There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: Jeremy Wells here with another episode. And today we are going to talk about a topic that I find pretty interesting. I actually haven't run across many of these lately, but I know they're out there. I know they're happening with as hot of a real estate market as we've had over the last, let me say, 4 or 5 years, although that has [00:00:30] cooled off the last couple of years. And this is the section 1031 exchange. Now, I am not necessarily an expert in 1031 exchanges. However, I've had to deal with a few of them on the reporting side. Uh, for the taxpayer who is doing that exchange. And it's it's an interesting concept, especially in the, uh, tcja or Tax Cuts and Jobs Act, uh, era. The rules changed as a result of [00:01:00] that law and made it to where only a specific kind of transaction qualifies. But then within that type of transaction, there's actually a lot of flexibility. And so it's an interesting topic, especially if you work with the real estate niche then. And I've had clients over the years who are real estate investors, some of them full time, some of them just starting to do it on the side. But in any case, a 1031 exchange is something that [00:01:30] taxpayers can use to their benefit. And it's something that can happen, uh, when you're preparing a return and all of a sudden you realize, uh, the taxpayer did this last year.
Jeremy Wells: Uh, and so it's something we need to be aware of. It's something we need to understand the basics of, in case that happens, in case we find ourselves preparing a return, uh, for a texture that involved a 1031 exchange. And it's something that our clients who are either starting to get involved in real estate or have been doing it for a while is something they're [00:02:00] going to be interested in exploring, maybe even doing. And so we need to be able to advise them on it. So what I want to do is lay out just a very basic understanding of what section 1031 is, what the intent is, and how it actually plays out in practice. What what, uh, reporting a 1031 exchange that has happened. Looks like I'll explain in a minute why we don't really get involved that much in the 1031 exchange as tax professionals. [00:02:30] Yes. The taxpayer might come to us with some questions beforehand. Hopefully, uh, hopefully they're coming to us beforehand. Sometimes they don't. Sometimes, uh, they've either done a few of them or they, uh, have gotten some help or some education from somewhere else. And so they go off and they do the 1031 exchange, and then they tell us about it when it comes time to prepare the return. And we have to figure out what happened. So, uh, it might be, uh, that the taxpayer has just kind of already done it.
Jeremy Wells: Or it might be that we're getting told about [00:03:00] it after it's happened, but in the middle, when the exchange actually happens, there's not really a role for us as the tax advisor unless the taxpayer includes us in that, in that conversation, in that decision making. And really, even though it's an important tool that real estate investors can use when it comes to building and developing and refining their real estate portfolio, there's [00:03:30] not really that much tax planning that is involved even around the exchange. I'll explain why I say that in a minute. That that that might be a little strange to say, because it is a very important tax tool for real estate investors to use. But as far as the actual tax planning goes, uh, really, there are only some limited situations where we would need to get involved at the time of the transaction to help the taxpayer understand what's [00:04:00] going to happen. Your most basic 1031 exchange. Once it's done, the taxpayer really isn't going to notice that it happened, other than the fact that they have avoided some taxable gain on on that transaction, on that exchange. So getting a little bit ahead of myself, let's walk through what the basics of a 1031 exchange is. Now we call it a 1031 exchange because it's based on section 1031 of the Internal Revenue Code. And originally [00:04:30] that code section allowed for certain kinds of transactions that were deemed what's called a like kind exchange.
Jeremy Wells: In other words, if you and I separately own some assets that are of a like kind and you are looking to sell your asset, I'm looking to sell my asset and they're of thereof that, like, kind. Then you and I could just arrange a swap, essentially. And [00:05:00] what would happen in that swap is I would sell my asset to you. You would sell your asset to me. But from my perspective, I haven't really put myself in a situation where I've got any economic gain as far as cash in the bank goes, because even though I sold my asset, in turn, I purchased another asset simultaneously. And you did the same thing. So in this case, uh, [00:05:30] to assess tax on some gain as a result of that transaction, uh, wouldn't be fair to the taxpayer because even though we've sold our assets individually, we haven't acquired any cash gain as a result of those transactions. And so we don't really have any cash sitting in the bank that we could use to pay the tax resulting from those transactions. So what? Section 1031 does is it creates [00:06:00] this situation where instead of recognizing the gain at the time of the exchange and imposing tax on that gain, instead it defers the gain. It's important to note that section 1031 defers the gain. It doesn't eliminate it. There is a misconception out there among those taxpayers who could use or want to use section 1031 exchanges.
