Articles Posted in Section 1031 Exchange

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Author: Matthew Riley

Matthew Riley is an attorney with Bona Law, primarily focused on antitrust, commercial litigation, real-estate, and federal administrative law.

Does property that started off as non-qualifying (i.e. primary residence), but over time has changed its character to fit a qualifying purpose fit within the requirements of Section 1031?

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Does property used concurrently for both non-qualifying and qualifying purposes, for example a primary residence, a part of which functions as an office space, qualify as Section 1031 property?

Over time the purposes a property serves can change or multiply.  When this occurs, the applicable tax rules may change as well.  For example, a primary residence may later become rental property and convert to a business or investment purpose.  Or, perhaps the property owner devotes part of their residence for use in a business.

The frequency of questions raised in relation to primary residences and whether or not such properties qualify for a Section 1031 Exchange has spurred the IRS to compose many well-developed tax rules pertaining to these circumstances.

These tax rules, though involving the disposition of Section 1031 property, primarily center upon two other issues:

The first concerns Section 121’s applicability to a Section 1031 Exchange; and the second instructs how to allocate and treat gains recognized in that Exchange.

We will take up the second part, categorizing and calculating taxable gains, later. Here we focus on the initial requirements that must be met before a primary residence can be included in a Section 1031 Like-Kind Exchange.

Section 121 applies when a taxpayer’s primary residence is sold [exchanged] and treats taxable gains from that exchange differently than Section 1031.   That is, Section 121 excludes taxable gains from a sale, up to $250,000 for a single taxpayer ($500,000 for those filing taxes jointly), from taxation.  This tax-free treatment of gains under Section 121 for primary residences differs from the tax-deferral treatment for business/investment properties under Section 1031.  Under certain circumstances, a taxpayer may be able to enjoy the tax advantages of both rules for the same property.

Generally, Revenue Ruling 59-229 disqualifies primary residences from a Section 1031 Like-Kind Exchange.  Revenue Procedure 2005-14, however, allows the Exchanger to use such property in an exchange when the property’s use as a primary residence is either concurrent or consecutive to its use for a qualifying business/investment purpose under Section 1031.

To qualify for tax-free and tax-deferral treatments under Section 121 and Section 1031, respectively, two conditions must be met.  First, the property must be held as the Exchanger’s primary residence for at least 2 years during a 5 year period ending on the date of the sale or exchange.  And, secondly, at the time of the sale or exchange, the Exchanger must have held the property long enough to establish and demonstrate an intention to use the relinquished property for a qualifying business or investment purpose.

For many, the second condition raises the question, How long does it take to establish a demonstrable intention to use a property for a qualifying business or investment purpose?  Unlike the first condition, which outlines a specific time requirement, the IRS does not provide the same bright-line holding period for the second condition.  Rather, whether the Exchanger has held the property long enough to establish the proper intention is determined on a case-by-case basis.  Case-law, legislative history, and heuristics provide guidance to determine whether the required holding period to establish business or investment intention has passed. You should consider the following:

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Author: Matthew Riley

Matthew Riley is an attorney with Bona Law, primarily focused on antitrust, commercial litigation, real-estate, and federal administrative law.

In my first blog post for Titles and Deeds I introduced what I consider the “Golden Rule” of real estate investing—Section 1031 Like-Kind Exchanges. As promised, I’ve returned to help you understand the fundamental rules governing these exchanges, so you can determine whether you may be eligible to enjoy the financial benefits of this rule.

Author: Matthew Riley

Matthew Riley is an attorney with Bona Law, primarily focused on antitrust, commercial litigation, real-estate, and federal administrative law. Prior to joining Bona Law, Mr. Riley’s legal practice emphasized transactional work involving real estate and mergers and acquisitions. Matthew’s professional passion is to educate and to clarify complex areas of the law to help clients achieve their goals. Matthew Riley graduated from the University of Kansas School of Law in 2013 and is licensed to practice law in Illinois. He is in the process of obtaining his admission in California.

