Wednesday May 8, 2024
Article of the Month
Section 1031 Exchanges and Charitable Giving, Part One
Many professional advisors have clients who are real estate investors. Over the years, these investors have purchased and sold properties under Sec. 1031 to defer recognition of capital gains. Over time, the burden of property maintenance and management may no longer be desirable. Selling the property, paying taxes and investing the money elsewhere may work for some individuals. Other clients, however, are looking for a way out of the property that fulfills their charitable goals without incurring significant tax burdens.
This article will provide an explanation of Sec. 1031 exchanges and discuss a few simple charitable giving methods to dispose of these holdings. Part Two of this series will discuss the benefits of more complex charitable giving models. The information will help advisors and donors understand how these properties can be used to fulfill their charitable goals.
When a property is sold, the seller will typically pay capital gains tax on the property. This is a tax on the difference between the cost basis and the sales price of the property. If a seller replaces one investment property for another, capital gains tax can be deferred under Sec. 1031.
To qualify as a Sec. 1031 exchange, the seller must meet the following requirements: (1) the seller must purchase another "like-kind" investment property, (2) the replacement property must be of equal or greater value, (3) all of the proceeds from the sale must be invested (it is permissible to receive cash at the conclusion of a transaction but it will be taxable), (4) the named title holder and taxpayer must be the same for both transactions, (5) the seller must identify the replacement property within 45 days of the transfer and (6) the seller must purchase the replacement property within 180 days of the transfer. IRC Sec. 1031.
"Like kind" property is property of the same nature or character, even if it differs in grade or quality. One kind or class of property may not be exchanged for property of a different kind or class. The state of the property, i.e., whether it is improved or unimproved will not matter as that component relates to the grade or quality of the property, not the nature of it. Reg. 1.1031(a)-1(b).
Prior to 2018, Sec. 1031 exchanges could be used for both real and personal property. For example, a business vehicle could have been exchanged for a replacement business vehicle and no taxes would have been paid on the Sec. 1031 exchange. In 2018, the Tax Cuts and Jobs Act (TCJA) permanently eliminated Sec. 1031 exchanges for personal property. Reg.1.1031(a)-1(a)(3). Thus, taxpayers can no longer do a Sec. 1031 exchange with vehicles, equipment, machinery, artwork, collectibles, patents or other intellectual property. However, certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible for non-recognition of gain or loss as like-kind exchanges.
Real property, as defined in Sec. 1031, includes land and improvements to land, unsevered natural products of land and water and air space superjacent to land. Reg. 1.1031(a)-3(a)(1). Intangible interests in such property, such as options to purchase, easements and leases, as well as interests defined as real property under state law are also included. Reg 1.1031(a)-3(a)(5), (6). Under applicable state law, the IRS has determined that interests such as perpetual water rights can qualify for Sec. 1031 treatment. Rev. Rul. 55-749.
To qualify for Sec. 1031 benefits, both properties must be held by the investor for use in a trade or business or for investment purposes. Thus, property used for personal reasons after the like-kind exchange, such as a primary residence or a vacation home, will not qualify. To be deemed an investment property, there must be an intention by the taxpayer to earn a return on the investment in the form of rent, dividends, interest or royalties. Investment intent is a facts and circumstances inquiry. See Reesink v. Commissioner, T.C. Memo 2012-118 (Apr. 23, 2012).
Advisors should act with caution when helping clients. In some situations, even dispositions of property that meet Sec. 1031 requirements will still be reported as ordinary gain. Such was the result in Gladys L. Gerhardt et al. v. Commissioner, 160 T.C. No. 9 (April 20, 2023), where taxpayers exchanged Sec. 1245 farm rental property comprised of pens, sheds, silos and equipment as well as raw land for new property. The taxpayers, having previously treated the property as Sec. 1245 property, tried to claim that the buildings on the site were incidental to the property and that the exchange was covered by Sec. 1031. The Tax Court determined, however, that while the transaction met the requirements of Sec. 1031, the property was depreciated under Sec. 1245. Thus, Sec. 1031 did not trump Sec. 1245 treatment and the disposition of the property required recognition of ordinary gain. The scope of this article does not include discussion of charitable giving for Sec. 1245 property.
Unrelated Parties
Another requirement of Sec. 1031 is that the property must be "held" for productive use. To meet that requirement, the taxpayer must have an "intent to hold" the Sec. 1031 property for investment purposes. There is no bright line test on what constitutes an intent to hold. Instead, it is based on the facts and circumstances of each exchange. One important factor, however, is the length of time that a taxpayer holds the replacement property. If the parties are unrelated, then there is no required length for the holding period. However, if the Sec. 1031 replacement property is exchanged immediately after it is acquired, it may be viewed as not being held for investment purposes. Rev. Rulings 84-121, 77-337, 57-244 and 75-292.
