CAN A TAXPAYER EXCHANGE HIS AUTOMOBILE UNDER SECTION 1031?

Interesting question.  Was the automobile an investment or used specifically in a trade or business?  If the automobile(s) is used in a trade or business or was an investment, then the answer would be yes, as this type of transaction would be declared a personal property exchange.  As a matter of fact, numerous automobile leasing companies, like HERTZ, AVIS, and NATIONAL RENTAL CAR, exchange their vehicles for new ones with the manufacturers. 

Of course they were not investments to the leasing companies, but they were used in their trade or business.  Another important point to remember in a personal property exchange, is that the like kind rule is extremely specific--a car for a car--not a car for a bus.  So we have two important points rules to consider:  #1—the personal property (in this case the automobile) must be used in the trade or business and can’t be “inventory” and #2--- the personal property definitions of “like kind” property are very strict.

SHOULD THE TAXPAYER WANT TO DO A 1031 EXCHANGE IF THEY HAVE A LOSS ON THEIR INVESTMENT PROPERTY?

If a taxpayer does a valid Section 1031 exchange and has a loss on the sale of the relinquished property, they will loose the loss deduction on their income tax return, because Section 1031 does not allow the taxpayer to recognize a loss.  So, based on these initial facts given, most taxpayers will generally not want to transact a 1031 exchange if they have a loss on their relinquished property, because they would rather show that loss on their income tax returns.

IDENTIFYING PROPERTIES IN A SECTION 1031 EXCHANGE?

I just received a phone call from an old client of mine when I was practicing law.  He is now retired and is exchanging his

Miami

investment properties for newer properties in the community he has recently moved to.  He asked, “How do I inform you of the properties I identified?”  He wanted to identify them orally over the phone to me. After all, I was his former attorney and he trusted me.  I tried to explain to him that this can become a problem, because if he gets audited by IRS, how does he prove that he identified the property he purchased?

The IRS Regulation, Section 1.1031(k)-1(c)3 does not require any particular wording or special IRS form to describe the replacement property that is being identified, but it does require that the replacement property be unambiguously described in a written document or agreement. 

At

Liberty

1031 Exchange Services, a/k/a Liberty1031, we prepare a form for our investors to fill out.  All they have to do is fill in the blank, describing the property, hopefully giving us its address, etc, and send the form back to us within the 45 day identification time limit.  For more information on the time limits, go to our website: www.liberty1031.com.   As a matter of fact, there are a lot of good resources at that site, for those of you that are interested in learning more about 1031 exchanges.

HOW DOES ONE IDENTIFY A PROPERTY FOR A 1031 EXCHANGE THAT HAS NOT BEEN BUILT YET?

The IRS Regulations, specifically Section 1.1031 (k)-1(e)(2), state that the taxpayer should give the legal description on the underlying land and, in addition, should give as much detail about the specific improvements that they can.  Do they have the plans?  Well then, attach the plans to the identification statement--give as many of the particulars as you can about the improvements.  You could give the size of the building, how many stories will it be, what type of construction is going to be used and what is the building going to be used for (i.e. motel, office building, warehouse, residential, etc).  Obviously, the taxpayer should try to be as specific as possible.

ANOTHER SECTION 1031 QUESTION ASKED BY THE STUDENTS AT CORNELL BUSINESS SCHOOL----DURING THE 45 IDENTIFICATION PERIOD, CAN THE TAXPAYER REVOKE THEIR IDENTIFICATION?

The Taxpayer can at any time during the 45 day identification period revoke or substitute properties that were previously identified.  According the IRS Regulations, see Section 1.1031(k)--1(c)(6) and (7), the taxpayer should revoke, in writing and in the same manner, the original properties that were identified.   So if the identification was in writing to a Qualified Intermediary, then the revocation should also be in writing to that same Qualified Intermediary.  A second part to that question was “Can the revocation for identification purposes be given orally?”  The answer to that is an unequivocal “NO.”  For more information on Identification rules, go to the resource section at our website:  www.liberty1031.com.

HOW DOES ONE IDENTIFY CORNELL BUSINESS SCHOOL STUDENT ASKS: WHO CANNOT ACT AS A QUALIFIED INTERMEDIARY IN A SECTION 1031 EXCHANGE?

The IRS Regulations refer to these types of parties as "disqualified persons."  Well then, who is a "disqualified person?" Disqualified people include:

-The taxpayer's agent at the time of the transaction
-Family members, including ancestors, descendants, and siblings--but interesting  enough-- not in-laws or cousins
-Corporations in which the taxpayer owns more than 10% of the stock of the corporation
-Trusts in which the taxpayer is both the fiduciary and beneficiary or fiduciary and grantor
-Partnerships in which the taxpayer owns more than 10% of the partnership, etc. 

I know you are asking yourself, “OK, what is an agent?”  The IRS Regulations define an agent for disqualification purposes as anyone who may have acted as the taxpayer's employee, attorney, accountant, investment banker, broker or real estate agent within the two year period of the sale of the relinquished property

SECTION 1031 QUESTIONS FROM THE CORNELL SCHOOL OF BUSINESS

I was asked a number of very interesting questions at the end of my lecture at

Cornell

University

.  The next 3 blogs will try to cover some of those questions. 

“What is incidental property, and must you identify it when doing a 1031 transaction?” 

The technical answer is that property whose use is merely incidental to the operation of a more valuable item of property is disregarded for identification purposes.  According to the Regulations, Section 1.1031(k)-1(c0(50(i), incidental property is property that is transferred, together with a larger item of property, and has a fair market value that does not exceed 15 percent of the value of the larger property to which it relates.   

What does this goble-dee-gook definition really mean?  Let me give you an example.  The taxpayer is selling a motel for $1,000,000.  Included in that sale is personal property consisting of 50 beds, 25 tables, 100 chairs, and 100 lamps, with a total value of $78,000.  15% of $1,000,000 is $150,000.   Obviously, the value of the personal property ($78,000) is less than 15% of the sales price and would not have to be separately identified.   This "incidental" rule is only important for figuring out whether proper identification was made pursuant to Section 1031. 

This type of transaction would be a multiple property exchange, because the taxpayer is exchanging real estate (value of $922,000) and also exchanging personal property (value of $78,000). This would require the taxpayer to find replacement real estate property totaling at least $922,000 and replacement personal property totaling at least $78,000.  This was a technical question which, unfortunately for you the reader, required a technical answer

WAYNER QUOTES WAYNER ANSWERING---WHAT WAS THE ORIGINAL PURPOSE OF SECTION 1031?

In an article I wrote a couple of years ago for a major real estate periodical, I was asked, “What are the benefits of Section 1031.”  I answered,   "Section 1031 Exchanges do wonders for the economy: they spur development, generate jobs, create wealth, and allow an individual to increase his or her net worth.  They do not deprive the Treasury of tax revenue; they merely allow investors to defer their capital gains taxes, not avoid them. Of course with appropriate estate planning, estate taxes may be avoided… 

While policymakers and tax experts wrestle with reforming the tax code to make it fairer and simpler, Section 1031 stands as an example of tax policy that really works.  It permits those with modest amounts of capital to transform themselves into financially successful and secure people, with positive ripple effects throughout the economy.”

5 TEASER QUESTIONS ON SECTION 1031

1.   Section 1031, which allows tax deferral of capital gains taxes on investment property or property used in a trade or business has been available to taxpayers since:                                     
a) 1986
b) 1991
c) 1945
d) 1921

ANSWER:  d)  In 1918, income taxes were imposed on the gain or loss of all dispositions of property.  But in 1921, the non-recognition of gain or loss on an exchange was added to the Internal Revenue Code.

2.  The following properties DO NOT qualify for a Section 1031 tax deferred exchange:

a)  stock in trade or property held primarily for sale
b)  stocks, bonds, or notes
c)   interests in a partnership
d)   personal property

ANSWER: a, b, and c do not qualify for a Section 1031 exchange.  Personal property is allowed to be exchanged for “like kind” personal property used in a trade or business under section 1031 (a)(1), but the definition of “like kind” is much more restrictive than for real property exchanges.

3.  Examples of a “like kind” real property section 1031 exchange are:
a) An apartment building for a piece of raw acreage
b) An apartment building for another apartment building
c) An apartment building for a condominium
d) An apartment building for the ownership of a 30 year lease
e) All of the above

ANSWER: The correct answer is (e) All of the above.  All real estate is defined as like kind with all other forms of real estate; so, yes, an apartment building is “like kind” under Section 1031 with raw acreage, another apartment building, a condominium and even a 30 year lease which in every state has been defined as real estate.

4. In order for there to be a valid Section 1031 Tax Deferred Exchange, the following must occur:
a) Both the Seller and Buyer must want each other’s property
b) Both of the taxpayers must exchange on their respective properties simultaneously.
c) Both the Seller and Buyer must be related to each other
d) The taxpayer that is exchanging must exchange for “like kind” property

ANSWER:  d)  The beauty of Section 1031 is that the taxpayer does not have to purchase the replacement property immediately. In fact, the taxpayer has up to 180 days to close on the replacement property from the date of his sale and does not have to purchase that property from his Buyer or a relative.  But the taxpayer must purchase property that is “like kind” to the property he relinquished.

5.  Which of the following will qualify for “like kind” status under Section 1031?
a)  a piece of raw acreage exchanged for a motel
b)  a farm for a tractor and trailer
c)  a bus for a SUV
d)  a typewriter for a computer

ANSWER:  a and d are like kind.  Any type of real estate for any type of real estate has been determined as “like kind” under Section 1031.  A typewriter, which was the precursor to the computer, has been classified as “like kind” to the computer, but a bus is not classified as like kind with a SUV.  Remember, personal property exchanges, are very restrictive.

SECTION 1031 EXCHANGES AND THE NAPKIN RULE

A number of our readers have asked about the Napkin Rule.  We answer that question and many others in the resources section of our company's website, www.liberty1031.com.  My suggestion to of all our bloggers is to go to that site for all of your 1031 information questions.  Below is an excerpt from the resource section, on the subject of the Napkin Rule.

Q. Do I have to acquire a property of equal or greater value?

Yes, you do in order to completely defer the applicable capital gains tax. To the extent that you purchase a property of lesser value, you will be taxed on the difference.

Q. Do I have to use all the cash proceeds from my sale on my purchase?
Yes, you must use all cash proceeds from the transaction in order to completely defer the applicable capital gains tax. To the extent you do not use all your proceeds on the purchase, you will be responsible for any tax on the difference.

Q. Do I have to obtain a mortgage on my replacement property in the same amount or same percentage of debt as I had on my relinquished property?

No. Just follow the above rules.

Q. Does Seller Financing jeopardize my exchange?

Seller Financing is considered boot, which means it is taxable in the year(s) that it is paid (considered an ‘installment sale’). There is a possibility that the Seller Financing (Note) can be placed into the exchange without paying taxes, but the note would have to be paid off or sold before the purchase of the replacement property.

FYI: These rules are often referred to as the Napkin Rule, because they were allegedly originally written on a cocktail napkin by the drafters of the rule.