1031 Exchange Blog

1031 EXCHANGE GENERAL

Regulation of Foreign Ownership in U.S. Property and 1031 Exchanges

08/05/24

United States real estate has long been an attractive investment opportunity to foreign investors. When investing in real estate, the ...

Authored by: meredithb@accruit.com

Authored on: Mon, 08/05/2024 - 21:43

1031 Exchange General

<h3 aria-level="2" paraeid="{11fe52c5-108a-4df9-ab36-c8c6cf08c6a1}{87}" paraid="590867357" role="heading">How 1031 Exchanges are Utilized in Real Estate Transactions Involving Foreign Investors </h3>

The Seller of U.S. property to a foreign investor can utilize a 1031 Exchange in the exact same way they would if they were selling property to a domestic investor that is a citizen of the United States. As the Seller they must abide by the standard 1031 Exchange rules and regulations to complete a valid 1031 Exchange for tax deferral.

But can a foreign investor use a 1031 Exchange when investing in U.S. Real Estate? The short answer is yes; foreign investors can use 1031 Exchanges for U.S. real estate investments. The longer answer includes added complexities that foreign investors must abide by to achieve tax deferral status.

Some key considerations for foreign investors regarding 1031 Exchanges include:

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U.S. Property Requirement: Both the property being sold, and the Replacement Property must be in the continental United States, with some exceptions. Learn more about the designation between <a href="https://www.accruit.com/blog/1031-exchanges-involving-foreign-property"… and domestic property</a>.
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Tax Identification Number: Foreign investors must obtain a U.S. Tax Identification Number (TIN) to complete a 1031 Exchange. 
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Withholding Requirements: Under FIRPTA, 15% of the gross sale price must be withheld for foreign Sellers of U.S. real estate. However, foreign investors can potentially avoid this withholding if their 1031 Exchange is properly structured. 
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Compliance with 1031 Exchange Rules: Foreign investors must follow the same rules as domestic investors, including the 45-day identification period and the 180-day completion period. 
</li>
</ol>

<h3 aria-level="2" paraeid="{11fe52c5-108a-4df9-ab36-c8c6cf08c6a1}{208}" paraid="766760711" role="heading">Foreign Investment in Real Property Tax Act (FIRPTA) </h3>

The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) was enacted by Congress to impose tax on foreign investors selling real estate assets in the United States. <a href="/blog/what-firpta-means-your-1031-exchange" title="FIRPTA and 1031 Exchanges">FIRPTA</a> mandates that anyone purchasing real estate assets from foreign individuals or entities must withhold a specified portion of the purchase price, which would ordinarily be paid to the foreign Seller. Buyers are required to withhold up to 15% of the gross sale price when purchasing from individual Sellers. This mandate ensures the foreign Seller pays the required capital gains taxes. Withholding can be avoided if a property becomes the purchaser’s personal residence and the sales price is no more than $300,000, if the 1031 Exchange is simultaneous i.e. The Seller and Buyer are exchanging properties with one another, or if the IRS has issued a withholding certificate to the foreign Seller.

While foreign investors can utilize a 1031 Exchange it requires advance planning. For a foreign investor to achieve tax deferral with a 1031 Exchange they file a Form 8288-B and successfully obtain a withholding certificate prior to the sale of their property. It is strongly encouraged that foreign investors consult with a professional tax advisor to determine if FIRPTA applies, help them obtain a U.S. Taxpayer Identification Number (TIN), and apply for a withholding certificate. In a 1031 Exchange, the Buyer must be informed in writing that a withholding certificate has been requested.

It is important to contact a reputable 1031 Exchange Qualified Intermediary, such as Accruit, well before the closing date to prepare all necessary exchange documentation, which must then be sent to the closing agent. Once the sale is finalized, the 45-day and 180-day identification deadlines commence.

<h2 aria-level="1" paraeid="{11fe52c5-108a-4df9-ab36-c8c6cf08c6a1}{252}" paraid="554727709" role="heading">Why are Foreign Investors Investing in US Real Estate? </h2>

Foreign Investors, and even countries, are drawn to investing in U.S. Real Estate for a multitude of reasons. Many of the reasons don’t differ from why U.S. citizens choose to invest in real estate. Reasons for foreign investment in U.S. real estate include:

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Stable Economic Environment: The U.S. economy is perceived as stable and resilient with strong legal protections for property rights, making it an attractive investment destination. 
</li>
</ol>

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Diversification: Investing in U.S. real estate allows foreign investors to diversify their portfolios, reducing risk by spreading investments across different geographic regions. 
</li>
</ol>

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High Returns: Historically, U.S. real estate markets, especially in major cities, have provided strong returns on investment through both rental income and property value appreciation. 
</li>
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Political Stability: The political stability and transparency in the U.S. attract investors seeking safe and secure investment environments compared to their home countries. 
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Investment Opportunities: The U.S. offers a wide range of real estate investment opportunities, from residential property to commercial real estate, catering to various investment strategies and goals. 
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Legal and Tax Advantages: The U.S. provides certain legal and tax benefits for real estate investors, such as the ability to use 1031 Exchanges to defer capital gains taxes. 
</li>
</ol>

<h3 aria-level="2" paraeid="{aeadfc80-22f4-489c-b378-a674081b996c}{101}" paraid="1205622584" role="heading">Foreign Investments in U.S. Real Estate  </h3>

As of March 2023, U.S. property sales to foreign Buyers totaled $53 billion. Across the country, 79% of the counties have at least one foreign investor present.

As far as specific sectors within the real estate market, Industrial and Multifamily real estate account for the largest portion of foreign commercial real estate investment. From Quarter 2 in 2020 to 2022, industrial real estate investment had grown from 15% to 30% of all foreign capital invested. Multifamily properties are second to industrial property at just under 30% of all foreign investment. A growing sector of real estate in recent years is agricultural land. Foreign ownership and investment in U.S. agricultural land, which includes farmland, forest land, and pastures, has also seen a significant increase over the last few years. Since 2017, this sector has grown almost 50%. According to the latest AFIDA report from 2021, more than 40 million acres of U.S. agricultural land is owned by foreign investors and companies. This equates to just under 2%of all U.S. land and over 3% of all privately held agricultural land.

While residential real estate remains a popular real estate sector of foreign investment, commercial property investment has grown in recent years. As of 2023, the leading countries in commercial property acquisitions include:

<ul>
<li>Canada – $15.98 billion</li>
<li>Singapore – $10.85 billion </li>
<li paraeid="{aeadfc80-22f4-489c-b378-a674081b996c}{194}" paraid="1133827584">Japan – $2.91 billion </li>
</ul>

<h2 aria-level="1" paraeid="{aeadfc80-22f4-489c-b378-a674081b996c}{207}" paraid="1552594057" role="heading">Regulations on Foreign Investment in U.S. Real Estate </h2>

Various governmental entities and numerous laws are utilized to regulate foreign investment in U.S. real estate. While there has been increased foreign investment in commercial and residential properties over the past few years, agricultural land has seen a significant rise, which has heightened national security concerns including foreign control over food supply and proximity to sensitive U.S. military and government bases. Congress has several committees tasked with addressing these concerns.

The Committee on Foreign Investment in the United States (CFIUS):

The CFIUS is an interagency committee authorized to review certain transactions involving foreign investment in the United States, as well as specific real estate transactions by foreign entities, to determine their impact on U.S. national security.

Members of CFIUS include:

<ul>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{6}" paraid="1339385761">Department of the Treasury (chair) </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{12}" paraid="1795226944">Department of Justice </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{18}" paraid="667805442">Department of Agriculture </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{24}" paraid="531472091">Department of Defense </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{30}" paraid="1833835112">Department of State </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{36}" paraid="2121681050">Department of Energy </li>
</ul>

White House Offices that Observe and Participate in CFIUS Activities:

<ul>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{48}" paraid="1996914236">Office of Management & Budget </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{54}" paraid="1876184897">Council of Economic Advisors </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{60}" paraid="743440026">National Security Council </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{66}" paraid="2023592656">National Economic Council </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{72}" paraid="1176605967">Homeland Security Council </li>
</ul>

Non-Voting, Ex-Officio Members:

<ul>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{84}" paraid="150299416">Director of National Intelligence </li>
<li paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{90}" paraid="1462290253">Secretary of Labor </li>
</ul>

These roles are defined by statute and regulation.

CFIUS operates under Section 721 of the Defense Production Act of 1950, as amended, and follows Executive Orders and the Code of Federal Regulations. The latest amendment was the Foreign Investment Risk Review Modernization Act (FIRRMA) in August 2018. Pursuant to these provisions, CFIUS allows the President to suspend or block certain foreign transactions. There are specific rules for how investigations and self-reporting can lead to these actions or exemptions for some foreign entities.

<h3 aria-level="3" paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{120}" paraid="2132209414" role="heading">Agricultural Foreign Investment Disclosure Act (AFIDA) </h3>

AFIDA provides the framework for the collection and dissemination of information on foreign transactions and ownership of agricultural land in the U.S. Since its enactment in 1978, the law and regulations have been administered by the USDA Farm Service Agency which requires foreign investors who acquire, transfer, or hold interest in U.S. agriculture land to report their holdings and transactions to the Secretary of Agriculture. FSA uses the info to compile and file an annual report with Congress and the data is also included in searchable spreadsheets on a county-by-county basis throughout the United States.

<h3 aria-level="3" paraeid="{99d45e40-17a9-4b85-b3f2-f14242e5a311}{142}" paraid="91074828" role="heading">Current Congressional Measures </h3>

In addition to the long-standing CFIUS and AFIDA regulations, there are measures pending in Congress to improve the current system.

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The Promoting Agricultural Safeguards & Security Act of 2023 (PASS) prohibits persons who are acting on behalf of China, Russia, Iran, or North Korea from purchasing or investing in U.S. agricultural land and companies. The President may waive this prohibition on a case-by-case basis if the President determines that the waiver is vital to U.S. national security interests. The bill also places the Secretary of Agriculture on CFIUS and requires CFIUS to review certain transactions involving investments by foreign persons in the U.S. agricultural sector. The Bill also requires the Department of Agriculture to report to Congress on the risks that foreign purchases of U.S. businesses engaged in agriculture pose to the agricultural sector of the United States. 
</li>
</ul>

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The Farmland Act of 2023 (Foreign Agricultural Restrictions to Maintain Local Agriculture and National Defense) was introduced to amend AFIDA to strengthen the oversight and transparency of AFIDA. Notably, the Act amends AFIDA by imposing a requirement that any entity (including a Buyer, Seller, real estate agent, broker, and title company) involved in the purchase or transfer of agricultural land in the United States shall (1) conduct due diligence relating to the agriculture land being purchased or transferred; and (2) certify to the Secretary of Agriculture that, to the best of the knowledge and belief of the entity, the entity is in compliance with all applicable provisions of AFIDA. It also would allow for review of any purchase or lease of U.S. ag land by a foreign entity which exceeds $5,000,000 in value or more than 320 acres that has taken place in the past 3 years. 
</li>
</ul>

The above measures regulated by legislation and executed by various committees help ensure our country remains diligent and aware of the potential risks that foreign investment in U.S. real estate could post on national security, as well as the US economy.

Foreign investors will continue to find U.S. real estate as an attractive investment opportunity and 1031 Exchanges continue to provide qualifying foreign investors the same tax deferral opportunities as U.S. citizens.

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.

Thu, 04/17/2025 - 19:08

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Using a 1031 Exchange for Transferrable Development Rights

07/30/24

“Development Rights” are just that, the right to develop property within limits set forth by state or local law. Transferrable ...

Authored by: meredithb@accruit.com

Authored on: Tue, 07/30/2024 - 19:01

1031 Exchange General

<h2 lang="EN-US" paraeid="{7be10b65-a843-4abe-8fc1-8f3426913fa2}{22}" paraid="1408158107" xml:lang="EN-US">What are Transferrable Development Rights? </h2>

"Development Rights" are defined as the unused rights to develop a property within the limits set by state or local laws. With states and municipalities increasingly imposing restrictions on new construction, the value of development rights has skyrocketed. Since 1916, more than 140 state and local governments have introduced regulations allowing unused development rights to be transferred to different parcels. Property owners can consult with a local land use professional to determine whether they can benefit from such a program. These rights can then be used to construct improvements, such as buildings with more floor space or height, or to build at higher density than would otherwise be allowed. Consequently, an owner with unused development rights can achieve significant financial gain by selling these Transferable Development Rights (TDRs) to another parcel owner looking to further develop their property.

The use of TDRs is a planning and preservation tool that is often used to protect agricultural, historic, or environmental resources while accommodating the needs of development. TDRs are the creation of state and local laws around the country that permit the owners of “preservation area” land to carve out the development rights of their property and sell them for use in a “receiving area”, usually nearby. Generally, developers purchase “development credits” and apply them to areas designated for growth at higher densities than would otherwise have been permitted. Once the property owner has sold their development rights, their land will be permanently restricted from further development.

The Internal Revenue Service addressed the issue of Development Rights in 2008 with the release of PLR 200805012. Simply stated, the question asked in that private letter ruling was whether Development Rights are like-kind for the purposes of IRC Section 1031 to a fee interest in Replacement Property. The IRS noted that state law defined an “interest in real property” to include:

“title in fee, a leasehold interest, a beneficial interest, an encumbrance, development rights, air space and air rights, or any other interest with the right to use or occupancy of real property or the right to receive rents, profits, or other income derived from real property.”

The IRS also noted the Treas. Reg. §1.1031(a)-1(b) provides that “like-kind” refers to the nature or character of the property and not to its grade or quality. Thus, real property in one asset class may be exchanged for real property in another asset class under §1031. The IRS concluded that the Development Rights to be acquired in this 1031 Exchange were like-kind to the fee interest being relinquished in the exchange.

The IRS addressed a similar issue a year later with the release of PLR 200901020. The specific question to be resolved in this PLR was whether residential density development rights are like-kind to other interests in real estate. As with the earlier PLR, the IRS pointed out that Development Rights constitute interests in real estate under state law. The Exchanger was to dispose of development rights within a 1031 Exchange, and then acquire a fee interest in real estate, an additional leasehold interest in real estate with 30 years or more remaining, and certain land use rights. After a detailed historical analysis of Development Rights and easements in 1031 Exchanges, the IRS concluded that the Development Rights to be transferred by the Exchanger are of like-kind to the fee interest in real estate, a leasehold interest in real estate with 30 years or more remaining, and the land use rights.

In December 2020, the IRS issued the long anticipated Final Regulations for real property transactions under Section 1031. The Regulations provided many examples of what constitutes real property as well as a framework for analyzing items that were not listed. Relevant to this discussion, Treas. Reg. §1.1031(a)-3(a)(5)(i) specifically identified “land development rights” as real property for the purposes of 1031 Exchanges. Additionally, property that is real property under state or local law will also be treated as real property for purposes of Section 1031 under Treas. Reg. §1.1031(a)-3(a)(6).

Based on this guidance from the IRS, Exchangers may sell or purchase Transferable Development Rights within a properly structured 1031 Exchange.

To further understand Transferable Development Rights and the utilization of 1031 Exchanges involving TDRs, let’s walk through a hypothetical scenario involving two property owners and how they both can utilize TDRs.

<h2 aria-level="1" paraeid="{a56b9721-de4b-4367-9b46-b98e07c39a72}{90}" paraid="1458865590" role="heading">Utilization of 1031 Exchange with Transferrable Development Rights </h2>

What does the owner of a three-story brownstone in New York have in common with the owner of a 100-acre farm in New Jersey? They each own something that they’re unaware of: Transferable Development Rights.

Our New York City brownstone is owned by a widow who lives comfortably, though with little money left over each month. She has considered selling her home and moving but is reluctant to do so given the sentimental value of the home and high interest rates. She recently consulted with one of her trusted advisors who suggested that she consider TDRs. Her home is approximately 3,000 square feet on a lot that would allow for a home of up to 6,000 square feet. Because her home is in a ‘special purpose district’, she could sell those unused 3,000 square feet to a developer of a ‘designated receiving zone’, and still retain full ownership of her home and land. While the values of TDRs vary widely across the state, for purposes of this illustration we will assume an incredibly modest $200 per square foot (NYC TDRs ranged from $51 to $223 per square foot in 2013.) Thus, multiplying $200 by 3,000 square feet, our homeowner will receive $600,000 for her TDRs.

The owner of Cherry Hill Farm is a third-generation farmer, raising a variety of crops on the last remaining active farm in the town that was once three-quarters farmland. Development has steadily encroached upon the family farm. Residential subdivisions border the farm on three sides and a county road runs through the middle. Developers have long targeted this property for the potential to build 75 or more homes. At the same time, the family farm, and its farmers market business face increasing pressure from supermarkets and warehouse clubs that sell corn, tomatoes, strawberries, and other competing products for lower prices. As with New York, prices of TDRs in New Jersey vary widely, so we will assume $10,000 per housing credit. (Nearby TDRs ranged from $10,000 to $50,000+ in recent years.) Thus, multiplying $10,000 by 75 housing units, our farming family will receive $750,000 for their TDRs. As in New York, the farming family will retain full ownership of the farm, with a deed restriction prohibiting future non-agricultural development.

For both transactions, the result is exposure to significant capital gains on the value of the TDRs. The top tax bracket in New York is 10.9%, and in New Jersey it is 10.75%.

<h3 aria-level="3" paraeid="{a56b9721-de4b-4367-9b46-b98e07c39a72}{163}" paraid="1474821731" role="heading">The Benefits to Our Property Owners </h3>

Our New York widow generated approximately $600,000 from the sale of TDRs associated with her brownstone. Absent a 1031 Exchange, she faced a potential tax bill of over $208,000 ($65,400 to the state, $120,000 in federal capital gains, and $22,800 in NIIT). Our New Jersey farmer garnered $750,000 from the sale of TDRs associated with their farm. Without the benefit of a 1031 Exchange, they faced a potential tax bill of nearly $260,000 ($80,625 to the state, $150,000 in federal capital gains, and $28,500 in NIIT). However, because we now know that they can utilize the benefits of a 1031 Exchange, they can defer associated taxes by deploying those funds toward the purchase of qualifying real estate, including management-free options like <a href="https://www.accruit.com/blog/passive-real-estate-investments-reits-and-… Statutory Trusts</a>.

<h3 aria-level="3" paraeid="{a56b9721-de4b-4367-9b46-b98e07c39a72}{185}" paraid="1101471267" role="heading">The Benefits of TDRs to Developers  </h3>

Developers who acquire TDRs from other properties benefit by being able to add height or density to their projects. In the case of our New York City brownstone, for example, the developer may have been able to build a 9,000 square foot duplex instead of a 6,000 square foot single family home. This effectively allows him 50% more density on the lot than he may have had without the TDRs. For the developer who acquired the TDRs from our farm family, perhaps he can now build 150 homes in his new subdivision rather than 75, because he bought that additional density from the farm family.

<h3 aria-level="3" paraeid="{a56b9721-de4b-4367-9b46-b98e07c39a72}{199}" paraid="1157019159" role="heading">The Benefits to the Community at Large  </h3>

The TDR system is considered to be a mechanism for controlling urban sprawl by concentrating or encouraging development in a specific direction. The use of TDRs is generally viewed more favorably than imposing harsh zoning restrictions on one area, which could cause landowners in that area to claim that there was an unconstitutional “taking” of their property rights. Instead, TDRs offer those property owners a financial incentive to participate in the conservation of their properties for environment, agricultural, or heritage purposes.

As always, Exchangers are reminded to consult with their tax and legal advisors, as state and local laws differ around the country. Further, under the terms of every Private Letter Ruling, Exchangers are advised that each PLR applies only to that Exchanger on that set of facts. Thus, this blog is not a substitute for the advice of competent tax and legal advisors.

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.

Tue, 07/30/2024 - 19:31

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Does an Exchange Cooperation Clause Constitute as Identification of Replacement Property for 1031 Exchange Purposes?

07/18/24

An Exchange Cooperation Clause was a critical implementation in the 1031 Exchange process, as non-simultaneous exchanges became more commonplace after the ...

Authored by: meredithb@accruit.com

Authored on: Thu, 07/18/2024 - 14:44

1031 Exchange General

<h2 aria-level="2" paraeid="{0f93b2da-f6e5-42ca-b63d-d0789cd283d4}{198}" paraid="1707356607" role="heading">What is the Exchange Cooperation Clause? </h2>

The Exchange Cooperation Clause, was an additional document instated after the Starker Case ruling which allowed 1031 Exchanges to be non-simultaneous, it required the Buyer of property involved in an exchange to “cooperate” with the exchange.

<h2 aria-level="2" paraeid="{0f93b2da-f6e5-42ca-b63d-d0789cd283d4}{210}" paraid="1717400141" role="heading">Why was the Exchange Cooperation Clause Needed?  </h2>

To better understand how the Clause came into effect, it is beneficial to start from the inception of Section 1031. IRC Section 1031 first made its way into the Tax Code in 1921, providing tax deferral when there was a “continuity of investment”. In this time period, it was thought that an exchange of Relinquished Property for Replacement Property had to be simultaneous and therefore “identification” of Replacement Property was irrelevant.

In 1983, simultaneous exchanges were no longer required as a result of the decision in the <a href="https://www.accruit.com/blog/%C2%ADare-tax-deferred-exchanges-real-esta…; rel="noreferrer noopener" target="_blank">Starker case</a>. The case concluded that an exchange does not have to be simultaneous to be valid. This monumental change for 1031 Exchange occurred prior to the role of the Qualified Intermediary, which meant an Exchanger planning to do a non-simultaneous 1031 Exchange would need the Buyer to cooperate in order for the 1031 Exchange to be valid.

The shift from simultaneous to delayed transactions raised the issue of handling sale proceeds. If the Seller controlled the proceeds, it would indicate a sale, not an exchange. To avoid this, the funds had to remain out of the Seller’s control and be used by the Buyer to purchase the Replacement Property, but that did not come without risks.

Risks of the Buyer being left with control of the funds included the Buyer not preserving the funds or facing liens, claims, or judgements tying up the money. A solution was to place the funds in a trust account, known as a Starker Trust, where neither the Seller nor the Buyer had access during the 45/180-day period. This ensured the funds were used for the Replacement Property or returned if no exchange occurred.

Initially, Sellers asked Buyers to sign the Starker Trust agreement at closing, but Buyers often resisted due to the complexity, deteriorating relationships, and need for legal review, sometimes resulting in additional fees for the Seller. Thus, resulting in an issue for the Exchanger who still needed the participation of the other party in order to complete a successful 1301 exchange.

<h2 aria-level="3" paraeid="{9a24a006-1943-414d-9fa0-ee5f2bcd4170}{17}" paraid="1665017921" role="heading">The Solution: The Exchange Cooperation Clause </h2>

Based on the challenges noted above, it was determined the only way a Seller could compel a Buyer to sign the necessary agreement was to include the Buyer's obligation within the purchase/sale agreement. Consequently, what became known as the Exchange Cooperation Clause began to appear in contracts, requiring the Buyer to execute the Starker Trust agreement.

The solution to this issue was to put language in the Purchase and Sale Agreement stating that the Buyer and/or Seller, as the case may be, would agree to “cooperate” with the other party attempting an exchange. Initially this language would get added to the Agreement, but in current times the language is often part of the standard sales contract.

Language found in contracts vary, but below is an example of a simple Exchange Cooperating Clause:

“Each of the parties hereto may assign its rights (but not its obligations) to Qualified Intermediary as defined in (and part of a tax deferred exchange) Internal Revenue Code 1031 and the Treasury Regulations thereunder acting to facilitate an exchange under Section 1031 and the regulations. Said exchange will be closed without cost, liability or delay to the non-exchange party.”

<h2 aria-level="2" paraeid="{9a24a006-1943-414d-9fa0-ee5f2bcd4170}{69}" paraid="1892731038" role="heading">Does an Exchange Cooperation Clause Constitute Replacement Property Identification? </h2>

Some may wonder if the existence of the Exchange Cooperation Clause satisfies the Identification Requirements set forth in the Tax Reform Act of 1984. The Tax Reform Act of 1984 introduced time limits, the <a href="https://www.accruit.com/blog/what-are-rules-identification-and-receipt-… and 180-day identification requirements</a>, and criteria to distinguish an exchange of properties from a traditional sale of a property and later purchase of a property.

Below are the absolute requirements to comply with the Identification rules:

2) MANNER OF IDENTIFYING REPLACEMENT PROPERTY.

Replacement Property is identified only if it is designated as Replacement Property in a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to either –

(i)     The person obligated to transfer the replacement property to the taxpayer (Regardless of whether that person is a disqualified person as defined in paragraph (k) of this section); or

(ii)    (ii) Any other person involved in the exchange other than the taxpayer or a disqualified person (as defined in paragraph (k) of this section).

There are several elements to the identification requirement noted above. First, the property has to be designated as Replacement Property, appear in a written document, signed by the Exchanger, and delivered to a party to the transaction, in this case the Seller, before the end of the 45-day identification period. So, does the existence of the Exchange Cooperation Clause satisfy all of these requirements?

A contract between Seller and Buyer executed within 45 days of the Relinquished Property covers four of the five above requirements, but it is difficult to take the position that a pre-printed Exchange Cooperation Clause in a form contract constitutes the subject property as “designated” Replacement Property.

However, in situations where the contract, with or without an Exchange Cooperation Clause and is altered from its standard state explicitly stating that the Buyer is designating this property as their 1031 Exchange property, it would seemingly meet all requirements above. But absent that, simply relying on the existence of an Exchange Cooperation Clause does not appear to meet the identification requirements.

With the introduction of the role of the <a href="/blog/what-qualified-intermediary" title="Role of a Qualified Intermediary">Qualified Intermediary</a> in the 1991 Regulations, the participation of the other party within a real estate transaction involving a 1031 Exchange was no longer necessary. In today’s contracts, the Clause is still typically included in preprinted contracts or added for precaution but is not truly necessary. As the rules and requirements under IRC Section 1031 evolved over the past decades, what was once a crucial practice requiring the Buyer to “cooperate”, is a thing of the past.

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.

Thu, 07/18/2024 - 17:08

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Real Estate: A Versatile Investment Strategy for All

07/11/24

Investing in real estate is a versatile and accessible strategy for individuals of any age and social class. It offers ...

Authored by: meredithb@accruit.com

Authored on: Thu, 07/11/2024 - 19:47

1031 Exchange General

<h2 paraeid="{8912e27f-eb22-4830-b087-5d6c764d760a}{201}" paraid="1893083294">Benefits of Real Estate Investment </h2>

Economic studies highlight the potential benefits and advantages of real estate investments compared to other investment options such as stocks. One of the primary benefits of real estate investment is the relative safety compared to some alternatives. While the stock market is known to be volatile, real estate is typically not as volatile and offers higher returns per unit of risk. This makes it an appealing option for risk-averse investors, especially those who are new to real estate investing and have limited capital. Another benefit is that real estate is a tangible asset. While stocks offer liquidity, the value of a physical asset like real estate tends to hold up better over time.

Real estate investments generally appreciate over time, averaging around 5% annual appreciation for single-family homes from 1987 through 2023. In recent years, appreciation rates have jumped. According to the S&P CoreLogic Case-Shiller U.S. National Home Price Index in April 2024, the national average annual gain was recorded at 6.4%. Certain states like Vermont and Rhode Island have seen astounding increases as of Q3 of 2023, which rose to over 13%.

As properties increase in value, investors can benefit from significant profits when they sell. Investors also have the option to utilize a 1031 Exchange for appreciated properties and exchange into higher-quality properties, continuously enhancing the value of their portfolios.

Diversification is another key advantage of real estate investment. By including real estate in their portfolios, investors can spread their risk beyond the stock market. This diversification means that if one investment underperforms, not all the investor’s money is compromised, thereby providing a more reliable return on investment (ROI).

Investing in real estate can be a powerful tool for building generational wealth. Properties can be passed down through generations, allowing families to accumulate and preserve wealth over time. For property inherited by heirs, <a href="https://www.accruit.com/blog/options-inherited-property-including-1031-… tax consequences and planning options</a> need to be considered.

<h2 aria-level="2" paraeid="{2882902a-20d6-4246-88c1-956f6d3995ce}{101}" paraid="180638600" role="heading">Real Estate Investment Strategies </h2>

<h3 aria-level="3" paraeid="{2882902a-20d6-4246-88c1-956f6d3995ce}{107}" paraid="1774107937" role="heading">Fractional Ownership of Real Estate: TICs and Triple Net Leases (NNN) </h3>

Fractional ownership is an investment structure that allows multiple investors to purchase a percentage ownership in an investment-grade asset. Fractional real estate ownership and other alternative investments provide for diversification, and financial advisors will often dedicate 10% of a clients’ portfolio towards such vehicles.

Tenant-In-Common

A <a href="https://www.accruit.com/blog/fractional-ownership-real-estate" rel="noreferrer noopener" target="_blank">Tenant-in-Common (TIC)</a> is a type of investment property structure that has gained popularity over time. In a TIC arrangement, multiple individuals hold shared tenure rights to owned property. Each tenant-in-common possesses a separate ownership interest in the same real property. The benefits of TICs include increased buying power and reduced costs for each co-owner, as well as the shared responsibility for the property managed by the partnership.

Triple Net Lease (NNN)

A Triple Net Lease (also known as NNN or triple-net) is a type of lease agreement where the tenant agrees to cover all property expenses, including real estate taxes, building insurance, and maintenance, in addition to paying rent and utilities. For landlords, NNNs provide a stable source of revenue, as well as alleviates them from being responsible for utility expenses, taxes, repair costs, and property management as these duties are passed to the tenant.

For investors, the benefits of Triple Net Leased properties include long-term, stable income and the potential for capital appreciation of the underlying property. They can invest in premium real estate without the hassles of managing vacancies, improvement costs, or leasing fees. Also, when the properties are sold, investors can reinvest their capital into another triple net lease or other real estate investment without incurring taxes through a 1031 tax-deferred exchange.

Delaware Statutory Trust (DST)

A <a href="https://www.accruit.com/blog/passive-real-estate-investments-reits-and-…; rel="noreferrer noopener" target="_blank">Delaware Statutory Trust (DST)</a> is a legal entity that holds title to real estate assets. A DST offers investors fractional ownership of larger and higher quality properties that they otherwise would not be able to individually purchase. A DST is also an option for those wanting passive ownership, as there are no daily management responsibilities. This investment option also offers diversification in allowing multiple property investment within a single investment. By investing in multiple properties, some of the risk connected to a single property investment can be mitigated.

Real Estate Investment Trust (REIT)

A Real Estate Investment Trust, or <a href="https://www.accruit.com/blog/passive-real-estate-investments-reits-and-…; rel="noreferrer noopener" target="_blank">REIT</a>, can be another viable option for those who prefer a more passive real estate investment. A REIT is a company that owns and operates income-producing real estate or related assets. A REIT can be thought of like a mutual fund that invests in real estate as opposed to stocks. Assets can include property like shopping centers, office buildings, multi-family housing, etc. Most REITs trade on major stock exchanges, which allow investors the benefit/option to invest in real estate without having to actively manage property.

The purpose of a REIT is to make money for investors through managing, buying, and selling real estate. When a REIT sells an asset, it is their responsibility to investors to replace the asset quickly, often utilizing a 1031 Exchange.

Residential and Commercial Properties

Many entry-level investors start with one residential or commercial property and they continue to grow their portfolios over time.

Residential rental homes are feasible option for newcomers to real estate investing, as they often offer a more affordable investment. Location is a primary concern when deciding where to purchase a rental property, as there needs to be adequate demand and economic stability in order to conduct a successful real estate investment, yet affordable enough to realistically secure a property without major risk. Home prices in expensive, high-value areas such as Seattle average around $880,000, and Washington, D.C., hovering around $625,000. These areas are not as accessible to those starting out in real estate investment, so looking at more affordable cities where the housing market is on the rise is a more viable route. In St. Louis, the average home price is $177,000, and Philadelphia at $225,000.

Let’s look at a scenario of a purchased single-family rental property and its appreciation value over 5 years.

5-Year Philadelphia Appreciation Rate Example:

<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">
Current Value: $225,000 
</li>
<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">
Original Price: $168,000 
</li>
<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">
Appreciation rate: 33.92% 
</li>
</ul>

($225,000 - $168,000) / $168,000 x 100 = 33.92%

Five years ago, the average home price in Philadelphia was $168,000. Now, it is $225,000. The appreciation rate of the home over 5 years was 33.92%, which breaks down to 6.8% annually. (around the national average). For investors, this is a $57,000 appreciation gain in 5 years in addition to a rental income stream. Additional ways value can be added to a property is through conducting improvements and locational popularity, which can sizably increase the value of a property over time in addition to general appreciation. With this increased value, an investor can utilize a 1031 Exchange for a Replacement Property leveraging the now increased value of their Relinquished Property, thus furthering their investment while deferring capital gains tax as well as other deductions such as mortgage interest, depreciation, property taxes, and operating expenses. Investments in other types of real estate can also provide <a href="/blog/amplify-returns-utilizing-1031-exchanges" title="Real Estate Investment Scenarios Using a 1031 Exchange">significant annual returns</a>.

In conclusion, investing in real estate presents an opportunity for individuals of all ages and backgrounds to build and preserve wealth. With its relatively low volatility and higher returns compared to other investment options, real estate is a favorable choice for risk-averse investors and those new to investing. The tangibility of real estate assets, coupled with appreciation potential, makes this a reliable and rewarding investment avenue.

Real estate investments not only offer potentially significant profits and portfolio diversification but also pave the way for building generational wealth. Whether through direct property ownership or more passive approaches like TICs, NNNs, and DSTs, there are various strategies to suit different investment goals and capital levels. Additionally, tax deferral strategies such as 1031 Exchanges further enhance the potential for returns when looking to grow or diversify a real estate portfolio.

Real estate remains a powerful tool for financial growth and stability, providing numerous benefits and opportunities for both novice and experienced investors alike.

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.

Thu, 07/11/2024 - 20:21

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The History of 1031 Exchanges

07/01/24

Gain a better understanding of the history of 1031 Exchanges and its evolution since becoming part of the Tax Code over 100 ...

Authored by: meredithb@accruit.com

Authored on: Mon, 07/01/2024 - 17:38

1031 Exchange General

Like-Kind Exchange first entered the United States Tax Code in 1921 shortly after the first income tax laws were issued in 1918. Since 1921, the statute has evolved into the tax deferral strategy we know today. We will look into key developments including the 1984 Tax Reform Act, which established the 45 and 180-day deadlines, and the landmark 1979 Starker decision that permitted delayed exchanges, as well as the 1991 Regulations, which introduced the role of the Qualified Intermediary, amongst other safe harbors. More recent legislation that affected 1031 exchanges, includes the 2017 Tax Cuts and Jobs Act which limited exchanges to real property and the 2020 Regulations that better defined real property.

<h2 paraeid="{4005547f-e686-4422-b894-91a1392578e8}{120}" paraid="1338961929">1918: First Income Tax Law </h2>

Before there could be an avenue for tax deferral, there first had to be associated taxes owed. The first income tax law was created in 1918, under the Revenue Act of 1918, which introduced the first codified income tax-rate structure in the United States with Normal Tax and Surtax. It was enacted during World War I in an effort to raise funds for the war effort. The Act did not provide for any type of tax-deferred like-kind exchange structure.

<h2 paraeid="{4005547f-e686-4422-b894-91a1392578e8}{148}" paraid="1895865313">1921: IRC Section 202 Gain or Loss not Recognized on Exchanges of Like-Kind Property  </h2>

The Revenue Act of 1921, also known as the Esch-Cummins Act, was a pivotal development in the evolution of tax-deferred exchanges. Its provisions allowed investors to exchange securities and non-like-kind property used in trade or business (unless the property acquired had a "readily realizable market value”) without immediately recognizing capital gains or losses. This attractive provision interested many real estate investors and laid groundwork for future legislation.

A key part of the Act was Section 202, which outlined rules for tax-deferred exchanges. This Section required that exchanged properties must be of similar use to avoid investors from bypassing immediate taxation by exchanging a real estate asset for a non-real estate asset. This requirement ensured the integrity of the tax-deferred exchange process and prevented abuse of the tax system. The rationale for the Act was that if parties traded properties and no cash was exchanged between them, then there wasn’t an event to assess a tax. It is indicated by congressional notes that the “continuity of an investment” should not result in a taxable event.

<h2 paraeid="{4005547f-e686-4422-b894-91a1392578e8}{189}" paraid="473227670">1954: Code Section Changed to Section 1031 </h2>

The 1954 Amendment to the Federal Tax Code changed Section 112(b)(1), previously Section 202 until renumbered with The Revenue Act of 1928, to Section 1031 of the Internal Revenue Code, providing today’s widely used term 1031 Exchange. The main takeaway of the amendment is that it adopted a stronger definition and description of a tax-deferred like-kind exchange and laid the foundation for the structure of like-kind real estate exchanges that are employed today.

<h2 paraeid="{4005547f-e686-4422-b894-91a1392578e8}{215}" paraid="2034547541">1979: Starker Decision: 9th US Circuit Court of Appeals </h2>

Prior to 1979 and the Starker decision, it was believed that 1031 exchanges had to be simultaneous, meaning at the same time the Exchanger sold their property, they were purchasing their new property. There was not a delay in the “exchange” of the two properties. In the case of TJ Starker v. United States, Starker and Crown Zellerbach Corporation exchanged timber property for “like-kind” property that was not immediately identified nor acquired. Crown Zellerbach had guaranteed that they would convey the Replacement Property within five years. The 9th US Circuit Court of Appeals had ruled in this case that Exchangers should still be covered by Section 1031 even if there is a delay in the closing of the Replacement Property. Prior to the decision, it was generally understood that it was an implicit requirement of a 1031 exchange that the transfers of property be simultaneous.

The Starker case introduced and approved the concept of delayed exchanges.

The five-year time frame involved in the decision was very open ended and as a result, the U.S. Treasury petitioned Congress to amend Section 1031 by adding time limits to the process.

<h2 paraeid="{b1580020-afd3-4acc-861c-f21f510ef3da}{42}" paraid="2145504453">1984: 45 and 180-Day Restrictions  </h2>

The Tax Reform Act of 1984 introduced IRC § 1031(a)(3) to add time restrictions on non-simultaneous exchanges. The Act further defined what “like-kind” property was and established a concrete timeline for 1031 Exchanges.

The 45-day identification period stipulates that an Exchanger has 45 days after the date of the sale of the Relinquished Property to identify the potential Replacement Property(ies) the Exchanger intend to acquire. The 180-day exchange period (or less depending on the due date for filing the tax return for the year of the sale) marks the total time the Exchanger has to complete the acquisition of the Replacement Property(ies).

<h2 paraeid="{b1580020-afd3-4acc-861c-f21f510ef3da}{104}" paraid="817744295">1991: Deferred Exchange Regulations Treas. Reg. § 1.1031 Issued </h2>

The final regulations on deferred exchanges proposed by The Treasury Department resolve deferral, constructive receipt, agency, and many other technical requirements which require careful attention to detail. The regulations introduced safe harbors to solve for problems previously experienced in the 1031 Exchange process and helped make it easier to accomplish a successful exchange <a href="https://www.accruit.com/blog/safe-harbors-core-section-1031-treasury-re… following these safe harbors</a>.

The safe harbors include:

<ul>
<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">
Allows the exchanger to secure the buyer's promise to pay for the new property. This security can be a mortgage, deed of trust, or a standby letter of credit. The buyer's promise can also be guaranteed by a third party. The secured property can be the one being sold or another property owned by the buyer. 
</li>
</ul>
</li>
<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">
Qualified Escrows or Trusts

<ul>
<li aria-setsize="-1" data-aria-level="2" data-aria-posinset="2" data-font="Courier New" data-leveltext="o" data-list-defn-props="{"335552541":1,"335559685":1440,"335559991":360,"469769226":"Courier New","469769242":[9675],"469777803":"left","469777804":"o","469777815":"hybridMultilevel"}" data-listid="1" role="listitem">
Removed the buyer’s involvement after the initial sale closing by using an escrow or trust to hold funds. This restricts the access an exchanger has to the funds, which ensures they avoid constructive receipt. The escrow or trust must state that the exchanger cannot borrow, receive, or benefit from the held funds.  
</li>
</ul>
</li>
</ul>

<ul>
<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">
The most important safe harbor. The Qualified Intermediary (QI) plays a critical role in facilitating exchanges under Section 1031, among other things taking away the need for any active participation by the Exchanger’s buyer. A QI must enter into a written agreement with the taxpayer and to acquire tax ownership of the Relinquished and Replacement Properties. This is usually accomplished via an assignment of the contract rights from the Exchanger to the QI.  Part of the QI’s role is to ensure the Exchanger is not deemed to come into actual or constructive receipt of net sales proceeds (exchange funds). A QI cannot be the taxpayer or a disqualified person (generally defined as someone not in an agency relationship with the Exchanger). The QI ensures that the exchange is structured according to the Regulations maximizing the Exchanger’s successful tax deferral.  
</li>
</ul>
</li>
<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="1" role="listitem">
Interest or Growth Factors

<ul>
<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="1" role="listitem">
Before the 1991 Treasury Regulations, funds from a buyer typically would be withheld for up to 180 days before being used to buy Replacement Property, which had potential to cause confusion over ownership. Special measures were taken, such as allowing the buyer to take title to the property at closing but also to retain interest on escrowed funds, which could unfairly favor the buyer at the expense of the Exchanger. Another option was to try and anticipate the interest which would be earned by the buyer and increase the sale price under the sale contract by that amount net of tax payment on the receipt of the interest. This safe harbor simplified all these difficulties allowing Exchangers to receive interest on their funds without the funds being considered actually or constructively theirs while on deposit. The interest earned must be reported as income, whether added to the purchase price of replacement property or received separately at the transaction's close.  
</li>
</ul>
</li>
</ul>

<h2 paraeid="{b1580020-afd3-4acc-861c-f21f510ef3da}{220}" paraid="119607282">1997: Taxpayer Relief Act: Distinction Between Foreign and Domestic Property</h2>

The Taxpayer Relief Act (TRA) of 1997 aimed to boost economic growth by reducing taxes for businesses and individuals through tax rate cuts, capital gains tax relief, and incentivizing investment in several sectors, including real estate. Before TRA, high capital gains tax rates discouraged foreign investment in US real estate. The TRA lowered the maximum capital gains tax rate from 28% to 20%, making US real estate more appealing to international investors.

The TRA also introduced the Foreign Investment in Real Property Tax Act (FIRPTA). FIRPTA simplified tax withholding requirements for foreign sellers of US real estate. These changes made it easier for international investors to navigate the regulatory landscape and facilitated their investments in the sector.

Additionally, The TRA implemented measures to further encourage foreign investment, such as the creation of Real Estate Investment Trusts (REITs). REITs allow foreign investors to invest in US real estate through publicly traded entities, offering benefits like diversification, professional management, and liquidity. This structure enabled foreign investors to gain exposure to the US real estate market without directly owning and managing properties.

<h2 paraeid="{1cac7709-93a7-4142-b815-d95527aff5cd}{33}" paraid="1284790677">2000: Rev. Proc. 2000-37 Introduces “Parking” Exchanges  </h2>

<a href="https://www.accruit.com/resources/rev-proc-2000-37-reverse-exchanges">R…. Proc. 2000-37</a> published by the IRS provides a safe harbor for “parking” exchanges, which includes Reverse Exchange and Build-to-Suit/Improvement Exchanges. A Reverse Exchange is when the Replacement Property is acquired prior to the Relinquished Property being sold.

The Safe Harbor within Rev. Proc. 2000-37 reads:

“The qualification of property as either replacement property or relinquished property for purposes of 1031 of the Internal Revenue Code and the regulations thereunder, or the treatment of the Exchange Accommodation Titleholder (EAT) as the beneficial owner of the replacement property or relinquished property for federal income tax purposes, if the property is held in a Qualified Exchange Accommodation Arrangement (QEAA), as defined in the revenue procedure.”

Under Rev. Proc. 2000-37, exchanges are accomplished by "parking" either the Replacement or Relinquished Property with a third party until the actual exchange of properties can take place. In this situation, a client would locate a third party, usually an exchange company, to act as an EAT. The client then assigns the contract for the Replacement Property to the EAT (though a lesser used procedure sometimes they transfer the Relinquished Property to the EAT). Using taxpayer or lender advanced funds, or a combination of the two, the EAT then acquires title to the Replacement Property and holds title until the client is able to sell the Relinquished Property. The contract for the Relinquished Property sale would then be assigned to a Qualified Intermediary (QI) who would transfer it to the buyer as part of a conventional 1031 exchange process. The QI applies the sale proceeds to acquire the Replacement Property from the EAT and those funds are used to repay the acquisition financing from the client and/or lender and as the last step transfers the Replacement Property to the client to complete the exchange.

With the introduction of the EAT taking title to the “parked” property, the Exchanger is considered to have sold the Relinquished Property prior to acquiring the Replacement Property. Without that proper sequence, a 1031 Exchange would not pass muster.

<h2 paraeid="{1cac7709-93a7-4142-b815-d95527aff5cd}{211}" paraid="564194341">2017: Tax Cut and Jobs Act Limits 1031 to Real Property Only </h2>

<a href="https://www.accruit.com/blog/tax-cuts-and-jobs-act-2017-and-its-effects… Tax Cuts and Jobs Act </a>(TCJA) of 2017 amended Section 1031 to only apply to exchanges of “real property”. Real property includes land, developed real estate, and other interests in real estate. The main takeaway is that personal property and certain intangible property exchanges, which were previously approved for tax deferral, were no longer covered under Section 1031, leaving only real estate capable of an exchange.

<h2 paraeid="{780db5f3-c9a9-4b9a-9f80-5eb877b9dd5b}{6}" paraid="746909873">2020: Expanded 1031 Regulations Further Defining Real Property </h2>

The IRS issued the <a href="https://www.accruit.com/blog/final-treasury-regulations-provide-clarity… regulations </a>defining real property for Section 1031 purposes in November 2020. Under Regs. Sec. 1.1031(a)-3(a)(1), the definition of real property includes, “land and improvements to land, unsevered natural products of land, and water and air space superjacent to land."

The regulations are complicated, but an example is provided where if a gas line going into a building is for heating purposes, it can be considered real property, but if it is used for something that is not part of the structural components of the building, such as cooking equipment, the gas line remains personal property.

These final regulations provided that state or local law determines the classification of a property as real property for Section 1031 purposes and provided additional guidance with regard to certain items affixed to the real estate.

The final regulations considered improvements to land to be considered real property under Section 1031 if they are classified as such by state/local law or are permanently affixed, the regulations provided a long list of examples.

<h2 paraeid="{780db5f3-c9a9-4b9a-9f80-5eb877b9dd5b}{86}" paraid="999545407">2023: Pennsylvania as the Last State to Recognize Section 1031 for State Tax Purposes Through PA H.B. 1342  </h2>

In July 2022, the Pennsylvania Legislature passed <a href="https://www.accruit.com/blog/1031-exchange-state-tax-withholding-requir…. 1342,</a> which provided extensive tax reform legislation. Before the introduction of this bill, Pennsylvania had been the only state that did not recognize Section 1031 for state personal income tax purposes. In Section 1031 exchanges before 2023, exchangers could defer capital gains taxes on the federal level, but not on PA state income taxes. The bill includes a provision that made Pennsylvania Personal Income Tax (PIT) observe federal income tax law, which includes the deferral of capital gains taxes under Section 1031. The bill enacted these changes to become effective December 31st of 2022, allowing for the recognition of Section 1031 tax deferral for all exchanges that started on or after January 1, 2023.

