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Can A Simultaneous 1031 Exchange be Done Without the Use of a Qualified Intermediary?

04/11/24

This article discusses the differences between simultaneous and delayed 1031 Exchanges, highlighting the complexities and risks associated with simultaneous exchanges when ...

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<h2 aria-level="2" paraeid="{e14c7f21-35e6-4ad8-b62c-3989ef3dbf0e}{220}" paraid="241059520" role="heading">Simultaneous Exchange versus Delayed Exchange </h2>

Most 1031 Exchanges take place on a delayed basis.  That is to say that the Exchanger sells his Relinquished Property to a buyer of choice and acquires Replacement Property from a seller of choice within 180 days thereafter, or by the due date for filing the tax return for the year of the sale, hence a delay in completed the exchange.  However, on occasion, there are just two or three parties who wish to directly exchange properties.  Because circumstances exist, they are able to exchange properties simultaneously, i.e. at the same exact time, rather than on a delayed basis.

Facing the circumstances of a simultaneous exchange, including the absence of the requirement of holding funds until the close of a transaction to complete the exchange present in a delayed exchange, the parties sometimes consider entering into a 1031 Exchange transaction without involving a Qualified Intermediary. While this can be done, as the use of a

Qualified Intermediary is not a precondition to a valid 1031 Exchange transaction, there are reasons why an Exchanger might want to use the same structure for a simultaneous 1031 Exchange that is customarily used for a delayed 1031 Exchange.

A simultaneous exchange may seem as simple as two parties exchanging deeds to their properties of the same fair market value to complete a valid 1031 Exchange or one party paying in cash to equalize the values. However, there is more to it, much of which being proper processes and documentation are often overlooked. Should an audit occur, the documentation will be relied upon to determine if the 1031 Exchange stands up to IRS scrutiny.

<h2 aria-level="2" paraeid="{f1031aba-4b1a-47f6-9029-3f5ef767ce6f}{7}" paraid="276549905" role="heading">Criteria for a Valid 1031 Exchange </h2>

As mentioned above, there are certain requirements that must be met for a valid 1031 Exchange in addition to merely exchanging properties via title transfer and possibly cash from one party to make up for a difference in fair market value.

<h3 aria-level="3" paraeid="{f1031aba-4b1a-47f6-9029-3f5ef767ce6f}{19}" paraid="829857247" role="heading">Intent to Exchange </h3>

For a 1031 Exchange to be valid, there has to be an expressed intent to exchange requiring the purchase and sale of the properties to be reciprocal and mutually interdependent. The typical tax deferred exchange agreement contains language covering this requirement. Without more, a standard form Purchase and Sale Agreement would not contain necessary language to this effect. The presence of an “exchange cooperation clause” in a form contract would not suffice for this purpose.

<h3 aria-level="3" paraeid="{f1031aba-4b1a-47f6-9029-3f5ef767ce6f}{31}" paraid="1013927235" role="heading">Exchange Requirement  </h3>

One of the primary drivers of the 1991 exchange regulations was to provide a way to maintain an “exchange event” between the parties while effectively taking the Exchanger’s buyer and seller out of the active participation in the Exchanger’s 1031 Exchange transaction. This was accomplished through the use of a new player, the <a href="/blog/find-right-qualified-intermediary-facilitate-your-1031-exchange" title="Find the Right Qualified Intermediary for Your 1031 Exchange">“Qualified Intermediary” (QI)</a>. The idea was that the QI could substitute for the Exchanger’s buyer and seller as the party with whom the Exchanger was exchanging the properties, i.e. an intermediary in the middle of the transaction. The buyer and seller could be just that, they did not have to actively participate in the exchange. However, a simultaneous exchange without the use of a QI requires those other parties to be involved in the exchange and that is not always something they are willing to undertake. The buyer would have to agree to obtain the property from the Seller in lieu of paying the Exchanger and to transfer that property to the Exchanger. Likewise, the Seller would have to agree to sell the property to the buyer in lieu of the Exchanger. Contracts between the parties would have to be consistent with this. Proper conveyances would need to be made, reps and warranties might have to run to parties other than the person to whom the property was being transferred to or from, etc. Certain jurisdictions may seek to impose transfer taxes on some of the conveyances.

<h3 aria-level="3" paraeid="{f1031aba-4b1a-47f6-9029-3f5ef767ce6f}{73}" paraid="575541871" role="heading">Actual or Constructive Receipt of Funds </h3>

Further, an Exchanger cannot be in actual or constructive receipt of any sale proceeds during the pendency of a 1031Exchange. When using a QI, including its secondary role of holding the exchange proceeds, even for a transitory moment, the regulations provide that with proper language in the exchange agreement and/or an accompanying “qualified escrow” agreement, the Exchanger will not be deemed to be in actual or constructive receipt. Conversely, with a simultaneous exchange using a routine closing escrow, that document may not have the type of language which insures against actual or constructive receipt.

<h3 aria-level="3" paraeid="{f1031aba-4b1a-47f6-9029-3f5ef767ce6f}{85}" paraid="1408985561" role="heading">Inexpensive Insurance </h3>

It is often said that a person’s purchase of their home might be the most significant purchase they make during their lifetime. Purchasing an investment or business use property is also a very significant event and so is the certainty of receiving tax deferral via a successful 1031 Exchange.

A buyer of a new home would not consider buying such an important property without the protection of title insurance. The 1031 Exchange regulations provide a “safe harbor” structure for the exchange of properties. The use of a Qualified Intermediary, such as Accruit, assures for a 1031 Exchange within the safe harbor to be preapproved by the IRS, which is equivalent to receiving title insurance. Think of it as Exchange Insurance. The cost of a 1031 Exchange is generally a minor amount, especially when considering the tax deferral at stake, so it is often considered a worthwhile expense to assure the transaction meets with the IRS requirements.

The drafters of the regulations understood while it is possible to do an exchange without using a Qualified Intermediary, Exchangers might like to take advantage of the safe harbor and the assurance it provides. So, they addressed this issue in the Preamble to the 1991 Regulations:

Extension of safe harbor rules to simultaneous exchanges

The rules in the proposed regulations, including the safe harbors, apply only to deferred exchanges. Commentators noted that the concerns relating to actual or constructive receipt and agency also exist in the case of simultaneous exchanges. They requested that the safe harbors be made available for simultaneous exchanges. Upon review, the Service has determined it necessary to make only the qualified intermediary safe harbor available for simultaneous exchanges. The final regulations provide, therefore, that in the case of simultaneous transfers of like-kind properties involving a qualified intermediary, the qualified intermediary will not be considered the agent of the taxpayer for purposes of section 1031 (a). Thus, in such a case the transfer and receipt of property by the taxpayer will be treated as an exchange. This provision is set forth in new §1.1031 (b)-2 of the final regulations and is effective for transfers of property made by taxpayers on or effective for transfers of property made by taxpayers on or after June 10, 1991.

In sum, while it is possible to structure a valid 1031 Exchange without engaging the services of a Qualified Intermediary, but there are some risks that certain required elements might inadvertently be missed invalidating the 1031 Exchange. Tax deferral is a gift, but to receive it, technical adherence is a necessity.  The drafters of the regulations understood this and chose to make the rules applicable to simultaneous 1031 Exchanges. The safe harbor structure set forth in the applicable regulations provide “exchange insurance” and the cost is minimal compared to the benefit of knowing the structure is preapproved.

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

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Can A Simultaneous 1031 Exchange be Done Without the Use of a Qualified Intermediary?

04/11/24

This article discusses the differences between simultaneous and delayed 1031 Exchanges, highlighting the complexities and risks associated with simultaneous exchanges when ...

1031 Exchange: Solution for Short-term Rental Property Owners Faced with Legislative Changes

04/09/24

This blog article covers short-term rentals, specifically the rise of Airbnb and VRBO, and how recent and proposed legislative changes ...

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<h2 aria-level="1" paraeid="{43096cfa-bd9e-49c3-9dbe-ba9b52a5a2ec}{14}" paraid="1747909047" role="heading">Short-term Rental Market Overview </h2>

Over the past 15 years, short-term rentals, such as Airbnb and VRBO, have become an increasingly popular investments for property owners. In 2020, the COVID-19 pandemic led to an explosive need for short-term rentals, which led many investors to turn their sights and funds toward short-term rentals. As of 2024, Airbnb has over four million hosts, or property owners, and seven million global listings, as many hosts own more than one rental property. In recent years, the short-term rental market has exploded. The average number of short-term rentals in the US in 2022 was 1,278,254, a 20.5% increase from 2021 and 2023 saw an additional 11% increase up to 1,424,441 total rentals. In 2022, the average monthly rental income from Airbnb in Denver was $3,540, for a combined annual rental income of $42,480.

It was reported in 2023 that 30% of vacation property owners and 32% of investment property owners have expressed interest in renting their homes as short-term rentals. While interest and inventory for short-term rentals has drastically increased over recent years, residents of high-interest areas are voicing concerns over the impact they feel short-term rentals may have on their neighborhoods. As a result, many cities and counties have begun to institute restrictions and even bans in specific high-tourism and urban areas which affect the return-on-investment potential for short-term rental property owners.

<h2 aria-level="2" paraeid="{43096cfa-bd9e-49c3-9dbe-ba9b52a5a2ec}{192}" paraid="1066438142" role="heading">Proposed Limits to Short-Term Rentals in Colorado </h2>

<h3 aria-level="3" paraeid="{43096cfa-bd9e-49c3-9dbe-ba9b52a5a2ec}{202}" paraid="1397955090" role="heading">County Specific </h3>

Increased restrictions and bans on short-term rentals can be seen across the country, but below are some specific examples of proposed legislation that would impact Colorado short-term rental property owners.

Park County, Colorado, which includes popular towns such as Alma and Fairplay, has experienced an increase in short-term rentals. In 2021, the county passed an ordinance that property owners must obtain an annual license. Additionally, the tourist-filled ski region is considering limiting or eliminating short-term rental properties as issues of housing scarcity, increased pricing, and neighborhood disturbance have been called into question. While Park County faces decisions regarding this industry, many towns and counties across Colorado, as well as other parts of the country, are also weighing the decision between allowing a strong rental market to continue or impose hard limits.

Another Colorado county dealing with proposed regulations is Summit County, home to many iconic and popular ski towns such as Breckenridge, Frisco, and Keystone. In terms of Summit County’s property tax rates, it was proposed earlier this year to increase tax rates based on classifications between lodging and residential properties. If short-term rental properties are classified as lodging properties, due to being booked as a short-term rental for more than 90 days per year, then the tax would be four times the residential rate. This large discrepancy would make it difficult for these property owners to cover their operating expenses or receive any meaningful return on investment, hence reducing property being used in this way.

<h3 aria-level="3" paraeid="{397345d8-4c11-4a4b-b7d9-4ed1a070c7ff}{45}" paraid="9735791" role="heading"> 
Colorado Senate Bills 33 & 2: </h3>

In Colorado, two proposed bills are set to address and revise guidelines regarding short-term rental properties. <a href="https://leg.colorado.gov/bills/sb24-033" rel="noreferrer noopener" target="_blank">Senate Bill 33</a> proposes that property, as well as the land it is on, can either be categorized as residential real property or lodging property. If the unit was leased for short-term stays over 90 days in the previous tax year, then it would be classified as lodging property. Otherwise, it would be residential real property. From this assessment, property taxes could be determined, highlighting large discrepancies between the classifications with lodging properties facing a much higher tax rate.

<a href="https://leg.colorado.gov/bills/sb24-002" rel="noreferrer noopener" target="_blank">Senate Bill 2</a> proposes amendments to current law, allowing counties to offer property tax credits or rebates to promote specific uses of real property addressing local concerns to the use of real property. These concerns may include issues affecting residents' health, safety, welfare, equity, housing access, and education. The bill would allow counties and cities to give tax breaks to properties that are used for mental health, childcare, and other areas of “specific local concern.” The bill defines an "area of specific local concern" as real property use that is diminishing or unavailable or deemed necessary for residents' well-being.

While these bills are in review, the property owners of <a href="https://kdvr.com/news/politics/colorado-politics-news/short-term-rental…; title="Proposed Short-term Rental Rental Tax Opposition">short-term rentals are pushing back</a> on what feels like an inaccurate characterization. Al Furlone is the manager of Winter Park Lodging Company and Steamboat Lodging Company, and a founding member of the Colorado Lodging and Resort Alliance. He claims to have conducted a survey of thousands of Colorado vacation rental homeowners and found that 89% of them only own one property. This survey conflicts with a popularized narrative that many of the short-term rental properties are controlled and managed by a few large corporations. Furlone wants policymakers to understand that this bill will be targeting and effecting individual property owners, not large business conglomerates attempting to utilize a lower tax rate by claiming vacation homes and hotels as residences.

<h2 aria-level="2" paraeid="{397345d8-4c11-4a4b-b7d9-4ed1a070c7ff}{173}" paraid="1294118417" role="heading">Trends Between City Bans & Restrictions </h2>

The three most common policies affecting short-term rental regulations are registration and licensing requirements, occupancy limits, and taxation.

<h3 aria-level="3" paraeid="{397345d8-4c11-4a4b-b7d9-4ed1a070c7ff}{211}" paraid="1723793303" role="heading">Registration & Licenses </h3>

For many cities and counties, registering properties as short-term rentals and obtaining appropriate permits and licenses are required. In this process, fees may be applicable, and rentals must meet criteria such as safety inspections or proof of insurance.

