Category: 1031 Exchange General

The reinvestment goal of any 1031 tax deferred exchange should be to buy replacement property of equal or greater value and to use up all the exchange proceeds in the closing of the replacement property without getting any cash back.  Receiving cash, sometimes called boot, won’t generally terminate the like-kind exchange, however, it will likely trigger a taxable event for the taxpayer, and should be avoided.
Sometimes, the taxpayer receives their replacement property settlement statement, and it shows that they are getting cash back.  What possibly could have caused this?  Below are a few examples of what may have caused the cash back scenario and what can be done to fix the settlement statement prior to the closing in order to avoid the cash boot:

Other credits may appear on the settlement statement
Taxpayer loan terms may need to be adjusted
Taxpayer may be purchasing other properties

Credits on the Settlement Statement Contributing to Cash Boot
If the settlement statement has a credit for earnest money that the taxpayer paid out of pocket, the settlement agent can show an offsetting debit line item and title it “Reimbursement of prepaid earnest money to the buyer.” However, if the qualified intermediary was instructed to pay the earnest money out of the exchange proceeds prior to closing, this offsetting debit is not an option because the taxpayer can’t be reimbursed for an item that they did not prepay out of their pocket.
If the other credits include a credit for property taxes, rent, or security deposit prorations, the taxpayer should consider asking the seller to pay these items to the taxpayer outside of closing or to ask the closer to show these items as paid outside of closing and not as a credit line item.  Even though these non-exchange items are customarily shown as a credit, it is best if they are handled outside of the closing. 
Adjusting Loan Terms to Avoid Cash Boot
If a taxpayer is buying replacement property and is obtaining a loan as a part of the purchase, care must be taken to ensure that all of the exchange proceeds are reinvested into its acquisition.  There have been lenders who have advised clients to combine exchange proceeds with a high balance loan, allowing the taxpayers to receive excess cash back in the closing process.  In their opinion, the cash back is related to the loan proceeds rather than the exchange proceeds.  Unfortunately, the Internal Revenue Service (IRS) does not interpret cash back through the closing that way.  From the IRS’s perspective, the taxpayer is tapping equity through the exchange, and the equity (cash) received will be considered taxable boot if it is done through the closing.  A better route would be to:

Lower the loan amount or
Consider a principle reduction on the settlement statement for the amount of the excess cash back

If the goal is to get some cash back without triggering taxation, one can refinance the relinquished property prior to starting an exchange or refinance the replacement property after the exchange is complete.  Refinancing the relinquished property prior to selling is generally discouraged unless you can argue that the refinance was not in anticipation of the upcoming exchange or it was for independent business reasons.  The preferred method is to refinance the replacement property after the exchange is complete.
Purchasing Additional Properties to Avoid Cash Boot
If cash remains after the measures above are taken, there is a chance the taxpayer has the intent to purchase more than one replacement property.  If that is the case, the closer should only credit the buyer for proceeds needed to purchase the property, without sending cash back to the buyer.  The remaining proceeds will be held by the qualified intermediary pending further purchase transactions.
If the taxpayer is struggling to find properties to consume their remaining exchange proceeds and still within the 45-day identification period, they should call their qualified intermediary or counsel to discuss alternative forms of investment.  Many taxpayers do not realize that investing in certain energy royalty interests, water rights, or passive fractional interests (Delaware Statutory Trusts) may qualify as like-kind under the 1031 rules and allow them to further their tax deferred reinvestment goals.
Photo:

The reinvestment goal of any 1031 tax deferred exchange should be to buy replacement property of equal or greater value and to use up all the exchange proceeds in the closing of the replacement property without getting any cash back.  Receiving cash, sometimes called boot, won’t generally terminate the like-kind exchange, however, it will likely trigger a taxable event for the taxpayer, and should be avoided.
Sometimes, the taxpayer receives their replacement property settlement statement, and it shows that they are getting cash back.  What possibly could have caused this?  Below are a few examples of what may have caused the cash back scenario and what can be done to fix the settlement statement prior to the closing in order to avoid the cash boot:

Other credits may appear on the settlement statement
Taxpayer loan terms may need to be adjusted
Taxpayer may be purchasing other properties

