Most Qualified Intermediaries will authorize the taxpayer to deed the relinquished property directly to the buyer and to receive the deed for the replacement property directly from the seller for the purpose of avoiding duplication of transfer taxes and in many states withholding taxes which may be imposed on the sale of property by a non-resident of the state.



The authority for direct deeding is granted by virtue of Reg. §1.1031(k)-1(g)(4)(iv) and Reg §1.1031(k)-1(g)(4)(v). Pursuant to Sub-Section (iv), a Qualified Intermediary is treated as acquiring and transferring title if: 1) The Intermediary acquires legal title to the relinquished property from the taxpayer or legal title to the replacement property from the seller and subsequently transfers the relinquished property title to the buyer and the replacement property title to the taxpayer; or 2) if the Intermediary enters into an agreement with a person other than the taxpayer, (the buyer), for the transfer of the relinquished property to that person and, pursuant to the agreement, the taxpayer transfers the relinquished property to the buyer; and 3) if the Intermediary enters into an agreement with a person other than the taxpayer, (the seller), for the transfer of the replacement property and, pursuant to the agreement, the seller transfers the replacement property to the taxpayer.



Pursuant to Sub-Section (v) an Intermediary is treated as entering into an agreement if the rights of the taxpayer are assigned to the Intermediary or before the date of transfer and all parties are notified in writing of the assignment.



In the typical exchange, the Intermediary, taxpayer and buyer of the relinquished property will execute an assignment or novation agreement assigning the taxpayer’s rights under the agreement to the intermediary. The assignment may contain a notice given by the Intermediary authorizing the buyer to transfer legal title directly to the taxpayer or the notice of direct deeding may be given in a separate document.



Additionally, on or before the date of transfer of the replacement property, (the closing), the Intermediary, taxpayer and seller of the replacement property will execute an assignment and notice of direct deeding, in one or several instruments, assigning the taxpayer’s rights under the agreement to the Intermediary and authorizing the seller to transfer Legal title directly to the taxpayer.



In each case, the Intermediary is treated as having acquired and transferred title to the property in accordance with the requirements of Reg. §1.1031(k)-1(g)(4)(iii).  

When selling property as part of a 1031 Exchange in NH it's important that investors use the exact same name on the replacement property that they used on their relinquished property. NH treats each entity, even the federally recognized "disregarded" Single Member LLC (SMLLC) as a separate and distinct entity for state tax purposes.  The state’s position will cause difficulties for exchangers when an investor wants to sell real estate out of one disregarded entity and purchase replacement property in a new disregarded entity. NH is the only state that ignores the disregarded entity rule.



All disregarded entities, including SMLLC's, disregarded limited partnerships, and grantor trusts doing business in NH with gross income in excess of $50,000 are required to report and pay business profits tax. Because the business profits tax is assessed on an entity by entity basis, NH asserts that in order to enjoy Section 1031 deferral, the exact same entity that sold the relinquished property must subsequently purchase the replacement property. Investors must plan accordingly so that there are no surprises when exchanging NH property.

A client recently asked how to treat an upcoming payment for a property with substantial gain that was about to be taken through eminent domain.  While the property may qualify for a 1031 Exchange, a 1033 “Involuntary Conversion� may be more advantageous in some situations. Typically, the events that result in an involuntary conversion in which you can defer gain recognition are theft, damage resulting from an “act of God� (i.e., a casualty) or the government's taking of your property for a public use.

If the property is involuntarily converted into other property which is similar or related in use, the gain is automatically deferred. But that doesn't happen too often. Normally, the lost property is converted into cash (insurance proceeds or a condemnation award) or into other property which isn't similar or related in use; in those situations, the gain is recognized unless the owner decides to do a 1031 Exchange. In a 1031 Exchange the investor must be careful not to take constructive receipt of the funds and to follow IRS guidelines for the 1031 Like Kind Exchange.

If you replace the involuntarily converted property with property that is similar or related in use within the specified time period, you can elect to defer the capital gains tax. To qualify, the replacement property must generally be purchased within two years of the close of the tax year in which the gain was realized. A three-year period applies for condemned property. Also, taxpayers can apply to the IRS for extensions of the replacement period. Even if you elect to defer your gain, you still must recognize gain to the extent that the replacement property costs less than the amount you received as compensation. The same 1031 exchange “equal or greater than� rule exists with the Involuntary Conversion. Additionally, you must reduce your basis in the new property by the amount of gain deferred. While the definition of “like kind� is more restrictive with the 1033 Involuntary Conversion, the timeframes are much more advantageous and the funds do not need to be held by an intermediary.

Note that the deferral rules don't apply to losses with Involuntary Conversions. In most cases, losses are deductible as casualty losses, subject to the limitations and special rules that apply to casualty losses.

A powerful sales tool when negotiating and structuring real estate transactions in this distressed real estate market is to have the seller carry back a promissory note alongside their 1031 Exchange. With “Seller Financing� the seller acts as a lender by lending money to the buyer and taking back an installment note secured by the property. We are frequently asked if it’s OK to carry a note on a relinquished property and also defer taxes through a 1031 Exchange. This can be done if structured properly by using one of two methods. The first option is to keep the note with the seller outside of the exchange and have the balance of the sale proceeds go to the Qualified Intermediary (QI) for the 1031 Exchange. The note would be treated on an installment sale basis and the seller may qualify for a partial 1031 Exchange.

