NestEgg Investing: 1031 Tenants in Common Exchanges

1031-721 Exchange: Conditions to Qualify

How to avoid or defer paying capital- gains taxes on the sale of your primary residence.  See prior posts (Avoiding Capital Gains on Your Primary Residence, A 1031-121 Example)

1031-721 Conditions to Qualify

•           You must have lived in your house for at least two of the past five years.

•           The profit on the sale of your home must be greater than the capital- gains tax exclusion -- $500,000 for married joint filers.

•           You must have established a home office or converted your home into a rental property, and you must purchase a similar property when you sell.

How to avoid or defer paying capital- gains taxes on the sale of your primary residence.

  -- Set up a home office or rent out your property. To qualify for a federal home-office tax deduction, you must use part of the home exclusively and regularly as your principal place of business, meaning for administrative or management  activities; as a place where the owner meets or deals with

patients, clients or customers in the normal course of trade or business; or for rental use.

  -- Make sure you file Form 8829 to claim the home-office deduction, or the IRS may not recognize the office portion of your home.

  -- When you are ready to sell, you can claim the standard capital-gains tax exclusion, up to certain limits: $250,000 (for most singles) and $500,000 (for joint filers). To qualify for the full exclusion, you must have lived in the home and used it as your primary residence for at least two of the five years

prior to the sale. If your gains exceed those limits due to the commercial portion, you can defer taxes on those gains by buying another commercial property, if that property is worth as much or more than the value of the commercial portion of the house you are selling.

A 1031-121 Exchange Example

1031-121 Example

Suppose you own a commercial property in which you have a

$400,000 capital gain. But rather than trade up for another investment property, you want to exchange for a "dream home" where you and your spouse can enjoy the good life. This can be done with careful planning and a Starker exchange.

The first step is to sell your investment property and have the sales proceeds held by a qualified third-party accommodator. The second step is to use those sales proceeds to acquire your ultimate dream home.

But that property must be a rental at the time of acquisition. Most tax advisers suggest renting it for at least six to 12 months after purchase to show rental intent. Then you can move in and convert it to your personal residence.

However, before you can sell the acquired residence and claim your $250,000 or $500,000 principal residence exemption of IRC 121, the Oct. 22, 2004 tax changes of Internal Revenue Code 121(d)(10) now require you to own the acquired residence at least five years and live in it as your principal residence at least 24 of the 60 months before its sale.

Next:  Making Sure You Qualify Conditions to Qualify Link

Avoiding Capital Gains on Your Primary Residence- 1031-121 EXCHANGE

1031-121 EXCHANGE

Under Section 121, you can sell your primary residence and exclude from taxable income up to $250,000 (single taxpayers) or $500,000 (married taxpayers filing jointly) in capital gains

A 1031-121 exchange allows the owner of, for example, an expensive house to use one benefit to exclude part of the gain from tax and the other to defer tax on the rest. And the gain excluded -- up to $250,000 for a single homeowner and $500,000 for a couple -- can be added to the "basis" of the new house, reducing the potential tax if it is sold.

The new break doesn't apply to all homeowners, only to those who have home offices, or those who convert their house -- or a portion of it – into a rental. The deferral applies only to the portion of the house used for commercial purposes.  In general, you must use part of the home "exclusively and regularly" as your principal place of business, or exclusively and regularly as a place to meet or deal with patients, clients or customers in the normal course of work -- or for rental use. If you are an employee, your business use must be for your employer's convenience, not yours.

Next:  A 1031-121 Example 1031-121 Example

            Making Sure You Qualify Qualifications

1031-721 Exchange How Does It Work?

1031-721 How Does It Work?

Step #1

•           The investor sells the Relinquished Property to a third-party buyer.

•           The sales proceeds are deposited into an account held by a QI.

Step #2

•           The investor purchases a Replacement Property from a REIT.

•           The QI uses the proceeds from the sale of the Relinquished Property held to acquire the Replacement Property.

Step #3

•           The investor leases the Replacement Property back to an Operating Partnership (OP) (structured either as an UPREIT or DOWNREIT), whose portfolio of properties is managed by the REIT the Replacement Property was purchased from.

-The OP is a separate entity from the REIT, and its ownership is divided into OP units.