Credits on the Settlement Statement Contributing to Cash Boot
If the settlement statement has a credit for earnest money that the taxpayer paid out of pocket, the settlement agent can show an offsetting debit line item and title it “Reimbursement of prepaid earnest money to the buyer.” However, if the qualified intermediary was instructed to pay the earnest money out of the exchange proceeds prior to closing, this offsetting debit is not an option because the taxpayer can’t be reimbursed for an item that they did not prepay out of their pocket.
If the other credits include a credit for property taxes, rent, or security deposit prorations, the taxpayer should consider asking the seller to pay these items to the taxpayer outside of closing or to ask the closer to show these items as paid outside of closing and not as a credit line item.  Even though these non-exchange items are customarily shown as a credit, it is best if they are handled outside of the closing. 
Adjusting Loan Terms to Avoid Cash Boot
If a taxpayer is buying replacement property and is obtaining a loan as a part of the purchase, care must be taken to ensure that all of the exchange proceeds are reinvested into its acquisition.  There have been lenders who have advised clients to combine exchange proceeds with a high balance loan, allowing the taxpayers to receive excess cash back in the closing process.  In their opinion, the cash back is related to the loan proceeds rather than the exchange proceeds.  Unfortunately, the Internal Revenue Service (IRS) does not interpret cash back through the closing that way.  From the IRS’s perspective, the taxpayer is tapping equity through the exchange, and the equity (cash) received will be considered taxable boot if it is done through the closing.  A better route would be to:

Lower the loan amount or
Consider a principle reduction on the settlement statement for the amount of the excess cash back

If the goal is to get some cash back without triggering taxation, one can refinance the relinquished property prior to starting an exchange or refinance the replacement property after the exchange is complete.  Refinancing the relinquished property prior to selling is generally discouraged unless you can argue that the refinance was not in anticipation of the upcoming exchange or it was for independent business reasons.  The preferred method is to refinance the replacement property after the exchange is complete.
Purchasing Additional Properties to Avoid Cash Boot
If cash remains after the measures above are taken, there is a chance the taxpayer has the intent to purchase more than one replacement property.  If that is the case, the closer should only credit the buyer for proceeds needed to purchase the property, without sending cash back to the buyer.  The remaining proceeds will be held by the qualified intermediary pending further purchase transactions.
If the taxpayer is struggling to find properties to consume their remaining exchange proceeds and still within the 45-day identification period, they should call their qualified intermediary or counsel to discuss alternative forms of investment.  Many taxpayers do not realize that investing in certain energy royalty interests, water rights, or passive fractional interests (Delaware Statutory Trusts) may qualify as like-kind under the 1031 rules and allow them to further their tax deferred reinvestment goals.
Photo:

A basic premise of the 1031 like-kind exchange is that the relinquished property and the replacement property have to be like-kind to one another.  But what constitutes like-kind in the context of real estate exchanges is probably not what you might suppose it to be.  Here, I will examine types of property interests that are considered like-kind to a conventional interest in real estate.
Where is “like-kind” defined?
The question of what like-kind is when exchanging real estate is very broad.  This is not defined in the tax code or in the 1031 exchange regulations, rather it follows case law history, sometimes going back to English Common Law and IRS rulings. For real estate, any type of real estate is like-kind to any other type. For example, an investment condominium would be like-kind to vacant land bought for appreciation. 
What are some other real estate property interests?
The fullest and most complete ownership in land is known as a fee simple, or a fee interest.  A fee simple ownership can pertain to a taxpayer’s relinquished property or the replacement property.  This is also the most common interest that people own in real estate.  However there are many additional types of property ownership that are considered as like-kind to a fee interest and like-kind to each other.  Such property interests include:

Installment Agreement for Deed (buying on contract)
Easements on real estate
Long term lease interest
Cooperative apartments
Certain oil, gas and mineral interests
Water rights not limited in term or amount
Certain option agreements for real estate purchase
Improvements made on real estate

