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

<h2>Holding periods</h2>

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

<h2>Related parties</h2>

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

<h2>Different entities</h2>

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

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

<h2>Already owned property</h2>

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

<h2>Refinance</h2>

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

<h2>Dissolution of a partnership</h2>

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

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

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

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

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

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

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

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

<h2>Conclusion</h2>

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

<p>At Accruit, we handle all types of complex exchanges. Have a situation you'd like to speak to an expert about? No problem. We're happy to have a free, no-obligation consultation with you.</p>
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<p>Sales of wind farms and turbines is becoming increasingly common and could become more so as renewable energy continues to grow as a part of the U.S. energy infrastructure. Wind farms are a source of renewable energy found around the world, and we can expect to see this industry expand&nbsp;here in the States. The sale of a renewable energy asset such as a wind farm or turbine may be from one taxpayer to another, or to a company who is in the business of aggregating these assets for its own business of acquiring, owning, and leasing such assets. The value of the wind farm or turbine is largely a function of the value of the lease, i.e. the rent/royalties, term, and strength of the lessee. Oftentimes the sale prices can be considerable, which in turn, may cause a significant tax event to the seller. In many instances, the availability of a tax deferred exchange under Section 1031 of the Internal Revenue Code can be the key to enabling a sale to take place by minimizing the tax burden to the seller.</p>

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

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

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

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

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

<h2>Summary</h2>

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

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

<p>Accruit has previously provided a summary of the rules pertaining to extensions of exchange transactions <a href="https://www.accruit.com/blog/how-federally-declared-disasters-affect-10…; target="_blank">due to federally declared disasters</a>.</p>

<p>The IRS has recently issued extensions&nbsp;for Section 1031 filing deadlines related to real estate located within certain counties in Alabama.</p>

<p>In Alabama, the IRS issued extensions for Clarke, Dallas, Marengo, Mobile, Perry, Washington, and Wilcox counties&nbsp;<a href="https://www.irs.gov/newsroom/irs-announces-tax-relief-for-hurricane-zet…; target="_blank">for hurricane Zeta that began on October 28, 2020</a>.</p>

<p>Accruit suggests that affected taxpayers consult with their tax and legal professionals as well as confirm on IRS website for any updates.</p>

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

<h2>The Situation</h2>

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

<h2>The Problem</h2>

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

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

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

<p>&nbsp;</p>

<p>&nbsp;</p>

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

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

<p>Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Mr. Spencer’s qualified intermediary (“QI”) to be held in escrow until the purchase of his replacement properties.</p>

<p>Within 45 days after the closing on the sale, Mr. Spencer properly identified four identical condos in one condo complex, conveniently located less than a mile from the local university. Each condo will be acquired for $249,000, with a gross acquisition value of $996,000—which is greater than the sale price of his relinquished property. Closings for the four condos all occurred within 180 days of the sale of the relinquished property, utilizing the exchange proceeds held by the QI and additional mortgage financing.</p>

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

<h2>The Result</h2>

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

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

<p>The majority of all 1031 exchanges are structured as either forward delayed exchanges or simultaneous exchanges. This is likely because of the perceived ease in completing such exchanges. But failing to consider a reverse exchange could be costing many taxpayers more than they think. Let’s compare the exchange strategies of two siblings, Jean, and her brother Jeremy.</p>

<h2>Forward Exchange</h2>

<p>Jeremy is certain that a forward delayed exchange is the best way to handle the exchange of his investment property. His current property – which we will call Strawberry Field – is worth around $400,000 and yields about $3,000 in monthly rental income.</p>

<p>On March, Jeremy enters into a contract to sell Strawberry Field for $400,000, with closing scheduled for April 1. Closing occurs without delay, after which the $400,000 in exchange proceeds are wired to his qualified intermediary (“QI”). The QI is paid $1,000 for its services, leaving Jeremy with $399,000 to reinvest. Jeremy promptly starts looking for appropriate replacement properties. He is targeting single-family or condo-style properties near the local university. On May 15, Jeremy submits his identification list, designating three potential replacement condos, each worth $200,000. By the end of the month, Jeremy has been able to negotiate contracts for the purchase of two of the condos. Closings for the condos are scheduled for July 31. As a result of some title-related delays, Jeremy is able to complete the acquisition of the two condos on August 31, 152 days, or a full five months after he sold Strawberry Field. Jeremy has lost five months of rental income, $15,000, and paid $1,000 to his qualified intermediary, for a “loss” of $16,000.</p>

<h2>Reverse Exchange</h2>

<p>Jean was always the more analytical of the siblings. She consulted her QI months before she began the process of upgrading her investment situation, and has determined that a reverse exchange better suits her needs. A reverse exchange is one that takes place in a reverse sequence, that is, the replacement property is effectively acquired before the old property is sold. While a taxpayer is not allowed to directly acquire the new property first, a <a href="http://https://www.accruit.com/blog/are-1031-reverse-tax-deferred-excha… exchange structure</a> using an exchange company can accomplish the same thing.&nbsp;Jean’s current investment property – which we will call Solsbury Hill – is worth around $400,000 and yields about $3,000 in monthly rental income.</p>

<p>On February 1, Jean enters into a contract to acquire Paisley Park, a fully occupied rental property, for $400,000. Closing is scheduled for April 1. Jean coordinates with her QI to structure this acquisition as the replacement property for a reverse exchange. Accordingly, with the QI’s aid, she forms a new LLC – Paisley Park LLC – to take title to Paisley Park. Formation of the LLC cost her about $500 including the legal fees, and the QI’s related exchange accommodation titleholder (“EAT”) was listed as the sole member of the entity. On April 1, Paisley Park LLC acquires Paisley Park, which is generating approximately $3,000 per month. Allowing the EAT to take title on her behalf, she is not considered to have acquired it herself but has taken it off the market and preserved her ability to use it as her replacement property once the relinquished property is sold.</p>

<p>Jean enlists the aid of her friendly real estate agent and begins marketing the sale of Solsbury Hill. Jean and her real estate agent successfully negotiate the sale of Solsbury Hill, and on June 1 she enters into a contract to sell the property for $400,000, with closing scheduled for August 1. As a result of some financing related delays, Jean’s buyer is finally able to complete the acquisition of Solsbury Hill on August 31. This is closed as the first leg of a routine forward exchange using the QI. Once closed, Jean is ready to <a href="https://www.accruit.com/blog/case-study-forward-exchange-real-estate">f… her exchange</a>.&nbsp;At this time, the EAT transfers membership of Paisley Park LLC to Jean, officially cementing Jean as the owner of Paisley Park. From the time Jean acquired Paisley Park until she disposed of Solsbury Hill was five calendar months. During this time, she had combined cash flow on the two properties of $30,000. She did have to pay $500 for the formation of the LLC, and her exchange fees were about $4,000, so she had net income of $25,500 during the same time when Jeremy had net losses of $16,000 – a difference of over $41,000.</p>

<h2>The Bottom Line</h2>

<p>For exchangers who have the financial capacity to do so, structuring transactions as reverse exchanges is an option that is often overlooked. Among other things, it takes away the pressure of having to narrow down choices of possible replacement property within 45 days of a sale of the original property. Consulting with a QI, as well as tax and legal advisors before embarking on the sale of investment real estate is highly recommended. The skilled and experienced team at Accruit can help structure forward and reverse exchanges, and even non-safe harbor reverse exchanges that may take longer than 180 days to complete.</p>
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