A 1031 exchange is based on a provision in the Internal Revenue Code (Section 1031) which provides that no gain or loss related to capital gains need be recognized on the “exchange” of any type of property used for business or investment.

A 1031 exchange allows an investor to sell an investment property and defer capital gains and depreciation recapture taxes by reinvesting 100% of their equity into another “like kind” property of equal or greater value.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

1031 exchanges provide an ideal solution for investors that want to keep real estate in their investment portfolio and:

• Redeploy dormant equity “locked” in their income properties.
• Defer the punitive capital gains and depreciation recapture taxes due when selling investment properties.
• Explore institutional-grade property investment options.

The primary advantages of completing a 1031 exchange include:

• Increasing your buying power through the deferment of federal capital gains taxes, thus allowing you to leverage these savings by putting them into the new property you are purchasing.
• Acquiring a replacement property with greater income potential, such as selling raw land and acquiring income-producing property.
• Consolidating several manage-intensive properties into one passively managed property, such as a net leased property.
• By deferring the tax, you have more money available to invest in another property.  Effectively, you receive an interest-free loan from the federal government in the amount you would have paid in taxes.
• Postponing any gain from depreciation recapture.
• Reallocating your investment portfolio without paying taxes on any gain.

Anyone who is considering selling a business or investment property should investigate the merits of a 1031 exchange.  By electing to use a 1031 exchange, the savvy investor has an opportunity to reinvest the federal capital gains that he would normally pay on a sale.  An investor can consider the savings resulting from a 1031 exchange as an interest-free loan from the IRS in which the principal may be increased through subsequent exchanges, and which may never require repayment if properly planned.

There are five major types of 1031 exchanges:

• Simultaneous Exchange: The exchange of the relinquished property for the replacement property occurs at the same time.
• Delayed Exchange: This is the most common type of exchange. A Delayed Exchange occurs when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. A Delayed Exchange is subject to strict time limits, which are set forth in the Treasury Regulations.
• Build-to-Suit (Improvement or Construction) Exchange: This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds.
• Reverse Exchange: A situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000. These transactions are sometimes referred to as “parking arrangements” and may also be structured in ways which are outside the safe harbor.
• Personal Property Exchange: Exchanges are not limited to real property. Personal property can also be exchanged for other personal property of like-kind or like-class.

Common misconceptions include:

• There are those who still believe an investor must “swap” properties in order to effect a successful 1031 exchange.  Although this was a requirement in the original code, it is no longer required today.  An investor is now able to sell his or her property in a normal manner, provided that he or she reinvests the returns of that sale in accordance with 1031 rules.
• Many believe that only investors in large commercial properties enjoy the benefits of a 1031 exchange, but this is not the case.  1031 exchanges apply to all investment properties, large and small.  1031 exchanges result in savings for a corporation selling a large shopping mall, and will also provide benefits for an individual selling a single-family home used as a rental property in a vacation area, or a retail net leased investment backed by a credit tenant.
• Many believe one must acquire a property of similar kind or type in order to qualify for the benefits of a 1031 exchange.  While the term “like-kind” exchange is often used in reference to 1031 exchanges, this term simply refers to real property held for business use or investment.  An investor can sell vacant land and acquire an apartment building or sell a warehouse and acquire raw land.  One can also sell a single property and use the proceeds to invest in three properties, or sell four properties while only acquiring one. Virtually any type of real property used for business use or investment will qualify.
• Many believe that 1031 exchanges are too complicated.  This is not the case; in fact, when working with a qualified 1301 exchange intermediary, the process is very simple.  The intermediary will keep you aware of the requirements you must comply with and ensure that everything is completed in strict compliance with 1031 regulations.

Aside from the deferment of capital gains tax, some of the other benefits enjoyed by 1031 exchange participants include:

• Increased buying power due to the availability of funds that normally would have gone to pay capital gains taxes.
• Preservation of your estate your selling power is increased since you can offer a more flexible selling price increases your income by exchanging for properties with greater income (More profitable locations, lower operating costs, more rental units or a higher rental income per unit, etc.) relocation of your business or investment property to a more profitable or desirable location. Expand you business into a larger space without tax penalties.
• All of these advantages culminate in the ability to speed wealth accumulation in real property ownership.

