Tag: 1031 Exchange Qualified Intermediary

Most users of Section 1031 understand the 180-calendar day deadline to complete their like-kind exchange.  This general understanding of the exchange period deadline is fine for most transactions, but many exchangers remain unaware of the more nuanced definition of this critical period.
What do the regulations say?
Section 1031’s underlying regulations state, “The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.”
What do the regulations mean?
The regulations generally allow for 180 calendar days for taxpayers to complete their 1031 exchanges that straddle tax years, taxpayers may seek installment tax reporting on IRS Form 6252 in the year of the relinquished property sale.  For instance, if the relinquished property closed between November 16 and December 31, the 45-day identification would be in the following calendar year.  Similarly, if the relinquished property closed after July 5, and potential replacement property was identified within the 45-day identification period but no replacement property was actually acquired, the end of the exchange period would be in the following calendar year.  If the 1031 exchange fails by non-identification or by failure to purchase a replacement property, the sale proceeds would be returned to the exchanger in a different tax reporting year.  In this circumstance, the IRS allows taxpayers to either report the gain in the year of sale or in the year the proceeds were received under IRC 453 installment sale rules.  This would allow the taxpayer to select the year of reporting that is most beneficial.  One might say that a year’s worth of tax deferral is available regardless of the exchange having failed.
Taxpayers Beware
Installment sale treatment generally requires a bona fide intent to complete an exchange.  This means that the taxpayer had reason to believe, based on the facts and circumstances at the beginning of the exchange, that a like-kind replacement property would be acquired during the exchange period.
Other installment sale issues:

If there was debt paid off at closing of the relinquished property and gain associated with this debt, relief is generally recognized in the year of sale. 
Depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale.
Interest is charged on the tax deferred if the sale price of the relinquished property is over $150,000 and certain other instalment obligations exceed $5 million.

For taxpayers who have a taxable gain, there is one additional issue to consider.  If you are unsettled about current tax rates, you may extend your tax return to report by October 15.  This way, you can wait and see if the Congress will change the rates and select the year of reporting that is most beneficial for you.
Check with your tax advisor to determine the correct tax forms and tax extensions to utilize along with the selection of the reporting year for your exchange.

Most users of Section 1031 understand the 180-calendar day deadline to complete their like-kind exchange.  This general understanding of the exchange period deadline is fine for most transactions, but many exchangers remain unaware of the more nuanced definition of this critical period.
What do the regulations say?
Section 1031’s underlying regulations state, “The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.”
What do the regulations mean?
The regulations generally allow for 180 calendar days for taxpayers to complete their 1031 exchanges that straddle tax years, taxpayers may seek installment tax reporting on IRS Form 6252 in the year of the relinquished property sale.  For instance, if the relinquished property closed between November 16 and December 31, the 45-day identification would be in the following calendar year.  Similarly, if the relinquished property closed after July 5, and potential replacement property was identified within the 45-day identification period but no replacement property was actually acquired, the end of the exchange period would be in the following calendar year.  If the 1031 exchange fails by non-identification or by failure to purchase a replacement property, the sale proceeds would be returned to the exchanger in a different tax reporting year.  In this circumstance, the IRS allows taxpayers to either report the gain in the year of sale or in the year the proceeds were received under IRC 453 installment sale rules.  This would allow the taxpayer to select the year of reporting that is most beneficial.  One might say that a year’s worth of tax deferral is available regardless of the exchange having failed.
Taxpayers Beware
Installment sale treatment generally requires a bona fide intent to complete an exchange.  This means that the taxpayer had reason to believe, based on the facts and circumstances at the beginning of the exchange, that a like-kind replacement property would be acquired during the exchange period.
Other installment sale issues:

If there was debt paid off at closing of the relinquished property and gain associated with this debt, relief is generally recognized in the year of sale. 
Depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale.
Interest is charged on the tax deferred if the sale price of the relinquished property is over $150,000 and certain other instalment obligations exceed $5 million.

For taxpayers who have a taxable gain, there is one additional issue to consider.  If you are unsettled about current tax rates, you may extend your tax return to report by October 15.  This way, you can wait and see if the Congress will change the rates and select the year of reporting that is most beneficial for you.
Check with your tax advisor to determine the correct tax forms and tax extensions to utilize along with the selection of the reporting year for your exchange.