Also, cities are instituting caps on short-term rentals through neighborhood-specific licenses. For example, the Mission Beach neighborhood in San Diego, California, has imposed regulations that no more than 30% of the available housing units can be short-term rentals. These limits are imposed and monitored by requiring residents to apply for a license to operate in the short-term rental market. Once the 20% limit has been reached, no additional short-term rental properties would be permitted.

<h3 aria-level="3" paraeid="{bc72e985-5a3e-42cd-a6e9-631944737f93}{1}" paraid="1079808568" role="heading">Occupancy Limits </h3>

Another common policy is occupancy limits. Some cities like Austin, Texas and Honolulu, Hawaii only allow a small number of guests, no large groups (typically a 6–10-person limit). This is often done to address concerns about noise, parking, and neighborhood disruption.

<h2 aria-level="3" paraeid="{bc72e985-5a3e-42cd-a6e9-631944737f93}{36}" paraid="1803896534" role="heading">Taxation </h2>

Lastly, taxation is implemented across the board for rental properties. Short-term rental owners are often subjected to various taxes, including sales, occupancy, local tourism, and property taxes. Proposed legislation is focused on increasing tax rates for short-term rentals to make them a less desirable investment, as well as potentially increasing reporting requirements or collection mechanisms for these taxes.

Overall, new legislation and regulations affecting short-term rental properties aim to balance the interests of property owners, residents, and local communities. While these regulations may impose additional requirements and costs on property owners, they are intended to address concerns related to housing affordability, neighborhood quality of life, and the overall impact of short-term rentals on local housing markets.

These are just a few examples of proposed legislative changes that will impact short-term rentals. It is important to note that regulations can vary significantly from one town or state to another. It's essential for hosts and travelers to research and comply with the specific regulations in their area to avoid potential legal issues. Additionally, the landscape of short-term rental regulations is continually evolving, so it's essential to stay informed about any updates or changes in local laws.

<h2 aria-level="2" paraeid="{bc72e985-5a3e-42cd-a6e9-631944737f93}{146}" paraid="1850278828" role="heading">Utilizing a 1031 Exchange to Exit Short-term Rentals and 1031 Exchanges </h2>

With looming regulations on short-term rentals, many property owners and investors may be looking for an exit. A 1031 Exchange would allow property owners to exit properties they are no longer able to use as intended, prior to new or pending legislation, while deferring tax on the real estate transaction. These property owners can redeploy the proceeds from the sale of the property into a different property type or one unaffected by short-term rental regulations.

According to the Internal Revenue Code (IRC) §1031, real estate assets that are held for productive use in a trade or business, or for investment are eligible for a 1031 Exchange. By that definition, short-term rentals meet the qualifications for a 1031 Exchange. With that, a safe harbor definition has been created by the Internal Revenue Service (IRS). If a property is used as a personal vacation or second home as well as a short-term rental for any amount of time during the year, the following safe harbors must be met in order to qualify for a 1031 Exchange:

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="1" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559682":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="1" role="listitem">
The owner has held the property for at least two years immediately preceding the 1031 Exchange.  
</li>
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="2" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559682":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="1" role="listitem">
During that period, the taxpayer rents the property to others at a fair market price for at least 14 days each year.  
</li>
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="3" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559682":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="1" role="listitem">
The taxpayer’s personal use of the property during that time is less than 14 days or 10% of the total days the property is rented to someone, which quantity is greater.   
</li>
</ul>

Transitioning from a short-term rental to a different kind of investment property through a 1031 Exchange offers investors an avenue to optimize their real estate portfolio and achieve a greater return on investment than new regulations are allowing. By utilizing an exchange, investors can shift from what can become a low-income producing property to something that will yield higher returns, whether that be a single-family rental home, oil & gas, office building, Delaware Statutory Trust (DST), or one of the many other qualifying Replacement Properties. A 1031 Exchange not only provides tax benefits but also allows investors to diversify their rental portfolios and potentially enhance long-term financial stability.

In conclusion, while the short-term rental market has experienced significant growth, increased regulations and proposed legislation raise challenges for property owners. With ongoing discussions in places like Park County, Colorado, and legislative efforts across the country, property owners are encouraged to explore a 1031 Exchange as an opportunity to defer tax while transitioning into a different real estate investment that can accomplish their current and future investment goals.

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

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1031 Exchange: Solution for Short-term Rental Property Owners Faced with Legislative Changes

04/09/24

This blog article covers short-term rentals, specifically the rise of Airbnb and VRBO, and how recent and proposed legislative changes ...

IRS Announces Tax Relief for Areas in Rhode Island and Maine due to Recent Severe Storms

04/05/24

The IRS has announced tax relief for multiple counties in Maine and Rhode Island that were previously impacted by severe ...

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<h2>Due to the severe storms and flooding of December 17th and January 9th, the IRS has issued tax relief for parts of Maine and Rhode Island. </h2>

The General postponement date is July 15th, 2024.

In Maine, individuals that reside or have businesses within Cumberland, Hancock, Knox, Lincoln, Sagadahoc, Waldo, Washington, and York counties qualify for tax relief as this time.

In Rhode Island, individuals that reside or have businesses within Kent, Providence, and Washington counties qualify for tax relief as this time.

An “Affected <a>(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer</a>” includes individuals who live, and businesses whose principal place of business is located in, the Covered Disaster Area. Affected <a>(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayers</a> are entitled to relief regardless of where the relinquished property or replacement property is located. Affected <a>(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayers</a> may choose either the General Postponement relief under Section 6 OR the Alternative relief under Section 17 of Rev. Proc. 2018-58. <a>(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayers</a> who do not meet the definition of Affected <a>(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayers</a> do not qualify for Section 6 General Postponement relief.

Option One: General Postponement under Section 6 of Rev. Proc. 2018-58 (Affected Taxpayers only). Any 45-day deadline or 180-day deadline (for either a forward or reverse exchange) that falls on or after the Disaster Date above is postponed to the General Postponement Date. The General Postponement applies regardless of the date the <a>Those certain items of real and/or personal property described in the relinquished property contract and qualifying as “relinquished property” within the meaning of Treasury Regulations Section 1.1031(k)-1(a); The "Old Asset”, property or properties given up or conveyed by a taxpayer as part of a 1031 exchange. Relinquished</a> Property was transferred (or the parked property acquired by the EAT) and is available to Affected Taxpayers regardless of whether their exchange began before or after the Disaster Date.

