Timing Year-End Real Estate Transactions

Commercial real estate executives often experience increased transaction velocity around the end of the year. Whether it is the company’s tax year or an external impetus driving a transaction, such as a counter party’s tax year, the end result is the same: executives end up contemplating the advantages and disadvantages of structuring end of the year like-kind exchanges. This issue is even more critical in our current legislative environment with tax policy changing “mid-stream” in an exchange. In this article we discuss two often missed tax planning points that revolve around timing of 1031 exchanges: (i) failed Section 1031 exchanges; and, (ii) the need to timely file for an extension if a taxpayer’s 180 day timeline in a 1031 exchange is cut short by April 15, 2011.

In the case of a failed or partial tax-deferred like-kind exchange transaction, a taxpayer may be able to defer his capital gain (or some portion thereof) into the 2011 tax year rather than the income tax year in which the relinquished property closed. With so much focus on the Bush Tax Cuts and a potential extension on Capitol Hill right now, it would be prudent for taxpayers to give themselves flexibility with a variety of tax scenarios they could face in 2011. Taxpayers could face no changes in 2011 or they could face higher capital gains rates. The ability to “elect the most favorable treatment” is ideal.

For example, say a calendar-year taxpaying entity sells a $15 million dollar asset on December 10, 2010, and is not sure whether or not he or she wants to do a 1031 exchange. If the taxpayer cashes out in 2010 and does not do a 1031 exchange, the answer is simple, he or she will be taxed in 2010 at prevailing rates upon disposition. However, if the taxpayer sells an asset and makes the asset part of a like-kind exchange in 2010 and the proceeds are held with a Qualified Intermediary, the tax implications instantly change from the prior scenario. The taxpayer would “go out hunting” for replacement property and be confined by the 45th day which would land in January, 2011. If he is successful finding eligible replacement property, there are no tax consequences (assuming he closes within 180 days); however, if the client does not find suitable replacement property the tax issue becomes when does he get access to his proceeds. The ability to defer the recognition and reporting of the taxable gain into the following income tax year depends on when the taxpayer has the right to obtain access to or receive the benefit from his 1031 exchange funds.

To repeat, if a taxpayer disposes of his relinquished property as part of a 1031 exchange and the relinquished property disposition closes on December 10, 2010, the 45th and 180th day will hit in 2011. The 45th and 180th days are the only opportunities for taxpayers to “get their proceeds back” from a Qualified Intermediary under the 1031(g)(6) limitations under the regulations.

If the taxpayer has not identified any like-kind replacement property within the 45 calendar day identification period the capital gain income tax liability could be recognized in the following income tax year pursuant to the installment sale rules under Section 453 of the Internal Revenue Code because the taxpayer did not have control or access to the funds until 2011 (the earliest opportunity- his 46th day).

The taxpayer can elect to recognize and report the capital gain income tax liabilities in either 2010 or 2011 at his or her discretion.

A related point is that the taxpayer needs to be mindful of these end of the year 1031 exchanges. If April 15th comes first, a taxpayer must file for an extension to get the full 180 days.

Needless to say the final month of 2010 can be a pivotal tax planning opportunity for year-end taxpayers executing real estate transactions. www.1031esgroup.com

The Senate is considering a proposition that will both extend a popular tax credit for first-time home buyers past the previous Nov. 30 deadline and expand it to include certain current homeowners. This development has implications which directly affect the market for 1031 like-kind exchanges, as it will propel home purchases, allowing many investors to exchange their rental properties in a 1031 exchange.

So far, ES Group has already facilitated three of these exchanges this week. The reasons for exchange have been somewhat varied. In two cases the owner simply exchanged their previous residential rental property for another, often times with a more desirable location, such as a rental property closer to a daughters college or in a potential ideal retirement community. In the other case, the owner was simply tired of running an active investment and decided to enter into a tenant-in-common syndicated commercial real estate investment (TIC). Either way, the tax credit is having an affect on those interested in utilizing the 1031 exchange.

