SECTION 1031 TAX FREE EXCHANGE TIC DEALS
My clients have a lot of interest this time of year in tax free exchanges. You can trade tax free just about any “like-kind” property “held for investment” under Code Section 1031 of the IRS code. Let’s take a very simple example: Perhaps you inherited an ocean front condo in Palm Beach which you have rented out over the years. With flood insurance rates rising and the polar ice caps melting you feel you would be better off with a mountain ski condo rental in Aspen. You want to sell one and buy the other but you realize you are going to pay a lot of tax. Section 1031 allows you to exchange one for the other tax free. You can keep trading up and pay no tax as long as the replacement is “like-kind” and the intent is to hold the replacement for “investment”. What defines “like-kind” “investment” and “intent” must be perfectly structured by your tax professional.
The above example is black and white and clearly qualifies for a 1031 exchange tax free deferral as “like-kind” and “held for investment” property. However, most 1031 deals are not so easy and black and white. The vast majority of 1031 deals can turn on a dime depending on the unique facts in each case. For example in a 2013 case, the US Tax Court held that a leasehold interest in a property with a term of 21 years exchanged for a fee simple interest in a property was not “like-kind”. Tax Court 2013-157, US vs VIP In another 2012 case the US Tax Court held that a property you use for your personal residence was not held for investment where the taxpayer placed a single advertisement in a neighborhood newspaper and moved in to use the property as his primary residence only two months later. Tax Court 2012-118, Reesink vs Commissioner
But don’t let these court decisions get you down. These cases are just examples of how not to structure 1031 deals. Correctly structured 1031 deals would allow for exchanging perhaps of a 30 year lease for a fee simple property. Moreover, again correctly structured, a 1031 deal could transfer your family into an investment property as a primary residence, but in my view, best practice requires the property to rent out for at least a year prior to the taxpayer moving in to the property as her primary residence. Furthermore, the facts would have to show that the taxpayer’s intent was to keep the property for investment, not for personal use. How do you prove your intent to the IRS? Your tax professional will need to document, record, and preserve your state of mind at the time of the exchange.
If I have not scared you off yet and you think you might be interested participating in a 1031 exchange, then you need to review all the hundreds of additional like kind exchange combinations from a McDonald’s franchise exchanged for timber producing land, to a patent and trademark exchanged for private airport. Before you choose a replacement consult your tax professional for the full list of all possible exchange combinations and choose one that is legally supportable by the facts unique to your situation and the one more importantly that best fits your financial and investment plan for the future.
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Your next step is to create the unique structure to make your deal come alive. As an example, let’s take a look at a very trendy structure being used these days, the make-up of the investors in most commercial office building deals. Best practices in my view calls for single member LLC investors organized by a sponsor. The CPA usually represents the sponsor in these deals and works with a qualified intermediary (QI) to eventually acquire as I suggest a commercial triple net leased property owned individually by each investor as a tenant in common (TIC). These organized investment pools are not partnerships but rather individual single member LLCs with their own unique 1031 sales history. Each TIC has sold their different properties with the funds flowing to the QI. The Sponsor has selected a replacement property within the required 45 day window which will be purchased by the QI with the total of all the TIC sales proceeds, Each TIC receives his pro-rata share until the property is fully funded and purchased. For example a TIC with a $5M contribution will receive 20% of a $25M replacement property. Finally, no partnership returns are required to be filed with the IRS. In fact, the Sponsor TIC agreement specifically states that the group is not a partnership because as you may already know partners in a partnership do not qualify for tax free 1031 treatment.
After the creation of the structure the next step is to select your Qualified Intermediary. I personally look for an intermediary who is a member of the Federation of Exchange Accommodators (FEA). According to the FEA: A Qualified Intermediary (QI) is the professional provider of the mandatory mechanics of an exchange. The use of a QI, as an independent party to facilitate a tax-deferred exchange, is a safe harbor established by the Treasury Regulations. Sometimes QI’s are referred to as “accommodators” or “exchange facilitators.” When the taxpayer engages the services of a QI, pursuant to an exchange agreement, the IRS does not consider the taxpayer to be in receipt of the funds. The sale proceeds go directly to the QI, who holds them until they are needed to acquire the replacement property. The QI then delivers the funds directly to the closing agent who deeds the property directly to the taxpayer. Here is a link to the FEA web site
We are almost ready to bulletproof the deal. The examples I have used are straightforward easy simple 1031 TIC deals. But the average deal and related structure is never that simple. Most average 1031 exchanges are amazingly complex deals with even more complex structures which must be perfectly extemporaneously executed and legally supported by the facts and circumstances surrounding each taxpayer’s unique situation. So the last step in the process is to bulletproof the structure in the event of an IRS audit of one of the TICs. Moreover, if and a TIC gets audited, usually all the TICs get audited so there is good reason to make sure these deals are executed flawlessly.
Before we conclude, just a word about the Delaware Statutory Trust (DST). DSTs are perfectly suited for one large Real Investment Trust (REIT) Trustee who manages and more importantly controls the whole deal. I do not recommend DSTs to my clients who are successful small business owners and investors. Innovators and entrepreneurs are going to want to control the direction and outcome of these deals. So again in my view the TIC not the DST is the way to go for individual and family business owners. For more on the difference between DSTs and TICs please consult your CPA.
In conclusion, as complex as these deals are, taxpayers love these 1031 exchanges because the up side, if the deal is correctly structured, is a very large tax deferral for perhaps forever. So I advise all of you to always consult your CPA tax advisor before attempting a 1031 TIC tax free exchange. Good luck from Chris Moss CPA in your 2013 year-end Section 1031 tax deferred exchange and see you all in 2014.
