Summer 2020 • Issue 69, page 1

1031 Tax Deferred Exchanges

By Brooks, Marc*

Many of you may know that I have continually been in the Escrow business since 1982, but what you may not know is that I have been administrating 1031 Tax Deferred Exchanges since 1986 and have been continually in the 1031 Tax Deferred Exchange Business since 1987. Thus, I have a unique perspective both on history and actual production.

As we came out of the Savings and Loan Crisis of the late 1970’s and early 1980’s, President Reagan based his 1981 economic plan on the idea that cuts in marginal tax rates would increase tax revenues. This economic plan was based largely on the economic theory known as ‘Supply Side Economics’. Today, what we refer to as the ‘1031 Exchange’ really came to significance in 1986 after multiple triggering events.

First, a seminal case allowing for like-kind deferred exchanges involving the Starker Family was decided in 1979, establishing the need for regulations regarding delayed tax-deferred like-kind exchanges. This case gave rise to the Deficit Reduction Act of 1984, which created the delayed tax-deferred like-kind exchange provisions that we have today. Then the Tax Reform Act of 1986, which changed how capital gains were taxed, triggered the tremendous explosion in the number of tax-deferred like-kind exchange transactions.

As a Receiver or Receiver’s Counsel, you might be saying why should we be concerned with a 1031 Exchange for a Defendant or even a prospective Purchaser at all? It is important that, in today’s environment, we consider the possible effects on both parties.

First, let’s examine the sale of real property from the perspective of the Defendant, then we will use the same example from the perspective of the potential Purchaser. Let’s make the assumption that the real property was a ‘Replacement’–or–‘Up-Leg’ Property in a 1031 Exchange is a Commercial Property, Retail Mall, Shopping Center and/or Residential Income Property, all that matters is that the Defendant held the property for ‘Investment Purposes’ (as defined by the IRS). Let’s make the following assumptions:

Furthermore, let’s make the Assumption that the ‘Relinquished’ – or – ‘Down-Leg’ Property was sold and used to acquire this ‘Replacement’ Property was as follows:

Basically, the Defendant took their entire proceeds of their sale of the ‘Relinquished’ Property and rolled it into the ‘Replacement’ Property. At quick glance one might say, the Defendant purchased for $30,000,000 with $10,000,000 in equity, sold for $28,000,000 with $6,000,000 Sounds like they lost money, or did they?

The Defendant acquired the aforementioned ‘Replacement’ Property via a 1031 Exchange. They, in effect, rolled their cost basis from the ‘Relinquished’ Property to the ‘Replacement’ Property. The reality is the Defendant still has a gain of approximately $14,000,000 and likely should enter into a new 1031 Exchange to continue to defer those Federal and State Taxes.

If the Defendant fails to enter into a 1031 Exchange at the time of the disposition the ‘Replacement’ Property, not only will the Defendant have the aforementioned $14,000,000 gain, but the Defendant may also have ‘Debt Relief’ which also may be taxable. This example also assumes that Defendant has not had a succession of several exchange properties that may have ‘Rolled Up’ into this ‘Replacement’ Property. It’s VERY common that sophisticated investors continue to ‘Roll Up’ or ‘Exchange-Up’ several times, thus the Defendant’s cost basis could be substantially lower than just one previous ‘Replacement’ Property. If there has been a chain of three, four or five properties previously ‘Rolled Up’ Exchange Properties (which in our example could be very likely) the Defendant’s cost basis could be substantially lower and, therefore, their tax gain/exposure could be substantially greater than $14,000,000.

It is not the responsibility of a Receiver, Escrow Holder, or 1031 Exchange Accommodator to give a Defendant tax advice. However, I do believe that it is our moral responsibility to point out to the Defendant that they could have substantial tax liability and strongly urge them to seek tax advice. I would even strongly suggest that a Receiver do so in writing. In addition to just doing the right moral thing, the last thing that any Receiver needs is to answer a complaint from the Defendant a year or two after the Receivership Estate has been dismissed when the Defendant receives a tax bill from the State, IRS, or both.

Let’s take a minute to address Purchasers who may be using exchange funds as all or a portion of the consideration when acquiring a Receivership Property (i.e., a ‘Replacement’ Property for their 1031 Exchange). Often they will want their Earnest Money Deposit to come from their Accommodator. Be aware this Accommodator may have special requirements. From the Earnest Money Deposit(s) to Amending the Purchase Contract/Escrow Instructions, be mindful, these ‘requirements’ are not etched in stone.

It is important to make note in any Purchase Agreement that while the Receiver may cooperate with Purchaser’s Exchange, the Receiver will not bear any costs or expenses associated with the exchange and will not adjust the closing date of the exchange to accommodate Purchaser’s Exchange. Additionally, if the Purchaser is utilizing our Receivership Property as a ‘Replacement’ Property to satisfy their 1031 Exchange, the Purchaser only has 180 days from the recordation of the deed of their ‘Relinquished’ Property to consummate their acquisition (with almost no exceptions). The Purchaser should acknowledge, in writing, that there could be unforeseen delays in closing (let’s say a delay in a court date, for example), and the Receiver is not responsible for same if the closing does not occur within the Purchaesr’s exchange timeline. The risk of this potentially significant tax burden should never be placed upon the Receivership Property.

In my almost three-and-a-half decades as an Escrow Agent here in California and 1031 Exchange Accommodator, I’ve only seen two exceptions to the 180 Day Closing Date rule. The first was when a Taxpayer lived or had their primary business in a County where the President of the United States declared that County a National Disaster Area. Such was the case in Los Angeles and Ventura Counties in the winter of 2018 as a result of Wild Fires (there was a 120-day extension). The second was now, due to COVID-19, wherein dates were extended to July 15, 2020; that’s it! My point is that, as a Receiver, you can’t commit to a closing date, nor be responsible if the closing date is extended for any reason!!

If you have any questions regarding 1031 Exchanges or Escrow, please feel free to reach out to me at any time - Marc Brooks is a CRF Member and Executive Vice President of Escrow of the West and can be reached at Mbrooks@EscrowoftheWest.com. If you need a 1031 Exchange Accommodator with over three decades of experience, please feel free to reach out to Kathy Brooks at Kathy@PrimeWestExchange.com.

*Marc Brooks is the Executive Vice President, Development, of Escrow of the West with offices in Beverly Hills, Westlake Village and Woodland Hills providing real estate escrow services for commercial sales, receiverships, 1031 exchanges, REO’s, trust sales, probate, new construction and other specialty escrows.