There are four major requirements that must be satisfied to complete a valid 1031 exchange:

• Qualifying Property: Certain types of property are specifically excluded from Section 1031 treatment: property held primarily for sale; inventories; stocks, bonds or notes; other securities or evidences of indebtedness; interests in a partnership; certificates of trusts or beneficial interest; and choses in action. In general, if property is not specifically excluded, it can qualify for tax-deferred treatment.
• Proper Purpose: Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer’s personal residence will not qualify.
• Like Kind: Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.
• Exchange Requirement: The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031.

There are four general guidelines that must be followed:

• The value of the replacement property must be equal to or greater than the value of the relinquished property.
• The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
• The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
• All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.

Once the money is deposited into an exchange account, funds can only be withdrawn in accordance with IRC 1031 regulations.  The taxpayer cannot receive any money until the exchange is complete.  If you want to receive a portion of the proceeds in cash, this must be done before the funds are deposited with the Qualified Intermediary.

A Qualified Intermediary is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code.  The QI cannot be the taxpayer or a disqualified person.

• Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer.
• The QI holds the sales proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds.
• The QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.

The exchange ends the moment the taxpayer has actual or constructive receipt (i.e. direct or indirect use or control) of the proceeds from the sale of the relinquished property.  The use of a QI is a safe harbor established by the Treasury Regulations.  If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds.  The sale proceeds go directly to the QI, who holds them until they are needed to acquire the replacement property.  The QI then delivers the funds directly to the closing agent.

The IRS regulations are very clear: the taxpayer may not receive the proceeds or take constructive receipt of the funds in any way, without disqualifying the exchange.

No, as long as the taxpayer has not transferred title, or the benefits and burdens of the relinquished property, she can still set up a tax-deferred 1031 exchange.  Once the closing occurs, it is too late to take advantage of a Section 1031 tax-deferred exchange (even if the taxpayer has not cashed the proceeds check).

No, not in most situations.  The IRS regulations allow the properties to be deeded directly between the parties, just as in a normal sale transaction.  The taxpayer’s interests in the property purchase and sale contracts are assigned to the QI.  The QI then instructs the property owner to deed the property directly to the appropriate party (for the relinquished property, its buyer; for the replacement property, taxpayer).

A taxpayer has 45 days after the date that the relinquished property is transferred to properly identify potential replacement properties.  The exchange must be completed by the date that is 180 days after the transfer of the relinquished property, or the due date of the taxpayer’s federal tax return for the year in which the relinquished property was transferred, whichever is earlier.  Thus, for a calendar year taxpayer, the exchange period may be cut short for any exchange that begins after October 17th.  However, the taxpayer can use the full 180 days by obtaining an extension of the due date for filing the tax return.

Unfortunately, there are no extensions available.  If the taxpayer does not meet the time limits, the exchange will fail and the taxpayer will have to pay any taxes arising from the sale of the relinquished property.

Potential replacement property must be identified in writing, signed by the taxpayer, and delivered to a party to the exchange who is not considered a “disqualified person”. A “disqualified” person is anyone who has a relationship with the taxpayer that is so close, the person is presumed to be under the control of the taxpayer. Examples include blood relatives, and any person who is or has been the taxpayer’s attorney, accountant, investment banker or real estate agent within the two years prior to the closing of the relinquished property. The identification cannot be made orally.

There are three rules that limit the number of properties that can be identified, and the taxpayer must meet the requirements of at least one of these rules:

• 3-Property Rule: The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or
• 200% Rule: Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property, or
• 95% Rule: The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.

No.  Any property that is held for productive use in a trade or business, or for investment, may qualify for tax-deferred treatment under Section 1031.  In fact, many exchanges are “multi-asset” exchanges, involving both real property and personal property.

A multi-asset exchange involves both real and personal property.  For example, the sale of a hotel will typically include the underlying land and buildings, as well as the furnishings and equipment.  If the taxpayer wants to exchange the hotel for a similar property, he would exchange the land and buildings as one part of the exchange. The furnishings and equipment would be separated into groups of like-kind or like-class property, with the groups of relinquished property being exchanged for groups of replacement property.

Although the definition of like-kind is much narrower for personal property and business equipment, careful planning will allow the taxpayer to enjoy the benefits of an exchange for the entire relinquished property, not just for the real estate portion.

A reverse exchange, sometimes called a “parking arrangement,” occurs when a taxpayer acquires a Replacement Property before disposing of their Relinquished Property.  A pure reverse exchange, where the taxpayer owns both the relinquished and replacement properties at the same time, is not allowed.  The actual acquisition of the “parked” property is done by an Exchange Accommodation Titleholder (EAT) or parking entity.