Jeremy Wells: And unfortunately, among [00:06:30] some tax practitioners out there, that 1031 just eliminates the gain from a like kind exchange. It doesn't eliminate the gain, it only defers it. And we'll talk about the mechanics of that later. But think of it this way. If I have an asset, I get rid of that asset and replace it with a different asset through a section 1031 exchange. And now as a result of that transaction, I would have recognized some [00:07:00] gain on that sale. However, because we did this as like kind exchange, there's no cash in the bank for me to be able to pay the tax on that. And so even though I have recognized some gain there, there is some gain that happened in terms of that transaction. I'm not going to include that gain in my taxable income until I sell whatever property [00:07:30] I replaced, the original asset that I owned with. Now, that means at some point I might sell that asset and I have even more gain, right? Because over time, if that asset appreciates in value, I'm paying tax not only on the gain after the transfer, but the gain that I deferred up until the point of that transfer. So yes, at some point I will have to pay tax on that gain with a certain exception, and I'll get [00:08:00] into that later. As far as how section 1031 exchanges can be part of tax planning and ultimately of estate planning.
Jeremy Wells: Um, but as far as the the actual transaction itself goes, uh, it's really just deferring that gain. It's not getting rid of it completely. So what is a like kind exchange? It's an exchange of property held for productive use in [00:08:30] a trade or business or for investment if that property is exchanged solely for property of like kind, which the replacement property is also to be held either for productive use in a trade or business, or for investment. Let's break this down a little bit. First of all, we're talking about property. Again like I said, Tax Cuts and Jobs Act restricted what's included here under property for purposes of [00:09:00] section 1031 exchange. But we are talking about property. We're talking about assets that you would hold. Uh, and so there's going to be a lot of kinds of property and other sorts of transactions that are not going to qualify for section 1031 exchange even before the the limits that Tax Cuts and Jobs Act. Added to this, however, uh, we're talking about assets and we're going to exchange those assets for other assets. And [00:09:30] those assets are held for productive use in a trade or business or for an investment. We're only talking about essentially depreciable assets that have been held in a trade or business or that were held for investment. Investment is going to be an important concept, and we're going to come back to that later on when we start thinking about what property actually qualifies to be included in a section 1031 like kind [00:10:00] exchange.
Jeremy Wells: And then we have to swap that property for other property of a like kind. And we'll talk about what that means more a little bit too. This is a point that I see confusing a lot of taxpayers as well as tax practitioners as well, because when we talk about like kind, we'll just how similar do they have to be? If I have an apartment building, do I have to exchange it for another apartment building? What about a single family home? What [00:10:30] about a commercial building? What about a piece of open land? Do those qualify as like, kind, or are they too dissimilar? We'll talk about those kind of situations in a few moments. And then the replacement property also has to be used productively in a trade or business or for investment. So in other words, we automatically can't use a section 1031 like kind exchange for personal property. [00:11:00] You can't use it for your personal residence. You can't use it for your vacation home that you're you're using strictly personally. Now, if it's a rental that you have some limited personal use of, it might qualify. Again, we'll talk about that here in a minute. But in terms of personal property that's not going to qualify.
Jeremy Wells: Collectibles uh, rare uh items that you might have. Those sorts of assets are not going to qualify even pre [00:11:30] tax cuts and jobs Act because those things were held for personal use. They weren't held for trade or business purposes and they weren't held for investment. Now taxpayer making a like kind Exchange has essentially reinvested the proceeds from the sale of the. Former property into purchasing the new property or the replacement property. And because [00:12:00] of this, we say that the taxpayer hasn't realized any economic gain. In a way that generates the funds to pay the tax on that gain. And again, this is. This is the logic behind section 1031. This is why we would create, uh, this. Set of rules by which taxpayer could do this sort of like kind of exchange and avoid. At least for now, having to pay tax on that gain. Again, that gain is deferred until [00:12:30] there's a sale that would generate funds to pay tax. So for example, if a like kind exchange happens and then a few years later, that taxpayer then sells the replacement property from that like kind exchange just in a normal sale. Now the taxpayer has acquired some funds to be able to pay the tax from the gain both of the replacement property and from the original property that was given up in that like kind exchange. And so [00:13:00] that both of those gains are going to be essentially rolled into one taxable gain that's recognized in the year of the sale of the replacement property.
Jeremy Wells: I'll talk about this a little bit more later, but it is actually possible to do subsequent like kind exchanges. So let's say you have a piece of property. You exchange it for another piece of property in a qualifying like kind exchange. It's then possible later on in the future to [00:13:30] take that replacement property and use that as the original property in another like kind exchange. This is often called chaining like kind exchanges. Um, and so each of those properties, each of those exchanges would then be a link in that chain of, of like kind exchanges. This can allow investors, uh, the or business owners, this can allow them the ability to stack those deferred [00:14:00] gains from each of those, like kind exchanges, uh, again and again and again. So essentially what you might have is multiple properties that have been owned at one time or another along that chain, and the gain from the sale of each of those properties up until that final replacement property, uh, would essentially be stacked up against each other. That can create an interesting situation, especially if [00:14:30] that taxpayer is able to roll that final property into an estate plan. Let's talk about qualifying Buying property. Originally, a section 1031 exchange included a lot of different kinds of property that was restricted after 2017 to only including real property.
