<p>Many investors are aware of 1031 exchanges, and their usefulness in their real estate portfolios. These investors use 1031 exchange to reposition their investments to other neighborhoods or other states, or to redistribute their investments to different asset classes. In today's blog post, we explore how to benefit from a 1031 exchange in a sale-leaseback transaction.</p>

<h2>The Situation</h2>

<p>Fred owns an auto repair shop in a busy downtown neighborhood. Fred purchased his shop 20 years ago for $200,000 when it was considered an up-and-coming portion of the city. Today the street where his shop sits is a busy downtown area with mixed-use properties driving the economy. Property values in and around the neighborhood have increased steadily during the past 20 years leaving Fred with a building worth $1,000,000. Business is good and Fred wants to expand into 2 additional shops in the suburbs that each of his children can run.</p>

<h2>The Problem</h2>

<p>Neither Fred nor his children have the capital to invest into two new shops without taking on additional debt or investors. The current building holds a lot of embedded value, but Fred cannot access the cash from this embedded value without selling the property. The real estate in the suburbs is affordable now, but they believe prices will continue to rise making future expansions even more difficult. Selling the property without completing a 1031 exchange would result in the following taxes for Fred’s business:</p>

<table align="center" border="0" cellpadding="5" cellspacing="1" style="width:750px;">
<tbody>
<tr>
<td>Capital gains on the appreciation</td>
<td>($800,000 x 20%)</td>
<td>$160,000</td>
</tr>
<tr>
<td>Affordable Care Act tax</td>
<td>($800,000 x 3.8%)</td>
<td>$30,400</td>
</tr>
<tr>
<td>Estimated state capital gains tax</td>
<td>($800,000x4.63%)</td>
<td>$37,040</td>
</tr>
<tr>
<td>Depreciation recapture</td>
<td>($102,564 x 25%)</td>
<td>$25,641</td>
</tr>
<tr>
<td>&nbsp;</td>
<td>&nbsp;</td>
<td>&nbsp;</td>
</tr>
<tr>
<td><strong>Total estimated tax owed</strong></td>
<td>&nbsp;</td>
<td><strong>$253,081</strong></td>
</tr>
</tbody>
</table>

<p>&nbsp;</p>

<p>&nbsp;</p>

<h2>The Solution: Sale-Leaseback, Coupled with a 1031 Exchange</h2>

<p>A sale-leaseback transaction occurs when an owner of a real estate asset sells the property and immediately signs a long-term lease agreement with the new owner to pay rent to occupy that same property. By completing a sale-leaseback, the seller/lessee can tap into capital otherwise locked inside an asset. The seller/lessee can sign a long-term triple-net (“NNN”) lease to control expenses. To maximize the funds to reinvest, the seller/lessee can complete a 1031 exchange on the sale-leaseback transaction.</p>

<p>Fred can enter into a sale-leaseback transaction on his original shop. This means Fred will continue to use the property for his auto-repair business by entering a long-term lease to pay monthly rent payments to the new owner. Fred can structure the lease as an NNN, so he pays all utilities and keeps everything in his business’ name for continuity purposes. Fred can trade equal or up in value of the $1,000,000 price from his original shop by either purchasing existing structures or completing a parking Improvement exchange to trade into new property within 180 days of closing on the sale-leaseback transaction.</p>

<h2>The Result</h2>

<p>Fred has successfully completed a 1031 exchange from one original asset to two new shops while continuing to keep his original business running. Fred acquired two properties in the suburbs to expand his business without taking on additional debt or losing majority control of his business to equity partners. By completing a 1031 exchange Fred is able to tap into his original property’s capital, defer the long-term capital gains, and grow his auto shop’s income stream.</p>

<p>Many investors are aware of the value of Section 1031 exchanges in their real estate portfolios. These investors use 1031 exchange to reposition their investments to other neighborhoods or other states, or to reallocate their investments to different asset classes.</p>

