1031 Exchange Blog

1031 EXCHANGE GENERAL

Understanding Related Party Rules in 1031 Exchanges

01/15/25

A "related party" includes certain family, business entities, and fiduciaries. Based on the Related Party Rule, many believe 1031 Exchanges involving ...

Authored by: meredithb@accruit.com

Authored on: Wed, 01/15/2025 - 15:11

1031 Exchange General

<p>There is often confusion surrounding 1031 Exchanges and related parties. A common misconception about 1031 Exchanges is that transactions involving related parties are prohibited. In reality, exchanges involving related parties are allowed, but come with stricter rules and oversight to ensure compliance with the tax code. Another point of confusion is what qualifies as a "related party". Many assume it applies only to relatives, but the definition extends beyond family to include certain business entities and fiduciary relationships. Understanding related party rules is critical for investors looking to utilize a 1031 Exchange that is compliant with the tax code.</p>

<h2 aria-level="2" paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{121}" paraid="1908381897" role="heading">Who is a Related Party? </h2>

<p paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{127}" paraid="1232734130">The Internal Revenue Code provides clear guidelines on who qualifies as a <a href="https://www.accruit.com/blog/1031-tax-deferred-exchanges-between-relate… party</a> in 1031 Exchanges. Under Sections 267(b) and 707(b)(1) of the Internal Revenue Code, related parties include: </p>

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<p paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{144}" paraid="1770392009">Immediate Family Members: Siblings, spouses, ancestors (parents, grandparents), and descendants (children, grandchildren). </p>
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<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="2" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="3" role="listitem">
<p paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{152}" paraid="1446133979">Business Entities with Significant Ownership or Control: Entities where the Exchanger holds more than 50% ownership, such as corporations, partnerships, or trusts; two corporations that are members of the same controlled group; and corporations and partnerships with more than 50% direct or indirect common ownership. </p>
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<p paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{160}" paraid="1626271083">Certain Fiduciary Relationships: Ex. An Exchanger and the fiduciary of a trust. </p>
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<p paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{168}" paraid="1226249788">Affiliated Businesses: Entities that are directly or indirectly controlled by the Exchanger or their immediate family. </p>
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<p paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{176}" paraid="364697859">This broad definition ensures that any transaction involving individuals or entities with close personal or financial ties is subject to heightened scrutiny. <a href="https://www.accruit.com/blog/video-related-party-rules-1031-exchange">T… Related Party Rules</a> are designed to prevent potential abuse, such as shifting tax liabilities or inflating property values in ways that undermine the intent of a 1031 Exchange. </p>

<p paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{197}" paraid="581392881">It's also important to note that these relationships are closely monitored to ensure the legitimacy of the transaction. If an exchange involving related parties fails to meet the requirements, the transaction may be disqualified, and tax deferral could be denied. Understanding these parameters is essential for Exchangers considering transactions with related parties. </p>

<h2 aria-level="2" paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{203}" paraid="1864790775" role="heading">The Tax Reform Act of 1984 </h2>

<p paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{209}" paraid="1705335478">Before the 1980s, Exchangers could potentially conduct a 1031 Exchange with related party real estate to manipulate property values or defer taxes improperly. For instance, two related parties might exchange properties where one has experienced significant appreciation, in order to shift tax liabilities. To address this issue, Congress strengthened the statute. The Tax Reform Act of 1984 introduced critical changes to related party exchanges, implementing safeguards to ensure these transactions were legitimate and not used to evade taxes. </p>

<h3 aria-level="3" paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{241}" paraid="623194901" role="heading">Direct Related Party Exchanges </h3>

<p paraeid="{855cee55-74a3-4f1f-8bb9-b798e897db83}{248}" paraid="28134364">The introduction of the two-year holding period under the Tax Reform Act of 1984 fundamentally reshaped the landscape of 1031 Exchanges involving related parties. This rule only applies to a direct swap, which occurs when both parties directly swap properties with one another simultaneously and stipulates that both parties must hold their new properties for at least two years following the transaction. If either party disposes of their exchanged property within the two-year window, the tax-deferral benefit is retroactively revoked, and the original capital gain becomes fully taxable in the year the property is transferred. Again, this rule is only true in a direct exchange between related parties and does not apply if an Exchanger sells their Relinquished Property to a related party or purchases their Replacement Property from a related party. </p>

<h4 aria-level="4" paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{65}" paraid="1995206494" role="heading"><em>Exceptions to the Two-Year Rule </em></h4>

<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{72}" paraid="2036733623">There are specific circumstances where the two-year holding period rule does not apply. One circumstance involves the death of an involved party. If one of the parties involved in the exchange passes away during the two-year period, the rule is waived. Another exception includes situations like eminent domain or natural disasters that force the disposition of a property. For example, the holding period requirement may be waived if a government agency acquires the property for public use or a disaster makes the property unusable. Lastly, the rule does not apply if the IRS determines through an audit that the transaction was not structured to avoid taxes, requiring the Exchanger to demonstrate legitimacy of their intent for the transaction. </p>

<h3 aria-level="3" paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{88}" paraid="1525750434" role="heading">Relinquished Property to Related Party Considerations </h3>

<p aria-level="2" paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{95}" paraid="118077204" role="heading">Selling Relinquished Property to a related party in a 1031 Exchange is generally more straightforward than other related party scenarios. Unlike direct exchanges, there are no specific holding period requirements if an Exchanger sells their Relinquished Property to a related party in a 1031 Exchange. As long as the sale of the Relinquished Property complies with IRC Section 1031 guidelines, such as proper use for business/investment purposes and adherence to identification and timing rules, it can proceed without any additional considerations. </p>

<h3 aria-level="3" paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{109}" paraid="1058865449" role="heading">Considerations for Buying Replacement Property from a Related Party </h3>

<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{116}" paraid="1447273265">Buying Replacement Property from a related party, however, involves stricter requirements. In order for this transaction to qualify under 1031 Exchange rules, the related party selling the Replacement Property must also be conducting a 1031 Exchange. In this case, the Replacement Property being acquired would simultaneously serve as the related party’s Relinquished Property. If the related party is not conducting a 1031 Exchange, the transaction would be disqualified from 1031 Exchange treatment under IRS regulations.  </p>

<h2 aria-level="2" paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{128}" paraid="1676427035" role="heading">Why Related Party Rules Exist </h2>

<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{135}" paraid="1390547871">The two-year holding period and Related Party Rules from the 1984 amendment were designed to protect the integrity of the tax system. Before these changes, related party transactions in 1031 Exchanges could be misused for tax avoidance. When it applies, the holding period seeks to avoid improper basis shifting between the related parties. For example, consider two related parties: Party A and Party B. Party A owns a property with a low adjusted basis while Party B owns a property with a high basis. If Party A exchanges their property for Party B’s property, Party A transfers their low basis to Party B, avoiding substantial taxation upon sale. Party B could then sell the acquired property after the exchange, incurring minimal taxable gain due to the higher basis, which undermines the intended purpose of a 1031 Exchange.   </p>