-Through the provisions of a “call” option, the OP is afforded the right, but not the obligation, to acquire the Replacement Property from the investor for a fixed purchase price. Or, alternatively, the investor can have a “put” option to sell the Replacement Property to the REIT

Step #4

•           If the UPREIT or DOWNREIT exercises the “call” or the investor exercise the “put”:

-The investor will transfer the Replacement Property to the UPREIT or DOWNREIT in exchange for OP Units.

-OP Units are the substantial economic equivalent of the REIT's common shares, and are convertible into the REIT's common shares on a one-for-one basis.

-Because there is a possibility that the “call” will not be exercised, the investor must acquire the Replacement Property knowing he will be holding the Replacement Property for investment purposes and may not ultimately receive OP Units.

Once an investor receives OP Units, how can he or she redeem those units?

•           The OP has the right to redeem investors for either cash or REIT common stock.

-TAXABLE EVENT: The receipt of cash or REIT common stock in exchange for OP Units brings an end to an investor’s tax deferral.

-Assuming an investor receives REIT common stock, the investor may liquidate such stock (prior to its listing) pursuant to the REIT's redemption program.

Exchanging into a REIT--1031-721 Analysis

1031-721 EXCHANGE

Although an investor cannot invest in REIT common stock as a Replacement Property, an investor can exchange full or fractional (TIC) ownership in a single property for partnership units in a large portfolio of investment-grade properties.  Known as real-estate investment trust operating partnership units, these can even later be converted into REIT stock (which is then a taxable event).  This process involves the combination of these two proven tax-deferral mechanisms (Sections 1031 & 721) under the Internal Revenue Code.

§ 721. NON-RECOGNITION OF GAIN OR LOSS ON CONTRIBUTION

(a) General rule-- No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.

(b) Special rule-- Subsection (a) shall not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (within the meaning of section 351) if the partnership were incorporated.   

(Next: 1031-721 How Does It Work Link). 

1031 TIC Exchanging Into A REIT

Great Article from the WSJ about doing a 1031 exchange into a REIT.  This new option of exchanging to a REIT has obvious benefits.  However, the IRS rulings are not completely clear.  Here's our analysis of the legality (1031-721 Analysis Link).  As always check with your tax advisor.

Staff Reporter of The Wall Street Journal

From The Wall Street Journal Online

If you like 1031s, you're going to love 721s.

As the market for 1031 exchanges is growing, so are the options for individual real-estate investors who conduct them. The latest is the 1031-721 exchange.

In 1031 exchanges, real-estate owners defer capital-gains taxes on the sale of property by purchasing another property of equal or greater value, according to rules set by the Internal Revenue Service. One variation is 1031 fractional exchange programs, also known as tenant-in-common programs, which allow sellers to make an exchange by buying an interest in a real-estate property as opposed to an entire property. Each investor receives proportional fractional distributions of the income generated from the property.

Now, some real-estate companies are broadening the reach of individual investors even more by allowing them to exchange full or fractional ownership in a single property for partnership units in a large portfolio of investment-grade properties. Known as real-estate investment trust operating partnership units, these can even later be converted into REIT stock.

These kinds of exchanges aren't new. Large, mostly institutional investors have long conducted such exchanges, mainly because it was often unlikely that a REIT would want the kind of properties owned by individual investors. But now some programs, like the one recently launched by Denver-based REIT Dividend Capital Trust, are offering individual investors the chance to conduct 1031-721 exchanges.

A 721 exchange generally works like this: An investor sells a property and buys a replacement property or a tenant-in-common interest, then after a period of time exchanges the property or interest for operating partnership units in a REIT. Investors still defer taxes because the exchange for units wouldn't trigger capital-gains taxes. And they receive dividends.

A REIT also can decide to sell tenant-in-common interests in a property it owns or is planning to buy. The investor who sells a property and buys an interest being sold by the REIT would, after a period of one to five years, have the right to convert the interest into REIT operating partnership units. In both scenarios, the investor has the option of converting the operating partnership units into REIT shares. Dividend Capital Trust sometimes assists the investor in identifying a replacement property it would be interested in eventually buying, or a tenant-in-common interest in a property the REIT would want to own.

"You are sharing in a pool of properties [in terms of the REIT's portfolio], not just one," giving the investor diversification, says Louis S. Weller, a principal at Deloitte & Touche LLP's national real-estate tax services group in San Francisco.