<h2>The Situation</h2>

<p>Andrea currently owns a mixed-use building with 5 residential units above a retail storefront. The property also has ample off-street parking on a 1½ acre lot and is situated near a busy commuter road. Nonetheless, her income from the property is limited due to the market rate for this type of property in her community. Andrea acquired the property about ten years ago for $500,000. A developer is interested in the converting the property into a convenience store and gas station, and has offered Andrea $700,000, which she is considering accepting.</p>

<h2>The Problem</h2>

<p>Andrea has grown disillusioned with the property because her state imposes stricter regulations on properties with five units or more, as well as the limited cash flow potential. She had been considering selling the property anyway, but her accountant has just told her that she will have a sizeable tax bill if she sells outright. In round numbers, Andrea can expect to pay taxes as follows:</p>

<table align="center" border="0" cellpadding="5" cellspacing="1" style="width:750px;">
<tbody>
<tr>
<td>Depreciation recapture tax</td>
<td>($128,000 x 25%)</td>
<td>$32,000</td>
</tr>
<tr>
<td>Capital gains tax</td>
<td>($200,000 x 20%)</td>
<td>$40,000</td>
</tr>
<tr>
<td>Estimated state capital gains tax</td>
<td>&nbsp;</td>
<td>$26,240</td>
</tr>
<tr>
<td>Affordable Care Act tax</td>
<td>($328,000 x 3.8%)</td>
<td>$12,464</td>
</tr>
<tr>
<td>&nbsp;</td>
<td>&nbsp;</td>
<td>&nbsp;</td>
</tr>
<tr>
<td><strong>Total estimated tax owed</strong></td>
<td>&nbsp;</td>
<td><strong>$110,704</strong></td>
</tr>
</tbody>
</table>

<p>&nbsp;</p>

<p>&nbsp;</p>

<p>Selling the property outright would net Andrea approximately $589,000 after the taxes. While Andrea wants to get away from the burdensome restrictions imposed on her by the state, and the developer’s offer is tempting, the prospect of losing nearly 16% of the sale price to taxes is less palatable than dealing with the state rules and regulations and limited cash flow.</p>

<h2>The Solution: A 1031 Exchange into Multiple Short-term Rental Properties</h2>

<p>Andrea will structure the sale of the building as part of a Section 1031 Like-Kind Exchange. After consulting with her attorney and a Qualified Intermediary (“QI”) like Accruit, Andrea now understands that “like-kind” does not require her to replace the old property with a multi-family or mixed-use property.</p>

<p>Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Andrea’s QI to be held on her behalf until the purchase of her 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.</p>

<p>Within 45 days after the closing on the sale, Andrea properly identified five furnished rental condos for approximately $150,000, for a total investment of $750,000. (Learn more about <a href="https://www.accruit.com/blog/what-are-rules-identification-and-receipt-…; target="_blank">Identification rules in 1031 exchanges</a>.) Closings on the various condos occurred over the next several months, well within 180 days of the sale of the relinquished property, utilizing the exchange proceeds held by the QI. After closing, each of the properties will be listed as short-term rentals on Airbnb, VRBO, or similar services. Andrea has now shifted her equity to multiple properties with significantly higher cash flow potential, without recognizing the gains.</p>

<p>Technically speaking, the furniture in the condos could be considered “boot” as it is not real estate. However, the furniture is used, and has been assigned a value of less than $10,000 in each of the units, for an aggregate value of less than $50,000. Since she will be selling the old property for $700,000, and the value of the new properties is $700,000, she will not be facing any taxable boot issues. Andrea will now be free of the more stringent rules imposed on properties greater than four units, and has prospects of better cash flow as well. Andrea structured the sale of the old property as part of a Section 1031 tax-deferred exchange, and has exchanged into replacement properties of equal value, to fully benefit from Section 1031.</p>

<h2>The Result</h2>

<p>Andrea has successfully completed a 1031 exchange from one mixed-use multi-family relinquished property into multiple replacement properties. She exchanged equal or up in value, using all of her equity, fully deferring the anticipated capital gains and depreciation recapture taxes. Andrea has now escaped the onerous burdens imposed by her state on owners of properties with more than four units, and is anticipating better cash flow as well.</p>

