayer first sells the properly being relinquished before purchasing the replacement property. On the other hand, a reverse IRC. § 1031 tax-deferred exchange (hereinafter, “reverse exchange”) is a tax-deferred 1031 exchange in which the taxpayer wishes to have the replacement property purchased before the relinquished property is sold. These types of exchanges, and their technical requirements, will be explained in fuller detail later on.

In any case, regardless of whether a forward or reverse exchange is employed, there must be an exchange trustee hired to help structure the exchange. This "exchange trustee," also referred to as a "qualified intermediary" or "facilitator," an individual who is not a related party to the taxpayer, nor is a service professional hired (i.e., attorney, accountant) for two years to perform other work for the client. Therefore, the current attorney for the client cannot also act as the exchange trustee to carry through the tax-deferred 1031 exchange.

In short, the exchange trustee will enter into a written exchange agreement with the taxpayer client. Pursuant to this agreement, the trustee acquires the relinquished property from the taxpayer and transfers it to the individuals who are purchasing it. Further, the trustee also acquires the replacement property for tit1e taxpayer client and transfers it to him. This agreement must set forth the identification and exchange period time limitations provided by the Internal Revenue Code, specifically IRC § 1031(a)(3).

The "identification period" is the 45-day period in which the taxpayer has to identify to the trustee what the replacement property is in a forward exchange (or identify what the relinquished property is in a reverse exchange). The 45-day period for real estate begins with the first closing. The identification may occur via contract signing or a written binder involving the 2nd property, or via a written letter to the exchange trustee describing the property as replacement property (or, in the case of a reverse exchange, relinquished property).

The “exchange period” is the 180-day period in which the taxpayer has to complete the entire exchange, whether reverse of forward. Therefore, if only one property was being relinquished and one property was being replaced, therefore only involving two real estate closings, then the 180-day period begins with the first closing, and ends with the second closing that must occur within 180 days of the first closing.

There are no extensions available on these time periods. Failure to identify within 45 days and failure to complete the entire exchange within 180 days renders the exchange unsuccessful with no tax deferral benefits. In addition, as part of the tax-deferred 1031 exchange, replacement property must be transferred to the taxpayer client in no longer than 180 days of the first closing or transferred prior to the due date of the taxpayer's income tax return, whichever is sooner.

It is important for the attorney of the taxpayer client to understand that, under no circumstances, can the taxpayer client ever have a right to receive or have the benefits of the proceeds from the sale of the relinquished property during both the identification period and the exchange period. Otherwise, the client is deemed to have “unfettered discretion” with the funds. Any funds to which the client is deemed to have unfettered discretion does not have the protection of tax deferral provided by the exchange. Therefore, in order for the sale proceed funds to qualify for the tax-deferred 103 I exchange, they must be paid directly to the exchange trustee acting on behalf of the taxpayer client and set apart in an account or CD opened by the trustee. The receipt by the exchange trustee of such funds is considered proper receipt of the relinquished property sale proceeds. However, from these funds, the exchange trustee can make disbursements pursuant to the exchange agreement that represent payments toward the purchase price of the replacement property, whether it be downpayment, balance of proceeds due, title bill, etc.

It is very important that the taxpayer client understand that replacement prope1ty must have a purchase price equal to or greater than the net sale price (calculated prior to mortgage payoff) of the relinquished property in order for the tax-deferred 1031 exchange to have no taxable income consequences. Also, a refund to taxpayers will be taxed at the appropriate rates for said amount.

The above generally describes the tax-deferred 1031 exchange, regardless of whether it is forward or reverse. Below further explains the forward and reverse exchanges and describes how they operate and the order of events of the exchanges.

A. The Forward I.R.C. § 1031 Tax-Deferred Exchange: Sell 1st, Purchase 2nd

A forward exchange of real property occurs when a client's closing for the sale of property being disposed of happens prior to the closing for the purchase of replacement property. In short, it is involves the initial transfer of relinquished property and subsequent receipt of replacement property. This type of exchange traditionally has been easier to accomplish then the reverse exchange and is more commonplace in practice. A real estate attorney representing a client who engages in a forward exchange must understand the procedure involved.

In short, the contract of sale for the relinquished property should contain a rider providing for the buyer and seller to cooperate in the execution of documentation for the tax-deferred 1031 exchange. Then, at closing, an exchange trust agreement, memorializing the terms of the forward and reverse exchange, an assignment of contract to the exchange trustee and notice of assignment, should be executed by the seller, buyer, and exchange trustee. All sale proceeds must be made payable to the exchange trustee, who will then open an account or CD for the taxpayer, to which only the exchange trustee has access. Subsequently, in addition to the identification of replacement property, there must be also an assignment of the contract for the purchase of replacement property to the exchange trustee for purposes of facilitating the tax-deferred 1031 exchange, and then an assignment back from the exchange trustee to the purchaser at closing. At closing, any balance due and owing to the seller can be paid directly out of the account or CD opened by the exchange trustee for the taxpayer client.

So long as the QEAA provides for the above and such steps are carried out, a reverse exchange with the use of a parking corporation .can be effectuated under safe harbor.

It is important to note that it the exchange trustee who should be the main officer and the director in control of the parking corporation during the exchange period, along with being the holder of the shares on behalf of the taxpayer client pursuant to the reverse exchange. Furthermore, at the sale of the relinquished property, the sale proceeds should still be payable to the exchange trustee who will then open an account or CD on the taxpayer's behalf long enough to enable the exchange trustee to payback any loans made by the taxpayer and any outside parties for the purchase of the replacement property via the first closing. At the end of the reverse exchange, the replacement property can deeded out directly to the taxpayer client and the parking corporation can be dissolved. Again, it is important to remember that the taxpayer cannot have unfettered discretion over the parking corporation nor over the replacement properly nor over the sale proceeds from the relinquished prope1iy during the identification and exchange periods.

Why It Is Helpful to Plan for the Tax-deferred 1031 Exchange as Early as Possible

As a practice tip, attorneys should discuss with their clients whether or not they will be participating in the tax-deferred 1031 exchange from the outset of the transaction, even before contract signing, if possible. It is very good practice for an attorney who has client partaking in the tax-deferred 1031 exchange to include a rider to the contract that alerts the other side to the transaction that there will be an exchange and that obligates them to comply with signing all documents necessary to effectuate the tax-deferred 1031 exchange.

Failure to execute such a rider at contract signing, whether for the sale of relinquished property or the purchase of replacement properly, is not fatal to the tax- deferred 1031 exchange. However, without such a rider, for the attorney runs the risk that the client may not receive cooperation from the opposing side in executing all exchange documents. In such a case where the other side to the transaction refuses to sign the necessary documentation because no rider to contract was included, the tax- deferred 1031 exchange cannot be completed and the client will be subject to paying full income tax on the sale of his real property. Therefore, advance preparation helps reduce the risk of these administrative problems occurring.

Beneficial Deferral of Income Tax via the Tax-Deferred 1031 Exchange and an Illustration of the Tax Bite Without Use of the Exchange

The benefit of a client taxpayer who completes the tax-deferred 1031 exchange is to defer the payment of income tax, specifically capital gains tax, until a later point in time. If a taxpayer can successfully implement this exchange and obtain such a deferral, then he is in effect leveraging the amount of finances available to be used in obtaining a replacement property. To understand this leveraging, we must briefly examine the tax rates (and the calculation thereof) to which real estate disposed of, without the use of the tax-deferred 1031 exchange, is subject to.

Under the current income tax rate structure that has been in place after the passage of the Taxpayer Relief Act of 2003, the federal capital gain tax rate assessed for an individual upon the disposition of real estate that is held long term, that is, held more than one (1) year, now is fifteen percent (15%). However, in computing any gain on disposition of long-term real estate taxpayer is also subjected to the twenty-five percent (25%) tax rate for depreciation recapture, The taxpayer is subjected to this twenty-five percent (25%) depreciation recapture in lieu of the fifteen percent (15%) long-term capital gains tax rate to the extent that the long term capital gain represents prior depreciation which was expensed (or that should have been expensed but the taxpayer failed to take a deduction for this even though he was eligible to be). In addition, there are state and local income taxes that must be accounted for by the taxpayer. For taxpayers subject to New York State and City taxes, there can be additional income tax for up to approximately eleven percent (11%) for a total effective tax rate of thirty-six percent (36%) before accounting for depreciation recapture.