<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{159}" paraid="1931635302">By addressing ambiguities surrounding these exchanges, the amendment boosts confidence in the fairness of the tax code. <a href="https://www.irs.gov/pub/irs-pdf/f8824.pdf">IRS Form 8824</a> reflects the heightened scrutiny of related party exchanges and outlines steps for Exchangers to ensure compliance. Specifically, lines 7-11 require Exchangers to disclose detailed information about the related party, the nature of the relationship, and whether the Relinquished and Replacement Property(ies) were transferred to/from a related party. These disclosures help the IRS identify potential compliance issues within a related party exchange. </p>

<h2 aria-level="2" paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{182}" paraid="1665446550" role="heading">Considerations for Related Party 1031 Exchanges </h2>

<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{192}" paraid="792644693">For Exchangers considering a 1031 Exchange that involves a related party, here are some key considerations: </p>

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<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{204}" paraid="2024623508">Plan for the Two-Year Holding Period: Ensure that both you and the related party can hold the exchanged properties for at least two years where it is applicable. Disposing of property before the two-year period will trigger immediate tax consequences. </p>
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<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{218}" paraid="60795666">Document the Transaction: Maintain clear records of the exchange, including appraisals, contracts, and any correspondence with the related party. This documentation will be critical if the IRS scrutinizes the transaction.  </p>
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<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{226}" paraid="430903581">Seek Professional Guidance: Related party transactions are complex and monitored closely by the IRS. To ensure compliance with all regulations, consult tax and legal advisors and work with a Qualified Intermediary like Accruit, who specializes in 1031 Exchanges. </p>
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<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{240}" paraid="1982709989">By understanding these considerations, Exchangers can confidently navigate the complexities of related party transactions while preserving the benefits of a 1031 Exchange. With careful planning, thorough documentation, and professional support, Exchangers can avoid common pitfalls and achieve a successful investment strategy.  </p>

<p paraeid="{11b2d51f-fe11-460b-a958-173b1993988c}{246}" paraid="1619764858"><em>The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.  </em>    </p>

Wed, 01/15/2025 - 20:04

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Key Considerations for Owning Investment Real Estate in an LLC and Navigating 1031 Exchanges

01/07/25

This article discusses some of the issues to be considered when investment real estate is owned in an LLC. Many ...

Authored by: marketing

Authored on: Tue, 01/07/2025 - 08:50

1031 Exchange General

<p>Many conversations with real estate investors who call us as an exchange <a href="/blog/what-qualified-intermediary" title="1031 Exchange Qualified Intermediary">Qualified Intermediary</a> start with an inquiry such as, “My investment property is owned in an LLC. Is there anything special for me to consider regarding my 1031 Exchange?” There are many considerations for issues that arise from real estate owned in an LLC.</p>

<p>It is common knowledge that “LLC” is an acronym for Limited Liability Company. A Limited Liability Company is a business structure specifically authorized by state statute, and the rules in each state vary. However, there are some commonalities that cross state lines. For example, the owners of the LLC are called “members.” A properly structured and operated LLC protects its members from being personally pursued for any of the LLC’s debts or liabilities. There are two main types of LLCs, single-member LLC and multi-member LLC. A single-member LLC, often abbreviated as “SMLLC”, is a disregarded entity. As a disregarded entity, it is treated as a “pass-through” entity for income tax purposes, and all income and losses are reflected on the member’s personal income tax return. A multi-member LLC is a legal partnership and is itself a Taxpayer that must file its own income tax return. The profits and losses in a multi-member LLC are shared among the members, proportionate to their investments in the LLC. For example, if one member contributed 50% of the start-up capital, another contributed 30%, and the remaining member contributed 20%, the profits and losses will be allocated proportionate to their contributions. Some states offer Series LLCs, which have some economies to offer when multiple LLCs are needed.</p>

<h3>Maintaining LLC Status</h3>

<p>To maintain the protections afforded by the LLC structure, the LLC members must comply with a variety of state rules. Typically, these include holding annual member meetings, paying annual LLC fees to the Secretary of State, maintaining an in state registered agent, keeping business and personal finances separate, avoiding the use of business funds for personal expenses, and complying with the entity’s Operating Agreement. Additionally, Multi-Member LLCs will have an Employer Identification Number (EIN), which is required for the necessary tax reporting for a partnership. A Single-Member LLC is not required to obtain an EIN, but is permitted to do so if the member so chooses. Further, if a real estate acquisition is funded with a bank loan, even for a single-member LLC, banking regulations require that the LLC have an EIN. Failure to comply with the rules the state imposes on LLCs could result in “piercing the corporate veil” and allowing creditors to have access to the members’ personal assets for satisfaction of debts and liabilities.</p>

<h2>Implications of Owning Investment Real Estate in an LLC</h2>

<p>To understand the implications of owning investment real estate within an LLC, the first thing that must be determined is whether the LLC is a single-member or multi-member LLC. This determination is important because of the <a href="/blog/same-taxpayer-requirement-1031-tax-deferred-exchange" title="Same Taxpayer Rule in a 1031 Exchange">Same Taxpayer Rule</a>, which mandates that the Taxpayer who sells the Relinquished Property(ies) must be the same Taxpayer that acquires the Replacement Property(ies), and the classification of the LLC plays a role in meeting this requirement. Clarifying whether the LLC is treated as a disregarded entity or separate taxable entity is crucial to ensuring compliance with this rule and avoiding complications in the exchange process.</p>

<p>At times, further inquiry needs to be conducted by the member(s) or their advisory team to confirm the type of entity. The Operating Agreement created at the time the LLC was formed will provide this distinction. The Operating Agreement contains many provisions including identifying the member(s) and verifying the relative ownership interests among the members, among others. Usually, the Operating Agreement is created when the LLC is formed with the assistance of an attorney or other professional service. However, when investors form LLCs online without professional assistance, or when they reside in states that do not require an Operating Agreement, they may not exist. In the absence of an Operating Agreement, it is best to determine whether the LLC files its own income tax returns or reflects the ownership of the real estate on the member’s personal income tax return. Due to the Same Taxpayer Rule, maintaining the tax continuity of the Exchanger is required, it is necessary to structure the 1031 Exchange consistent with the way the LLC has been filing annual tax returns. If it can be confirmed that the LLC is being treated as a disregarded entity, then the 1031 Exchange can be structured by reflecting the member as the Taxpayer.</p>

<p>When the Relinquished Property is owned in a Single-Member LLC, a disregarded entity, it gives the Exchanger some additional flexibility in the acquisition of the Replacement Property(ies). This is ideal because many investors often prefer to acquire new properties in a new Single-Member LLC to enjoy the protections afforded by the LLC structure noted above, including liabilities and debts being isolated within the LLC. So long as the same member is the member of the new SMLLC, they are in compliance with the Same Taxpayer Rule. Additionally, a surface level advantage of a SMLLC is that investors often like to name their LLCs to correspond with the property that it owns, i.e., ‘1313 Mockingbird Lane LLC.’ Naturally, the investor would not want to acquire 1428 Elm Street in the name of 1313 Mockingbird Lane LLC. Since 1313 Mockingbird Lane LLC is a disregarded entity, the investor can acquire the Replacement Property under 1428 Elm Street LLC without jeopardizing the 1031 Exchange. The important thing to note is that owning both the Relinquished and Replacement Properties in a SMLLC provides for ongoing protections afforded by the LLC structure.</p>

<p>As noted above, a Multi-Member LLC is a tax partnership, and its own unique Taxpayer. When a Multi-Member LLC owns the property, the 1031 Exchange is to be set up under the name of the LLC. For example, when the members of 4 Privet Drive LLC want to sell their current investment property, their options for purchasing Replacement Property are somewhat limited because of the Same Taxpayer Rule. They could acquire the Replacement Property in the name of 4 Privet Drive LLC, which wouldn’t make much sense if they are acquiring 1630 Revello Drive. In addition, using the old LLC to hold the new property might make the new LLC liable for claims that may come up in regard to the old property ownership. However, because they wish to maintain the protections of the LLC structure, while also changing the way the new property is held, a new LLC, 1630 Revello Drive LLC, could be created to take title in that name, if 4 Privet Drive LLC is the sole member of the new entity.</p>

<h2>1031 Exchange Involving Multi-Member LLCs</h2>

<p>Sometimes when property is held within a Multi-Member LLC not all members have the same opinion of what they want to do with their portion of the sale proceeds. One possibility is where all members of the LLC want to go their separate ways, each doing their own 1031 Exchange. That results in what would be called a “drop and swap”, where all members drop their LLC interest to a Tenants-In-Common interest and complete their own 1031 exchanges. Much has been written about the <a href="/blog/1031-drop-and-swap-out-partnership-or-llc" title="Drop and Swap Strategy in a 1031 Exchange">drop and swap</a> strategy, and its relative merits in the 1031 exchange context.</p>

<p>However, if multiple members are willing to stay inside the LLC, even though one party wishes to leave, there are other options. Consider a three-member LLC, where each member owns 1/3 of the membership interests, but one member wishes to leave. In this situation, Three Friends LLC could allow one member to leave in exchange for a 1/3 <a href="/resources/rev-proc-2002-22-tenants-common" title="Revenue Procedure 2002-22 Tenants in Common">Tenant-in-Common</a> interest in the real estate, while the other two members remain inside Three Friends LLC. At closing, the departing member takes their respective share of the proceeds while Three Friends LLC continues and completes its 1031 Exchange with 2/3 of the proceeds. Note that this is a simplified statement of how the structure changes, and investors considering this should consult with their tax and legal advisors prior to initiating an exchange.</p>

<p>Adding members to the LLC also has multiple possible outcomes. If the LLC is already a partnership, then admitting additional members does not change anything for 1031 Exchange purposes. There are accounting issues that the accountant would normally address. However, if the LLC was a single-member LLC, which is being treated as a disregarded entity, then adding a new member creates a partnership, which cannot be a disregarded entity. This situation often arises when one spouse has premarital investment property, and they are now wanting to structure a 1031 Exchange and add their spouse as a partner on the Replacement Property. For example, when Gomez was single, he bought his current investment property and the title is vested in Addams Realty Holdings LLC, of which he is the sole member. Now that he is contemplating a 1031 Exchange, Morticia wants to be a member of the LLC so that she has ownership interests in the Replacement Property. This should not be done, as it would convert the disregarded entity into a partnership, creating a new Taxpayer. It should be possible to change to a partnership when some time has passed from the exchange transaction. It is best to consult with the tax adviser to determine the appropriate amount of time.</p>

<h3>Community Property States</h3>

<p>Community <a href="/blog/1031-exchanges-state-tax-law-considerations" title="State Law and Community Property States pertaining to a 1031 Exchange">property laws</a> dictate how property is owned and managed between spouses in certain states. These laws establish that all assets acquired during the marriage are considered jointly owned by both spouses, regardless of whose name is on title. Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. These laws impact 1031 Exchanges for LLCs owned by married couples who live in those states. According to IRS Revenue Procedure 2002-69, if the LLC is properly formed, its only members are a married couple who reside in a community property state, and the couple elected to treat the LLC as a disregarded entity for federal tax purposes, the IRS will recognize it as disregarded. This allows flexibility for spouses residing in a Community Property state who are involved in a 1031 Exchange. to treat the LLC as a disregarded entity for federal tax purposes, the IRS will recognize it as disregarded. This allows flexibility for spouses residing in a Community Property state who are involved in a 1031 Exchange.</p>

<p>In looking at the example above, if Gomez and Morticia live in a community property state, Gomez could add Morticia as a member of Addams Realty Holdings LLC without jeopardizing the LLC's status as a disregarded entity. This means their 1031 Exchange could proceed with the same LLC even though Morticia will be added as a member of the LLC.</p>

<p>As discussed, owning investment real estate in an LLC can add an additional layer of complexity when a 1031 Exchange is being considered. When structuring a 1031 Exchange involving real estate vested in an LLC or being bought in the name of an LLC, additional care must be taken to ensure compliance with the 1031 Exchange rules. Exchangers are encouraged to consult with their tax and legal advisors before the move forward with the sale or purchase of investment real estate, and to engage a Qualified Intermediary like Accruit, before the first closing that will be part of their 1031 Exchange.</p>

<p><em>The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.</em></p>

Tue, 01/07/2025 - 14:53

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Case Study: Drop & Swap Scenario in a Three-Person LLC

12/13/24

The Drop & Swap strategy is often used when an entity with multiple members owns an investment property that they are ...

Authored by: meredithb@accruit.com

Authored on: Fri, 12/13/2024 - 18:59

1031 Exchange General

<p><a href="https://www.accruit.com/blog/same-taxpayer-requirement-1031-tax-deferre… Same Taxpayer Rule</a> is a key requirement in 1031 Exchanges. The same individual or entity selling the Relinquished Property(ies) must also acquire the Replacement Property(ies) in order to qualify for tax deferral using a 1031 Exchange. Navigating this can become complex when a property is held in a multi-member limited liability company “LLC” and the property owners involved have different financial or investment goals. Ownership by a three member LLC is not the same taxpayer as ownership by the three members individually. In such cases, the “Drop & Swap” strategy can offer a practical solution. A Drop & Swap involves restructuring ownership, generally by transferring shared ownership into individual ownership before proceeding with a 1031 Exchange. This strategy allows co-owners to either proceed with a 1031 Exchange or cash-out, meeting various objectives within a shared investment. To put this strategy into practice, we’ll examine a three-member LLC that owns an investment property, where each member has differing plans for the proceeds from the sale of the owned property.  </p>

<h2 aria-level="2" paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{127}" paraid="842106443" role="heading">The Facts </h2>

<p paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{133}" paraid="631407208">Three members of an LLC—Joe, Sarah, and Matt—co-own a commercial property in Denver. The property, initially purchased for $2.5 million, is now valued at $4 million, having appreciated significantly over the 10 years it has been owned by the LLC. The members of the LLC have decided to sell the property and utilize a 1031 Exchange to defer taxes and reinvest in like-kind property. While Matt intends to "swap" his share for like-kind property using a 1031 Exchange, Joe and Sarah want to “drop” their interest and cash out due to personal reasons, such as needing funds to pay for their children’s college, wanting to invest in stocks using the funds, etc. </p>

<h2 aria-level="2" paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{151}" paraid="2034322484" role="heading">The Problem </h2>

<p paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{157}" paraid="590918088">Since two out of the three of the LLC members are "dropping," the decision is made to terminate the LLC in order to complete the transaction. Once the LLC dissolves, Joe and Sarah want to exit the transaction and receive their portion of the sale proceeds. The problem arises in how to appropriately structure the sale and distribution of the proceeds to allow each to proceed independently.    </p>

<h2 aria-level="2" paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{179}" paraid="1446644651" role="heading">The Solution </h2>

<p paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{185}" paraid="787663336">Using professional advisers and a properly structured transaction, the property can be transferred with a single deed “dropped” from the LLC to the three individuals as <a href="https://www.accruit.com/resources/rev-proc-2002-22-tenants-common">Tena… (TIC)</a>. Below are the some of the general steps and considerations of the process in which the distribution and transfer of ownership could work: </p>

<ol role="list" start="1">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="1" data-font="" data-leveltext="%1." data-list-defn-props="{"335552541":0,"335559685":720,"335559991":360,"469769242":[65533,0],"469777803":"left","469777804":"%1.","469777815":"multilevel"}" data-listid="6" role="listitem">
<p paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{202}" paraid="817087632"><strong>LLC Termination:</strong> The LLC will cease to exist upon conveyance of the property by deed to the members, and the property can then be sold by the three individuals. Since the LLC is now terminating, the ownership interests will be split among the three members, with each receiving a 1/3 interest in the property, with the value of approximately $500,000 attributed to each, not taking into account closing costs or any debt payoff. </p>
</li>
</ol>

<ol role="list" start="2">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="2" data-font="" data-leveltext="%1." data-list-defn-props="{"335552541":0,"335559685":720,"335559991":360,"469769242":[65533,0],"469777803":"left","469777804":"%1.","469777815":"multilevel"}" data-listid="6" role="listitem">
<p paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{228}" paraid="2072551916"><strong>Sale of Property by the Tenants-in-Common:</strong> Once the property becomes held by them in their own names, at the time of closing, they can act at closing independently from one another.    </p>
</li>
</ol>

<ol role="list" start="3">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="3" data-font="" data-leveltext="%1." data-list-defn-props="{"335552541":0,"335559685":720,"335559991":360,"469769242":[65533,0],"469777803":"left","469777804":"%1.","469777815":"multilevel"}" data-listid="6" role="listitem">
<p paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{240}" paraid="1136190522"><strong>Alternative for Liability Protection:</strong> Alternatively, for liability protection, Joe, Sarah, and Matt may choose to hold their ownership interests in the property through multiple single-member LLCs. This allows them to maintain limited liability protection while still benefiting from the transition to individual ownership. </p>
</li>
</ol>

<ol role="list" start="4">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="4" data-font="" data-leveltext="%1." data-list-defn-props="{"335552541":0,"335559685":720,"335559991":360,"469769242":[65533,0],"469777803":"left","469777804":"%1.","469777815":"multilevel"}" data-listid="6" role="listitem">
<p paraeid="{714fd4cd-dcb5-4cc7-ac89-5f4094cae21a}{254}" paraid="1203721617"><strong>Dropping and Swapping:</strong> While Joe and Sarah "drop" from the exchange and face taxation on their gains, Matt is still able to continue with the 1031 Exchange by completing a swap into like-kind property using his 1/3 interest. The drop for Joe and Sarah means they will not reinvest and will incur tax, while Matt will proceed with his swap. </p>
</li>
</ol>

<h3 aria-level="3" paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{7}" paraid="284750919" role="heading">Holding Period Considerations for a Drop & Swap </h3>

<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{13}" paraid="1234306216">When the LLC is dissolved, and the property is distributed to individual members, it's beneficial that anyone doing an exchange hold the property for some period of time before initiating the exchange. If the drop (distribution) and swap (1031 Exchange) occur too close together, the IRS might question the transaction, at least in Matt’s case, as he intends to complete a 1031 Exchange. IRS Code Section 1031 states: </p>

<p style="margin-left:50px">"No gain or loss shall be recognized on the exchange of real property <strong>held</strong> for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be <strong>held </strong>either for productive use in a trade or business or for investment."</p>

<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{81}" paraid="1025693428">There is no specific defined term for which the property must be held. Clearly in a drop & swap the property has been held for an extended period of time by the LLC, but not very long by the individual who is trying to execute the exchange. In general, the longer the period between the drop and the sale, the better it is to maximize the holding period. </p>

<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{87}" paraid="10323909">However, there are scenarios where re-establishing a holding period may not be necessary. For example, another common scenario involving a Drop & Swap might occur if Joe and Matt both wanted to remain invested and complete a 1031 Exchange, while Sarah alone wanted to cash out. In this case, Sarah would receive a 1/3 Tenants-in-Common interest and 1/3 of the sale proceeds, resulting in a taxable event for her. Meanwhile, the multi-member LLC would remain intact, with Joe and Matt continuing as members to complete a 1031 Exchange using the remaining 2/3 of the proceeds. </p>

<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{98}" paraid="2060346325">By structuring the transaction this way, the LLC itself continues to satisfy the holding period requirements for the 1031 Exchange, avoiding the need to re-establish a fresh holding period. This approach can simplify the process for the remaining members, provided that the facts align, and the transaction is carefully structured. </p>

<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{109}" paraid="327100955">To enhance the validity of the drop & swap, there are a few to keep in mind to plan ahead including the following:   </p>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="1" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="8" role="listitem">
<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{119}" paraid="860219213"><strong>Complete the Drop Before Contract Execution:</strong> If possible, try and have the drop completed prior to the execution of the Relinquished Property disposition contract in order that it may be signed by the individuals rather than having it signed by the LLC and later assigned to the individuals. </p>
</li>
</ul>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="2" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="8" role="listitem">
<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{127}" paraid="2079227390"><strong>Separate the Transactions by Tax Years:</strong> Completing the drop in one tax year and the swap in a subsequent tax year helps separate the drop action from the IRS 1065 Partnership Return, particularly <a href="https://www.irs.gov/pub/irs-pdf/f1065.pdf">Schedule B 12</a>, from the reporting by the individual of an exchange on <a href="https://www.irs.gov/pub/irs-pdf/f8824.pdf">IRS Form 8824</a>. </p>
</li>
</ul>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="3" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"multilevel"}" data-listid="8" role="listitem">
<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{146}" paraid="147739674">While holding the property for a sufficient period, it does not necessarily affect Joe and Sarah who are cashing out anyway, but it can be helpful to Matt to establish a new holding period and minimizing raising red flags and maximizes his 1031 Exchange qualifying under IRS guidelines. </p>
</li>
</ul>

<h2 aria-level="2" paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{160}" paraid="217101162" role="heading">In Summary </h2>

<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{180}" paraid="1863224207">Joe and Sarah successfully "drop" out of the LLC, take their share of the sale proceeds, and pay taxes on their profits. Matt completes his 1031 Exchange and achieves tax deferral on his portion of the sale. While Joe and Sarah are no longer invested in the property and will pay taxes on their capital gains, Matt continues to expand his real estate portfolio.  </p>

<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{186}" paraid="604148591">In the end, Joe, Sarah, and Matt achieve their respective objectives: Joe and Sarah use their taxed funds to pay for their children’s education and individual investment ventures, while Matt reinvests his share into like-kind investment property.  </p>

<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{192}" paraid="764024897">Drop & Swaps are complicated and involve many considerations and documentation not necessarily referenced here. As always, Exchangers are encouraged to consult with their tax and legal advisors before proceeding with the drop and swap as the sale of an investment or business-use property. Additionally, they should secure the services of a Qualified Intermediary before the first closing involved in their exchange. </p>

<p paraeid="{dee420d0-7d0f-4a53-bf7d-270c1a1c5e31}{202}" paraid="2090153969"><em>The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.       </em></p>

Mon, 12/16/2024 - 17:19

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Direct Deeding Under IRC Section 1031

11/25/24

The article discusses the evolution and current practices of property deeding in a 1031 Exchange, highlighting key legislative changes and the ...

Authored by: meredithb@accruit.com

Authored on: Mon, 11/25/2024 - 15:03

1031 Exchange General

<p paraeid="{70c2d05c-7bc2-4113-8417-bc986625313b}{192}" paraid="238745568">For those mildly familiar with a 1031 Exchange, it is generally well understood that in a typical exchange, the Exchanger sells the Relinquished Property to the Buyer with the assistance of a title or escrow company or some other settlement agent. Most know that Replacement Property must be identified within 45 days of the sale and acquired within 180 days (or less due to the filing date for the year’s tax return, unless extended). Parties also know that the use of a Qualified Intermediary is highly advisable to assure compliance with <a href="https://www.accruit.com/sites/default/files/Internal%20Revenue%20Servic… § 1031</a>. However often Exchangers or their advisors are unsure how the flow of deeds takes place under a delayed exchange following the 1991 Treasury Regulations on the subject. </p>

<h2 aria-level="2" paraeid="{70c2d05c-7bc2-4113-8417-bc986625313b}{209}" paraid="1427850445" role="heading">Evolution of Deeding in a 1031 Exchange </h2>

<h3 aria-level="3" paraeid="{70c2d05c-7bc2-4113-8417-bc986625313b}{219}" paraid="451140126" role="heading">Property Prior to The Starker Case </h3>

<p paraeid="{70c2d05c-7bc2-4113-8417-bc986625313b}{225}" paraid="1269104462">The Starker case ushered in the modern era of tax deferred exchanges in the early 1980s.  Prior to that time, it was thought that an exchange had to be simultaneous. As part of a single closing transaction, the Exchanger sold and conveyed the Relinquished Property to his Buyer, in lieu of cash payment, which resulted in the Buyer obtaining the Exchanger’s target property from its Seller and arranged for the Buyer to transfer said property as Replacement Property to the Exchanger. As a result, the Exchanger and the Buyer completed an exchange. The Starker case changed everything when the Court held that nothing in IRC §1031 required that the sale and purchase had to be simultaneous. It wasn’t until the legislative response in the Tax Act of 1984 that the 180-day exchange period was added to the Tax Code, prior it was open ended under the Starker ruling. </p>

<h3 aria-level="3" paraeid="{70c2d05c-7bc2-4113-8417-bc986625313b}{231}" paraid="1417192659" role="heading">Following The Starker Case Decision </h3>

<p paraeid="{70c2d05c-7bc2-4113-8417-bc986625313b}{244}" paraid="1429231326">The period between the Starker decision and 1991, due to the ability to complete a transaction on a delayed basis, brought up a myriad of unanswered questions including how to handle deeding of properties when an exchange is delayed. The original Code Section from 1921, as amended, did not really contemplate non-simultaneous structures. Given the confusion, it was unclear how legal title had to flow where the exchange was on a delayed basis. The Starker case involved a five-year window for the Buyer to acquire and transfer Replacement Property back to Starker. In The Tax Reform Act of 1984, Congress amended Section 1031 to limit the time to receive Replacement Property from the Buyer to the current period of 180 days. </p>

<h2 aria-level="2" paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{1}" paraid="1159592914" role="heading">Deeding in a 1031 Exchange Post 1991 Regulations </h2>

<p paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{8}" paraid="88901504">By providing the Regulations, the drafters attempted to answer all the open questions and to provide some certainty around the necessary process of an Exchange, including how to deed the title. This entailed making sure that that an actual exchange was still taking place, not simply a sale followed by a purchase within a certain time period, as well as making the exchange process as seamless as possible. A significant part of this was introducing the concept of the Qualified Intermediary (QI), who could substitute for the Buyer as a party with whom the Exchanger could exchange properties. </p>

<p paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{14}" paraid="1537562100">The primary purpose of a QI was to take the Buyer out of any necessary participation in the Exchanger’s exchange transaction. In other words, the Buyer did not have to acquire Replacement Property from a third-party seller and transfer it to the Exchanger. </p>

<h3 aria-level="3" paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{20}" paraid="152381074" role="heading">QI Taking Tax Ownership to Properties </h3>

<p paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{33}" paraid="1852129219">The Regulations set forth several ways for the QI to meet the obligation of exchanging with the Exchanger. The first one is: “An intermediary is treated as acquiring and transferring property if the intermediary acquires and transfers legal title to that property”. Compliance with this provision means the QI takes legal title by deed from the Exchanger and deeds the Relinquished Property to the Buyer and takes legal title by deed from the Seller and deeds the Replacement Property to the Exchanger.   </p>

<h3 aria-level="3" paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{41}" paraid="2096083106" role="heading">Assignment of Rights in Lieu of Deeding to the QI </h3>

<p paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{48}" paraid="1186638157">Under the Regulations, if the QI joins the seller as a named party under the Relinquished Property Contract, and similarly, joins the buyer as a named party under the Replacement Property Contract, that is all that is necessary. But a far easier alternative exists to make the necessary nexus between the Exchanger and QI. This option entails the Exchanger to assign the rights under the sale and purchase agreements to the QI and provide written notice to all parties to the agreements of the assignment. This is the option that is most commonly used. It does from time beg the question, when using the “assignment of rights” process does it require the QI to take title to the properties? </p>

<p paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{112}" paraid="457523389">The answer is No, it is not required; the Exchanger can issue a direct deed to the Buyer of the Relinquished Property and receive a direct deed from the Seller of the Replacement Property. The availability of a direct deed is inferred from the Regulations as well as explicitly referenced in several IRS Rulings. It is interesting to note that Like-Kind Exchanges section of IRS Publication 544 (2023), Sales and Other Disposition of Assets tracks the language of the Regulations generally but explicitly adds the parenthetical underlined below: </p>

<p style="margin-left:50px">An intermediary is treated as acquiring and transferring the property you give up if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than you for the transfer of that property to that person and, pursuant to that agreement, that property is transferred to that person (<u>that is, by direct deed from you</u>). An intermediary is treated as acquiring and transferring replacement property if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters  into an agreement with the owner of the replacement property for the transfer of  that property and, pursuant to that agreement, the replacement property is transferred to you (<u>that is, by direct deed to you</u>). </p>

<p paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{204}" paraid="134464029">The ability to maintain a valid 1031 Exchange while still being able to direct deed properties between the Buyers and Sellers of an exchange not only simplifies the exchange process but can also be helpful to avoid transfer taxes that can occur when title work is involved, as well as avoid potential liabilities attached to properties such as environmental issues. Should a QI, or other party, have to take direct deed to a property and absorb its liabilities, even just for a matter of time, that could cause friction in an Exchangers ability to acquire desired properties. </p>

<p paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{214}" paraid="156318446">An additional outcome of the Regulations and introduction of the QI was that the Regulations made it very clear that during the pendency of the exchange, the Exchanger could not be in actual or constructive receipt of the sale proceeds, also termed exchange funds. Contrary to public belief, the primary purpose of the QI was not to hold the funds during this period, rather the Regulations set forth five different alternatives to hold funds in an acceptable manner. None of them included reference to the QI holding them, but by practice this became the simplest and most common way to protect the funds, which holds true today.   </p>

<p paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{220}" paraid="324029842">At one time, to effectuate an exchange the Exchanger and the Buyer had to trade deeds, even if the Buyer acquired the trade property via a deed from a third-party Seller. The Starker case opened a new door from simultaneous exchanges to delayed exchanges, resulting in the need for additional clarification which were addressed in 1991 by the Regulations. Although past practice and the Regulations both approved the passing of deeds between the parties, the Regulations also sanctioned direct deeding by utilizing a QI and the “assignment of rights” process which simplified a 1031 Exchange and provided protections for all parties involved. </p>

<p paraeid="{356376aa-ca7b-4e28-a813-d1a3a5b20cf1}{230}" paraid="1778762121"><em>The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.       </em> </p>

Tue, 11/26/2024 - 16:13

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Considerations for a 1031 Exchange that Spans Two Years

11/20/24

1031 Exchanges help real estate investors defer taxes by reinvesting sale proceeds into new property. Exchanges occurring in the second half ...

Authored by: meredithb@accruit.com

Authored on: Wed, 11/20/2024 - 21:12

1031 Exchange General

<h2 aria-level="2" paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{28}" paraid="1368980169" role="heading">1031 Exchanges Across Tax Years </h2>

<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{34}" paraid="1634579820">IRC Section 1031 Regulations specify that, “The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of tax imposed for the taxable year in which the transfer of the relinquished property occurs.” In other words, an Exchanger generally has 180 days to complete the 1031 Exchange by acquiring Replacement Property(ies), allowing them to defer taxes by reinvesting proceeds. </p>

<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{56}" paraid="1099383346">However, if a 1031 Exchange begins in the second half of the year, specifically after July 5th, it may “straddle” two tax years, meaning the 180-day exchange deadline falls within the next calendar year. For a successful 1031 Exchange fully completed sooner, tax straddling has no impact on the exchange, it only comes into play if the 1031 Exchange continues to hold funds at the time of the <a href="https://www.accruit.com/blog/early-release-exchange-funds-possible-unde… possible distribution date</a> under the regulations due to failure to acquire all identified Replacement Property by day 180 and having funds left in the exchange account. This same straddle can also result for exchanges that close on the Relinquished Property sale on or after November 17th. In most cases, an Exchanger cannot get the funds back prior to the expiration of the 45-day identification period, pushing the earliest funds return date until January 1st, or later, of the following year. This same result can occur if there are additional properties identified but not acquired and there are leftover funds in the exchange account. </p>

<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{105}" paraid="1834026367">An additional consideration to be aware of for exchanges initiated after October 18th, Exchangers may not receive the full 180 days due to the April 15th tax deadline unless they <a href="https://www.accruit.com/blog/end-year-tax-considerations-2024">file for a tax extension</a>. To take full advantage of the 180-day period, they would need to submit Form 4868, which grants an additional six months to file income taxes. </p>

<h2 aria-level="2" paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{142}" paraid="1102779953" role="heading">What Happens if a 1031 Exchange Fails? </h2>

<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{148}" paraid="1095711419">If a 1031 Exchange results, in whole or in part, with any of unused funds remaining, they are returned to the Exchanger, and all applicable taxes have to be paid on those funds. For a 1031 Exchange that starts and ends within the same year, 2024 for example, the Exchanger will be subject to pay the associated taxes as part of their 2024 Tax Return. In the event a 1031 Exchange spanned across two tax years, for example, it was started in 2023 and then resulted in a return of funds in 2024, the Exchanger has the option of which year they want to recognize the “gain” from the Relinquished Property sale (not depreciation recapture and certain other taxes). Default reporting provides that the gain from the sale is recognized in the year the exchange funds are received, rather than the year it was started. In this event, the Exchanger is able to defer the taxes until their 2024 tax filing deadline (April 15, 2025, for individual filings) by applying the IRS Installment Sale rules under Section 453. The reporting of the receipt of the (installment) payment is done via IRS Form 6252. This option provides flexibility, allowing Exchangers to manage tax obligations more effectively and take advantage of tax deferral short-term, even when the exchange results in the Exchanger’s receipt of any funds.  </p>

<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{156}" paraid="807483728">For example, consider a 1031 Exchange initiated on December 1st, 2024. The 45-day identification deadline would fall on January 15, 2025, with the 180-day exchange period ending on May 30, 2025. If the exchange results in unused funds, whether due to non-identification or a lack of full Replacement Property acquisition, the Exchanger will not receive the exchange proceeds back until the subsequent tax year from the start of their exchange, in this example 2025. In this case, the IRS allows Exchangers to choose between reporting the gain in the year of the sale or in the year the proceeds were received through Section 453 installment sale rules. A special election needs to be made to report the gain in 2024 should the Exchanger desire the same. Using the installment sale treatment essentially provides a one-year deferral on payment of tax on the gains from the Relinquished Property. </p>

<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{174}" paraid="2006729837">Another scenario is when an Exchanger acquires Replacement Property(ies) but does not fully utilize exchange funds, resulting in taxable “boot”. By structing the receipt of the boot as an installment sale, an Exchanger can spread the tax liability over time. Instead of paying taxes on the entirety of the boot in the year of the 1031 Exchange, an Exchanger can pay taxes only on the amount received each year under the installment sale. </p>

<h3 aria-level="3" paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{184}" paraid="1852558626" role="heading">Common Scenarios Where a 1031 Exchange Fails and How Installment Sale Treatment Can Help </h3>

<p aria-level="3" paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{195}" paraid="190446258" role="heading">Several scenarios can lead to the failure of a 1031 Exchange, but in some cases, installment sale treatment may provide an alternative tax-deferral strategy: </p>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="1" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"hybridMultilevel"}" data-listid="1" role="listitem">
<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{201}" paraid="25221165">Failure to Identify Replacement Property: The Exchanger may be unable to identify Replacement Property(ies) within the required 45-day period and the expiration of the identification period crosses into the following tax year </p>
</li>
</ul>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="2" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"hybridMultilevel"}" data-listid="1" role="listitem">
<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{211}" paraid="1348317539">Failure to Acquire Identified Properties: The Exchanger identifies Replacement Property(ies) within the 45-day period but does not acquire any by the 180-day deadline. </p>
</li>
</ul>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="3" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"hybridMultilevel"}" data-listid="1" role="listitem">
<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{221}" paraid="2063430299">Failure to Expend all the Exchange Funds:  Replacement Property has been acquired, but additional property has been identified, and excess funds still remain in the account, but the Exchanger does not wish to acquire any additional property. </p>
</li>
</ul>

<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{231}" paraid="455496157">In all of these cases, opting for installment sale treatment can help reduce the immediate tax burden, provided the initial intent to complete a 1031 Exchange is maintained. </p>

<h2 aria-level="2" paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{239}" paraid="117829066" role="heading">Considerations for Determining Which Year to Report the Failed Exchange </h2>

<p paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{245}" paraid="159388278">Some of the considerations for which tax year to report and pay the gain include:   </p>

<h3 aria-level="3" paraeid="{568ee3a8-4dd0-4a52-8a76-b9bb22263d8e}{251}" paraid="702208879" role="heading">Reporting in Year of Returned Funds (latter year) </h3>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="1" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"hybridMultilevel"}" data-listid="3" role="listitem">
<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{5}" paraid="279751839">The “time value of money”, i.e. all things being equal, most people would rather pay tax a year later and have those funds working for them without penalty for the year </p>
</li>
</ul>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="3" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"hybridMultilevel"}" data-listid="3" role="listitem">
<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{19}" paraid="1336735135">An Exchanger may have a change in income coming up, such as retiring or some other event, that might push him into a lower tax bracket in the following year </p>
</li>
</ul>

<h3 paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{30}" paraid="1663507726">Reporting in Year of Property Sale  </h3>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="4" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"hybridMultilevel"}" data-listid="3" role="listitem">
<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{37}" paraid="384232076">The Exchanger may have losses in the year of sale that she might be able to offset against the taxable gain. </p>
</li>
</ul>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="5" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"hybridMultilevel"}" data-listid="3" role="listitem">
<p lang="EN-US" paraeid="{cde8aacd-1fb9-4452-a6f9-f64fd870ef52}{46}" paraid="273406577" xml:lang="EN-US">The Exchanger may believe that capital gain rates may be higher in future years and may want to pay the tax at the current rate rather than risk paying them later when I higher rate may be in effect. </p>
</li>
</ul>

<h2 aria-level="2" paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{72}" paraid="1893186675" role="heading">Understanding the Pros and Cons of Choosing Installment Sales </h2>

<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{80}" paraid="313813151">Choosing the installment sale route carries no IRS penalties and adds flexibility, which is particularly beneficial when an exchange crosses into a new tax year and funds are returned in that year. The IRS considers installment sale treatment the default reporting method for an unsuccessful exchange that straddles tax years unless the Exchanger specifically elects to report the gain in the year of the Relinquished Property sale.  </p>

<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{96}" paraid="2037466242">However, an installment sale can have drawbacks, including:    </p>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="1" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"hybridMultilevel"}" data-listid="2" role="listitem">
<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{104}" paraid="994600991">Debt paid off at the closing of the Relinquished Property, gain associated with the debt is typically recognized in the year of sale, leading to immediate tax liabilities.  </p>
</li>
</ul>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="2" data-font="Symbol" data-leveltext="" data-list-defn-props="{"335552541":1,"335559685":720,"335559991":360,"469769226":"Symbol","469769242":[8226],"469777803":"left","469777804":"","469777815":"hybridMultilevel"}" data-listid="2" role="listitem">
<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{112}" paraid="654869189">Depreciation recapture under Sections 1245 or 1250 is taxed as ordinary income, potentially resulting in a significant tax burden. If the sale price exceeds $150,000 and installment obligations exceed $5 million, interest is charged on the deferred taxes, raising the overall cost.  </p>
</li>
</ul>

<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{120}" paraid="1238140996">It is important to note that the rules governing Section 453 installment sales are specific. Installment sales do not apply to all transactions, and they do not defer any gain related to debt relief. </p>

<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{132}" paraid="332915467">1031 Exchanges that span across two tax years require careful planning and consideration to ensure the Exchanger can fully benefit from IRS rules, including installment sales under Section 453. Installment sales offer a valuable benefit for deferring taxes should an exchange fail, or significant exchange proceeds remain unused. It is essential to consult with tax and/or legal advisors to fully understand to concepts covered in this blog.  </p>

<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{146}" paraid="861811375">Consulting advisors to work in combination with a highly credentialed Qualified Intermediary such as Accruit can help Exchangers make informed choices and better manage tax their implications associated with the sale of real estate investments. </p>

<p paraeid="{b7103877-0f3a-400c-b23e-8b24aea043df}{164}" paraid="352048689"><em>The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.       </em> </p>

Wed, 11/20/2024 - 22:08

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Can You Change Qualified Intermediaries During a 1031 Exchange?

