Tax Strategy

Exchange Strategies

1. The Non-Tax Motives to an Exchange.
   1. Trading Up. An investor can improve the quality of the investment he or she owns.
   2. Change the type of investments, such as management intensive property to less management intensive property or to change the relative risk in certain types of investment.
   3. To improve the rate of return on investments, from non-income producing to income producing or from low appreciation potential to high appreciation potential.
   4. To provide geographic or economic diversity of investments.
   5. To restructure liabilities.
   6. Reducing federal and state income taxes provides additional capital to invest in additional properties and financial independence.
   7. To plan for Retirement and/or Estate Planning.

2. Retirement Planning. The main reason I see individuals purchasing investment real estate, repairing and improving their investments and carefully managing them is to provide for future retirement and college cash needs. A primary motivation is to purchase the property with debt and to allow the rental income to pay off the debt over the negotiated term. At that point in time the equity of the investment is either used to purchase additional investment real estate or fund college or retirement needs.

   An investment in real estate can be likened to an investment in an Individual Retirement Account. There are many similarities and some striking differences that make investment in real estate even more attractive where all sales are conducted within the context of tax deferral provisions of Section 1031.

   Individual Retirement Accounts

   1. Generally, all of the investment earnings and gains from the sale of investments inside an IRA account are tax deferred during the accumulation phase.
   2. IRA accounts, as is the case for all retirement accounts, are limited by the amount that may be added to the account each year.
   3. Expenses associated with the IRA account are generally not deductible or their deduction is limited.
   4. Upon reaching the age of distribution, the IRA account owner must begin to liquidate the IRA account and receive into income the computed annual distributable amount as ordinary income.
   5. The Account balance of the taxpayer at death is currently subject to income taxes based, in part, on the payout method that is required to be made under the laws at the time of the taxpayer’s death. Furthermore, the account balance may also be subject to federal and state estate tax based on the law at the time of the decedent’s death. For many prosperous taxpayers, this cumulative tax can consume in excess of 65% or more of the account balance.

   Investment Real Estate

   1. Generally, the rental income may be offset by business expenses including mortgage interest attributable to debt used to purchase the investment. Furthermore, the taxpayer may further reduce taxable income by a non cash deduction commonly referred to as depreciation. This effectively shields the taxpayer’s income by the amount of the original purchase over the depreciable life of the investment. Gains from the sale of the investment real estate are tax deferred as long as the statutory rules of Section 1031 are met.
   2. An individual investor is not limited by the amount in which he or she may invest in real estate each year.
   3. Expenses associated with the real estate investment are generally deductible and losses generated by the investment are generally deductible for full time investors. The rules regarding passive activity losses are beyond the scope of this web site. If you believe that you may be subject to these rules, please consult your tax advisor.
   4. Real Estate Investors are never required to liquidate their investment and take the proceeds into income.
   5. The value of the investment real estate may be offset by the outstanding liabilities at the date of death. If the value of the taxpayer’s estate may cause it to be subject to taxation, the taxpayer may consider borrowing against the value of the real estate to provide for cash to pay estate taxes. The value of the real estate investment is not subject to income taxes at the date of death. Under current law, the adjusted basis of the property in the hands of the deceased taxpayer is increased up to the fair market value, whether or not the estate is subject to federal estate tax or state estate tax.

   As you can see there are significant advantages to the investment in real estate in providing for financial independence and increasing an investors net worth.

3. Estate Planning.

   1. Death of a Taxpayer Prior to Completion of a Deferred Exchange.
      1. The deferred exchange can be completed and qualify for non-recognition of gain under IRC section 1031. PLR 9829025.
      2. The service has ruled that if the deferred exchange is closed there is no income in respect of a decedent (JIRD) under IRC section 691.
      3. If the exchange were not completed the transaction would be a taxable sale arising from a contract entered while the taxpayer was alive and the gain would be IRD under IRC section 691.
      4. In general, JIRD must be included in the gross income of the recipient; however, the recipient may claim a deduction on any estate or generation skipping taxes paid on the income.
      5. The service also ruled that the replacement property was entitled to a basis step up under IRC section 1014. Note the change in the law for estates created after 12/31/2009 discussed earlier.
   2. Identification of replacement property after death of the taxpayer
      1. In PLR 9829025; the taxpayer held the relinquished property in a revocable trust. The trustee of the trust would be able to identify the replacement property. The fact that upon the death of the taxpayer the trust became irrevocable was not an issue discussed in the letter ruling.
      2. If property is not held in trust, the executor would have to identify property.
         1. Appointment of executor.
         2. Authority of executor without probate court approval.
         3. 45-day identification period cannot be extended.
      3. Exchanges by Estates. Property acquired by trust or estate from decedent should be considered held for investment or used in the trade of business if the property met the requirement while held by decedent. Estate of Morris v Comr., 55 TC 636 (1971) and Estate of Gregg v. Comr., 69 TC 468 (1977).
   3. Exchanges of Properties Subject to Special Use Valuation (IRC section 2032A) or Installment Payments (IRC 6166) Under IRC section 2032A. Certain qualified real property held by an estate is subject to special use valuation when included in the estate of a decedent.
      1. The decedent’s heirs are required to continue to hold the qualified real property and continue the qualified use of the property.
      2. A disposition of the qualified real property within 10 years after the death of the decedent will generally trigger an estate tax on the reduced value of the qualified real property.
      3. An exchange of qualified real property for other qualified real property which also meets the requirements of IRC section 1031 will avoid estate tax recapture on the estate tax avoided by the special use valuation. IRS section 2032A(i).
      4. Property acquired must be qualified exchange real property and the property must be used for same qualified use under IRC section 2032A as the original property
      5. Exchange must qualify under IRC section 1031 as a tax-deferred like-kind exchange.
      6. Under IRC section 6166, an estate may elect to defer estate taxes for up to fourteen years for closely held businesses.
      7. Sale or disposition of closely held business will generally accelerate deferred estate tax.
      8. IRS has rules that where interest in qualified business is exchanged in transaction qualifying under IRC section 1031 for other property and replacement property is mere change in form estate tax may not be accelerated. PLR 91169009.
      9. Not all exchanges qualifying under IRC section 1031 will avoid acceleration of estate taxes.
      10. IRC section 6166 requires that transactions are a mere change in form or do not materially alter the business or interest of the business in the interest of the estate in the business.
   4. Use of Exchanges to Implement Estate Plans. Transfers to certain grantor trusts should not adversely impact exchanges. Replacement property may be transferred to certain types of grantor trusts immediately after acquisition without tainting the qualified use requirement.
      1. Not all grantor trusts (technical grantor trusts where income beneficiary is other than grantor) may be eligible. If grantor is beneficiary of revocable trust, subsequent transfer may be ignored. Subsequent transfer to grantor trust after related party exchange may not be disposition under IRC section 1031(1) PLR 9116009.
      2. Gifts of Property and Exchanges. Replacement property acquired for the purpose of making a gift to a family member may not meet the qualified use requirement IRC section 103 1. Click v. Comr., 78 TC 255 (1982). Where the taxpayer continues to use property in a trade or business and subsequently gifts property to children, property may qualify even if estate planning was significant factor in selection of replacement property. Wagensen v. Comr., 74 TC 653 (1980). A donee who acquires property by gift would have to establish that property was held for investment or productive use in a trade or business by the donee prior to engaging an exchange.
   5. Exchanges and Family Partnerships. Family partnerships are common estate planning vehicles. Typically, older family members will claim a discount on property transferred to a family partnership when making gifts of partnership interests. Issues in formation of a Family Partnership may include realty transfer taxes, increased real property taxes and income tax planning. Occasionally the taxpayer would like to contribute property to a family partnership which the taxpayer intends to exchange. If the property is exchanged prior to the contribution, an issue will arise whether the replacement property meets the qualified use requirement. If the property is contributed and then exchanged, family partnership may not hold property for a qualified use.
   6. Other Techniques for “Disappearing Value”. Trade or give to older generation an asset that is worth more to inheriting party than to market. This is treated much like a family partnership and should not be a current gift (Not covered by “anti-freeze” rules). Care must be taken so that tenants-in-common interest is not recast as a de facto partnership.
      1. Example I - Father and daughter each exchange separately owned relinquished property for tenants-in-common interest in a single replacement property. Upon father’s death, estate values property taking a lack-of-marketability and minority discount.
      2. Example 2 - Mother transfers relinquished property in a deferred exchange. Sons acquire fee interest in potential replacement property. In “build-to-suit” exchange, Mother (through QI) simultaneously acquires long-term leasehold interest and QI constructs leasehold improvements as replacement property. The leasehold interest is in effect a “wasting asset” so that value will decrease over time. At lease termination sons (as fee owners) will acquire leasehold improvements without recognition of taxable income. See IRC section 109. The “Anti-freeze” rules should not apply.
   7. Under section 101 4(a)( I), the basis of property acquired from the decedent is the fair market value of such property on the date of the decedent’s death. However, Section 10 14(e) provides that in the case of a decedent dying after 1981, the basis of appreciated property acquired by the decedent by gift during the one year period ending on the date of the decedent’s death, which was acquired by the donor, or the spouse of such donor, from the decedent or passes from the decedent to such donor or his spouse, has a basis equal to the adjusted basis of such property in the hands of the decedent immediately before his death. Note that the planned repeal the estate tax after 2009, the section 1014 step up in adjusted basis will apply to property acquired from the decedent dying before the year 2010. For property acquired from the decedent dying after 2009, section 1022 provides the modified carry over basis scheme.