Jeremy Wells: Since the start [00:15:00] of tax year 2018, like kind, exchanges only involve real property. So we're talking buildings, land, uh, significant improvements to the land. Now, we'll talk later on about what within that might not necessarily be qualifying. There might be aspects of real estate that still don't qualify. And we'll talk about how we handle those as part of the exchange as well. Also, the taxpayer has to intend to hold [00:15:30] that replacement property for productive use in a trade or business or for investment. Now, over time, Um. Uh. This has been the the cause of several, uh, many, in fact, uh, disagreements between the IRS and taxpayers. Uh, and a lot of these have wound up in the court system. The courts have essentially held that it's a question [00:16:00] of facts and circumstances that has to be determined at the time of the exchange itself. There are several several tax court cases that have arisen as a result of questioning whether the taxpayer actually intended to use that replacement property for business or investment, or was using that as a disguise for what was [00:16:30] essentially gaining a personal asset and being able to defer the gain from the sale of the original asset into that new personal asset. Think about why that might be problematic. Even if we're limiting to just real estate and thinking about real estate. Imagine that I've got some rental property that would be qualifying property. I'm using it productively in a trade or business or for investment.
Jeremy Wells: It's a it's a rental property. Let's say it's a single family home. [00:17:00] And I find another single family home that I really like, but it's out of my price range, and I would actually like to live in that new single family home. But I don't want to just go buy it myself. And I've got this rental here. I don't want to sell the rental and then have to pay tax on the gain from that rental. And I've identified this single family home that I would love to move into. What if I just said, yeah, sure, I'll buy that single family home. I'll [00:17:30] exchange the one I already own for that one. Call it a section 1031 exchange. Wait a couple months and then move into that replacement property. And I'll just tell everybody in the meantime that I intended to rent it out, even though I wound up using it as my personal residence. Now, interestingly, there are some tax court cases that look like that scenario I just explained. And interestingly enough, some of them have different results. One [00:18:00] of the most important of these tax court cases, in terms of setting precedent for what the Tax Court is looking for, and one that you see cited in a lot of subsequent tax court cases is click v Commissioner. This was in 1982. So in click the taxpayer exchanged her farm uh from uh for uh two properties each with land in a house.
Jeremy Wells: Uh, and so this is already [00:18:30] getting at the definition of what is like kind mean and a like kind exchange. But let's assume for the moment that it clicked that this was a like kind exchange, a form for two properties with land and a house on each of those properties. Now, what's interesting here is that on the very same day that the exchange went down clicks, two children and their families moved into each of those houses. So one family moved [00:19:00] into each of the houses. And then seven months later, she transferred ownership of those houses to each of the families that lived in them. Now, clicks argument was that she had the farm, which was used productively as a farm, and so that qualifies. And she transferred that into the two homes. She exchanged that farm for those two homes, and she allowed the families to live there and in the meantime [00:19:30] collected rent for them. At least that's the story that she gave. So to her, this was a like kind exchange. This was this should have qualified. This was exchanging one property, the farm that was used productively for two properties, two houses that were also, according to the taxpayer, used productively. However, when she transferred by way of a gift those two houses to the families living in them, that called into question whether [00:20:00] she actually intended at the time of the exchange for those two replacement properties, those two single family homes, for them to be used as, uh, used for investment.
Jeremy Wells: The facts and circumstances that the court looked at, including the fact that her relatives moved into those houses on the day after the exchange, and then that relatively quickly, just seven months later, she transferred. She didn't sell. She [00:20:30] gifted those homes to those families really made the court question whether that was a truly a bona fide, uh, acquisition of those replacement properties for investment. So the tax Court determined that the exchange did not qualify, uh, as click. The taxpayer clearly never intended to actually hold those replacement properties as rentals or as investments. Now, in another case in Adams [00:21:00] v Commissioner, and this was in 2013, the taxpayer exchange a rental for a fixer upper. Right. Uh, this is out in California. The the rental was a qualifying property. It was a piece of real estate that had been used productively for investment. And then Adams, uh, acquired that by way of a 1031 exchange, uh, for a fixer upper. Now, Adams son had significant experience in home building and renovations, [00:21:30] and so he made a great candidate for his father to essentially hire to fix up this newly acquired home. The home was in pretty bad shape. It had been left derelict. Uh, squatters had moved into it, and so it needed a lot of work.
