<p>Earlier in the year I discussed Congress’ intent to move toward tax reform.&nbsp; Chairman Hatch of the Senate Finance Committee had announced bipartisan tax reform working groups in January with recommendations due in late May, a deadline that was postponed twice.&nbsp; The writing was on the wall for “business only” tax reform with the intention of providing tax relief for corporations.&nbsp; These proposals were met with dissension by the majority of U.S. businesses operating as pass-through entities.&nbsp; Simultaneously, international tax reform was gaining momentum in parallel with the emptying of the highway trust fund coffers and the newly proposed international trade acts reforms.&nbsp;</p>

<h2>We're Not Out of the Woods</h2>

<p><a href="http://www.bkd.com/articles/2014/analysis-of-chairman-camps-draft-tax-r…; target="_blank">The Tax Reform Act of 2014</a>, which includes a complete repeal of 1031 like-kind exchanges, continues to loom as a starting point for comprehensive reform.&nbsp; And the <a href="http://www.treasury.gov/resource-center/tax-policy/Documents/General-Ex…; target="_blank">President’s Green Book budget proposal</a> also severely limits the use of 1031s.</p>

<p>What’s the old saying?&nbsp; “History does not repeat itself, but it rhymes.”<br />
<br />
As we watch this Congress work hard to keep promises by passing reforms, the always lingering question is still, “Who is going to pay for tax reform?” During last month's discussions on transportation legislation, Senator Pat Roberts (R-Kan.) pointed out the increasing difficulty to find enough spending cuts to cover the costs of the long list of programs that need funding.</p>

<p>“We’re looking in every corner for every pay-for. It is just terribly difficult to find this kind of money, and we’re probably painted into the corner on a lot of different issues.”</p>

<h2>1031s Should Not Be the Pay-For</h2>

<p>Through multiple coalition efforts, the 1031 industry continues to pressure Congress to leave 1031 like-kind exchanges in their current state. Through letters, independent studies, face-to-face meetings, testimonials and fund raisers, the supporters of <a href="/blog/new-study-confirms-like-kind-exchanges-encourage-job-creation-and-stimulate-economic-growth">growing our economy</a>, expanding employment, and capital formation continue to push for certainty around 1031 like-kind exchanges. It's been an extensive and costly effort. Still, it's August and once again, the frustration of the inaction in our nation’s capital remains a constant.</p>

<p>If bonus deprecation is extended or section 179 expanded, your company will likely determine the impact of this retroactive incentive bill. At the same time, what will this mean for 2016? What changes need to be made today in your business IF Congress does NOT act?&nbsp; What if they do act?&nbsp; What is the cost to your business if the changes impact your current tax position significantly? It is very hard, if not impossible, to build and thrive in today’s business climate by awaiting actions beyond your control.&nbsp; Across the country, we are seeing tremendous growth in every business sector. The economy is expanding and businesses want to reinvest in growth, however the continued uncertainty is a huge obstacle to long-range planning.&nbsp; IF the Highway Trust Fund bill eventually moves through Congress, IF the President signs off, IF the bill funds more than 15 months of emergency fixes to our infrastructure, IF IF IF!&nbsp;</p>

<h2>Contact Your Representatives</h2>

<p>It’s crucial to remember that we are not out of the woods. Tax reform discussions will be back in 2016, so we need to educate Congressional leaders now as to why 1031s are important to your business and to the economy. Reach out and schedule in-district meetings with your representatives; meet them on your turf; let them hear you loud and clear that 1031 like-kind exchanges are a powerful tool you use in your business.&nbsp; As a constituent, share with your elected officials your stories of growth and new employee-hiring numbers.&nbsp; Describe your five year plan IF and ONLY IF they can provide certainty for you to plan your business.</p>

<p>The national associations to which you belong often provide tools and information to contact or identify your representatives. If they don't, <a href="mailto:brenta@accruit.com?subject=Tax Reform blog">contact me</a>. I'll gladly give you the contact information you need as well as discuss talking points and strategy, and I would be happy to provide you with white papers and studies to support your discussion. The time to get involved and have Congress hear your voice is NOW!</p>

<p>Utilizing a long term ground lease on real estate owned by a party related to the taxpayer can enable a taxpayer to invest proceeds into making improvements on that property. In a recent blog post we discussed build-to-suit and property improvement exchanges.&nbsp; As that post made clear, a taxpayer cannot do improvements on property that is already owned by the taxpayer. Another post pertaining to <a href="/blog/1031-tax-deferred-exchanges-between-related-parties">exchange transactions between related parties</a> underscored the admonition against a taxpayer acquiring replacement property from a related party.&nbsp; Merging these two issues provides an opportunity for us to discuss the potential of a taxpayer using exchange proceeds to improve a property owned by a related party.</p>