Utilizing a long term ground lease on real estate owned by a party related to the taxpayer can enable a taxpayer to invest proceeds into making improvements on that property. In a recent blog post we discussed build-to-suit and property improvement exchanges.  As that post made clear, a taxpayer cannot do improvements on property that is already owned by the taxpayer. Another post pertaining to exchange transactions between related parties underscored the admonition against a taxpayer acquiring replacement property from a related party.  Merging these two issues provides an opportunity for us to discuss the potential of a taxpayer using exchange proceeds to improve a property owned by a related party.
This type of transaction is made possible by introducing a long term lease for the property into the ownership structure of the land.  For 1031 exchange purposes, a long term lease is defined as a lease with 30 years or more to run, including renewal options.  As an example, a ten year ground lease with two ten year options would be a sufficient interest in the land to constitute an ownership of the “leasehold estate” by the lessee which is legally recognizable as a separate and distinct ownership from that of the underlying land itself.  This long term interest is considered like-kind to a direct (“fee”) interest in land.  Consequently if improvements are built upon the land those improvements belong to the ground lessee and conversely, the land owner, the related party, has no ownership rights in those improvements.    
Looking back to the rules disallowing a taxpayer to build on property it already owns, this issue can be resolved by having an Exchange Accommodation Titleholder (“EAT”) become the ground lessee and for the EAT to build the improvements per the plans and specifications required by the taxpayer (This was the gist of the first blog referenced above).  Further, if the interest in a long term ground lease, including improvements upon the property, is recognized as a separate and distinct real property interest, then the taxpayer’s receipt of these leasehold improvements should not be deemed to be received from the underlying related party land owner.
This structure was the subject of a 2002 Private Letter Ruling. In that fact pattern the related party was not the land owner but rather a lessee itself of the property under a long term lease.  As stated above, a long term lease interest for 1031 exchange purposes is the same as a fee interest and, as such, the ground lease was subleased to an EAT for purposes of constructing upon the property.  This structure was approved.
A short time later PLR 200329021 was issued.  In this case too, the related party had a lease in excess of thirty years.  The leasehold interest was assigned to an EAT for purposes of constructing taxpayer desired improvements.  This structure got a favorable ruling from the IRS.
The most recent ruling on this structure was PLR 201408019. In this case a part of the property leased to the related party was subleased to an EAT with a lease term in excess of thirty years.  Similar to the findings in the prior Private Letter Rulings, the IRS ruled that the sublease and the improvements were like kind to the taxpayer’s fee interest in the relinquished property.
There were a couple of common threads to these rulings which someone structuring such a transaction should keep in mind. 

First, a fair market rental payment was paid by the EAT to the lessor/sublessor. Sometimes in practice the start of those payments is deferred for the first 180 days of the sublease in order to avoid having the EAT getting involved with the rent payment. 
Second, the lease/sublease should have 30 or more years to run as of the time the EAT leases the property. 
Lastly, the rulings all had language suggesting that neither the related party nor the taxpayer should dispose of its interest for at least two years, which is a requirement of one of the exceptions to the related party rules. 

Regarding this last item, one could argue that had the related party been the land owner, the two year holding requirement would not be needed since the taxpayer would receive nothing from the related party throughout the transaction.  The fact that the EAT is leasing the property from the related party should not be relevant. The situation in the Private Letter Rulings involved the EAT taking an assignment of the ground lease from the related party and the ground lease was ultimately transferred to the taxpayer. Nevertheless, it is not usually necessary in these transactions for a party to dispose of either property within two years, so it is not a burdensome requirement in any event. Also, most advisors agree that the lease relationship can be terminated after a time in excess of two years when the exchange transaction is considered “old and cold.”
So, quite often a taxpayer – whether an individual, partnership or limited liability company – has the desire to use exchange proceeds towards building upon land owned by a related person or entity.  The taxpayer can take advantage of the legal fiction that improvements to property under a long term ground lease do not constitute building upon the underlying land owned by a related party and therefore they can use exchange proceeds to fund the improvements. They are acquiring the improvements from the EAT and not the related party.
Documents for a build-to-suit under a ground lease on property owned by a related party include:

Qualified Exchange Accommodation Agreement
Ground Lease
Build-to-Suit Agreement between Taxpayer and EAT
Agreement between Contractor and Owner
Evidence of Liability Insurance, including Builder’s Risk coverage
Environmental Indemnity

