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IRC Section 1031 Exchange Qualified Use Requirements

04/12/22

Does your property meet the productive use or qualified use requirement for a 1031 exchange? Here are examples of those that ...

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We recently examined <a href="/blog/1031-exchange-holding-period-requirements">the duration a taxpayer must hold a relinquished and replacement property</a> to satisfy the requirement that exchanged assets must be held for investment or used in a business or trade.  The conclusion was that there is no specific time limit for an asset to be deemed to having been held, rather it is a facts and circumstances test.  In this post, we will look into the issue of “qualified use” as another key element in a successful tax deferred exchange.

IRC Section 1031(a)(1) provides “In general no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment”.

Let’s look at some examples where the productive or qualified use requirement may, or may not, apply in a 1031 exchange.

<h2>Vacation Homes and Qualified Use</h2>

<a href="/blog/1031-exchange-rules-vacation-homes-primary-residences-and-mixed-use-properties">A taxpayer’s vacation home or second residence</a> can be eligible for a 1031 exchange if specific requirements are met. The property must have been held for investment for at least 24 months prior to the exchange. Additionally, the property must have been rented out at fair market value for a minimum of 14 days within each of the 12 months and the taxpayer cannot have used the property personally for more than 14 days, or 10% of the days the property was rented, within each of the 12 month periods.

<h2>Taxpayer Occupied Multi-Family Property and Qualified Use</h2>

A multifamily property such as a two flat or three flat, where the owner lives in one unit and rents out the other unit(s) can be the subject of an exchange of the investment portion.  The sale would be split where the taxpayer could receive directly the net proceeds pertaining to the personal use unit and could cause the net proceeds pertaining to the investment unit(s) to go to fund the exchange account. In most cases, the gain associated with the owner occupied unit could also be deferred under IRC Section 121, the Code section dealing with the sale of a personal residence.

Keep in mind that the assignment of contract rights under the relinquished property agreement must be modified to show what percentage interest of the whole property will be the subject of the assignment to the qualified intermediary.

<h2>Taxpayer Occupied Farm Land and Qualified Use</h2>

Similarly, exchanges of farmland are very common.  Often the personal residence of the owner sits on the farmland.  Again, as in the other examples, the percentage of the land that is used for farming can be exchanged and the percentage used for the dwelling can be sheltered under IRC Section 121.

<h2>Mixed Use Personal Residences and Qualified Use</h2>

There are taxpayers who have mixed use of their personal residence.  An example of this might be a psychologist who uses a room in the home as the office to meet with clients.  If the square footage of this room is 10% of the entire residence than a 10% interest in the relinquished property could be sold as part of an exchange.

<h2>Death of a Taxpayer and Qualified Use</h2>

As the saying goes, the only sure things in life are death and taxes.  We have covered taxes above, so let’s look at the effect of the death of the taxpayer on the issue of qualified use.  If a taxpayer dies prior to the anticipated sale of relinquished property, the heirs get the property with a stepped up basis and would not have a need for tax deferral.  However in the event a taxpayer dies after the start of an exchange and the sale of the relinquished property, the gain would be due without an acquisition of replacement property.  Despite the estate not having qualified use of the property itself, there are various favorable IRS rulings allowing the estate to acquire the replacement property and defer the gain recognition.

<h2>Summary</h2>

The exchange rules require that the relinquished and replacement properties be ones that are held for productive use in a business or trade or as an investment. This “productive use,” often referred to ‘qualified use” can sometimes cause confusion where there is both a personal use of a property and also a qualified use of part of the same property.  In most cases, the qualified use portion of the property can be separated and be the subject of a §1031 exchange.

Updated 4/12/2022.

Metatags:

Title:

IRC Section 1031 Exchange Qualified Use Requirements

04/12/22

Does your property meet the productive use or qualified use requirement for a 1031 exchange? Here are examples of those that ...

1031 Drop and Swap out of a Partnership or LLC

1031 exchange

04/04/22

A drop and swap is a practice allowing a subset, or portion, of a partnership or LLC to engage in ...