The history of 1031 Exchanges displays a vast evolution in tax policy and real estate investment strategies over the past century. From inception of like-kind exchanges in 1921 to its current state, property owners have been utilizing this powerful tax deferral strategy to reinvest into the US economy. Provisions such as the introduction of the role of a Qualified Intermediary and the limitation of exchanges to real property have played pivotal roles in the modern definition of Section 1031. Together, Accruit and colleagues across the 1031 Exchange and real estate industry look forward to continuing to support and protect 1031 Exchanges in their current state.

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.

Tue, 07/02/2024 - 15:13

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Options for Inherited Property Including a 1031 Exchange

06/06/24

When dealing with inherited real estate, questions often arise as to what the heirs should do with the property, and ...

Authored by: meredithb@accruit.com

Authored on: Thu, 06/06/2024 - 14:34

1031 Exchange General

We often get questions about what happens when Grandpa dies, and his heirs inherit his investment real estate, including whether the heirs should sell the real estate as part of a 1031 Exchange and whether there are other tax implications. This blog will address many of these questions.

<h2 aria-level="2" paraeid="{454c741d-9ccc-49c3-9cb1-70b66da3f8a2}{189}" paraid="1064159122" role="heading">Potential for Step-Up in Basis </h2>

Suppose Grandpa has investment real estate that he purchased for $200,000, with an adjusted basis of $100,000, and a current fair market value of $500,000. Prior to death, Grandpa could sell this property as part of a 1031 Exchange and defer the Capital Gains taxes on his investment. If he were to sell it outright, without the benefit of a 1031 Exchange, he would incur a Depreciation Recapture Tax of 25% on the $100,000 of depreciation that he has taken, and a Capital Gains tax hit of 20% on the $300,000 of gain, costing him $85,000 in federal taxes. Depending on where Grandpa lives, there could also be State Taxes to consider (as high as 13.3% in California). But if Grandpa were to die today, with the $500,000 fair market value, his heirs would inherit the property with a “step-up in basis.”

The step-up in basis is a provision in the current federal tax law that allows heirs to inherit the property at the fair market value as of the date of death. In this case, the current basis of $100,000 is adjusted – or “stepped-up” – from the previous basis to the $500,000 fair market valuation at the time of Grandpa’s death. Thus, Grandpa and his heirs have deferred capital gains and depreciation recapture taxes indefinitely.

If Grandpa has a will, the property will pass to his heirs according to his plans as articulated in the will. If Grandpa does not have a will, or if his will is determined to be invalid, his estate will have to go through the process of probate. A court will appoint an administrator of Grandpa’s estate. The administrator will locate Grandpa’s heirs, inventory his estate, and then distribute the various assets according to state law.

<h2 aria-level="2" paraeid="{454c741d-9ccc-49c3-9cb1-70b66da3f8a2}{213}" paraid="593570073" role="heading">Effects of Inherited Property on Heirs </h2>

When heirs inherit property, there is more to consider than just the fact that they received property at no initial cost. This is where Estate and Inheritance taxes come into play.

<h3 aria-level="3" paraeid="{454c741d-9ccc-49c3-9cb1-70b66da3f8a2}{225}" paraid="47242186" role="heading">Estate and Inheritance Tax </h3>

At the federal level, there is an Estate Tax on assets over $13.61 million. Thus, if Grandpa’s total estate is valued at or below that threshold, there is no federal Estate Tax owed. Twelve states, plus the District of Columbia impose Estate Taxes, and another six states impose Inheritance Taxes. (Estate Taxes are paid by the estate, on the value of the estate. The heirs pay Inheritance Taxes, on the value of what they receive.) As with the federal Estate Taxes, state level Estate Taxes would be imposed on Grandpa’s estate above certain thresholds. For example, Oregon begins to impose its Estate Tax at $1 million, and Connecticut starts at $12.92 million. As for the states with Inheritance Taxes, all of them exempt spouses from having to pay Inheritance Taxes, and some fully or partially exempt children or parents. However, in Pennsylvania, for example, Grandpa’s children or grandchildren would be required to pay 4.5% Inheritance Tax on the value of what they receive.

<h3 aria-level="3" paraeid="{454c741d-9ccc-49c3-9cb1-70b66da3f8a2}{239}" paraid="1098640191" role="heading">Example of Potential Financial Obligations with Inherited Property </h3>

If Grandpa has a will and leaves his investment real estate to his Pennsylvania grandchild, that grandchild would be inheriting $500,000 of investment real estate, and their Pennsylvania Inheritance Tax burden would be $22,500. The grandchild could sell the real estate and use the cash proceeds to pay this Inheritance Tax obligation. If the grandchild were to sell the property to pay the Inheritance Tax obligations, there likely is no current capital gains implication since the sale will occur shortly after the inheritance at the stepped-up basis.

But the grandchild could also pay that tax obligation with personal funds, and then maintain the property as an ongoing investment for years to come. If they choose this option, and later sell the property for $750,000, their capital gain is $250,000 ($750,000 - $500,000 = $250,000). The practical effect is that the capital gain between Grandpa’s adjusted basis and the grandchild’s inheritance of that property was eliminated by the step-up in basis. Without it, the grandchild would have had a significantly higher taxable gain after the sale ($750,000 - $100,000 = $650,000).

<h2 aria-level="2" paraeid="{e481fd99-db13-4fcc-b174-95acc27469e5}{2}" paraid="2052393771" role="heading">Inherited Property: Keep or Sell?  </h2>

Heirs of inherited property must determine what they wish to do with the property long-term. If they choose to hold onto it, they will incur the typical costs of ownership of real estate, including property taxes, insurance, maintenance, etc.

One option would be to keep it as a rental property, using the income to offset expenses, and perhaps derive additional passive income. This, of course, means that they now must undertake all of the activities of a landlord, perhaps in a community that is inconvenient. If they maintain the property as a rental, they could also benefit from potential additional appreciation over the years. Historically, the national average appreciation rate is 3% to 5% for residential real estate, though this is not guaranteed. In fact, during the 2007 market correction, the average home in America saw a 13% decrease in value.

After holding the property as a rental for a few years, the heir could sell this property as part of a properly structured 1031 Exchange, perhaps to relocate the property to a more convenient location, reinvest in a different asset class, or even consider a Delaware Statutory Trust if they do not wish to be an active landlord.

In this example, Grandpa included his investment real estate in his overall estate planning strategy, passing an appreciated asset to a grandchild. Investors are encouraged to discuss their specific tax and estate planning needs with their financial planner, attorney, and accountant.

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.

Thu, 06/06/2024 - 15:01

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1031 EXCHANGE GENERAL

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