Utilizing a long term ground lease on real estate owned by a party related to the taxpayer can enable a taxpayer to invest proceeds into making improvements on that property. In a recent blog post we discussed build-to-suit and property improvement exchanges.  As that post made clear, a taxpayer cannot do improvements on property that is already owned by the taxpayer. Another post pertaining to exchange transactions between related parties underscored the admonition against a taxpayer acquiring replacement property from a related party.  Merging these two issues provides an opportunity for us to discuss the potential of a taxpayer using exchange proceeds to improve a property owned by a related party.
This type of transaction is made possible by introducing a long term lease for the property into the ownership structure of the land.  For 1031 exchange purposes, a long term lease is defined as a lease with 30 years or more to run, including renewal options.  As an example, a ten year ground lease with two ten year options would be a sufficient interest in the land to constitute an ownership of the “leasehold estate” by the lessee which is legally recognizable as a separate and distinct ownership from that of the underlying land itself.  This long term interest is considered like-kind to a direct (“fee”) interest in land.  Consequently if improvements are built upon the land those improvements belong to the ground lessee and conversely, the land owner, the related party, has no ownership rights in those improvements.    
Looking back to the rules disallowing a taxpayer to build on property it already owns, this issue can be resolved by having an Exchange Accommodation Titleholder (“EAT”) become the ground lessee and for the EAT to build the improvements per the plans and specifications required by the taxpayer (This was the gist of the first blog referenced above).  Further, if the interest in a long term ground lease, including improvements upon the property, is recognized as a separate and distinct real property interest, then the taxpayer’s receipt of these leasehold improvements should not be deemed to be received from the underlying related party land owner.
This structure was the subject of a 2002 Private Letter Ruling. In that fact pattern the related party was not the land owner but rather a lessee itself of the property under a long term lease.  As stated above, a long term lease interest for 1031 exchange purposes is the same as a fee interest and, as such, the ground lease was subleased to an EAT for purposes of constructing upon the property.  This structure was approved.
A short time later PLR 200329021 was issued.  In this case too, the related party had a lease in excess of thirty years.  The leasehold interest was assigned to an EAT for purposes of constructing taxpayer desired improvements.  This structure got a favorable ruling from the IRS.
The most recent ruling on this structure was PLR 201408019. In this case a part of the property leased to the related party was subleased to an EAT with a lease term in excess of thirty years.  Similar to the findings in the prior Private Letter Rulings, the IRS ruled that the sublease and the improvements were like kind to the taxpayer’s fee interest in the relinquished property.
There were a couple of common threads to these rulings which someone structuring such a transaction should keep in mind. 

First, a fair market rental payment was paid by the EAT to the lessor/sublessor. Sometimes in practice the start of those payments is deferred for the first 180 days of the sublease in order to avoid having the EAT getting involved with the rent payment. 
Second, the lease/sublease should have 30 or more years to run as of the time the EAT leases the property. 
Lastly, the rulings all had language suggesting that neither the related party nor the taxpayer should dispose of its interest for at least two years, which is a requirement of one of the exceptions to the related party rules. 

Regarding this last item, one could argue that had the related party been the land owner, the two year holding requirement would not be needed since the taxpayer would receive nothing from the related party throughout the transaction.  The fact that the EAT is leasing the property from the related party should not be relevant. The situation in the Private Letter Rulings involved the EAT taking an assignment of the ground lease from the related party and the ground lease was ultimately transferred to the taxpayer. Nevertheless, it is not usually necessary in these transactions for a party to dispose of either property within two years, so it is not a burdensome requirement in any event. Also, most advisors agree that the lease relationship can be terminated after a time in excess of two years when the exchange transaction is considered “old and cold.”
So, quite often a taxpayer – whether an individual, partnership or limited liability company – has the desire to use exchange proceeds towards building upon land owned by a related person or entity.  The taxpayer can take advantage of the legal fiction that improvements to property under a long term ground lease do not constitute building upon the underlying land owned by a related party and therefore they can use exchange proceeds to fund the improvements. They are acquiring the improvements from the EAT and not the related party.
Documents for a build-to-suit under a ground lease on property owned by a related party include:

Qualified Exchange Accommodation Agreement
Ground Lease
Build-to-Suit Agreement between Taxpayer and EAT
Agreement between Contractor and Owner
Evidence of Liability Insurance, including Builder’s Risk coverage
Environmental Indemnity

