Can a partner or member trade their share of a property interest upon sale?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself. The section generally provides
“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 for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.” As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members.
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share. The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
How is a 1031 drop and swap done?
A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position. If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
IRS Form 1065 U.S. Return of Partnership Income
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.” Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis.
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange. Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
Underlying Loan Considerations
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member. As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member. In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses. So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents. This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
Deemed Partnership
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership. This would negate a drop and swap. Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs. The least amount of management by the co-owners is helpful to avoid partnership characterization. Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property.
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship. The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership. It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible. Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
Summary
The possibility of structuring of a
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1031 Drop and Swap out of a Partnership or LLC
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1031 Drop and Swap out of a Partnership or LLC
Can a partner or member trade their share of a property interest upon sale?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself. The section generally provides
“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 for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.” As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members.
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share. The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
How is a 1031 drop and swap done?
A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position. If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
IRS Form 1065 U.S. Return of Partnership Income
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.” Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis.
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange. Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
Underlying Loan Considerations
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member. As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member. In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses. So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents. This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
Deemed Partnership
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership. This would negate a drop and swap. Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs. The least amount of management by the co-owners is helpful to avoid partnership characterization. Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property.
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship. The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership. It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible. Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
Summary
The possibility of structuring of a -
1031 Drop and Swap out of a Partnership or LLC
Can a partner or member trade their share of a property interest upon sale?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself. The section generally provides
“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 for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.” As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members.
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share. The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
How is a 1031 drop and swap done?
A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position. If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
IRS Form 1065 U.S. Return of Partnership Income
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.” Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis.
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange. Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
Underlying Loan Considerations
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member. As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member. In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses. So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents. This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
Deemed Partnership
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership. This would negate a drop and swap. Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs. The least amount of management by the co-owners is helpful to avoid partnership characterization. Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property.
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship. The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership. It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible. Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
Summary
The possibility of structuring of a -
Does Little to No Gain on an Investment Property Mean No Need for a 1031 Exchange?
Many investors know that they can shelter the capital gains on the sale of investment properties when they structure the sale as part of a Section 1031 like-kind exchange. However, they are typically unsure about the consequences of a transaction involving the sale of an investment property with little or no gain.
The Situation
Mike owns an investment property that he bought as part of a 1031 exchange at the height of the real estate market in 2006 for approximately $296,000. With the decline in the real estate market over the next few years, the property was worth only about $209,000 in 2012. Mike received an offer for $305,000 in 2020, and is not sure whether a 1031 exchange is the right course of action.
The Problem
Mike’s initial thoughts regarding the current house are that he paid $296,000 for the house and the current offer is $305,000. His analysis is:
Purchase $296,000
Sale $305,000
Gain $9,000
20% Fed Cap Gains $1,800
5% State Cap Gains $450
Total Tax Burden $2,250
However, Mike has forgotten a couple of critical facts. First, he acquired this property in 2006 as part of a 1031 exchange, in which he sheltered a substantial gain. Second, he neglected to account for the depreciation recapture on both transactions. The real math for Mike’s current exchange is:
Purchase #1 $223,000
Sale #1 $295,000 (5-year hold)
Gain #1 $72,000
20% Fed Cap Gains $14,400*
5% State Cap Gains $3,600*
5 Years Depreciation $40,505
Fed Recapture (25%) $10,126*
State Recapture (5%) $2,025*
Purchase #2 $296,000
Sale #2 $305,000 (14-year hold)
Gain #2 $9,000
20% Fed Cap Gains $1,800
5% State Cap Gains $450*
14 Years Depreciation $150,690
Fed Recapture (25%) $37,673*
State Recapture (5%) $7,535*
TAXES OWED WITHOUT EXCHANGE
Property 1
20% Fed Cap Gains $14,400*
5% State Cap Gains $3,600*
Fed Recapture (25%) $10,126*
State Recapture (5%) $2,025*
Property 2
20% Fed Cap Gains $1,800
5% State Cap Gains $450*
Fed Recapture (25%) $37,673*
State Recapture (5%) $7,535*
TOTAL TAXES DUE $77,609
When Mike overlooked the previous 1031 exchange, he neglected to account for the deferred taxes from that transaction. He also overlooked the significant depreciation he had taken during the time he owned this current property. While the gain on this current property is nominal, the potential tax liability in an outright sale would be substantial due to the need to recognize previously deferred taxes as well as the depreciation recapture.
The Solution: 1031 Exchange
Mike will sell this property as part of another 1031 exchange. After consulting with his attorney and a Qualified Intermediary (QI) like Accruit, Mike now understands that a 1031 Exchange is a tax deferral strategy, and that he would need to recognize those previously deferred taxes upon a sale. Mike visited the Capital Gains Calculator on the Accruit website to get a better understanding of the tax ramifications of a sale without another 1031 exchange.
Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Mike’s QI to be held on his behalf until the purchase of his replacement property. This is necessary because a person doing an exchange cannot come in actual or constructive receipt of the net sale proceeds while the exchange is pending.
Within 45 days after the closing on the sale, Mike identified suitable replacement property (learn more about Identification rules in 1031 exchanges). Mike completed the acquisition of that property approximately sixty days later, well within 180 days of the sale of his relinquished property, utilizing the exchange proceeds held by his QI. Mike has now relocated his investment to a more investor friendly town.
The Result
Mike has successfully completed a 1031 exchange from a single-family home in a town that imposes heavy regulatory burdens on landlords to a neighboring town that is more investor friendly. He exchanged equal or up in value, using all of his equity, and thereby fully deferred the capital gain and depreciation recapture taxes on this property, as well as from his previous investment property.
Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property. -
Does Little to No Gain on an Investment Property Mean No Need for a 1031 Exchange?
Many investors know that they can shelter the capital gains on the sale of investment properties when they structure the sale as part of a Section 1031 like-kind exchange. However, they are typically unsure about the consequences of a transaction involving the sale of an investment property with little or no gain.
The Situation
Mike owns an investment property that he bought as part of a 1031 exchange at the height of the real estate market in 2006 for approximately $296,000. With the decline in the real estate market over the next few years, the property was worth only about $209,000 in 2012. Mike received an offer for $305,000 in 2020, and is not sure whether a 1031 exchange is the right course of action.
The Problem
Mike’s initial thoughts regarding the current house are that he paid $296,000 for the house and the current offer is $305,000. His analysis is:
Purchase $296,000
Sale $305,000
Gain $9,000
20% Fed Cap Gains $1,800
5% State Cap Gains $450
Total Tax Burden $2,250
However, Mike has forgotten a couple of critical facts. First, he acquired this property in 2006 as part of a 1031 exchange, in which he sheltered a substantial gain. Second, he neglected to account for the depreciation recapture on both transactions. The real math for Mike’s current exchange is:
Purchase #1 $223,000
Sale #1 $295,000 (5-year hold)
Gain #1 $72,000
20% Fed Cap Gains $14,400*
5% State Cap Gains $3,600*
5 Years Depreciation $40,505
Fed Recapture (25%) $10,126*
State Recapture (5%) $2,025*
Purchase #2 $296,000
Sale #2 $305,000 (14-year hold)
Gain #2 $9,000
20% Fed Cap Gains $1,800
5% State Cap Gains $450*
14 Years Depreciation $150,690
Fed Recapture (25%) $37,673*
State Recapture (5%) $7,535*
TAXES OWED WITHOUT EXCHANGE
Property 1
20% Fed Cap Gains $14,400*
5% State Cap Gains $3,600*
Fed Recapture (25%) $10,126*
State Recapture (5%) $2,025*
Property 2
20% Fed Cap Gains $1,800
5% State Cap Gains $450*
Fed Recapture (25%) $37,673*
State Recapture (5%) $7,535*
TOTAL TAXES DUE $77,609
When Mike overlooked the previous 1031 exchange, he neglected to account for the deferred taxes from that transaction. He also overlooked the significant depreciation he had taken during the time he owned this current property. While the gain on this current property is nominal, the potential tax liability in an outright sale would be substantial due to the need to recognize previously deferred taxes as well as the depreciation recapture.
The Solution: 1031 Exchange
Mike will sell this property as part of another 1031 exchange. After consulting with his attorney and a Qualified Intermediary (QI) like Accruit, Mike now understands that a 1031 Exchange is a tax deferral strategy, and that he would need to recognize those previously deferred taxes upon a sale. Mike visited the Capital Gains Calculator on the Accruit website to get a better understanding of the tax ramifications of a sale without another 1031 exchange.
Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Mike’s QI to be held on his behalf until the purchase of his replacement property. This is necessary because a person doing an exchange cannot come in actual or constructive receipt of the net sale proceeds while the exchange is pending.
Within 45 days after the closing on the sale, Mike identified suitable replacement property (learn more about Identification rules in 1031 exchanges). Mike completed the acquisition of that property approximately sixty days later, well within 180 days of the sale of his relinquished property, utilizing the exchange proceeds held by his QI. Mike has now relocated his investment to a more investor friendly town.
The Result
Mike has successfully completed a 1031 exchange from a single-family home in a town that imposes heavy regulatory burdens on landlords to a neighboring town that is more investor friendly. He exchanged equal or up in value, using all of his equity, and thereby fully deferred the capital gain and depreciation recapture taxes on this property, as well as from his previous investment property.
Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property. -
Does Little to No Gain on an Investment Property Mean No Need for a 1031 Exchange?
Many investors know that they can shelter the capital gains on the sale of investment properties when they structure the sale as part of a Section 1031 like-kind exchange. However, they are typically unsure about the consequences of a transaction involving the sale of an investment property with little or no gain.
The Situation
Mike owns an investment property that he bought as part of a 1031 exchange at the height of the real estate market in 2006 for approximately $296,000. With the decline in the real estate market over the next few years, the property was worth only about $209,000 in 2012. Mike received an offer for $305,000 in 2020, and is not sure whether a 1031 exchange is the right course of action.
The Problem
Mike’s initial thoughts regarding the current house are that he paid $296,000 for the house and the current offer is $305,000. His analysis is:
Purchase $296,000
Sale $305,000
Gain $9,000
20% Fed Cap Gains $1,800
5% State Cap Gains $450
Total Tax Burden $2,250
However, Mike has forgotten a couple of critical facts. First, he acquired this property in 2006 as part of a 1031 exchange, in which he sheltered a substantial gain. Second, he neglected to account for the depreciation recapture on both transactions. The real math for Mike’s current exchange is:
Purchase #1 $223,000
Sale #1 $295,000 (5-year hold)
Gain #1 $72,000
20% Fed Cap Gains $14,400*
5% State Cap Gains $3,600*
5 Years Depreciation $40,505
Fed Recapture (25%) $10,126*
State Recapture (5%) $2,025*
Purchase #2 $296,000
Sale #2 $305,000 (14-year hold)
Gain #2 $9,000
20% Fed Cap Gains $1,800
5% State Cap Gains $450*
14 Years Depreciation $150,690
Fed Recapture (25%) $37,673*
State Recapture (5%) $7,535*
TAXES OWED WITHOUT EXCHANGE
Property 1
20% Fed Cap Gains $14,400*
5% State Cap Gains $3,600*
Fed Recapture (25%) $10,126*
State Recapture (5%) $2,025*
Property 2
20% Fed Cap Gains $1,800
5% State Cap Gains $450*
Fed Recapture (25%) $37,673*
State Recapture (5%) $7,535*
TOTAL TAXES DUE $77,609
When Mike overlooked the previous 1031 exchange, he neglected to account for the deferred taxes from that transaction. He also overlooked the significant depreciation he had taken during the time he owned this current property. While the gain on this current property is nominal, the potential tax liability in an outright sale would be substantial due to the need to recognize previously deferred taxes as well as the depreciation recapture.
The Solution: 1031 Exchange
Mike will sell this property as part of another 1031 exchange. After consulting with his attorney and a Qualified Intermediary (QI) like Accruit, Mike now understands that a 1031 Exchange is a tax deferral strategy, and that he would need to recognize those previously deferred taxes upon a sale. Mike visited the Capital Gains Calculator on the Accruit website to get a better understanding of the tax ramifications of a sale without another 1031 exchange.
Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Mike’s QI to be held on his behalf until the purchase of his replacement property. This is necessary because a person doing an exchange cannot come in actual or constructive receipt of the net sale proceeds while the exchange is pending.
Within 45 days after the closing on the sale, Mike identified suitable replacement property (learn more about Identification rules in 1031 exchanges). Mike completed the acquisition of that property approximately sixty days later, well within 180 days of the sale of his relinquished property, utilizing the exchange proceeds held by his QI. Mike has now relocated his investment to a more investor friendly town.
The Result
Mike has successfully completed a 1031 exchange from a single-family home in a town that imposes heavy regulatory burdens on landlords to a neighboring town that is more investor friendly. He exchanged equal or up in value, using all of his equity, and thereby fully deferred the capital gain and depreciation recapture taxes on this property, as well as from his previous investment property.
Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property. -
1031 Tax Deferred Exchanges Between Related Parties
Historically, real estate transactions were not uncommon amongst family and other related parties. Given this and prior history of taxpayers utilizing family or related parties to manipulate the existing IRS regulations on 1031 exchanges, Congress amended the code section to include Related Party rules in relation to 1031 exchanges. Due to today’s booming real estate market, it is even more popular for family to try to help the younger generation start their real estate investment journey, which makes it more important than ever to understand the Related Party rules outlined below.
Background to the Related Party rules
Tax deferral under section 1031 of the U.S. tax code is very taxpayer-friendly, potentially allowing taxpayers to defer capital gain, depreciation recapture, healthcare tax, and state tax. However, to take advantage of this code section, taxpayers have to play fair and strictly follow the rules. In the past, it was possible to manipulate the rules to achieve a favorable outcome by bringing a party related to the taxpayer into the transaction. In 1989, Congress amended the code section to stop this abuse. The amendment prohibits taxpayers from entering into transactions with related parties, subject to a few limited exceptions. According to the legislative history of §1031(f) “if a related party exchange is followed shortly by a disposition of the property, the related parties, have in effect, cashed out of the investment.”
This new section, 1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—
(i) the related person disposes of such property, or
(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”
What was the abuse that gave rise to the Related Party rules?
Take as an example “Parent Company” which has Property A for sale with a lot of built-in gain and no need to acquire a replacement property. Its affiliate, “Subsidiary Company” owns Property B of similar value with a high basis. In any exchange, the basis is carried over from the relinquished property to the replacement property. So rather than sell the properties outright, the two companies enter into an exchange with one another to defer taxes. Parent Company holds Property B indefinitely, but shortly after the exchange, Subsidiary Company sells Property A. Since Subsidiary Company has a high basis in Property A, there is little tax effect to it upon the sale. This was a common occurrence prior to the 1989 Related Party rules addition to section 1031.
Can any part of a taxpayer’s exchange transaction involve a related party?
Often a taxpayer will sell the relinquished property to a related party while acquiring replacement property from an unrelated party. This structure is not prohibited by the Related Party rules since it does not involve the taxpayer carrying over tax basis into the property sold (it is carried over into the property being purchased), and therefore there is no opportunity for the tax abuse that the rules seek to curb. Between 2007 and 2010 there were a series of -
1031 Tax Deferred Exchanges Between Related Parties
Historically, real estate transactions were not uncommon amongst family and other related parties. Given this and prior history of taxpayers utilizing family or related parties to manipulate the existing IRS regulations on 1031 exchanges, Congress amended the code section to include Related Party rules in relation to 1031 exchanges. Due to today’s booming real estate market, it is even more popular for family to try to help the younger generation start their real estate investment journey, which makes it more important than ever to understand the Related Party rules outlined below.
