<p>We've historically been known as the leader in personal property 1031 like-kind exchanges, but we want to make sure that everybody realizes Accruit's value for real estate 1031 exchanges, as well. The bottom line is this: the things that make us ideal for personal property exchanges - our patented 1031 exchange process (the only one of its kind in America), our outstanding one-to-one customer service, our uncompromising commitment to financial and data security - also apply to commercial real estate.</p>
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<p>We've just completed a new brief that explains <a href="/sites/default/files/Real%20Estate_0.pdf" target="_blank">Accruit's real estate capabilities and value proposition</a> in more detail and we invite you to have a look. It also includes a case study that illustrates a typical exchange. If you have any questions, <a href="/contact-us" target="_blank">contact us</a>.</p>

<p>Recently, I came across an article written by Hal Vandiver for the Material Handling Industry of America regarding the <a href="http://www.mhia.org/news/industry/8505/economic-recovery-package-extend…; target="_blank">current Economic Stimulus Package and its impact on asset-owning businesses</a>. Mr. Vandiver described the initial benefit of this measure very well, including some mathematical analysis of asset purchases that occur in 2008 or 2009. Put simply, the continuation of Bonus Depreciation and increased Section 179 deductions as economic stimulation have a significant impact for companies able to take advantage of these measures. That said, there is a hangover looming in the distance of which these companies should be aware. That hangover is "depreciation recapture" caused by an artificially lower basis than would normally apply to these assets. Clearly, these stimulation measures are a double-edged sword, in the form of immediate increased depreciation expense, yet an artificially lower basis (therefore higher taxes) if these assets are sold before the end of their MACRS recovery lives.</p>

<p>Having myself recently written an article comparing the American Recovery and Reinvestment Act of 2008 to 1031 Exchanges, I thought perhaps an extension of the math used by Mr. Vandiver to include a look at the remaining basis of these assets would demonstrate depreciation recapture and connect the dots between these active economic stimulation measures and Section 1031 Exchanges.</p>

<p>What follows is an analysis outlining the benefits of Section 179, Bonus Depreciation and 1031 Exchanges for MACRS 5-year assets (Mr. Vandiver reviewed 7-year assets; however the principles are the same, and the application of 5-year recovery periods is more common for transportation assets, equipment, aircraft, information systems and many other assets). For calculation of depreciation recapture, I have assumed an 80% residual value for assets sold in year 2 of their recovery periods, and a blended income tax rate of 37%. To understand the implications for any transaction you are contemplating for your business, be sure to contact your tax advisor.</p>

<p><strong><em>SCENARIO 1: BASELINE - STANDARD DEPRECIATION</em></strong> (pre and post 2008-2009 tax years)</p>

<p>New Machine Purchase - $100,000</p>

<p>Standard MACRS Depreciation (20%) - $20,000</p>

<p>Asset Basis after 1^st Year (includes ½ year of 2^nd year depreciation*) - $64,000</p>

<p>Selling Price in 2^nd Year - $80,000</p>

<p>Gain on Sale - $16,000</p>

<p>Depreciation Recapture (37% Income Tax on Gain) - $5,920</p>

<p><strong><em>SCENARIO 2: BASELINE WITH BONUS DEPRECIATION</em></strong> (2008-2009 tax years)</p>

<p>New Machine Purchase - $100,000</p>

<p>1^st Year Bonus Depreciation (50%) - $50,000</p>

<p>PLUS Standard MACRS Depreciation on Remaining Basis (20% * $50k) - $10,000</p>

<p>Asset Basis after 1^st Year (includes ½ year of 2^nd year depreciation*) - $32,000</p>

<p>Selling Price in 2^nd Year - $80,000</p>

<p>Gain on Sale - $48,000</p>

<p>Depreciation Recapture (37% Income Tax on Gain) - $17,760</p>

<p><strong><em>SCENARIO 3: BASELINE WITH STANDARD SECTION 179 DEDUCTION</em></strong> (pre and post 2008-2009 tax years)</p>

<p>New Machine Purchase - $400,000</p>

<p>Section 179 Deduction - $128,000</p>

<p>Standard MACRS Depreciation (20% * $272k) - $54,400</p>

<p>Asset Basis after 1^st Year (includes ½ year of 2^nd year depreciation*) - $174,080</p>

<p>Selling Price in 2^nd Year - $320,000</p>

<p>Gain on Sale - $135,920</p>

<p>Depreciation Recapture (37% Income Tax on Gain) - $50,290</p>

<p><strong><em>SCENARIO 4: BASELINE WITH BONUS AND INCREASED SECTION 179 DEDUCTION</em></strong> (2008-2009 tax years)</p>

