<p>Sales of wind farms and turbines is becoming increasingly common and could become more so as renewable energy continues to grow as a part of the U.S. energy infrastructure. Wind farms are a source of renewable energy found around the world, and we can expect to see this industry expand&nbsp;here in the States. The sale of a renewable energy asset such as a wind farm or turbine may be from one taxpayer to another, or to a company who is in the business of aggregating these assets for its own business of acquiring, owning, and leasing such assets. The value of the wind farm or turbine is largely a function of the value of the lease, i.e. the rent/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 tax deferred exchange under Section 1031 of the Internal Revenue Code can be the key to enabling a sale to take place by minimizing the tax burden to the seller.</p>

<h2>Use of Easement for Sale</h2>

<p>As many people know, <a href="https://www.accruit.com/blog/understanding-like-kind-requirement-1031-e…; target="_blank">1031 exchanges must involve like-kind property sold and purchased</a>. This means an interest in real estate must be exchanged for another interest in real estate. In the case of a solar farm sale, the key is structuring it so that the disposition of the asset is considered the sale of real estate. A sale of a lessor’s interest in a lease does not constitute a real estate interest. However, a real estate sale can be accomplished by creating, or transferring an existing easement, on which the solar arrays are situated. There is substantial case law providing that easements generally are a real property interest. <a href="https://www.irs.gov/pub/irs-wd/1149003.pdf&quot; target="_blank">One particular Private Letter Ruling</a> provides validation of such a structure for the exchange of a cell tower easement. Although a Private Letter Ruling is “private” and can only be relied on by the recipient, the IRS does publish them to let the public know its position on the subject of the ruling.</p>

<h2>Facts of the Private Letter Ruling</h2>

<p>Facts of the PLR included a proposed “exclusive easement” for the site of the cell phone tower and “non-exclusive easements” for road access to the tower, maintenance, and access to the rooftop. Transfer of the easement also included an assignment of the lease from the taxpayer to the easement owner. PLR references that most easements are perpetual unless the easement owner abandons the site for a number or years. It also states that a small number of easements are long term but not perpetual in duration.</p>

<p>This PLR provides a roadmap to structing an easement sale which includes the transfer of the lease of the cell tower or billboard located on the easement. It is important to note that the ruling references perpetual and long-term easements. That raises the question whether any wind farm or turbine sale requires a perpetual easement. In the PLR, the easement was to cease if the easement owner abandoned the property. That would seem to affect its otherwise perpetual nature. In addition, in the Analysis section of the PLR, the Service specifically noted that the “Taxpayer will acquire, own and lease perpetual and long-term easements…” [emphasis added]. In the Conclusion section of the PLR the Service states that “an easement acquired by Taxpayer under and Easement Agreement is an “interest in real property” that qualifies, under § 856(c)(5(B), as a real estate asset…”. There is no reference in the conclusion indicating that the long-term easement would be treated differently than a permanent easement.</p>

<h2>Summary</h2>

<p>There is an active market in the sale of wind farms and turbines. Similar renewable energy assets such as solar farms and arrays should be capable of being exchanged in the same manner as wind farms and turbines. While some of these assets are valued based upon the value of the lease associated with the asset, an owner’s interest in a lease cannot be the subject of a 1031 exchange. Private Letter Ruling 1149003 provides some guidance on how to structure the transfer of the lease value by selling the easement under the leased asset. To maximize the validity of the easement, it would be best if the easement were perpetual in nature. However, it may be possible to do the exchange that is long term in nature.</p>

<p>As always, it is always advisable to consult with professional tax or legal advisors before proceeding with such a transaction. Accruit has facilitated many of these types transactions over the years and is available to assist as the Qualified Intermediary.</p>

<p>Many investors are aware of 1031 exchanges&nbsp;and their usefulness in their real estate portfolios. These investors use a 1031 exchange to reposition their investments to other neighborhoods, or other states, or to redistribute their investments to different asset classes. However, many investors overlook the value of a 1031 exchange as an estate planning tool.</p>