<p>This type of transaction is made possible by introducing a long term lease for the property into the ownership structure of the land.&nbsp; For 1031 exchange purposes, a long term lease is defined as a lease with 30 years or more to run, including renewal options.&nbsp; As an example, a ten year ground lease with two ten year options would be a sufficient interest in the land to constitute an ownership of the “leasehold estate” by the lessee which is legally recognizable as a separate and distinct ownership from that of the underlying land itself.&nbsp; This long term interest is considered like-kind to a direct (“fee”) interest in land.&nbsp; Consequently if improvements are built upon the land those improvements belong to the ground lessee and conversely, the land owner, the related party, has no ownership rights in those improvements.&nbsp; &nbsp;&nbsp;</p>

<p>Looking back to the rules disallowing a taxpayer to build on property it already owns, this issue can be resolved by having an Exchange Accommodation Titleholder (“EAT”) become the ground lessee and for the EAT to build the improvements per the plans and specifications required by the taxpayer (This was the gist of the first blog referenced above).&nbsp; Further, if the interest in a long term ground lease, including improvements upon the property, is recognized as a separate and distinct real property interest, then the taxpayer’s receipt of these leasehold improvements should not be deemed to be received from the underlying related party land owner.</p>

<p>This structure was the subject of a 2002 Private Letter Ruling. In that fact pattern the related party was not the land owner but rather a lessee itself of the property under a long term lease.&nbsp; As stated above, a long term lease interest for 1031 exchange purposes is the same as a fee interest and, as such, the ground lease was subleased to an EAT for purposes of constructing upon the property.&nbsp; This structure was approved.</p>

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

<p>The most recent ruling on this structure was <a href="/exchange-library/irs-private-letter-ruling-plr-201408019" target="_blank">PLR 201408019</a>. In this case a part of the property leased to the related party was subleased to an EAT with a lease term in excess of thirty years.&nbsp; Similar to the findings in the prior Private Letter Rulings, the IRS ruled that the sublease and the improvements were like kind to the taxpayer’s fee interest in the relinquished property.</p>

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

<ul>
<li>First, a fair market rental payment was paid by the EAT to the lessor/sublessor. Sometimes in practice the start of those payments is deferred for the first 180 days of the sublease in order to avoid having the EAT getting involved with the rent payment.&nbsp;</li>
<li>Second, the lease/sublease should have 30 or more years to run as of the time the EAT leases the property.&nbsp;</li>
<li>Lastly, the rulings all had language suggesting that neither the related party nor the taxpayer should dispose of its interest for at least two years, which is a requirement of one of the exceptions to the related party rules.&nbsp;</li>
</ul>

<p>Regarding this last item, one could argue that had the related party been the land owner, the two year holding requirement would not be needed since the taxpayer would receive nothing from the related party throughout the transaction.&nbsp; The fact that the EAT is leasing the property from the related party should not be relevant. The situation in the Private Letter Rulings involved the EAT taking an assignment of the ground lease from the related party and the ground lease was ultimately transferred to the taxpayer. Nevertheless, it is not usually necessary in these transactions for a party to dispose of either property within two years, so it is not a burdensome requirement in any event. Also, most advisors agree that the lease relationship can be terminated after a time in excess of two years when the exchange transaction is considered "old and cold."</p>

<p>So, quite often a taxpayer - whether an individual, partnership or limited liability company - has the desire to use exchange proceeds towards building upon land owned by a related person or entity.&nbsp; The taxpayer can take advantage of the legal fiction that improvements to property under a long term ground lease do not constitute building upon the underlying land owned by a related party and therefore they can use exchange proceeds to fund the improvements. They are acquiring the improvements from the EAT and not the related party.</p>

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

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

<p>Accruit's Chief Operating Officer, <a href="http://www.bizjournals.com/denver/print-edition/2015/08/21/karen-kemerl…; target="_blank">Karen Kemerling</a>, is one of three finalists for <em>Denver Business Journal</em>'s 2015 Outstanding Women in Business award in the Banking, Finance and Accounting category.</p>

<p>Each year, the <a href="http://www.bizjournals.com/denver/news/2015/07/17/who-are-the-2015-outs…; target="_blank"><em>Denver Business Journal</em></a> recognizes Denver's most influential women with awards in the categories of Architecture, Engineering and Construction; Banking, Finance and Accounting; Communications, Media and Public Relations; Education, Government and Nonprofits; Health Care; Large Business Owner; Law; Mile High Leaders; Real Estate; Small Business Owner; Technology and Telecommunications; Lifetime Achievement and the newly added Energy Industry.</p>

<p>The other finalists in the Banking, Finance and Accounting category are Kathryn Albright of U.S. Bank and Barbara Brohl of the Colorado Department of Revenue. View a <a href="http://www.bizjournals.com/denver/news/2015/07/17/who-are-the-2015-outs…; target="_blank">slideshow of the 2015 finalists in all categories</a> and join the <a href="http://www.bizjournals.com/denver/event/118391#eventDetails&quot; target="_blank">Outstanding Women in Business Awards Luncheon</a> on Thursday, August 20, 2015.</p>

<p><a href="http://www.bizjournals.com/denver/print-edition/2015/08/21/karen-kemerl…; target="_blank">Read "Karen Kemerling scores in the accounting game" in the <em>Denver Business Journal</em></a>.</p>

<p>There is an old adage that states “Just because you can do something-doesn’t mean you should.” This sage advice certainly applies to choosing a qualified intermediary to facilitate a 1031 like-kind exchange. The use of a qualified intermediary is essential to completing a successful 1031 exchange because, while the process of completing an exchange is straightforward, the rules are complicated and loaded with potential pitfalls for the exchanger if the exchange is not properly prepared.</p>

<p>To simplify the discussion and underscore the potential challenges of selecting a qualified intermediary, let’s identify parties<span style="color:#ff0000;"> </span>who cannot act as a qualified intermediary. This list is relatively short and essentially disqualifies those who have acted in some advisory capacity for your company during the two years prior to a potential exchange:</p>

<ol>
<li>Related Parties – Including certain family members and business entities with shared/common ownership.</li>
<li>Agents – Including individuals that have provided services to the exchanging taxpayer as an employee, attorney, accountant, investment banker or broker within the two year period ending on the date of the transfer of the first of the relinquished properties.</li>
</ol>

<p>Aside from the above, virtually anyone can legally act in the capacity of a qualified intermediary, and therein lies the potential for disaster.</p>

<p>I spoke about 1031 exchanges recently at a conference where one of the attendees, an equipment dealer who had advised a customer on their like-kind exchange, stated his belief that the only requirement for a qualified intermediary was that they be a third party who could hold the money from the sale of the relinquished equipment until the seller requires the money for the purchase of replacement property.</p>

<p>While it's true that any third party can legally provide the service outlined above, they'll likely fall short of providing a properly-structured 1031 exchange that satisfies the Internal Revenue Service's safe harbor guidelines. I inquired further:</p>

<ul>
<li>Did the selling party execute an Exchange Agreement outlining the safe harbor compliance rules? Without specific restrictions on the sales proceeds contained in this agreement, the exchanger still has constructive receipt of funds from the sale.</li>
<li>Did the third party create a separate bank account for the specific benefit of the seller/exchanger during the exchange period?</li>
<li>Did the seller notify the buyer that they had assigned their interests and rights in the sold equipment to the qualified intermediary?</li>
<li>Did your customer notify the seller that he had assigned his interests and rights in the new equipment to the qualified intermediary?</li>
<li>Did your customer send a Replacement Property Identification Notice to the qualified intermediary before the expiration of the identification period, identifying the equipment the buyer planned on purchasing by one of the two approved methods?</li>
<li>Did you (the equipment store) notify the customer that he had 45 days to identify potential replacement equipment and up to 180 days from the sale of the used equipment to purchase the new replacement equipment?</li>
<li>Did you provide all of the documentation and signatures required by the Treasury to ensure that the seller indeed satisfied the IRC safe harbor compliance rules and regulations?</li>
</ul>

<p>When the color returned to his face and the nausea had passed, the equipment dealer uttered the far too common response of someone who had purported to serve as a qualified intermediary but was not one.&nbsp; “All we did was hold the money and then forward it to the seller when it came time to buy.”</p>

<p>Like-kind exchanges offer sellers of used equipment a tremendous opportunity to reinvest in funds that would otherwise be lost to taxes, but in order to enjoy this benefit exchangers must follow a document and deadline driven process. When engaging a qualified intermediary, be certain that they understand the necessary documents, steps, and safe harbors that are inherent in Section 1031. Doing so will result in a properly-structured and secure exchange.</p>
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<p>1031 like-kind exchanges or tax deferred exchanges have been part of the United States tax code since 1921, yet they continue to be the subject of a number of misconceptions, some of which are addressed below.</p>

