Brigitte Echave

The terms of a normal 1031 Exchange Agreement call for the exchange period to end on or before the end of the expiration of midnight on the earlier of (i) the 180th day after the date upon which the Exchangor has transferred the Relinquished Property or (ii) the due date (including extensions actually obtained) for Exchangor's tax return for the taxable year in which the transfer of the Relinquished Property occurs. This time of year brings questions from many Exchangor's wishing to defer tax but also wondering if they have funds left that have not been used to purchase replacement property when will the tax be due on those funds.

Lets say that your exchange Relinquished Property closed any time after July 5, 2010 this date means that you have the potential of straddling a tax year with your exchange. In the case of closing on July 5, 2010 your 180th day would be January 1, 2011. If you made a valid identification of replacement property during your 45 day identification period but you did not utilize all of your exchange proceeds to purchase replacement property or your exchange failed then you would receive the balance of your proceeds on January 2, 2011.

Ask your tax consultant if you can report the proceeds under the IRC Section 453 (Installment Sales Basis). If you do decide to report on an Installment Sales Basis then you could potentially pay the taxes in 2012.

Qualifications for a 453 Installment Sale are numerous. Considerations for the 1031 Exchange are:

Did you have a bona-fide intent to participate in a 1031 Exchange at the outset of the sale of your relinquished property? Of course, as with any tax planning, there are certain caveats: you must pass the "bona fide" intent requirements of the Code. A taxpayer is treated as having a bona fide intent only if it is reasonable to believe, based on the facts and circumstances present, that like kind property will be acquired before the end of the exchange period (the 180th day). Partnerships may be required to report the gain in the year the property was sold (due to Revenue Procedure 2003- 56) and quarterly taxpayers need to coordinate this approach with their CPA. Estimated Payment Rules may dilute or completely eliminate the tax straddling benefit for certain taxpayers.

Section 453A further provides that (1) where an obligation is outstanding as of the close of a taxable year and (2) the face amount of all such obligations held by the taxpayer that rose during, and are outstanding as of the close of, such taxable year, exceeds $5 million, interest must be paid on the deferred tax liability with respect to such obligations.

As with any tax strategy. one size fits all approach does not work for everyone. Each taxpayer should strategize with their independent CPA or tax advisor to determine what their best approach would be.

Consider the following scenarios:

Mr. and Mrs. Jones sell a residential rental property for $350,000 on December 1, 2010 and enter into a 1031 exchange whereby their proceeds are transferred to the QI and placed into a qualified escrow account. The Jones' then set out to find replacement property. They contact their broker and view several properties and write offers on two properties. Both offers are rejected, subsequently no identification is made and their funds are disbursed to them on January 16, 2011 (day 46). The property which was sold to generate the $350,000 will be reportable on the 2010 tax return but the recognized gain will be reported on the 2011 return using the installment sale provisions of the IRS.

Mr. and Mrs. Jones sell a residential rental property for $350,000 on December 1, 2010 and enter into a 1031 exchange whereby their proceeds are transferred to the QI and placed into a qualified escrow account. The Jones' then set out to find replacement property. They contact their broker and view several properties and write offers on two properties. Both offers are accepted and they identify the properties to their QI before midnight of January 15, 2011. On February 12, 2011, one of the two properties closes escrow and on March 15, 2011 the second property falls out of escrow due to reasons beyond the Jones' control. On May 31, 2011 (the 181st day) the balance of the exchange funds are disbursed to the Jones'. On their 2010 tax return (which they had filed after April 15th-an extension of their tax year had been filed) they report the sale of their rental property and the purchase of one replacement property as a deferred capital gain. The recognized gain will be reported on the 2011 tax return using the treasury regulations of IRC Section 1031 Exchange which includes a provision permitting a taxpayer to utilize the installment sale method provided under IRC Section 453.

Today I received a call from one of my long time customer relating to their current 1031 Exchange. They wanted to know if they could use seller financing to purchase their Replacement Property. It appears that the Replacement Property they would like to purchase exceeds the amount they currently have in their exchange. The property they sold as part of this exchange was debt free. My customer is not sure if they will be able to obtain a loan from a Lender. You see, they are Realtors and they are having a hard time obtaining a loan due to current market conditions. Their credit score is in the 800's but they are still unable to get the loan they need. In this case they may want to look to the Seller of their anticipated Replacement Property to carry back a note on the property. My investor has over 50% cash as a down payment, so this may be attractive to the Seller of the Replacement Property.

The next question asked by my customer was - Can I then sell another investment property and use the proceeds to payoff this Replacement Properties loan? If my customer is hoping to defer the taxes on the "second" investment property being sold, the answer is no. The IRS requires that in a 1031 Exchange all proceeds be used to purchase Replacement Property not to pay loans down on existing investment property owned by the taxpayer. I suggested to my customer that they try to sell the other investment property (since the current 1031 Exchange deadline isn't until February of 2011) and include the proceeds within the same exchange. Then they could use the existing exchange funds and the "new exchange" funds (from the second investment property) to purchase the contemplated Replacement Property and receive the dual deferment they are looking for.

In today's market our customers are looking for solutions and ideas. What are your thoughts?

Record low real estate prices make real estate investing in the US attractive to international buyers.    When purchasing real estate within the US many foreign investors are not aware that upon the sale of the real estate asset they are subject to the FIRPTA withholding tax of 10%.  The best advice any one in real estate can give to aforeign investor is for the investor to immediately apply for an ITIN - International Tax Identification Number.   Applying for an ITIN at the outset of purchasing property within the US would best serve the foreign investor in the long run as they will then be able to sell and close without the holdup of obtaining an ITIN from the IRS which can take as long as 6 weeks or more. 

Since the sale or other disposition of a U.S. real property interests by a foreign person is subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), many investors should look at the possibility of participating in a 1031 Tax Deferred Exchange.  FIRPTA authorized the United States to tax foreign persons on dispositions of U.S. real property interests.  Persons purchasing U.S. real property interests from foreign persons, are required to withhold 10 percent of the amount realized.  The 10% withholding is submitted by the BUYER to the IRS using the Internal Revenue's form 8288.  A sale of property owned by a foreign person cannot close escrow to a purchaser without an ITIN issued to the foreign seller by the IRS.   

Many confuse a common exception to the FIRPTA withholding which exists and is strictly for a residence which the foreign investor resides at as their personal residence (for at least 50% of the time); and in which the sale price is not more than $300,000.00.  This exception is not for use in the sale of an investment property owned by the foreign investor. 

Since investment property has strict personal use limitations the foreign seller of investment property may want to consider the use of a 1031 Tax Deferred Exchange.  If the investor is going to purchase another investment property then the 1031 Exchange would be beneficial to defer the capital gains and to also eliminate the required FIRPTA withholding.  In order to take advantage of these two benefits the investor will need to apply for (immediately) a withholding certificate from the IRS and an ITIN (if one has not already been applied for and issued).  The withholding certificate requires an ITIN in order to file for the certificate (both can be filed at the same time - but again this may cause the request to take longer than is available to meet the successful closing on the transaction).  The forms for both can be obtained from our office or directly from the IRS website (IRS.gov).

Remember that FIRPTA impacts all foreign sellers, next time you have a transaction with a foreign seller be certain to ask them about these important issues as you may help to save your deal and to save the seller dollars in taxes which will result in their having more money to invest in the next property; AND we all know how that benefits everyone involved! 

Brigitte Echave is a  Certified Exchange Specialist® and an approved Real Estate Trainer.    With over 26 years in the real estate business and 20 years specializing in 1031 Tax Deferred Exchanges  you should call Brigitte with all your 1031 Exchange needs and questions. 

Having worked in the 1031 Exchange arena for many years now, I am often asked by potential customers how do I protect myself from loss of my funds while you are holding them as the Qualified Intermediary.

For many years our industry has touted the fact that "We carry a Fidelity Bond" as a protection to our customers. With the down-turn in the real estate industry there have been many Qualified Intermediaries that have lost the principal amounts which were entrusted to them by an Investor during the participation of a 1031 Exchange. One very large Qualified Intermediary (affiliated with the 3rd largest title company at the time - 2008) found that the funds of their investor client were illiquid due to the investment vehicle they used (Auction Rate Securities). When in operation this Qualified Intermediary would often advertise that they held a very large Fidelity Bond which would cover the client should a loss occur. Unfortunately, as many investors have come to find out, the Fidelity Bond may not have.

So what does a Fidelity Bond cover:

Well the primary coverage of a Fidelity Bond is to protect the holder (an employer) of employee theft. The bond will pay for loss or damage to money, securities and other property directly from theft or forgery by an employee.

You might ask yourself so how does that help me (the consumer), well generally speaking it does not. The party that can draw upon a Fidelity Bond is the actual holder of the bond not the general public or someone who has been harmed by the company.

Next time you encounter someone who is touting that your transaction will be covered by a Fidelity Bond ask to see where in the bond it declares that it can be drawn upon by a third party? Ask if you can be added as a loss payee.

Generally they will be unable to supply you with this and as a result here are some other ways that you can protect yourself when you engage a Qualified Intermediary (QI):

Ask your QI if they utilized both the QI safe harbor AND Qualified Escrows safe harbor of the Internal Revenue Code Section 1031. With a Qualified Escrow an escrow is established with the bank (the bank that is holding the exchange funds during the exchange) in which the bank agrees that they will not release the funds to the QI without the express written consent of the client (you the taxpayer doing the exchange).

Also review the QI agreement and be certain that it stipulates that the Exchange funds will never be placed in the QI's general operating fund and that all clients funds are held in segregated FDIC Insured Money Market Accounts. Ask the QI how they invest the funds -- there should be no exotic investments made with the clients monies (e.g. Auction Rate Securities, Stocks, Real Estate etc).

Each Investor client should be there own advocate and ask questions. Your Intermediary should have no issues with your questions and should be able to produce any document you are requesting. Protect yourself by establishing that your funds will be protected by a Qualified Escrow during your 1031 Exchange transaction.

In the end, the goal is to preserve your principal and to defer your capital gains allowing you the Investor the maximum benefit of your 1031 Exchange. You and your monies should be priority number 1.

There is a current legislative proposal in Congress (and supported by the current administration) that would reclassify promoted interest (carried interest), currently treated as capital gains for tax purposes, as ordinary income. The bottom line effect would be an enormous tax increase on rental property owners and investors and disc...ourage real estate partnerships from investing in communities. The final legislation will be determined by a House/Senate Conference Committee that is debating the measure now. According to Jim Arbury, senior vice president for government affairs at the NMHC, "The most effective lobbying at this point would be for CAA members to make as many phone calls as possible to the district offices of Democrat congressmen and women. The district offices need to tell Washington that the phones are ringing off the hook." Arbury adds that the basic message should be, "Don't change the taxation of carried interest. This is a job killer and will lead to lower property values and a lower tax base. We already have enough unemployment without adding to it." Click the link below to find your Congressional representative and how to contact their district offices. http://www.govtrack.us/congress/findyourreps.xpd?state=AZ . (for your state change the state code at end of url e.g. AZ change to CA) More information on this issue (including a sample letter to Congress) can be found on the NMHC website by visiting www.nmhc.org/goto/CarriedInterest.