<p>A new, in-depth study of the U.S. commercial real estate market found that 1031 like-kind exchanges strengthen the market and stimulate job creation, investment, and economic growth.</p>

<p>“The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate” analyzed more than 1.6 million real estate transactions over an 18-year period. It was commissioned by the Real Estate Like-Kind Exchange Coalition, comprised of organizations across all sectors of the industry, in response to legislative proposals to repeal <a href="/exchange-library/internal-revenue-code-section-1031" target="_blank">Section 1031</a>.</p>

<p><a href="http://www.1031taxreform.com/ling-petrova/&quot; target="_blank">Read an overview of the Ling-Petrova Study at the FEA's website</a>.</p>

<h2>Study Findings:</h2>

<ul>
<li><strong>Like-kind exchanges encourage investment.</strong>&nbsp; On average, taxpayers using a like-kind exchange acquire replacement property that is $305K-$422K more valuable than the relinquished property, while replacement properties without using an exchange are cheaper or of equal value.</li>
<li><strong>Like-kind exchanges contribute significant federal tax revenue</strong>.&nbsp; In 34 percent of exchanges, some federal tax is paid in the year of the exchange. More importantly, over the long run, like-kind exchanges boost tax revenue because of the higher tax liability that arises in the years following the initial exchange.</li>
<li><strong>Like-kind exchanges lead to job creation</strong>.&nbsp; Real estate acquired through a like-kind exchange is associated with greater investment and capital expenditures (i.e., job-creating property upgrades and improvements) than real estate acquired without the use of like-kind exchange.</li>
<li><strong>Like-kind exchanges result in less debt</strong>.&nbsp; When the price of the replacement property is close to, or less, than the price of the relinquished property, like-kind exchanges result in a 10 percent reduction in borrowing, or leverage, at the time of the acquisition.</li>
</ul>

<p>Additionally, in response to legislative proposals to eliminate like-kind exchanges, the study found that such action would have the following deleterious effects:</p>

<ul>
<li><strong>Taxes would increase for thousands of commercial property owners</strong>.&nbsp; For a typical property owner who defers his or her gain on a commercial property, repealing like-kind exchanges would raise the effective tax rate on the taxpayer’s investment (including rental income and gain; nine-year holding period) from 23 percent to 30 percent.</li>
<li><strong>Property values would drop.</strong>&nbsp; In order for a commercial property to generate the same rate of return for the investor (if section 1031 were repealed), prices would have to decline. In local markets and states with moderate levels of taxation, commercial property price would have to decline 8 to 12 percent to maintain required equity returns for investors expecting to use like-kind exchanges when disposing of properties. These price declines would reduce the wealth of a large cross-section of households and slow or stop construction in many local markets.</li>
<li><strong>Rents would increase.</strong>&nbsp; Over time, real rents would need to increase from 8 to 13 percent before new construction would be economically viable.&nbsp; These higher rents would reduce the affordability of commercial space for both large and small tenants. The price declines and rent effects of eliminating real estate like-kind exchanges would be more pronounced in high-tax states.</li>
<li><strong>Real estate sales activity would decline.</strong>&nbsp; Like-kind exchanges increase the liquidity of the real estate market.&nbsp; An analysis of 336,572 properties that were acquired and sold between 1997 and 2014 showed that properties involved in like-kind exchanges had significantly shorter holding periods.</li>
</ul>

<p>The study’s authors, Dr. David Ling (finance professor at the University of Florida’s Warrington College of Business and past president of the American Real Estate and Urban Economics Association) and Dr. Milena Petrova (finance professor at Syracuse University’s Whitman School of Management), analyzed more than 1.6 million real estate transactions over an 18-year period (1997 – 2014).&nbsp; Combined, the total volume of the transactions (unadjusted for inflation) is $4.8 trillion.</p>

<p>“The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate” was developed using the most comprehensive database of US commercial real estate activity in existence.</p>

<h2>Call in Advance</h2>

<p>Taxpayers often lose opportunities for 1031 tax deferred exchanges simply by not being informed and planning ahead.&nbsp; We frequently receive calls from a taxpayers who have already sold the relinquished property and would now like to exchange it for a replacement property.&nbsp; Often they still hold the proceeds check and have not deposited it, erroneously thinking that depositing the funds would be the factor that would invalidate an exchange.&nbsp; Unfortunately for several reasons, it's too late to enable the taxpayer to complete the exchange.</p>

<p>First, once the title company issues a check made out to the taxpayer, that person is in "actual receipt" of the funds.&nbsp; The <a href="/exchange-library/internal-revenue-service-regulations-irc-%C2%A71031">IRS regulations</a> provide any attempt at an exchange is not valid if the taxpayer has any "rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property" pertaining to the sale proceeds.&nbsp; So the error of failing to contact the exchange company until immediately after the sale of the relinquished property would disqualify any exchange attempt.&nbsp;</p>

<p>Even if the taxpayer were to return the check to the title company in exchange for a check made payable to the qualified intermediary, the taxpayer still could not qualify for an exchange.&nbsp; Under the regulations, the taxpayer needs to assign certain contract rights that he or she has under the relinquished property contract to the qualified intermediary no later than the day of closing.&nbsp; Further, the notice of this assignment is also required to be given to the relinquished property buyer.&nbsp; Failure by the taxpayer to assign the contract rights and notify the buyer of that assignment on a timely basis would, by itself, prevent any attempt at a deferred exchange.</p>

<h2>Reverse Exchanges</h2>

<p>These delays in getting the exchange company involved often take place in connection with <a href="/blog/are-1031-reverse-tax-deferred-exchanges-real-estate-approved-irs">reverse exchanges</a>. &nbsp;A reverse exchange occurs when the taxpayer needs to close on the acquisition of the replacement property prior to the disposition of the relinquished property.&nbsp; This is sometimes referred to as a pure reverse exchange.&nbsp; The IRS does not recognize the validity of a pure reverse exchange.&nbsp; Had a taxpayer facing the acquisition of the new property before the sale of the old property called the exchange company prior to the acquisition of the new property, it would have been fairly simple to structure the transaction to qualify for tax deferral.&nbsp; This would involve the exchange company taking title to the new property on the date of closing and holding it for the benefit of the taxpayer until immediately after the sale of the relinquished property.&nbsp; At that time the exchange company would transfer the property to the client. Had a phone call been made to the exchange company a few days or more before the closing on the replacement property, there would have been time to structure the transaction to fit the IRS rules.</p>

<h2>Summary</h2>

<p>In short, there are a myriad of rules and procedures that need to be adhered to in order to structure a successful deferred exchange. Section 1031 is much form over substance and there are many ways for an exchange to get tripped up.&nbsp; First and foremost of these is failure to call the qualified intermediary well before the sale transaction is to take place to make sure all necessary documents are in place and that they are signed by the necessary parties. Maintaining close contact with the exchange company, can help the taxpayer navigate the safe harbors.&nbsp;</p>

<p>^{<a href="https://www.flickr.com/photos/photoloni/&quot; target="_blank">Photo Credit: Alon</a>}</p>

<p>Owners of heavy equipment tend to avoid such questions until it's time to sell some of their business assets.&nbsp; Even with initial planning under their belts, many equipment owners will incorrectly frame their equipment dispositions within the context of capital gains tax.&nbsp; This can be a costly mistake, as capital gains rates tend to be lower than the ordinary income tax rates actually triggered by the sale of depreciable assets.&nbsp; In order to clear up some of this confusion, let's review capital gains and depreciation recapture, both commonly known as "gains."</p>

<h2>Capital Gains</h2>

<p>The disposition of a capital asset, such as investment real estate, typically triggers a capital gain or a capital loss.&nbsp; As a general rule, the amount of the gain or loss is the asset's sale price less its adjusted basis.&nbsp; Adjusted basis is characteristically known as the asset's original acquisition costs minus its accumulated depreciation expenses.&nbsp; Capital assets are defined under Section 1221 of the Internal Revenue Code and do not typically include items such as inventory (held for resale), and depreciable property (used in a trade or business).&nbsp;</p>