Let’s look more closely at a few of these other real estate interests. 
Installment Contracts for Deed
In the case of a person’s interest as a purchaser under an Installment Agreement for Deed, also known as Articles of Agreement for Deed, due to the legal principle of equitable conversion, the purchaser under the contract is considered to own the real estate even though the purchaser does not receive a deed until all payments due under the Agreement for Deed are made.  As such, the purchaser could sell his or her interest under the contract and buy something outright like a fee interest in real estate.
Easements
An easement is another real property ownership interest that can be exchanged for a fee interest in real estate.  For example an owner of land which contains a cell tower can sell that interest by conveying the buyer an easement on the portion of land where the cell tower is situated.  This often includes the assignment of the cell tower lease to the easement purchaser as well.  Although the lessor’s interest in the lease cannot be the subject of a real estate exchange, the value of the rental income under the lease can affect the value of the easement being transferred.
Leases
A lessee’s interest under a long-term lease has long been considered by the courts and the IRS to constitute a real estate interest.  As such it may be exchanged for a fee interest.  To distinguish a long-term lease from anything less, the lease has to have 30 years or more to run as of the time of sale of the lease interest.  Although the remaining term of the lease may be of some lesser term at the time of sale, for determining whether it is long-term includes the time of any option periods under the lease.  As an example, if at the time of the sale of the lease, it has ten years to run, but it also includes two ten-year renewal options, that would be considered a lease of thirty years or more.  As such it could be exchanged for a fee interest.
Cooperative Apartments and Land Trusts
Cooperative apartments, known as co-ops, are generally owned by unit owners as holders of stock in the corporation which holds title to the property.  In addition, the unit owner usually gets a lease to his or her unit.  Although exchanges of stock are not allowed under the tax code, the IRS has issued several letter rulings confirming for 1031 exchange purposes, the interest of a taxpayer in a co-op can be exchanged for other interests in real estate. 
Illinois-type land trusts (found in various other states as well) are similar. The land trust company, the trustee, holds legal title to the real estate on behalf of its customer, the land trust beneficiary.  Sales of certificates of trust or beneficial interest are not permitted under the exchange rules, but the nature of the beneficiary’s ownership in a land trust is so much like any direct real property interest that the IRS allows the trustee’s sale of the trust’s interest or a taxpayer selling the beneficial interest in the trust to be treated as like-kind to a fee interest as replacement property.
Mineral Rights
Oil, gas and other mineral rights have become increasingly popular as replacement property for taxpayers. These royalty interests provide the taxpayer with an investment where there are no management headaches, and the rates of return are often higher than a conventional real estate “armchair” investment.  These royalty interests give the holder a percentage of the mineral interest taken from the property and are considered like-kind ownership trading from a direct real estate investment or trading from a mineral interest into a fee interest.
Property Improvements
As a general matter, a person or entity owning land also owns whatever property improvements are situated on the land.  But it is possible to separate the improvements from the underlying land.  A party can convey improvements to another party without conveying the underlying property.  It is also quite common for the owner of land to lease the land to a party who would erect and own improvements.  This is done via a ground lease. This lease technique can be particularly helpful to certain taxpayers who want to use proceeds of sale of a relinquished property to build on property owned by an entity that is related to the taxpayer.
Under IRS rules, a taxpayer cannot build on property the taxpayer already owns.  Nor can the taxpayer acquire replacement property from a related party.  However, should the taxpayer’s exchange facilitator enter into a ground lease with the related party property owner, build the improvements per the plans and specs of the taxpayer and later turn the improvements over to the taxpayer, the taxpayer is not deemed to have built on property owned by a related party.  The reason for this is because the property owner owns the fee which is separate from the lease interest of the facilitator, and consequently the taxpayer is not receiving any replacement property from a related party.
Summary
While all 1031 tax-deferred exchanges require the relinquished and replacement property to be like-kind, with real estate exchanges the definition of like-kind is very broad.  The real estate does not have to be similar in use.  While at first glance there are various interests in real estate that may not appear to be like-kind, upon further analysis, many types of less ordinary real estate interests are like-kind.

A basic premise of the 1031 like-kind exchange is that the relinquished property and the replacement property have to be like-kind to one another.  But what constitutes like-kind in the context of real estate exchanges is probably not what you might suppose it to be.  Here, I will examine types of property interests that are considered like-kind to a conventional interest in real estate.
Where is “like-kind” defined?
The question of what like-kind is when exchanging real estate is very broad.  This is not defined in the tax code or in the 1031 exchange regulations, rather it follows case law history, sometimes going back to English Common Law and IRS rulings. For real estate, any type of real estate is like-kind to any other type. For example, an investment condominium would be like-kind to vacant land bought for appreciation. 
What are some other real estate property interests?
The fullest and most complete ownership in land is known as a fee simple, or a fee interest.  A fee simple ownership can pertain to a taxpayer’s relinquished property or the replacement property.  This is also the most common interest that people own in real estate.  However there are many additional types of property ownership that are considered as like-kind to a fee interest and like-kind to each other.  Such property interests include:

Installment Agreement for Deed (buying on contract)
Easements on real estate
Long term lease interest
Cooperative apartments
Certain oil, gas and mineral interests
Water rights not limited in term or amount
Certain option agreements for real estate purchase
Improvements made on real estate