With the tax credits extension, it seems only logical that there will continue to be an upswing of 1031's in this area. Especially since residential values have been faring better recently, recovering from their precipitous decline. The economy, though posting a positive GDP in the latest quarter, remains in an economic quagmire with unemployment still high and showing little signs of lessening in the near future. Thus, selling now to people incentivized by tax credits could be less risky than waiting for opportunities during a "jobless recovery". These government incentives will not continue forever and investors need to constantly keep an eye on where they would like to end up.   

 Recently, I have been searching for an automobile to replace my current 1990 Volvo Station Wagon. When I speak to people about this search I often hear about how "this is a great time to buy a car", the economy is terrible and buyer power is at an all time high. Operating under this assumption, I made multiple visits to various auto dealers, assuming each time a great deal awaited me. But to my surprise and utter frustration, the fabled deals did not exist. Instead I encountered four letters which I thought would be of no value in this climate: MSRP.

In an economy where GDP is shrinking and unemployment is going up, how could MSRP possibly matter? As far as I understood, "MSRP world" went away about 2 years ago and we are now living in something called "discount world". But this fact did not resonate with dealers; they were intent on getting close to their MSRP value.

When I mentioned this to a co-worker, he exclaimed that the same thing was currently hampering commercial real estate. Buyers and sellers were living on different planets, each with their own set of prices. For proof you can check out this report from CA Real Estate Journal. The divide between the two is eerily reminiscent of those middle school dance scenes we see in movies, where the boy and girls stand on opposite sides of the room, each waiting for the other side to come to them. Likewise, you can imagine buyers and sellers standing on opposite sides of a room, nervously eyeing each other, looking for some sign or signal that the other side may be willing to close the gap and concede to their price point.     

Of course in the movies eventually some bold individual breaks the ice, causing a chain reaction whereby both sides meet nicely in the middle. So when will that happen for commercial real estate? When will we find common ground? Well of course if we knew that, there would be no issue, our situation would be resolved. As it is, we must linger in uncertainty, standing on opposite sides of the price spectrum, waiting for that mutual resolution. Until then, I'll just keep low-balling dealers.  

Everybody wants to go green these days and as it turns out, there is a way for those owning real estate to do so as well (without installing solar panels or wind turbines). The solution is found within something known as a "Conservation Easement", a government provision enacted to provide incentive for private owners who donate their land for conservation purposes. By applying the 1031 exchange to this process, a property owner can both preserve the environment and make a new real estate investment.

            A conservation easement is essentially a deeded fee interest that Land Trust Commissions or other government entities buy in order to preserve the natural state of the land. It comes in handy in two distinct situations: 1. You own property and want to sell it but do not want it to be developed for environmental reasons, 2. You own property and want to sell it but cannot find a buyer. In both situations a conservation easement can be beneficial, as the government will use the land in an environmentally friendly way and provide consideration through its purchase of the easement.

An easements value is determined by taking the value of the land without the conservation easement and subtracting that from the value of the land with it. The 1031 comes into play when there has been sufficient appreciation on the property to make the sale of an easement subject to capital gains tax.

 For Example:

 Mr. Bolan has owned a plot of undeveloped land for 20 years. Over the course of these 20 years the land appreciated in value from $1 million to $10 million. Now Mr. Bolan wants to sell the land but does not want to see it developed, thus he pursues a conservation easement. The land is valued at $4 million with the easement, so $10 million (the lands unrestricted price) - $4 million (the lands price restricted by conservation easement provisions) nets a $6 million easement.

 The issue Mr. Bolan runs into is that he will face a substantial capital gains tax, because of the properties appreciation, when he sells the easement. What he can do instead is trade his $6 million easement, in a 1031 exchange, for land of equal value.

 Note: This transaction would have to be structured, from the very beginning, as a 1031 to work. To make a 1031 viable, a qualified intermediary would need to take title to both the land and the revenues gained from its sale NOT the actual owner. If the owner were to receive money directly from the sale of the easement a 1031 transaction would be impossible.

 Continuing with the example, Mr. Bolan (through his intermediary) receives $6 million from his sale of the easement. The cash is then used to buy an apartment complex, which will provide Mr. Bolan with a steady flow of cash. All of this is done while avoiding the capital gains tax Mr. Bolan would have faced if he just cashed the easement. Through application of the 1031 exchange, he is able to both preserve his previous property and acquire a new one, all the while avoiding capital gains tax.

