Real Property Law

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Preparing your Client for a 1031 Exchange
Mary Kay Kennedy, Vice President and Counsel, First American Exchange Company, LLC, San Jose
E-mail: mkkennedy@firstam.com

Introduction
Vesting
Transfer of Ownership
Using the Equity in the Real Property
Refinancing the Relinquished Property
Exchanges between “Related Persons”
Conclusion


Introduction
Planning ahead when doing a 1031 exchange can mean the difference between a successful and failed exchange. This article discusses the main issues that should be addressed when a client plans to exchange investment real estate.

Vesting
The number one question a lawyer should ask when a client decides to do an exchange is “Who is the taxpayer?” Basic 1031 rules require that the same taxpayer be on both sides of the exchange. If John Smith owns the relinquished property, John Smith must also acquire the replacement property. (There are some limited exceptions to this with respect to disregarded entities, such as single member limited liability companies).

This sounds simple, but in many cases the client fails to focus on the fact that the property to be sold (the “relinquished property”) is not actually owned by them, but by another entity, such as a limited liability company or partnership. For example, if the relinquished property is owned by a limited liability company, and the client owns a one-third membership interest in the LLC, the client cannot simply exchange out of his membership interest into a new real estate investment.

Transfer of Ownership
One solution to the problem of multiple-ownership is to dissolve the entity and transfer the interest in the real estate to the various owners as tenants-in-common. At the closing, some owners sell their tenant-in-common interest for cash, and others exchange their interest for new replacement property. This solution is more likely to succeed if the transfer of the property to the partners or members is completed long before the exchange, rather than immediately before, because it will minimize the risk that the IRS can claim that the individual members or partners held the property for sale rather than for investment, or that the exchange was really an attempted exchange of a partnership interest, which is excluded as like-kind property under §1031.

Using the Equity in the Real Property
In order to completely defer tax in a 1031 exchange, the investor must take all of the equity from the relinquished property and invest it in the replacement property. If an investor decides to use only a portion of the equity to acquire the replacement property, the balance that is retained by the investor (the “boot”) is not like-kind property and therefore is taxable. This poses a problem for some investors who own property for a long time and have built up a lot of equity. The investors may want to extract some cash from the investment, but if they do so in connection with an exchange, they end up with taxable boot.

Refinancing the Relinquished Property
One solution is to refinance the relinquished property before the exchange or the replacement property after the exchange. Funds from a refinancing are not taxable, but refinancing property immediately before or after an exchange is not risk free. The IRS has argued under the substance over form and step transaction theories that loan funds were actually obtained in the exchange and should be taxable. Most tax advisors recommend that investors take two steps to reduce the risk that funds from a refinance be considered exchange funds. First, separate the date of the refinance from the date of the exchange as much as possible. Second, make sure your client is able to establish a business purpose for the refinancing. Planning the refinance with this in mind will make it much more likely that an investor will be able to refinance without the funds being considered taxable.

Exchanges between “Related Persons”
Another common issue is whether an investor can exchange property with a “related person.” Under the regulations, a “related person” includes the investor’s siblings, spouse, ancestors and lineal descendants. “Related person” also includes certain affiliated companies. For example, two entities (corporations and/or partnerships) are related persons if the same person owns more than 50 percent of both entities. In addition, the fiduciary of a trust and either the grantor or beneficiary of that trust are considered related entities.

Under IRC §1031(f), if an investor exchanges property with a related person, both the investor and the related person must hold the property that is acquired in the exchange for at least two years after the exchange. If either the investor or the related person sells or transfers the property before the end of the two-year period, the gain that would have otherwise been deferred must be recognized. Moreover, the IRS has recently published several rulings, including Revenue Ruling 2002-83, that prohibit an investor from acquiring replacement property in an exchange from a related party, whether or not the property is acquired indirectly through the use of a qualified intermediary, and whether or not it is held for two years.

There may be circumstances in which an investor can acquire replacement property from a related person. In Private Letter Ruling 200440002, the IRS ruled that a partnership could acquire replacement property from another partnership that was a related party because the related partnership was also doing a 1031 exchange. The IRS reasoned that since neither party was cashing out of their investment, the prior rulings disallowing non-recognition treatment were not applicable to that case.

Conclusion
Investors should always consult with their tax advisors prior to structuring an exchange, but advanced legal planning is needed in some instances. The sooner you can discuss and solve issues relating to entity structures, refinancing and exchanging with related parties, the more likely your client will benefit from a successful tax-deferred exchange.

 

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