<p>New Machine Purchase - $400,000</p>

<p>Section 179 Deduction - $250,000</p>

<p>PLUS Bonus Depreciation (50% * $150k) - $75,000</p>

<p>PLUS Standard MACRS Depreciation (20% * $75k) - $15,000</p>

<p>Asset Basis after 1^st Year (includes ½ year of 2^nd year depreciation*) - $48,000</p>

<p>Selling Price in 2^nd Year - $320,000</p>

<p>Gain on Sale - $272,000</p>

<p>Depreciation Recapture (37% Income Tax on Gain) - $100,640</p>

<p>For each of the above scenarios, the application of Section 1031 Exchange treatment would defer the recognition of gain on sale; therefore the depreciation recapture problem is removed. Assets that take advantage of either of these economic stimulation measures and are sold at any point before the end of their recovery lives will face artificially lower bases, and therefore suffer from larger depreciation recovery issues in the form of higher taxes. Fortunately, these inflated tax payments can be postponed through the utilization of 1031 Exchanges.</p>

<p>While this analysis is intended to demonstrate the depreciation recapture issue, rather than the complete benefit of Section 1031 Exchanges, it is worth noting that at any point during or after an asset's MACRS recovery life, Section 1031 Exchanges can have a significant bottom-line impact until such time as their market-driven residual values become insignificant.</p>

<p><em>*Assuming the Midyear Convention is utilized for determining remaining basis in these assets, and that the asset has not reached the end of its MACRS depreciable life, these assets will receive an additional depreciation allowance equal to ½ of the allowable depreciation for the year in which they are sold. The MACRS schedule allows a half year of depreciation in the first and last recovery years. Consult your tax advisor to understand the Convention required for your asset types and placed in service dates (i.e. if more than 40% of the MACRS property is placed in service in the last quarter, the Midquarter Convention must be used).</em></p>

<p><em>__________</em></p>

<p><em>Thanks to Joe Lane for pointing me to this article.</em></p>

<p>1031 exchanges are typically of the "forward" variety - they start when you sell an asset and then buy a replacement asset of like-kind. But more and more our clients are finding themselves in the position of needing to purchase a new asset before they sell their old one. Experienced exchangers know that the 45-day identification period for identifying new property is tight, and many investors want the opportunity to get their replacement property in place before they sell. Other clients may have both their sale and their purchase all lined up but at the last minute they lose their buyer and there goes the sale. Now they're ready to buy but can't sell. How can they still do an exchange?</p>

<p>The solution is a reverse exchange. In a reverse you can purchase your new property before you sell your old property and still get all the benefits of a 1031 like-kind exchange. The reverse 1031 exchange transaction is permitted under <a href="/sites/default/files/Rev%20Proc%202000-37_0.pdf" target="_blank">Revenue Procedure 2000-37</a>. &nbsp;Although reverse exchanges were taking place way before the year 2000, this RevProc gives us clear safe-harbor guidelines for this type of an exchange.</p>

<p><strong>This is how it works.</strong> The IRS will not let you hold title or ownership to both your new and your old property at the same time, but they will allow your Qualified Intermediary (QI) to take title to your new property for you until you can sell your old one. This is called "parking a property. " Your QI can do this by way of a single member LLC that's opened up specifically for your exchange. This LLC is called an Exchange Accommodation Titleholder, more commonly referred to as an EAT, and it does just what is says: it holds the title - that's it. The property is leased from the EAT to the taxpayer/exchanger. This allows the taxpayer/exchanger to have full access to the new property and to make money from that new property right away.</p>

<p>How does the EAT pay for the new property? Simple, they rely on the taxpayer. The taxpayer can buy with cash or get a lender. If a lender is used, it must be willing to have the EAT sign the security instrument for the loan, as they are going to be the owners of the new property. With a safe harbor reverse exchange an EAT does not necessarily have to be on the loan as a borrower, but if the bank insists, the EAT will be a non-recourse borrower with all recourse going to the taxpayer. Also, the taxpayer needs to be prepared to add the EAT to the insurance of the parked property.</p>

<p>So how do you know that the EAT will not sell your property to someone else while you're waiting to sell? Easy, a purchase option is always part of the Qualified Exchange Accommodation Agreement. That is the legal document that allows the exchanger and the EAT to move into a parking arrangement. This purchase option gives the exchanger the exclusive right to buy the replacement property from the EAT, and that is exactly what the exchanger will do right after they sell. The exchanger must take title to the new property from the EAT within 180 days after it is parked, and they must identify what they are selling within 45 days of parking.</p>