Let’s look more closely at a few of these other real estate interests. 
Installment Contracts for Deed
In the case of a person’s interest as a purchaser under an Installment Agreement for Deed, also known as Articles of Agreement for Deed, due to the legal principle of equitable conversion, the purchaser under the contract is considered to own the real estate even though the purchaser does not receive a deed until all payments due under the Agreement for Deed are made.  As such, the purchaser could sell his or her interest under the contract and buy something outright like a fee interest in real estate.
Easements
An easement is another real property ownership interest that can be exchanged for a fee interest in real estate.  For example an owner of land which contains a cell tower can sell that interest by conveying the buyer an easement on the portion of land where the cell tower is situated.  This often includes the assignment of the cell tower lease to the easement purchaser as well.  Although the lessor’s interest in the lease cannot be the subject of a real estate exchange, the value of the rental income under the lease can affect the value of the easement being transferred.
Leases
A lessee’s interest under a long-term lease has long been considered by the courts and the IRS to constitute a real estate interest.  As such it may be exchanged for a fee interest.  To distinguish a long-term lease from anything less, the lease has to have 30 years or more to run as of the time of sale of the lease interest.  Although the remaining term of the lease may be of some lesser term at the time of sale, for determining whether it is long-term includes the time of any option periods under the lease.  As an example, if at the time of the sale of the lease, it has ten years to run, but it also includes two ten-year renewal options, that would be considered a lease of thirty years or more.  As such it could be exchanged for a fee interest.
Cooperative Apartments and Land Trusts
Cooperative apartments, known as co-ops, are generally owned by unit owners as holders of stock in the corporation which holds title to the property.  In addition, the unit owner usually gets a lease to his or her unit.  Although exchanges of stock are not allowed under the tax code, the IRS has issued several letter rulings confirming for 1031 exchange purposes, the interest of a taxpayer in a co-op can be exchanged for other interests in real estate. 
Illinois-type land trusts (found in various other states as well) are similar. The land trust company, the trustee, holds legal title to the real estate on behalf of its customer, the land trust beneficiary.  Sales of certificates of trust or beneficial interest are not permitted under the exchange rules, but the nature of the beneficiary’s ownership in a land trust is so much like any direct real property interest that the IRS allows the trustee’s sale of the trust’s interest or a taxpayer selling the beneficial interest in the trust to be treated as like-kind to a fee interest as replacement property.
Mineral Rights
Oil, gas and other mineral rights have become increasingly popular as replacement property for taxpayers. These royalty interests provide the taxpayer with an investment where there are no management headaches, and the rates of return are often higher than a conventional real estate “armchair” investment.  These royalty interests give the holder a percentage of the mineral interest taken from the property and are considered like-kind ownership trading from a direct real estate investment or trading from a mineral interest into a fee interest.
Property Improvements
As a general matter, a person or entity owning land also owns whatever property improvements are situated on the land.  But it is possible to separate the improvements from the underlying land.  A party can convey improvements to another party without conveying the underlying property.  It is also quite common for the owner of land to lease the land to a party who would erect and own improvements.  This is done via a ground lease. This lease technique can be particularly helpful to certain taxpayers who want to use proceeds of sale of a relinquished property to build on property owned by an entity that is related to the taxpayer.
Under IRS rules, a taxpayer cannot build on property the taxpayer already owns.  Nor can the taxpayer acquire replacement property from a related party.  However, should the taxpayer’s exchange facilitator enter into a ground lease with the related party property owner, build the improvements per the plans and specs of the taxpayer and later turn the improvements over to the taxpayer, the taxpayer is not deemed to have built on property owned by a related party.  The reason for this is because the property owner owns the fee which is separate from the lease interest of the facilitator, and consequently the taxpayer is not receiving any replacement property from a related party.
Summary
While all 1031 tax-deferred exchanges require the relinquished and replacement property to be like-kind, with real estate exchanges the definition of like-kind is very broad.  The real estate does not have to be similar in use.  While at first glance there are various interests in real estate that may not appear to be like-kind, upon further analysis, many types of less ordinary real estate interests are like-kind.

A basic premise of the 1031 like-kind exchange is that the relinquished property and the replacement property have to be like-kind to one another.  But what constitutes like-kind in the context of real estate exchanges is probably not what you might suppose it to be.  Here, I will examine types of property interests that are considered like-kind to a conventional interest in real estate.
Where is “like-kind” defined?
The question of what like-kind is when exchanging real estate is very broad.  This is not defined in the tax code or in the 1031 exchange regulations, rather it follows case law history, sometimes going back to English Common Law and IRS rulings. For real estate, any type of real estate is like-kind to any other type. For example, an investment condominium would be like-kind to vacant land bought for appreciation. 
What are some other real estate property interests?
The fullest and most complete ownership in land is known as a fee simple, or a fee interest.  A fee simple ownership can pertain to a taxpayer’s relinquished property or the replacement property.  This is also the most common interest that people own in real estate.  However there are many additional types of property ownership that are considered as like-kind to a fee interest and like-kind to each other.  Such property interests include:

