1031 News

When I had my CPA practice, I used to tell people, 'you never get ripped off by someone you don't trust.' What I mean is, usually after a high profile fraud case, the victim often says something like, "I can't believe this happened," or "He seemed like such a nice guy." You never hear the victim say, "I'm not surprised. I knew he was going to rip me off..."

Likability is a good reason to do business with someone, but it's not a good reason to trust them. In a high profile case that has made national news, the secret fiscal life of Colorado Qualified Intermediary (or "QI"), Royal "Scoop" Daniel, III, is becoming more provocative as the details of his financial dealings are revealed.

Colorado Securities Commissioner, Fred Joseph has determined that TIC interests sold in the state of Colorado by Mile High Capital and Replacement Property Solutions are considered securities rather than real estate.  Replacement Property Solutions was the qualified intermediary arm of Mile High Capital, a real estate investment firm.  Both companies have been closed by the State and their principals indicted for securities fraud.

A TIC (Tenant-In-Common) interest is a small ownership slice of a large property.  In 2002 the IRS ruled that TIC interests qualify for 1031 exchanges.  This means an investor can sell a piece of investment property and buy a partial interest in a large property, such as an office building or an apartment complex.  Prior to the IRS ruling, there was confusion as to whether TICs were treated as real estate, or as partnership interests (which are not allowed as 1031 exchange replacement property).

One of the basic concepts of a 1031 exchange is if something qualifies as “real estate” under state law, it qualifies as “real estate” for purposes of a 1031 exchange. For example, several years ago we were involved in an exchange of an oil and gas pipeline that crossed several states. Whether or not that pipeline was considered real estate depended on the laws of each state. As a result, we ended up with a situation where the portion of the pipeline in one state was classified as real estate, even though it was above ground, while another section of pipeline in another state was NOT considered real estate, even though it was buried in the ground.

In a recently released court case, the IRS challenged a state’s characterization of a property. This is the first time I’ve seen them do this, and it causes me some concern with how some types of exchanges are handled in Colorado.

Rule #4 of my six basic rules for 1031 exchanges is you can not touch the money between the sale of your Old Property and the purchase of your New Property. IRS law requires that you use an independent third party (called a Qualified Intermediary) to handle your exchange. At least that’s the general rule. When you’re dealing with the IRS, there are usually exceptions to the rules, and such is the case with this rule. Being aware of this exception can save you the cost of an intermediary, which runs at least $500 in most parts of the country.

One of the critical requirements for a 1031 exchange is the same taxpayer must hold title to both the Old and New Properties in the exchange. While the exact amount of time these properties must be held is not defined by the IRS, it is clear that it has to be the same taxpayer, and both properties must be held for investment.

If Fred and Sue, for example, own an apartment building they are selling as joint tenants, and buy a replacement property for their exchange as joint tenants, then clearly the exchange involved the same taxpayers since Fred and Sue were on title for both the Old and New Properties. But what if Fred and Sue wish to protect themselves by putting the New Property into an LLC as soon as they acquire it? Most attorneys would say that was a smart business decision and quickly set up the LLC for them.

...if you have control over a transaction . . . the IRS could view your transaction as a violation...

1031 exchanges involve property you hold for investment, not your personal residence.  So why write an article about doing a 1031 exchange on your personal residence?  Everyone knows that your personal residence does not qualify for a 1031 exchange!  Or does it?

When you sell a residence you’ve lived in for two of the last five years, $500,000 of the gain is tax free if you’re married; ($250,000 if you are single).  This is your personal residence, which does not have anything to do with 1031 exchanges, right?  However it might.  You know the two-of-the-last-five-years rule, but did you ever ask yourself what the property was used for during the other three years?

As we start to wind down towards the end of the year, now is a good time to point out that 1031 exchanges are a great vehicle to use in shifting gain between two tax years. For example, if Fred and Sue sell their purple duplex on December 1, 2006, their 45-day identification deadline for their exchange is January 14, 2007. Section 1031 of the Internal Revenue Code requires that they send a list of potential acquisition properties to their intermediary no later than, in this example, this date. Failure to do so will terminate their exchange, causing the gain from the sale of their purple duplex to be taxable.

As a result of the current real estate slowdown, we’re starting to see clients selling properties with negative equities.  By negative equity, I mean situations where they might owe more than the property is worth they can sell the property for.  Because of this, some interesting questions arise.  How does negative equity affect a persons ability to do a 1031 exchange?  Can you do an exchange when you owe more than the property is selling for?  Why bother if there is no cash, or if you have to bring cash to the table?

Most people (even many real estate professionals) tend to think of cash as the same as “gain.”  Therefore, according to their thinking, if you don’t receive any cash from a sale, you don’t have any gain.  And if you, as the seller, have to bring cash to the closing, you must have a loss, right?

Suppose Fred and Sue sell their bare lot on September 30, 2005 for $100,000 and buy a gorgeous red condo on February 15, 2006 for $90,000, completing their exchange. They have bought down by $10,000, and as a result they have $10,000 of proceeds left over. This money is returned to them by their intermediary after the close of their exchange. When is the $10,000 taxable? In 2005 when they sold the land? Or in 2006 when they received the check from the intermediary?

The big rage in real estate these days are TIC interests. TIC stands for "tenant-in-common," which is the legal title that these types of interests hold title to property. TIC interests are program investments similar to the partnership tax shelters of the 1970s and '80s, in that they pull together a group of investors to purchase one large property.

There are two major reasons for this great surge in these type of investments: the first is that the IRS approved TICs as suitable replacement properties for 1031 exchanges in 2002. Prior to that date it was uncertain whether a TIC interest could be purchased as the replacement for a 1031 exchange because their structure so closely resembles a partnership. As a result investors were wary of them. Today, however, approximately 70% of the TIC interests are purchased by such investors.