11/06/24

A common question we see through our Live Chat is “Can I change my Qualified Intermediary during a 1031 Exchange?” Generally, ...

Authored by: meredithb@accruit.com

Authored on: Wed, 11/06/2024 - 16:18

1031 Exchange General

<h2 aria-level="2" paraeid="{99b011a5-7ba7-4475-b518-ace3cd02b5dd}{230}" paraid="1671084840" role="heading">The Role of the Qualified Intermediary in a 1031 Exchange </h2>

<p paraeid="{99b011a5-7ba7-4475-b518-ace3cd02b5dd}{236}" paraid="1917195774">By definition, a <a href="https://www.accruit.com/blog/what-qualified-intermediary">Qualified Intermediary (QI)</a> is an independent third-party that facilitates IRS Section 1031 tax-deferred exchanges. The primary function of a QI is to serve as a conduit in the exchange, managing the acquisition and transfer of properties while ensuring compliance with the detailed rules established by IRS Regulations. This oversight is crucial for maintaining the integrity of the exchange to achieve tax deferral. Additionally, it is essential that the Exchanger avoids actual or constructive receipt of the proceeds from the sale of the Relinquished Property during the period between the sale and the purchase of the Replacement Property(ies). The Regulations suggest several methods to ensure that the Exchanger is not deemed to have access to those funds. Typically, this requirement is met by having the QI hold the funds on behalf of the Exchanger. </p>

<h2 aria-level="2" paraeid="{99b011a5-7ba7-4475-b518-ace3cd02b5dd}{255}" paraid="2009462040" role="heading">How the Qualified Intermediary Facilitates the 1031 Exchange </h2>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{6}" paraid="1596802534">The regulation clearly states that the Qualified Intermediary "acquires the Relinquished Property from the taxpayer, transfers the Relinquished Property [to the Buyer], acquires the Replacement Property, and transfers the Replacement Property to the taxpayer." This is accomplished using assignments, legal documents that the QI prepares as part of the exchange.  </p>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{20}" paraid="662144789">In these assignments, the Exchanger assigns their rights, but not their responsibilities, under the contracts for both the sale of the Relinquished Property and the purchase of the Replacement Property(ies). The QI then arranges the transfer of the Relinquished Property to the Buyer and handle the receipt of the Replacement Property(ies) from the Seller, ensuring the properties are exchanged. </p>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{58}" paraid="1393877026">Although the deeds to the properties never physically pass through the Qualified Intermediary and the QI never holds legal title, the assignments create a legal framework that makes it appear as though this transfer occurs. Essentially, the Exchanger is transferring the Relinquished Property to the QI and receiving the Replacement Property(ies) from the QI. This is where the actual exchange takes place, within the legal framework of the two assignments. </p>

<h2 aria-level="2" paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{64}" paraid="488393184" role="heading">Why Exchangers Want to Change Qualified Intermediaries </h2>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{70}" paraid="78756428">Periodically, we receive inquiries from Exchangers who have already sold their Relinquished Property and are in the middle of a 1031 Exchange but are seeking to change their Qualified Intermediary. There are several reasons why an Exchanger might consider this change. Sometimes, it's due to a lack of responsiveness from their current Qualified Intermediary, with unanswered calls and emails causing frustration. In other cases, the Exchanger may feel that the QI does not demonstrate the level of competence required to inspire confidence that their exchange is being managed properly. </p>

<h2 aria-level="2" paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{76}" paraid="842027719" role="heading">Why Exchangers Can’t Change Qualified Intermediaries Mid-Exchange </h2>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{82}" paraid="357991820">Unfortunately, once a 1031 Exchange is underway, an Exchanger cannot switch Qualified Intermediaries. This is because the QI must be involved in both the sale of the Relinquished Property and the purchase of the Replacement Property(ies) as noted in the above section. Swapping intermediaries partway through would invalidate the exchange, according to IRS Regulation §1.1031(k)-1(g)(4)(iii). Thus, the same QI must handle both transactions to maintain compliance.  </p>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{88}" paraid="1938690703">According to Regulation §1.1031(k)-1(g)(4)(iii), a Qualified Intermediary must: </p>

<ol role="list" start="2">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="2" data-font="" data-leveltext="%1." data-list-defn-props="{"335552541":0,"335559685":720,"335559991":360,"469769242":[65533,0],"469777803":"left","469777804":"%1.","469777815":"hybridMultilevel"}" data-listid="1" role="listitem">
<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{109}" paraid="814337252">Enter into a written agreement with the Exchanger (known as the "exchange agreement"). As part of this agreement, the QI is required to acquire and transfer the Relinquished Property, as well as acquire and transfer the Replacement Property(ies) to the Exchanger. </p>
</li>
</ol>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{115}" paraid="929955425">There is one circumstance under which an Exchanger may change Qualified Intermediaries, but it is very narrow. If the Exchanger has begun working with a Qualified Intermediary, and even gone so far as to sign exchange documents, but the first real estate transaction that is part of the exchange has not been consummated, the Exchanger can change QIs without problem. More succinctly, if the first sale or purchase that is part of the exchange has not yet closed escrow, the exchange has not technically begun, and the Exchange may change to a more suitable QI. </p>

<h2 aria-level="2" paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{124}" paraid="2044031694" role="heading">The Importance of Expertise in Complex 1031 Exchanges </h2>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{130}" paraid="1170553297">Not all Qualified Intermediaries are equally skilled or experienced and given the inability to change QIs mid-exchange it is crucial to choose a “qualified” QI from the start. Some QIs focus solely on handling simple forward delayed exchanges, which are the most basic type of 1031 Exchange. However, Exchangers may sometimes realize mid-process that they need a more advanced exchange that also requires an Exchange Accommodation Titleholder (EAT), such as a <a href="https://www.accruit.com/blog/1031-exchanges-involving-construction-and-… improvement exchange</a>, which is beyond the expertise of many QIs. At this point, they would be stuck without the option to change QIs and if full tax deferral relied on their ability to do a forward improvement exchange, they would be facing a potentially taxable event. </p>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{141}" paraid="2088934522">Whether an Exchanger is planning for a simple or complex 1031 Exchange, it is always encouraged that they choose a Qualified Intermediary well versed in all types and complexities to fully ensure tax deferral. It is essential to select a Qualified Intermediary before the first closing of a 1031 Exchange, as switching mid-process is not allowed. Not all QIs have the expertise to manage complex exchanges, so consult your tax and legal advisors early on. Choosing an experienced QI, such as Accruit, ensures that your 1031 Exchange is managed efficiently and in full compliance with IRS regulations. </p>

<p paraeid="{09113ce1-731d-480d-8585-cbff1c225b5a}{151}" paraid="866183348"><em>The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.         </em></p>

Wed, 11/06/2024 - 18:59

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1031 EXCHANGE GENERAL

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