<p>It's really that easy. After the taxpayer sells the EAT will use the exchange proceeds to pay back the taxpayer what they owe them and give title of the asset to the taxpayer/exchanger. If this <em>does</em> still sound a little tricky to you, not to worry. Accruit has several reverse exchange experts who can address all your questions about a typical reverse as well as more complicated reverses (such as exchange first reverses, straddles, and improvement exchanges).</p>

<p>As we told you last week, <a href="/blog/federation-exchange-accommodators-praises-passage-new-exchange-facilitator-regulations-co">the FEA was successful once again in pushing regulations </a>through the Colorado House and Senate to provide consumer&nbsp;protection for those conducting 1031 like-kind exchanges in the state. <a href="/sites/default/files/Colorado_HB09-1254.pdf">The Governor signed HB09-1254 into law on 4/16/09</a>.&nbsp; <a href="/sites/default/files/WA_Senate_BIll_0.pdf">Washington's Governor signed a similar law on Monday, April 13</a>.&nbsp; Who next?&nbsp; Texas?&nbsp;Maine? Arizona? Oklahoma?&nbsp; The ideal goal is to maintain reciprocity between these states so that QIs can deliver consistent guidance and maintain reasonable standards for customers across the country.</p>

<p>Right now there are&nbsp;five states <a href="/blog/california-idaho-nevada-and-washington-qi-bills-now-available">(CA, NV, ID, WA&nbsp;&amp; CO) </a>that have some form of qualified intermediary regulations on the books.&nbsp; <a href="/sites/default/files/CA_QI_Law.pdf">California</a> took the lead by adopting regulations that provide exchangers certain levels of protection and requiring prudent investment standards ensuring liquidity and protection of principal.&nbsp; Colorado recognized the importance of achieving consistency; it also understood the importance of safeguarding consumers while simultaneously protecting an industry that facilitates growth for Colorado companies.&nbsp;&nbsp;Texas, Arizona, Oregon and Oklahoma are all leaning toward a model law that supports reasonable regulations, but&nbsp;Nevada and Idaho have passed regulations that are either very difficult to follow or aren't business friendly at all.&nbsp; It's been two years since Nevada enacted their law and they still don't have final guidance on how exchangers need to ensure compliance.&nbsp; Now it seems that Maine wants to follow Idaho's laborious, expensive and unrealistic standards, forcing QIs to complete reams of paperwork, provide background checks, register with the state and create very specific banking structures just to&nbsp; provide a well established federal tax service to businesses in their state - all at a tremendous cost.</p>

<p>There will be more states, more laws, more dollars spent to accomplish&nbsp; - in the end - the same result.&nbsp; Encouraging your state to adopt model law is a good idea for everybody.&nbsp; There's no reason to reinvent the wheel.</p>

<p>While on the campaign trail, Barack Obama made greening America's infrastructure a huge priority for his administration. As noted in the <em>Los Angeles Times</em>, Obama planned</p>

<blockquote>
<p>to spend $150 billion over the next decade to promote energy from the sun, wind and other renewable sources as well as energy conservation. Plans include raising vehicle fuel-economy standards and subsidizing consumer purchases of plug-in hybrids. Obama wants to weatherize 1 million homes annually and upgrade the nation's creaky electrical grid. His team has talked of providing tax credits and loan guarantees to clean-energy companies.</p>

<p>His goals: create 5 million new jobs repowering America over 10 years; assert U.S. leadership on global climate change; and wean the U.S. from its dependence on imported petroleum.</p>
</blockquote>

<p><a href="http://www.newscientist.com/article/dn16905-congress-delays-obamas-gree…; target="_blank">He's currently battling Congress</a> for the appropriations required to turn his vision into reality, and the resistance from Capitol Hill raises once again a question that's been bouncing around the office here for the last six months: <strong><em>why not revise the tax code to make wind, hydroelectric, solar and other renewable technologies "like-kind" with traditional fossil technologies?</em></strong> This would allow energy companies that wanted to transition into green energy to employ Section 1031 Like-Kind Exchanges, thereby speeding the switch-over considerably.</p>

<p>Some quick background. At present 1031 Exchanges can only be performed on assets that are either "like-kind" or "like-class." Whether assets are "like-class" is determined by the General Asset Class (GAC) or North American Industry Classification System (NAICS) codes. If the assets do not fall within the same class, they can still be considered like-kind by the IRS and exchanged. However, the exchange will be outside the like-class safe harbor and the determination of whether the assets are like-kind will need to focus on the nature or character of the property.</p>

<p><a href="https://www.census.gov/naics/&quot; target="_blank">The NAICS codes that are relevant for this discussion are found in sections 31-33</a>. Code 333132 defines Oil and Gas Field Machinery and Equipment Manufacturing while code 3336 covers Engine, Turbine, and Power Transmission Equipment Manufacturing. As such, the Internal Revenue Code would not allow an LKE between the two, even though both are used for the same purpose.</p>

<h4>The ABC Energy Case</h4>

<p>America's energy industries understand the need to green their operations. According to the American Petroleum Institute, US oil and natural gas industry companies are investing more than all of private industry and the federal government combined in new energy technologies to meet future energy needs.</p>

<ul>
<li>Oil and Gas Companies - $121.3B</li>
<li>Other Private - $58.2B</li>
<li>Federal Government - $8.2B</li>
</ul>

<p>On carbon mitigation alone, oil and gas companies outspend the federal government by nearly three times</p>

<ul>
<li>Oil and Gas Companies - $42B</li>
<li>Federal Govt - $15B</li>
</ul>

<p>With this in mind, let's illustrate the case of ABC Energy. Imagine that ABC is a large firm (market cap of $175 billion) that currently focuses on oil and natural gas exploration, development, production and distribution. Like every other energy company in America they can see the writing on the wall and realize that if they're to be successful in the long term that they must evolve from an <em>oil</em> company into a full-spectrum <em>energy</em> company. As a result, they're already investing significantly in renewables.</p>

<p>They believe that this evolution will happen over X years at a cost of Y. But what are the values for X and Y? There's going to be tremendous political (and consumer) pressure to shorten X, but these are balanced against the obvious business pressures to mitigate Y. Part of the transition will be accomplished organically, as old assets are retired, and tax credits can also ease the burden some. Of course, in the current political climate, most legislators will be eager to steer clear of "tax breaks for Big Oil" stories.</p>

<p>The upshot is that Y will remain too high to spur a quick transition.</p>

<p><strong>Now, let's consider what might happen if the tax reform proposed here were enacted.</strong> (In a good-faith attempt to make the scenario as plausible as possible we're going to use what we believe to be very conservative numbers.)</p>

<p>At the end of 2008 ABC reported $60B in Property, Plant and Equipment assets. Let's say that half of this number would potentially be eligible for 1031 exchange treatment. Senior leadership at ABC now has a new path toward sustainable production that didn't exist before, and since it's already investing in renewables and green tech research, it makes good business sense to begin using Like-Kind Exchanges to accelerate its transition. Over the span of 10 years (let's use something close to the timeframe imagined by President Obama and Al Gore's <a href="http://www.wecansolveit.org/">We initiative</a> , although there's every reason to think the pace can be sped up) ABC aggressively begins exchanging fossil assets. When you combine federal and state rates the total tax bill on the sale of existing assets would be approximately 40%, which means they're able to defer around $12B, which they immediately reinvest in their new sustainable energy production assets - wind, solar, etc.</p>

<p>ABC is one company, and while they're big they're hardly the largest (they're roughly half the size of ExxonMobil). On a revenue basis, ABC represents a little over 2% of the US oil and gas sector's revenues for 2008, so if we assume that its profile is more or less average by industry standards, <em><strong>this proposal could potentially unleash more than $600 billion for green energy development</strong></em>.</p>

<p>At this point, let's remember two things. First, we're aiming low. Second, at this point we're still only talking about the oil and gas sector - to get the full impact of this proposal you'd also have to factor in a similar transition by coal companies.</p>

<p>We're still trying to nail down the math on the scenario presented above, but we feel comfortable that what is described is in the right ballpark, and are continuing to work on firming up the actual industry numbers. Thanks for tolerating the fuzzy math, and if you're able to help us tighten up the scenario, please let us know.</p>

<h4>What Are the Potential Objections?</h4>

<p>In imagining how we might get an idea implemented, we have to consider what barriers would stand in the way. A few objections have occurred to us, but so far there are very good answers to each. Let's take them one at a time.</p>

<p><strong>1: Such a change would be very difficult to implement.</strong> Not necessarily. The standard route for amending the tax code runs through Congress, obviously, and that's always a complex process. However, the IRS has tools at its disposal that could potentially expedite fossil-to-green exchanges, at least in the short term. One is called a Private Letter Ruling (PLR). "The IRS private letter ruling is applicable to that tax situation and that taxpayer only." However, PLRs are often treated as precedent, and there's no reason to think that one couldn't be used to signal to energy firms that the agency is ready to accept fossil-to-green exchanges as eligible for 1031 by virtue of "same use" status. The second (and more powerful) approach could involve the use of a <a href="http://legal-dictionary.thefreedictionary.com/revenue+ruling&quot; target="_blank">Revenue Ruling</a>.</p>

<p><strong>2: What is proposed can be done already.</strong> This is true in principle. ABC could, if its CPAs and attorneys agreed that it was a defensible move, go ahead and execute such an exchange and then make their case before the IRS on audit. However, this is risky - they could potentially be exposed to the full tax bill plus penalties if they failed to convince the IRS. If companies have done this in the past (or are doing it currently) we're not aware of it, and at the very least it's likely that the risk noted here would serve as a significant barrier for any energy company.</p>

<p><strong>3: There will be major public and political resistance to "tax breaks for oil companies."</strong> While there certainly might be such a response, this program is very explicitly <em>not</em> a tax break for oil companies. Three reasons:</p>

<ul>
<li>They can perform 1031 exchanges within NAICS class now. This means that if there is a "tax break" involved, it exists already, and worse, it's an incentive to <em>continue reliance on fossil fuel resources</em>, which is the opposite of the government's stated goal.</li>
<li>Existing tax incentive proposals do come with direct budget implications - federal monies are being shifted to energy enterprises. But this proposal has no such impact. There are no new tax revenues that would be realized in the absence of the proposal - that is, no proposal, business as usual.</li>
<li>We're not talking about a permanent revenue transfer. If the proposal were adopted these taxes would be <em>deferred</em>, not forgiven.</li>
</ul>

<p>To this equation add add the tax revenue implications associated with the creation of all those green collar jobs and the ripple that a half-trillion dollar development spree would set off in support and peripheral markets.</p>

<p>As a result, this seems like an idea that would be a win for both major parties (and even the Libertarians and Greens). Objections might be voiced, but at this point it seems like there are solid answers to them.</p>

<p>There are obviously a number of gaps that need filling in, and there may well be a strong argument against that hasn't occurred to us yet. Hopefully our readers can help us vet the idea and decide whether it's something that needs to be pursued more aggressively.</p>

<p>Multiple states have recently passed laws regulating Qualified Intermediaries, and we've now made the text of these bills available for download.</p>

<p>Below is the Federation of Exchange Accommodators statement on the California bill's passage:</p>

<blockquote>
<p><strong>CALIFORNIA QI BILL ENACTED INTO LAW</strong></p>

<p>October 2, 2008</p>

<p>The Governor of California signed SB 1007 into law and a copy of the new law is attached. We believe that this represents a victory for the FEA and the QI industry. Many FEA members worked hard to get the law into a form that would accomplish the goal of providing consumer protection to exchangers without unduly burdening the QI industry.</p>

<p>The provisions of the new law will be effective for all exchanges after January 1, 2009. Therefore, you should review the requirements to be sure that your company is in compliance if you do business in California.</p>

<p>What does the law provide? The California law does not provide for registration or licensing, but does provide for insurance and investment standards for exchange facilitators. The major provisions of California bill are as follows:</p>

<p>1. Application. The law applies to all exchange facilitators considered to be "doing business in California". "Doing business" means the relinquished property in the exchange is located in California, or the EAT holds title to property in California. It also applies to someone who maintains an office in California or advertises in California provided the relinquished property is in California.</p>

<p>2. Insurance, Bonding and/or Security Requirements. Exchange facilitators must:</p>

<p>(A) (1) maintain a fidelity bond of at least $1,000,000, OR (2) deposit cash, securities or a letter of credit for at least $1,000,000, OR (3) use a qualified escrow or trust; AND</p>

<p>(B) (1) maintain errors and omissions insurance of at least $250,000, OR (2) deposit cash, securities or a letter of credit letter in that amount.</p>

<p>3. Investment Standards. Exchange facilitators must act as a custodian of the exchange funds and meet the "prudent investor" standard in the investment of funds, and satisfy investment goals of liquidity and preservation of principal. The exchange facilitator cannot comingle exchange funds with operating accounts, or loan or transfer funds to an affiliate (other than to an affiliate financial institution or to an exchange accommodation titleholder pursuant to the exchange contract).</p>

<p>4. Prohibited Acts. Exchange facilitators must not engage in various bad acts, such as material misrepresentations, false advertising, failure to account for moneys or property, failure to return exchange funds to clients, fraud, criminal conduct, etc.</p>

<p>5. Notification of Change of Ownership. Exchange facilitators must notify clients in writing within 10 days after a change in ownership (more than a 50% change).</p>
</blockquote>