Illustration of the Full Imposition of Taxes

To illustrate more fully, suppose a Staten Island, N.Y. resident disposed of real estate used as a rental on the borough which she had held on to for more than one year, thereby making it long term. Suppose here, total capital gain equaled $50,000. In addition, assume there had been prior depreciation properly expensed on Schedule E, a form concerning rental income and expenses that is attached to tax return Form 1040, individual income tax return, in relation to these premises in the amount of $32,000 over the years.

The tax bite on this disposition can be determined as follows:

Step One: Calculate the federal income tax liability

a) depreciation recapture at the 25% federal rate upon the first $32,000 of $50,000 of long-term capital gain, which represent prior depreciation expensed:

$32,000 + 25% = $8,000

(Note: the depreciation recapture at the 25% rate can only be imposed upon total amount of gain up to prior depreciation; therefore, had prior depreciation been $60,000 but the total capital gain was still $50,000, then the total federal tax liability upon the disposition would be: 50,000 + 25% = $12,500.)

b) long-term capital gain rate tax of 15% upon $18,000, which is the excess of the total $50,000 over the portion of gain representing prior to depreciation in the amount of $32,000:

$18,000 + 15% = $2,700

c) total federal tax liability upon $50,000 of long-term capital gain:

depreciation recapture upon $32,000 at 25%:             $8,000

long-term capital gain rate upon $18,000 at 15%:       $2,700     

Total Federal Tax Liability                                                 $10,700

Step Two:  Calculate the entire federal, state, and city income tax liabilities on the disposition:

Assuming a combined New York State and City rate of eleven percent (11%), the amount clue to New York in total is:

$50,000 + 11% = $5,500

Total New York State and City Tax Liability is $5,500.

Step Three:   Calculate the entire federal, state, and city income tax liabilities on the disposition.

Federal Income Tax:                                       $10,700

New York State/City Income Tax:                 $5,500       

Total Income Tax Liability                              $16,200

Therefore, without exploring the tax-deferred 1031 exchange, this Staten Island individual taxpayer described above with $50,000 in long-term gain on disposition of his rental property who fails to take advantage of the tax-deferred 1031 exchange can pay up to $16,200 in taxes. If that is the case, then this individual taxpayer has $16,200 less in cash with which she can use toward buying any future property that will replace the property that was just sold.

Instances When the Tax-deferred 1031 Exchange Mav Not Be Needed

A tax-deferred 1031 exchange of real property can be a useful tool in providing a taxpayer with an opportunity of financial leverage in not having to earmark sale proceeds toward the payment of income taxes at the current time. However, the tax-deferred 1031 exchange is not useful in any of the following circumstances where:

1. the taxpayer client needs access to the sale proceeds for other than real estate needs, such as personal issues including payoff of personal debt and expenses (i.e., credit card debt, medical bills);
   
2. the taxpayer client has a capital loss either from the sale of other investments in the same tax year that the relinquished property is sold or carried over from the prior year(s), the dollar amount of that is large enough to offset the part or all of the gain on the sale of the relinquished property;
   
3. the taxpayer client will realize a loss on the sale of relinquished property; or
   
4. the taxpayer client has no desire to continue to maintain any real estate or acquire additional property for investment or business purposes.
   

If any of the factors listed in 1 to 4 is present, then the tax-deferred 1031 exchange is not appropriate for the client. The client and/or his attorney may need to contact the client's accountant to help make these determinations. To execute a tax-deferred 1031 exchange where any of the above exists produces no benefit for the client. Again, the exchange is a tax-deferred exchange. If there is a loss on the real estate to be sold or a capital loss carryover from another investment that can be applied against the real estate being sold so that the capital gain is substantially reduced, then there is no tax to defer via the tax-deferred 1031 exchange. Furthermore, in order to avail of the non­ recognition provisions of IRC § 1031, the client must want to continue with a long-term investment and replacement property. Thus, if the client does not wish to continue having real estate for investment or business purposes nor wishes to increase his holdings, the purpose of having the tax-deferred 1031 exchange is defeated.