The second option is to sell the property, carry back an installment note and complete a 1031 Exchange with the note assigned to the QI along with any cash proceeds from the sale.  Then exchanger then has three additional options; (1) assign the note to the replacement property seller as part of the purchase price, (2) sell the note for cash at a discount with the proceeds used to fund the acquisition of the replacement property or (3) add cash equal to the face value of the note (buy your own) note to complete the exchange.

Check back next week for another strategy in a difficult selling environment; the Reverse 1031 exchange. In addition to reverse exchanges we will also be discussing Vacation Home exchanges and the new Home Exclusion (Section 121) rules in upcoming posts. As always, we recommend that investors seek counsel from their accountant or attorney to discuss all of their options when buying or selling property.

With the collapse of the real estate market over the last year a many people feel that they do not have any capital gain issues on a sale because the properties have declined in value since their high in 05 and 06. However, the actual purchase price and the circumstances may make this loss a taxable event.  Here are some examples:

Example 1: Definite loss

If a taxpayer bought an income property in 2006 for $800,000 and is now going to sell it for $600,000 today, they have a loss of $200,000; less depreciation that may be applied to offset future gain.

Example 2: Definite loss

If the taxpayer had placed a loan of $640,000 in 2006 on the $800,000 value and the property is now being sold for $600,000; the seller will have to pay $40,000 out of pocket at closing.  They would still have a loss of $200,000 if it had been a straight purchase in 2006.

Example 3: Actual Gain

Now let's assume that in 2006 the seller had exchanged into the $800,000 property from a property that had been acquired in 1996 for $200,000. Let's assume they had taken $65,000 in depreciation leaving a basis in 2006 of $135,000 and a gain of $665,000. 

The property purchased at $800,000 through a §1031 exchange in 2006 is now being sold for $600,000. The basis is $135,000 and thus they still have a $465,000 taxable gain; not a loss of $200,000.  (They can do another IRC §1031exchange). 

Example 4:  Actual Gain

If the taxpayer had refinanced the exchange property in 2006 for $640,000 and now they are selling for $600,000 they will have to pay $40,000 out of pocket at closing.  Additionally, there is still a gain of $465,000 (Sale of $600,000 minus basis of $135,000).

If the bank accepts the loss of $40,000 the taxpayer has a forgiveness of debt.  The forgiveness of debt is taxable and gets added to the basis of $135,000 giving us a new basis of $175,000. 

   $40,000.00 (forgiveness of debt) taxable

   $425,000.00 (gain) taxable ($600,000.00 minus stepped up basis of $175,000.00)  

   $465,000.00 taxable at Long Term Capital Gains rates

Example 5:  Actual Gain

A property was purchased in 2000 for $500,000 and in 2007 the investor refinances at the appraised value of $800,000.  Now the taxpayer decides to sell for $600,000.  His basis is $500,000, minus depreciation.  If we assume depreciation of $70,000 our basis would be $430,000.  There is not a loss of $200,000 ($800,00 minus $600,000) rather there is a taxable gain of $170,000. ($600,000 sale price - $430,000 basis). 

It is important to note that if a seller uses this property in a §1031 exchange they would be able to defer their taxes. Beware all may not be as it appears! A perceived loss may still be taxable.

The recent financial meltdown, 1031 regulatory changes, government intervention and recent failure of a national Qualified Intermediary (QI) are causing many would be 1031 exchangers to ask the question “how safe are my funds if I do a 1031 Exchange�?

As a custodian of exchange funds, a QI must invest in a manner that provides sufficient liquidity and preserves the principal of all funds held in escrow. Maintaining insurance, bonding, cash deposits and/or letters of credit would be the absolute minimum requirements. A Fidelity Bond and Errors & Omissions policy will protect exchangers from theft, embezzlement of funds and human error but not bank failure or a QI bankruptcy. Maintaining a Fidelity Bond, an E&O policy and segregating operating expenses from exchange funds are the minimal requirements in the Model Laws for QI’s. For maximum protection; deposits need to be held in segregated (by exchanger), dual signature, fully insured, FDIC/SIF protected bank accounts, with the bank named as the escrow agent. With segregated bank deposit accounts, exchangers have the benefit of FDIC insurance and no risk that their exchange funds are being commingled with other exchangers’ funds or the QI’s operating account. Funds held in segregated bank accounts may also come with additional protection through state insurance programs such as the MA Share Insurance Fund (SIF) which offers depositors a 100% guarantee on all funds in excess of the FDIC limit for member banks. SIF coverage is extremely important as the majority of exchange deposits exceed the $250,000 FDIC guarantee limit.

Exchangers along with their advisors need to perform due diligence on their prospective QI to make sure that they are dealing with a reputable firm and that the funds held during the exchange process are secure. If a QI has 50 exchanges going on at once and all 50 suddenly need to close tomorrow on the replacement properties using all funds held, can the QI provide all the funds?

Will Rogers once said, “I am more concerned about the return of my money than the return on my money.� Exchange Authority continues to offer the maximum amount of protection available in the §1031 Exchange industry and is proud to offer all exchangers a 100% guarantee on all funds held in the Qualified Escrow safe harbor with Fidelity Bank and through multiple layers of protection so that when it’s time to release funds - they are guaranteed to be returned.