20A — March 19 - April 15, 2021 — 1031 Exchange — M id A tlantic Real Estate Journal
1031 E xchange
s that your final an- swer?” You may rec- ognize the question By Dwight Kay and Betty Friant, Kay Properties Understanding the potential advantages of the 200% Rule in a 1031 exchange “I How does the 200% Rule work?
rules. If the combined price of the identified replacement properties exceeds the 200% maximum limit – even by a fraction of a percent – it won’t be accepted. Hypothetical Example: Expanding your options A married couple sold their manufacturing business that included the sale of the prop- erty that housed the busi- ness, giving the couple $2 million to invest in a 1031 Exchange. The couple plans to retire and both agree that they don’t want a replace- ment property or properties that will require hands-on management. The husband wants to buy a Triple Net Leased (NNN) fast food res- taurant for $1.2 million, while the wife is in favor of a $1.5 million NNN dollar store. Both properties are listed on the 45-Day Form, bringing the total to $2.7 million. They decide to use the 200% Rule, which allows for up to $1.3 million in ad- ditional property listings. The couple agrees to split the remaining $1.3 million across multiple DST invest- ments, and they choose to identify: • $100,000 in a multifam - ily apartment DST property to limit exchanges to only real property, there was concern that the inclusion of some per- sonal property would taint the exchange of real property and make it ineligible for like-kind exchange treatment. To address this concern, the final regulations provide an incidental property rule that allows a certain amount of incidental personal property to be received without invali- dating the like-kind exchange. According to the Final Regula - tions, the personal property will be considered incidental to real property acquired if the personal property is typically transferred together with the real property and the aggre- gate fair market value of the personal property does not ex- ceed 15% of the aggregate fair
located in Denver • $200,000 in a multifamily apartment DST property lo- cated in Dallas • $250,000 in a debt free DST portfolio of NNN leased pharmacies and e-commerce distribution facilities • $250,000 in a NNN dialy - sis facility DST portfolio with locations nationwide • $500,000 in a DST portfolio of NNN dollar stores Overall, the 200% Rule allows the couple to identify these seven possible options within their 45-Day period. The DSTs are all packaged and ready to go with closings that can easily close within a week. The couple uses the re- maining time to conduct more research and due diligence on the NNN Dollar General and KFC. In the end, they decide to buy the KFC for $1.2 million, but they like the diversity of being about to buy a $500,000 DST interest in a portfolio of dollar stores versus a single location. The remaining $300,000 is spent in the two apartment DSTs. In this case, the ability to leverage the 200% rule was advantageous in giving the couple more options and more time to make a final market value of the replace- ment property or properties. While the receipt of inci- dental personal property will not invalidate the like-kind exchange, it is important to note that the personal property may result in some tax on the transaction. The preamble to the Final Regulations confirms that any incidental personal property received would still be considered taxable “boot” received in the exchange under the provisions of Sec. 1031. The Final Regulations pro - vide some much-needed cer- tainty for taxpayers seeking to complete Sec. 1031 exchanges after TCJA. Brian T Lovett, CPA, CGMA, JD is a tax partner based in Withum’s East Brunswick office. MAREJ continued on page 26A
Exchangers can identify any number of properties as long as the gross price does not exceed 200% of the fair market value of the re- linquished property (twice the sale price). It is typi- cally used when an investor wants to identify four or more properties. This is the most commonly used rule for investors considering DST investments, because of the flexibility in being able to list multiple properties to build a diversified DST portfolio. The minimum investment amount for DSTs typically starts at $100,000 whereas most commercial real estate properties are priced above $1 million. So, for an inves- tor who has $1 million to reinvest, they could opt to put all of that $1 million into one DST (which is typically not recommended even when the DST has many properties inside of it), or they can divide that $1 million into as many as 10 completely separate DSTs. An important mistake to avoid is to make sure the list of identified properties does not exceed the 200% limit. The IRS is a stickler for the Regulations (including land, improvements to land and inherently permanent structures), if the property is considered real property under state or local law, or if it is considered real property based on all the facts and cir- cumstances as outlined in the Regulations. The Regulations include numerous examples that help to lend some clarity to the IRS position on the issue of real property. Another issue raised by the change in the TCJA is the idea of like-kind exchanges involv- ing some amount of non-like kind personal property. In exchanges of real property, there is occasionally some per- sonal property that comes along with the real property. In light of the change in TCJA
made famous by the popular TV game show Who Wants to Be a Millionaire? Choosing the right answer in this game gives you a shot at winning big money, while the wrong answer leaves you with nothing. Investors conducting a 1031 Exchange face a similar make or break decision when it comes to iden- tifying suitable replacement properties. The right choices can help streamline a smooth and suc- cessful execution of a 1031 Exchange. Choosing wrong with properties that may not be viable or deals that are unable to close within the 180-day time period can derail the entire 1031 Exchange. The good news is that investors do get to identify more than one replacement property. How- ever, just like the gameshow, once that 45-day deadline hits for identifying replacement options, those answers are final. Making the most of that short list is one reason that the 200% Rule is a popular choice for many investors. The 200% Rule allows an investor to identify the largest number of replacement options with four or more properties or Delaware
Statutory Trust (DST) replace- ment investments. Under Section 1031 of the Internal Revenue Code, tax- payers who are seeking to defer recognition of capital gains and related federal income tax liability from the sale of a property are required to formally identify a replacement property or properties within 45-days from the date that the origi- nal property is relinquished (the day they closed the es- crow on the property they sold). The tax code gives tax- payers three different options for identifying replacement properties on that 45-Day Property Identification Form – the 200% Rule, the 3-Prop- erty Rule or the 95% Rule. So, which is the best option to use? Every situation is different. However, for those investors who want to maxi- mize their potential options and identify four or more replacement properties, the 200% Rule is a good choice to explore. In Proposed Regulations issued in June 2020, the IRS attempted to provide a defini - tion of real property for Sec. 1031 purposes and outlined a purpose or use test that looked to the function of the property in question in determining whether the property was real property eligible for Sec. 1031. In response to the Proposed Regulations, the IRS received a number of comments con- tending that the purpose or use test would improperly narrow the scope of definition of real property and may treat prop- erty that has long been con- sidered “real property” as not eligible for like-kind exchange. In Final Regulations is - sued recently, property will be considered real property if it is specifically listed in
By Brian T. Lovett, CPA, CGMA, JD, Withum IRS releases final regulations on Sec. 1031 Like-Kind Exchanges
he Tax Cuts and Jobs Act of 2017 (“TCJA”) ma d e s i g n i f i c a n t
c h a n g e s to types of property that qualifies for l i k e - k i n d e x c h a n g e t r e a tmen t . Specifically, a f t e r t h e TCJA, only
Brian T. Lovett
real property qualified for tax deferred exchange under Sec. 1031. This substantially reduced the number of trans- actions Sec. 1031 could apply to, but also led to a number of questions about what would qualify as “real property” eligi- ble for Sec. 1031 deferral in the eyes of the IRS, as that term is not defined in Sec. 1031.
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