What is a 1031 Exchange?

   A 1031 Exchange refers to a real estate transaction realized under the rules of Section 1031 of the Internal Revenue Code

in order to defer relevant taxes until a future date. (Section 1031 provides that no gain or loss shall be recognized for tax purposes on the exchange of property held for productive use in a trade or business, or for investment.) A typical transaction involves a property owner trading a property for another "like kind" replacement property. The IRS sees the transaction as having reinvested the sale proceeds into another property thus no economic gain has been realized that would generates the funds to pay the taxes.

What are the benefits of a 1031 Exchange?

A 1031 exchange enables the property owner to defer or completely eliminate potential taxes associated with the sale of real property. By deferring the taxes the owner has more money available, on an interest free basis, to invest and thus can afford a more expensive property then otherwise would be affordable.

What does "like Kind" mean in a Real Estate transaction?

Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.

Does this mean I have to actually trade properties?

No. Section 1031 allows for the sale of a property with the proceeds going to a "qualified intermediary" who then holds the funds until the replacement property if ready to be purchased.

What is a "Qualified Intermediary"?

A Qualified Intermediary (also known as an Accomidator) is a person or entity that hold the funds recieved from the sale of the relinquished property in escow, until the replacement property is purchased; thereby ensuring that the rules around section 1031 are abided by.

What types of taxes can I defer?

A 1031 exchange allows for the deferment of Federal, and in most cases state, capital gain and depreciation recapture taxes.

Is there a time limit to complete the 1031 Exchange?

Yes, the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or the due date of the tax return for the year in which the property was relinquished.

What does not qualify for a 1031 Exchange?

Any of the following do not qualify: Stocks, bonds, loans, partnership interests, personal residences, and certificates of trust.

What is a "boot?"

A "Boot" is anything of value exchanged which is not "like-kind" to the relinquished property. In most cases this takes the form of either cash or mortgage debt to equalize the transaction. www.info-pedia.com

The 1031 exchange is a great instrument for property owners who wish to defer their capital gains tax. However, not all states treat 1031 exchanges equally. California regulations stipulate that any appreciation in property value accrued in California is subject to their state taxes, regardless of whether or not that property was exchanged for one in another state before its sale. This means that CA property owners cannot escape CA state taxes, even if they exchange their property for one in another state.

            Most states conform to federal income tax treatment of like kind (1031) exchanges, where all capital gains taxes are deferred until the properties eventual sale. This is generally interpreted to mean that one is only subject to taxes of the state where the property is sold, discounting the state taxes of any state where the property was exchanged from.  Meaning that if I owned a property in NV, exchanged it for one in ID and subsequently sold it, I would only be responsible for federal and ID taxes, not those from NV.

            California is a notable exception to this. It employs a “claw-back” provision, entitling the state to tax any gain on property that occurs in California, regardless of where the property is eventually sold.

For example:

Say Mr. Newcombe bought a property in CA for $100. After appreciating to $200, he exchanges it for one in ID. While in ID the property further appreciates to $400. Feeling he has had enough of owning property, he sells it for $400, showing a total capital gain of $300. Mr. Newcombe would not only be liable for $300 of capital gains taxes in ID, but $100 of capital gains taxes in CA as well.

Note: The reciprocal of this situation does not come into effect. If Mr. Newcombe owned property in ID and exchanged for property in CA, he would only be subject to CA state taxes, not those of ID.

            From the above example it is clear that owning property in California and exchanging it for property in another state leaves one open to double taxation. There is no way to avoid this situation unless one stays out of CA entirely or performs the final sale there. Being taxed in CA would of course be undesirable because it has some of the highest income tax rates, 9.55% and 10.55% for earnings over $47,055 and $1,000,000 respectively. The claw-back provision really hurts people when they try to exchange out of California’s stringent tax system into a friendlier one such as Texas, which has no income tax. In situations such as this, the “claw-back” provision acts like a hand reaching out of the grave to grab and tax people one last time. Needless to say, before making an investment in CA, ensure it will be worth the high amount of taxes you will eventually pay for it.