ipx1031.com

Basics of a 1031 Exchange

The Wisconsin Real Estate Symposium

Tues. September 18, 2007

Appleton, Wisconsin

ipx1031.com

Speaker Profiles

• Ken Zacharias, CPA

Shareholder, Green Bay

Schenck Business Solutions

920-436-8700 Phone

920-436-7808 Fax

Ken.Zacharias@schencksolutions.com

ipx1031.com

Speaker Profiles

• Gabrielle Glass, MBA, CESAssistant Vice President, Midwest RegionRegional Account ManagerInvestment Property Exchange Services866-458-1031 Toll Free Phone877-776-3128 Toll Free Faxgabrielle.glass@fnf.com

ipx1031.com

Qualified Intermediary

The use of a Qualified Intermediary is essential to completing a valid delayed exchange. The Qualified Intermediary performs several vital functions in an exchange.

Acts as a Principal

To qualify as an exchange a reciprocal trade or actual exchange must take place in each IRC §1031transaction. This means the Exchanger must enter into a written exchange agreement and assign to a Qualified Intermediary: (1) their interest as seller of the relinquished property and (2) their interest as buyer of the replacement property. By becoming an actual party to the exchange, a reciprocal trade takes place even when there are three or more parties involved in an exchange transaction (i.e. when the Exchanger is purchasing the replacement property from someone other than the buyer of their relinquished property). The Qualified Intermediary cannot be the Exchanger and must be an Independent Party (not DISQUALIFIED) to the transaction.

The use of a Qualified Intermediary allows for “DIRECT DEEDING” of the properties involved in the exchange. This is only allowed with the use of a Qualified Intermediary.

ipx1031.com

Holds Exchange Proceeds From Constructive Receipt

The Exchanger cannot have the right to receive, pledge, borrow, or otherwise receive the benefits of the exchange proceeds. If the Exchanger actually or constructively receives any of the proceeds from the sale of their relinquished property, those proceeds will be taxable as boot and the entire exchange may be jeopardized.

Prepares Legal Documentation

Several legal documents are necessary in order to properly complete an exchange, including an Exchange Agreement, two Assignment Agreements and Exchange Closing Instructions to each closer.

Provides Quality Service

Although the process is relatively simple, the rules are complicated and filled with potential pitfalls. An experienced Qualified Intermediary is essential to a smooth transaction.

Qualified Intermediary (cont’d)

ipx1031.com

1031 Exchange Industry Currently Unregulated

• $300+ Million of Exchange Funds Stolen Early in 2007 by Shuttered Qualified Intermediaries

• Financial Controls at IPX1031• HR 3420 Introduced August 3. 2007 to Require

Federally Insured Intermediaries• FEA Trade Association Petitions FTC for Consumer

Protection Requiring Reserves or Letter of Credit, Bonding and Background Checks/Fingerprinting…

• Visit www.1031.org

ipx1031.com

What is a 1031 Exchange?

• The regulations define a deferred exchange as:

An exchange in which a taxpayer (the “exchanger”)

transfers property held for productive use in a

trade or business or for investment and later

receives property to be held for either of these

qualified purposes.

ipx1031.com

Internal Revenue Code Section 1031

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

Investors complete tax-deferred exchanges to defer the capital gain tax on the disposition of their investment properties. The motivation to exchange often falls along standard risk-reward or cash flow-appreciation scales. If a seller of investment property plans to purchase and reinvest the funds in another investment property and has a capital gains tax consequence, the purchase contract should include exchange cooperation language.

§1031 DEFERS taxes . . . NOT a tax-free transaction.

ipx1031.com

1031 ExchangeTax Rates on Real Estate Sale• Federal Long-Term

− Capital gain for individuals15% maximum− Capital gain for corporations 35% maximum− Real estate depreciation recapture 25%− Equipment and pre-1987 Section 1250 accelerated depreciation recapture (ordinary income

rates)

• Wisconsin− Equipment depreciation (ordinary income rates)− Capital gain and real estate depreciation – 60% exclusion from ordinary rates

ipx1031.com

Comparing the Tax Consequence: A Sale Versus the Exchange of Investment Property

1. Calculate the adjusted basis in the property:

Original purchase price of the property

Plus non-expensed capital improvements

Minus depreciation on improvements

(27.5 yr. for 10 years for residential rental)