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<h2>Can a partner or member trade their share of a property interest upon sale?</h2>

One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a <a href="/services/1031-exchange">1031 exchange</a> and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself.  The section generally provides

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like kind which is held for productive use in trade or business or for investment”.

However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership."  As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members.

While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share.  The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”

A <a href="https://www.accruit.com/blog/drop-and-swap-or-swap-and-drop" title="1031 tax exchange drop and swap">1031 tax exchange drop and swap</a> can take place in several different ways.  As mentioned above, when the majority of members wish to cash out, the taxpayer can transfer his membership interest back to the LLC in consideration of his receipt of a deed for a percentage fee interest in the property equivalent to his former membership interest.  The taxpayer would then own a tenant in common (TIC) interest in the relinquished property together with the LLC.  At closing each would provide their deed to the buyer and the former member can direct his share of the net proceeds to a qualified intermediary.

At times, the majority of members will wish to complete an exchange and one or more minority members will wish to simply cash out.  The drop and swap can be used in this instance also by dropping applicable percentages of the property to the exiting members while the limited liability company completes an exchange at the LLC level and the former members cash out and pay the taxes due.

<h2>Meeting the “Held For” Requirement in a Drop and Swap</h2>

As indicated above, in order for property to be exchanged, it must have been held by the taxpayer for use in a business or for investment.  So, if on the eve of the closing on the sale of the relinquished property a fee interest is conveyed to the exiting member, that member would be hard pressed to claim that she personally had held the property for any real period of time. However, when outgoing members wish to cash out, the “held for” requirement is less of an issue since the exchange is done at the LLC level and the LLC has clearly held the property for a qualified use for a significant length of time.  It does not matter that the outgoing members will not have satisfied the holding period requirement since they are not seeking exchange status.

For quite some time there have been recommendations from different groups to the IRS to allow outgoing members to be able to tack on their holding period as members to their individually-held ownership interest prior to an exchange. The Joint Committee of Taxation, which every several years comes up with suggested tax-related recommendations, has stated:

“For purposes of determining whether property satisfies the holding requirement under Section <a href="https://www.accruit.com/blog/understanding-like-kind-requirement-1031-e…; title="1031 like kind exchange">1031 like kind exchange</a> rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”

To date the IRS has not adopted this position.  If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.

<h2>IRS Form 1065 U.S. Return of Partnership Income</h2>

In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to <a href="http://www.irs.gov/pub/irs-pdf/f1065.pdf">Form 1065</a>. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property."  Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis.

As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange.  Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.

<h2>Underlying Loan Considerations</h2>

When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member.  As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member.  In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.

Almost all loans secured by property contain “due on transfer” clauses.  So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents.  This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.

<h2>Deemed Partnership</h2>

There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership.  This would negate a drop and swap.  Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs.  The least amount of management by the co-owners is helpful to avoid partnership characterization.  Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property.

For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship.  The terms of such an agreement comes from IRS guidance in the form of <a href="http://www.irs.gov/pub/irs-drop/rp-02-22.pdf">Rev. Proc. 2002-22</a>. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership.   It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible.  Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.

<h2>Summary</h2>

The possibility of structuring of a <a href="https://www.accruit.com/property-owners/1031-exchange-explained" title="1031 tax exchange">1031 tax exchange</a> by a subsection of the partners in a partnership or members in an LLC, is one of the most common questions asked by taxpayers to their exchange facilitator or their advisers.  While at one time this was done regularly and with apparent impunity, over time the IRS has taken steps to limit this deferral opportunity when the taxpayer has failed to hold the property for an amount of time. The technique of “dropping” an interest to a partner in the form of a tenant in common ownership of title to the property and then “swapping” that interest is very popular.  The same can be true when a member wishes to cash out where the LLC seeks to do an exchange.  There are some planning steps that can be taken in order to provide the exchange transaction the best chance to pass IRS muster.

Updated 4/4/2022.

Metatags:

Title:

1031 Drop and Swap out of a Partnership or LLC

1031 exchange

04/04/22

A drop and swap is a practice allowing a subset, or portion, of a partnership or LLC to engage in ...