<p>Review the <a href="https://www.accruit.com/services/1031-exchange#Forward%20Exchange&quot; target="_blank">basics of&nbsp;Forward Exchange</a>, which you may review with your tax and legal advisors.</p>

<p>Before the COVID-19 pandemic, the $16 trillion US commercial real estate (CRE) market was enjoying over a decade of positive growth when examining CRE prices, transaction volume, CRE equity markets and mortgage originations. With the onset of COVID-19 in Q1 2020, not only did the CRE markets freeze, they also remained in limbo for most of the summer of 2020. CRE landlords were immediately faced with the realization that tenants perhaps would not be returning in the coming months, if not at all in the future.</p>

<p>CRE investments are typically long-term holds balanced by occupancy rates, economic conditions, capitalization rates, liquidity opportunities,and effective operational environments. But that was then,and this is now.</p>

<h2>The Post-Pandemic Shift in Commercial Real Estate</h2>

<p>To retain optimal use of CRE in our nation, the ability to repurpose effectively is a must. It is critical to both the stability of markets and our overall economy. In a study by the Bureau of Economic Analysis presented by Deloitte in July 2019, it was estimated that the finance, insurance, and real estate markets make up the largest portion of the US GDP, holding just over 20%. The largest sector of real estate includes multi-family housing, office building, hotels, retail, and dining, all of which are suffering in this new era, while the other contributors to CRE—industrial, data centers and technology supporting properties—are all flourishing.</p>

<p>A significant amount of CRE is held in large investor funds, REITS, DST (Delaware Statutory Trusts) or other passive investment vehicles. These investors not only demand a return on invested dollars, but also, they must ensure their investments are being efficiently deployed. Absent a long-term strategy to effectively repurpose non-producing real estate investments, economic recovery will lag. So,to ensure that any unnecessary friction during a recession does not impede growth, investment goals, and overall job expansion, our Congress must balance short-term gain against sustained economic growth as we cautiously move into 2021.</p>

<h2>1031 Exchange is an Asset</h2>

<p>Like-kind exchanges, or Section 1031 as referenced&nbsp;in our tax code, promote the free movement of real estate investments without burdening the investor with untimely taxes if the intent is simply repurposing unproductive properties. Think about moving real estate investments from a retail mall or shopping center to a state-of-the-art industrial warehouse facility. Since 1921, Section 1031 of the Internal Revenue Code has continued to remove unnecessary friction to support efficient deployment of capital invested in the largest sector of our GDP. Under Section 1031, 100% of qualifying exchange proceeds must be deployed in other qualifying real estate. Additionally, the economic impact of reducing friction encouraged by 1031 exchanges provides revenue opportunities to real estate brokers and dealers, title agents, attorneys, moving companies, interior designers, landscape firms, remodeling professionals to name just a few.</p>

<p>Over the next five plus years, our CRE markets will migrate to support a hybrid of then and now. More warehouses, less retail. Individual workspaces over small cubicles. Work from home being the norm, not the exception. Redefining the restaurant experienceby allowing for expanded dining spaces and larger prepping areas for online ordering. The CRE market will change as we know it today so long as the right incentives are maintained and those growing the economy are not penalized by contributing to its growth.</p>

<p>Even with a vaccine in our sights, the CRE markets are poised to be reinvented. Like-kind exchanges play an important role to accelerate the CRE transformation and provide the right tool to not only recover, but also stimulate our economy.</p>

<p>Discuss your 1031 exchange options with one of our subject matter experts.</p>

<p>&nbsp;</p>
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<h2>The Situation</h2>

<p>George and Martha Campbell currently own a 15-acre farm that has been in his family for generations. George inherited the farm 20 years ago when his father died. The farm is situated along a busy road, including a prime intersection in a small town in central New Jersey. Residential, multi-family, and office development have been very active in recent years, and the Campbells frequently receive solicitations from developers. The Campbells would like to pass the farm onto their children and grandchildren, and certainly want to see the family’s heritage preserved.</p>