The Significance of Related Parties in the Tax-Deferred 1031 Exchange

The topic of related parties is very important to the tax-deferred 1031 exchange. A related party, defined in IRC § 267 (b) and 707 (b) (!), includes relatives, agents and fiduciaries of the taxpayer, the accountant, lawyer, etc. The presence of related parties in certain roles can destroy the validity of a tax-deferred 1031 exchange.

A related party is prohibited, first of all, from acting as the exchange trustee and qualified intermediary in a tax-deferred 1031 exchange. In addition, in the past, a taxpayer had flexibility in choosing from whom he could purchase the replacement property as part of a tax-deferred 1031 exchange. Such property could have been purchased from a relative or a stranger; it did not matter. However, the IRS has placed a restriction upon the taxpayer deciding to make the purchase of replacement property via Revenue Ruling 2002-83, 2002-49 I.R.B. 927, which was issued in December 2002.

Specifically, the revenue procedure prohibits a taxpayer from purchasing replacement property from a related party. On a positive note, the revenue procedure does not prohibit the taxpayer from selling his relinquished property to a related party. However, if there is a sale to a related party, then there must be a two year holding period. All properties, that is, the relinquished property purchased by the related party and the replacement prope1iy purchased by the taxpayer client, are to be held for at least two years by the parties post-closing.

Again, the prohibition is on the purchase of replacement property, not on the sale of relinquished property.

Again, it is important that attorneys advise their clients to be sure that they do not purchase the replacement property from a related party, as it will jeopardize the tax- deferred 1031 exchange should the taxpayer client ever be audited by the IRS.

Conclusion

In brief, every real estate attorney should have a basic understanding of what the tax-deferred 1031 exchange is, how it functions, and whether it has any relevance to a client engaging in the disposition and acquisition of business or investment property. Hopefully, this article has provided our fellow members with a solid foundation explaining the tax-deferred 1031 exchange.

SIX ROOMS OVER SIX ROOMS AT :HEARTLAND VILLAGE, STATEN ISLAND, NEW YORK

RELEVANT FACTS

The calculation of gain is demonstrated as follows:

To calculate the amount of taxable gain of the above two family premises, we must perform calculations with respect to each half of the premises:

50% allocated to the principal residence portion of the premises

50% allocated to the rental portion of the premises

		Rental	Residence
Net Sales Price of $ 700,000:		$ 350,000	$  350,000
Less: Adjusted Cost Basis - Purchase Price	$  60,000
Plus: Improvements	$100,000
Less: Depreciation Adjusted Cost Basis	(100,000) $ 60,000:	(30,000)	(30,000)

Taxable Gain of $320,000:       All of gain is taxable

None of gain is taxable;

$320,000 gain or principal residence is excluded from federal income tax-pursuant to IRC Section 121

Depreciation recapture @25% on first    $ 15,000

$ 60,000 of $320,000 gain:

Federal at 15% tax rate on excess of      $ 39,000

$320,000 over $ 60,000, or $260,000

New York State and City at a combined   $ 32,000
Estimated 10% tax rate

Projected Taxes due of $86,000:              $86.000

Raymond Liebman, Esq., CPA, is a practicing attorney and CPA for over 50 years who now specializes in real estate and business transactions. He has given numerous seminars to attorneys,  CPAs and realtors on structuring real estate transactions to meet the Internal Revenue requirements on Internal Revenue Code section 1031.  In addition, Mr. Liebman has acted in various capacities (whether attorney or qualified intermediary) in multi-million dollar  real estate exchanges throughout the country.  Mr. Liebman has been chairman of the Richmond County Bar Association committee on taxation since 1988 and has given over 50 CLE seminars on various topics within this time.  Mr. Liebman is also on the faculty of the academy for professional education and has lectured extensively throughout the country. In addition, other local venues where Mr. Liebman has lectured are the Bay Ridge Lawyers Association, NYSSCPA, Department of the U.S. Treasury, Civil Court City of New York (court attorneys and small claims arbitrators) Staten Island board of realtors and the New Jersey Enrolled Agents. Should anyone have any further questions concerning the mechanics of the exchange or of this article, please contact the author at 718-987-5070.