<h2>The Situation</h2>

<p>Mr. Spencer currently owns a mixed-use building on a prime downtown corner in a small town in central New Jersey. There are 21 office spaces, four apartments, and off-street parking. Mr. Spencer’s current estate plan would have this property pass to his four grandchildren upon his death.</p>

<h2>The Problem</h2>

<p>Mr. Spencer’s new estate planning attorney has pointed out that if each grandchild inherits 25% of the same property, they may not be able to agree on what to do with the property when they inherit it. The attorney suggests that one may wish to sell the property to receive the cash windfall; another may wish to refinance it so they can make upgrades to it and increase the rent; the third may want to refinance it so that they can use the cash in other ways; and perhaps the fourth grandchild is a little Bohemian and cannot decide what he wants to do. At the same time, Mr. Spencer does not want to sell the property outright and pay hefty capital gains and depreciation recapture taxes.</p>

<p>Let’s assume Mr. Spencer acquired the property 20 years ago for $250,000 and has made $50,000 in improvements during that time and took approximately $125,000 in depreciation, resulting in an adjusted basis of $175,000. It is anticipated that the sale price of the existing property will be $850,000. Without a 1031 exchange, Mr. Spencer would be expecting to pay taxes as follows:</p>

<table align="center" border="0" cellpadding="5" cellspacing="1" style="width:750px;">
<tbody>
<tr>
<td>20% capital gains on the appreciation</td>
<td>($675,000 x 20%)</td>
<td>$13,500</td>
</tr>
<tr>
<td>25% recapture on depreciation taken</td>
<td>($125,000 x 25%)</td>
<td>$31,250</td>
</tr>
<tr>
<td>Affordable Care Act tax</td>
<td>($675,000 x 3.8%)</td>
<td>$25,650</td>
</tr>
<tr>
<td>NJ State capital gains on the appreciation</td>
<td>($675,000 x 8.97%)</td>
<td>$60,547</td>
</tr>
<tr>
<td>NJ State depreciation recapture</td>
<td>($125,000 x 8.97%)</td>
<td>$11,212</td>
</tr>
<tr>
<td>&nbsp;</td>
<td>&nbsp;</td>
<td>&nbsp;</td>
</tr>
<tr>
<td><strong>Total tax paid</strong></td>
<td>&nbsp;</td>
<td><strong>$142,159</strong></td>
</tr>
</tbody>
</table>

<p>&nbsp;</p>

<p>&nbsp;</p>

<h2>The Solution: 1031 Exchange</h2>

<p>Mr. Spencer will structure the sale of the existing mixed-use property as part of a Section 1031 tax-deferred exchange. He has determined that he will trade equal or up in value and maintain a mortgage of at least the same value as on the mixed-use property, to fully benefit from Section 1031.</p>

<p>Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Mr. Spencer’s 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, Mr. Spencer properly identified four identical condos in one condo complex, conveniently located less than a mile from the local university. Each condo will be acquired for $249,000, with a gross acquisition value of $996,000—which is greater than the sale price of his relinquished property. Closings for the four condos all occurred within 180 days of the sale of the relinquished property, utilizing the exchange proceeds held by the QI and additional mortgage financing.</p>

<p>Thereafter, Mr. Spencer revised his Will to direct that each grandchild would inherit their own condo.</p>

<h2>The Result</h2>

<p>Mr. Spencer has successfully completed a 1031 exchange from one relinquished property into four replacement properties. He exchanged equal or up in value, equal or up in equity, and equal or up in mortgage value, fully deferring the $142,159 in anticipated taxes. Upon Mr. Spencer’s eventual death, the grandchildren will inherit the condos at the fair market value as of the date of his death, receiving a step-up in the basis. The depreciation recapture and capital gains taxes will have been completely avoided.</p>

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

<h2>Can Franchise Rights be Exchanged?</h2>

<p>Since becoming law in 1921, the rationale for the inclusion of tax deferred exchanges in the IRS code, has been that a taxpayer who is vested with an asset and who receives in exchange other like-kind assets, and no cash, there is a continuity of holding the same or similar assets. Since the same kind of assets were sold and bought and the taxpayer pocketed no cash, the transaction isn't seen as a taxable event. The gain on the sale of the first assets, the relinquished property , is deferred until the acquired like-kind assets, the replacement property , are sold without a further exchange.</p>

