Category: 1031 Exchange General

There are many benefits to owning real estate – appreciation, diversification, mortgage interest deduction, and 1031 tax deferment are a few. However, not everyone has the capital to purchase high-end properties like a Donald Trump. Because of the high cost of real estate, many investors seek out angel funding and bank loans to make up their capital shortfalls. Yet, there is another way for an investor to own real estate, and that is fractional ownership. Fractional ownership is an investment structure that allows multiple investors to purchase a percentage ownership in an investment-grade asset.
Benefits of Fractional Ownership of Real Estate
Diversification
Fractional ownership, formerly the province of the savvy mogul who has built a career owning, operating, leasing, and selling real estate, has attracted individual investors who seek an alternative investment to stocks, bonds, and mutual funds they may already own. Fractional real estate ownership and other alternative investments provide for diversification, and financial advisors will often dedicate 10% of a clients’ portfolio towards such vehicles.
The 3 T’s of Real Estate
Fractional ownership can be very attractive to real estate investors who wish to unburden themselves of real estate’s 3 T’s (tenants, toilets, and trash). The day-to-day realities of owning real estate – grounds maintenance, property up-keep, and leasing – are not an issue for fractional owners. Investors can enjoy all the benefits of a solid return while not laboring over the 3 T’s.
Options for Fractional Ownership of Real Estate
In the United States, there are two primary options for those interested in fractional real estate ownership:  Delaware Statutory Trust (DST) and Tenant-In-Common (TIC) ownership. Each option has become increasingly popular as an alternative investment over the past decade because each affords opportunities for individual investors to own investment-grade property – commercial real estate with more income-generating potential than smaller residential property.
Tenant-in-Common (TICs)
Tenant-in-common (TIC) is an investment property structure that was established during the 1990s and has grown in popularity since. Think of a TIC as a form of shared tenure rights to properties owned.  Tenants-in-common each own a separate interest in the same real property. The advantages of a TIC are that each tenant-in-common has stronger buying power and fewer costs, and that each shares responsibilities for a property that is owned by the partnership. 
Delaware Statutory Trusts (DSTs)
DSTs are legal entities created as trusts within the state of Delaware in which each investor owns a “beneficial interest” in the DST. DSTs have gained popularity over the last few years due to the ability to secure financing and attract more investors with lower minimum investment thresholds. Another advantage of a DST is that a lender underwrites a single borrower, as opposed to the multiple borrowers within the TIC structure. Furthermore, there is no stated IRS limit to the number of investors a DST may have, versus the 35 maximum of the TIC.  Consequently, larger properties may be purchased while keeping the minimum investment size to around $100,000.  Finally, DSTs do not allow for any input from beneficial interest owners, unlike TICs, which need to get unanimous approval from all TIC members.
Jokingly, a wise man once told me that a DST is the “Arnold Schwarzenegger version of a TIC.”
Conclusion
DSTs and TICs afford individual investors entry into large commercial property, either through a cash investment (typically $100,000 and up) or a 1031 exchange of real assets. Before investing in a DST or TIC, be certain to research the property and the company sponsoring the DST or TIC, and engage a qualified intermediary for your like-kind exchange.