<h2>The Problem</h2>

<p>The Campbells are getting older and no longer have the energy to operate the farm in a manner that makes it self-sufficient. Getting up before sunrise and working until sunset or beyond has taken its toll on the Campbells. Planting the hay, maintaining the equipment, and then harvesting the hay is a business better suited for a younger couple. Fluctuations in the price of hay, along with the complete lack of cashflow for months at a time, only serve to exacerbate the problems the Campbells are facing. Mr. Campbell would prefer to pass the farm onto his children and grandchildren, and he certainly does not want to sell the property outright and pay hefty capital gains taxes.</p>

<p>Let’s assume that Mr. Campbell inherited the property 20 years ago, and the fair market value at the time was $1,000,000. It is anticipated that the value of the entire property in an outright sale would be more than $2,500,000. Without a 1031 exchange, the Campbells would be expecting to pay taxes as follows:</p>

<table align="center" border="0" cellpadding="5" cellspacing="1" style="width:750px;">
<tbody>
<tr>
<td>Capital gains on the appreciation</td>
<td>($1,500,000 x 20%)</td>
<td>$300,000</td>
</tr>
<tr>
<td>Affordable Care Act tax</td>
<td>($1,500,000 x 3.8%)</td>
<td>$57,000</td>
</tr>
<tr>
<td>NJ State capital gains on the appreciation</td>
<td>($1,500,000 x 8.97%)</td>
<td>$134,550</td>
</tr>
<tr>
<td>&nbsp;</td>
<td>&nbsp;</td>
<td>&nbsp;</td>
</tr>
<tr>
<td><strong>Total estimated tax owed</strong></td>
<td>&nbsp;</td>
<td><strong>$491,550</strong></td>
</tr>
</tbody>
</table>

<p>&nbsp;</p>

<p>&nbsp;</p>

<h2>The Solution: A Conservation Easement, Coupled with a 1031 Exchange into Delaware Statutory Trusts</h2>

<p>The Campbells will sell a conservation easement, permanently restricting the use of the property to farm-related uses. They will be able to continue to farm as much or as little of the farm as they wish and may even convert to a less labor-intensive operation. The total sale price of the easement will be $2 million, and the Campbells will structure the sale as part of a Section 1031 tax-deferred exchange. They will trade equal or up in value, to fully benefit from Section 1031.</p>

<p>Upon the sale of the farm, the exchange proceeds were sent directly to the Campbells’ qualified intermediary (“QI”) to be held in escrow until the purchase of his replacement properties.</p>

<p>Within 45 days after the closing on the sale, the Campbells properly identified interests in a variety of Delaware Statutory Trusts. (<a href="https://www.accruit.com/blog/delaware-statutory-trusts-1031-exchange-in…; target="_blank">More information about 1031 exchanges into DSTs</a>) Closings on the various DSTs occurred over the next several weeks, well within 180 days of the sale of the relinquished property, utilizing the exchange proceeds held by the QI.</p>

<h2>The Result</h2>

<p>The Campbells have successfully completed a 1031 exchange from one labor intensive relinquished property into multiple passive replacement properties. They exchanged equal or up in value, using all their equity, fully deferring the anticipated capital gains taxes. The Campbell farm has now been preserved against future development, and the DSTs are generating passive income for the Campbells that exceeds their farm-related income.</p>

<p><a href="https://www.accruit.com/services/1031-exchange#Forward%20Exchange&quot; target="_blank">Learn more about the step-by-step processes</a> involved in completing a tax deferred exchange and review with your tax and legal advisors.</p>

<p>Accruit is seeing more and more investors and companies leveraging the benefits of 1031 exchange to go “green” by investing in energy efficient buildings and renewable energy like solar arrays and wind farms. Beyond the purely environmental benefits, companies and investors are realizing the added investment value and cost savings of these green investments. This includes lower ongoing energy costs, higher resale values, stable income production and upfront and ongoing tax incentives.</p>