To best defend against an IRS challenge, many advisors suggest holding the replacement Sec. 1031 property for at least one year and treating the replacement property as investment property on the taxpayer's tax return for that time period. The one-year suggestion is not an absolute rule but merely a guideline to prevent a "step transaction" designation by the IRS. The shorter the holding period, the higher the risk grows that the taxpayer will not meet Sec. 1031's productive use requirement.
When a Sec. 1031 exchange involves related parties, the tax code imposes a two-year holding period. Sec. 1031(f). A related party includes a family member, such as a sibling, spouse, ancestor, or lineal descendant, or one who is defined as related under IRC Section 707(b) or 267(b). For example, an individual is considered related to an entity for tax purposes if they own more than 50% of that entity. An estate's executor is also deemed related to the estate's beneficiaries under this definition. Rev. Rul. 2002-83.
The purpose of the two-year rule is to avoid basis "shifting" between related parties. If either the taxpayer or the related party disposes of the replacement property within two years, then the taxpayer's exchange with the related party becomes taxable. There are three exceptions to this rule in the following situations: 1) dispositions related to the death of a party, 2) a compulsory or involuntary conversion or 3) upon proof that the early disposition was not for avoidance of income tax. Sec. 1031(f)(2)(A), (B), (C). None of the exceptions apply to gifts to family or to charitable trusts.
Substantiation
Charitable gifts of real estate are subject to the IRS rules on gift substantiation for noncash assets. For gifts of noncash property valued in excess of $250, the donor is required to provide substantiation, including a contemporaneous written acknowledgement, which must be obtained from the nonprofit if the donor claims a charitable deduction. If the donated property exceeds $5,000 in value, Form 8283 must be filed with the tax return on which the deduction is taken and the donor must obtain a qualified appraisal prepared by a qualified appraiser. The qualified appraisal may be acquired as early as 60 days prior to the date of the charitable contribution and no later than the date on which the donor's tax return is due, including extensions.
Basis
Gain is deferred, but not erased or forgiven in a like-kind exchange. The taxpayer must calculate and keep track of his or her basis in the replacement property. Generally, the replacement property purchased will retain a carryover basis from the original property but will be adjusted. Typically, the basis will be equal to the carryover basis, plus the cost of that property minus any gain deferred in the exchange. When the replacement property is ultimately sold, the original deferred gain plus any additional gain since the purchase of the replacement property is taxable.
When Sec. 1031 assets such as real property are held as long-term capital assets, they may be a good fit for a variety of charitable gift types. The appropriate gift type will depend on the value of the asset that the donor wishes to transfer and the donor's philanthropic goals. Another important consideration is the organization's ability and willingness to manage the asset. A nonprofit organization looking to accept gifts of real estate must perform its due diligence to determine whether it can handle the risks involved. The nonprofit should have a thorough gift acceptance policy that covers all types of gifts involving real estate.
Since the value of the donated Sec. 1031 property will likely be over $5,000 in value, the donor will need a qualified appraisal to substantiate the charitable income tax deduction. Because this is an appreciated asset, the donor can use the charitable deduction to offset up to 30% of their adjusted gross income and carry forward the excess deduction for an additional five years. In some cases, if the donor is considered a "dealer" of real estate, the property is considered an ordinary income asset. In this case, the donor's deduction will be limited to cost basis. If structured correctly, many charitable gifts offer the ability to bypass gain, even with Sec. 1031 replacement property. Best practices include ensuring the Sec. 1031 property has been held as an investment for over one year, the property is debt-free and the donor is not considered a dealer of real estate.
Outright Donation
The simplest and most straightforward donation of real property to a nonprofit is an outright gift. The donor transfers the asset to a nonprofit and receives a charitable income tax deduction. The amount of the deduction will depend on whether the asset is a capital asset or an ordinary income asset. If it is a capital asset that has been held for longer than one year, the donor will be entitled to a full fair market value deduction. If the asset is treated as an ordinary income asset in the hands of the donor or has been held for less than one year, the donor's deduction will be based on the donor's cost basis in the asset.
Donor Advised Fund
Another relatively simple donation option is a donor advised fund (DAF). Oftentimes, a donor wishes to dispose of property and receive a charitable deduction now but is unsure which charitable organization to benefit. In these cases, the donor may choose to donate Sec. 1031 property to a DAF to meet his or her goals. The DAF will also manage the property which saves the donor time and resources. The donor will bypass capital gains and can make charitable recommendations through the DAF.