<p>Upon the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, the types of assets qualifying for tax deferral through an exchange changed dramatically. Tax deferral through 1031 exchanges would only be allowed for what is considered real property (land, buildings, etc.) and not for personal property (heavy equipment, cars, franchises. Therefore, since the passage of the TCJA, the actual franchise rights no longer qualify for a like kind exchange to defer taxes on gains. However, should the investor own the underlying real property where the Franchise resides the investor still could qualify for an exchange on the underlying land/building.</p>

<h2>What Qualifies for Tax Deferral upon the Sale of a Franchise?</h2>

<p>Perhaps the most common inquiries around franchise exchanges are those that involve fast food restaurants. An owner might have one or more franchise locations that have greatly increased in value over time, value that the owner would like to parlay into additional restaurants. The exchange of such a business was formerly a more straightforward matter because the IRS regarded the business as a whole entity that included the value of any underlying assets. This changed shortly before 1991's exchange regulations, and now the IRS requires that each underlying asset be separated and valued individually.</p>

<p>For owners/investors of franchises this means that the value of the franchise rights are separate from the value of land, buildings and furniture, fixtures and equipment (FF&amp;E). A restaurant franchise valued at $300,000 for the franchise rights and $750,000 for the land/building can separate the sale of the land/building from the sale of the franchise rights. The land/building would then qualify for a like-kind exchange into land/building for a new franchise or a multitude of other real property deemed like-kind such as a multi-family rental building or farmland.</p>

<p>It's worth noting that any value associated with goodwill, including trademarks and trade names, is not capable of being exchanged, because the regulations state that goodwill is "inherently unique and inseparable from the business." For this reason, sellers of businesses may wish to minimize the value of the goodwill and increase another component asset of the sale which will be capable of receiving like-kind exchange treatment. Inventory and cash-on-hand are also not part of a franchise exchange since, unlike equipment, these assets are not held for use in a business or trade.</p>

<h2>Retaining the Services of a Qualified Intermediary</h2>

<p>A qualified intermediary (QI) is necessary for most exchanges in which the relinquished assets are sold to a buyer and the replacement assets are being acquired from a seller, who is not the same as the buyer of the relinquished assets. The taxpayer essentially sells the relinquished assets to the QI, who in turn sells them to the buyer. Similarly, the taxpayer purchases the replacement assets from the QI, who acquires those assets from the seller. In effect, the taxpayer completes an exchange with the QI. Selecting the correct QI is a decision that should not be taken lightly. Read on to learn more about the considerations for <a href="https://www.accruit.com/blog/1031-exchange-tips-selecting-right-qi&quot; target="_blank">choosing the right QI for your transaction</a>.</p>

<p>1031 like-kind exchanges or tax deferred exchanges have been part of the United States tax code since 1921, yet they continue to be the subject of a number of misconceptions, some of which are addressed below.</p>

<h2>Myth: 1031 like-kind exchanges are only for the wealthy</h2>

<p>This misconception arises from the visibility that high-profile companies or individuals have when exchanging a large office building or rental property and deferring the tax on the sale of that property. What is being missed is that average everyday people are utilizing like-kind exchanges as well.</p>

<p>A small business owner who owns his 25,000 sq ft warehouse can defer gain on the sale of that space when he uses the proceeds to purchase another building or even a piece of land. An individual who defers tax on selling a small rental property when she buys a replacement property is also taking advantage of Section 1031 of the tax code. These sorts of transactions made by small businesses and middle class investors are frequent, even if they don’t make the headlines.</p>

<p>I had the opportunity to meet a teacher recently in Denver, Colorado who, upon learning about our company, related her own like-kind exchange story. She had purchased a rental home four years ago for a terrific price, and when the market went up, she was able to enter into a contract to sell it for a profit. She was lucky to have a smart accountant who advised her to structure the transaction as an exchange with a qualified intermediary enabling her to reinvest all of the proceeds in another rental, thereby deferring tax on the sale. She did so and has now profited enough to secure a down payment on three rental properties, about which she remarked, “On a teacher’s salary, without 1031s, I would never have been able to own three rentals.”</p>

