Happy Holidays From Exeter 1031 Exchange Services, LLC

Tax Planning When A Tax Deferred Exchange Fails at Year-End

What happens when you start a Tax Deferred Exchange transaction, but you are unable to acquire any of the replacement properties that you identified within the prescribed Tax Deferred Exchange deadlines?  The bad news is your Tax Deferred Exchange is now taxable. The good news is your Tax Deferred Exchange may not be immediately taxable.

It is possible to defer all or some of your taxable gain into the following income tax year even with a failed Tax Deferred Exchange transaction.  It will, of course, depend upon the individual facts and circumstances in your specific Tax Deferred Exchange transaction.  It is critical that you consult with your Tax Deferred Exchange Qualified Intermediary and your income tax advisor when your Tax Deferred Exchange transactions appears to be headed for failure.  

Partial Tax Deferred Exchange

For example, if multiple identified replacement properties are part of the same Tax Deferred Exchange but not all of the replacement properties will or can be acquired, it can result in a partial Tax Deferred Exchange.  Partial Tax Deferred Exchanges can mean that you have traded down in value or have exchange proceeds that were not use and are left over from the sale of your relinquished property.  Partial Tax Deferred Exchange transactions can still defer part of your taxable gain in certain circumstances.  

Installment Sale Treatment Under Section 453 

Section Numbers 1031 and 453 of the Internal Revenue Code ("Code") work in conjunction with each other and can provide significant benefits even when a Tax Deferred Exchange fails.  You may be able to defer all or part of your taxable gain from a failed or partial Tax Deferred Exchange into the following tax year rather than the current tax year under Section 453 (Installment Sale Code).  It will depend on whether your Tax Deferred Exchange Agreement includes language prohibiting your right to access your Tax Deferred Exchange funds until the following income tax year.

For example, if you dispose of your relinquished property as part of a Tax Deferred Exchange and the relinquished property sale closes on December 1st of a specific taxable year, the 45th calendar day identification deadline and the 180th calendar day exchange period both land in the following income tax year.

If you did not identify any replacement property(ies) within the 45 calendar day identification period your taxable gain will be recognized in the following tax year because you did not have the legal right to access your Tax Deferred Exchange funds until the 46th calendar day, which would be in the following income tax year.

Likewise, if you did not acquire some or all of your identified replacement property(ies) during the 180 calendar day exchange period your taxable gain would be recognized in the following tax year because you did not have the right to access your Tax Deferred Exchange funds until after the 180th calendar day deadline has passed, which is also in the following income tax year.

You can also elect — at your sole discretion — to recognize and report the taxable gain in the current tax year in which the relinquished property sold instead of deferring it into the next tax year should you chose to do so. 

California FTB To Assess Penalties When a Deferred Sales Trust is Used to Save a Failed 1031 Exchange

The California Franchise Tax Board ("FTB") has ruled that certain types of installment sale transactions that have been "structured" or "drafted" pursuant to Section 453 of the Internal Revenue Code ("Code") and have been promoted and used to "save" failed 1031 Exchange transactions will not qualify for tax-deferred treatment in California when used in this manner.

California FTB is Aware of Certain Installment Arrangements

The FTB is aware of certain arrangements in which a 1031 Exchange investor and/or Qualified Intermediary attempt to convert proceeds from the sale of the investor's relinquished property that is part of a failed 1031 Exchange, or any unused proceeds from a partial 1031 Exchange, into an installment arrangement such as an installment note or other similar arrangement in which payments are to be paid out over two or more years.

It was made clear by the FTB that these arrangements do not qualify for a deferral of gain recognition under Sections 453 or 1031 of the Code since, among other reasons, these sections and the federal doctrine of constructive receipt do not support such a deferral of gain recognition.

These tax-deferred installment sale transaction structures have been promoted under various names over the years, including Private Annuity Trusts, Deferred Sales Trusts, Monetized Installment Sales, Self-Directed Installment Notes, among others.

Qualified Intermediaries Put On Notice

1031 Exchange Qualified Intermediaries must withhold and remit certain amounts to the California FTB when a 1031 Exchange either fully or partially fails.  Qualified Intermediaries were put on notice by the California FTB through the issuance of California FTB Notice 2019-05 dated September 24, 2019.  This notice was issued specifically to let Qualified Intermediaries know that the California FTB will impose failure to withhold penalties against the Qualified Intermediaries who actively participate in these installment sale transactions where boot or proceeds from a failed 1031 Exchange are converted into an installment sale or note or similar arrangement in which payments are to be paid out over two or more years.

Investor and Qualified Intermediary Beware

It is critical that investors have both their legal and tax advisors review any real estate transaction structure before proceeding, especially in cases where there is no guidance from the Internal Revenue Service and/or state taxing authorities.  Interest and penalties can be devastating, so it is important that the investor knows and understands the risks involved with such transaction structures. 

Personal Property 1031 Exchanges Still Allowed by California Franchise Tax Board

Update to Blog Post as of December 26, 2020 

The California Franchise Tax Board has now conformed in late 2019 to the changes affecting Section 1031 of the Internal Revenue Code that were contained in the Tax Cuts and Jobs Acts of 2017.  Personal Property 1031 Exchanges no longer qualify in California. 

The Like Kind Exchange (LKE) is a tax deferred transaction or strategy allowed under Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations ("1031 Exchange").  This means it is a Federal tax code.  However, most state governments conform to (or follow) the Federal tax code, with certain limited exceptions or adjustments made at the state level.  

Pennsylvania Does Not Recognize 1031 Exchanges

Perhaps the most notable exception is the State of Pennsylvania, which does not recognize the 1031 Exchange for state tax purposes. Investors can still sell property and defer the payment of Federal capital gain and depreciation recapture taxes, but would recognize and pay Pennsylvania taxes.  

California Franchise Tax Board 

California is no exception.  The California Franchise Tax Board (FTB) has generally conformed to Section 1031 of the Internal Revenue Code, although they take a much more aggressive position on certain issues during audits than does the Internal Revenue Service. 

Personal Property 1031 Exchanges Still Allowed in California 

However, California did not conform to (or follow) the changes affecting Section 1031 of the Internal Revenue Code that were contained in the Tax Cuts and Jobs Act of 2017.  The Tax Cuts and Jobs Act of 2017 eliminated the ability to structure a 1031 Exchange on the sale of personal property (non-real-estate) at the Federal level.  

Investors can still use the 1031 Exchange to defer the payment of their California taxes on the sale of personal property that is held and used as rental, investment or business use property.  They would, of course, have to pay the Federal capital gain and depreciation recapture taxes, but would at least be able to defer the payment of the California taxes. 

Maryland Nonresident Withholding Tax on Sale of Real Property Adds Complexities to 1031 Exchanges

Investors who sell Maryland real estate that has been held for rental, investment or business use should be aware of the Maryland Nonresident Withholding Tax when they sell their investment real property.  The Maryland Nonresident Withholding Tax can complicate the administration of a tax-deferred exchange transaction under Section 1031 of the Internal Revenue Code ("1031 Exchange"). 

Maryland Does Recognize 1031 Exchanges

The state of Maryland does in fact recognize 1031 Exchanges and does allow the seller of Maryland real estate held for rental, investment or business use to defer the payment of state income taxes under certain circumstances and provided they meet certain requirements. 

Application for Certificate of Full or Partial Exemption 

The seller must submit an Application for Certificate of Full or Partial Exemption (MD Form MW506AE) of the nonresident withholding tax at least twenty-one (21) days before the closing of the sale of their relinquished property.  Payment of the nonresident withholding tax will NOT be required as long as the the nonresident seller provides the Certificate of Full or Partial Exemption issued by the Comptroller's Office to the settlement agent at closing.

Full or Partial Exemption 

The Certificate of Full or Partial Exemption will provide either a full exemption from withholding or will provide a partial amount of nonresident withholding tax that is to be withheld at the closing of the sale of the relinquished property.

1031 Exchange Qualified Intermediaries (Accommodators) Are Not Created Equal

Taxpayers often think 1031 Exchange Qualified Intermediaries are all created the exact same – but Qualified Intermediaries are absolutely not created equal – and the differences can be significant and crucial.  Were you aware that there is absolutely no regulatory body or government agency oversight available for Qualified Intermediaries, and that only about one percent of Qualified Intermediaries are licensed, regulated, audited and have minimum equity capital requirements?  That is very scary when you think about how much client funds they are holding for taxpayers' 1031 Exchange transactions.  

I have seen many 1031 Exchange Qualified Intermediaries go under over my 35 year career in the 1031 Exchange industry and most of those could have been avoided had there been any kind of regulatory or governmental oversight and audit of those Qualified Intermediaries. 

Qualified Intermediaries are an extremely crucial part of any successful 1031 Exchange transaction.  They have three (3) very important responsibilities, which include preparing the 1031 Exchange agreements and documents to properly structure the taxpayer's 1031 Exchange, working with the taxpayer and their advisors to ensure a successful 1031 Exchange transaction and probably the most important responsibility – hold, protect and safeguard taxpayers' 1031 Exchange funds. 

Taxpayers should be diligent when evaluating and selecting a Qualified Intermediary since they hold significant amounts of 1031 Exchange funds. 

Governmental Regulatory Oversight Ensures Safety and Soundness 

Government oversight by a regulatory body, such as the State Division of Banking, State Department of Financial Institutions, Office of the Comptroller of the Currency (OCC) or the Federal Reserve, will ensure that the 1031 Exchange Qualified Intermediary is operating in a safe, sound and secure manner.  This is very important since they have such tremendous fiduciary responsibilities.  The vast majority of Qualified Intermediary failures could have been prevented through this governmental oversight and audit. 

Qualified Trust Accounts Protect Investors’ Funds 

Qualified Intermediaries should deposit, hold and safeguard taxpayers' 1031 Exchange funds in separate, segregated Qualified Trust Accounts or Qualified Escrow Accounts.  The court ruled in the LandAmerica 1031 Exchange bankruptcy case that the 1031 Exchange funds held by LandAmerica 1031 Exchange were corporate (not client) funds and were subject to the creditor claims in the bankruptcy since the monies were not held in Qualified Escrow Accounts as authorized by the Department of the Treasury Regulations.  Qualified Escrow Accounts clearly delineate 1031 Exchange funds as fiduciary (client) funds and not corporate funds in the event the 1031 Exchange Qualified Intermediary files for either voluntary or involuntary bankruptcy. 

Exeter Trust Company

Exeter 1031 Exchange Services, LLC deposits, holds and safeguards its clients' 1031 Exchange funds in separate, segregated Qualified Trust Accounts at Exeter Trust Company.  Exeter Trust Company is licensed, regulated, and audited by the Wyoming Division of Banking.  It is required to maintain significant levels of equity capital.  

Bonding, Insurance and Equity Capital Provide Financial Strength and Stability

1031 Exchange Qualified Intermediaries’ should provide substantial levels of fidelity bond coverage, errors and omissions insurance coverage, fiduciary insurance coverage and maintain substantial equity capital as an added and appropriate safety net for errors or losses in a 1031 Exchange transaction.  Taxpayers should always evaluate the methods and processes put in place by the Qualified Intermediary to track, monitor and protect 1031 Exchange funds through internal controls, checks and balances. 

There is Absolutely NO Substitute for Experience 

Taxpayers need more than just a 1031 Exchange transaction processor.  Taxpayers should be able to go to a 1031 Exchange Qualified Intermediary for advice and guidance on the absolute best practices in the administration of 1031 Exchange transactions.  Interview the Qualified Intermediaries that you are looking at to ensure the administrators have the technical depth, experience and expertise necessary for the administration of 1031 Exchange transactions.  Taxpayers need assistance, so the 1031 Exchange Qualified Intermediary should be willing to work with the investor and their legal and tax advisors to ensure a successful 1031 Exchange transaction. 

Exeter 1031 Exchange Services, LLC Hosts 1031 Exchange Workshop in Cheyenne, WY

Unraveling the Mystery of 1031 Exchanges Workshop 

Exeter 1031 Exchange Services, LLC schedules its first free 1031 Exchange Workshop in its new Mountain Regional Office located in Cheyenne, Wyoming.

Unraveling the Mystery of 1031 Exchanges is a basic to intermediate level workshop and round table discussion on 1031 Exchanges that will help those attending unravel the mystery of completing successful 1031

1031 Exchange Workshop
Cheyenne, Wyoming

Exchanges transactions. 

What is a 1031 Exchange? What are the benefits and advantages?  How do you structure one?  What should you watch out for?  

The workshop discussion will include the requirements, structures, processes, strategies, and compliance issues necessary to successfully complete a 1031 Exchange. This is not just any seminar; it’s an educational workshop where you can roll up your sleeves, learn and ask as many questions as you like.

Hosted and Presented by Exeter 

Unraveling the Mystery of 1031 Exchanges is hosted by Tony Hammock, Senior Vice President, Chief Trust Officer and Trust Operations Manager along with Patrick Bailon, 1031 Exchange Administrator, in Exeter's new Mountain Regional Office.  The workshop will be presented by Bill Exeter, President and Chief Executive Officer and Maureen H. Brown, Senior Vice President and Exchange Services Group Manager.  

RSVPs Required 

RSVPs are required as seating is extremely limited.  There are only twenty-five (25) seats available, so click here to register for this 1031 Exchange Workshop.