Does Little to No Gain on an Investment Property Mean No Need for a 1031 Exchange?

03/30/22

Deciding whether or not to do a 1031 Exchange when large gains are involved is a simple answer, YES! But, a 1031 ...

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Many investors know that they can shelter the capital gains on the sale of investment properties when they structure the sale as part of a Section 1031 like-kind exchange. However, they are typically unsure about the consequences of a transaction involving the sale of an investment property with little or no gain.

<h2>The Situation</h2>

Mike owns an investment property that he bought as part of a 1031 exchange at the height of the real estate market in 2006 for approximately $296,000. With the decline in the real estate market over the next few years, the property was worth only about $209,000 in 2012. Mike received an offer for $305,000 in 2020, and is not sure whether a 1031 exchange is the right course of action.

<h2>The Problem</h2>

Mike’s initial thoughts regarding the current house are that he paid $296,000 for the house and the current offer is $305,000. His analysis is:

Purchase                      $296,000

Sale                              $305,000

Gain                             $9,000

20% Fed Cap Gains        $1,800

5% State Cap Gains       $450

Total Tax Burden           $2,250

However, Mike has forgotten a couple of critical facts. First, he acquired this property in 2006 as part of a 1031 exchange, in which he sheltered a substantial gain. Second, he neglected to account for the depreciation recapture on both transactions. The real math for Mike’s current exchange is:

Purchase #1                  $223,000

Sale #1                         $295,000          (5-year hold)

Gain #1                         $72,000

20% Fed Cap Gains        $14,400*

5% State Cap Gains       $3,600*

5 Years Depreciation     $40,505

Fed Recapture (25%)     $10,126*

State Recapture (5%)     $2,025*

Purchase #2                  $296,000

Sale #2                         $305,000          (14-year hold)

Gain #2                         $9,000

20% Fed Cap Gains        $1,800

5% State Cap Gains       $450*

14 Years Depreciation   $150,690

Fed Recapture (25%)     $37,673*

State Recapture (5%)     $7,535*

TAXES OWED WITHOUT EXCHANGE

Property 1

20% Fed Cap Gains        $14,400*

5% State Cap Gains       $3,600*

Fed Recapture (25%)     $10,126*

State Recapture (5%)     $2,025*

Property 2

20% Fed Cap Gains        $1,800

5% State Cap Gains       $450*

Fed Recapture (25%)     $37,673*

State Recapture (5%)     $7,535*

TOTAL TAXES DUE         $77,609

When Mike overlooked the previous 1031 exchange, he neglected to account for the deferred taxes from that transaction. He also overlooked the significant depreciation he had taken during the time he owned this current property. While the gain on this current property is nominal, the potential tax liability in an outright sale would be substantial due to the need to recognize previously deferred taxes as well as the depreciation recapture.

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

Mike will sell this property as part of another 1031 exchange. After consulting with his attorney and a Qualified Intermediary (QI) like Accruit, Mike now understands that a  1031 Exchange is a tax deferral strategy, and that he would need to recognize those previously deferred taxes upon a sale. Mike visited the <a aria-label="Capital Gains Calculator" href="/capital-gains-calculator" title="Capital Gains Calculator">Capital Gains Calculato</a>r on the Accruit website to get a better understanding of the tax ramifications of a sale without another 1031 exchange.

Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Mike’s QI to be held on his behalf until the purchase of his replacement property. This is necessary because a person doing an exchange cannot come in actual or constructive receipt of the net sale proceeds while the exchange is pending.

Within 45 days after the closing on the sale, Mike identified suitable replacement property (learn more about <a aria-label="1031 Exchange Rules and Regulations" href="/blog/what-are-rules-identification-and-receipt-replacement-property-irc-%C2%A71031-tax-deferred-exchange" title="1031 Exchange Rules and Regulations">Identification rules in 1031 exchanges</a>). Mike completed the acquisition of that property approximately sixty days later, well within 180 days of the sale of his relinquished property, utilizing the exchange proceeds held by his QI. Mike has now relocated his investment to a more investor friendly town.

<h2>The Result</h2>

Mike has successfully completed a 1031 exchange from a single-family home in a town that imposes heavy regulatory burdens on landlords to a neighboring town that is more investor friendly. He exchanged equal or up in value, using all of his equity, and thereby fully deferred the capital gain and depreciation recapture taxes on this property, as well as from his previous investment property.

Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.

As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property.

Metatags:

Title:

Does Little to No Gain on an Investment Property Mean No Need for a 1031 Exchange?

03/30/22

Deciding whether or not to do a 1031 Exchange when large gains are involved is a simple answer, YES! But, a 1031 ...

1031 Tax Deferred Exchanges Between Related Parties

03/28/22

The Related Party rules amend section 1031 of the tax code to prevent taxpayers from using a related party to abuse ...

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Historically, real estate transactions were not uncommon amongst family and other related parties. Given this and prior history of taxpayers utilizing family or related parties to manipulate the existing IRS regulations on 1031 exchanges, Congress amended the code section to include Related Party rules in relation to 1031 exchanges. Due to today's booming real estate market, it is even more popular for family to try to help the younger generation start their real estate investment journey, which makes it more important than ever to understand the Related Party rules outlined below.

<h2>Background to the Related Party rules</h2>

Tax deferral under <a href="/exchange-library/internal-revenue-code-section-1031">section 1031 of the U.S. tax code</a> is very taxpayer-friendly, potentially allowing taxpayers to defer capital gain, depreciation recapture, healthcare tax, and state tax.   However, to take advantage of this code section, taxpayers have to play fair and strictly follow the rules.  In the past, it was possible to manipulate the rules to achieve a favorable outcome by bringing a party related to the taxpayer into the transaction. In 1989, Congress amended the code section to stop this abuse. The amendment prohibits taxpayers from entering into transactions with related parties, subject to a few limited exceptions. According to the legislative history of §1031(f) “if a related party exchange is followed shortly by a disposition of the property, the related parties, have in effect, cashed out of the investment.”

This new section, 1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—

(i) the related person disposes of such property, or

(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”

<h2>What was the abuse that gave rise to the Related Party rules?</h2>

Take as an example “Parent Company” which has Property A for sale with a lot of built-in gain and no need to acquire a replacement property.  Its affiliate, “Subsidiary Company” owns Property B of similar value with a high basis. In any exchange, the basis is carried over from the relinquished property to the replacement property.  So rather than sell the properties outright, the two companies enter into an exchange with one another to defer taxes.  Parent Company holds Property B indefinitely, but shortly after the exchange, Subsidiary Company sells Property A.  Since Subsidiary Company has a high basis in Property A, there is little tax effect to it upon the sale.  This was a common occurrence prior to the 1989 Related Party rules addition to section 1031.

<h2>Can any part of a taxpayer’s exchange transaction involve a related party?</h2>

Often a taxpayer will sell the relinquished property to a related party while acquiring replacement property from an unrelated party.  This structure is not prohibited by the Related Party rules since it does not involve the taxpayer carrying over tax basis into the property sold (it is carried over into the property being purchased), and therefore there is no opportunity for the tax abuse that the rules seek to curb.  Between 2007 and 2010 there were a series of <a href="http://www.irs.gov/pub/irs-wd/0709036.pdf" target="_blank">IRS Private Letter Rulings</a> confirming this position.

However, when a taxpayer sells relinquished property to a third party and acquires replacement property from a related party, the tax abuse opportunity is present, despite the fact that the related parties are not exchanging with one another. By purchasing property from a related party, the taxpayer can potentially dispose of low basis property without recognizing the gain.

<h2>What relationships constitute related parties?</h2>

Rather than reinventing the wheel, the drafters of the Related Party rules chose to refer to existing code sections which already defined “related persons” for other purposes.  Section 1031(f) states that “For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267 (b) or 707 (b)(1).”  Those relationships in these code sections include

<ul>
<li>Members of the same family unit (siblings, spouse, ancestors, and lineal descendants);</li>
<li>Corporation where more than 50% of the value of the stock is owned directly or indirectly by or for one particular individual;</li>
<li>Two (2) corporations that are in the same controlled group (as defined in subsection (f);</li>
<li>A grantor and a fiduciary of any trust;</li>
<li>A fiduciary of one trust and the fiduciary and/or beneficiary of another trust where the same person is the grantor for both trusts;</li>
<li>A fiduciary of a trust and a beneficiary of the same trust;</li>
<li>Corporation where more than 50% of the value of the stock is owned directly or indirectly by or for one particular trust or by or for the grantor or fiduciary of the trust;</li>
<li>An organization qualified under Section 501 of the Internal Revenue Code (relating to certain educational or charitable non-profit organizations) which is controlled directly or indirectly by a specific person or (if such person is an individual) by members of the family of such individual;</li>
<li>A corporation and a partnership if the same person or persons own: more than 50% in value of the outstanding stock of the corporation, and more than 50% of the capital interest, or the profits interest, in the partnership;</li>
<li>An S corporation and another S corporation or a C corporation if the same person or persons own more than 50% in value of the outstanding stock of each corporation;</li>
<li>A partnership and a person owning, directly or indirectly, more than a 50% capital interest or a 50% profits interest, in such partnership;</li>
<li>Two partnerships in which the same person or persons own, directly or indirectly, more than a 50% capital interest or a 50% profits interest, in both partnerships;</li>
<li>An executor of an estate and the beneficiaries of the estate.</li>
</ul>

There are sometimes opportunities for transactions that may involve relatives, although not defined as related parties.  Exchanges with aunts, uncles, nieces, nephews, in-laws may fall into that category.  Additionally, oftentimes parties hold 50% interests in partnerships, LLCs or company stock, as opposed to more than 50%.

<h2>Summary</h2>

The underlying rational for a tax deferred exchange is the continuity of investment without a cashing out.  Prior to the Related Party rules, the taxpayer could use a related party to effectively cash out of an investment, while technically abiding by the requirements of a deferred exchange. Next, we examine <a href="/blog/1031-exchange-related-party-rules-exceptions-and-misconceptions">exceptions to and misconceptions of the Related Party rules for 1031 exchanges</a>.

Updated 3/28/2022.

Metatags:

Title:

1031 Tax Deferred Exchanges Between Related Parties

03/28/22

The Related Party rules amend section 1031 of the tax code to prevent taxpayers from using a related party to abuse ...

1031 Exchanges for Condominium Deconversions

03/24/22

Condominium decoversions are increasingly popular in urban areas, such as Chicago, due to the increasing need for rental properties. Special ...

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Condominium deconversions have been taking place quite frequently in the greater Chicagoland area and elsewhere.  For reasons including the ones set forth below, a condominium deconversion takes place when 75% (or in some jurisdictions a higher percentage) of the owners choose to sell the building to someone interested in converting it to use as an apartment building.  A deconversion can be precipitated by one or more factors.  Rental properties may be in short supply in the area and converting the building to apartments may be far more valuable than the aggregate value of the individual condo units.  Also, as the building gets older and requires more regular fix ups, unit owners are reluctant to continuously pay for special assessments that might otherwise keep the property in proper condition.  Furthermore, the need for ongoing special assessments may make it difficult to sell the unit or at the very least have a negative impact on the price.

<h2>Requirements for a 1031 Exchange</h2>

Like any other sale of real estate, those who utilized their unit as an investment or business use property and are seeking to use a tax deferred exchange have to adhere to the specific governing regulations.  One such requirement is that the exchange company, known as a Qualified Intermediary (QI), has to take tax ownership of the property from the property owner and to transfer that ownership to the buyer. Click to learn more about <a aria-label="Qualified Intermediary services" href="/qi-services" title="Qualified Intermediary Services">QI services</a>. This can be accomplished by the taxpayer deeding the property to the QI and the QI deeding to the buyer.  Another permitted way to accomplish this is for the QI to be a party to the sale agreement, meaning that the QI has a legal obligation to cause legal title to be conveyed to the buyer.  These two options are somewhat cumbersome. In order to make that process as simple as possible, the Treasury Department provided a shortcut in the regulations to accomplish tax ownership of the relinquished property passing through the QI.

(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that  agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.

In short, sellers’ “rights” in and to the sale agreement have to be assigned to the QI and all parties to the agreement have to receive written notice of this assignment. However, meeting this requirement in a sale of an individual owner’s unit presents a practical problem since typically when it comes to condominiums the sale agreement is signed only by the condominium association, and not by the actual unit owner.

<h2>Meeting 1031 Exchange Rules on a Conversion Property</h2>

In this blog writer’s shop, we attempt to bridge this gap by having slightly different language on this Assignment of Relinquished Property when it involves a sale due to conversion.  The italicized part of the assignment document appears below:

Assignment.  The undersigned (“Exchanger”) hereby assigns to Accruit, LLC (“Accruit”) all of Exchanger's rights (but not Exchanger’s liabilities or obligations), referred to hereafter as the “Assignment”, under that certain Purchase and Sale Agreement (the “Relinquished Property Contract”) between the ____________ Condominium Association as Seller, of which ___________ is a condominium unit owner as to her percentage ownership in the comment elements in the ______________ Condominium Association pursuant to 765 ILCS 605/15 of the Illinois Condominium Property Act, the unit owner being the Exchanger and Relinquished Property Buyer being the buyer (identified above).  If not previously provided, simultaneously with the execution of this Assignment by the parties, Exchanger shall promptly provide Accruit with a copy of the Relinquished Property Contract.

The challenge is assigning the rights to the unit owner’s sale of the unit in a situation where the unit owner is not a direct signer nor party of the agreement.  Instead, the taxpayer is assigning the rights in his or her derivative capacity as an owner in the property being sold to the party seeking to change the property into an apartment building. Notice of the assignment is also given to the parties to the contract, usually by tendering it to their lawyers as the agent for the parties.

Sales of condominium buildings are happening regularly, and many unit owners are seeking to receive tax deferral by utilizing a 1031 exchange opportunity.  The manner in which the sale contract is signed presents a slight challenge to meet the requirements set forth in the 1031 exchange rules.  However, the spirit of those rules can be followed with an assignment of rights whereby the language in the assignment is changed slightly to account for the lack of a unit owner’s being a direct party to the sale agreement.

Metatags:

Title:

1031 Exchanges for Condominium Deconversions

03/24/22

Condominium decoversions are increasingly popular in urban areas, such as Chicago, due to the increasing need for rental properties. Special ...

Cash Out Refinance Before or After a 1031 Exchange?

capital gains tax

03/21/22

Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg ...

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Most taxpayers wish to defer tax in full when completing a <a href="/services/1031-exchange">1031 exchange</a>.  In order to accomplish this, one simple rule of thumb is that the taxpayer must trade “up or equal” in value.  Perhaps a better way to look at this is to make sure the net proceeds of sale (i.e. the amount held in the exchange account) are used in full and the taxpayer puts on equal or greater debt on the new property compared to the amount paid off at the time of closing on the sale.  Another expression sometimes used is that the taxpayer should have “no net debt relief.”  Any cash taken out at closing and any debt that is not covered could be subject to:

<ul>
<li>Capital gains tax</li>
<li>Recapture of depreciation</li>
<li>State taxes</li>
<li>Net Investment Income Tax (also known as Affordable Care Act tax)</li>
</ul>

Oftentimes with exchange transactions, taxpayers wish to receive some cash out for various reasons.  Any cash generated at the time of the sale that is not reinvested is referred to as “boot” and the amount is taxable.  There are a couple of possible ways to gain access to that cash while still receiving full tax deferral.

<h2>Refinancing Relinquished Property Prior to Closing</h2>

For an owner of real estate, not engaging in a 1031 exchange, who wishes to refinance it at any time, any cash proceeds received are not subject to tax. However, in many cases, a taxpayer looking ahead to an upcoming exchange of his property may find himself with a high amount of equity and relatively low (or no) debt, this will require him to reinvest all the cash (and match debt).  The taxpayer may wish to finance or refinance the property pulling cash out and later go to closing with higher debt and lower cash equity, as a result his reinvestment requirements for the replacement exchange property are suddenly very different.  Essentially he walks away from the transaction with the debt on the property paid off, cash in his pocket, higher debt and lower equity in his replacement property and total tax referral The problem with this approach is that the IRS does not like it.  It is almost like cheating.  Essentially it is substituting new debt for cash taken out.  Since the taxpayer cannot take out cash on a tax deferred basis at closing, essentially doing the same thing just prior to the closing should be disallowed as well. The IRS does not look favorably upon a step transaction, which basically means that if something is not allowed to be done in a direct fashion (taking out cash at closing), by taking a few additional steps to avoid the application of the rule, is not allowed either.

There are a couple of facts which may improve the IRS position on these refinance transactions.  One of these is the impression that the refinance is not done in anticipation of the exchange of the property.  In general, the more time that elapses between any cash out refinance and the eventual sale of the property is in the taxpayer’s best interest  There is no bright line safe harbor for this, but at the very least if it is done somewhat prior to listing the property, that fact would be helpful.  The other consideration that comes up a lot in IRS cases is the presence of independent business reasons for the refinance.  Maybe the taxpayer’s business is having cash flow problems.  Maybe the property needs a new roof, etc.  To the extent that the refinance is done for other reasons and not solely to effect a favorable change to the debt and equity numbers, a taxpayer should be able to refinance even while contemplating a subsequent 1031 exchange of the property.

<h2>Refinancing Replacement Property After Closing</h2>

As was stated above, in the absence of any exchange transaction, a taxpayer who chooses to do a cash out refinance does not trigger any tax.  The question then is whether that principle applies to refinancing to pull equity out after the acquisition of the replacement property is complete.  Is that taxpayer in any different position from one who is doing a cash out refinance for property held but not part of an exchange transaction?  Probably not and accordingly, the IRS does not seem to disallow these post-exchange refinancings.  The American Bar Association Section on Taxation addressed these issues, and others, as part of an open report it prepared after the exchange rules came out.  The committee concluded that in the case of pre-exchange refinance the taxpayer is no longer obligated to pay the debt once the loan is paid off at the closing, while still retaining the cash.  In a post-exchange transaction, the taxpayer retains the cash but has an outstanding obligation to repay the debt.  The committee concluded:

<blockquote>
“The key to the distinction between pre-and post-exchange refinancings is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for pre-exchange relinquished property refinancing upon transfer of the relinquished property.  A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth.”
</blockquote>

Consistent with this reasoning, one noted author used the term “nanosecond” to indicate how long a taxpayer needs to wait before entering into a cash out refinance on the replacement property.  In other words, once a taxpayer owns the replacement property and refinances it incurring a repayment obligation, that taxpayer is in no different position than anyone else owning property and refinancing it.  Most authors take a similar position, but caution not to have the cash out refinance done concurrently with the acquisition of the property nor to have it prearranged prior to the purchase of the property.  Best practice would be to start the cash out refinance process any time after the replacement property acquisition.

<h2>Summary of Cash Out Refinance in 1031 Exchange</h2>

Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg of an exchange.  Any sums paid to the taxpayer at closing are subject to taxation.  As an alternative, a taxpayer may wish to refinance the relinquished property before the exchange or refinance the replacement property after the exchange.  In the absence of mitigating factors, refinancing the relinquished property is generally discouraged, however  refinancing the replacement property should not result in any tax issues and should not jeopardize the tax deferral on the transaction.  The primary logic for these positions is that with the former, the taxpayer is able to pay off the loan debt at the closing, whereas in the second alternative the taxpayer retains the debt obligation as an offset to the receipt of cash.

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Updated 3/21/2022.

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Cash Out Refinance Before or After a 1031 Exchange?

capital gains tax

03/21/22

Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg ...

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