What is a reverse 1031? No it is not a football game plan. Commonly known as a reverse exchange or a reverse Section 1031 tax free exchange, this very trendy tax savings variation on the traditional Starker exchange has roared back to life. If you read my article on 1031 Exchanges you are somewhat familiar with tax free exchange investment strategy. We are now going to take a look at this same tax free strategy but in reverse. As an example, the Smiths give you 30 days advance notice before their hotel in Carmel CA property officially lists for $10M. Your dream has always been to purchase that hotel. You are certain you could buy the hotel if you sell those three rental properties you own but you have to move quickly.. Unfortunately your tax attorney has some bad news She says “Even if you could sell your property within the next thirty days, deprecation recapture turns your already low basis into negative territory causing at least $5M of your $10M sales price to go to the IRS in taxes.” But your tax attorney has some good news too:: "a tax free and reverse section 1031 exchange, could save you 5M in taxes." Interested in how this is possible? Stay with us on TaxView with Chris Moss CPA to see how a reverse Section 1031 tax free exchange can save you taxes and help to preserve your wealth.
Just to refresh your memory, a traditional easy 1031 starts out with a sale of your investment called the “relinquished” property. Your retain the service of a qualified intermediary (QI) who escrows the proceeds. Not all QIs are qualified as experts in their field. Make sure your QI is a member of the Federation of Exchange Accomodators. After you choose a QI you trust you must identity within 45 days an investment you want to buy called the “replacement” property. Within 180 days your QI purchases the replacement property and then transfers ownership to you. All gain on the sale of your first property is deferred and adjusted into the basis of the replacement property. In theory the gain could be deferred forever unless Congress changes the rules. It’s that simple.
Now let’s tackle the reverse 1031 play. The IRS has given us a winning strategy as we sprint through a safe harbor pocket provided by Rev Proc 2000-37, Also in play is IRS Bulletin 2000-40. (Page 308-310), Before this Rev Proc came out on the field there was surprisingly little guidance from the coaches at US Tax Court on how to play this game. There was just one tax court case that I found which is the poster case for how not to handle a reverse exchange play. DECLEENE vs IRS 115 T.C. No. 34 US Tax Court.
The facts of the case are relatively simple, Decleene operated a trucking business since 1977 and leased the building on McDonald Street land Decleene owned. In 1992, Decleene purchased Lawrence Drive land with his intent to eventually house his trucking business on that land. In 1993 P sold the McDonald Street and Lawrence Drive land to Western Lime and Cement (WLC) in exchange for WLC constructing a building on Lawrence Drive and then conveying back Lawrence drive to Decleene. On their 1993 tax return, the Decleene’s disclosed a tax free exchange with WLC as a taxable sale of the Lawrence land (boot) and a like kind exchange of McDonald for improved Lawrence with no gain or loss reported to the IRS. The IRS audited the 1993 tax return indicating that the Lawrence property had never really been “sold” to WLC by Decleene. The Decleene’s appealed to US Tax Court Decleen vs IRS.
Judge Beghe points out that Decleene purchased the replacement property directly with WLC, without the participation of a third-party exchange facilitator or qualified intermediary (QI) a year or more before he relinquished the McDonald property. In the following year Decleene transferred title to Lawrence subject to an “exchange agreement’ again not to a QI but directly to WLC. The Court concludes that “in foregoing the use of a third party QI Decleene created an inherently ambiguous situation. The reality of the subject transactions as we see them is a taxable sale of the McDonald Street property to WLC. Petitioner’s prior quitclaim transfer to WLC of title to the unimproved Lawrence Drive property, which petitioners try to persuade us was petitioner’s taxable sale, amounted to nothing more than a parking transaction by petitioner with WLC. In substance, petitioner never disposed of the Lawrence Drive property and remained its owner during the 3-month construction period because the transfer of title to WLC never divested petitioner of beneficial ownership. IRS wins, Decleene loses.
What does all this mean if you spot a deal of a lifetime that you want to purchase now and pay for it with tax free money from a future sale of property you presently own? It is clear form Decleene that you must use a QI if you want to survive an IRS audit. In fact, you should assemble the following team you trust: commercial real estate agent, tax attorney, and QI either in person or by conference call to map out the reverse 1031 exchange tax strategy that fits your unique situation. Furthermore, if you intend to pay off a mortgage on the relinquished property or incur new debt on the replacement property be aware that not all lenders understand complex reverse 1031 exchanges, so add to your team an experienced 1031 banker as well. Finally, have your tax attorney fully disclose to the government the nature of the reverse exchange in an attachment to your income tax return. Ask your attorney to put in writing that your unique reverse exchange complies with the safe harbor provided by Rev Proc 2000-37 and that she will be there to defend you in the likely event of an IRS audit years later.
In conclusion, if you correctly execute, a 1031 reverse exchange in compliance with Rev Proc 2000-37 and fully disclose your tax strategy in your tax return before filing, you will have bullet proofed your return from IRS audit years later, and assisted your family in preserving wealth, savings taxes, and achieving your financial goals. Happy 1031 Exchanges to all.
Thank you for joining us on TaxView with Chris Moss CPA.
Chris Moss CPA