Equals Adjusted Basis

To Estimate the Potential Capital Gain Tax:

$200,000

$ 35,000

$ 58,181

$176,819

ipx1031.com

Sales price of property

Minus transactions costs

Minus adjusted basis

Equals Total Gain on Sale

$550,000

$ 31,500

$176,819

$341,681

2. Use the adjusted basis to determine the total gain on the sale:

Comparing the Tax Consequence:

A Sale Versus the Exchange of Investment Property (cont’d)

ipx1031.com

3. Calculate the State Capital Gain:

Total Gain on Sale

Multiply by Wisconsin State capital gain tax rate,if any (assume 6.75%) after applying 60% exclusion

Comparing the Tax Consequence:

A Sale Versus the Exchange of Investment Property (cont’d)

$9,225 (A)

$341,681

ipx1031.com

4. Calculate the Federal Long-Term Capital Gain:

Total Gain Less Depreciation Recapture

($341,681 – 58,181 = $283,500)

Multiply by Federal capital gain tax rate 15%

$283,500

$42,525 (B)

Comparing the Tax Consequence:

A Sale Versus the Exchange of Investment Property (cont’d)

ipx1031.com

Capital Gain From Depreciation Taken

Multiply by Federal 25% tax rate

$58,181

$14,545 (C)

Comparing the Tax Consequence:

A Sale Versus the Exchange of Investment Property (cont’d)

5. Calculate the Capital Gain due to Depreciation Taken:

ipx1031.com

$66,295

6. Total of Taxes A + B + C Equals the

Capital Gain Tax Exposure that is Deferred

Through a § 1031 Exchange.

Comparing the Tax Consequence:

A Sale Versus the Exchange of Investment Property (cont’d)

Note: Exchanger may receive some credits at State level for Federal Taxes Paid

ipx1031.com

Requirements for a Valid 1031 Exchange

• Is There Gain or Loss?• Qualified Property• Purpose Requirement• Like-Kind Requirement• Holding Period “No Safe Harbor”• Exchange Requirement• Time Limits

Extensions Allowed under Rev Proc 2007-56, Section 17 for affected taxpayers in Federally Declared

Disaster Areas-

check IRS website for updates

ipx1031.com

When is an Exchange Appropriate?

Before entering into an exchange the Exchanger must consider the following:

1. Does the Exchanger really want replacement like kind property?

2. Will the tax benefit from using an exchange outweigh the transaction costs?

ipx1031.com

Starker Case (1979)

• Following Starker vs. U.S., Congress, in 1984, Congress enacted rules which permit non-simultaneous exchanges under certain conditions– Identification (45 days)– Close of Exchange (180 days or tax return due

date)– 95% of exchanges are delayed structure

ipx1031.com

Basic 1031 RulesAs a general “rule of thumb,” to obtain a deferral of the entire capital gain tax the Exchanger must:

To the extent the Exchanger fails to observe these rules, they will be subject to capital gain taxes.

Thumb-nail test for 100% deferral: => in value; => equity.

2. Obtain equal or greater financing on the replacement property than was paid off on the relinquished property (Replacement property debt can be offset with cash put into the exchange.).

1. Reinvest all of the net proceeds from the relinquished property.

3. Receive nothing in the exchange but like kind property.

ipx1031.com

Balancing the Exchange

Value

Equity

Mortgage

Relinquished Replacement

Exchanger goes up in value, across in equity and up in mortgage:

$150,000

$ 50,000

$100,000

$225,000

$50,000

$175,000

Example I.

No Tax is due.

ipx1031.com

Balancing the Exchange

Value

Equity

Mortgage

Relinquished Replacement

Exchanger goes up in value, up in mortgage and keeps $10,000 of net proceeds:

$150,000

$ 50,000

$100,000

$225,000

$40,000

$185,000

Example II.

Tax is due on $10,000 of Cash Boot.

ipx1031.com

Balancing the Exchange

Value

Equity

Mortgage

Relinquished Replacement

Exchanger goes down in value, across in equity and down in mortgage:

$150,000

$ 50,000

$100,000

$125,000

$ 50,000

$ 75,000

Example III.

Tax is due on the $25,000 of Mortgage Boot

ipx1031.com

Balancing the Exchange

Value

Equity

Mortgage

Relinquished Replacement

Exchanger goes down in value, across in equity and down in mortgage:

$800,000

$200,000

$600,000 75% d/e

$ ?

$ 200,000

$ ? 55% d/e

Example IV.

Tax is due on Mortgage Boot if TIC is a lower d/e ratio than asset exchanger traded

ipx1031.com

Vacation Homes and 1031 Exchanges

• Can you sell your “second” home and do a 1031 exchange?• Favorable 2005 Tax Court Case Rivera v. Commissioner (not a

1031 ruling)• Unfavorable Tax Court Memorandum 2007-134 Moore v.

Commissioner-course of conduct personal use (never rented) so prospect for appreciation on resale was not primary intent for Georgia residents

• How to prove investment intent?– Rental Activity– Personal-Use/Dormant (avoid wear and tear)– Depreciation Schedule

ipx1031.com

Related Party Issues

Note: Exchanges structured to avoid these rules will not qualify for tax deferral.

1. Transfer due to death or involuntary conversion.

2. Transfer where it is established to the satisfaction of the IRS that there is no tax avoidance intent.

Exceptions to the 2-Year Holding Period:

Related parties can complete an exchange if both parties hold onto the property they received for 2 years. If either related party disposes of their property prior to the 2-year holding period, the entire transaction will be taxable to both parties in the year of disposition. The 2 year period is tolled during the term of any “puts” or “calls” on the property. IRC Section 1031 (f).

ipx1031.com

Related Party Issues (cont’d)

Related parties include:

Note: Exchanges structured to avoid these rules will not qualifyfor tax deferral.

1. Exchangers spouse, siblings, descendents or ancestors

2. Two corporations that are members of same controlled group

3. A grantor, fiduciary or beneficiary of any trust

4. Related C corporation, S corporation or partnership in which there is more than a 50% ownership or controlling interest [IRC Sections 267 (b) and 707 (b) (1)]

ipx1031.com

Related Party Exchange Scenarios

Buyer of Relinquished Property is the Related Party — Will be recognized, with the only limitation being that the Taxpayer completes the purchase of Replacement Property. We now have guidance that the Related Party Buyer does not need to his or her own exchange and has no two year holding requirement. PLR 200709036, PLR 200712013, PLR 200616005.

ipx1031.com

Related Party Exchange Scenarios

1. Seller of Replacement Property is Related Party — Will not qualify, even if Exchanger uses an Intermediary. IRS will restructure as a three party exchange: Exchanger and related party seller first exchange properties, then related party seller immediately sells relinquished property to buyer for cash without holding property for 2 years. However, if related party seller reinvests in a tandem 1031 (rather than cashing out), the Exchanger’s 1031 exchange will be respected.

2. PLR 9748006 The Mommy TAM; PLR 200126007

3. Rev Rul 2002-83; PLR 2004-40002; PLR 2006-16005

ipx1031.com

A disqualified party is a person or entity who:

Disqualified Parties

2. Is related to the Exchanger by substituting 10% for 50% (IRC Sections 267 (b) and 707 (b) for related corporations,partnerships or trusts);

OR

1. Is a “Related Party” to the Exchanger;

OR

ipx1031.com

• Employee • Real Estate Broker or Agent

• Attorney • Investment Bank or Broker

3. Within the 2 years preceding the transfer of the relinquished property, the person acted as the Exchanger’s:

• Accountant

Disqualified Parties (cont’d)

Exceptions - if the person or entity only provides the Exchanger with:

A. Routine financial, trust, title insurance or escrow services; orB. Services solely with respect to the exchange of property.

Note: To obtain the Safe Harbor protection against constructive receipt of the exchange funds a disqualified person or entity may not act as an intermediary for the exchange.

ipx1031.com

Bill Introduced to Double Exchange Deadlines

• Rep. Adrian Smith of Nebraska (R) Introduced HR 3039 Jul 12, 2007

Farmland Relief Act of 2007

90 days to Identify and 360 Days to Reinvest

ipx1031.com

1031 Exchanges

• Question and Answer Period