Installment Agreement for Deed (buying on contract)
Easements on real estate
Long term lease interest
Cooperative apartments
Certain oil, gas and mineral interests
Water rights not limited in term or amount
Certain option agreements for real estate purchase
Improvements made on real estate

Let’s look more closely at a few of these other real estate interests. 
Installment Contracts for Deed
In the case of a person’s interest as a purchaser under an Installment Agreement for Deed, also known as Articles of Agreement for Deed, due to the legal principle of equitable conversion, the purchaser under the contract is considered to own the real estate even though the purchaser does not receive a deed until all payments due under the Agreement for Deed are made.  As such, the purchaser could sell his or her interest under the contract and buy something outright like a fee interest in real estate.
Easements
An easement is another real property ownership interest that can be exchanged for a fee interest in real estate.  For example an owner of land which contains a cell tower can sell that interest by conveying the buyer an easement on the portion of land where the cell tower is situated.  This often includes the assignment of the cell tower lease to the easement purchaser as well.  Although the lessor’s interest in the lease cannot be the subject of a real estate exchange, the value of the rental income under the lease can affect the value of the easement being transferred.
Leases
A lessee’s interest under a long-term lease has long been considered by the courts and the IRS to constitute a real estate interest.  As such it may be exchanged for a fee interest.  To distinguish a long-term lease from anything less, the lease has to have 30 years or more to run as of the time of sale of the lease interest.  Although the remaining term of the lease may be of some lesser term at the time of sale, for determining whether it is long-term includes the time of any option periods under the lease.  As an example, if at the time of the sale of the lease, it has ten years to run, but it also includes two ten-year renewal options, that would be considered a lease of thirty years or more.  As such it could be exchanged for a fee interest.
Cooperative Apartments and Land Trusts
Cooperative apartments, known as co-ops, are generally owned by unit owners as holders of stock in the corporation which holds title to the property.  In addition, the unit owner usually gets a lease to his or her unit.  Although exchanges of stock are not allowed under the tax code, the IRS has issued several letter rulings confirming for 1031 exchange purposes, the interest of a taxpayer in a co-op can be exchanged for other interests in real estate. 
Illinois-type land trusts (found in various other states as well) are similar. The land trust company, the trustee, holds legal title to the real estate on behalf of its customer, the land trust beneficiary.  Sales of certificates of trust or beneficial interest are not permitted under the exchange rules, but the nature of the beneficiary’s ownership in a land trust is so much like any direct real property interest that the IRS allows the trustee’s sale of the trust’s interest or a taxpayer selling the beneficial interest in the trust to be treated as like-kind to a fee interest as replacement property.
Mineral Rights
Oil, gas and other mineral rights have become increasingly popular as replacement property for taxpayers. These royalty interests provide the taxpayer with an investment where there are no management headaches, and the rates of return are often higher than a conventional real estate “armchair” investment.  These royalty interests give the holder a percentage of the mineral interest taken from the property and are considered like-kind ownership trading from a direct real estate investment or trading from a mineral interest into a fee interest.
Property Improvements
As a general matter, a person or entity owning land also owns whatever property improvements are situated on the land.  But it is possible to separate the improvements from the underlying land.  A party can convey improvements to another party without conveying the underlying property.  It is also quite common for the owner of land to lease the land to a party who would erect and own improvements.  This is done via a ground lease. This lease technique can be particularly helpful to certain taxpayers who want to use proceeds of sale of a relinquished property to build on property owned by an entity that is related to the taxpayer.
Under IRS rules, a taxpayer cannot build on property the taxpayer already owns.  Nor can the taxpayer acquire replacement property from a related party.  However, should the taxpayer’s exchange facilitator enter into a ground lease with the related party property owner, build the improvements per the plans and specs of the taxpayer and later turn the improvements over to the taxpayer, the taxpayer is not deemed to have built on property owned by a related party.  The reason for this is because the property owner owns the fee which is separate from the lease interest of the facilitator, and consequently the taxpayer is not receiving any replacement property from a related party.
Summary
While all 1031 tax-deferred exchanges require the relinquished and replacement property to be like-kind, with real estate exchanges the definition of like-kind is very broad.  The real estate does not have to be similar in use.  While at first glance there are various interests in real estate that may not appear to be like-kind, upon further analysis, many types of less ordinary real estate interests are like-kind.

Because we live in such a rapidly changing business environment, I find that people enjoy input and feedback from other business owners on matters of tax and finance. What works and why? What ideas and strategies am I missing? Is there a reason other business owners are adopting certain strategies that I have not considered? Should I consider them now?
The following explores feedback and input from our ongoing national discussions with clients, prospects, political leaders, industry associations, and others. Some, all, or none may be relevant to your business and cash model, but given that the one certainty in today’s business environment is continued uncertainty, the following will provide food for thought as the tax and finance landscape continues to ebb and flow.
1031 Exchanges as a Source of Business Cash
If you own a business and if, as part of that business, you buy equipment that you later sell to purchase new/replacement equipment, you have income tax exposure that averages 40% on those sales proceeds. If you are sending that money to the treasury, you are literally paying unnecessary taxes, and that money could be better used in your business. Period.  While there are a few business owners who will simply pay these taxes instead of redirecting these funds to new equipment purchases, the vast majority of owners would rather put the money to better use in their business.
At the end of the day, a 1031 like-kind exchange affords you the ability to defer the tax and invest those dollars back into your business. You still owe the money, but the payback terms are flexible. You get to decide when you pay it back, and you get to decide how to use it. You don’t have to tap into existing lines of bank credit. (usually a good thing), and you enjoy the benefits of the cash without the usual encumbrance associated with debt.
Cost of Capital
Virtually all of the tax reform talk in Washington is about eliminating deductions and reducing the overall tax rate, and any money your company chooses to retain and invest will ultimately be paid back at the prevailing tax rate and not the current tax rate. If you deferred taxes on the sale of used equipment at a 39% income tax rate, and someday you pay back those taxes at a 25% or 30% income tax rate, you’ve permanently pocketed the difference.
The American business owner has been lulled into a false sense of security with cheap money. No one thinks cheap capital will continue indefinitely. In fact, we are already beginning to see “cost creep” on lines of credit and capital loans. While the cost of capital is still relatively low, it is rising. Accessing permanently cheap cash via a 1031 exchange is one way to keep a large chunk of your business capital relatively cheap.
Internal Rate of Return
I love this discussion with business owners. Most competently run companies will have an Internal Rate of Return (IRR) of 6-12%, depending on many factors. When they realize that they can access cash via like-kind exchange deferrals for a fraction of their IRRs, few can find fault in deferring that tax money and plugging it into their businesses.
Cash is King
Three simple words, “Cash is King,” drives America’s business success. It’s hard to argue with the premise that more cash – especially cheap cash – is anything but a good thing for a business owner. If your business is regularly disposing of business equipment and owing taxes on such disposal, you might want to talk with your tax adviser about the cash-generating benefits of a 1031 like-kind exchange program.
 
Photo:

Because we live in such a rapidly changing business environment, I find that people enjoy input and feedback from other business owners on matters of tax and finance. What works and why? What ideas and strategies am I missing? Is there a reason other business owners are adopting certain strategies that I have not considered? Should I consider them now?
The following explores feedback and input from our ongoing national discussions with clients, prospects, political leaders, industry associations, and others. Some, all, or none may be relevant to your business and cash model, but given that the one certainty in today’s business environment is continued uncertainty, the following will provide food for thought as the tax and finance landscape continues to ebb and flow.
1031 Exchanges as a Source of Business Cash
If you own a business and if, as part of that business, you buy equipment that you later sell to purchase new/replacement equipment, you have income tax exposure that averages 40% on those sales proceeds. If you are sending that money to the treasury, you are literally paying unnecessary taxes, and that money could be better used in your business. Period.  While there are a few business owners who will simply pay these taxes instead of redirecting these funds to new equipment purchases, the vast majority of owners would rather put the money to better use in their business.
At the end of the day, a 1031 like-kind exchange affords you the ability to defer the tax and invest those dollars back into your business. You still owe the money, but the payback terms are flexible. You get to decide when you pay it back, and you get to decide how to use it. You don’t have to tap into existing lines of bank credit. (usually a good thing), and you enjoy the benefits of the cash without the usual encumbrance associated with debt.
Cost of Capital
Virtually all of the tax reform talk in Washington is about eliminating deductions and reducing the overall tax rate, and any money your company chooses to retain and invest will ultimately be paid back at the prevailing tax rate and not the current tax rate. If you deferred taxes on the sale of used equipment at a 39% income tax rate, and someday you pay back those taxes at a 25% or 30% income tax rate, you’ve permanently pocketed the difference.
The American business owner has been lulled into a false sense of security with cheap money. No one thinks cheap capital will continue indefinitely. In fact, we are already beginning to see “cost creep” on lines of credit and capital loans. While the cost of capital is still relatively low, it is rising. Accessing permanently cheap cash via a 1031 exchange is one way to keep a large chunk of your business capital relatively cheap.
Internal Rate of Return
I love this discussion with business owners. Most competently run companies will have an Internal Rate of Return (IRR) of 6-12%, depending on many factors. When they realize that they can access cash via like-kind exchange deferrals for a fraction of their IRRs, few can find fault in deferring that tax money and plugging it into their businesses.
Cash is King
Three simple words, “Cash is King,” drives America’s business success. It’s hard to argue with the premise that more cash – especially cheap cash – is anything but a good thing for a business owner. If your business is regularly disposing of business equipment and owing taxes on such disposal, you might want to talk with your tax adviser about the cash-generating benefits of a 1031 like-kind exchange program.
 
Photo:

Because we live in such a rapidly changing business environment, I find that people enjoy input and feedback from other business owners on matters of tax and finance. What works and why? What ideas and strategies am I missing? Is there a reason other business owners are adopting certain strategies that I have not considered? Should I consider them now?
The following explores feedback and input from our ongoing national discussions with clients, prospects, political leaders, industry associations, and others. Some, all, or none may be relevant to your business and cash model, but given that the one certainty in today’s business environment is continued uncertainty, the following will provide food for thought as the tax and finance landscape continues to ebb and flow.
1031 Exchanges as a Source of Business Cash
If you own a business and if, as part of that business, you buy equipment that you later sell to purchase new/replacement equipment, you have income tax exposure that averages 40% on those sales proceeds. If you are sending that money to the treasury, you are literally paying unnecessary taxes, and that money could be better used in your business. Period.  While there are a few business owners who will simply pay these taxes instead of redirecting these funds to new equipment purchases, the vast majority of owners would rather put the money to better use in their business.
At the end of the day, a 1031 like-kind exchange affords you the ability to defer the tax and invest those dollars back into your business. You still owe the money, but the payback terms are flexible. You get to decide when you pay it back, and you get to decide how to use it. You don’t have to tap into existing lines of bank credit. (usually a good thing), and you enjoy the benefits of the cash without the usual encumbrance associated with debt.
Cost of Capital
Virtually all of the tax reform talk in Washington is about eliminating deductions and reducing the overall tax rate, and any money your company chooses to retain and invest will ultimately be paid back at the prevailing tax rate and not the current tax rate. If you deferred taxes on the sale of used equipment at a 39% income tax rate, and someday you pay back those taxes at a 25% or 30% income tax rate, you’ve permanently pocketed the difference.
The American business owner has been lulled into a false sense of security with cheap money. No one thinks cheap capital will continue indefinitely. In fact, we are already beginning to see “cost creep” on lines of credit and capital loans. While the cost of capital is still relatively low, it is rising. Accessing permanently cheap cash via a 1031 exchange is one way to keep a large chunk of your business capital relatively cheap.
Internal Rate of Return
I love this discussion with business owners. Most competently run companies will have an Internal Rate of Return (IRR) of 6-12%, depending on many factors. When they realize that they can access cash via like-kind exchange deferrals for a fraction of their IRRs, few can find fault in deferring that tax money and plugging it into their businesses.
Cash is King
Three simple words, “Cash is King,” drives America’s business success. It’s hard to argue with the premise that more cash – especially cheap cash – is anything but a good thing for a business owner. If your business is regularly disposing of business equipment and owing taxes on such disposal, you might want to talk with your tax adviser about the cash-generating benefits of a 1031 like-kind exchange program.
 
Photo:

When setting out to conduct a 1031 like-kind exchange, it’s important to know the rules associated with Section 1031 of the tax code. The following rules are key:

Identification of any and all replacement properties by day 45 of the exchange
Acquisition of the identified replacement properties by day 180 of the exchange
Prohibitions on personal use of the investment property for more than 14 days in either of the first two years of ownership
Rental of investment property for at least 14 days in each of the first two years of ownership

How will the IRS know?
Owners of investment property must understand that there is no gray area related to any of the above issues, and while most investors get that, some want to push the boundaries of the law.  These more aggressive investors will typically ask the following questions:

How will the IRS know if I make changes after day 45?
I may not be able to close by day 180, but can’t I just report that I did?
How will the IRS know if I use the property for more than 14 days each year?
Will the IRS know if I don’t rent the property for at least 14 days each year?

 The overarching theme of these questions is, “How will the IRS know?” 
The IRS has many methods to collect and audit data, but a somewhat new approach involves collecting data from our cell phones.  That’s right, the tool we use to be more productive also makes the IRS more productive.  These phones we carry are storing evidence that could be used against overly aggressive property owners in tax court.
A Picture is Worth Thousands of Dollars
In one case, a taxpayer told the IRS they constructed and purchased a new property by day 180 of their like-kind exchange.  During the audit, the IRS reviewed the photos saved on the taxpayer’s smartphone.  The pictures showed the various phases of the new construction at the job site, and each picture bore a date stamp.  The IRS found specific pictures of the job site with date stamps after day 180 of the exchange, revealing that the property in question was far from complete on day 180.  Only the foundation had been poured! This left the taxpayer with some explaining to do.
Location, Location, Location
In another case, a taxpayer reported that they were renting a property and not using it for personal reasons.  This property was located in a different state from the taxpayer’s primary residence.  During an audit, the IRS was able to review the taxpayer’s smartphone activity and discovered that the phone was communicating with a cell tower located very close to the taxpayer’s “rental.”  The phone’s communication process with this tower occurred for at least two months during one year.  This information helped the IRS prove that the taxpayer was actually using the “rental” for personal purposes, beyond what is allowed by law.
The IRS Likes You on Facebook
It’s been reported that the IRS is tracking taxpayer activity on social media sites like Facebook and eBay in its quest to minimize the amount of revenue lost to tax evasion each year, an estimated $300 billion.
Big Data: Not Just a Buzzword
Taxpayers need to be fully aware of the risks when venturing outside Section 1031’s regulations.  That’s why it’s important to involve the right team of experienced professionals – an experienced tax advisor and an experienced qualified intermediary – who can highlight important issues and help structure a like-kind exchange without violating the rules.  Big data is more than a buzzword; it’s a reality with a staggering amount of individual data points being collected on each of us. How exactly the IRS will know is unclear, but that they will is certain.
Photo:

When setting out to conduct a 1031 like-kind exchange, it’s important to know the rules associated with Section 1031 of the tax code. The following rules are key:

Identification of any and all replacement properties by day 45 of the exchange
Acquisition of the identified replacement properties by day 180 of the exchange
Prohibitions on personal use of the investment property for more than 14 days in either of the first two years of ownership
Rental of investment property for at least 14 days in each of the first two years of ownership

How will the IRS know?
Owners of investment property must understand that there is no gray area related to any of the above issues, and while most investors get that, some want to push the boundaries of the law.  These more aggressive investors will typically ask the following questions:

How will the IRS know if I make changes after day 45?
I may not be able to close by day 180, but can’t I just report that I did?
How will the IRS know if I use the property for more than 14 days each year?
Will the IRS know if I don’t rent the property for at least 14 days each year?

 The overarching theme of these questions is, “How will the IRS know?” 
The IRS has many methods to collect and audit data, but a somewhat new approach involves collecting data from our cell phones.  That’s right, the tool we use to be more productive also makes the IRS more productive.  These phones we carry are storing evidence that could be used against overly aggressive property owners in tax court.
A Picture is Worth Thousands of Dollars
In one case, a taxpayer told the IRS they constructed and purchased a new property by day 180 of their like-kind exchange.  During the audit, the IRS reviewed the photos saved on the taxpayer’s smartphone.  The pictures showed the various phases of the new construction at the job site, and each picture bore a date stamp.  The IRS found specific pictures of the job site with date stamps after day 180 of the exchange, revealing that the property in question was far from complete on day 180.  Only the foundation had been poured! This left the taxpayer with some explaining to do.
Location, Location, Location
In another case, a taxpayer reported that they were renting a property and not using it for personal reasons.  This property was located in a different state from the taxpayer’s primary residence.  During an audit, the IRS was able to review the taxpayer’s smartphone activity and discovered that the phone was communicating with a cell tower located very close to the taxpayer’s “rental.”  The phone’s communication process with this tower occurred for at least two months during one year.  This information helped the IRS prove that the taxpayer was actually using the “rental” for personal purposes, beyond what is allowed by law.
The IRS Likes You on Facebook
It’s been reported that the IRS is tracking taxpayer activity on social media sites like Facebook and eBay in its quest to minimize the amount of revenue lost to tax evasion each year, an estimated $300 billion.
Big Data: Not Just a Buzzword
Taxpayers need to be fully aware of the risks when venturing outside Section 1031’s regulations.  That’s why it’s important to involve the right team of experienced professionals – an experienced tax advisor and an experienced qualified intermediary – who can highlight important issues and help structure a like-kind exchange without violating the rules.  Big data is more than a buzzword; it’s a reality with a staggering amount of individual data points being collected on each of us. How exactly the IRS will know is unclear, but that they will is certain.
Photo: