Rental Property 1031 Exchange Rules

A client recently came to us with the following 1031 situation:

We have named a property in Edina, which is priced at $450k. We plan to rent it out at the beginning, and move in later. Our question is, how long do we have to rent out the house before we can move in and convert it to our primary residence, without the profit gain penalty?

No Clear Answer

That is a very good question, for which there is not a clear answer.

We know from the Internal Revenue Code that your initial intention (mental state) must be to hold the Replacement Property for productive use in a trade or business or for investment. It is okay to have an “indeterminate” long term intention as to what you may do with it much later. However, I would not say with 100% certainty that you will be able to move in to it as your home at this time.

The Code

26 U.S. Code § 1031 - Exchange of property held for productive use or investment

(a)  Nonrecognition of gain or loss from exchanges solely in kind 

(1)  In general

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Holding Periods

There is not a bright line minimum time period that I can point you to. The safe answer is “The longer…the better.”  Two years of holding it for investment / business purposes may be sufficient for most taxpayers. Check with your CPA or tax adviser about your specific situation.

• Start Your 1031 Exchange: If you have questions about 1031 rental properties and holding periods, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

TIC (Tenancy in Common) 1031 Exchanges

TIC stands for a Tenancy in Common which is an old-fashioned way to own real estate. It's a co-ownership arrangement going back to Old English common law where the serfs got together and collectively pooled their money to acquire an estate. In this article, we explain the benefits of a TIC as they relate to 1031 exchanges.

Benefits of a TIC

If you're looking to redeploy some cash and you can't afford to buy a real estate investment on your own you can bring in a TIC co-owner - someone to invest with you on that replacement property. Each of you would have an ownership interest in the property proportionate to your contribution. So if you provide 45% of the down payment you would be entitled to 45% of the property. Your co-owner will then get the other 55% if they put down their proportionate share of the purchase.

Partnership Interests are Excluded from 1031

The reason that tenancy in common is so important is that in the Internal Revenue Code section 1031, partnership interests are excluded from 1031. So if I want to bring in money with me on a purchase I can't bring in a partner and own the property in a partnership.

But what I can bring in is an investor or investors as tenants in common and we can take down that property kind of like a pie chart for each of us has a proportionate interest in the property allocated based on how much can we contribute for the buy.

Practice Tip:  If you want to be treated as a tenancy in common, then do not file a partnership tax return with your TIC co-owners for the property, because that may undue all of your hard work in trying to arrange for your interest in the property to be treated as a qualifying interest in real property.

• Start Your Exchange: If you have questions about tenancy in common law, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

How are my 1031 Exchange Funds Secured?

When you sell your relinquished property and the proceeds have gone off into cyberspace to some qualified intermediary’s account you may feel vulnerable. You may feel a hollow feeling in your stomach because you don't know where your money is or how it's being secured.

Safeguarding your Exchange Funds

How do you safeguard those funds in the interim between the sale of the relinquished property and the purchase of your new property? The way that I like to do it is to have the intermediary set up a separate segregated bank escrow account and have the title company that's closing your relinquished property wire transfer proceeds directly into that escrow account.

In addition to that I like to have the bank enter into a separate exchange escrow agreement between you and the intermediary that says the bank depository will not withdraw or allow anyone to access the funds without the intermediary’s written instruction and your co-authorization so the money is locked-down. You know exactly where your money is and you know exactly what the requirements are to get the money out, including your co-written authorization.

Qualified Intermediary Requirements

On top of those requirements it’s important to make sure that the intermediary has a Fidelity Bond, an errors and omissions policy, and it's a good idea that you are taking steps to prevent cyber fraud with password protected PDFs, encrypted emails, and data protection so your information isn't accessible to cyber criminals.  Always work with an experienced professional qualified intermediary company that has a long track record of providing safe, secure facilitation services. 

• Start Your Exchange: If you have questions about how 1031 exchange funds are secured, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

What is a Pure or True Reverse 1031 Exchange?

Some of the case law that exists for 1031 exchanges came from scenarios that occurred before the 1991 Treasury regulations. They gave greater clarity and safe harbor certainty to deferred exchanges. In this article we are going to talk about a few case examples that outline pure or true reverse 1031 exchanges.

Rutherford Case Example

One case involving cattle that is really interesting is called Bennie D. Rutherford, T.C. Memo 1978-505. In this case from 1978 a taxpayer received the replacement property first and then later was going to transfer the relinquished property to complete the exchange. So they acquired a replacement property first and then were going to dispose of the relinquished property second. A key factor in the court's determination was the written contractual pre-arrangement to swap the properties

In this transaction the taxpayer owned the replacement property before they even had created the relinquished property. Nevertheless the IRS challenged the transaction. However, at the end of the day United States Tax Court held in favor of the taxpayer for what was in effect a pure or true reverse exchange done without a facilitator and done without a qualified intermediary.

Biggs vs. Commissioner

A similar result was held in Biggs vs. Commissioner, 632 F.2d 1171 (5th Cir. 1980) as to real property that was acquired first, before the relinquished property was conveyed; in this case the exchange was also made an express condition of a contract between the parties. As such the transactions were held to be interdependent and that they culminated in an exchange rather than a sale and separate purchase.

In Private Letter Ruling 9823045 and 9814019, the IRS pronounced that the exchange of certain easements (that were received first) was a reverse like-kind exchange and stated that it was a valid like-kind exchange, even though the taxpayer acquired the replacement property (power line easements) first and then subsequently deeded the relinquished property (existing easement) at a later time.

Most tax commentators do not recommend that clients attempt to structure pure reverse exchanges because the safe harbor under Rev. Proc. 2000-37 provides much more certainty.

• Start Your 1031 Exchange: If you have questions about true reverse exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

What is Direct Deeding in a 1031 Exchange?

Many people are asking “what is direct deeding?” In the olden days before the 1991 regulations, when you did a 1031 exchange you would physically deed the property to your intermediary and then the intermediary would sell the relinquished property to a third-party buyer. So the intermediary came into the chain of title.

Then the intermediary would acquire the replacement property and deed it to you to complete your exchange. Again the intermediary would come into chain of title on the replacement property. Well those extra deeds that had to run through the intermediary created extra expenses, paperwork, and complications.

1991 Regulations

In the 1991 regulations it was adopted that the intermediary could merely be assigned the benefits or rights in the contract between you and the buyer of your relinquished property, and between you and the seller of the replacement property. So the intermediary, rather than taking a direct deed in the properties, would instead merely be assigned the rights in these purchase agreements or sales contracts with the other parties.

And by doing that we now allow the taxpayer to deed relinquished property directly to their buyer, and to receive the replacement property by deed directly from their seller. There's one caveat - the assignment of the purchase agreements under Old English common law and under the regulations adopted by the IRS; those assignments were not considered effective unless everyone to the original contract was given a written notice of that assignment.

Written Notice

So in order for the assignment to the intermediary to be considered valid we must give written notice to all of the other parties to the purchase agreements which generally means you want the buyer of the relinquished property to sign an acknowledgment that says "yes I received notice that the seller has assigned their interest in the purchase agreement to the intermediary." And the seller of the replacement properties says "yes I acknowledge I was given written notice of the assignment by the buyer to their qualified intermediary." These acknowledgements of notice don’t adversely affect the other parties in the least but they serve as substantiation to prove you gave the written notices that are required.

It’s a prudent practice to put a cooperation clause in your purchase and sale agreements requiring the other parties (including any assignees) to cooperate in providing these written acknowledgments at or prior to closing.  That way you will have the proof (in writing) that you complied with the regulations for direct deeding

• Start Your Exchange: If you have questions about direct deeding, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved