<p>Because we live in such a rapidly changing business environment, I find that people enjoy input and feedback from other business owners on matters of tax and finance. What works and why? What ideas and strategies am I missing? Is there a reason other business owners are adopting certain strategies that I have not considered? Should I consider them now?</p>

<p>The following explores feedback and input from our ongoing national discussions with clients, prospects, political leaders, industry associations, and others. Some, all, or none may be relevant to your business and cash model, but given that the one certainty in today’s business environment is continued <em>uncertainty</em>, the following will provide food for thought as the tax and finance landscape continues to ebb and flow.</p>

<h2>1031 Exchanges as a Source of Business Cash</h2>

<p>If you own a business and if, as part of that business, you buy equipment that you later sell to purchase new/replacement equipment, you have income tax exposure that averages 40% on those sales proceeds. If you are sending that money to the treasury, you are literally paying <em>unnecessary taxes</em>, and that money could be better used in your business. Period. &nbsp;While there are a few business owners who will simply pay these taxes instead of redirecting these funds to new equipment purchases, the vast majority of owners would rather put the money to better use in their business.</p>

<p>At the end of the day, a 1031 like-kind exchange affords you the ability to defer the tax and invest those dollars back into your business. You still owe the money, but the payback terms are flexible. You get to decide when you pay it back, and you get to decide how to use it. You don’t have to tap into existing lines of bank credit. (usually a good thing), and you enjoy the benefits of the cash without the usual encumbrance associated with debt.</p>

<h2>Cost of Capital</h2>

<p>Virtually all of the tax reform talk in Washington is about eliminating deductions and reducing the overall tax <em>rate</em>, and any money your company chooses to retain and invest will ultimately be paid back at the <em>prevailing</em> tax rate and not the <em>current</em> tax rate. If you deferred taxes on the sale of used equipment at a 39% income tax rate, and someday you pay back those taxes at a 25% or 30% income tax rate, you’ve permanently pocketed the difference.</p>

<p>The American business owner has been lulled into a false sense of security with cheap money. No one thinks cheap capital will continue indefinitely. In fact, we are already beginning to see “cost creep” on lines of credit and capital loans. While the cost of capital is still relatively low, it is rising. Accessing permanently cheap cash via a 1031 exchange is one way to keep a large chunk of your business capital relatively cheap.</p>

<h2>Internal Rate of Return</h2>

<p>I love this discussion with business owners. Most competently run companies will have an Internal Rate of Return (IRR) of 6-12%, depending on many factors. When they realize that they can access cash via like-kind exchange deferrals for a fraction of their IRRs, few can find fault in deferring that tax money and plugging it into their businesses.</p>

<h2>Cash is King</h2>

<p>Three simple words, “Cash is King,” drives America’s business success. It’s hard to argue with the premise that more cash - especially cheap cash - is anything but a good thing for a business owner. If your business is regularly disposing of business equipment and owing taxes on such disposal, you might want to talk with your tax adviser about the cash-generating benefits of a 1031 like-kind exchange program.</p>

<p>&nbsp;</p>

<p>Photo: <a href="https://www.flickr.com/photos/amagill/&quot; target="_blank">Andrew Magill</a></p>

<p>When setting out to conduct a 1031 like-kind exchange, it’s important to know the rules associated with Section 1031 of the tax code. The following rules are key:</p>

<ul>
<li>Identification of any and all replacement properties by day 45 of the exchange</li>
<li>Acquisition of the identified replacement properties by day 180 of the exchange</li>
<li>Prohibitions on personal use of the investment property for more than 14 days in either of the first two years of ownership</li>
<li>Rental of investment property for at least 14 days in each of the first two years of ownership</li>
</ul>

<h2>How will the IRS know?</h2>

<p>Owners of investment property must understand that there is no gray area related to any of the above issues, and while most investors get that, some want to push the boundaries of the law.&nbsp; These more aggressive investors will typically ask the following questions:</p>

<ul>
<li>How will the IRS know if I make changes after day 45?</li>
<li>I may not be able to close by day 180, but can’t I just report that I did?</li>
<li>How will the IRS know if I use the property for more than 14 days each year?</li>
<li>Will the IRS know if I don’t rent the property for at least 14 days each year?</li>
</ul>

<p>&nbsp;The overarching theme of these questions is, “How will the IRS know?”&nbsp;</p>

<p>The IRS has many methods to collect and audit data, but a somewhat new approach involves collecting data from our cell phones.&nbsp; That’s right, the tool we use to be more productive also makes the IRS more productive.&nbsp; These phones we carry are storing evidence that could be used against overly aggressive property owners in tax court.</p>

<h2>A Picture is Worth Thousands of Dollars</h2>

<p>In one case, a taxpayer told the IRS they constructed and purchased a new property by day 180 of their like-kind exchange.&nbsp; During the audit, the IRS reviewed the photos saved on the taxpayer’s smartphone.&nbsp; The pictures showed the various phases of the new construction at the job site, and each picture bore a date stamp.&nbsp; The IRS found specific pictures of the job site with date stamps after day 180 of the exchange, revealing that the property in question was far from complete on day 180.&nbsp; Only the foundation had been poured! This left the taxpayer with some explaining to do.</p>

<h2>Location, Location, Location</h2>

<p>In another case, a taxpayer reported that they were renting a property and not using it for personal reasons.&nbsp; This property was located in a different state from the taxpayer’s primary residence.&nbsp; During an audit, the IRS was able to review the taxpayer’s smartphone activity and discovered that the phone was communicating with a cell tower located very close to the taxpayer’s “rental.”&nbsp; The phone’s communication process with this tower occurred for at least two months during one year.&nbsp; This information helped the IRS prove that the taxpayer was actually using the “rental” for personal purposes, beyond what is allowed by law.</p>

<h2>The IRS <em>Likes </em>You on Facebook</h2>

<p>It’s been reported that <a href="http://fortune.com/2015/10/26/irs-spying-devices/&quot; target="_blank">the IRS may be using Stingray surveillance equipment</a> to obtain information from unknowing taxpayers for use in potential criminal investigations.&nbsp; Articles also suggest that <a href="http://www.businessinsider.com/the-irs-ramps-up-online-tracking-2013-5&…; target="_blank">the IRS is tracking taxpayer activity on social media sites like Facebook and eBay</a> in its quest to minimize the amount of revenue lost to tax evasion each year, an estimated $300 billion.</p>

<h2>Big Data: Not Just a Buzzword</h2>

<p>Taxpayers need to be fully aware of the risks when venturing outside Section 1031’s regulations.&nbsp; That’s why it’s important to involve the right team of experienced professionals - an experienced tax advisor and an experienced qualified intermediary - who can highlight important issues and help structure a like-kind exchange without violating the rules.&nbsp; Big data is more than a buzzword; it’s a reality with a staggering amount of individual data points being collected on each of us. How exactly the IRS will know is unclear, but that they will is certain.</p>

<p>Photo: <a href="https://www.flickr.com/photos/intelfreepress/9663345203&quot; target="_blank">Intel Free Press</a></p>

<p>No matter where you stand politically, there are certain things we can all agree upon, including the benefits of Section 1031 of the tax code.&nbsp; Section 1031 like-kind exchanges (LKEs) have been around since 1921, and, at their core, encourage continuity of investment - allowing asset owners to defer taxable gains into replacement assets rather than cashing out. From a planning and growth perspective, that’s particularly powerful as Section 1031 allows investors to follow opportunity - by moving their investments anywhere across the United States – without income tax penalty.</p>

<h2>Who benefits from Section 1031?</h2>

<p>Yes, ”The Donald” does benefit from 1031s, but so do ordinary American taxpayers, including rental property owners, farmers, collectors, rental car companies, construction contractors, and leasing companies.&nbsp; LKEs can be utilized by any taxpayer in any tax bracket and can significantly increase their cash flow.&nbsp; This increased cash is an effective economic stimulant, allowing asset owners to keep their money working in their businesses.</p>

<h2>We need more jobs.</h2>

<p>Both sides of the political spectrum say we need to create more jobs.&nbsp; Taken as a whole, the 1031 exchange process is job creation on steroids.&nbsp; Below is an example of Donald Trump saying “You’re hired” not “You’re fired” to an army of professionals.</p>

<p>Let’s say Trump receives an offer to buy one of his commercial real estate properties.&nbsp; Upon accepting the offer, a waterfall of events will take place:&nbsp;</p>

<ul>
<li>CPAs and attorneys will review the purchase and sale contract.&nbsp;</li>
<li>Inspectors will arrive to verify the property’s condition.</li>
<li>Settlement agents and attorneys will be engaged.</li>
<li>Improvements to the property will likely be made requiring contractors and materials.</li>
<li>Financing might be sought, requiring lenders and appraisers to be brought in.&nbsp;</li>
</ul>

<p>In this case, Trump’s interested in a like-kind exchange and will need to hire a qualified intermediary.&nbsp; The qualified intermediary will invest the funds at a bank and Mr. Trump will hire another broker to assist him in finding one or more replacement properties, triggering another team of professionals to facilitate the purchase.&nbsp; Finally, a team of accountants will be hired to file the final tax returns showing the positive impact of the LKE.</p>

<h2>Why would the government want to take away 1031?</h2>

<p>Some politicians believe that by taking away this section of the tax code, more tax dollars will be captured without impacting the investment/job creation process described above.&nbsp; Frankly, they are wrong and taking away this powerful tax deferment tool will discourage investment in American assets and in American workers.&nbsp; Why would Congress endanger the American economic environment during this fragile period?</p>

<h2>What can I do to save 1031?</h2>

<p>Please visit <a href="http://www.1031taxreform.com">www.1031taxreform.com</a&gt; for more facts and learn why this section of the tax code needs to be kept in place.&nbsp; Review the testimonials from average Americans who have benefited from this section of the code and please <a href="https://www.votervoice.net/FEA/campaigns/36117/respond">contact</a&gt; Congress to let them know you oppose the proposal to eliminate like-kind exchanges.</p>

<p>Photo:&nbsp; <a href="https://www.flickr.com/photos/gageskidmore/&quot; target="_blank">Gage Skidmore</a></p>

<p>A successful like-kind exchange (LKE) requires that there be both relinquished and replacement property.&nbsp; As such, equipment owners must actually sell old equipment and purchase new or used units as like-kind replacements.&nbsp; Another LKE requirement states the proceeds generated from the sale of the old (relinquished) assets must be subject to specific restrictions.&nbsp; These monetary restrictions are usually satisfied through employing a qualified intermediary (QI), whose responsibilities include safeguarding the sale proceeds until the replacement property is acquired.&nbsp; Found within Section 1031’s underlying restrictions and often referred to as the “g(6) restrictions,” these rules forbid the equipment owner from having any right to receive, pledge, borrow, or otherwise obtain the benefits from the sale proceeds residing in their like-kind exchange account.</p>

<p>Immediately after the sale transaction, the QI will typically receive the proceeds directly from the buyer.&nbsp; This deposit is usually net of various items, such as:</p>

<ul>
<li>Broker fees</li>
<li>Auctioneer costs</li>
<li>Debt payoffs/pay downs</li>
</ul>

<p>Generally, if the equipment owner were to receive any of the sale proceeds, or use it to pay off or pay down debt unrelated to the equipment being sold, the receipt could trigger a violation of the g(6) restrictions and possibly ruin the like-kind exchange.&nbsp;</p>

<p>For owner/operators, most equipment transactions are fairly simple and do not involve anything beyond pay offs or pay downs of debt related to the relinquished property.&nbsp; When the sale triggers a debt payment, it is a matter of instructing the broker, auctioneer, or buyer to send a portion of the purchase funds to the lender with any remaining amounts to be delivered to the qualified intermediary.&nbsp; However, there are cases where lenders (or lienholders) do not wish to receive payment related to the sale of the property.&nbsp; Instead, they seek to take hold of the proceeds or arrange for some sort of pledge against the funds held in the exchange account.&nbsp; While it’s understandable the lienholder would want to secure their interest in a traditional manner, these traditional arrangements would likely violate the terms of the g(6) restrictions and potentially taint the equipment owner’s like-kind exchange.</p>

<h2>What’s a Lender/Lienholder to do?</h2>

<p>In cases where the lienholder wishes to retain their secured interest, from sale of the relinquished property through the acquisition of the replacement property, there are three recommended techniques:</p>

<ul>
<li>The Standing Disbursement Instruction</li>
<li>The Irrevocable Right to Approve</li>
<li>A Pledge of Interest in a New Subsidiary</li>
</ul>

<p>Each technique may be done through adding specific language directly to the like-kind exchange agreement with your QI, or through a separate agreement.&nbsp;</p>

<h2>Standing Disbursement Instruction</h2>

<p>The standing disbursement instruction simply states that at the end of the exchange, any remaining exchange funds shall be paid to the lienholder, rather than back to the equipment owner. &nbsp;</p>

<h2>The Irrevocable Right to Approve</h2>

<p>The irrevocable right to approve method inserts the lienholder into the process for:</p>

<ul>
<li>Identifying replacement property and,</li>
<li>disbursing exchange funds for the acquisition of the replacement property.&nbsp;</li>
</ul>

<p>This method requires the lienholder physically sign any LKE identification forms and disbursement requests made of the quailified intermediary.</p>

<h2>A Pledge of Interest in a New Subsidiary</h2>

<p>A pledge of interest in a new subsidiary requires that the equipment owner, prior to the sale, transfer the relinquished property into a single member limited liability company (LLC).&nbsp; The lienholder then takes a pledge of this new LLC’s interests as security.&nbsp; After the sale of the old property the lienholder retains a secured interest in the LLC, with the LLC’s primary asset being the amount held by the Qualified Intermediary.</p>

<h2>Summary</h2>

<p>All three of the above methods may be used separately, or together to mitigate the lienholder’s security risks. &nbsp;After the acquisition of the replacement property, the lienholder may make standard arrangements to directly attach a lien on the replacement property.&nbsp; It is advisable that all parties seek the advice of an experienced tax attorney.&nbsp; Failure to address security concerns can be risky for the secured party, and failure to address these concerns correctly can be potentially invalidate the equipment owner’s like-kind exchange.</p>

<p>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.&nbsp; As that post made clear, a taxpayer cannot do improvements on property that is already owned by the taxpayer. Another post pertaining to <a href="/blog/1031-tax-deferred-exchanges-between-related-parties">exchange transactions between related parties</a> underscored the admonition against a taxpayer acquiring replacement property from a related party.&nbsp; 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.</p>

<p>This type of transaction is made possible by introducing a long term lease for the property into the ownership structure of the land.&nbsp; For 1031 exchange purposes, a long term lease is defined as a lease with 30 years or more to run, including renewal options.&nbsp; 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.&nbsp; This long term interest is considered like-kind to a direct (“fee”) interest in land.&nbsp; 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.&nbsp; &nbsp;&nbsp;</p>

<p>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).&nbsp; 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.</p>

<p>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.&nbsp; 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.&nbsp; This structure was approved.</p>

<p>A short time later <a href="/exchange-library/irs-private-letter-ruling-plr-200329021" target="_blank">PLR 200329021</a> was issued.&nbsp; In this case too, the related party had a lease in excess of thirty years.&nbsp; The leasehold interest was assigned to an EAT for purposes of constructing taxpayer desired improvements.&nbsp; This structure got a favorable ruling from the IRS.</p>

<p>The most recent ruling on this structure was <a href="/exchange-library/irs-private-letter-ruling-plr-201408019" target="_blank">PLR 201408019</a>. 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.&nbsp; 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.</p>

<p>There were a couple of common threads to these rulings which someone structuring such a transaction should keep in mind.&nbsp;</p>

<ul>
<li>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.&nbsp;</li>
<li>Second, the lease/sublease should have 30 or more years to run as of the time the EAT leases the property.&nbsp;</li>
<li>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.&nbsp;</li>
</ul>

<p>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.&nbsp; 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."</p>

<p>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.&nbsp; 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.</p>

<p>Documents for a build-to-suit under a ground lease on property owned by a related party include:</p>

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

<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>Fallacy: 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 an office building or a rental property and deferring the tax on the sale of that asset. What is being missed is that average everyday people are utilizing like-kind exchanges as well.</p>

<p>An individual who defers tax on selling a small rental property when she buys a replacement property is 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 mechanic recently in Phoenix, Arizona who, upon learning about our company, related his own like-kind exchange story. He had purchased a rental home four years ago for a terrific price, and when the market went up, he was able to enter into a contract to sell it for a profit. He was lucky to have a smart accountant who advised him to structure the transaction as an exchange with a qualified intermediary enabling him to reinvest all of the proceeds in another rental, thereby deferring tax on the sale. He did so and has now profited enough to secure a down payment on three rental properties, about which he remarked, “On a mechanics salary, without 1031s I would never have been able to own three rentals.”</p>

<h2>Fallacy: A 1031 exchange must be simultaneous.</h2>

<p>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="/blog/what-are-1031-exchange-deadlines">1031 exchange deadlines</a>, but the 180-day completion period allows for non-simultaneous exchanges. It is even possible, in a <a href="/blog/are-1031-reverse-tax-deferred-exchanges-real-estate-approved-irs">reverse exchange</a>, to purchase replacement property up to 180 days prior to selling the relinquished property.</p>

<h2>Fallacy: The Relinquished Property must be the exact same as the Replacement Property in order to be “like-kind.”</h2>

<p>In real estate, the term “like-kind” is remarkably broad. Most 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.</p>

<h2>Fallacy: 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>

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

<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="/blog/1031-like-kind-exchange-impact-study-results-released">stimulate economic growth</a>. They are an intentional and integral aspect of United States tax law, not a tax avoidance strategy.</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<span style="color:#ff0000;"> </span>informed.</p>