<p><br />
Furthermore, capital gain transactions are classified as either "short term" or "long term," where short term refers to those assets held for less than one year and long term refers to assets held for longer than one year.&nbsp; This is important to note as short term capital gain transactions are taxed at ordinary income rates and can reach amounts in excess of 40%.&nbsp; However, dispositions classified as long term have benefited from historically low tax rates, with most taxed no higher than 15%.&nbsp; In reviewing Tax Topic 409 – "Capital Gains and Losses," the Internal Revenue Service states that:</p>

<blockquote>
<p>"…some or all net capital gain may be taxed at 0% for the 10% or 15% ordinary income tax brackets. However, a 20% rate on net capital gain applies in tax years 2013 and later to the extent that a taxpayer's taxable income exceeds the certain thresholds.</p>

<p>There are other exceptions where capital gains may be taxed at rates greater than 15%, including, but not limited to, gains from selling collectibles (like coins or art) are taxed at a maximum 28% rate."</p>
</blockquote>

<p>It's also important to note that special tax rates related to capital gains transactions are not available to C corporations.&nbsp;</p>

<h2>Depreciation Recapture</h2>

<p>Some equipment owners may have dispositions triggering the capital gains tax.&nbsp; However, most of their sales will involve the disposal of non-appreciating business-use personal property, including:</p>

<ul>
<li>Over-the-road tractors</li>
<li>Trailers</li>
<li>Heavy equipment – construction and agricultural</li>
</ul>

<p>Sales of these assets typically trigger gains associated with depreciation recapture, taxed at higher ordinary income tax rates.&nbsp; Stated simply, the Internal Revenue Service forces a recapture of past depreciation expense as taxable income in the year of the asset(s) sale.&nbsp; This is best illustrated by example:</p>

<p><img alt="Determining Tax Exposure" src="/sites/default/files/files/determining-tax-exposure.png" style="margin: 5px; width: 500px; height: 474px;" /></p>

<p><br />
As you can see, the amount subject to recapture is limited to the difference between the asset's sale price and its adjusted basis.&nbsp; So there's no full recapture of the depreciation expense taken (in previous years).&nbsp;</p>

<h2>Section 1031 Like-Kind Exchanges – Solving the Gain Problem</h2>

<p>Whether gains come in the form of depreciation recapture or as capital gain, the Internal Revenue Code generally requires taxpayers to recognize these amounts as taxable income.&nbsp; Fortunately, Section 1031 provides an exception to this general requirement and allows equipment owners a proven pathway to sell business assets without incurring the related tax liability.&nbsp; If the sale (in the above example) would have received like-kind exchange treatment, the entire $160,000 of tax liability would not have been triggered.&nbsp; Instead, that amount could have been used to invest in replacement assets, allowing the equipment owner to reinvest in the growth of their business.&nbsp; Remember, like-kind exchanges require advance planning with the right team.&nbsp; Asset owners should always approach like-kind exchanges with care and be sure to involve their tax advisors prior to the sale of any business-use assets.</p>

<h2>Exchanges Straddling Two Tax Years</h2>

<p>Often an exchange period will continue from the end of one year to the beginning of the next.&nbsp; For instance, a taxpayer who sells relinquished property on December 1 will expect expiration of the 45 day identification to occur on January 14 of the next tax year.&nbsp; Similarly, a taxpayer who closes on the sale of relinquished property on September 1 and duly identified possible replacement property within the identification period will expect the 180 day exchange period to expire on February 27 of the next calendar year.</p>

<p>Taxpayers who receive all, or a portion, of their exchange balances in the year following the sale of their relinquished property will receive installment sale treatment for the balance returned.&nbsp; Effectively, this means that they will not have to report the gain on their sale until the time their tax return for the year of the distribution is due.</p>

<p>There is, of course, a catch.&nbsp; A taxpayer should not sell a property with these timelines merely to put off the payment of the gains that are otherwise due.&nbsp; According to the exchange regulations, the taxpayer must have a bona fide intent to do an exchange, even if it is ultimately unsuccessful in whole or in part.&nbsp;</p>

<p>The regulations state:</p>

<blockquote>
<p>“The provisions of paragraphs (j)(2)(i) and (ii) of this section do not apply unless the taxpayer has a bona fide intent to enter into a deferred exchange at the beginning of the exchange period. A taxpayer will be treated as having a bona fide intent only if it is reasonable to believe, based on all the facts and circumstances as of the beginning of the exchange period, that like-kind replacement property will be acquired before the end of the exchange period.”</p>
</blockquote>

<p style="margin-left:-4.5pt;">Taxpayers who have the requisite bona fide intent and receive the payout from the exchange account in the second tax year will automatically receive installment sale treatment with the gain to be reported in the year of the distribution from the account.&nbsp; In the event the taxpayer has losses in the year of the property sale, the taxpayer can elect to recognize the gain in that year rather than the subsequent year.</p>

<h2 style="margin-left: -4.5pt;">Fallback Strategy for Failed Exchange or Exchange with Unused Proceeds</h2>

<p>A portion of exchanges inevitably result in the inability of the taxpayer to identify possible replacement property by the required 45th day from the sale.&nbsp; In other instances, the taxpayer duly identifies one or more possible replacement properties but elects not to acquire the property by the end of the 180 day exchange period.&nbsp; Also, at times a taxpayer will properly identify and acquire replacement property, but does not use up the full available balance of exchange funds.&nbsp; In each of these instances, converting the exchange transaction into an installment sale can provide favorable tax deferral on the amounts in question.&nbsp; There are companies in the marketplace that will assume the qualified intermediary’s obligation to return funds to the taxpayer and, in turn, will enter into an installment agreement with the taxpayer providing for receipt of the funds over time.&nbsp; Some of the features and benefits of such an arrangement include:</p>

<ul>
<li>Tax deferral option even when intended exchange does not take place (or for sums leftover)</li>
<li>The installment payments to the taxpayer are secured</li>
<li>The taxpayer can design the payment stream</li>
<li>The taxpayer can receive the certainty of fixed income</li>
<li>Earn interest of the funds on a pre-tax basis, rather than a lesser amount on an after tax basis</li>
<li>Defer income to a time of lower income in retirement years</li>
<li>Ability to borrow up to 85% of the amount involved</li>
</ul>

<h2>Summary</h2>

<p>Installment sale treatment comes into play when an exchange involves the sale of relinquished property in one tax year and the receipt of replacement property in the following year.&nbsp; Also, for failed exchanges or for exchanges in which some proceeds are left unused, converting the exchange into an installment sale can be a good option in lieu of deferral under Section 1031 of the Internal Revenue Code.</p>

<h2>Seller Financing in the Context of a 1031 Exchange</h2>

<p>It is not unusual for a taxpayer to finance the buyer in whole or in part.&nbsp; Such transactions may or may not involve the seller's intent to complete a 1031 exchange.&nbsp; The structure of the seller’s financing can take the form of a note and mortgage/deed of trust from the buyer or under Articles of Agreement for Deed.&nbsp; The specific form should not impact the seller’s options in structuring an exchange as part of the transaction.&nbsp;</p>

<p>Under an installment sale using a note and mortgage/deed of trust, the question frequently arises whether a taxpayer can structure an exchange when the balloon payment becomes due, rather than at the time the parties enter into the installment sale.&nbsp; Similar questions are raised with Articles of Agreement for Deed - can the exchange be done at the time of the balloon payment when the buyer is receiving the deed? It cannot, since, for tax and legal purposes, the point of transfer of ownership occurs when the parties enter into the note and mortgage or an Articles of Agreement for Deed rather than when the balloon payment is made or when the deed is issued.</p>

<h2>Taxpayer Receiving Cash and a Note</h2>

<p>It's very common for the taxpayer/seller to receive money down from the buyer and to carry a note for the additional sum due.&nbsp; At times, this arrangement is entered into because the parties wish to close, but the buyer’s conventional financing is taking more time than expected.&nbsp; In this instance, the note should be made payable to the qualified intermediary (the exchange company).&nbsp; To the extent that the buyer can procure the financing from the institutional lender before the taxpayer closes on the replacement property, the note may simply be substituted for cash from the buyer’s loan.&nbsp;</p>