Background to the Related Party rules
Tax deferral under section 1031 of the U.S. tax code is very taxpayer-friendly, potentially allowing taxpayers to defer capital gain, depreciation recapture, healthcare tax, and state tax. However, to take advantage of this code section, taxpayers have to play fair and strictly follow the rules. In the past, it was possible to manipulate the rules to achieve a favorable outcome by bringing a party related to the taxpayer into the transaction. In 1989, Congress amended the code section to stop this abuse. The amendment prohibits taxpayers from entering into transactions with related parties, subject to a few limited exceptions. According to the legislative history of §1031(f) “if a related party exchange is followed shortly by a disposition of the property, the related parties, have in effect, cashed out of the investment.”
This new section, 1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—
(i) the related person disposes of such property, or
(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”
What was the abuse that gave rise to the Related Party rules?
Take as an example “Parent Company” which has Property A for sale with a lot of built-in gain and no need to acquire a replacement property. Its affiliate, “Subsidiary Company” owns Property B of similar value with a high basis. In any exchange, the basis is carried over from the relinquished property to the replacement property. So rather than sell the properties outright, the two companies enter into an exchange with one another to defer taxes. Parent Company holds Property B indefinitely, but shortly after the exchange, Subsidiary Company sells Property A. Since Subsidiary Company has a high basis in Property A, there is little tax effect to it upon the sale. This was a common occurrence prior to the 1989 Related Party rules addition to section 1031.
Can any part of a taxpayer’s exchange transaction involve a related party?
Often a taxpayer will sell the relinquished property to a related party while acquiring replacement property from an unrelated party. This structure is not prohibited by the Related Party rules since it does not involve the taxpayer carrying over tax basis into the property sold (it is carried over into the property being purchased), and therefore there is no opportunity for the tax abuse that the rules seek to curb. Between 2007 and 2010 there were a series of -
1031 Tax Deferred Exchanges Between Related Parties
Historically, real estate transactions were not uncommon amongst family and other related parties. Given this and prior history of taxpayers utilizing family or related parties to manipulate the existing IRS regulations on 1031 exchanges, Congress amended the code section to include Related Party rules in relation to 1031 exchanges. Due to today’s booming real estate market, it is even more popular for family to try to help the younger generation start their real estate investment journey, which makes it more important than ever to understand the Related Party rules outlined below.
Background to the Related Party rules
Tax deferral under section 1031 of the U.S. tax code is very taxpayer-friendly, potentially allowing taxpayers to defer capital gain, depreciation recapture, healthcare tax, and state tax. However, to take advantage of this code section, taxpayers have to play fair and strictly follow the rules. In the past, it was possible to manipulate the rules to achieve a favorable outcome by bringing a party related to the taxpayer into the transaction. In 1989, Congress amended the code section to stop this abuse. The amendment prohibits taxpayers from entering into transactions with related parties, subject to a few limited exceptions. According to the legislative history of §1031(f) “if a related party exchange is followed shortly by a disposition of the property, the related parties, have in effect, cashed out of the investment.”
This new section, 1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—
(i) the related person disposes of such property, or
(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”
What was the abuse that gave rise to the Related Party rules?
Take as an example “Parent Company” which has Property A for sale with a lot of built-in gain and no need to acquire a replacement property. Its affiliate, “Subsidiary Company” owns Property B of similar value with a high basis. In any exchange, the basis is carried over from the relinquished property to the replacement property. So rather than sell the properties outright, the two companies enter into an exchange with one another to defer taxes. Parent Company holds Property B indefinitely, but shortly after the exchange, Subsidiary Company sells Property A. Since Subsidiary Company has a high basis in Property A, there is little tax effect to it upon the sale. This was a common occurrence prior to the 1989 Related Party rules addition to section 1031.
Can any part of a taxpayer’s exchange transaction involve a related party?