Utilizing a long term ground lease on real estate owned by a party related to the taxpayer can enable a taxpayer to invest proceeds into making improvements on that property. In a recent blog post we discussed build-to-suit and property improvement exchanges.  As that post made clear, a taxpayer cannot do improvements on property that is already owned by the taxpayer. Another post pertaining to exchange transactions between related parties underscored the admonition against a taxpayer acquiring replacement property from a related party.  Merging these two issues provides an opportunity for us to discuss the potential of a taxpayer using exchange proceeds to improve a property owned by a related party.
This type of transaction is made possible by introducing a long term lease for the property into the ownership structure of the land.  For 1031 exchange purposes, a long term lease is defined as a lease with 30 years or more to run, including renewal options.  As an example, a ten year ground lease with two ten year options would be a sufficient interest in the land to constitute an ownership of the “leasehold estate” by the lessee which is legally recognizable as a separate and distinct ownership from that of the underlying land itself.  This long term interest is considered like-kind to a direct (“fee”) interest in land.  Consequently if improvements are built upon the land those improvements belong to the ground lessee and conversely, the land owner, the related party, has no ownership rights in those improvements.    
Looking back to the rules disallowing a taxpayer to build on property it already owns, this issue can be resolved by having an Exchange Accommodation Titleholder (“EAT”) become the ground lessee and for the EAT to build the improvements per the plans and specifications required by the taxpayer (This was the gist of the first blog referenced above).  Further, if the interest in a long term ground lease, including improvements upon the property, is recognized as a separate and distinct real property interest, then the taxpayer’s receipt of these leasehold improvements should not be deemed to be received from the underlying related party land owner.
This structure was the subject of a 2002 Private Letter Ruling. In that fact pattern the related party was not the land owner but rather a lessee itself of the property under a long term lease.  As stated above, a long term lease interest for 1031 exchange purposes is the same as a fee interest and, as such, the ground lease was subleased to an EAT for purposes of constructing upon the property.  This structure was approved.
A short time later PLR 200329021 was issued.  In this case too, the related party had a lease in excess of thirty years.  The leasehold interest was assigned to an EAT for purposes of constructing taxpayer desired improvements.  This structure got a favorable ruling from the IRS.
The most recent ruling on this structure was PLR 201408019. In this case a part of the property leased to the related party was subleased to an EAT with a lease term in excess of thirty years.  Similar to the findings in the prior Private Letter Rulings, the IRS ruled that the sublease and the improvements were like kind to the taxpayer’s fee interest in the relinquished property.
There were a couple of common threads to these rulings which someone structuring such a transaction should keep in mind. 

First, a fair market rental payment was paid by the EAT to the lessor/sublessor. Sometimes in practice the start of those payments is deferred for the first 180 days of the sublease in order to avoid having the EAT getting involved with the rent payment. 
Second, the lease/sublease should have 30 or more years to run as of the time the EAT leases the property. 
Lastly, the rulings all had language suggesting that neither the related party nor the taxpayer should dispose of its interest for at least two years, which is a requirement of one of the exceptions to the related party rules. 

Regarding this last item, one could argue that had the related party been the land owner, the two year holding requirement would not be needed since the taxpayer would receive nothing from the related party throughout the transaction.  The fact that the EAT is leasing the property from the related party should not be relevant. The situation in the Private Letter Rulings involved the EAT taking an assignment of the ground lease from the related party and the ground lease was ultimately transferred to the taxpayer. Nevertheless, it is not usually necessary in these transactions for a party to dispose of either property within two years, so it is not a burdensome requirement in any event. Also, most advisors agree that the lease relationship can be terminated after a time in excess of two years when the exchange transaction is considered “old and cold.”
So, quite often a taxpayer – whether an individual, partnership or limited liability company – has the desire to use exchange proceeds towards building upon land owned by a related person or entity.  The taxpayer can take advantage of the legal fiction that improvements to property under a long term ground lease do not constitute building upon the underlying land owned by a related party and therefore they can use exchange proceeds to fund the improvements. They are acquiring the improvements from the EAT and not the related party.
Documents for a build-to-suit under a ground lease on property owned by a related party include:

Qualified Exchange Accommodation Agreement
Ground Lease
Build-to-Suit Agreement between Taxpayer and EAT
Agreement between Contractor and Owner
Evidence of Liability Insurance, including Builder’s Risk coverage
Environmental Indemnity