Jeremy Wells: Uh, Adams, the taxpayer's son, uh, had his family, uh, but had experience with renovating these kinds of properties. And so started the renovation work and eventually got it to the point to where he and his family could [00:22:00] move into, uh, that home. He spent the next three months repairing it. Uh, and then he and his family moved into it. The father essentially agreed to exchange three months worth of rent as payment, uh, for repairing and renovating the home. So even though there was no cash exchange, the father essentially said to the son, sign. I'll [00:22:30] let you live in this home three months, rent free. You keep working on renovating and repairing it. Then the father started to charge rent. After that three month period, it was below market rent. And the court noted that. But it was rent and there were actual cash payments. And the son ended up missing one payment. But that was it. Other than that, the son was regularly making those cash payments to the father and despite that, despite it being below market rent, the [00:23:00] court wound up determining that the taxpayer Adams indeed intended to use the replacement property for investment. So in this case, even though the taxpayer that acquired the property let his son and his son's family move into the house, and even though the rent that he charged was below market rate at the time, the court still sided with the taxpayer and argued that or held that the property [00:23:30] actually did qualify, and it was indeed a section 1031 exchange.
Jeremy Wells: So you can see there are just some slight differences in the fact patterns here. But the court wound up coming to a different conclusion. In the Clark case, it was not a qualifying section 1031 exchange. However, in the Adams case it was. Now in another case, this is Moore v Commissioner in 2007, the taxpayer exchange one vacation property [00:24:00] for another. Now the taxpayers the Moores used both of these vacation properties personally, and they never made any attempts to rent either one of them out. This is actually a an interesting case because even though they never attempted to rent them out, the taxpayers argued that they did hold them for investment. Now, to them, investment meant waiting for the market to essentially [00:24:30] appreciate the value of the homes. And in general, that's that's kind of how a common person would define an investment. I'm going to buy something. I hope its value goes up over time. If it does, I'll sell it. I'll make a little bit of profit. That's sort of the stripped down to its core. That's the bare bones definition of an investment. However, in this case, the court held that that's not really in the spirit of what Congress meant when they used the term investment in section 1031. [00:25:00] And just the mere expectation of an increase in value is not sufficient to establish that investment intent.
Jeremy Wells: It's pretty clear in this case that the taxpayer's only use these properties personally. And that, combined with such a stripped down definition of investment, really worked against them in this case. So here the more's [00:25:30] pretty clearly had a transaction that did not qualify as a like kind exchange. Now on the other hand, in Goolsbee versus commissioner, this is a 2010 case. The taxpayer's exchange their personal residence for a replacement property. And in this period this was this was allowable. But they exchanged the their personal residence for a replacement property. Now, they placed a single ad in a neighborhood newspaper [00:26:00] of the replacement property. This wasn't even a a town or community newspaper. This was probably something closer to like a neighborhood or even an HOA newsletter. Uh, they never checked with the homeowners association to determine if rentals were even allowed within this community. This was something that came up, uh, in the court case, the court asked the taxpayers about the background of them attempting [00:26:30] to rent the property, and it came up that they didn't even know if rentals were allowed. They couldn't answer one way or the other whether rentals were allowed in the community. Within two months of that advertisement for the the new home trying to rent it out, the taxpayers had moved into the property. They refinished the basement. They listed it one time in the newsletter.
Jeremy Wells: They didn't even know whether rentals were allowed, and within two months they had moved into it and [00:27:00] used it as their personal residence. In this case, the court also held that there really was no investment intent here, that it was pretty clearly a sham transaction for the taxpayers to try to defer the gain on the sale of personal residence into what ended up being, uh, pretty quickly, in this case another personal residence. And so the court disallowed the application of section 1031 to [00:27:30] that transaction. And then in Reesink versus commissioner a 2012 case, the taxpayers moved into the replacement property eight months after buying it. So here we've got a little bit longer time frame eight months. But remember back in click that was about seven months. So it's not necessarily a matter of time here that can help the taxpayer. But it's not a critical factor. But here, eight months after purchasing the replacement property, the [00:28:00] taxpayers uh, moved into it. Now, in the meantime, in those eight months, they had placed multiple fliers around town. They had even shown the house to two potential renters. And one of those renters was actually a witness for the tax court case. Um, and so the the court actually was able to hear from one of the prospective renters. It turns out that the property was outside of the price range of both the renters, but it was pretty clear to the court that the taxpayers had made a genuine effort [00:28:30] to try to rent out the property, and in the meantime, they did wait a little bit longer to try to move into that property.
Jeremy Wells: So all of that supported the taxpayer's position that they had intended to use that replacement property for investment. And the court ended up finding on behalf of the taxpayers here that this was a qualifying section 1031 exchange. So, again, it's not necessarily a matter of waiting a certain number of months. It's not a matter of whether you advertised [00:29:00] that property for rent or not. It's the culmination of all of these different facts and circumstances that builds up a case of whether you were actually genuinely trying to exchange that property or not. Now, there are certain kinds of individuals, persons that cannot participate in a section 1031 like kind exchange. In fact, section 1031 refers to these as disqualified persons in section 1031 F persons disqualified [00:29:30] if she acts as an agent of the taxpayer within two years of the transfer of the first of the relinquished properties in an exchange. It's actually possible to have more than one property on either end of the of the exchange. You can you can exchange multiple properties. You can receive multiple properties in in a section 1031 exchange. But if anyone is involved as an agent within that transfer, within [00:30:00] two years of the relinquishment of the first property, then that makes the exchange.
Jeremy Wells: And if that person is on the other end of the transaction, then that's not going to qualify as a section 1031 exchange. Now agents include the taxpayers, employees, Attorneys, accountants, unfortunately, investments brokers or bankers or real estate agents or brokers. So you can't do a section 1031 exchange with any of those people within, [00:30:30] uh, two years, essentially. Um, so think about it this way. If someone prepared your tax return, but they did that 3 or 4 years ago and you haven't worked with them since, that person would actually be eligible to do a section 1031 exchange with. However, if you worked with a real estate agent within the last two years, you would not be allowed to do a qualifying section 1031 exchange with that person, at least not without waiting until it's been more than two years since you worked with that individual. Now, [00:31:00] also, a person is disqualified if she's related to the taxpayer, as defined in IRC section 267 B and section 707 B, now 267 B is going to define uh, individuals that are closely related 707 b is going to define the relationship between a partner and a partnership, and then that partner with the other partners. So we're talking about close family members such as parents, siblings, spouses, children. [00:31:30] We're also looking at corporations in which the taxpayer owns more than 10% of the stock.
Jeremy Wells: The way it's phrased in 267 B is 50%, but section 1031 replaces that 50% with 10%. So it doesn't even have to be that you are a majority owner in that corporation that you're trying to do that exchange with just 10% is all it takes to disqualify that corporation or that partnership from being eligible to [00:32:00] be on the other end of that section 1031 exchange from you. So if it's a corporation in which the taxpayer owns more than 10% of the stock, or if it's a partnership with more than 10%, uh, capital interest in that partnership, and then also trust grantor's, fiduciaries and beneficiaries, and then estate executors and beneficiaries. Those people can't do section 1031 exchanges with each other. Those would just create conflicts of interest. So what do we mean when we say like kind [00:32:30] property, like kind refers to. And this is a direct quotation from the section 1031 regulations, the nature and character of the property and not to its grade or quality. One kind or class of property may not be exchanged for property of a different kind or class. Now what? What does that mean? That doesn't really help a lot. Now, to say that [00:33:00] it's not grade or quality is a little bit helpful. So in other words, if I have a an apartment building that has five units, does that mean that it's in the same class or character as an apartment building with 50 units.
Jeremy Wells: It might be because we're not talking about the size, the grade or the quality. We're looking at the nature and character, and in that case, we would look at these two buildings [00:33:30] as both being apartment buildings, and therefore they would be of a like kind. They would be of the same nature and character. But now, how far does that go in general when it comes to real estate? If we're looking at what the common person would term real estate. So we're looking at land and the buildings that would be on those land, on that land. Then we're talking about like kind. So in other words, just because one property is [00:34:00] residential use and the other one is commercial use, we're talking about an apartment building versus an office building. It's still going to be of the same nature and character. And so those would be like kind if we're even talking about raw land as real estate versus developed land with buildings on it. Again, we're still talking about like kind here. So even though we have reduced the applicability of section 1031 to just real estate within that [00:34:30] label of that category of real estate, it's pretty broad as far as what would qualify as like kind and, and that that quota definition specifically comes from Treasury Regulation section 1.10 31 a hyphen one b now courts consider the respective interests in the physical properties. The nature of the title conveyed the rights of the parties, the duration of the interests, and any other [00:35:00] factor bearing on the nature or character of those properties as distinguished from their grade or quality.