Yes. Although the Treasury Regulations still do not apply to reverse exchanges, the IRS issued “safe harbor” guidelines for reverse exchanges on September 15th, 2000, in Revenue Procedure 2000-37.  Compliance with the safe harbor creates certain presumptions that will enable the transaction to qualify for Section 1031 tax-deferred exchange treatment.

In a typical reverse (or “parking”) exchange, the “Exchange Accommodation Titleholder” (EAT) takes title to (“parks”) the replacement property and holds it until the taxpayer is able to sell the relinquished property.  The taxpayer then exchanges with the EAT, who now owns the replacement property.  An exchange structured within the safe harbor of Rev. Proc. 2000-37 cannot have a parking period that goes beyond 180 days.

If the reverse exchange period exceeds 180 days, then the exchange is outside the safe harbor of Rev. Proc. 2000-37.  With careful planning, it is possible to structure a reverse exchange that will go beyond 180 days, but the taxpayer will lose the presumptions that accompany compliance with the safe harbor.

Yes. This is known as a Build-to-Suit or Construction or Improvement Exchange.  It is similar in concept to a reverse exchange.  The taxpayer is not permitted to build on property she already owns.  Therefore, an unrelated party or parking entity must take title to the replacement property, make the improvements, and convey title to the taxpayer before the end of the exchange period.

A realized gain is the increase in the taxpayer’s economic position as a result of the exchange.  In a sale, tax is paid on the realized gain.  A recognized gain is the taxable gain. A recognized gain is the lesser of the realized gain or the net boot received.

Boot is any property received by the taxpayer in the exchange which is not like-kind to the relinquished property.  Boot is characterized as either “cash” boot or “mortgage” boot.  The realized gain is recognized to the extent of net boot received.

Mortgage boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he or she assumes or places debt on the replacement property. The taxpayer receives mortgage boot when he or she is relieved of any debt on the replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, he or she is considered to be relieved of debt. The debt relief portion is taxable, unless offset when netted against other boot in the transaction.

Cash boot is any boot received by the taxpayer other than a mortgage boot. Cash boot may be in the form of money or other property.

There are four major boot netting rules:

• Cash boot paid offsets cash boot received.
• Cash boot paid offsets mortgage boot received (debt relief).
• Mortgage boot paid (debt assumed) offsets mortgage boot received.
• Mortgage boot paid does not offset cash boot received.

In a sale-leaseback transaction, an owner/user decides it would be beneficial to lease the space it currently occupies and owns, rather than continuing to own it.  The property is marketed to an investor who agrees to lease the space back to the selling entity.

The sale-leaseback process involves four steps:

• Purchase: An investor purchases an existing fixed physical facility (but not the business activity conducted in that facility) from an owner/user that is operating its business out of the facility.
• Leaseback: The seller leases back the existing facility for a set term, makes periodic lease payments, continues to own and control the business activity conducted in the facility, and retains all profits generated by the business activity.
• Financing: The seller uses the cash payment from the sale of the existing facility to finance the construction of a new physical facility, to expand the business, or for any other purpose.
• Option: At the end of the lease period, the seller has the option to renew the lease on the existing facility, purchase the existing facility back, or move the business activity out of the existing facility and terminate the relationship.

The three basic requirements a sale-leaseback candidate must meet in order to qualify for the transaction are as follows:

• Physical Facility: The seller must own an existing fixed physical facility that an entity can purchase.
• Lease: The seller must intend to lease back the existing facility from the buyer.
• Credit Rating: In most sale-leaseback transactions, the seller generally must obtain either an investment grade credit rating or credit enhancement from a source having an investment grade credit rating.

A firm could obtain an investment-grade credit rating, or it could use credit enhancement provided by a third party.

• Credit Rating: A credit rating must be issued by the international rating agency of either Standard & Poor’s, Moody’s, or Fitch Ratings.  An investment-grade credit rating would be an S&P or Fitch rating of BBB- or higher, or a Moody’s rating of Baa3 or higher.  A firm can obtain a “desk-top” review from  a consultant to determine if an investment-grade credit rating is possible.  The website addresses for the rating agencies are as follows:

Standard & Poor’s: www.standardandpoors.com/

Moody’s: www.moodys.com/

Fitch: www.fitchratings.com/

• Credit Enhancement: Credit enhancement is when a firm uses the investment-grade credit rating of a third party to raise its credit rating to investment grade.  Examples of third parties that might provide credit enhancement include sovereigns, governmental agencies, insurance companies, and banks.

Often times, an investment group that raises the funds to purchase a firm’s existing physical facility or facilities does so through Wall Street partners and major institutional and individual investors.  These entities typically require that a sale-leaseback candidate (or another entity leasing back the existing facility) has an investment-grade credit rating or credit enhancement since these are credit-based leases.

The primary benefits of a sale-leaseback transaction include the following:

• Improved  Balance Sheet: By selling appreciated real estate, a long-term liquid asset can be replaced with a liquid asset (cash).  In addition, a mortgage appears on the balance sheet as a liability, while an operating lease does not.  If you have no debt on the existing facility and build a new facility with the cash from the sale of the existing facility, the new facility will have no debt. The lease on the existing facility will usually be a contingent liability. No debt enhances a company’s balance sheet, credit rating, and ratios (e.g., debt to equity, return on assets, and return on equity).
• Improved Income Statement: The real estate sale can reduce the negative impact of depreciation and interest on your income statement.
• Access to Capital: The equity received from the transaction can be deployed in core operations that yield higher returns than appreciation of real estate.  The proceeds also can be used to pay down debt.
• Improved Stock Value: An increase in liquid assets and a reduction in debt can project a better financial picture and result in increased stock value for a public company.
• Better Access to Long-Term Capital: With an improved balance sheet and income statement, a company can improve its credit status.
• 100% Financing: A firm can raise cash equal to 100% of the market value of the existing facility — more than if it borrowed funds against the existing facility.  A firm can raise 100% of the cash from a single source.  It does not have to raise debt and/or equity financing from multiple sources.
• 100% Tax Deduction: A firm can deduct 100% of the lease payments for tax purposes.  With debt financing, a firm can deduct only a portion of the loan payments.
• Favorable Rent Payments: The lease payment may prove relatively inexpensive compared to the return the company gets on the sale of the property.
• Maintain Control and Increase Liquidity: A company will continue to have total control of, and retain all of the profits from, the operation of the business activity conducted in the existing facility.  The facility was sold, not the business activity.
• High Return: The cash a firm was has tied up in its existing facilities is typically generating a much lower return than it could yield if the firm reinvested that cash in a new project facility, the expanded its business activities, or engaged in new ventures.  By selling and leasing back existing facilities, a firm continus to control and profit from the business activities conducted in the existing facilities, and can reinvest the freed up cash in new high-return activities.
• Leverage: By completing a sale-leaseback, a firm raises the funds needed to expand its business or to invest in new ventures.
• Lower Risk: Many projects are financed with risky short-term debt.  Conversely, a sale-leaseback allows a firm to lock into a long-term fixed lease, raise the money to pay off the short-term debt it currently holds, and continue to control and profit from the business activity conducted in that facility.
• Property Management: By selling its real estate and leasing it back from the new owner, a company may elect not to manage the property in an effort to free up time, energy and capital resources.
• Fast Process: Typically, a sale-leaseback transaction only takes 3-6 months once the negotiations have been finalized.  It is a relatively simple process and has far fewer requirements than traditional financing methods.  At closing, the seller receives full payment for the purchase of the existing facility.

Moody’s Investors Service notes “increasing numbers of corporations are using sale-leasebacks as a way to move the costs of real estate investments off their balance sheets.”  They list AT&T, Saks Fifth Avenue, K-Mart, and Wal-Mart as examples of corporations that have sold corporate headquarters or retail stores and leased them back.

A  sale-leaseback transaction is uniquely suited to the needs of both large and small corporations and governments with a large investment in physical facilities.

No.  A firm can use the cash payment from the sale of its existing physical facility for any purpose.  How it uses the cash is totally unrelated to the purchase and leaseback of the existing facility.

A sale-leaseback candidate does not have to own the land. However, investors typically require the ability to obtain a long-term lease on the land.

Upon the expiration of the lease, the firm can negotiate a new lease for the facility, or oftentimes purchase the facility back at a market price. Finally, the firm can move its business activities out of the facility and terminate the relationship.

To inquire for our opinion on whether or not your project is a viable sale-leaseback candidate, please provide the following information: