section 1031 for legistlative review 12.16.09

© 2009 Edmund & Wheeler, Inc. All rights reserved. The enclosed materials are provided for educational purposes only and do not constitute tax, accounting, legal or investment advice.

Section 1031 For Legislative Review

By

George E. Foss III, President

Edmund & Wheeler, Inc.

567 Cottage Street

Littleton, NH 03561

603‐444‐0020

www.section1031.com

Edmund & Wheeler, as a Qualified Intermediary (QI), has been facilitating Section 1031 Exchanges for over 28 years. We have developed this review to provide the reader with a solid understanding of Section 1031 basics and the strategic ways in which Section 1031 is utilized.

Please contact our offices for clarification or additional information.

Edmund & Wheeler, Inc. is a member in good standing of the:

© 2009 Edmund & Wheeler, Inc. All rights reserved. The enclosed materials are provided for educational purposes only and do not constitute tax, accounting, legal or investment advice. Rev 12.16.09 1

Contents

Section 1031 for Legislative Review

Contents .......................................................................................................................................................1

Primary Objectives of This Review ...............................................................................................................2

What is an Exchange? ..................................................................................................................................2

The Five Critical Elements of a Section 1031 Exchange ..............................................................................3

The Regulation .............................................................................................................................................3

An Exchange at a glance ..............................................................................................................................3

Section 1031 (a)(1) IRS Code .......................................................................................................................3

Exceptions to Section 1031 ..........................................................................................................................4

Investment Purpose and the Benefits of an Exchange .................................................................................5

The Three Essential Elements ......................................................................................................................5

Like-Kind Requirements ...............................................................................................................................5

Examples of Like-Kind ..................................................................................................................................6

Personal Property .........................................................................................................................................7

Timing Is Everything .....................................................................................................................................7

Who Qualifies for an Exchange? ..................................................................................................................8

The Five Most Common Section 1031 Misconceptions ................................................................................8

What about the States? ................................................................................................................................9

New Hampshire & Disregarded Entities ........................................................................................................9

What is Boot .................................................................................................................................................10

What is New Money ......................................................................................................................................10

The Most Common Exchange Types ............................................................................................................10

Alternative Exchange Strategies (Tenants-in-common) ................................................................................11

TIC Characteristics .......................................................................................................................................14

How Does it Work? .......................................................................................................................................12

TIC Benefits ..................................................................................................................................................13

Section 1031 Glossary ..................................................................................................................................15


We will begin by providing you with some of the

very important basic aspects of Section 1031.

We find that may investors absolutely qualify

for 1031 treatment, but their advisors are

sometimes lacking in this basic understanding.

We will then be exploring Section 1031 from the

professional’s viewpoint, going through some

real live examples and relating some

information on alternative exchange strategies.

This document has been designed to assist you

in becoming proficient in the basics of a Section

1031 Exchange.

An Exchange can be a very complex and time‐

consuming endeavor. As QI’s, we understand all

of the mechanics and the myriad of rules and

regulations surrounding an Exchange. Our goal

for this document is to assist you in becoming

familiar with the tactical and strategic aspects of

Section 1031.

Section 1031 is fundamentally about the

relocation and reallocation of your client’s real

estate assets, all without paying capital gains

taxes. Relocation could be across the street, or

across the nation. Clients can relocate their

holdings to several markets, creating

geographical diversity. They can also reallocate

holdings by combining multiple holdings into

one more valuable property. They can sell

apartment buildings and Exchange for single‐

family housing units, or they can opt for one of

the passive real estate investments available

and leave the day‐to‐day management of real

estate to a professional property management

team.


Section 1031 exchanges are reported on Form 8824,

attached to the Form 1040 Tax Return. It is important

that all of the documentation leading up to and used

during the exchange explicitly states that an exchange is

taking place and not an ordinary sale. The taxpayer

cannot touch the funds or it will trigger the tax. The

Relinquished Property and the Replacement property

must be investment/business use property in the

taxpayer’s hands. All exchanges must be concluded

within 180 days, as may be reduced by the initial due date

of the Federal Tax Return.