There are many benefits to owning real estate – appreciation, diversification, mortgage interest deduction, and 1031 tax deferment are a few. However, not everyone has the capital to purchase high-end properties like a Donald Trump. Because of the high cost of real estate, many investors seek out angel funding and bank loans to make up their capital shortfalls. Yet, there is another way for an investor to own real estate, and that is fractional ownership. Fractional ownership is an investment structure that allows multiple investors to purchase a percentage ownership in an investment-grade asset.
Benefits of Fractional Ownership of Real Estate
Diversification
Fractional ownership, formerly the province of the savvy mogul who has built a career owning, operating, leasing, and selling real estate, has attracted individual investors who seek an alternative investment to stocks, bonds, and mutual funds they may already own. Fractional real estate ownership and other alternative investments provide for diversification, and financial advisors will often dedicate 10% of a clients’ portfolio towards such vehicles.
The 3 T’s of Real Estate
Fractional ownership can be very attractive to real estate investors who wish to unburden themselves of real estate’s 3 T’s (tenants, toilets, and trash). The day-to-day realities of owning real estate – grounds maintenance, property up-keep, and leasing – are not an issue for fractional owners. Investors can enjoy all the benefits of a solid return while not laboring over the 3 T’s.
Options for Fractional Ownership of Real Estate
In the United States, there are two primary options for those interested in fractional real estate ownership:  Delaware Statutory Trust (DST) and Tenant-In-Common (TIC) ownership. Each option has become increasingly popular as an alternative investment over the past decade because each affords opportunities for individual investors to own investment-grade property – commercial real estate with more income-generating potential than smaller residential property.
Tenant-in-Common (TICs)
Tenant-in-common (TIC) is an investment property structure that was established during the 1990s and has grown in popularity since. Think of a TIC as a form of shared tenure rights to properties owned.  Tenants-in-common each own a separate interest in the same real property. The advantages of a TIC are that each tenant-in-common has stronger buying power and fewer costs, and that each shares responsibilities for a property that is owned by the partnership. 
Delaware Statutory Trusts (DSTs)
DSTs are legal entities created as trusts within the state of Delaware in which each investor owns a “beneficial interest” in the DST. DSTs have gained popularity over the last few years due to the ability to secure financing and attract more investors with lower minimum investment thresholds. Another advantage of a DST is that a lender underwrites a single borrower, as opposed to the multiple borrowers within the TIC structure. Furthermore, there is no stated IRS limit to the number of investors a DST may have, versus the 35 maximum of the TIC.  Consequently, larger properties may be purchased while keeping the minimum investment size to around $100,000.  Finally, DSTs do not allow for any input from beneficial interest owners, unlike TICs, which need to get unanimous approval from all TIC members.
Jokingly, a wise man once told me that a DST is the “Arnold Schwarzenegger version of a TIC.”
Conclusion
DSTs and TICs afford individual investors entry into large commercial property, either through a cash investment (typically $100,000 and up) or a 1031 exchange of real assets. Before investing in a DST or TIC, be certain to research the property and the company sponsoring the DST or TIC, and engage a qualified intermediary for your like-kind exchange.

Owners of heavy equipment tend to avoid such questions until it’s time to sell some of their business assets.  Even with initial planning under their belts, many equipment owners will incorrectly frame their equipment dispositions within the context of capital gains tax.  This can be a costly mistake, as capital gains rates tend to be lower than the ordinary income tax rates actually triggered by the sale of depreciable assets.  In order to clear up some of this confusion, let’s review capital gains and depreciation recapture, both commonly known as “gains.”
Capital Gains
The disposition of a capital asset, such as investment real estate, typically triggers a capital gain or a capital loss.  As a general rule, the amount of the gain or loss is the asset’s sale price less its adjusted basis.  Adjusted basis is characteristically known as the asset’s original acquisition costs minus its accumulated depreciation expenses.  Capital assets are defined under Section 1221 of the Internal Revenue Code and do not typically include items such as inventory (held for resale), and depreciable property (used in a trade or business). 

Furthermore, capital gain transactions are classified as either “short term” or “long term,” where short term refers to those assets held for less than one year and long term refers to assets held for longer than one year.  This is important to note as short term capital gain transactions are taxed at ordinary income rates and can reach amounts in excess of 40%.  However, dispositions classified as long term have benefited from historically low tax rates, with most taxed no higher than 15%.  In reviewing Tax Topic 409 – “Capital Gains and Losses,” the Internal Revenue Service states that:

“…some or all net capital gain may be taxed at 0% for the 10% or 15% ordinary income tax brackets. However, a 20% rate on net capital gain applies in tax years 2013 and later to the extent that a taxpayer’s taxable income exceeds the certain thresholds.
There are other exceptions where capital gains may be taxed at rates greater than 15%, including, but not limited to, gains from selling collectibles (like coins or art) are taxed at a maximum 28% rate.”