Jeremy Wells: This is an important point. Sometimes the transaction will involve legal rights to property or the ability to use that property. For example, none of those issues are going to be considered as bearing on the nature or character, right? Uh, well, [00:35:30] they excuse me, they are going to be considered as bearing on the nature or character. They're not going to be considered as part of the grade or quality. So again, if we have two properties that are of a like kind, and you and I have, uh, varying levels of the same rights to use that property, we're still exchanging essentially the same nature or character. We're still essentially exchanging rights to use that property. It's not going [00:36:00] to matter as much whether the, uh, the property has different levels of rights or that we're exchanging different levels of rights to that property in general, because now we're just restricted to real estate. This doesn't come up as much. We pretty much just see 1031 exchanges happening where we just have swaps of deeds that I'm just swapping. I'm selling my deed to this property. You're selling your deed to your property to me, and [00:36:30] there's not going to be that many restrictions on that, if any at all.
Jeremy Wells: If we start looking at including restrictions, then it might cause some issues. But in general, from a business perspective and sometimes as tax advisors, we we have to, uh, we have to write the law to account for specific cases. But then we have to think about what we would actually come across in the real world. And from a business perspective, when it comes to section 1031 exchanges, usually we're just seeing [00:37:00] swapping deeds back and forth, really with relatively little restrictions on what the rights conveyed as a result of that transaction are now for real estate. In particular, all qualifying real property located in the US, improved or unimproved, is like kind property, and then all qualifying property outside the US is like kind, but property [00:37:30] located inside the US is not like kind with property outside the US. And this comes from section 1031 H. So you cannot do a qualifying section 1031 exchange for a piece of real estate in the US, with another piece of real estate outside the US. I've actually had to advise clients on this before because, uh, they want to start dabbling in rental markets [00:38:00] outside the US, or, uh, they have rental properties outside the US they now live permanently in the US and they want to dispose of those rental properties, but they want to do it in a way that's tax efficient and start building up their rental portfolio here in the US.
Jeremy Wells: Unfortunately, that's just not allowed by 1031 H. You can't use section 1031 to exchange a property outside the [00:38:30] US for one inside the US, or vice versa. Those are not going to be like kind property, even though they might be exactly the same. They might both be single family homes. They might both be apartment buildings, they might both be office buildings. But because one of them is outside the US, one of them is inside, by definition, by statute, they're not going to be like kind real property. I keep using that phrase, but real property includes land and improvements to land, unsecured natural products [00:39:00] of land, and the water and air space that is super adjacent to land. This comes out of Treasury Regulation 1.10 31 a hyphen 3A1. So this is what we mean when we say real estate. If it's one of those three, if it's land and improvements to land, that means the buildings that are actually on the land if it's unsecured natural products of land. So the raw materials that are still in [00:39:30] or on the land qualify, and then the water and airspace above and below, uh, the land now the unsecured natural products is an interesting one. There are court cases that look at this. So for example, an orchard of apple trees, the trees themselves would be considered unsecured natural products of land. The apples growing on them would be until they're harvested.
Jeremy Wells: There was a [00:40:00] court case in which the orchard owner tried to claim Aim the harvested apples as part of a section 1031 exchange, and arguing that it was a natural product of the land, and the court said once they're harvested, once they're no longer attached to that tree, it's no longer, uh, real property. It's no longer part of that. It becomes part of inventory or something else. Improvements to land inherently [00:40:30] include permanent structures and the structural components of those inherently permanent structures. The regulations include certain criteria for determining whether an improvement is an improvement to land or a structural component. It's important to note the difference, but it's also important to realize that the the structures and the structural components of those structures are both possible to be included within that definition of real estate. There [00:41:00] are, interestingly, also certain intangible Tangible assets that qualify as real property for purposes of section 1031. When I was researching 1031 exchanges for, uh, for another, uh, discussion and then for this podcast, I came across this and it was actually pretty interesting to me. I hadn't realized this before, but fee ownership, co-ownership of land, a leasehold, an option to acquire real property, an easement [00:41:30] stock and a cooperative housing corporation, and then shares in a mutual ditch, reservoir or irrigation company, uh, as well as land development rights. All of those are intangible assets, yet they qualify as able to be included as real estate within a real property, uh, within a section 1031 exchange.
Jeremy Wells: So just because a taxpayer comes to you and has one of these intangible assets may not necessarily [00:42:00] mean that they can't engage in a section 1031 exchange. If that intangible asset is one of these parts of a A real property, one of these, uh, parts of real property, then it might be qualifying to include in section 1031 exchange. Now, it's important to note also that most like kind exchanges today are actually deferred like kind exchanges technically. And this is what a lot of, uh, taxpayers [00:42:30] will get involved in these days. This is what most of the like kind exchanges I've come across have been these deferred like kind exchanges. The original conception of like kind exchange is that it's simultaneous swap. But really what's happening most of the time now. And this is covered under IRC 1030 1A3 is actually a delayed exchange. I know I want to sell the property I have, I know I want to acquire another property, but it's [00:43:00] just not reasonable for me to be able to make those two transactions happen on the exact same day. So is there any window in which I can make both of those transactions happen? Not simultaneously, but still have them qualify as a single exchange for purposes of section 1031. So we get two rules here that are codified in the code. The first is the 45 day identification rule.
Jeremy Wells: So the taxpayer has to identify the replacement property [00:43:30] within 45 days after closing on the sale of the relinquished property. So if I sell my property, I have to formally identify and I have to do this in writing with my signature the replacement property. Now I can identify multiple properties, but I have to identify at least one. And that happens when I designate it unambiguously. That's the term used in the code. I have to unambiguously identify that property [00:44:00] by sending a signed document to a person obligated to transfer the replacement property, which is usually going to be the the owner, the seller, or to someone involved in the exchange, such as an intermediary, an escrow agent, or a title company. That unambiguous identification has to have a clear either legal description, street address, or a distinguishable name. Usually it's the street address, but it could also be the distinguishable name. If it's if it's a building that everyone in the community knows by a name. [00:44:30] Um, you know, usually like theaters or big office buildings. They have a certain name, the Sears Tower, for example, which isn't even the Sears Tower anymore, but we'll let that one go. And then there's also the 180 day receipt rule. The taxpayer has to receive the replacement property within 180 days of what's called the exchange period. And that exchange period begins on the date the taxpayer transfers the relinquished property and [00:45:00] ends on the earlier of the 180 day.
Jeremy Wells: After that, relinquished property is given up or the due date, including extensions of the taxpayer's income tax return for the year of the transfer of the relinquished property. So in the year of that relinquishment, on that day that that property is relinquished, you've got 180 days after that or the due date, including [00:45:30] the six month extension of that income tax return. It's the earlier of those two days is when that exchange period happens. It's very important if you're working with a taxpayer and advising one who wants to do a 1031 exchange. Now, usually they'll be able to get an explanation of this from the intermediary. Or if they're using one or, uh, they, they will find this out somewhere else where they're learning about 1031 exchanges. But but a lot of times not. And it's kind of confusing the way [00:46:00] that exchange period can have two different end dates. So it might be worth it if you know that a taxpayer is involved in a like kind exchange or is trying to set one up, uh, the 45 day window is really important. I've seen, uh, like kind exchanges get blown because taxpayer couldn't identify, uh, replacement property within the 45 days. But then, uh, the 180 day rule is a little bit easier to fall within. And you might actually talk to the taxpayer, especially if you're preparing their return.
Jeremy Wells: You might actually [00:46:30] talk to the taxpayer about it, uh, before that window closes. And it might be worth having a conversation about when that exchange period actually ends. Now, for deferred like kind exchange, there are four safe harbors there. These aren't, uh, required there. Safe harbors. Uh, and they're not mutually exclusive. The taxpayer could use more than one of these, and the taxpayer could come up with a method to complete the deferred like [00:47:00] kind exchange other than one of these safe harbors. Again, they're not required. However, using one of these safe harbors is going to help the taxpayer guarantee that the transaction does qualify as a deferred like kind exchange. Of the four, there's a security or guarantee arrangement where the buyer of the relinquished property provides a guarantee, standby letter of credit, or a third party guarantee of the obligation to acquire the replacement property. Another one is qualified escrow [00:47:30] account safe Harbor. The proceeds from the sale of the first property are placed in a qualified escrow account or qualified trust. That's another way that can happen. So that's the second safe harbor. The third safe harbor is by far the most common, and this is the one we typically see. And in fact, this has almost become synonymous with a deferred 1031 exchange. And that's using a qualified Intermediary. Interestingly enough, there is not a specific definition in the [00:48:00] regulations of what a qualified intermediary actually is.
Jeremy Wells: However, typically you see title agents working as keys. There might be some professionals who specialize specifically in section 1031 exchanges, but they'll put themselves out as they'll advertise themselves as qualified intermediaries. They might also go by the term accommodator. They're essentially accommodating that transaction, but they hold the proceeds from the sale of the relinquished property and then facilitate the acquisition of the replacement property. So [00:48:30] the key here that you're getting from these safe harbors is that at no time should the taxpayer ever have control of the funds from the sale of the relinquished property. That's really a key to making sure that one of these deferred like kind exchanges happen. If you think about a basic 1031 exchange, it's just a swap. There's no cash exchanged ever. So that would make it unless there's boot, which is a separate conversation. Um, but if it's just [00:49:00] a straight up swap, then there's no concern about holding funds in escrow. However, if we're talking about a deferred like kind exchange, then there would in fact be, uh, some some funds being held somewhere. You don't want the taxpayer to have control of those funds. In fact, there's a there's a fourth safe harbor that anticipates the possibility that those funds might be held in escrow for a while. And this is the interest or growth factor, uh, safe harbor. And this essentially says that the taxpayer can't get any benefit [00:49:30] from those funds being held until after the exchange is complete.