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

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

<p>An individual who defers tax on selling a small rental property when she buys a replacement property is taking advantage of Section 1031 of the tax code. These sorts of transactions made by small businesses and middle-class investors are frequent, even if they don’t make the headlines.</p>

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

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

<p>The most common type of 1031 exchange is a forward exchange, in which the proceeds from the sale of one asset is used to purchase an asset considered to be like-kind within 180 days.</p>

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

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

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

<h2>Fallacy: 1031 exchanges are a tax loophole.</h2>

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

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

<p>Nearly 100 years later, like-kind exchanges continue to support sales and purchases of real estate and business assets, encourage business expansion, and <a href="/blog/1031-like-kind-exchange-impact-study-results-released">stimulate economic growth</a>. They are an intentional and integral aspect of United States tax law, not a tax avoidance strategy.</p>

<h2>Conclusion</h2>

<p>Clearing up the misconceptions about what 1031 like-kind exchanges are and how they work continues to be part of Accruit’s mission, since the first step to employing like-kind exchanges is understanding them. If there’s any audience to whom the use of 1031s is limited, it’s the<span style="color:#ff0000;"> </span>informed.</p>

<p>There are many benefits to owning real estate – appreciation, diversification, mortgage interest deduction, and 1031 tax deferment are a few. However, not everyone has the capital to purchase high-end properties like a Donald Trump. Because of the high cost of real estate, many investors seek out angel funding and bank loans to make up their capital shortfalls. Yet, there is another way for an investor to own real estate, and that is fractional ownership. Fractional ownership is an investment structure that allows multiple investors to purchase a percentage ownership in an investment-grade asset.</p>

<h2>Benefits of Fractional Ownership of Real Estate</h2>

<p><strong>Diversification</strong></p>

<p>Fractional ownership, formerly the province of the savvy mogul who has built a career owning, operating, leasing, and selling real estate, has attracted individual investors who seek an alternative investment to stocks, bonds, and mutual funds they may already own. Fractional real estate ownership and other alternative investments provide for diversification, and financial advisors will often dedicate 10% of a clients’ portfolio towards such vehicles.</p>

<p><strong>The 3 T’s of Real Estate</strong></p>

<p>Fractional ownership can be very attractive to real estate investors who wish to unburden themselves of real estate’s 3 T’s (tenants, toilets, and trash). The day-to-day realities of owning real estate - grounds maintenance, property up-keep, and leasing – are not an issue for fractional owners. Investors can enjoy all the benefits of a solid return while not laboring over the 3 T’s.</p>

<h2>Options for Fractional Ownership of Real Estate</h2>

<p>In the United States, there are two primary options for those interested in fractional real estate ownership:&nbsp; Delaware Statutory Trust (DST) and Tenant-In-Common (TIC) ownership. Each option has become increasingly popular as an alternative investment over the past decade because each affords opportunities for individual investors to own investment-grade property – commercial real estate with more income-generating potential than smaller residential property.</p>

<p><strong>Tenant-in-Common (TICs)</strong></p>

<p>Tenant-in-common (TIC) is an investment property structure that was established during the 1990s and has grown in popularity since. Think of a TIC as a form of shared tenure rights to properties owned.&nbsp; Tenants-in-common each own a separate interest in the same real property. The advantages of a TIC are that each tenant-in-common has stronger buying power and fewer costs, and that each shares responsibilities for a property that is owned by the partnership.&nbsp;</p>

<p><strong>Delaware Statutory Trusts (DSTs)</strong></p>

<p>DSTs are legal entities created as trusts within the state of Delaware in which each investor owns a “beneficial interest” in the DST. DSTs have gained popularity over the last few years due to the ability to secure financing and attract more investors with lower minimum investment thresholds. Another advantage of a DST is that a lender underwrites a single borrower, as opposed to the multiple borrowers within the TIC structure. Furthermore, there is no stated IRS limit to the number of investors a DST may have, versus the 35 maximum of the TIC.&nbsp; Consequently, larger properties may be purchased while keeping the minimum investment size to around $100,000.&nbsp; Finally, DSTs do not allow for any input from beneficial interest owners, unlike TICs, which need to get unanimous approval from all TIC members.</p>

<p>Jokingly, a wise man once told me that a DST is the “Arnold Schwarzenegger version of a TIC.”</p>

<h2>Conclusion</h2>

<p>DSTs and TICs afford individual investors entry into large commercial property, either through a cash investment (typically $100,000 and up) or a 1031 exchange of real assets. Before investing in a DST or TIC, be certain to research the property and the company sponsoring the DST or TIC, and engage a qualified intermediary for your like-kind exchange.</p>