It’s also important to note that special tax rates related to capital gains transactions are not available to C corporations. 
Depreciation Recapture
Some equipment owners may have dispositions triggering the capital gains tax.  However, most of their sales will involve the disposal of non-appreciating business-use personal property, including:

Over-the-road tractors
Trailers
Heavy equipment – construction and agricultural

Sales of these assets typically trigger gains associated with depreciation recapture, taxed at higher ordinary income tax rates.  Stated simply, the Internal Revenue Service forces a recapture of past depreciation expense as taxable income in the year of the asset(s) sale.  This is best illustrated by example:

As you can see, the amount subject to recapture is limited to the difference between the asset’s sale price and its adjusted basis.  So there’s no full recapture of the depreciation expense taken (in previous years). 
Section 1031 Like-Kind Exchanges – Solving the Gain Problem
Whether gains come in the form of depreciation recapture or as capital gain, the Internal Revenue Code generally requires taxpayers to recognize these amounts as taxable income.  Fortunately, Section 1031 provides an exception to this general requirement and allows equipment owners a proven pathway to sell business assets without incurring the related tax liability.  If the sale (in the above example) would have received like-kind exchange treatment, the entire $160,000 of tax liability would not have been triggered.  Instead, that amount could have been used to invest in replacement assets, allowing the equipment owner to reinvest in the growth of their business.  Remember, like-kind exchanges require advance planning with the right team.  Asset owners should always approach like-kind exchanges with care and be sure to involve their tax advisors prior to the sale of any business-use assets.

Owners of heavy equipment tend to avoid such questions until it’s time to sell some of their business assets.  Even with initial planning under their belts, many equipment owners will incorrectly frame their equipment dispositions within the context of capital gains tax.  This can be a costly mistake, as capital gains rates tend to be lower than the ordinary income tax rates actually triggered by the sale of depreciable assets.  In order to clear up some of this confusion, let’s review capital gains and depreciation recapture, both commonly known as “gains.”
Capital Gains
The disposition of a capital asset, such as investment real estate, typically triggers a capital gain or a capital loss.  As a general rule, the amount of the gain or loss is the asset’s sale price less its adjusted basis.  Adjusted basis is characteristically known as the asset’s original acquisition costs minus its accumulated depreciation expenses.  Capital assets are defined under Section 1221 of the Internal Revenue Code and do not typically include items such as inventory (held for resale), and depreciable property (used in a trade or business). 

Furthermore, capital gain transactions are classified as either “short term” or “long term,” where short term refers to those assets held for less than one year and long term refers to assets held for longer than one year.  This is important to note as short term capital gain transactions are taxed at ordinary income rates and can reach amounts in excess of 40%.  However, dispositions classified as long term have benefited from historically low tax rates, with most taxed no higher than 15%.  In reviewing Tax Topic 409 – “Capital Gains and Losses,” the Internal Revenue Service states that:

“…some or all net capital gain may be taxed at 0% for the 10% or 15% ordinary income tax brackets. However, a 20% rate on net capital gain applies in tax years 2013 and later to the extent that a taxpayer’s taxable income exceeds the certain thresholds.
There are other exceptions where capital gains may be taxed at rates greater than 15%, including, but not limited to, gains from selling collectibles (like coins or art) are taxed at a maximum 28% rate.”

It’s also important to note that special tax rates related to capital gains transactions are not available to C corporations. 
Depreciation Recapture
Some equipment owners may have dispositions triggering the capital gains tax.  However, most of their sales will involve the disposal of non-appreciating business-use personal property, including:

Over-the-road tractors
Trailers
Heavy equipment – construction and agricultural

Sales of these assets typically trigger gains associated with depreciation recapture, taxed at higher ordinary income tax rates.  Stated simply, the Internal Revenue Service forces a recapture of past depreciation expense as taxable income in the year of the asset(s) sale.  This is best illustrated by example:

As you can see, the amount subject to recapture is limited to the difference between the asset’s sale price and its adjusted basis.  So there’s no full recapture of the depreciation expense taken (in previous years). 
Section 1031 Like-Kind Exchanges – Solving the Gain Problem
Whether gains come in the form of depreciation recapture or as capital gain, the Internal Revenue Code generally requires taxpayers to recognize these amounts as taxable income.  Fortunately, Section 1031 provides an exception to this general requirement and allows equipment owners a proven pathway to sell business assets without incurring the related tax liability.  If the sale (in the above example) would have received like-kind exchange treatment, the entire $160,000 of tax liability would not have been triggered.  Instead, that amount could have been used to invest in replacement assets, allowing the equipment owner to reinvest in the growth of their business.  Remember, like-kind exchanges require advance planning with the right team.  Asset owners should always approach like-kind exchanges with care and be sure to involve their tax advisors prior to the sale of any business-use assets.

Owners of heavy equipment tend to avoid such questions until it’s time to sell some of their business assets.  Even with initial planning under their belts, many equipment owners will incorrectly frame their equipment dispositions within the context of capital gains tax.  This can be a costly mistake, as capital gains rates tend to be lower than the ordinary income tax rates actually triggered by the sale of depreciable assets.  In order to clear up some of this confusion, let’s review capital gains and depreciation recapture, both commonly known as “gains.”
Capital Gains
The disposition of a capital asset, such as investment real estate, typically triggers a capital gain or a capital loss.  As a general rule, the amount of the gain or loss is the asset’s sale price less its adjusted basis.  Adjusted basis is characteristically known as the asset’s original acquisition costs minus its accumulated depreciation expenses.  Capital assets are defined under Section 1221 of the Internal Revenue Code and do not typically include items such as inventory (held for resale), and depreciable property (used in a trade or business). 

Furthermore, capital gain transactions are classified as either “short term” or “long term,” where short term refers to those assets held for less than one year and long term refers to assets held for longer than one year.  This is important to note as short term capital gain transactions are taxed at ordinary income rates and can reach amounts in excess of 40%.  However, dispositions classified as long term have benefited from historically low tax rates, with most taxed no higher than 15%.  In reviewing Tax Topic 409 – “Capital Gains and Losses,” the Internal Revenue Service states that:

“…some or all net capital gain may be taxed at 0% for the 10% or 15% ordinary income tax brackets. However, a 20% rate on net capital gain applies in tax years 2013 and later to the extent that a taxpayer’s taxable income exceeds the certain thresholds.
There are other exceptions where capital gains may be taxed at rates greater than 15%, including, but not limited to, gains from selling collectibles (like coins or art) are taxed at a maximum 28% rate.”

It’s also important to note that special tax rates related to capital gains transactions are not available to C corporations. 
Depreciation Recapture
Some equipment owners may have dispositions triggering the capital gains tax.  However, most of their sales will involve the disposal of non-appreciating business-use personal property, including:

Over-the-road tractors
Trailers
Heavy equipment – construction and agricultural

Sales of these assets typically trigger gains associated with depreciation recapture, taxed at higher ordinary income tax rates.  Stated simply, the Internal Revenue Service forces a recapture of past depreciation expense as taxable income in the year of the asset(s) sale.  This is best illustrated by example:

As you can see, the amount subject to recapture is limited to the difference between the asset’s sale price and its adjusted basis.  So there’s no full recapture of the depreciation expense taken (in previous years). 
Section 1031 Like-Kind Exchanges – Solving the Gain Problem
Whether gains come in the form of depreciation recapture or as capital gain, the Internal Revenue Code generally requires taxpayers to recognize these amounts as taxable income.  Fortunately, Section 1031 provides an exception to this general requirement and allows equipment owners a proven pathway to sell business assets without incurring the related tax liability.  If the sale (in the above example) would have received like-kind exchange treatment, the entire $160,000 of tax liability would not have been triggered.  Instead, that amount could have been used to invest in replacement assets, allowing the equipment owner to reinvest in the growth of their business.  Remember, like-kind exchanges require advance planning with the right team.  Asset owners should always approach like-kind exchanges with care and be sure to involve their tax advisors prior to the sale of any business-use assets.

Exchanges Straddling Two Tax Years
Often an exchange period will continue from the end of one year to the beginning of the next.  For instance, a taxpayer who sells relinquished property on December 1 will expect expiration of the 45 day identification to occur on January 14 of the next tax year.  Similarly, a taxpayer who closes on the sale of relinquished property on September 1 and duly identified possible replacement property within the identification period will expect the 180 day exchange period to expire on February 27 of the next calendar year.
Taxpayers who receive all, or a portion, of their exchange balances in the year following the sale of their relinquished property will receive installment sale treatment for the balance returned.  Effectively, this means that they will not have to report the gain on their sale until the time their tax return for the year of the distribution is due.
There is, of course, a catch.  A taxpayer should not sell a property with these timelines merely to put off the payment of the gains that are otherwise due.  According to the exchange regulations, the taxpayer must have a bona fide intent to do an exchange, even if it is ultimately unsuccessful in whole or in part. 
The regulations state:

“The provisions of paragraphs (j)(2)(i) and (ii) of this section do not apply unless the taxpayer has a bona fide intent to enter into a deferred exchange at the beginning of the exchange period. A taxpayer will be treated as having a bona fide intent only if it is reasonable to believe, based on all the facts and circumstances as of the beginning of the exchange period, that like-kind replacement property will be acquired before the end of the exchange period.”

Taxpayers who have the requisite bona fide intent and receive the payout from the exchange account in the second tax year will automatically receive installment sale treatment with the gain to be reported in the year of the distribution from the account.  In the event the taxpayer has losses in the year of the property sale, the taxpayer can elect to recognize the gain in that year rather than the subsequent year.
Fallback Strategy for Failed Exchange or Exchange with Unused Proceeds
A portion of exchanges inevitably result in the inability of the taxpayer to identify possible replacement property by the required 45th day from the sale.  In other instances, the taxpayer duly identifies one or more possible replacement properties but elects not to acquire the property by the end of the 180 day exchange period.  Also, at times a taxpayer will properly identify and acquire replacement property, but does not use up the full available balance of exchange funds.  In each of these instances, converting the exchange transaction into an installment sale can provide favorable tax deferral on the amounts in question.  There are companies in the marketplace that will assume the qualified intermediary’s obligation to return funds to the taxpayer and, in turn, will enter into an installment agreement with the taxpayer providing for receipt of the funds over time.  Some of the features and benefits of such an arrangement include:

Tax deferral option even when intended exchange does not take place (or for sums leftover)
The installment payments to the taxpayer are secured
The taxpayer can design the payment stream
The taxpayer can receive the certainty of fixed income
Earn interest of the funds on a pre-tax basis, rather than a lesser amount on an after tax basis
Defer income to a time of lower income in retirement years
Ability to borrow up to 85% of the amount involved

Summary
Installment sale treatment comes into play when an exchange involves the sale of relinquished property in one tax year and the receipt of replacement property in the following year.  Also, for failed exchanges or for exchanges in which some proceeds are left unused, converting the exchange into an installment sale can be a good option in lieu of deferral under Section 1031 of the Internal Revenue Code.

Exchanges Straddling Two Tax Years
Often an exchange period will continue from the end of one year to the beginning of the next.  For instance, a taxpayer who sells relinquished property on December 1 will expect expiration of the 45 day identification to occur on January 14 of the next tax year.  Similarly, a taxpayer who closes on the sale of relinquished property on September 1 and duly identified possible replacement property within the identification period will expect the 180 day exchange period to expire on February 27 of the next calendar year.
Taxpayers who receive all, or a portion, of their exchange balances in the year following the sale of their relinquished property will receive installment sale treatment for the balance returned.  Effectively, this means that they will not have to report the gain on their sale until the time their tax return for the year of the distribution is due.
There is, of course, a catch.  A taxpayer should not sell a property with these timelines merely to put off the payment of the gains that are otherwise due.  According to the exchange regulations, the taxpayer must have a bona fide intent to do an exchange, even if it is ultimately unsuccessful in whole or in part. 
The regulations state:

“The provisions of paragraphs (j)(2)(i) and (ii) of this section do not apply unless the taxpayer has a bona fide intent to enter into a deferred exchange at the beginning of the exchange period. A taxpayer will be treated as having a bona fide intent only if it is reasonable to believe, based on all the facts and circumstances as of the beginning of the exchange period, that like-kind replacement property will be acquired before the end of the exchange period.”

Taxpayers who have the requisite bona fide intent and receive the payout from the exchange account in the second tax year will automatically receive installment sale treatment with the gain to be reported in the year of the distribution from the account.  In the event the taxpayer has losses in the year of the property sale, the taxpayer can elect to recognize the gain in that year rather than the subsequent year.
Fallback Strategy for Failed Exchange or Exchange with Unused Proceeds
A portion of exchanges inevitably result in the inability of the taxpayer to identify possible replacement property by the required 45th day from the sale.  In other instances, the taxpayer duly identifies one or more possible replacement properties but elects not to acquire the property by the end of the 180 day exchange period.  Also, at times a taxpayer will properly identify and acquire replacement property, but does not use up the full available balance of exchange funds.  In each of these instances, converting the exchange transaction into an installment sale can provide favorable tax deferral on the amounts in question.  There are companies in the marketplace that will assume the qualified intermediary’s obligation to return funds to the taxpayer and, in turn, will enter into an installment agreement with the taxpayer providing for receipt of the funds over time.  Some of the features and benefits of such an arrangement include:

Tax deferral option even when intended exchange does not take place (or for sums leftover)
The installment payments to the taxpayer are secured
The taxpayer can design the payment stream
The taxpayer can receive the certainty of fixed income
Earn interest of the funds on a pre-tax basis, rather than a lesser amount on an after tax basis
Defer income to a time of lower income in retirement years
Ability to borrow up to 85% of the amount involved

Summary
Installment sale treatment comes into play when an exchange involves the sale of relinquished property in one tax year and the receipt of replacement property in the following year.  Also, for failed exchanges or for exchanges in which some proceeds are left unused, converting the exchange into an installment sale can be a good option in lieu of deferral under Section 1031 of the Internal Revenue Code.

Exchanges Straddling Two Tax Years
Often an exchange period will continue from the end of one year to the beginning of the next.  For instance, a taxpayer who sells relinquished property on December 1 will expect expiration of the 45 day identification to occur on January 14 of the next tax year.  Similarly, a taxpayer who closes on the sale of relinquished property on September 1 and duly identified possible replacement property within the identification period will expect the 180 day exchange period to expire on February 27 of the next calendar year.
Taxpayers who receive all, or a portion, of their exchange balances in the year following the sale of their relinquished property will receive installment sale treatment for the balance returned.  Effectively, this means that they will not have to report the gain on their sale until the time their tax return for the year of the distribution is due.
There is, of course, a catch.  A taxpayer should not sell a property with these timelines merely to put off the payment of the gains that are otherwise due.  According to the exchange regulations, the taxpayer must have a bona fide intent to do an exchange, even if it is ultimately unsuccessful in whole or in part. 
The regulations state:

“The provisions of paragraphs (j)(2)(i) and (ii) of this section do not apply unless the taxpayer has a bona fide intent to enter into a deferred exchange at the beginning of the exchange period. A taxpayer will be treated as having a bona fide intent only if it is reasonable to believe, based on all the facts and circumstances as of the beginning of the exchange period, that like-kind replacement property will be acquired before the end of the exchange period.”

Taxpayers who have the requisite bona fide intent and receive the payout from the exchange account in the second tax year will automatically receive installment sale treatment with the gain to be reported in the year of the distribution from the account.  In the event the taxpayer has losses in the year of the property sale, the taxpayer can elect to recognize the gain in that year rather than the subsequent year.
Fallback Strategy for Failed Exchange or Exchange with Unused Proceeds
A portion of exchanges inevitably result in the inability of the taxpayer to identify possible replacement property by the required 45th day from the sale.  In other instances, the taxpayer duly identifies one or more possible replacement properties but elects not to acquire the property by the end of the 180 day exchange period.  Also, at times a taxpayer will properly identify and acquire replacement property, but does not use up the full available balance of exchange funds.  In each of these instances, converting the exchange transaction into an installment sale can provide favorable tax deferral on the amounts in question.  There are companies in the marketplace that will assume the qualified intermediary’s obligation to return funds to the taxpayer and, in turn, will enter into an installment agreement with the taxpayer providing for receipt of the funds over time.  Some of the features and benefits of such an arrangement include:

Tax deferral option even when intended exchange does not take place (or for sums leftover)
The installment payments to the taxpayer are secured
The taxpayer can design the payment stream
The taxpayer can receive the certainty of fixed income
Earn interest of the funds on a pre-tax basis, rather than a lesser amount on an after tax basis
Defer income to a time of lower income in retirement years
Ability to borrow up to 85% of the amount involved

Summary
Installment sale treatment comes into play when an exchange involves the sale of relinquished property in one tax year and the receipt of replacement property in the following year.  Also, for failed exchanges or for exchanges in which some proceeds are left unused, converting the exchange into an installment sale can be a good option in lieu of deferral under Section 1031 of the Internal Revenue Code.