Jeremy Wells: So it's going to be interest or, you know, I suppose, dividends if it was invested into some sort of account, but in general, it's going to be held in a savings account or money market account, something like that. But it should be held by a qualified intermediary, uh, or an in an escrow account, something like that. So that there's no question that the taxpayer never had access to those funds. Now, again, these safe harbors aren't they're not mutually [00:50:00] exclusive. They're not required. Um, and like I said, most of the time we're using a qualified intermediary, uh, in order to facilitate these exchanges, a like kind exchange is going to be reported on form 8824. There are three parts to the form. There's actually a fourth part. Um, but it's so specific. I'm not even going to talk about it here. I've not engaged in in any sort of transaction that required that fourth part. If you did, hopefully [00:50:30] you would have enough experience with like kind exchanges to where you would understand what's happening in that fourth part. But the three the first three parts are the are the main ones that anyone working with real estate investors or rental owners that could see, uh, like kind exchange coming their way as part of tax prep, uh, would need to be familiar with part one is essentially a description of both of the properties, including the the original, uh, acquisition date and transfer date of the relinquished property, the identification date.
Jeremy Wells: Remember [00:51:00] that 45 day period to identify the target property and then the receipt date of that replacement property? Uh, and then there's also a related party question. Now there are some rules about related parties. If this exchange includes a related party, then the form 8824 has to be reported for the next two years after. And neither uh, side, neither party [00:51:30] in this exchange can sell or otherwise, uh, exchange or transfer those properties within the next two years after the like kind exchange goes down. So if you are doing an exchange with a related property with, excuse me, with a related party that is also a qualifying person, uh, then you have to disclose that on form 8824, part two. Is that related party disclosure that I was just talking about? If in part one you identify, you answer yes to that last question [00:52:00] about it being a related party involved in that exchange. And then part three is calculation of the deferred gain, the recognized gain, and the basement or of the replacement property. Now that calculation is can can be interesting. Essentially we're attempting to avoid any recognition of gain. However, some things that can lead to that is depreciation recapture or boot. Essentially boot is when the taxpayer receives [00:52:30] any property or especially cash along with the replacement property. In those cases that can lead to the recognition of gain.
Jeremy Wells: In general, though, we want to avoid that. So most taxpayers, when it comes to a like kind exchange You're going to avoid that, or they're going to understand that whatever they're receiving is going to be boot. Now, there is actually a cap on how much of that boot could be taxable. [00:53:00] And that would be the recognized gain. So if there is boot involved in a section 1031 exchange, then you just have to remember that the taxpayer could be on the hook as far as recognized gain up to either the amount of the boot or to the recognized gain, whichever is the lower of those two, in addition to any depreciation, is going to have to be recaptured or anything like that. So that's essentially the calculation of the realized gain and the recognized [00:53:30] gain. And then the basis of the new property will essentially be the basis of the old property. Again, the idea of a like kind exchange is that you're relinquishing the old property and you're essentially transferring that into the new property. The difference, of course, is going to be that deferred gain. So we don't really have to keep up with that. We don't have to separately record that or track that, because we're just saying [00:54:00] that our basis in the new property is the same as the basis in the old property. Now, there are some parts of that calculation that's done in part three of 8824.
Jeremy Wells: That might change that a little bit, but in general, we're not going to see that. We're just going to see the new property replace the old property on the depreciation schedule. And we continue with that basis, and we even continue with the depreciation the same. So wherever we're at in the depreciable life, the number of years of depreciation, the accumulated depreciation [00:54:30] of the relinquished asset, we're going to carry that over generally into the new asset. And then if that new asset is someday sold then we're going to have the uh the deferred gain will show up in the calculation of the recognized gain on the the new property that's going to be sold. Now, there's a lot more nuance, of course. Section 1031 exchanges than I've gone over here. There's a lot of rules about related parties. There's a lot of rules about gain recognition, and [00:55:00] those might all be good in a follow up class. But for now, these are the basics. This is the basic amount of knowledge that you need to understand to start talking to some of your in real estate investor tax clients about how these 1031 exchanges might be able to help them. And if one just happens to find its way in last year's work papers for a client that you're working on in return, and you need to prepare form 8824, hopefully this is enough information to at least point you in the right direction to [00:55:30] find the answers for reporting that exchange.