Using An LLC to Donate Sec. 1031 Property
Many nonprofits prefer to accept Sec. 1031 property that is donated through an entity, such as an LLC. The donor sets up a DAF and transfers ownership in the LLC to the nonprofit or a DAF. The donor receives a tax deduction based on the fair market value. The property is then sold, and the nonprofit terminates the LLC. The donor's counsel should review the steps to ensure the LLC is closed and that the holding period for the LLC is met for a fair market value deduction.
The prevalence of Sec. 1031 exchanges has led to innumerable questions regarding tax consequences, especially for donors ready to exit their Sec. 1031 properties. It is important for taxpayers who are interested in disposing of these properties to understand the tax implications. While there are many rules to follow when it comes to Sec. 1031 exchanges, a donation of Sec. 1031 property offers donors a great opportunity to fulfill philanthropic goals and take advantage of important tax benefits.
This article will provide an explanation of Sec. 1031 exchanges and discuss a few simple charitable giving methods to dispose of these holdings. Part Two of this series will discuss the benefits of more complex charitable giving models. The information will help advisors and donors understand how these properties can be used to fulfill their charitable goals.
General Requirements
When a property is sold, the seller will typically pay capital gains tax on the property. This is a tax on the difference between the cost basis and the sales price of the property. If a seller replaces one investment property for another, capital gains tax can be deferred under Sec. 1031.
To qualify as a Sec. 1031 exchange, the seller must meet the following requirements: (1) the seller must purchase another "like-kind" investment property, (2) the replacement property must be of equal or greater value, (3) all of the proceeds from the sale must be invested (it is permissible to receive cash at the conclusion of a transaction but it will be taxable), (4) the named title holder and taxpayer must be the same for both transactions, (5) the seller must identify the replacement property within 45 days of the transfer and (6) the seller must purchase the replacement property within 180 days of the transfer. IRC Sec. 1031.
What is "Like Kind" Property?
"Like kind" property is property of the same nature or character, even if it differs in grade or quality. One kind or class of property may not be exchanged for property of a different kind or class. The state of the property, i.e., whether it is improved or unimproved will not matter as that component relates to the grade or quality of the property, not the nature of it. Reg. 1.1031(a)-1(b).
Prior to 2018, Sec. 1031 exchanges could be used for both real and personal property. For example, a business vehicle could have been exchanged for a replacement business vehicle and no taxes would have been paid on the Sec. 1031 exchange. In 2018, the Tax Cuts and Jobs Act (TCJA) permanently eliminated Sec. 1031 exchanges for personal property. Reg.1.1031(a)-1(a)(3). Thus, taxpayers can no longer do a Sec. 1031 exchange with vehicles, equipment, machinery, artwork, collectibles, patents or other intellectual property. However, certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible for non-recognition of gain or loss as like-kind exchanges.
Real property, as defined in Sec. 1031, includes land and improvements to land, unsevered natural products of land and water and air space superjacent to land. Reg. 1.1031(a)-3(a)(1). Intangible interests in such property, such as options to purchase, easements and leases, as well as interests defined as real property under state law are also included. Reg 1.1031(a)-3(a)(5), (6). Under applicable state law, the IRS has determined that interests such as perpetual water rights can qualify for Sec. 1031 treatment. Rev. Rul. 55-749.
What is Investment Property?
To qualify for Sec. 1031 benefits, both properties must be held by the investor for use in a trade or business or for investment purposes. Thus, property used for personal reasons after the like-kind exchange, such as a primary residence or a vacation home, will not qualify. To be deemed an investment property, there must be an intention by the taxpayer to earn a return on the investment in the form of rent, dividends, interest or royalties. Investment intent is a facts and circumstances inquiry. See Reesink v. Commissioner, T.C. Memo 2012-118 (Apr. 23, 2012).
Advisors should act with caution when helping clients. In some situations, even dispositions of property that meet Sec. 1031 requirements will still be reported as ordinary gain. Such was the result in Gladys L. Gerhardt et al. v. Commissioner, 160 T.C. No. 9 (April 20, 2023), where taxpayers exchanged Sec. 1245 farm rental property comprised of pens, sheds, silos and equipment as well as raw land for new property. The taxpayers, having previously treated the property as Sec. 1245 property, tried to claim that the buildings on the site were incidental to the property and that the exchange was covered by Sec. 1031. The Tax Court determined, however, that while the transaction met the requirements of Sec. 1031, the property was depreciated under Sec. 1245. Thus, Sec. 1031 did not trump Sec. 1245 treatment and the disposition of the property required recognition of ordinary gain. The scope of this article does not include discussion of charitable giving for Sec. 1245 property.