Seller Financing in the Context of a 1031 Exchange
It is not unusual for a taxpayer to finance the buyer in whole or in part.  Such transactions may or may not involve the seller’s intent to complete a 1031 exchange.  The structure of the seller’s financing can take the form of a note and mortgage/deed of trust from the buyer or under Articles of Agreement for Deed.  The specific form should not impact the seller’s options in structuring an exchange as part of the transaction. 
Under an installment sale using a note and mortgage/deed of trust, the question frequently arises whether a taxpayer can structure an exchange when the balloon payment becomes due, rather than at the time the parties enter into the installment sale.  Similar questions are raised with Articles of Agreement for Deed – can the exchange be done at the time of the balloon payment when the buyer is receiving the deed? It cannot, since, for tax and legal purposes, the point of transfer of ownership occurs when the parties enter into the note and mortgage or an Articles of Agreement for Deed rather than when the balloon payment is made or when the deed is issued.
Taxpayer Receiving Cash and a Note
It’s very common for the taxpayer/seller to receive money down from the buyer and to carry a note for the additional sum due.  At times, this arrangement is entered into because the parties wish to close, but the buyer’s conventional financing is taking more time than expected.  In this instance, the note should be made payable to the qualified intermediary (the exchange company).  To the extent that the buyer can procure the financing from the institutional lender before the taxpayer closes on the replacement property, the note may simply be substituted for cash from the buyer’s loan. 
It is more likely that the taxpayer’s 180 day exchange period will fall prior to the receipt of funds into the exchange account.  In this case, a solution is for the seller to “buy” his own note from his exchange account with fresh cash.  Essentially, the taxpayer advances personal funds into the replacement property while not receiving the equivalent amount of cash from the buyer at that time. These funds can be cash that the taxpayer already has available, or it can be from a loan that the taxpayer takes out to buy the note.  The benefit to the note buyout is that the future principal payments received by the taxpayer over time will be fully tax deferred. 
In the example above, care should be taken as to when the note (or installment agreement) should be turned over to the taxpayer. There is a natural tendency to pass the cash and note simultaneously. After all, the client is putting into the exchange account the exact same value that he is taking out.  However, because the regulations prohibit the taxpayer from the “right to receive money or other property pursuant to the security or guaranty arrangement,” it is probably better to receive the cash into the account sometime prior to the purchase of the replacement property, while assigning the note to the seller after all the replacement property has been acquired.  Some qualified intermediaries will have a form that they will sign acknowledging the substitution of cash for the note with a promise to distribute the note upon the closing of the exchange account.
Conclusion
There are various scenarios in which an installment sale can impact tax deferral.  In some cases deferral can be attained by the taxpayer’s substitution of cash into an exchange account for an installment note or a sale under articles of agreement for deed. In our next post, we examine more complex instances involving installment sales and 1031 exchanges.

Seller Financing in the Context of a 1031 Exchange
It is not unusual for a taxpayer to finance the buyer in whole or in part.  Such transactions may or may not involve the seller’s intent to complete a 1031 exchange.  The structure of the seller’s financing can take the form of a note and mortgage/deed of trust from the buyer or under Articles of Agreement for Deed.  The specific form should not impact the seller’s options in structuring an exchange as part of the transaction. 
Under an installment sale using a note and mortgage/deed of trust, the question frequently arises whether a taxpayer can structure an exchange when the balloon payment becomes due, rather than at the time the parties enter into the installment sale.  Similar questions are raised with Articles of Agreement for Deed – can the exchange be done at the time of the balloon payment when the buyer is receiving the deed? It cannot, since, for tax and legal purposes, the point of transfer of ownership occurs when the parties enter into the note and mortgage or an Articles of Agreement for Deed rather than when the balloon payment is made or when the deed is issued.
Taxpayer Receiving Cash and a Note
It’s very common for the taxpayer/seller to receive money down from the buyer and to carry a note for the additional sum due.  At times, this arrangement is entered into because the parties wish to close, but the buyer’s conventional financing is taking more time than expected.  In this instance, the note should be made payable to the qualified intermediary (the exchange company).  To the extent that the buyer can procure the financing from the institutional lender before the taxpayer closes on the replacement property, the note may simply be substituted for cash from the buyer’s loan. 
It is more likely that the taxpayer’s 180 day exchange period will fall prior to the receipt of funds into the exchange account.  In this case, a solution is for the seller to “buy” his own note from his exchange account with fresh cash.  Essentially, the taxpayer advances personal funds into the replacement property while not receiving the equivalent amount of cash from the buyer at that time. These funds can be cash that the taxpayer already has available, or it can be from a loan that the taxpayer takes out to buy the note.  The benefit to the note buyout is that the future principal payments received by the taxpayer over time will be fully tax deferred. 
In the example above, care should be taken as to when the note (or installment agreement) should be turned over to the taxpayer. There is a natural tendency to pass the cash and note simultaneously. After all, the client is putting into the exchange account the exact same value that he is taking out.  However, because the regulations prohibit the taxpayer from the “right to receive money or other property pursuant to the security or guaranty arrangement,” it is probably better to receive the cash into the account sometime prior to the purchase of the replacement property, while assigning the note to the seller after all the replacement property has been acquired.  Some qualified intermediaries will have a form that they will sign acknowledging the substitution of cash for the note with a promise to distribute the note upon the closing of the exchange account.
Conclusion
There are various scenarios in which an installment sale can impact tax deferral.  In some cases deferral can be attained by the taxpayer’s substitution of cash into an exchange account for an installment note or a sale under articles of agreement for deed. In our next post, we examine more complex instances involving installment sales and 1031 exchanges.