Here are some myths regarding tax deferred exchanges, that you may have heard. Which may effect your understanding of a 1031 Exchange. Please review the three most common myths below.
Myth 1
“A taxpayer must acquire replacement property with an investment property similar in ‘use’ to the investment property relinquished, i.e. apartments for apartments, land for land, offices for offices.“
The real fact is the Internal Revenue Service has applied a very flexible interpretation to the “like-kind” requirement defining it as having reference to the nature or character of the property and not its grade or quality. Therefore developed property, of any product type, may be exchanged for a leasehold interest in real estate if there is an excess of 30 years remaining in the lease. Optional renewal periods are treated as part of the leasehold term.
An exchange of cooperative housing corporation stock for condominium units in the same physical project will qualify where the local law provides that a cooperative housing project with leases in excess of 30 years is tantamount to a condominium. The fact that the parties held the property in different form, i.e., exchange of an interest in property held as a tenant-in-common with property held in fee simple without any co-tenants, will not affect the qualification as a tax deferred exchange.
Real Estate located outside of the United States and real estate located within the United States are not considered to be like-kind property. Therefore, exchanges involving foreign and U. S. real estate do not qualify for non-recognition-of-gain treatment under the like-kind exchange rules. The definition of United States when used in a geographical sense in the Internal Revenue Code includes only the State and the District of Columbia. United States territories such as Guam do not qualify as “like-kind” property.
Myth 2
“In a real estate 1031 Exchange, a tax-payer may designate as many properties as he/she wishes as long as a diligent effort is made within the 180 period.“
The 1991 regulations published by the Department of Treasury clarified the identification period for the delayed exchange.
The Identification Period: The “Identification period” is a 45-day period beginning on the date the taxpayer transfers the relinquished property. The period ends at midnight of the 45th day.
The Exchange Period: The “exchange period is a 180 day period beginning on the date the taxpayer transfers the relinquished property and ends at midnight on the 180th day. However, if the taxpayer is required to file his return prior to the final day of the exchange period, the date on which the tax-payer is required to file his tax return (giving consideration to extensions) becomes the final day of the “exchange period.”
In the situation where the taxpayer, as part of the same exchange, transfers more than one piece of property, the regulations mandate that the time period for the “identification period” and the “exchange period” begin to run with the first transfer.
Where the identification period or the exchange period ends on a Saturday, Sunday, or legal holiday, the identification period or exchange period is not extended. Acts of God or a natural disaster will not extend these periods or permit other properties to be identified in the event the replacement property(ies) identified is/are destroyed.
Replacement property must be identified “unambiguously in writing signed by the tax-payer and hand delivered, mailed or other-wise sent before the end of the 45-day identification period to a third party (i.e. the qualified intermediary) involved in the exchange other than the taxpayer or a related party.”
Replacement properties must be identified as follows: (a) Three properties of any fair market value, or (b) any number of properties as long as their aggregate fair market value (irrespective of net equity) at the end of the identification period does not exceed 200% of the value of the relinquished properties.
The Code provides for two exceptions:
Property actually acquired by the taxpayer within the 45-day identification period is deemed to have met the identification requirement without the requirement for a specific designation notice; and
If more than three properties are identified, and the aggregate fair market value exceeds 200%, the taxpayer must purchase 95% of the property identified. A taxpayer may substitute a property for one previously identified by submitting a letter of revocation and replacement to the third party before the 45th day. For purposes of identification, incidental property is disregarded. Incidental property is considered property normally transferred with a larger property and which as a fair market value of less that 15% of the larger property. The identified property must be substantially the same as the property officially identified. Property under construction must include as much detail as is practicable at the time identification is made. It must be substantially the same property when received as was identified.
Myth 3
“Once a taxpayer has completed a §1031 Exchange with real estate, the taxpayer does not need to concern himself about the Internal Revenue Service.“
When the dreaded annual IRS tax deadline is behind all great American taxpayers, a breath of relief can be taken until the all-to-well-known tax auditor knocks the exchanger’s front door.
In the first Mid-Exchange, “Myths” and “Facts” article published, we mentioned the exchange Period ended on the 180th day. However, if the taxpayer is required to file his return prior to the final day of the the exchange period, the date on which the taxpayer is required to file his tax return (giving consideration to extensions) becomes the final day of the “exchange period.” In other words, the fact is any taxpayer with an April 15th return filing deadline who relinquished a property on or before December 31st of the prior year, and who did not acquire a replacement property by the tax return filing deadline of April 15th of the following year, should have filed an extension beyond the 180th day.
If an exchanger met the extension hurdle, all should be well and fine unless and until the much dreaded auditor knocks at the door. If any exchanger utilized the services of a qualified intermediary, there is a higher probability that the exchange transaction will not be scrutinized as closely as if the Qualified Intermediary Safe Harbor did not apply. However, the following audit issues are usually raised by an examining agent:
1. Are the properties like-kind? Form 8824 specifically asks for descriptions of the relinquished property and the replacement property.
2. Is the replacement property held for investment or productive use in a trade or business? Form 8824 further asks if the replacement property was sold or disposed of during the taxable year.
3. Was the exchange with a related party under §1031?
4. Was the exchange a deferred exchange? If so, was the identification period requirement and the exchange period requirement satisfied?
5. Was the amount of gain reported properly calculated?
6. Was any nontaxable boot received in the exchange?
7. Was the basis of the replacement property properly calculated?
Form 8824 and common practices suggest several routine issues will be part of an exchange audit. Deferred exchanges will be examined for compliance with the regulations, closing statements will be examined to ensure that gain is properly calculated, actual use of the relinquished and replacement property may be examined to ensure that properties are not held primarily for sale, properties are like-kind, and properties are held for productive use in a trade or business or held for investment and there is not personal use. Where partnerships are concerned, a transaction will be scrutinized more carefully.
Recent case law gives guidance for examination by the Service. In the simultaneous and deferred exchange scenario, the Service has been unsuccessful in raising the issue of substantial implementation of an exchange unless a sale has actually closed before an exchange by converting a purchase into a §1031 exchange, the Service has successfully raised the issue of substantial implementation of a sale.