Why Related Party Transactions were Created to Prevent Basis Shifting

Related party transactions were designed to stop abuses that were happening in the realm of 1031. In this article, we are going to talk about why related party transactions were created to prevent basis shifting.

An Example

Imagine you own two subsidiaries. One subsidiary is a $40 million property that was bought 30 years ago and has low basis (owned in entity A). Recently, you bought another $40 million property in entity B. In the past you could just do an inter-company transfer – a swap between these two wholly owned subsidiaries and move the basis between the two properties. This is known as basis shifting. The IRS wanted to stop the practice of basis shifting so they created rules that state that when you do a related party transaction, you and your related property cannot transfer properties for at least two years. There also cannot be an intent to avoid the imposition of the tax.

What’s the difference between legitimately wanting to defer tax and illegitimately trying to avoid the imposition of the tax? That’s hard to quantify. To combat this, the IRS requires that those who do related party transactions must provide a written narrative on form 8824 stating why your related party transaction is not an abuse of the rules.

CPEC1031, LLC in Minneapolis, MN

At CPEC1031, LLC our team of professionals is well-equipped to handle all the aspects of your like-kind exchange of real estate. We have more than two decades of experience facilitating real property exchanges all over the United States. Contact us today at our Minneapolis offices to set up a time to chat with one of our qualified intermediaries, learn about the process, and see how a like-kind exchange can help you defer capital gains taxes when selling qualifying investment property.

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

Defer the tax. Maximize your gain.

© 2024 Copyright Jeffrey R. Peterson All Rights Reserved

Video - An Explanation of the 3 Identification Rules Under Section 1031

There are several identification rules in a 1031 exchange. Most mom and pop investors keep it simple by identifying three or fewer properties. When you identify three or fewer properties, you’re not constrained by a value cap. You could identify the Sears Tower in Chicago, the Empire State Building in New York, and the IDS Center in Minneapolis. These are three properties.

If, however, you’re going to identify more than three properties, the total aggregate value of all your identified properties cannot exceed twice the value of what you relinquished. If you sold a property for $10 million, you can list up to $20 million as replacement property. However, if you sold a property at $100,000, then your cap is $200,000. Is that enough bandwidth? In that instance, probably not and you might be better off with one of the other identification rules.

The third rule (the 95% rule) isn’t used very often. It’s typically used in big portfolio purchases involving oil, gas, and mineral purchases. If you’re buying a huge portfolio, and one of the wells runs dry and you decide not to purchase it, that’s fine as long as you’re getting 95% of the total value of everything you identified.

Here’s where it gets crazy. Some DSTs are comprised of a multitude of components. You may blow yourself out of three property contention just by identifying one multi-property DST. Nobody really knows for certain whether a DST is one property or the sum of its parts for identification purposes. Let’s say you want to identify a DST. You should ask your advisor how many component parts are in that DST. If it’s comprised of a multitude of properties, you may need to get into value specifics to see what identification rule is best for you. You should also ask your advisor about how debt from the DST will be allocated to you based on the amount of money you put into it.

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

Defer the tax. Maximize your gain.

© 2024 Copyright Jeffrey R. Peterson All Rights Reserved

Video - How Many Days Does a Person Have to Identify Their 1031 Property?

In a 1031 exchange, you’ve got 45 days after the close of escrow to identify your properties and 180 days total to complete your exchange. The day of closing is day zero. By midnight of the 45th day you need to have sent in the identification. Technically you can send in your identification to persons other than the intermediary. That’s a little irregular, but it does happen. You may identify to the seller of the replacement property or the title officer who closed the transaction. You can identify to people that were involved in the transaction but were not your agent.

Most of the time when we receive property identifications we countersign and date them, scan them into the system, and then send them back to the taxpayer so that everybody knows the identification was completed in a timely manner.

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

Defer the tax. Maximize your gain.

© 2024 Copyright Jeffrey R. Peterson All Rights Reserved

When to Consider a Post Like-Kind Exchange Refinance

What if you’ve completed a construction 1031 exchange of your new office building and deferred 100% of your gains, but you don’t have enough capital to furnish the property. What are your options post-exchange?

One option would be to go to your banker and ask them to set up a post-exchange refinance and borrow money against your equity in the property. This would be a separate and distinct transaction from the 1031 exchange. Can you have your cake and eat it too in this type of situation? The answer is yes, but you may have to delay your gratification. The time to have this discussion is not before you’ve purchased the property, but after. When you borrow money against your replacement property that’s not gross income. You have a separate obligation to repay that loan so you can get your hands on that equity.

A very successful strategy that many real estate investors use is to put a line of credit on all of their rental properties after they acquire them in separate, subsequent transactions. There are a lot of unforeseeable circumstances that could bite a real estate investor (the pandemic being a good recent example). When you have a line of credit for business purposes you can tap into that equity if you need it.

Defer Capital Gains Taxes with 1031 Exchanges

1031 exchanges were built into the Internal Revenue Code as a way to incentivize investors to continue their investments, thus stimulating the economy. When done correctly, a 1031 exchange allows you to defer up to 100% of your capital gains taxes when selling qualifying property. This can be an attractive offer for many investors who are wary of a hefty tax bill. If you are considering a 1031 exchange of your property, contact a qualified intermediary at CPEC1031 to talk about your options. Our team has over twenty years of experience working with clients on all types of 1031 exchanges.

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

Defer the tax. Maximize your gain.

© 2024 Copyright Jeffrey R. Peterson All Rights Reserved

Video - How did the 1031 Exchange Come to Be?

Let’s talk about the history of 1031 exchanges. Often considered the godfather of the 1031 exchange, T.J. Starker was a lumber baron in Oregon. He had lots of appreciated real estate that people wanted to buy, but he didn’t want to pay taxes. So he said “I’ll sell you these lands but you need to give me back some real estate in exchange.” This blew everyone’s mind because it was a non-simultaneous exchange. Starker was giving up his old land for new land that he would designate in the future.

The case went all the way to the Supreme Court and Starker won on a procedural argument. That case because the precedent of opening the floodgates of non-simultaneous exchanges. This made the IRS and treasury very nervous because there were no guardrails on 1031 to constrain the process. So Congress gave the IRS and treasure the authority to write their own regulations.

In 1984 they excluded partnerships from 1031 treatment, and they added the 45 day identification period and the 180 day exchange period. So now when you do a 1031 exchange you have to identify by midnight of the 45th day what properties you want to purchase. That rule was not written with the taxpayer’s success in mind. One strategy is to act like a chess player and think two moves ahead. Before you even sell your relinquished property, find what you want to buy as your replacement property.

The syndicators of real estate have products that are sold and regulated as securities. These products are typically referred to as DSTs (Delaware Statutory Trusts). When you own a beneficial interest in a DST you are deemed to own your proportionate share of the underlying real estate of the DST, and you’re deemed to take subject to the underlying debt that’s allocable to you. Using a DST could be a good backup option for your 1031 exchange if you need it.

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

Defer the tax. Maximize your gain.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved