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The Smart Lawyer’s Guide to Finance
1031 Swaps: What you need to know
By Mike Hogan
June 2007

Imagine you bought an avocado “ranch,” say, about ten years ago as the sole investor for $80,000. Over the years, on late nights as you slogged away on briefs or SEC filings, you took a brief respite to picture yourself retired in a hammock with nothing else to worry about than soil-clay density. But recently the value of the ranch land shot up past $400,000. All that equity’s got you thinking about cashing in to pursue dreams of a tropical paradise.

Those dreams will fade once you pick up a calculator and punch in the tax bite. Here’s an example: 15% federal capital gains, 9.25% (California) tax on capital gains, 3.3% state withholding until next April 15, recapture of depreciation on the trees and infrastructure. It won’t take long to approach your $80,000 investment

Sure you’re still left with a couple hundred thousand in profit. But spread over a decade of property taxes, water bills and paying an avocado wrangler, it’s not an impressive return on an $80,000, investment. Are you ever going to see that tropical beach or will Uncle Sam keep you down on the avo ranch?

You might start looking for what Internal Revenue Service would consider a “like kind” investment for your proceeds under Section 1031 of the Internal Revenue Code. This is not exercise for the lackadaisical: you must identify a new investment vehicle equal to or greater than your ranch profit within 45 days of the ranch sale and buy it within 180 days. Doing this correctly may avoid what the IRS affectionately refers to as a “taxable event.” The piper won’t come calling until the new investment is sold – or its rollover is sold, or its rollover is sold.

What is a “like kind” investment? As long as the money isn’t converted to personal use, “many other real estate investments would qualify,” says Aubrey Morrow, a certified financial planner with San Diego’s Financial Designs Ltd. There are limitations, however. For example, the 1031 proceeds can’t wind up in a personal residence. But an investment in business such as a rental house or condominium, apartment building, retail center, or a industrial building are okay either as sole owner or with a fractional interest, also known as a tenant in common interest (TIC). The popularity if TICs had increased since the issuance of Revenue procedure 2002-22, March 2002, explained Morrow. Individuals “can elect a fractional interest along with many other owners of a large institutional real property,” he says, “and generally receive higher income, renewed tax reduction, deed and title, all without property management”

Ownership Structure

It’s crucial to look at the ownership structure, explains Radah Butler, president of San Francisco-based Investment Property Exchange Services, Inc., a national Qualified Intermediary. “For example, if you are obtaining a fee interest in real property –even if it’s a fractional interest –then it qualifies. But if you are acquiring an interest in partnership, and the partnership will own the property, then that would not be an investment that qualifies under the code,” Butler says.

Generally, the manner in which title to the property is held also must remain the same: if the asset sold was owned by an individual or a partnership or a corporation, the new property has to be held in the same manner. And while the exchange is in process, sale proceeds have to be held by a Qualified Intermediary (QI), someone unrelated to the seller, and who is not considered the seller’s agent, says Butler. Her firm provides QI services nationwide and is a member of the Federation of Exchange Accommodators.

Most other stipulations in the code relate to minority transactions, adds Brian Tormey, vice president of 1031Vest, LLC ( www.1031vest.com ), a New York based provider of nationwide QI services. Anything from baseball cards to airplanes could be exchanged, but real estate is usually the asset involved. And 1031 exchanges are very structured transactions, in which the paperwork has to be filed in multiple steps.

“Its’ like jumping through fiery rings,” says Tormey. “If you land on your feet, you feel great. But nick one of those rings, and your exchange could be disqualified.”

It’s the QI’s job to make sure no rings get nicked for a relatively low price. Typically that includes a set-up fee around $750 and a share of the interest on banked proceeds. Kate Gallivan, Senior Product Manager for J.P. Morgan Property Exchange Inc. explains that ultimately charges are negotiable and depend upon the size of the exchange, how long it takes and the complexity of the exchange. “It can make sense for fleets of vehicles, corporate aircraft, even rail cars,” says Gallivan, “as long as the asset holds its value.” (In addition to real estate, J.P. Morgan Property Exchange Inc. is involved in the use of 1031s to exchange corporate assets.)

Broaden Horizons

Another popular 1031 method is the Tenants-in-Common exchange. Under guidelines issued by the IRS in 2002, sole ownership in investment property can be exchanged for a fractional share of larger, more leveraged investment held in common with many other investors.

“A TIC can widen horizons of the investor who wants to trade out of property, but doesn’t want to go into another local rental with all the management headaches,” says Butler.

The TIC investment had outside property management. TICs are generally large institutional properties; they are considered securities and are available through licensed representatives. To determine whether a property qualifies, explains Morrow, the three-prong legal test of Howey v. Commissioner is applied. There must be: an investment of money in a common enterprise; made with the expectation of a return; and the return must be based on the entrepreneurial efforts of another.

TICs can be found through registered representatives, financial advisors or the Tenants in Common Association ( www.ticassoc.org ). A TIC is best used to exchange fully depreciated income property that no longer generates significant tax benefits or growth in return, says Morrow. Swapping it for a fractional interest in a higher-ticket investment provides ongoing tax advantage (besides side-stepping capital gains), and the potential for higher positive cash flow and property appreciation. A TIC is also a way for a relatively small investor to reach beyond local opportunities. A TIC is usually of sufficient complexity that it bears revue by an accountant and a lawyer, advises Butler. State tax laws will vary

Getting back to the ranch-sale dilemma, the federal capital gains obligation not only can be deferred throughout your life, says Morrow, but erased entirely when the property is correctly transferred to heirs under federal tax code’s family limited partnership guidelines. “You swap until you drop, says Morrow, “and when you drop the capital gains tax is forgiven due to the step-up in basis which allows your heirs to sell without any capital gain taxes. However, larger estates must be aware of estate taxes and plan accordingly.”

Sound complex? It can be. “Actually, we always recommend having an attorney-and, probably, an accountant – review every exchange to see how the transaction fits an individual’s situation.” Says Hugh Pollard, vice president and regional exchange manager of First American Exchange Company, LLC. Pollard, an attorney, is president of the Federation of Exchange Accommodators, the national trade association for the QI industry. The FEA, through its Certified Exchange Specialists program, provides accreditation for QIs and a website ( www.1031.org ) full of useful 1031 information.