<h2>Myth: A 1031 exchange must be simultaneous</h2>

<p>When the tax code was first added in 1921, all exchanges were simultaneous. Over time, the <a href="https://www.accruit.com/blog/1031-exchange-any-other-name&quot; target="_blank">two-party simultaneous exchange</a> was expanded a bit in order to provide greater opportunity to complete an exchange.&nbsp;The most common type of 1031 exchange is a forward exchange, in which the proceeds from the sale of one asset is used to purchase an asset considered to be like-kind within 180 days.</p>

<p>There are other <a href="https://www.accruit.com/blog/what-are-1031-exchange-deadlines&quot; target="_blank">1031 exchange deadlines</a>, but the 180-day completion period allows for non-simultaneous exchanges. It is even possible, in a <a href="https://www.accruit.com/blog/are-1031-reverse-tax-deferred-exchanges-re…; target="_blank">reverse exchange</a>, to purchase replacement property up to 180 days prior to selling the relinquished property.&nbsp;</p>

<h2>Myth: The relinquished property must be exactly the same as the replacement property in order to be “like-kind”</h2>

<p>In real estate, the term “like-kind” is remarkably broad. In fact, all real estate property is considered “like-kind.” Land can exchange into an office building; a rental home can exchange into a Delaware Statutory Trust (DST); a multi-family complex can exchange into twenty rental homes. The list could go on, but the point is that there are many options in real estate when doing an exchange.&nbsp;</p>

<h2>Myth: 1031 exchanges are a tax loophole</h2>

<p>Congress established 1031 like-kind exchanges as part of the Internal Revenue Code in 1921 with two primary purposes:</p>

<ul>
<li>To avoid unfair taxation of ongoing investments</li>
<li>To encourage active reinvestment</li>
</ul>

<p>Nearly 100 years later, like-kind exchanges continue to support sales and purchases of real estate and business assets, encourage business expansion, and <a href="https://www.accruit.com/blog/1031-like-kind-exchange-impact-study-resul…; target="_blank">stimulate economic growth</a>. They are an <a href="https://www.accruit.com/blog/preserving-section-1031&quot; target="_blank">intentional and integral aspect of United States tax law</a>, not a tax avoidance strategy. In fact, about 88% of properties acquired through an exchange are later sold through a taxable event.</p>

<h2>Conclusion</h2>

<p>Clearing up the misconceptions about what 1031 like-kind exchanges are and how they work continues to be part of Accruit’s mission, since the first step to employing like-kind exchanges is understanding them. If there’s any audience to whom the use of 1031s is limited, it’s the informed.</p>

<p>Most people are aware that the federal tax law changed at the beginning of 2018 due to the passage of the Tax Cuts &amp; Jobs Act. Some of the significant changes included reducing the capital gain rates and lowering tax rates on corporations. Among other things&nbsp;<a href="https://www.accruit.com/blog/tax-cuts-and-jobs-act-2017-and-its-effects…; target="_blank">the Act eliminated personal property from the tax deferral provisions of IRC §1031</a>, leaving only real estate as an asset eligible for such deferral. This was a significant departure from how §1031 was utilized by taxpayers since its inception in 1921.</p>

<p>Many types of real estate include machinery, equipment and other components that may or may not be considered part of the real estate. Before the change in the law, it was not quite as significant whether those items were so inherently a part of the real estate that they were deemed real estate itself. If they were determined to be personal property and it was likely the trade would include like kind replacement personal property, then the character would not matter much; the real estate portion would be deferred as would the personal property portion.</p>

<p>In order to add clarity to these determinations as to what constituted real estate in this context, in <a href="https://www.accruit.com/blog/proposed-regulations-1031-exchange&quot; target="_blank">June of 2020, the IRS put out proposed regulations</a> on the subject. Essentially, each component had to be analyzed separately to determine whether it was land, an inherently permanent structure, or a structural component of an inherently permanent structure. Land was rather clear but some of the other determinations were difficult to make. For instance, in regard to a component of a structure, the determination was largely based upon function. An example in the regulations referenced different treatment for a gas line that serviced the property generally for heating purposes,&nbsp;compared to a gas line that was used for cooking food that was served by the business. The former was considered part of the real estate for exchange purposes and the latter being used towards the “production of income” and therefore not so. Furthermore, the proposed regulations suggested that reference to local law characterization would not be taken into consideration. This was a departure from prior analyses where local law was a significant part of the determination.</p>

<p>In any event, the IRS took into consideration the significant amount of feedback received and changed the final regulations in favorable ways. Under the final regulations, the asset is considered real estate if (i) it is specifically listed as such in the regulations or (ii) if it is real estate under state or local law and last (iii) if it is “considered real property based on all the facts and circumstances under the various factors provided in the final regulations.”</p>

<p><em>It should be worth noting that the classification of an asset for exchange purposes is not determinative of its classification for other purposes such as taking of depreciation. The asset can be considered real estate for one purpose and personal property for another.</em></p>

<p>The final regulations introduced another favorable rule. After personal property exchanges were disallowed, if exchange funds were directed to a closing for the purchase of replacement property whose purchase price included a personal property component, the exchange could be put at risk. This was seen as an unpermitted use of exchange funds on the part of the taxpayer which, in turn, violated the entire exchange. To provide a solution to this dilemma, the service borrowed on a provision from the original exchange regulations regarding the identification of personal property that was typically incidental to the real property. Examples are office furnishings in the purchase of an office building or hotel furnishings with the purchase of the hotel. This rule, known as the “incidental property rule” states that the personal property did not have to be separately identified from the real property but must be incidental to the real replacement property, having an aggregate fair market value not greater than 15% of the fair market value of the real estate, and must typically be transferred with the real property in a standard commercial transaction. Under the final regulations should part of the purchase price of the real estate include the value of personal property fitting this definition, it will not be considered “actual or constructive” receipt of the funds by the taxpayer otherwise compromising the exchange.</p>

<p>Again, it should be noted that this rule pertains to avoiding a taxpayer getting boxed in when a real estate purchase includes some customary personal property that is not being paid for separately. However, that is not to say that it is disregarded nor considered part of the real estate for gain purposes. It still retains its character as non like-kind property compared to the original sale of real estate.</p>

<p>If you have questions about an exchange that includes property as described above, please&nbsp;get in touch with one of our subject matter experts to discuss your situation specifically.</p>

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<p>After the real estate transactions in a 1031 exchange have been completed, there is a final step to report the exchange to the IRS so that the deferral is recognized. <a href="https://www.irs.gov/instructions/i8824&quot; target="_blank">Filing form 8824</a> is not simply "another" tax form. It is a critical step to appropriately document that a like-kind exchange has occurred. Once those financial statements are complete, accountants can utilize this information to prepare related tax returns. For owners who have completed a <a href="https://www.accruit.com/blog/understanding-like-kind-requirement-1031-e…; title="1031 like-kind exchange">1031 like-kind exchange</a>, Form 8824 will need to be prepared and filed with the Internal Revenue Service (IRS).</p>

<h2>What is Form 8824?</h2>

<p>Titled, “Like-Kind Exchanges (and section 1043 conflict-of-interest sales)," Form 8824 serves two primary purposes:</p>

<ul>
<li>To allow business owners to report the deferral of gains through Section <a href="https://www.accruit.com/blog/primer-1031-exchanges-and-related-types-ex…; title="1031 tax deferred exchange">1031 tax deferred exchange</a> transactions</li>
<li>To allow certain members of the Federal Government to report the deferral of gain through conflict-of-interest sales</li>
</ul>

<p>The form is divided into four distinct parts, including:</p>

<ul>
<li>Part I – Information on the like-kind exchange</li>
<li>Part II – Related Party Exchange Information</li>
<li>Part III - Realized Gain or (Loss), Recognized Gain, and Basis of Like-Kind Property Received</li>
<li>Part IV – Deferral of Gain From Section 1043 Conflict-of-Interest Sales</li>
</ul>

<h2>Part I – Information on the Like-Kind Exchange</h2>

<p>This section covers the basics of the <a href="https://www.accruit.com/property-owners/1031-exchange-explained&quot; title="1031 exchange">1031 exchange</a>, including:</p>

<ul>
<li>Description of the like-kind property (given up)</li>
<li>Description of the like-kind property (received)</li>
<li>Date the given-up property was originally acquired</li>
<li>Date the received property was actually received</li>
</ul>

<p>Part one also asks if any like-kind property was either sold to or purchased from a related party. If the answer is yes, then the form’s preparer must complete Part II. If the answer is no, then the preparer may skip Part II and move on to complete Part III.</p>

<h2>Part II – Related Party Information</h2>

<p>It’s interesting to note, this section does not require any calculations. It simply asks for some basic information about the related party transaction, including:</p>

<ul>
<li>The related party’s name, address and relationship</li>
<li>Timing of any dispositions (by the related party) of the property received from property owner</li>
<li>Timing of dispositions related to the property acquired</li>
</ul>

<h2>Background on Related Parties</h2>

<p>Part II addresses very specific concerns regarding what is known as basis shifting. In these transactions, <a href="https://www.accruit.com/blog/1031-tax-deferred-exchanges-between-relate…; target="_blank">related parties were working together by exchanging low basis property for high basis property</a> with the immediate plans to sell, at a gain, the lower basis property. By following this strategy, related taxpayers were effectively reducing the gain on the sale of the low basis property. For like-kind exchange purposes, related parties are defined under Internal Revenue Code Section 267(b) or 707(b)(1) and can include:</p>

<ul>
<li>Family members, including brothers and sisters, husbands and wives, lineal descendants, ancestors</li>
<li>Individuals and corporations, where more than 50% of the value of the stock is owned directly or indirectly by or for the individual</li>
<li>A corporation and a partnership if the same persons own more than 50% in the value of the outstanding stock of the corporation and more than 50% of the capital interest or profits interest in the partnership.</li>
</ul>

<h2>Part III – Realized Gain or Loss, Recognized Gain, and Basis of Like-Kind Property Received</h2>

<p>This entire section is dedicated to determining the results of the like-kind exchange. Of the 14 total lines contained within this section, eight are simple addition and subtraction fields. This leaves the form’s preparer with some additional work to gather the data for the remaining six fields. It’s critical to avoid being fooled by the form’s apparent simplicity. The tax preparer must understand the precise meaning of this section’s terminology and each line’s requirement in order to complete the form correctly. Amongst other things, Part III will require the following:</p>

<ul>
<li>Fair market value and adjusted basis of other property given up</li>
<li>Cash received and fair market value of other property received</li>
<li>Net liabilities received by the other party</li>
</ul>

<h2>Part IV – Deferral of Gain From 1043 Conflicts-of-Interest Sales.</h2>

<p>This section, although provides a reporting requirement for a deferral of Gain, has little to do with a like-kind exchange. Part IV requires reporting on capital gains deferral on the sale of the property that would cause a conflict for those serving as an officer or employee of the executive branch of the federal government. Congress enacted section 1043 to further the collective good by eliminating a tax-based barrier for entry into public service. Interesting, but not relevant to 1031s.</p>

<h2>Summary</h2>

<p>For the vast majority of property owners, part IV of Form 8824 will simply not apply, and as such it can be ignored. However, property owners should carefully report each and every exchange of like-kind property using the first three parts of this form. In doing so, property owners can effectively communicate to the IRS why the disposition(s) of their real estate, should not trigger any income taxation.</p>

<p>Accruit is a&nbsp;<a href="https://www.accruit.com/property-owners/work-with-us&quot; tabindex="-1" title="1031 Exchange Qualified Intermediary">1031 Exchange Qualified Intermediary</a>&nbsp;and facilitates 1031 exchanges. Always consult your CPA or tax advisor for advice pertaining to your specific tax situation. For more information, visit&nbsp;<a href="https://www.accruit.com/&quot; tabindex="-1" title="www.accruit.com">www.accruit.com</a>&nbsp;or call (800) 237-1031.</p>

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