An exchange is handled in the same manner as a regular

sale with the exception that a third party, the Qualified

Intermediary (QI), provides documentation, acts as

Escrow Agent, and handles all funds.


As can be seen from the Section 1031 statute language, at #2:

2) Exception

This subsection shall not apply to any exchange of—

(A) stock in trade or other property held primarily for sale,

(B) stocks, bonds, or notes,

(C) other securities or evidences of indebtedness or interest,

(D) interests in a partnership,

(E) certificates of trust or beneficial interests, or

(F) choses in action.

So these things cannot be exchanged under Section 1031. This was not always the case.

The original statute was passed on March 8, 1921, and was silent on the items named

above, especially (B) stocks, bonds, or notes. It didn’t take Roaring 20’s Investors long to

figure out that they could sell shares with losses and exchange shares with gains. Two

years later, in 1923, the party was over, and all of the exceptions except (D) were added;

(D) came along in 1984.


It’s important to understand the difference

between investment property and property

“held for sale.” Property that is held for sale is

technically inventory in the hands of the

taxpayer and is therefore not eligible for Section

1031 treatment.

The Exchange Agreement created by the

Qualified Intermediary gives the QI legal

standing by way of an assignment of the

Contract Rights in both the old property and the

new property. From the Exchangor’s

perspective, a sale does not occur, but rather an

exchange of properties. Both must be used by

the taxpayer for investment or productive use.

The “Like‐Kind” Test must be satisfied.

The point to remember is that it does not matter the type of real estate that the taxpayer owns, it is how the property is

used in their hands. It must be for investment, commercial or business use. A single‐family residence is like kind to every

other kind of real property as long as the single‐family residence is NOT Personal Use or Dealer Property.


Question:

“Can you do a 1031 exchange when selling and assigning the rights under a long term cell tower lease valued based upon anticipated income from rent?”

Answer: A cell tower lease is typically on a patch of land on which the tower is erected, and a right‐of‐way access to the site. The Landlord owns the land & easement which is leased, and the tenant owns, and must later remove the improvements. The lease would describe all of this, and state an initial term plus a number of options to renew. If you can add the number of years remaining in the initial term and in all of the options to renew together and get a result that equals or exceeds 30 years, then the leasehold is exchangeable for another leasehold of 30 years or more, or for a fee interest in real estate. Said another way, the lease must have 30 or more years left to run counting all options to renew to be exchangeable for a fee. The underlying properties must be of Like‐Kind. IRS Regs 1.1031(a)‐1(c). The income from the lease has no bearing on the exchangeability of the asset; it's

only that the lease pertains to real property and that it has a remaining term that

qualifies, as above. However, the income does play a part in the valuation of the lease, as

to be completely tax‐deferred; the Replacement Property must be valued equal to or

greater than the Relinquished Property. So, the payments to be made under the lease in

the future have to be given a Present Value.


When Section 1031 was first codified in 1921, it was for the benefit of farmers who

objected to paying a two (2%) percent capital gains tax on their farm property, both real

and personal. Certain items of personal property are exchangeable as long as they fall

into the same asset class or product code. All aircraft is like‐kind to all other aircraft for

instance, but is not like kind to other items of machinery.

The North American Industry Classification System for Sectors 31‐33 is the best sources for

determining like kind for personal property.

www.census.gov/naics (for a complete description of the allowable categories)

The Exchange will begin on the day the deed is

conveyed to the purchaser. The 45 day and 180 day

clocks will begin the following day. Contracts for sale

and purchase do not trigger the beginning on an

exchange, it always happens on the day of the first

leg of the transaction. This is also true for reverse

exchanges.

Only Presidentially declared disasters would provide

for extension of these time sensitive dates.


Exchanges can be conducted regardless of whether the

taxpayer is an individual or some form of other entity.

It is important to remember that the same taxpayer

must sell and then buy. The IRS is tracking the taxpayer

identification number (EIN). Single member LLC’s and

revocable trusts (disregarded for tax purposes) may

also exchange property.

The Five Most Common Section 1031 Misconceptions

1 All Section 1031 Exchanges must involve swapping or trading with other property owners.

Well before delayed exchanges were codified (by IRS) in 1991, all simultaneous exchange transactions of Real Estate

required the actual swapping of deeds plus the simultaneous closing among all parties to a 1031 exchange. In most cases

these types of exchanges were comprised of many of exchanging parties, as well as numerous exchange real estate

properties. Now today, there's no such requirement to swap your own property with someone else's property, in

order to complete an IRS approved exchange. The rules have been refined and ratified to the point cash rather than the

property deeds can be used.

2 It’s required that all types of Section 1031 Exchanges must close simultaneously.

There was a time when all types of exchanges had to be closed on a simultaneous (same day) basis, now they (1031) are

rarely completed this way. As a matter of fact, a majority of the exchanges executed are closed now as delayed

exchanges.

3 “Like‐kind” means purchasing the same type of property which was sold.

There is a common misconception that “Like‐Kind” is literal. There are currently 2 types of properties that qualify as a

'like‐kind': Property held for investment and/or Property held for a productive use, as in a trade or business.

This statement is a perfect example of another 1031 exchanging myth. There are no provisions within either the IRS

Code or the US Treasury Regulations that can restrict the amount and number of real estate properties that can be

involved in an exchange. Thus, in exchanging out of several properties into one replacement property or the reverse of

this in selling of one property and acquiring several others, are all perfectly acceptable strategies.

5 Section 1031 is NOT a path to cash.

You can take cash out of a Section 1031 Exchange; however, the cash that you take out will be immediately taxable.


Why do cash‐strapped states permit Section 1031 Exchanges?

Because by failing to do so, they miss out on investment capital that would have otherwise come to them, and studies have

shown that there are more dollars arriving than leaving on a net basis. But these dollars have owners, and it’s these owners of

funds that hesitate to invest in locales where they cannot later get their money out.

In recent examples, Georgia, Mississippi, Oregon and South Carolina all had laws on the books that said that a Section 1031

Exchange within the state was fine, but outside the state was not; going outside the state subjected the entire gain (both gain

before the funds arrived and gain while the funds were in‐state) to the state capital gains tax.

Needless to say, billions of dollars that would have otherwise gone to these four states went elsewhere. Now all four have

repealed these laws, in Georgia’s case, retroactively. Montana is the most recent state to consider, and then reject an out‐of‐

state limitation on Section 1031.

Pennsylvania, however, doesn’t seem to get it: Section 1031 is not recognized even in‐state, and PA state tax on all real estate

transfers, sales or exchanges, is due.

New Hampshire follows the Federal Rules very closely (but see below), as does Maine, Vermont and Rhode Island. In these

latter three states, one must present a Waiver of Withholding to the Settlement Agent or state taxes will be due. This Waiver

Rule also exists in NJ, NY, MD, SC, GA, CA, OR, HI and in other states.

Vermont has a special rule for its 6‐Year Land Gains Tax: Both the Relinquished (old) Property and the Replacement (new)

Property must be in‐state, but the Holding Period shifts too, so the New Property starts at a higher point on the 6‐year

Exclusion Ladder. (For EVEN or UP Exchanges only; for DOWN Exchanges, some of the Land Gains Tax is due.)

New Hampshire Warning: The name(s) on the deed to the Relinquished Property must exactly match the name(s) on the deed

to the Replacement Property. The only exception is a revocable (grantor) trust, which New Hampshire (and IRS) ignores.

Do not let your client take the new property in a single‐member LLC (SMLLC) unless the old property was in the same SMLLC;

any change of entity, although it may be disregarded for IRS purposes, is FULLY RECOGNIZED for New Hampshire Business

Profits Tax (BPT) purposes.

This means, for the moment, than Tenant‐in‐Common (TIC) investments are out of bounds for NH taxpayers, because of the

fact that the TIC sponsor insists that the investment be held in a newly created (Delaware) SMLLC.

The state has issued Notices of Assessment to taxpayers for transactions as far back as 2005. Litigation is pending. Stay

tuned….


Boot Netting Rules:

1. Cash paid to buy New Property offsets cash received and/or any debt relief in the sale of old property. 2. Debt assumed or incurred to buy the New Property

offsets any debt relief (but not any Cash received) in the

sale of the Old Property.

Net new cash and Net new debt adds to the Adjusted

Basis, however, Other Property added (vehicle, computer,

etc.) does not. If Other Property is added, pay tax on

these articles on Lines 12‐14.

Strike Price is the selling price of the Relinquished (old)

Property less sales costs.

By far, the most common type of Exchange is the Delayed

Exchange. This simple Exchange allows a client to sell his

property, identify a new property (within 45 days), and

then purchase a Replacement property (s) with the funds.

Often times The Reverse and Build‐to‐Suit Exchanges are

misunderstood and not presented to clients. This can be

and extremely costly mistake. Often times the clients that

have the most to gain by an Exchange do not realize that

these types of Exchanges are possible. Not only are they

possible, they tend to be the most powerful vehicles for

leveraging the Government’s money!


Of the alternative Exchange strategies, the Tenants‐In‐

Common vehicle has become increasingly popular in

the past few years. TICS offer the clients the

opportunity to passively invest in a Grade A Real Estate

Offering, resulting in monthly payments without the

hassles of owning and managing typical investment

real estate.

Since 2002 the IRS has recognized TIC properties as

eligible for Exchange under Section 1031. Since that

time, hundreds of spectacular properties have been

purchased by TIC sponsors and sold to investors that

would not typically own this type of real estate. See

Rev. Proc 2002‐22.

As a fractional ownership, a group of owners (not to

exceed 35) can take ownership in Grade A investment

property.

A check is sent each month with the appropriate share

of the revenues generated by the property, and the

properties are typically managed by the best property

managers available in the area.

Along with the positive aspects of owning a TIC,

investors can be subject to “cash calls” should the

properties expenses exceed its income.


TICs are purchased in much the same way as any property. With the primary

difference being that the property is identified well in advance, and the

ownership position is reserved until closing.

Note that there is also non‐recourse financing involved, with all the benefits

associated with Exchanging with debt.

TICs can provide an unprecedented level of diversity

by spreading a fractional real estate investment

throughout multiple geographies, classes and areas.

Many clients have Exchanged whole ownership in

one type of building located in one area, to many

types of buildings in many areas!


1 Freedom from day‐to‐day

management responsibilities. With no more property to manage, you have more leisure time to relax or pursue other Interests. In addition, because someone else is managing the property for you, there are no geographical limitations. You are free to invest in real estate markets nationwide.

2 Professional people managing the property on your behalf.

The typical Exchange Equity deal is on a long‐term lease to a Credit Rated Tenant (A+‐BBB) who will have strong financials and extensive experience in the management and upkeep of the property. This is the underpinning of the approach of a typical TIC sponsor. This allows them to examine offerings in all sectors, types, and locations of real estate. In addition, because many sponsors co‐invest in the properties that they sponsor, they have a vested interest in the performance of the properties. You can relax because it is the tenant’s responsibility to maintain the property, and for the sponsor to collect the rents, service the mortgage (if any), and handle all of the other asset management responsibilities.

3 Increased monthly cash flow.

Your investment in a TIC interest provides you with a check every month. The cash flow that owners typically receive generally starts at 6.25‐8% per annum. Because exchangors take on a new depreciation schedule, however, cash distributions are typically 50‐100% tax sheltered, depending upon asset class and leverage. The equity appreciation in well‐located real estate speaks for itself.

4 Properties are identified and researched for you.

TIC sponsors do all of the work of locating, negotiating to purchase, providing all of the required due diligence, arranging for the financing, and other work necessary to acquire the new investment property and set up the TIC program. A wide range of TIC properties exist for sale, in many different asset classes and geographical locations, so with the help of your TIC sponsor, you will be able to easily identify possible properties within the requisite 45 days, and acquire them within 180 days. In many cases, TIC sponsors offer a "back‐up" in case your preferred purchase becomes unavailable for some reason.

5 Invest in larger, safer, higher‐quality institutional properties.

As a TIC, you end up with a larger, higher‐quality building leased to Credit Tenants with greater financial strength and stability than any other type of real estate investment typically available to individual investors.


6 Benefit from multiple tax advantages.

Not only can you defer capital gains taxes until death, at which point they are forgiven, but you also can gain additional tax advantages through a new depreciation schedule and in doing so typically shelter 50‐100% of your cash flow.

7 Gain non‐recourse debt.

Accredited investors assume institutional grade, pre‐arranged, non‐recourse (no personal guarantee) financing with easy approval. You can invest in properties that have no debt, or in ones with up to 75% leverage.

8 Start investing with as little as $50,000.

TIC investments have a much lower minimum investment than sole ownership allowing for greater flexibility. Variable investment sizes can start as low as $50,000 and can be structured to match an owners’ equity and debt requirements.

9 A first‐class way to diversify your assets.

Large net proceeds may be split among several properties, and so invested in several different markets and asset classes.

10 Preserve your capital by investing in properties that continue to appreciate.

Profits can be locked in by selling out of highly appreciated markets and then re‐investing 100% of the net proceeds from those sales into growth markets.

11 Simplify your estate planning.

TIC can simplify wealth transfer and estate issues. After all, it’s much easier to divide a monthly check among heirs than it is to divide a building.


Section 1031 Glossary

Section 1031 Exchange This very simply is a Section 1031 Tax Deferral which permits taxpayers to reinvest the proceeds from the sale of property held for investment or business purposes into another investment or business property, and defer capital gains tax that would otherwise be due on the initial sale.

Adjusted Basis The original basis plus any improvement costs minus the full depreciation on the property.

Agreement for Transfer Purchase agreement, offer and acceptance, sales agreement, earnest money agreement, real estate contract or other contract contemplating the purchase or sale of real property.

Boot This is the property the taxpayer receives in the exchange which does not qualify as “like kind" property. Cash proceeds are the most common form of boot and a boot is subject to taxation. There is also the concept of “Mortgage Boot” which is the net relief of indebtedness, and is also subject to taxation.

Capital Gain The taxpayer pays tax at capital gains rates (after the recapture of accumulated depreciation since 5‐1‐97) on the net difference in value between the Relinquished Property less selling costs and the Replacement Property plus selling costs. If the value of the new property exceeds the value of the old property, there is no tax due, provided all of the funds coming from the sale of the old property are administrated by a Qualified Intermediary and the rules of Section 1031 are followed.

Construction Section 1031 Exchange You may purchase Replacement Property that is not yet built. In the case of real estate, the value of the land and improvements on the Replacement Property must equal to or exceed the value of the Relinquished Property; the improvements do not have to be completed prior to the expiration of the 180 days, nor does there have to be a Certificate of Occupancy issued.

However, in the case of personal property, the value of the new property must equal or exceed the value of the old property and the improvements must be complete and the property placed in service by the 180th day.

Constructive Receipt This is a term that refers to the Section 1031 Exchangor or other disqualified persons having unrestricted control of the funds from the property sold and Constructive Receipt will invalidate a tax deferred Section 1031 exchange.

Contract Section 1031 Exchange A "Contract Exchange" is the tax‐deferred exchange of: The Buyer’s ownership in a Sales Contract on real property, for different real property, or for a contract or option on different real property; or the Option Holder’s exchange of an Option to purchase real property, for different real property, or for an option or contract on different real property. Essentially, a "contract exchange" is a Section 1031 exchange of an open option to purchase, or an open Sales Contract, rather than a Section 1031 exchange of the underlying real estate itself.


Cooperation Clause

A clause that is added to the purchase on sales agreement requiring the person who is not the Exchangor to use

their best efforts to assist the Exchangor in consummating a Section 1031 tax deferred exchange.

Exchange Accommodation Titleholder The Exchange Accommodation Titleholder "EAT" is a specially formed entity used to hold title to one of the properties during a Construction Exchange or a Reverse Exchange.

Exchangor The actual owner of the investment property looking to make a tax deferred exchange. Unfortunately an Exchangor cannot be an owner that wishes to defer capital gains tax on a second home. See "like kind" property definition.

Exchange Funds Account a.k.a. the Qualified Escrow Account The account established by the qualified intermediary (QI) to hold the exchange funds.

Exchange Period A 180 day window in which the Exchangor has to complete a tax deferred exchange. During the Exchange Period there is a 45 day Identification Period in which the Exchangor must identify which property or properties that will be purchased. Both time periods begin on the day of the sale of the Relinquished Property.

The Fair Market Value This is the likely selling price as defined by the market at a specific point in time.

Forward Delayed Exchange A type of exchange which occurs when a property is sold "Relinquished Property" and another property is purchased "Replacement Property" within 180 days following the sale of the Relinquished Property.

Identification Period The time period that begins upon the "close of escrow" of the Relinquished Property. During this 45‐day period, the Section 1031 Exchangor must identify the Replacement Property in order to continue with the Section 1031 exchange transaction.

Identification Letter An Identification Letter form is used to identify potential Replacement property or properties which is sent to the Qualified Intermediary within 45 days of closing of the “Relinquished Property” to be placed into the client’s file.

IRS Section 1031 Tax Code Internal revenue code Section 1031.

"Like‐Kind" Property "Like kind" real estate property is basically any real estate under US state law that is NOT your personal residence or NOT a second home, and NOT property you deal in.

The Napkin Rule You must buy a Replacement Property of equal or greater value to the Relinquished Property in order to completely defer the applicable capital gains tax. If you purchase a property of lesser value, you will be responsible for any tax on the difference. You must use all the cash proceeds from the sale on your purchase in order to completely defer the applicable capital gains tax. If you don’t use all your proceeds on the purchase, you will be responsible for any tax on the difference.


Personal Property Any property belonging to the Section 1031 Exchangor that is non real estate related.

Qualified Escrow Account The account established by the Qualified Intermediary (QI) to hold the exchange funds.

Qualified Intermediary (QI) The Intermediary is also known as, QI, Accommodator, Facilitator and Qualified Escrow Holder. A party, not otherwise disqualified, that helps to facilitate the exchange and holds funds in escrow.

Real Estate Exchange A type of Exchange of real property for real property. All types of real property are "like kind" for other real property, including vacant land, residential, commercial, and even long term leases in excess of 30 years (counting options to renew).

Relinquished Property The original property being sold by the taxpayer when executing a Section 1031 exchange.

Replacement Property Is the new property being acquired by the taxpayer when executing a Section 1031 exchange.

Reverse Exchange This is the type of exchange in which the Replacement Property is purchased before the sale of the Relinquished Property. Reverse Exchanges take two forms; see Case #2 and Case #5 in the handbook’s text.

Rules of Identification The guidelines that must be followed when making a Section 1031 tax deferred exchange, such as the 3 Property Rule, 200% Rule, and 95% Rule.

Settlement Agent Definitions include: Title agent, closing officer, escrow officer, settlement officer, closing agent, closing attorney, settlement attorney.

Tax Deferred Exchange The procedure outlined under IRS Code Section 1031 involving a series of rules and regulations that must be met in order to take full advantage of deferring capital gains tax on the sale of investment real estate or certain types of personal property. Section 1031 tax‐deferred exchanges are also commonly known as: Starker exchanges, delayed exchanges, like‐kind exchanges, 1031 exchanges, Section 1031 exchanges, tax‐free exchanges, nontaxable exchanges, real estate exchanges, real property exchanges. Though all of these terms refer to the same thing, the most typical term used today is the Section 1031 Exchange.

Tenancy In Common (TIC) A fractional or partial ownership interest in a piece of property, rather than owning the entire piece of property.