<p>Our customers are accomplishing the alignment of their investment and environmental objectives in a multitude of ways:</p>

<ul>
<li>Investors or businesses may currently own a property where they don’t have the capital or desire to retrofit it to be more energy efficient, but also have a large gain if they sold and then moved to a new location. Using a 1031 Exchange the owner of the building can exchange out of the energy inefficient property and into a ‘greener’ building, deferring taxes on their gains in their original property.</li>
<li>Similar to the previous scenario, but the investor can’t find an energy efficient new building to purchase. Many real estate investors and companies are unaware that they can leverage a 1031 exchange to purchase and then make substantial improvements to that property over a 180-day period. In this case, the investor can leverage an improvement exchange to sell their current property and use the proceeds to purchase and then improve the new property to become more energy efficient.</li>
<li>An investor wishes to exchange into or out of a solar or wind farm. The value of solar arrays or wind farms is largely a function of the value of the lease, i.e. the rent or royalties, term, and strength of the lessee. Oftentimes the sale prices can be considerable, which in turn, may cause a significant tax event to the seller . In many instances, the availability of a 1031 exchange can be the key to enabling a sale to take place by minimizing the tax burden to the seller</li>
</ul>

<p>Everyone agrees that going green is good for the environment, but the cost of doing so can take a bite out of the bottom line. There are numerous upfront and ongoing tax benefits to encourage investment, but that may not be enough to overcome the upfront negative tax implications of selling property at significant gain.</p>

<p>This isn't the case if the power of the 1031 exchange is utilized. An exchange will allow real estate investors and companies to apply capital to a green investment that they would normally have to pay to the IRS. This is called leverage, and it is one of the great benefits of the 1031 exchange. Having this money available to purchase or improve new property can also negate the need for a lender.</p>

<p>So go ahead - go green and save some green at the same time.</p>

<p>For additional reading on green energy, real estate, and 1031 exchange, <a href="https://www.accruit.com/blog/renewable-energy-1031-exchanges-wind-farms…; target="_blank">see our recent article about windfarms and turbines</a>.</p>

<p>Since 1921, the rules for qualifying and completing 1031 exchanges have gradually broadened and become less restrictive. Even so, there are do’s and don’ts as well as several gray areas of which taxpayers should be aware. The topics below could each be the subject of their own post. They are raised here to draw your attention, and to invite further discussion with your advisors, and the team at Accruit.</p>

<h2>Holding periods</h2>

<p>There are no standard or specific holding periods by which a taxpayer must abide for property to meet the definition of “like kind” or held for investment or business use (the only exception is Related Parties, discussed below). Holding periods are, therefore, determined on a case-by-case basis regarding the taxpayer’s genuine intentions based in part on: (i) their reasons for acquiring, holding, and disposing of the property; (ii) the taxpayer’s primary occupation; (iii) previous 1031 exchange activity; and (iv) use of property. Generally, the longer the holding period the better. However, a taxpayer who is disqualified from utilizing the benefits of Section 1031 would not then qualify merely because of a long holding period. What the Code, the courts, and the IRS want to prevent is taxpayers holding property primarily for sale and attempting to defer their taxes utilizing Section 1031 (e.g., a builder of residential subdivisions).</p>

<h2>Related parties</h2>

<p>The current rules are complex and restrictive, and all potential related party exchangers are encouraged to seek the guidance of their tax and legal counsel. Selling a relinquished property to a related party as part of an exchange transaction may be acceptable, provided the related party holds the property for a mandatory 24-month holding period. Acquiring a replacement property from a related party with exchange funds may also be acceptable, if the related party does their own 1031 exchange and holds their replacement property for two years and does not “cash out” of that property. (<a href="https://www.buzzsprout.com/270590/5561182">Listen to Max Hansen discuss the intricacies of related party issues</a>)</p>

<h2>Different entities</h2>

<p>Generally, to qualify for Section 1031 the same entity that transferred the relinquished property must acquire the replacement property. For example, if the old property is being sold by an LLC, the new property should be acquired by the same LLC. It clearly should not be acquired by another entity, which would be a completely different taxpayer. There are some limited exceptions in the event an LLC is a single-member LLC, and the new property is being acquired by a new LLC with the same single member as the former LLC.</p>

<p>A similar issue arises when spouses are involved in an exchange transaction. For example, if the old property is owned solely by Husband, the new property should not be acquired by Husband and Wife. Conversely, if the old property is owned by Husband and Wife, the new property should be acquired in the same fashion. There are some very narrow exceptions to these rules, which go beyond the scope of this newsletter.</p>

<h2>Already owned property</h2>

<p>The “like kind” requirement will not have been met if the taxpayer attempts to transfer any exchange value from the relinquished property into property the taxpayer already owns. For example, the taxpayer cannot reinvest the proceeds from the sale of a relinquished property into upgrades at taxpayer’s other property. Further, the proceeds from the relinquished property may not be used to pay down existing debt on taxpayer’s other property.</p>

<h2>Refinance</h2>

<p>It is generally accepted that the taxpayer can receive equity from the replacement property through the placement of a new loan (refinance). However, the taxpayer must not refinance the old or relinquished property “in anticipation” of an exchange by placing a loan on the relinquished property once the taxpayer has taken steps to dispose of such property unless the taxpayer: 1) uses those proceeds to acquire or improve the replacement property, and 2) has no actual or constructive receipt of such proceeds. It generally helps is there is a bona fide business reason for any refinance within the parameters of an exchange transaction.</p>

<h2>Dissolution of a partnership</h2>

<p>The Code is clear – partnership interests do not qualify for Section 1031 tax deferral. Yet taxpayers’ advisors routinely recommend the following strategy:</p>

<ol>
<li>Dissolve partnership.</li>
<li>Create new entity (tenancy-in-common).</li>
<li>Distribute pro-rata share to individuals (previously partners).</li>
<li>Exchange individual tenancy-in-common interests at will.</li>
</ol>

<p>Two fundamental problems arise from this advice:</p>

<p>1. The Code requires that property must be “held for productive use in a trade or business or investment.” This implies there must be a holding period, for tenancy in common interests distributed out of a partnership although, as discussed above, the holding period requirement is uncertain. (<a href="https://www.accruit.com/blog/1031-drop-and-swap-out-partnership-or-llc&…; target="_blank">Read more about&nbsp;“Drop and Swap” exchanges</a>)</p>

<p>2. If the new structure is construed by the IRS as merely a strategy or series of steps to avoid the exclusion pertaining to partnership interests, the exchange would be disallowed.</p>

<h2>Terminating an exchange and receiving the net proceeds</h2>

<p>Occasionally, a taxpayer wants or needs to terminate an exchange after the net proceeds have been transferred to the Qualified Intermediary. Pursuant to the Treasury Regulations and a valid exchange agreement, the taxpayer may receive the net proceeds:</p>

<ol>
<li>After the 45-day identification period if there are no properties identified, or</li>
<li>After the 45-day identification period but before the end of the 180-day exchange period if all identified properties have been acquired, or</li>
<li>After the 180-day exchange period.</li>
<li>Upon the occurrence of a “material and substantial” contingency that the taxpayer had provided for at the time of identification. (An example could be that the taxpayer identified the property subject to the ability to have the zoning changed before the end of the exchange period. <a href="https://www.accruit.com/blog/like-kind-exchange-insight-when-can-exchan…; target="_blank">Read more&nbsp;on the release of exchange funds</a>)</li>
</ol>

<h2>Conclusion</h2>

<p>If any of these issues is or may be present in your 1031 exchange, it is strongly recommended that you discuss them with your tax and legal advisors, and your qualified intermediary, as soon as possible. Accruit’s leadership team has over 170 years of combined experience in working with taxpayers and their advisors in structuring successful 1031 exchanges.</p>

<p>At Accruit, we handle all types of complex exchanges. Have a situation you'd like to speak to an expert about? No problem. We're happy to have a free, no-obligation consultation with you.</p>
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