Often a taxpayer will sell the relinquished property to a related party while acquiring replacement property from an unrelated party. This structure is not prohibited by the Related Party rules since it does not involve the taxpayer carrying over tax basis into the property sold (it is carried over into the property being purchased), and therefore there is no opportunity for the tax abuse that the rules seek to curb. Between 2007 and 2010 there were a series of -
1031 Exchanges for Condominium Deconversions
Condominium deconversions have been taking place quite frequently in the greater Chicagoland area and elsewhere. For reasons including the ones set forth below, a condominium deconversion takes place when 75% (or in some jurisdictions a higher percentage) of the owners choose to sell the building to someone interested in converting it to use as an apartment building. A deconversion can be precipitated by one or more factors. Rental properties may be in short supply in the area and converting the building to apartments may be far more valuable than the aggregate value of the individual condo units. Also, as the building gets older and requires more regular fix ups, unit owners are reluctant to continuously pay for special assessments that might otherwise keep the property in proper condition. Furthermore, the need for ongoing special assessments may make it difficult to sell the unit or at the very least have a negative impact on the price.
Requirements for a 1031 Exchange
Like any other sale of real estate, those who utilized their unit as an investment or business use property and are seeking to use a tax deferred exchange have to adhere to the specific governing regulations. One such requirement is that the exchange company, known as a Qualified Intermediary (QI), has to take tax ownership of the property from the property owner and to transfer that ownership to the buyer. Click to learn more about QI services. This can be accomplished by the taxpayer deeding the property to the QI and the QI deeding to the buyer. Another permitted way to accomplish this is for the QI to be a party to the sale agreement, meaning that the QI has a legal obligation to cause legal title to be conveyed to the buyer. These two options are somewhat cumbersome. In order to make that process as simple as possible, the Treasury Department provided a shortcut in the regulations to accomplish tax ownership of the relinquished property passing through the QI.
(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.
In short, sellers’ “rights” in and to the sale agreement have to be assigned to the QI and all parties to the agreement have to receive written notice of this assignment. However, meeting this requirement in a sale of an individual owner’s unit presents a practical problem since typically when it comes to condominiums the sale agreement is signed only by the condominium association, and not by the actual unit owner.
Meeting 1031 Exchange Rules on a Conversion Property
In this blog writer’s shop, we attempt to bridge this gap by having slightly different language on this Assignment of Relinquished Property when it involves a sale due to conversion. The italicized part of the assignment document appears below:
Assignment. The undersigned (“Exchanger”) hereby assigns to Accruit, LLC (“Accruit”) all of Exchanger’s rights (but not Exchanger’s liabilities or obligations), referred to hereafter as the “Assignment”, under that certain Purchase and Sale Agreement (the “Relinquished Property Contract”) between the ____________ Condominium Association as Seller, of which ___________ is a condominium unit owner as to her percentage ownership in the comment elements in the ______________ Condominium Association pursuant to 765 ILCS 605/15 of the Illinois Condominium Property Act, the unit owner being the Exchanger and Relinquished Property Buyer being the buyer (identified above). If not previously provided, simultaneously with the execution of this Assignment by the parties, Exchanger shall promptly provide Accruit with a copy of the Relinquished Property Contract.The challenge is assigning the rights to the unit owner’s sale of the unit in a situation where the unit owner is not a direct signer nor party of the agreement. Instead, the taxpayer is assigning the rights in his or her derivative capacity as an owner in the property being sold to the party seeking to change the property into an apartment building. Notice of the assignment is also given to the parties to the contract, usually by tendering it to their lawyers as the agent for the parties.
Sales of condominium buildings are happening regularly, and many unit owners are seeking to receive tax deferral by utilizing a 1031 exchange opportunity. The manner in which the sale contract is signed presents a slight challenge to meet the requirements set forth in the 1031 exchange rules. However, the spirit of those rules can be followed with an assignment of rights whereby the language in the assignment is changed slightly to account for the lack of a unit owner’s being a direct party to the sale agreement.