Option Two: Section 17 Alternative (Available to (1) Affected <a>(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayers</a> and (2) other taxpayers who have difficulty meeting the exchange deadlines because of the disaster. See Rev. Proc. 2018-58, Section 17 for conditions constituting “difficulty”). Option Two is only available if the relinquished property was transferred (or the parked property was acquired by the EAT) on or before the Disaster Date. Any 45-day or 180-day deadline that falls on or after the Disaster Date is extended to THE LONGER OF: (1) 120 days from such deadline; OR (2) the General Postponement Date. Note the date may not be extended beyond one year or the due date (including extensions) of the tax return for the year of the disposition of the relinquished property (typically, if an extension was filed, 9/15 for corporations and partnerships and 10/15 for other taxpayers).

<a href="https://www.irs.gov/newsroom/irs-announces-tax-relief-for-taxpayers-imp… for full details on the Maine tax relief from the IRS</a>.

<a href="https://www.irs.gov/newsroom/irs-announces-tax-relief-for-taxpayers-imp…; title="IRS Tax Relief Rhode Island December 17, 2023 Severe Storms and Flooding">Visit for full details on the Rhode Island December 17th Storms tax relief from the IRS.</a>

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

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IRS Announces Tax Relief for Areas in Rhode Island and Maine due to Recent Severe Storms

04/05/24

The IRS has announced tax relief for multiple counties in Maine and Rhode Island that were previously impacted by severe ...

Considerations for Investing in DSTs and Debt Replacement Requirements

04/03/24

Learn more about DSTs as Replacement Property in a 1031 Exchange including the roles involved and the restrictions imposed by Revenue ...

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Revenue Ruling 2004-86 addresses the qualification of DSTs as potential Replacement Property in a 1031 Exchange under Internal Revenue Code (IRC) Section 1031. In this ruling, the Internal Revenue Service (IRS) acknowledges that an exchange of real property for a beneficial interest in a Delaware Statutory Trust (DST), which owns real property, is considered a like-kind exchange under Section 1031 of the Internal Revenue Code. This was a groundbreaking Revenue Ruling because it imposed stricter standards of the ownership structure and use of property held in a DST than was previously found in Revenue Procedure 2002-22, which currently regulates the Tenants in Common (TIC) form of ownership.

The ruling considers the nature of a DST, which are recognized as separate entities from their owners under Delaware law, with beneficial interests considered personal property. However, for federal income tax purposes, these beneficial interests are treated as direct ownership of the underlying real property assets, allowing for the tax-free exchange under Section 1031. This means that a 1031 Exchange can be carried out without immediate tax consequences, as the beneficial interest in the DST is treated as equivalent to direct ownership of real property for the purposes of the exchange.

<h2>Overview of Delaware Statutory Trusts (DSTs)</h2>

<h3>Accredited Investor Standard</h3>

To qualify for investment in a DST, an Exchanger must be an Accredited Investor. The Securities and Exchange Commission (SEC) provides guidelines for who may qualify as an Accredited Investor, which includes measures of wealth, income, and financial sophistication. To qualify as an Accredited Investor based on net worth, an individual must have a net worth over $1 million, excluding the value of the primary residence, either individually or jointly with a spouse or partner. For income-based qualification, an individual must have had an income over $200,000, or a combined income of $300,000 with a spouse or partner, in each of the prior two years and expect the same for the current year.

In the realm of private placements, the verification of an Exchanger’s Accredited Investor status is a critical step that sponsors of DSTs must undertake. This process is not only a regulatory requirement, but also a measure to protect both the sponsor and the investor. Typically, the verification involves a thorough review of financial documentation provided by the Exchanger, which may include a detailed financial questionnaire. The questionnaire often covers aspects such as income, net worth, investment experience, and risk tolerance. Additionally, the sponsor may request financial statements or other supporting documents to substantiate the information provided in the questionnaire.

This due diligence ensures that the investor meets the specific criteria set forth by the SEC for Accredited Investors, which, in turn, qualifies them to partake in DST investments. It's a safeguarding protocol that maintains the integrity of the investment process and upholds the standards of the private securities market.

<h3>DST Structure</h3>

A DST is a legal entity under Delaware law that allows up to 2000 investors. Investors have no management rights or voting power, only quarterly income distribution rights proportional to their respective beneficial interests. A DST Sponsor establishes the DST for holding real estate assets, acquires properties to include within the DST’s portfolio, and develops the investment offering detailing the potential returns and risks for investors. Sponsors also dictate when to sell properties within the Trust, ensures compliance with all regulatory requirements and filings associated with the DST, and communicates with investors regarding the performance and management of the real estate assets. The DST's management is handled by a signatory trustee, not the Delaware trustee, whose role is limited.

Lenders favor DSTs over TIC because they involve a single loan to one entity rather than multiple owners, reducing complexity and bankruptcy risks. For federal tax purposes, a DST is treated as a Trust if it adheres to certain "fixed investment trust" criteria; otherwise, it may be considered a partnership or corporation. 
The DST must not be traded on an established securities market, and its trustee is limited to specific administrative duties, primarily the collection and distribution of income to the beneficial owners. The beneficial interests in the DST are treated as interests in a grantor trust, with the owners deemed to hold undivided fractional interests in the DST's real property for federal tax purposes.

DST Restrictions Under Revenue Ruling 2004-86 
The Revenue Ruling imposes significant restrictions on the powers of the DST's trustee, colloquially referred to as the "seven deadly sins," to ensure that the DST does not operate as a business entity, which would disqualify it from 1031 exchange eligibility. These prohibitions include the trustee's inability to:

<ol>
<li>Dispose of the Trust's assets and acquire new ones, except for the dissolution of the trust following a sale.</li>
<li>Purchase assets other than short-term investments.</li>
<li>Accept additional contributions to the Trust after the initial offering is closed.</li>
<li>Renegotiate or refinance the debt on the property, unless necessitated by a tenant's bankruptcy or insolvency.</li>
<li>Renegotiate leases or enter into new leases, except in cases of tenant bankruptcy or insolvency.</li>
<li>Retain cash other than necessary reserves, instead of distributing it to beneficiaries.</li>
<li>Make substantial modifications to the property, barring legal requirements.</li>
</ol>

These limitations are designed to prevent the DST from being classified as a partnership or corporation for federal tax purposes, which would invalidate the beneficial interests as Replacement Property in a 1031 Exchange. Due to these constraints, DSTs are typically most appropriate for properties with long-term, triple-net leases to creditworthy tenants as the graphic below illustrates. This structure allows for passive, in lieu of active investment, aligning with the intent of IRC Section 1031 to defer capital gains taxes through like-kind exchanges.

<drupal-media data-align="center" data-entity-type="media" data-entity-uuid="382d7865-0f57-4e14-971e-eae6df11d180"></drupal-media>

<h3>Entry Points in a DST</h3>

When an Exchanger is considering a DST as Replacement Property there are two common entry points to start the process, each being regulated differently, as discussed below.

<h4>Registered Investment Adviser (RIA)</h4>

Many Accredited Investors will have an RIA and therefore they are a common channel for entering the DST market. Under the fiduciary standard, an RIA must prioritize their clients' interests above their own, ensuring that advice given is in the client's best interest. This includes a commitment to transparency, honesty, and diligence, avoiding conflicts of interest, and making decisions that align with the client's financial goals and risk tolerance. Fiduciaries have a duty to evaluate the full spectrum of a broker-dealer's services, not just the commission costs, and ensuring clients are not burdened with unnecessary expenses. Regular assessment of the broker-dealers' performance is crucial to uphold the best execution standard. Additionally, fiduciaries must disclose any potential conflicts of interest and obtain informed consent from clients before proceeding with transactions that may affect them. RIAs are regulated by the SEC and when engaging in placing a client in a DST usually obtain a due diligence fee but cannot charge a commission. RIA’s earn fees to manage assets and grow wealth, versus a transactional-based sale of a security in the case of a broker/dealer as discussed below who are commission based.

<h4>Broker Dealers</h4>

Brokers of DST beneficial interests are often regulated under the Financial Industry Regulatory Authority (FINRA). Brokers typically earn up to a 7% commission on the sale of a beneficial interest in a DST. Under FINRA, Brokers are bound not by a fiduciary standard, but rather a suitability standard. FINRA Rule 2111 is designed to ensure that investment recommendations made by broker-dealers or associated persons are suitable for their customers. The rule mandates that these professionals must perform due diligence to understand a customer's investment profile, which encompasses a range of factors from age and financial situation to investment goals and risk tolerance.

<h2>Debt Replacement and Exchange Value</h2>

As with any 1031 Exchange, the equal or up in value rule requires Exchangers to roll over all the net equity from the sale and have equal or greater debt on the new property. If an Exchanger fails to reinvest all the cash generated from the sale of Relinquished Property, they will incur a taxable event referred to as “cash boot.” If an Exchanger fails to take on debt on Replacement Property equal or greater to the debt payoff on the Relinquished Property, they will incur a taxable event referred to as “mortgage boot.” If Exchangers satisfy the equal or up in value rule, they will generally not incur a taxable event in the 1031 Exchange from mortgage boot or cash boot received.

Familiarity with this concept matters because in a leveraged DST, Exchangers acquire a beneficial interest in a trust that holds debt-financed properties. A lender for the property makes one loan to the DST. The leverage ratio, which is the amount of debt compared to equity, can vary. For instance, a 50% leverage means that half of the Trust's portfolio value is financed through debt. Under Delaware law, beneficial owners are not liable for the obligations of the DST. However, even though the debt is non-recourse to the Exchanger, they receive credit towards the debt replacement requirement under Sec. 1031 when selling property leveraged with recourse debt as discussed below.

For Exchangers to eliminate the possibility of <a href="/blog/what-cash-boot-1031-exchange" title="Boot in a 1031 Exchange">mortgage boot</a>, a taxable event, the DST must have a similar debt-to-equity ratio when compared to the Relinquished Property the Exchanger sold to comply with the equal or up in value concept. 
Historically, Relinquished Property sales average about 25% loan to value (LTV). So, when it pertains to DST LTV, the exchange party needs to pay close attention to acquiring equal or greater non-recourse debt to prevent a taxable event.

If the ratios are not aligned between the Relinquished Property LTV and newly acquired DST LTV, adjustments can be made to match the required debt replacement. For example, if the Exchanger is selling at 25% LTV and acquiring at 55% LTV in a leveraged DST, then there is no equal or up violation so long as all equity is reinvested because the Exchanger acquired more debt than they relinquished. However, if selling at 60% LTV and acquiring at 55% LTV in a leveraged DST, then mortgage boot would occur as to the 5% variance, unless the exchange party offsets fractionally with another leveraged DST portfolio to average out at 60% LTV or injects 5% fresh equity, cash, into the purchase to offset the LTV variance.

<h3>Passive Investment Debt Replacement Calculator</h3>

Reinvesting all debt and equity generated from the sale of Relinquished Property is more nuanced when acquiring a DST, because each single asset DST or portfolio DST will have a unique LTV. Additionally, the Exchanger has no control over the LTV on a particular DST, they merely have to decide which, if any, of the investments are a fit for them.

To simplify the process of ensuring debt is replaced equal or up in value in a passive real estate investment, Accruit created a <a href="/debt-replacement-calculator" title="Debt Replacement Calculator for Passive Real Estate Investments">Debt Replacement Calculator</a>. First, accurately input the Relinquished Property details including the debt payoff on the Relinquished Property. Next, an Exchanger can input one or more unique DST Replacement Properties and their associated LTV to assess the potential for a taxable event based on mortgage or cash boot.

It's important for Exchangers to consult with tax professionals to understand the specific implications of this calculator on an individual situation. Although DST debt is non-recourse, if an Exchanger exits a DST interest upon the Sponsor selling the asset and then decides to acquire a fee simple interest, such as a single-family rental home, as Replacement Property, they will need to replace the non-recourse debt with recourse debt or inject fresh equity (i.e. cash infusion) to prevent mortgage boot. This is particularly important to flag as oftentimes investors are encouraged to “double up” on non-recourse debt with passive real estate investments, which will obviously cause exit issues with mortgage boot as discussed above.

<h2>Additional DST Considerations</h2>

<h3>DST as Pure Debt Replacement Option</h3>

A “zero-coupon” leveraged DST portfolio is an investment structure where the Trust does not pay out earnings but instead reinvests them, allowing the value of the investment to grow over time. This type of portfolio is often leveraged significantly, sometimes at 80% or higher, which means that for every dollar of equity, there are four dollars of debt. While this can amplify gains if the property appreciates, it also increases risk. The zero-coupon aspect means that investors do not receive regular income distributions, but they may benefit from the potential appreciation of the property's value over time.

If you are selling an investment property for $1,000,000 but there is a loan outstanding for $800,000, then you at 80% LTV. Exchangers may creatively employ the use of a zero-coupon DST to prevent incurring mortgage boot by acquiring a beneficial interest in a zero-coupon DST as to their remaining debt to satisfy the debt replacement requirements under the equal or up in value rule. For instance, if the Relinquished Property was over leveraged, the acquisition of a zero-coupon DST matching the LTV of the Relinquished Property would allow the Exchanger to reinvest their recourse debt into non-recourse debt in the Replacement Property DST and not incur a taxable event related to that debt payoff. <

<h3>Umbrella Partnership Real Estate Investment Trust (UPREIT)</h3>

Section 1031 does not allow a direct exchange into a partnership or LLC interest since those interests are not classified as real property interests.  An example is an investment in a Real Estate Investment Trust (“REIT”). The interests are just paper membership certificates that gives an investor an interest in the partnership and not the real property owned by the partnership or LLC. Even though the REIT is a denominated as a “trust” it is actually taxed as a partnership, usually has multiple co-owners, and sometimes is large enough to be publicly traded on the stock exchange.

An <a href="/blog/can-you-1031-exchange-reit" title="721 Exchange UPREIT Process for Investing in REITS via 1031 Exchange and DST">UPREIT</a> offers a unique investment structure that allows for the deferral of capital gains taxes through a combination of 1031 Exchange and <a href="/blog/what-difference-between-1031-exchange-and-721-exchange " title="721 Exchange Versus 1031 Exchange">721 Exchange</a>. Exchangers without institutional-quality real estate can combine 1031 and 721 to ultimately invest into a REIT. Neither step triggers capital gains taxes. First, the 1031 Exchange facilitate by the Qualified Intermediary permits Exchangers to swap real estate for a beneficial interest in a DST which holds institutional-grade property. This step is tax-deferred, maintaining the investor's capital gains tax liability.

Next, the 721 Exchange, coordinated by the DST Sponsor, which occurs a couple years later, allows the contribution of the DST interest to a REIT operating partnership in exchange for Operating Partnership units (“OP units”), again deferring capital gains taxes. Functionally, the 721 Exchange allows a REIT to purchase a property from a DST at its fair market value. In return, the investor holding a beneficial interest in the DST is compensated with OP units in the REIT. This transaction is governed by Section 721 of the Internal Revenue Code. It's a sophisticated process that offers Exchangers the opportunity to transition from direct property ownership to holding a share in a diversified real estate portfolio managed by the REIT, while deferring capital gains taxes when properly executed. The OP units received are typically valued equivalently to the contributed property and carry similar tax benefits to direct real estate ownership, such as depreciation. However, it's important to note that converting OP units into common shares of the REIT might trigger a taxable event.

This two-step 1031/721 process provides exchangers with several benefits. Firstly, it enables access to a diversified portfolio of high-quality real estate managed by professionals, which might be beyond the reach of individual exchangers otherwise. Secondly, it offers the possibility of permanent tax deferral, as heirs can receive a stepped-up basis in the OP units upon the investor's death, potentially erasing the deferred tax debt. Additionally, the full divisibility of OP units allows for greater flexibility in investment decisions, and the active management of the portfolio can lead to enhanced performance over time.   It's important to note that to participate in a 721 Exchange, the property contributed must typically be of institutional-grade quality, which may not be a feasible option for all Exchangers. However, by first converting a nonqualifying property into a DST interest through a 1031 exchange, exchangers can effectively upgrade their holdings to meet the criteria for a 721 Contribution with a REIT. This strategic maneuvering within the real estate market can be an effective way for exchangers to defer capital gains taxes while gaining exposure to premium real estate assets.

In conclusion, DSTs, and other forms of passive real estate investments are becoming increasingly popular for investors. Our goal is to unpack the overall process, structure, and general requirements to achieve tax deferral through a 1031 Exchange for any of these investments. As always, Exchangers should consult with their tax preparer to understand the implications fully and ensure compliance with all tax laws and regulations including the necessary holding period required prior to investing into any of these avenues.

Metatags:

Title:

Considerations for Investing in DSTs and Debt Replacement Requirements

04/03/24

Learn more about DSTs as Replacement Property in a 1031 Exchange including the roles involved and the restrictions imposed by Revenue ...

Amplify Returns by Utilizing 1031 Exchanges

04/03/24

This article explores the potential for a greater return on investment property owners can reap when utilizing a 1031 Exchange on ...

Body:

Real estate investors understand the importance of strategic decisions to enhance their portfolios and maximize returns, but the owner of one business property or family-owned land might not be as familiar with these practices. One powerful tool at a property owner’ s disposal is a 1031 exchange, a provision in the Internal Revenue Code that allows you to defer capital gains taxes, depreciation recapture, state tax, and net investment income tax when selling an investment or business property and reinvesting the proceeds into qualified replacement property. In this article, we'll look at different scenarios of selling a property held for investment or business use and utilizing a 1031 exchange to reinvest in various property asset classes, including a rental house, an industrial warehouse, and a Delaware Statutory Trust (DST).

<h2 aria-level="2" paraeid="{fadaaa7e-5975-4ad7-83d5-95394795dd62}{27}" paraid="1663958951" role="heading">Understanding a 1031 Exchange </h2>

Before we dive into the specifics of each asset class, it's crucial to understand the fundamentals of a 1031 exchange. This tax deferral strategy enables investors to defer taxes that would otherwise be associated with the sale of the property, by reinvesting the sale proceeds into qualified replacement property within a specified time frame. To qualify for a 1031 exchange, the Relinquished Property and the Replacement Property must both be held for productive use in a trade or business or for investment and held by the same tax entity.

<h3 aria-level="3" paraeid="{fadaaa7e-5975-4ad7-83d5-95394795dd62}{43}" paraid="776916789" role="heading">Key Requirements for a 1031 Exchange: </h3>

Like-Kind Property: The Replacement Property must be of like-kind to the Relinquished Property, but this does not necessarily mean identical. For example, you can exchange a commercial property for a residential property. For purposes of a 1031 exchange, all business or investment property is like-kind.

Identification Period: Within 45 days of selling the Relinquished Property, you must identify potential Replacement Property(ies) in writing, following one of the three available <a href="https://www.accruit.com/blog/what-are-rules-identification-and-receipt-… rules</a>.

Closing Period: The Replacement Property must be acquired, and the exchange completed, within 180 days from the sale of the Relinquished Property.

Now, let's explore the potential of reinvesting in different asset classes as Replacement Property in a 1031 exchange.

<h2 aria-level="2" paraeid="{fadaaa7e-5975-4ad7-83d5-95394795dd62}{150}" paraid="1949574642" role="heading">Potential 1031 Exchange Reinvestment Scenarios </h2>

Before we dive into examples of reinvestment options through a 1031 Exchange, let’s look at investment scenarios that do not involve a 1031 Exchange.

Let’s assume a property owner inherited family land and has personally owned, or held, the land for 20 years. Due to urban expansion, the property owner has been offered $2 million by a developer to sell the land. The value of land when inherited was $1.2 million, so upon the sale of land, roughly $230,000 would be owed in Capital Gains Tax, State Tax, and Net Investment Income Tax without a 1031 Exchange. The property owner has reinvestment options that do not involve like-kind property. Some of the most common avenues include, stocks and bonds, mutual funds, and Exchange-Traded Funds (ETFs).

Let’s look at the estimated annual returns for each of these avenues. Note, the total reinvestment into these avenues is roughly $1,770,000 due to the taxable event without a 1031 Exchange.

Stocks and Bonds:

Average Return: Stocks historically yield an average annual return of 7-10%, while bonds offer a more conservative but stable return ranging from 2-5%.

Total Annual Return: Based on the above averages total annual returns could be expected from $35,400-$177,000 annually.

Mutual Funds:

Average Return: Historical average annual returns for mutual funds typically range between 5-8%.

Total Annual Return: Based on the above averages total annual returns could be expected from $88,500-$141,600 annually.

Exchange-Traded Funds (ETFs):

Average Return: Historical average annual returns for well-diversified ETF portfolios tend to align with stock market performance, around 7-10%.

Total Annual Return: Based on the above averages total annual returns could be expected from $123,900-$177,000 annually.

<h2 aria-level="2" paraeid="{34703980-e088-489d-87eb-c104e79d3ab6}{115}" paraid="1585139260" role="heading">Potential 1031 Exchange Reinvestment Scenarios </h2>

Now, let's explore the potential returns of reinvesting in different asset classes as Replacement Property in a 1031 Exchange. By utilizing a 1031 Exchange for the real estate transaction the reinvestment requirement for full tax deferral is the $2 million sale price.

Rental House Investment:

One of the most common choices for investors utilizing a 1031 exchange is the acquisition of a rental house. Residential real estate offers stability, potential for appreciation, and a consistent income stream through rental payments.

Potential Annual Returns:

Appreciation: Historically, residential real estate has shown steady appreciation. On average, the annual appreciation rate for single-family homes in the United States has hovered around 3-5%.

Rental Income: The rental market's performance varies by location, but a well-chosen property in a desirable area can provide a steady rental income. A conservative estimate for annual rental yield is between 4-6% of the property's value.

Total Annual Return: Based on the above averages for Appreciation and Rental income, a total between 7% - 11% annual returns could be expected, equating to $140,000-$220,000 annually.

Tax Benefits: Besides deferring capital gains taxes, rental property owners can benefit from tax deductions, such as depreciation, mortgage interest, property taxes, and operating expenses.

Industrial Warehouse:

Investing in industrial real estate, particularly storage warehouses, offers unique advantages. The growing demand for e-commerce and logistics has increased the appeal of this asset class, providing investors with the potential for both appreciation and robust rental income.

Potential Annual Returns:

Appreciation: Industrial real estate has witnessed strong appreciation in recent years due to the increasing reliance on online shopping and the need for efficient logistics. Annual appreciation rates can range from 6-8%.

Rental Income: Industrial storage warehouses can generate substantial rental income, especially in prime locations. Rental yields may range from 6-8%, depending on the specific market and property characteristics.

Total Annual Return: Based on the above averages for Appreciation and Rental income, a total between 12% - 16% annual returns could be expected, equating to $240,000-$320,000 annually.

Long-Term Leases: Industrial tenants often sign long-term leases, providing stability and a consistent cash flow for investors.

Tax Benefits: Similar to a rental home, an industrial warehouse would also provide benefits from tax deductions, such as depreciation, mortgage interest, property taxes, and operating expenses.

Delaware Statutory Trust (DST):

For investors seeking a passive approach to real estate ownership, Delaware Statutory Trusts (DSTs) offer an intriguing option. A DST is a legal entity that holds title to real estate assets, allowing investors to own a fractional interest in a larger, higher quality property than they could purchase on their own, without the day-to-day management responsibilities.

Potential Annual Returns:

Appreciation: Historically, institutional-grade properties including apartment complexes, retail centers, and commercial buildings of properties have shown average annual appreciation rates ranging from 3% to 5% in stable markets over the long term.

Annual Return: DSTs typically focus on income-producing properties, such as apartment complexes, commercial buildings, or retail centers. Investors on average can expect between a 4-9% annual rate of return.

Total Annual Return: Based on the above averages for Appreciation and annual return income, a total between 7% - 14% annual returns could be expected, equating to $140,000-$280,000 annually.

Tax Benefits: DST investors generally receive an annual statement from the Sponsor allocating the investors share of depreciation, mortgage interest, property taxes, and other tax benefits.

Diversification: DSTs provide diversification by allowing investors to own a portion of multiple properties within a single investment. This diversification can mitigate risks associated with a single property or market.

<h2 aria-level="2" paraeid="{b6f45eac-3420-4a1c-9b60-0c6b5c23e8a6}{100}" paraid="1260724357" role="heading"> 
1031 Exchanges Impact on Return on Investment </h2>

In conclusion, utilizing a 1031 Exchange to transition from one property to another is a strategic move for property owners or investors looking to optimize their real estate investments. By carefully considering the potential returns and characteristics of traditional investments compared to like-kind real estate investments, investors can increase their reinvestment and tailor their real estate investments to align with their financial goals and risk tolerance.

Before embarking on a 1031 Exchange, it is crucial to consult with tax professionals, legal advisors, and real estate experts to ensure compliance with regulations and to make informed decisions. Additionally, market conditions and investment landscapes can change, so staying informed about current trends and conducting thorough due diligence is essential for long-term success in real estate investing.

A well-executed 1031 Exchange can not only defer four levels of tax but also serve as a catalyst for diversification, capital growth, and enhanced income streams within a carefully curated real estate portfolio.

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

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Title:

Amplify Returns by Utilizing 1031 Exchanges

04/03/24

This article explores the potential for a greater return on investment property owners can reap when utilizing a 1031 Exchange on ...

Reverse and Property Improvement Exchanges Outside the Safe Harbor

03/27/24

The article covers the historical evolution and regulations of Section 1031 of the Tax Code, focusing on Reverse Exchanges and Property ...

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<h2 aria-level="1" paraeid="{f9d25216-1388-4fb4-b80a-f2e651cca622}{193}" paraid="635633104" role="heading">Evolution </h2>

The idea that an exchange of a like kind property for another should not subject a Taxpayer, or Exchanger, to a tax payment so long as they did not “cash out” formed the basis for Section 1031 to become part of the Tax Code in 1921. At one time almost all asset types could be exchanged, but in the present era, only real estate can be exchanged. The rationale for this tax deferral was based on the fact that the Exchanger maintained a “continuity of investment” in the asset, and it would be unfair to assess a tax under the circumstances of maintaining the investment in the “like kind” property. Then, as well as now, applicable taxes were deferred until some final cash out disposition, if any.

There were additions to the Code section over time but there were still a lot of open questions as the use of §1031 gathered steam over the years. In 1991, the IRS sought to provide more certainty on what could or could not be done and promulgated some regulations to provide a safe harbor that people could follow when entering into a tax deferred exchange. The 1991<a href="/sites/default/files/Internal%20Revenue%20Service%20Regulations%20IRC%20Section.pdf"> regulations</a> included distinct safe harbors:

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Security or Guaranty Arrangements 
</li>
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="2" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="3" role="listitem">
Qualified Escrow and Qualified Trust Accounts 
</li>
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="3" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="3" role="listitem">
Use of Qualified Intermediaries 
</li>
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="4" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="3" role="listitem">
Interest and Growth Factors 
</li>
</ul>

During a comment period before the 1991 rules came into effect, many people wrote in to the Internal Revenue Service (IRS) asking if the final rules could provide some guidance when circumstances dictated that the Replacement Property needed to be acquired before the sale of the Relinquished Property, commonly referred to as a Reverse Exchange, or when a portion of the Relinquished Property sale proceeds needed to be allocated to construction or improvement on the new property, a Construction or Improvement exchange. The IRS replied to these comments by declining to include such guidance but indicated that it would continue to study the issue and provide rules on it in the future. It took some time, but in the year 2000, that guidance was published in <a href="/sites/default/files/Rev%20Proc%202000-37_0.pdf" title="Revenue Procedure 200-37 pertaining to 1031 Exchanges">Revenue Procedure 2000-37</a>.

<h2 paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{18}" paraid="853233036">Safe Harbor for Reverse and Improvement Exchanges </h2>

Like the Forward Exchange Rules before it, IRS Rev. Proc. 2000-37 provided a new safe harbor for Reverse and Construction/Improvement Exchanges. Among other things, the rules required having a third party, referred to as an Exchange Accommodation Titleholder, park title to the subject property as part of the necessary structure. Also, it was a condition of the safe harbor that the transaction, including the title parking arrangement, could go on no longer than 180 days.

<h2 paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{30}" paraid="547767587">Traditional Structuring for Reverse and Improvement Exchange Prior to the Safe Harbor </h2>

Prior to the issuance of this Rev. Proc. in 2000, there was some case law on Reverse and Property Improvement Exchanges. The gist of which was that it could be done via a title parking arrangement, but it was necessary for the third-party parking Accommodator to have true “benefits and burdens” of ownership. This was a very high bar to reach and required such things as:

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Risk of gain or loss required should the market value change over the term of the parking arrangement 
</li>
<li aria-setsize="-1" data-aria-level="2" data-aria-posinset="2" data-font="Arial" data-leveltext="•" data-list-defn-props="{"335552541":1,"335559685":1440,"335559991":360,"469769226":"Arial","469769242":[9675],"469777803":"left","469777804":"•","469777815":"hybridMultilevel"}" data-listid="2" role="listitem">
“Skin in the game” from the Accommodator, often thought to be a minimum of 5% of the equity 
</li>
<li aria-setsize="-1" data-aria-level="2" data-aria-posinset="3" data-font="Arial" data-leveltext="•" data-list-defn-props="{"335552541":1,"335559685":1440,"335559991":360,"469769226":"Arial","469769242":[9675],"469777803":"left","469777804":"•","469777815":"hybridMultilevel"}" data-listid="2" role="listitem">
Lease of the property back to the Exchanger during the parking term with true economics and arm’s length dealing 
</li>
<li aria-setsize="-1" data-aria-level="2" data-aria-posinset="4" data-font="Arial" data-leveltext="•" data-list-defn-props="{"335552541":1,"335559685":1440,"335559991":360,"469769226":"Arial","469769242":[9675],"469777803":"left","469777804":"•","469777815":"hybridMultilevel"}" data-listid="2" role="listitem">
Exchanger could not be the agent of the accommodator 
</li>
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Exchanger could not simply provide a blanket guarantee on any bank loan made to the Accommodator for the purchase price and/or cost of improvements 
</li>
</ul>

As can be imagined, meeting these criteria suggested by the case law was hard to do. The 2000 regulations changed most of this and for all intents and purposes just required the Accommodator to be in legal title during the 180 term of the transaction. Simplifying the requirements provided many Exchangers the ability to enter into these parking arrangements without tax risk.

<h2 paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{115}" paraid="554584921">Rev. Proc. Position on Structuring Outside the Safe Harbor </h2>

The regulations recognized that it was not always possible to have a parking transaction be concluded within 180 days. For example, in the case of new construction or property improvements, it takes time to get architect plans, permits, deal with inclement weather conditions, etc. Taking this into consideration, the Regs included a paragraph suggesting that “no (adverse) inference” was to be made for deals structured outside the safe harbor, specifically it states:

“No inference is intended with respect to the federal income tax treatment of arrangements similar to those described in this revenue procedure that were entered into prior to the effective date of this revenue procedure. Further, the Service recognizes that "parking" transactions can be accomplished outside of the safe harbor provided in this revenue procedure. Accordingly, no inference is intended with respect to the federal income tax treatment of "parking" transactions that do not satisfy the terms of the safe harbor provided in this revenue procedure, whether entered into prior to or after the effective date of this revenue procedure.”

This language was meant to leave the window open for matters that required more than 180 days to accomplish a completed exchange. For transactions that could only be done for a period in excess of 180 days, the only practical way was to resort to the benefits and burdens approach referred to above and, as before, that was difficult to adhere to.

<h2 paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{203}" paraid="1349343978">The Case of Estate of George H. Bartell, Jr. v. Commissioner, 147 T.C. No. 5 (2016) </h2>

As so many times before, the landscape for these transactions changed once again with the ruling in the Bartell case that was issued in 2016. That case pertained to a taxpayer who structured an exchange involving new construction with a corresponding parking arrangement for 24 months. The actual period ended up being 17 months. Unlike traditional deals outside the safe harbor, it did not have benefits and burdens built in, rather it merely had a third-party Accommodator, referred to by the Court as a “warehousing” entity, hold title during the parking term. Predictably, the IRS challenged the tax reporting since it did not comply with historical requirements for a structure outside the safe harbor. However, the Federal District Court examined some cases on the subject and reached the conclusion that the case law primarily required a third party to be in title to the property during the period of construction.

This finding by the Court was a radical departure from what practitioners expected and opened up the door to many more parking transactions to be structured following the Bartell model. While the IRS was bound by the decision, it expressed its continuing disagreement with the holding by filing a “non-acquiesce” to the decision, meaning that it did not agree to be bound by it in other cases. This meant that persons in other Federal Districts could not necessarily rely on the case holding as applicable law.

However, gradually since 2016 real estate investors and business owners have been structuring deals requiring more than 180 days in conformity with the Bartell decision. At this time in 2024, such a matter being done outside the safe harbor is somewhat commonplace and certainly the IRS is aware that it happens. A lot of time has elapsed since the case holding and there is no evidence that the IRS has disallowed this structure since then so it would seem that a parking arrangement that uses an Accommodator but does not require benefits and burdens to that party, is indeed possible.

Like all tax related matters that are not the equivalent of a published safe harbor, it is always recommended to seek advice from your professional advisers to ensure that any perceived tax risk is properly assessed.

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

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Reverse and Property Improvement Exchanges Outside the Safe Harbor

03/27/24

The article covers the historical evolution and regulations of Section 1031 of the Tax Code, focusing on Reverse Exchanges and Property ...

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