Holding Period
Unrelated Parties
Another requirement of Sec. 1031 is that the property must be "held" for productive use. To meet that requirement, the taxpayer must have an "intent to hold" the Sec. 1031 property for investment purposes. There is no bright line test on what constitutes an intent to hold. Instead, it is based on the facts and circumstances of each exchange. One important factor, however, is the length of time that a taxpayer holds the replacement property. If the parties are unrelated, then there is no required length for the holding period. However, if the Sec. 1031 replacement property is exchanged immediately after it is acquired, it may be viewed as not being held for investment purposes. Rev. Rulings 84-121, 77-337, 57-244 and 75-292.
To best defend against an IRS challenge, many advisors suggest holding the replacement Sec. 1031 property for at least one year and treating the replacement property as investment property on the taxpayer's tax return for that time period. The one-year suggestion is not an absolute rule but merely a guideline to prevent a "step transaction" designation by the IRS. The shorter the holding period, the higher the risk grows that the taxpayer will not meet Sec. 1031's productive use requirement.
Example 1Related Parties
Peggy, age 75, currently owns a building worth $2 million that she acquired nine months ago through a Sec. 1031 exchange. Because she has been trading up over the years, her basis in the property is quite low. Peggy has owned the building for nine months and treated the building as investment property, including on her latest income tax return. She recently learned of the benefits of a Charitable Remainder Unitrust (CRUT) from a local charity she supports and wonders if she can transfer the property now to avoid capital gains on the sale. While it is July and Peggy does not meet the suggested one-year holding period, there is no evidence of an "intent to sell" at the time of the acquisition of the replacement Sec. 1031 property nine months prior. Based upon this information and the advice of her attorney, Peggy decides to wait until November to transfer the property to a CRUT and use the lifetime income payments to travel.
When a Sec. 1031 exchange involves related parties, the tax code imposes a two-year holding period. Sec. 1031(f). A related party includes a family member, such as a sibling, spouse, ancestor, or lineal descendant, or one who is defined as related under IRC Section 707(b) or 267(b). For example, an individual is considered related to an entity for tax purposes if they own more than 50% of that entity. An estate's executor is also deemed related to the estate's beneficiaries under this definition. Rev. Rul. 2002-83.
The purpose of the two-year rule is to avoid basis "shifting" between related parties. If either the taxpayer or the related party disposes of the replacement property within two years, then the taxpayer's exchange with the related party becomes taxable. There are three exceptions to this rule in the following situations: 1) dispositions related to the death of a party, 2) a compulsory or involuntary conversion or 3) upon proof that the early disposition was not for avoidance of income tax. Sec. 1031(f)(2)(A), (B), (C). None of the exceptions apply to gifts to family or to charitable trusts.
Example 2
Rich, age 81, owns a commercial building that leases office space. He acquired the building 15 months ago for $1 million from his son through a Sec.1031 exchange. The building is in an up-and-coming area. Rich has made some improvements to the property and found long-term tenants. Even though he has not listed the property for sale, a potential buyer approached him with a $2 million offer. Although he had not planned to sell, this offer is too good for Rich to pass up. Because he received the property from his son, Sec. 1031 imposes a two-year holding period. Thus, he is nine months short of the two-year holding requirement for related parties. Any disposition – by either sale or gift – before the two-year period would trigger Rich's deferred gain. None of the exceptions to the two-year holding period apply to Rich's situation. Because he does not want to trigger capital gains taxes, Rich decides to pass on the offer and keep his commercial building.
Charitable Donation Basics for Sec. 1031 Property
Substantiation
Charitable gifts of real estate are subject to the IRS rules on gift substantiation for noncash assets. For gifts of noncash property valued in excess of $250, the donor is required to provide substantiation, including a contemporaneous written acknowledgement, which must be obtained from the nonprofit if the donor claims a charitable deduction. If the donated property exceeds $5,000 in value, Form 8283 must be filed with the tax return on which the deduction is taken and the donor must obtain a qualified appraisal prepared by a qualified appraiser. The qualified appraisal may be acquired as early as 60 days prior to the date of the charitable contribution and no later than the date on which the donor's tax return is due, including extensions.
Basis
Gain is deferred, but not erased or forgiven in a like-kind exchange. The taxpayer must calculate and keep track of his or her basis in the replacement property. Generally, the replacement property purchased will retain a carryover basis from the original property but will be adjusted. Typically, the basis will be equal to the carryover basis, plus the cost of that property minus any gain deferred in the exchange. When the replacement property is ultimately sold, the original deferred gain plus any additional gain since the purchase of the replacement property is taxable.
Example 3
Betsy purchased a rental duplex six years ago for $198,000 plus $2,000 in closing costs. She has depreciated $6,000 per year on the property. Her depreciated cost basis is now $164,000 ($200,000 - $36,000). This year, she decided to sell the duplex for $264,000 and purchase a larger complex down the road for $400,000 with cash she received from a recent inheritance. The difference in basis in the replacement property and her realized amount in the sale ($400,000 - $264,000) is $136,000; this amount is added to the depreciated basis of the original property ($136,000 + $164,000) for a total of $300,000. Thus, Betsy's new basis is $300,000 and she has deferred taxes on the capital gain from the sale of the duplex.
Potential Charitable Giving Vehicles
When Sec. 1031 assets such as real property are held as long-term capital assets, they may be a good fit for a variety of charitable gift types. The appropriate gift type will depend on the value of the asset that the donor wishes to transfer and the donor's philanthropic goals. Another important consideration is the organization's ability and willingness to manage the asset. A nonprofit organization looking to accept gifts of real estate must perform its due diligence to determine whether it can handle the risks involved. The nonprofit should have a thorough gift acceptance policy that covers all types of gifts involving real estate.
Since the value of the donated Sec. 1031 property will likely be over $5,000 in value, the donor will need a qualified appraisal to substantiate the charitable income tax deduction. Because this is an appreciated asset, the donor can use the charitable deduction to offset up to 30% of their adjusted gross income and carry forward the excess deduction for an additional five years. In some cases, if the donor is considered a "dealer" of real estate, the property is considered an ordinary income asset. In this case, the donor's deduction will be limited to cost basis. If structured correctly, many charitable gifts offer the ability to bypass gain, even with Sec. 1031 replacement property. Best practices include ensuring the Sec. 1031 property has been held as an investment for over one year, the property is debt-free and the donor is not considered a dealer of real estate.
Outright Donation
The simplest and most straightforward donation of real property to a nonprofit is an outright gift. The donor transfers the asset to a nonprofit and receives a charitable income tax deduction. The amount of the deduction will depend on whether the asset is a capital asset or an ordinary income asset. If it is a capital asset that has been held for longer than one year, the donor will be entitled to a full fair market value deduction. If the asset is treated as an ordinary income asset in the hands of the donor or has been held for less than one year, the donor's deduction will be based on the donor's cost basis in the asset.
Donor Advised Fund
Another relatively simple donation option is a donor advised fund (DAF). Oftentimes, a donor wishes to dispose of property and receive a charitable deduction now but is unsure which charitable organization to benefit. In these cases, the donor may choose to donate Sec. 1031 property to a DAF to meet his or her goals. The DAF will also manage the property which saves the donor time and resources. The donor will bypass capital gains and can make charitable recommendations through the DAF.
Using An LLC to Donate Sec. 1031 Property
Many nonprofits prefer to accept Sec. 1031 property that is donated through an entity, such as an LLC. The donor sets up a DAF and transfers ownership in the LLC to the nonprofit or a DAF. The donor receives a tax deduction based on the fair market value. The property is then sold, and the nonprofit terminates the LLC. The donor's counsel should review the steps to ensure the LLC is closed and that the holding period for the LLC is met for a fair market value deduction.
Example 4
Ashley is nearing retirement and no longer wants to manage the 12-unit apartment building she purchased through a Sec. 1031 exchange 15 years ago. The building is owned by her single member LLC, Ashley's Apartments, LLC as the sole asset. Her adjusted cost basis is $350,000 and the current value is estimated at $920,000. She has supported many local charities over the years and would like to continue her philanthropic work after she retires. Because real estate values have skyrocketed in her area, selling the property outright will produce a capital gains tax of $135,660 ($570,000 x 23.8%). Ashley decides to donate the property to a DAF. She will get a tax deduction this year for her contribution and may start to recommend charitable distributions.
Conclusion
The prevalence of Sec. 1031 exchanges has led to innumerable questions regarding tax consequences, especially for donors ready to exit their Sec. 1031 properties. It is important for taxpayers who are interested in disposing of these properties to understand the tax implications. While there are many rules to follow when it comes to Sec. 1031 exchanges, a donation of Sec. 1031 property offers donors a great opportunity to fulfill philanthropic goals and take advantage of important tax benefits.
Published August 1, 2023
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