<p>It is more likely that the taxpayer’s 180 day exchange period will fall prior to the receipt of funds into the exchange account.&nbsp; In this case, a solution is for the seller to “buy” his own note from his exchange account with fresh cash.&nbsp; Essentially, the taxpayer advances personal funds into the replacement property while not receiving the equivalent amount of cash from the buyer at that time. These funds can be cash that the taxpayer already has available, or it can be from a loan that the taxpayer takes out to buy the note.&nbsp; The benefit to the note buyout is that the future principal payments received by the taxpayer over time will be fully tax deferred.&nbsp;</p>

<p>In the example above, care should be taken as to when the note (or installment agreement) should be turned over to the taxpayer. There is a natural tendency to pass the cash and note simultaneously. After all, the client is putting into the exchange account the exact same value that he is taking out.&nbsp; However, because the regulations prohibit the taxpayer from the “right to receive money or other property pursuant to the security or guaranty arrangement,” it is probably better to receive the cash into the account sometime prior to the purchase of the replacement property, while assigning the note to the seller after all the replacement property has been acquired.&nbsp; Some qualified intermediaries will have a form that they will sign acknowledging the substitution of cash for the note with a promise to distribute the note upon the closing of the exchange account.</p>

<h2>Conclusion</h2>

<p>There are various scenarios in which an installment sale can impact tax deferral.&nbsp; In some cases deferral can be attained by the taxpayer’s substitution of cash into an exchange account for an installment note or a sale under articles of agreement for deed. In our next post, we examine <a href="/blog/installment-sales-and-1031-like-kind-exchanges-part-2">more complex instances involving installment sales and 1031 exchanges</a>.</p>

<hr />
<p>&nbsp;</p>
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<h2>Are 1031 Exchanges simply a loophole for wealthy taxpayers?</h2>

<p>No. Like-kind exchanges provide individuals and businesses, both small and large, incentive to replace old investment property and business-use assets with new assets that are like-kind. The economy is stimulated in exactly the way intended when Section 1031 was written in 1921 – by allowing for the continued sale and purchase of real estate for business use. Deferring taxes on the sale of the old assets makes the purchase of new assets possible.</p>

<h2>Doesn't the government lose revenue as a result of 1031 exchanges?</h2>

<p>When a like-kind exchange occurs, Section 1031 provides the mechanism to defer taxable gain recognition in return for reinvestment of 100% of the sales proceeds back into a “like-kind” asset, and it accounts for the new asset on the tax books in a specific manner: Every dollar that is deferred in a 1031 exchange must be subtracted from the amount that can be depreciated from the replacement asset.</p>

<p>The U.S. Treasury immediately offsets tax revenue losses by disallowing future tax depreciation equal to the gain that was deferred under an exchange. So, when a company files its taxes the year following a deferral, less depreciation expense is taken due to the disallowance and more income tax is paid. Over the tax life of the replacement property, the foregone depreciation is <strong>EXACTLY</strong> equal to the original deferral amount. The extra taxes collected by the U.S. Treasury during the tax life are also <strong>EXACTLY</strong> equal to the taxes otherwise paid under a sale transaction. This relationship between deferral and depreciation is outlined in a paper recently released by the Federation of Exchange Accommodators, <a href="https://www.accruit.com/sites/default/files/FEA-Depreciation-and-LKEs.p…; target="_blank">"Understanding the Impact of Depreciation on Like-Kind Exchanges."</a></p>

<h2>Conclusion</h2>

<p>Section 1031 provides for tax deferral – not evasion or abuse – and the benefit to the taxpayer is one of timing. Would you rather pay the tax now or later? Exchangers opt to reinvest the revenue from asset sales into updated assets that allow them to stay competitive. The tax is paid in the reduction of depreciation that the U.S. Treasury allows, and the timing benefit to the taxpayer provides the cash-flow necessary to grow their business.</p>

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