While investors doing this get diversity in terms of investments, there also is risk. For one thing, there's a loss in the investor's ability to keep exchanging. You cannot exchange back the operating partnership units for ownership or fractional ownership in a single property. You can only convert the units into REIT shares. And taxes will be incurred in that transaction.

There's also the risk of the REIT executives managing the properties badly, or some of the properties in the portfolio performing poorly, which could drag down the overall portfolio and the value of the ownership units. It also exposes the investor's investment to stock-market whims, not just property performance.

1031 TIC Exchange Triple Net Leases, The Management Free Option

An increasingly popular 1031 exchange option is the triple net lease  (ie. "NNN").  A triple net lease is a long term lease where the tenant pays for all maintenance, taxes, insurance, and utilities.  Usually, these NNN leases are with well know franchises or chain stores such as Walmart, Walgreens, Pizza Hut, and Starbucks. 

The advantages of exchanging your investment property (either individually or through a tenants in common) into a NNN property are:

1) Zero maintenance

2) Zero occupancy risk- high credit tenants sign long term leases

3) Lower principal risk (because of #2)

4) If you purchase through a tenants in common structure, you can buy a larger, and thus higher yielding property

The attached article provides a good overview: article link

Avoiding Capital Gains on Your House: Wall Street Journal Article

A great article on deferring capital gains on your primary residence.  Check out our more formal analysis:  1031-121 Analysis Link

2/10/05 Wall St. J. D1
2005 WL-WSJ 59840615

The Wall Street Journal
(Copyright (c) 2005, Dow Jones & Company, Inc.)

Thursday, February 10, 2005

IRS Decision Aids Home Sellers

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Recent Move Allows Those With Home Offices, Rental Units, to Defer Taxes on
Some Gains

By Ray A. Smith

A RECENT decision by the Internal Revenue Service could provide considerable relief to many homeowners facing huge price gains when they sell. The sharp appreciation of house prices in recent years means many people could face steep capital-gains taxes. But in late January, the IRS put forth new guidelines that allow certain homeowners to defer paying taxes on a
significant portion of those gains. The new break doesn't apply to all homeowners, only to those who have home
offices, or those who convert their house -- or a portion of it -- into a rental. The deferral applies only to the portion of the house used for
commercial purposes.

Still, that affects a substantial amount of people. According to the IRS, the number of individual tax returns filed claiming deductions for home offices
rose to about 2.5 million in 2002, the latest data available, from about 1.7 million in 1997. In a 2004 survey, the National Association of Realtors
found that 12% of respondents said they were buying other houses, but keeping their existing homes -- presumably for investment purposes.

Some observers say the IRS's move will lead more people to rent their homes or set up a home office -- or lead people who already have such offices to
report them. "People in the past would always question whether it was worth it to deduct a home office," says Julie A. Welch, an accountant and director of
the tax department at Meara, King & Co., a Kansas City, Mo., auditing and accounting firm. "But now with this new pro-taxpayer guidance, it makes a
whole lot more sense. If you structure it right, you can exclude or defer gain in almost all cases."

Next week, the IRS is scheduled to formally publish the new guidelines. Previously, homeowners weren't sure which circumstances allowed them to
defer or exclude the gains from the "commercial" parts of their residences.

The guidance comes at a time when many homeowners, especially those who have lived in their houses for a number of years, are sitting on huge price
gains. Home prices in the U.S. have risen 63% from the third quarter of 1999 to the third quarter of 2004, according to home-price research company Fiserv CSW
Inc., of Cambridge, Mass. A number of housing markets have seen increases far beyond that.

Given the complexity of the guidelines, known as Revenue Procedure 2005-14, it makes sense to consult with a lawyer or tax adviser before attempting to
take advantage of them. For one thing, the IRS has complex rules on claiming expenses for business
use of your home. In general, you must use part of the home "exclusively and regularly" as your principal place of business, or exclusively and regularly
as a place to meet or deal with patients, clients or customers in the normal course of work -- or for rental use. If you are an employee, your business
use must be for your employer's convenience, not yours.

Additionally, in order to take advantage of the deferral, the owner must purchase another property through what is called a 1031 "like-kind"
exchange, and it must be either a commercial property or have a commercial component equal or greater to the value of the commercial portion of the property
being sold. For people selling a home, the top capital-gains rate, currently 15%, typically applies to profits of more than $250,000 for most single people
and $500,000 for married couples filing jointly. For owners who bought in fast-appreciating markets five years ago, the profits from a sale could
easily exceed those limits, meaning they would have to pay capital-gains taxes. When the current limits were set in 1997, lawmakers assumed few people would
cross the profit threshold.

Here is how it works: If a married couple sells for $900,000 a house that cost, say, $200,000, the couple can exclude $500,000 of their $700,000 gain.
Assuming they had rented the entire house before the sale, they could defer paying taxes on their remaining $200,000 gain by buying a replacement
commercial property costing at least that much through a 1031 exchange.

If the couple had instead maintained a home office that was valued at $75,000, they could defer paying taxes on that amount if they purchased a commercial
property of the same or greater value.

"It's a good thing for homeowners who also have a home business because it clarifies that they can later sell the house and still use the principal
residence exclusion for the entire house, even if they were using part of it for business," says Randy Markowitz, an accountant and partner with FGMK
LLC, in Bannockburn, Ill.

Another benefit: The couple also can defer back taxes on any depreciation deduction they took earlier on the commercial part of the property. Gains
from depreciation deductions are taxed at 25%, much higher than the 15% capital-gains tax.

While the new guidance helps homeowners, it also can open up a legal and accounting minefield. "Trouble could come from trying to claim the
home-office treatment when it's not eligible, claiming too large a percentage of a residence as a home office, or not satisfying the highly technical 1031
rules," says Louis S. Weller, of Deloitte & Touche LLP's national real-estate tax services group in San Francisco.
Some homeowners may find the road to qualifying for this new break a little daunting. For example, when trying to sell a home and defer the gains on the
commercial portion, it no longer is simply selling a house but structuring an exchange transaction, which means filling out more tax forms and adhering to
strict deadlines and rules. It is more akin to being a commercial investor than a homeowner.

In a 1031 exchange, the replacement property has to be identified within 45 days, and the exchange has to be completed within 180 days, or the tax
deferral is forfeited. A specialized 1031 intermediary has to be retained to handle the transaction. Fees for intermediaries run as much as $1,000.

"If you don't set it up as an exchange, then you won't get the tax-deferral treatment," says Adam Handler, of the like-kind exchange services group with
PricewaterhouseCoopers in Los Angeles. "Most people, if they're thinking about selling a house, are not thinking about the exchange machinery."

New Tax Break

A new decision by the IRS could help cut your taxes when you sell your home.

Here's who benefits:

-- You must have lived in your house for at least two of the past five years.

-- The profit on the sale of your home must be greater than the capital- gains tax exclusion -- $500,000 for married joint filers.

-- You must have established a home office or converted your home into a rental property, and you must purchase a similar property when you sell.

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How to Lower Your Home Capital-Gains Taxes

New guidance from the IRS clarifies how to avoid or defer paying capital- gains taxes on the sale of your primary residence.

-- Set up a home office or rent out your property. To qualify for a federal home-office tax deduction, you must use part of the home exclusively andregularly as your principal place of business, meaning for administrative or
management activities; as a place where the owner meets or deals with patients, clients or customers in the normal course of trade or business; or
for rental use.

-- Make sure you file Form 8829 to claim the home-office deduction, or the IRS may not recognize the office portion of your home.

-- When you re ready to sell, you can claim the standard capital-gains tax exclusion, up to certain limits: $250,000 (for most singles) and $500,000
(for joint filers). To qualify for the full exclusion, you must have lived in the home and used it as your primary residence for at least two of the five
years prior to the sale. If your gains exceed those limits due to the commercial portion, you can defer taxes on those gains by buying another commerical
property, if that property is worth as much or more than the value of the commercial portion of the house you are selling.

What You Can and Can't Do In a 1031 TIC Exchange

As always, check with your tax advisor, but here is what our research suggests is possible under 1031 tax laws.  Some of these options are highly sensitive to IRS rulings.  If we hear of more information, we'll post it on this blog.

Download cancant_do_1031.pdf 

How to Complete a 1031 Exchange

The 1031 tax code allows you to roll-over capital gains from the sale of one building into the purchase of a new property on a tax deferred basis. 

The step by step process is as follows:

1. Consult with your CPA, financial planner, attorney or other advisor to determine if you would benefit from a §1031 exchange.

Disposing of Your Relinquished Property

2. Instruct your real estate agent or attorney to insert a clause into the Purchase and Sale Contract requiring the buyer to cooperate with the exchange process.

3. Inform your escrow officer or closing professional that you will be engaging in a §1031 exchange.

4. Contact a Qualified Intermediary (QI) to open your exchange. Provide the QI with the following information:

a. Your name, address, telephone and fax numbers, e-mail address and taxpayer’s tax identification number;
b. Sales price of the property;
c. Amount of third-party debt or seller carry-back financing;
d. Escrow or closing agent’s or attorney’s name, telephone and fax numbers, e-mail address and file number;
e. Copy of the Purchase and Sale Contract
f. Copy of the Preliminary Title Report or Commitment for Title Insurance;
g. Copy of the Escrow Instructions (if available).

5. Execute an Exchange Agreement with the QI.

6. Execute an Assignment, Acceptance and Notice Agreement transferring your rights under the Purchase and Sale Contract and the Escrow Instructions to the QI and notifying all parties to the transaction of the assignment.

7. Execute a Qualified Escrow Account Agreement with the QI and its affiliate title  insurance company. This segregated Qualified Escrow Account safeguards your exchange funds from any liens from our creditors.

8. Inform the QI of the progress of your transaction. At the closing, your escrow or  closing agent will disburse any net equity from the relinquished property to your segregated Qualified Escrow Account and transfer the title directly to the buyer. The QI will notify you in writing when the QI receives your exchange proceeds. The QI will deposit your funds in a segregated Qualified Escrow Account with its affiliate, title  insurance company. The title insurance company will invest your funds in a secure, liquid investment vehicle where your principal will not fluctuate and you will earn a competitive interest rate. You will receive monthly statements on this account.

Identifying Potential Replacement Property

9. Mail, fax or hand deliver a signed description of your identified properties to the QI within 45 calendar days after the transfer of the title of your relinquished property. When  identifying your replacement property, you must comply with one of two identification rules.

3-Property Identification Rule
You may identify up to 3 potential replacement properties without regard to value.

Or

200%-Property Identification Rule

You may identify more than 3 potential replacement properties as long as the total fair market value of your identified properties does not exceed 200% of the fair market value of your relinquished property. If the fair market value of your identified properties exceeds the 200% rule, then you must purchase 95% of the aggregate fair market value of your identified properties (excluding any revoked identified properties).

You may revoke a property identification at any time during the 45-calendar-day period and identify new potential replacement properties. New identifications and revocations must be in writing. Any property that is acquired during the 45-calendar-day period is considered to have been identified.

Acquiring Your Replacement Property

10. Select and close on one or more of your identified replacement properties on or  before the earlier of the following dates: a) 180 calendar days after the transfer of the title of your first relinquished property; or b) the due date of the tax return (including filing extensions) for the year in which your relinquished property closes.

11. Defer all capital gain on your transaction by purchasing property that is equal to or greater in value than your relinquished property; reinvest all of the net equity from your relinquished property in the replacement property; and acquire debt on the replacement property that is equal to or greater than the debt on your relinquished property. You may also complete a partial exchange. You will incur tax liability on the non-qualifying portion.

12. Instruct your real estate agent or attorney to insert a clause into the Purchase and Sale Contract, requiring the seller to cooperate with the exchange.

13. Contact your escrow or other closing professional to arrange for the closing of your replacement property.

14. Inform your exchange administrator at the QI that you are closing on your replacement property. Provide the QI with your closing information.

15. Execute an Assignment, Acceptance and Notice Agreement transferring your rights under the Purchase and Sale Contract and the Escrow Instructions to Diversified Exchange Corporation and notifying all parties to the transaction of the assignment.

16. Keep in close contact with your exchange administrator at the QI until the replacement property closes and the funds are wired. The exchange administrator will disburse the net equity from your relinquished property to the escrow or closing agent’s account. The escrow or closing agent will disburse funds to the seller, who will transfer the title directly to you, the buyer.

Receiving Your Exchange Funds

You may have access to your exchange funds when you have met one of the following conditions:
-You have purchased all of your replacement property and your identification period has elapsed; or
-You have failed to identify any replacement property within the 45-calendar-day period; or
-Your 180-calendar-day exchange period has expired; or
-A material and substantial contingency has occurred after the end of the identification period that:
1) relates to the exchange
2) is provided for in writing
3) is beyond the control of you or a disqualified person.

The Internal Revenue Service requires the QI to strictly adhere to the above criteria.