No one wants to pay taxes, and most, if given the option, would pay less.  The United States Tax Code declares certain events taxable (ex. receiving wages, selling property), and establishes rules to assess how much a taxpayer owes on those events.  In some cases the Tax Code empowers taxpayers to choose which tax rules apply, and thereby, how much tax is owed.  Therefore, knowing the tax rules and how they apply to certain taxable events can result in significant and beneficial tax consequences for you and your business.

Like-Kind Exchanges are governed by Section 1031 of the United States Tax Code, as well as Judicial Opinions, Revenue Regulations, Procedures, and Rulings issued by the IRS. Section 1031 should be known as the real estate investor’s “Golden Rule”.  By “Golden Rule” I mean it is a rule investors can apply to accumulate wealth significantly faster than investors who do not follow the rule.

A Like-Kind Exchange is an investment strategy whereby one property is sold and replaced by the acquisition of another of the same kind.  In such an exchange, any taxes that otherwise would be charged to an investor’s capital gains on the relinquished or sold property, are deferred.  The deferment of these taxes allows the investor to enhance their purchasing power in acquiring a replacement property.  To illustrate the ramifications to an investor choosing to apply the Like-Kind Exchange rules, consider the following (fictional) scenario:

Ronald Lump is an investor who got a “steal-of-a deal”, paying $500,000 for an apartment building in an up-and-coming neighborhood in San Diego. After holding onto the property for a couple years and finding his property greatly appreciated from a neighborhood renovation project, Ronald decides to cash out and purchase a bigger-and-better beach front apartment complex in La Jolla. Ronald finds a buyer who purchases his apartment building for $1,000,000.

Below is a table showing the differences in Ronald Lump’s financial position post-sale when applying and not applying the Like-Kind Exchange rules.

Ronald’s Selling Price $1,000,000.00
Ronald’s Original Purchase Price $500,000.00
Total Taxable Gain After Sale $500,000.00
When Like-Kind Rules Are Applied When Like-Kind Rules Are Not Applied
Capital Gains Tax Rate on Taxable Gain N/A 20%
Tax Due After Sale $0 $100,000.00
Total Amount Available to Ronald Post–Sale that can be Reinvested Into the Beach Front Apartment Complex  

 

$1,000,000.00

 

 

$900,000.00

As you can see, applying the Like-Kind Exchange rules enhance an investor’s financial position or purchasing power to acquire a replacement property.  Ronald Lump, by following and meeting the requirements under Section 1031 will have $100,000.00 more than he otherwise would to reinvest in another like-kind property.  Over time, through structuring multiple property exchanges in this way, the value of an investor’s investment portfolio is better preserved and substantially enhanced.

In later blog posts I will provide a basic understanding of what Section 1031 requires and how you can apply it in your next investment.  I will focus solely on real estate exchanges, though Like-Kind Exchanges can be used in exchanges involving other business or investment assets.  The rules and requirements established in Section 1031 are complex, and if not closely followed by an investor, will disqualify an exchange from tax deferment treatment.  Real estate investors structuring a Like-Kind Exchange are strongly encouraged to obtain an attorney’s assistance in preparing and executing such an exchange. By following this “Golden Rule” of real estate investing, you can work to maximize your investing power now and into the future.

Here is a table of contents of our Section 1031 Exchange Articles:

INTRODUCTION – GOLDEN RULE TO REAL ESTATE INVESTMENT

PART 1 – THE RELINQUISHED PROPERTY (SOLD PROPERTY) MUST HAVE BEEN HELD BY THE EXCHANGER FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMEST PURPOSES.

  • PART 1.3 – How do you characterize vacant and unproductive land, which is not used for personal enjoyment nor in furtherance of any trade or business purpose?

PART 2 – THE EXCHANGER MUST INTEND TO HOLD THE REPLACEMENT PROPERTY (ACQUIRED PROPERTY) FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMENT PURPOSES. 

PART 3 – BOTH THE RELINQUISHED AND REPLACEMENT PROPERTY MUST HAVE A NATURE AND CHARACTER THAT IS “LIKE-KIND” WITH THE OTHER.