Avoiding Taxes on the Sale of Your Business or Investment Property through a Tax Deferred Exchange
Efforts to jump-start the economy over the past several years have resulted in dramatic increases in the first year depreciation available to taxpayers. With 50% bonus depreciation for the 2008 and 2009 tax years, a taxpayer may deduct as much as 60% of the purchase price of many types of new depreciable property in the year the property is placed in service. However, what the tax man giveth, the tax man taketh away. When property is sold for more than its depreciated value (adjusted basis), the gain may be recaptured and be subjected to tax at ordinary income rates.
Under Internal Revenue Code §1031, business and investment property may be exchanged tax-deferred for other business or investment property if both properties are of “like-kind.” Taxation of gain from the sale of old property (“relinquished property”) in a like-kind exchange is deferred until the new property (“replacement property”) is disposed of in a subsequent taxable transaction. Therefore, a like-kind exchange is a powerful tax-planning device, but one that requires careful attention to many specific and technical requirements.
The original intent of §1031 was to provide tax-free treatment to transactions involving the reciprocal, simultaneous exchange of like-kind properties. Today, however, regulatory safe harbors allow for tax-free treatment in non-simultaneous and multi-party exchanges. While the safe harbors are not the only means of accomplishing a deferred exchange, tax advisers usually seek to comply with the deferred exchange safe harbors because the rules outside the safe harbors are uncertain.
Regulatory Safe Harbors. A non-simultaneous exchange in which the relinquished property is transferred before the replacement property is acquired is referred to as a “forward exchange”. If the replacement property is acquired before the relinquished property is sold, it is generally referred to as a “reverse exchange”. Forward and reverse exchanges are similar in many respects, but a few of the key differences are discussed below.
Forward Exchange. The “forward exchange” is the most common form of non-simultaneous exchange. A taxpayer may desire to use a forward exchange, for example, when a buyer has been located for the relinquished property, but the replacement property hasn’t been located yet, or isn’t yet ready for delivery to the taxpayer. The taxpayer/seller usually enters into a purchase agreement with a purchaser, and then assigns the taxpayer’s rights in the purchase agreement to a qualified intermediary (a “QI”), who generally is an independent third party. The taxpayer either transfers the relinquished property (i) to the QI, which then immediately transfers the relinquished property to the purchaser, or (ii) directly to the purchaser. The QI does not need to take title to the relinquished property or replacement property for the exchange to qualify under this safe harbor.
To qualify for the safe harbor, the taxpayer cannot receive the proceeds of the sale. Instead, the QI will establish a “qualified escrow account”, and receive and hold the proceeds in the escrow account until they are needed to purchase the replacement property. The taxpayer must identify the replacement property within 45 calendar days after the taxpayer sells the relinquished property and must receive the replacement property by the earlier of (i) 180 days after the sale, or (ii) the due date (including extensions) of the taxpayer’s tax return for the year of sale.
A similar process applies to the purchase of the replacement property. The taxpayer would contract with the seller of the replacement property and assign its rights in the purchase agreement to the QI. The QI would then use the funds that were escrowed from the sale of the relinquished property to pay a portion of the purchase price of the replacement property, and the taxpayer would pay any balance of the purchase price directly to the seller. The seller would transfer title to the replacement property either directly to the taxpayer, or through the QI to the taxpayer.
Reverse Exchange. In certain cases, a taxpayer may want (or need) to acquire the replacement property before the taxpayer finds a suitable buyer for the relinquished property. However, the IRS will not allow the taxpayer to own both the relinquished and replacement properties at the same time. The IRS has fashioned a special safe-harbor procedure to treat a “reverse exchange” as a qualified tax deferred exchange. This safe harbor is similar in many respects to the safe harbor for a forward exchange, but has a few more procedural requirements.
The IRS will respect a reverse exchange accomplished through the use of a qualified exchange accommodation arrangement (“QEAA”) involving a “parking company.” There are two basic variants of a reverse exchange under the QEAA safe-harbor. First, in an “exchange last” reverse exchange, the replacement property is transferred to a parking company, which holds the replacement property until the taxpayer finds a buyer for the relinquished property. At this point, the taxpayer and the parking company exchange the replacement property and the relinquished property. The taxpayer may transfer title to the relinquished property directly to the third party buyer, rather than transfer title through the parking company.
Second, in an “exchange first” reverse exchange, the parking company acquires replacement property and immediately exchanges it for the taxpayer’s relinquished property. Rather than taking title to the replacement property and transferring it to the taxpayer, the parking company may direct that the replacement property be transferred directly from the seller to the taxpayer. The parking company then holds the relinquished property for sale until a buyer is found. A taxpayer may prefer an exchange first reverse exchange, with title passing directly to the taxpayer, if the taxpayer needs to be the first to place the replacement property in service, as would be necessary for the replacement property to qualify for bonus depreciation.
The 45 day and 180 day requirements apply to reverse exchanges, similar to forward exchanges. Generally, this means that a taxpayer must identify relinquished property within 45 days, and close on the transfer of relinquished property within 180 days, of acquiring the replacement property. In addition, certain techniques are commonly used in reverse exchange safe harbors to enable the parking company to acquire the property or to shift risk away from the parking company to the taxpayer. In particular, the taxpayer may loan purchase money funds directly to the parking company, may guarantee a purchase money loan, and may lease the property from the parking company. Additionally, the taxpayer and the parking company may agree to fixed formula prices or puts and calls designed to assure that changes in value of the property held by the parking company do not adversely affect the parking company’s interests.
As an example of an “exchange last” reverse exchange, assume that Taxpayer currently owns fully depreciated relinquished property, with a $1 million value, and locates replacement property with a value of $2 million. The Taxpayer enters into a QEAA with an exchange accommodation titleholder (EAT) to purchase the replacement property from the seller. Taxpayer loans $2 million to the EAT, which the EAT uses to purchase the replacement property. The EAT then leases it to Taxpayer until Taxpayer finds a buyer for the relinquished property. The rent paid by Taxpayer to lease the replacement property from the EAT is the same amount as the payments required by the loan. Within 45 days after the EAT purchases the replacement property, Taxpayer identifies the relinquished property as property it intends to exchange for the replacement property. When a buyer is found, Taxpayer transfers the relinquished property, and assigns $1 million of the loan, to the EAT in exchange for the $2 million replacement property. The EAT sells the relinquished property to the buyer and uses the $1 million proceeds to repay Taxpayer the $1 million remaining balance of the loan. All transactions must occur within 180 days. Provided all the elements of the QEAA are met, the Taxpayer won’t recognize the $1 million gain inherent in the relinquished property until Taxpayer sells the replacement property.
State Sales and Use Tax Considerations. Most states impose a sales tax that a buyer must pay at the time of purchase, based on the “purchase price” of the property. Many states allow a trade-in credit for purposes of calculating the sales tax, based on the value of the relinquished property that is exchanged for the replacement property.
Most sales tax statutes are tailored to simultaneous exchanges; while most §1031 exchanges are non-simultaneous. A few states have addressed this head-on, allowing trade-in credit for any exchange that falls within §1031. Other state trade-in statutes do not clearly allow for the gap in time between the trade-in of the relinquished property and the purchase of replacement property. A taxpayer may be at risk in taking a trade-in credit in such states. While Nebraska statutes do not specifically address §1031 deferred exchanges, we have been successful in obtaining favorable rulings from the Department of Revenue, allowing trade-in credits in a number of deferred exchanges.
Where a trade-in credit is not clearly allowed, additional planning may reduce the sales tax burden. For example, a common technique used in equipment acquisitions is the “sale for resale” structure in which an entity purchases equipment sales tax free and leases it to the taxpayer, thereby avoiding sales tax on the full purchase price. However, this structure is not completely sales tax-free, since it usually requires sales tax payments to be made on the amount of the lease payments. Other exemptions may be available, as well. Therefore, examination of relevant state law should start well before the exchange takes place in order to ensure that sales taxes are minimized in connection with a §1031 exchange.
Structuring a §1031 exchange can be a complicated endeavor. We have implemented tax deferred exchanges for a number of clients. Therefore, if you would like to discuss any of these strategies, please contact any member of the McGrath North Tax Group.
Practice Pointers
1. What Is “Like Kind” Property? Code §1031 provides no guidance on how to determine whether one property is of like-kind with respect to other property. Over time, different interpretations of the term “like-kind” have evolved for real property and personal property:
a. When real estate is exchanged for other real estate, the like-kind principle has been applied quite liberally. In one case, an interest in mineral rights was considered to be like-kind to an interest in a hotel. In another case, improved real estate was considered like-kind to unimproved real estate.
b. In contrast, a more narrow interpretation has been applied to personal property. Under IRS regulations, depreciable tangible personal property will be considered exchanged for like-kind property if it is exchanged for property of a “like-class.” A series of more detailed rules distinguish properties which are of a “like-class.”
2. Identification of Replacement Properties. Generally, the maximum number of replacement properties that a taxpayer may identify are: (a) three properties, without regard to their fair market value (“FMV”), or (b) any number of properties as long as their aggregate FMV as of the end of the forty-five (45) day identification period does not exceed 200% of the aggregate FMV of all relinquished properties as of the date the relinquished properties were transferred by the taxpayer.
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