Sherry recently received this from the exchange client who was the subject of this debate I had with her CPA on the definition of like kind for poultry houses.  

I thank you for the excellent service you provided us, including the “short course” for our accountant.  He told me later that you had convinced him and that he would have done just what we did.  GREAT !!!!  Look forward to your response.  Thanks again.

I should also point out that I have yet to receive a single note of disagreement over my interpretation of like kind in this regard.

This kind of thing, where I have to educate IRS employees and other tax practitioners on the proper way to handle things, has gone on for decades.  Nobody in the tax profession, especially me, can truthfully make the claim to know everything about the tax laws.  No such person exists.  The laws and rules literally change daily and we all have to learn new things constantly.  However, in situations like this, I can’t help but wonder how many people were the victims of the misinformed tax pros.  With thousands of poultry houses in this area (Tyson country), this easily could have cost a lot of farmers a ton of taxes that could have easily been legally avoided.

Is Your Vacation Home Also an Investment? – The Wall Street Journal looks at the issue of whether vacation homes qualify for 1031 exchanges.

Over the past few decades, I have had several debates about what constitutes “like kind” as part of Section 1031 tax deferred exchanges.  A new type of disagreement that I had never heard of in my 27+ years of consulting on 1031 exchanges came up a few weeks ago, as Sherry was working with an exchange client who wanted to dispose of a poultry farm and replace it with a different kind of farm property.  Their CPA had told them that such an exchange was not legal, which led to the following email exchange between me and that client’s CPA.   

From The Exchange Client:

Our accountant tells us that the 4 poultry houses (with a Tyson contract) will not fall under a 1031 because they are a single purpose agricultural unit and would be considered a personal business and “theoretically” could be moved.  We questioned this because we thought we could use them in the exchange also and further reduce the tax load.

My first email to the client’s CPA:

As you know, some kinds of real estate are allowed by IRS to be depreciated under Section 1245, while others are under Section 1250. The definition of like kind for 1031 exchanges does not distinguish between depreciation classes. 

The only description given in IRS rules, regulations and instructions has been “real property for real property” without regard to class.  In all of my years working in this area, I have never seen or heard anything from IRS requiring that the original and replacement properties be depreciable under the same code section (1245 or 1250).  What is more critical is how state law classifies the property.  If they treat it as real property and not personal property, then it falls under the same general classification for 1031 exchanging.

Over the years, I have actually prepared a number of returns where Section 1245 real property has been exchanged for 1250 real property and IRS has never had any problems.

I just pulled out one of my main reference sources regarding 1031 exchanges, the Thomson-West book “Tax Free Exchanges Under Section 1031.”  I couldn’t find any distinction regarding exchanging between Section 1245 and 1250 properties.  They have a short list of some examples where different kinds of real property have been treated as qualifying like kind under Section 1031.  Some of these aren’t even under Section 1245 or 1250; so the definition of like kind for real property is very very wide.

I will copy these pages and fax them to you later this afternoon.

I hope this clears up any confusion you may have.

Kerry Kerstetter

His Reply:

Kerry, I got your fax.  I agree that there are no class distinctions regarding section 1250 property and that the the choices here are very broad.  However, the exchange of 1245 property for real estate is denied by the regs.  How do you get around the IRS definition of poultry houses? 

 

The fact that your exchanges have never been challenged doesn’t mean the IRS agrees with them.  I’m wondering if your contracts are being attached to returns, and whether they separately identify all the section 1245 property involved. If not, maybe we should try one and see if it flies. If you have no objections, we could do the client’s contract in that manner, and I’ll submit a copy with their return. 

 

Let me know.  Thanks. 

My Answer:

As I’ve said, we’ve never had any problems with IRS accepting the classification of poultry houses as business real property as long as they were assessed by the local counties as such.

This is very similar to a situation I have frequently encountered over the past 20+ years when discussing 1031 exchanges with various people.  A common misconception is that only the exact same kinds of real estate must be involved in an exchange.  For example, a single family rental house can only be replaced with another single family rental house.  Or an office building can only be replaced with an office building; and so on.  I have heard this from many tax pros, as well as from IRS auditors.  When I explain that the definition of “like kind” is any type of business or investment real property for any type of business or investment property, they ask me when the rules were changed to allow this kind of cross-over between different kinds of real estate.  I then explain that those were always the rule and it was never restricted to the same exact kinds of real estate.  IRS’s own instructions for valid like kind exchanges include examples of different types and classes of real estate being involved. 

However, as you know, with personal property, the definition of valid “like kind” is much more narrow and is where the depreciation classes used are extremely important in deciding whether the original and replacement property qualify for Section 1031 treatment.

The 8824s reporting the exchanges have always included complete descriptions of the properties involved; so IRS has had plenty of chances to see where special use properties such as poultry houses and self storage units have been exchanged for completely different kinds of real properties.  IRS has never had any problems with the returns I prepared and we have never heard of any problems with tax returns that were prepared by other accountants for these same kinds of exchanges.  

I’ve never attached an actual exchange agreement to the tax returns that I have prepared, and I have no way of knowing if any other tax preparers attached any to the returns they prepared.  However, I have always been a big believer in attaching a ton of explanatory info to tax returns when there are things that may be considered out of the ordinary. That is the main reason I have never believed in the IRS’s electronic filing program.  If you feel such a need to attach a copy of the exchange agreement to the clients’ 1040, by all means do that.  I am completely confident that there will be no problem from IRS in regard to this.

Kerry Kerstetter

What I didn’t include in any of emails was the fact that I also went through the TaxTools questionnaire / flowchart regarding qualification for a 1031 exchange with this client’s info and it qualified with no problem.  In fact, it never asks for the type of depreciation that was claimed on either the original or replacement property.  As I mentioned earlier, I had never seen or heard of that being a factor in determining like kind status of property.  As long as the county assessed the poultry houses as real property (which it did) and not personal property, IRS would honor that as like kind for an exchange into other types of business or investment real property.  

Q:

Subject: sale of personal residence

I bought a lot in 3/04. Sold my house in 8/04. built a new house and moved in 1/05. I now want to sell and move to a place with less mildew problems. Is there any exchange possibilities? If not when does the 2 years start/end.

Any help would be appreciated

A:

Since you have been using this property as a personal residence, it is not eligible for a 1031 exchange.

Your only possible way out of a taxable gain would be if you can get a doctor to verify in writing that the mildew problem is a health hazard for you.  In that case, you would be eligible for the prorated exclusion of  $342.47 per day that you lived there ($684.93 per day if married), starting from when you moved in.  Any gain above that would be subject to tax, which is why you also want to do a thorough job of accounting for your cost basis in the lot and home so that your gain is as small as possible.

You can see more on this on my main website.

Your own personal tax advisor should be able to provide more specific numbers for your unique situation.

Good luck.

Kerry Kerstetter

 

Q:

Subject: Vacant Land Sale Question

Hi.  I am hoping you can answer my question.  We bought out house in June 04, it has two parcels…one the primary residence sits on, the other is an adjoining lot.  We are selling the lot for 150K.  Are the proceeds subject to taxation, if so, how much?  Any help would be appreciated.  Thank you!

A:

It depends on a couple of things. 

What was the lot used for?  If it was an extension of your living space, it could qualify for the tax free exclusion, as long as you sell the actual residence portion within two years of selling the lot.

I covered this on my website under the topic of  “Vacant Land.”

If it wasn’t used as part of your living space, it will not qualify for the primary residence tax free exclusion.  However, if you have been classifying the lot as “investment property” it could be disposed of under Section 1031, which would require you to follow all of its rules, as described at www.tfec.com.

Your personal tax advisor should be able to give you more specifics for your unique situation.

Good luck.

Kerry Kerstetter

 

Follow-Up Q:

I really appreciate your prompt response.  Nice to know someone cares out there!  Just to clarify, if I sell the lot (which is part of our primary living space), we would absolutely have to sell our main home within two years or face taxes retroactively on the vacant land sale?  Thanks again.

 

 Regards,

A:

There’s actually another twist to your situation as well, which is why you really need to be working one on one with a tax pro.

Assuming that you moved into the home in June 2004 and didn’t just buy it then, you need to be concerned about the two year rule.  If you sell your home before the two year anniversary of occupying it, you will need to have a valid reason (health, employment, or other unforeseen event) in order to qualify for the pro-rated exclusion.  If you have no such reason, you will have to pay taxes on both portions of your sale, the lot and the home.

However, if you sell the home after June 2006 and before the two year anniversary of the lot sale, you should be okay.

One more warning. The issue of selling the lot before the two year anniversary of its purchase is in the infamous gray area of tax law.  Some people think that would automatically disqualify it from the tax free exclusion, unless it is due to the unforeseen circumstances; while others believe the date of the sale of the main home dictates the treatment of both portions of the sale. 

All of this discussion assumes that there will be a large profit on the sale of the lot to be concerned with.  Your original
question was unclear on how the lot was acquired.  If it was bought in a separate transaction from the home purchase, you will have to use that price as its cost basis.  However, if it was lumped in with the home purchase, you have some flexibility in allocating the purchase price between the two portions, as long as no such allocation was specified in your purchase contract. 

I have had several cases similar to this, where a client has spun off some land shortly after purchasing a large parcel.  Since the sales took place shortly after the purchases, I had no qualms about allocating the same amount as the sales prices as the cost bases of those particular parcels.  This gave them a break-even on the sale, or a loss after deducting selling costs.  That is something you may want to look into when you discuss your particular situation with your own personal tax advisor.

Good luck.

Kerry Kerstetter

Q:

Question:

Selling  a home that is used for rental and exchanging to another home for rental, using the 1031.

In this case, husband owns the property and resides in another residence in another town. Wife lives and works in the town where new rental is

acquired.

Is it possible to rent out the newly acquired property to the wife who has no financial interest in it and files separate federal and state income tax returns? Would this meet the requirement of being a rental?

A:

That could work.  You will need to be sure to charge a fair market rent, which you will report on Schedule E of your 1040.   Your wife will also need to book her payments as rent and not as something else, such as mortgage interest.

You also need to know that the home will not qualify for the tax free residence sale while it is considered a rental, by either you or your wife.

Your personal tax advisor should be able to give you more guidance.

Good luck.

Kerry Kerstetter

It’s a shame that there are still so many people, including far too many tax and real estate professionals, who are unclear on how Section 1031 like kind tax deferred exchanges work.  One common misconception that I often encounter is that the exchange can only be one for one; dispose of one property and replace it with a single property costing at least as much as the original property’s net price.  That has never been true, and has actually been a very unwise move when working with very expensive properties.  Diversifying by replacing one expensive property with several of lower value is a great way to avoid the classic investing mistake of putting all of one’s eggs in a single basket.  The most replacement properties I can recall in an exchange I worked on was twenty, several years ago when a client sold some Bay Area property and replaced it with 20 homes in Texas.

Which brings up another common misconception; that the replacement property has to be in the same state as the original.  While there are a very few states that may tax exchanges that move equity beyond their borders, that is not true for the IRS.  In fact, more than half of the exchanges that Sherry has been handling for the past 11 years have been between states, and none of them were taxable for Federal or State purposes. 

What triggered these comments was this article from the Wall Street Journal on how an investor replaced one $3.7 million Atlanta property with 33 properties in Florida.  He did run into the biggest problem in working with multiple properties; closing them all within the 180 day statutory replacement period.  He ended up with some taxable gain because some of the properties didn’t make the cut-off.  This is why it’s so important to start working on the replacement process as early as possible, ideally before the disposal leg of the exchange has even been wrapped up.  Too many investors make the big mistake of not even starting to look for their replacement properties until near the end of their 45 day identification period. 

Q:

Subject: Exchange Question

 

we would like to sell a second home and buy another second with the equity earned.  would we qualify for a tax-free exchange? 

 

thank you.

 

A:

Check out this post from almost a year ago:

Kerry Kerstetter

Follow-Up:

Kerry,

Thank you and your reply is helpful.  We usually spend only a couple weeks there a year and have made dramatic improvements over seven years.  During that time the property has tripled in value.  From your answer of last year, it seems we would be okay.  Please let us know if you disagree.

Thanks again for your help.

Reply:

If that’s all the time you visit the property each year, you could make the case that it is time doing maintenance to protect your investment and not having a personal pleasure vacation.

As we always need to keep in mind, the burden of proving the case in tax matters lies with you.  You should do everything possible to document the investment intent and usage of the properties (old and replacement) so that you will have no fear of any IRS challenge in the extremely rare chance that they ask about it.

One thing you can do to better document the property as investment is to describe the interest and property taxes on your Schedule A as being for “Investment Property” and not for a personal or second residence.  You should do that on any tax return that you haven’t yet filed.

Having qualified the property as being eligible for a 1031 exchange, all of those rules would apply.  This means that you need to reinvest the entire proceeds into new property, not just your equity.  As is explained on the Tax Free Exchange Corporation website, your target replacement price for a completely tax deferred exchange is the selling price of the old property less the direct selling costs.  Mortgages that are paid off as part of the disposal leg are considered part of the proceeds and will require you to either take on an equal or higher mortgage on the new property or use your own cash to make up the difference.  Any amount by which you miss the target replacement price will be taxable gain.   

Good luck.  I hope this helps.  You should work with your own personal tax advisor to calculate your potential taxes on the property sale in order to properly weigh the advantage of doing a 1031 exchange.

Kerry Kerstetter

 

Q:

Kerry,

What final tax documents must be given to Exchanger at the end of the exchange?  What tax documents must be given to the other party to the exchange?

 

I want to know the tax documents the accommodator gives to the exchanger and the Seller (if any).  I do know tax documents have to be given to the exchanger; but I am not sure which documents eg:  8824   must be sent.  I want to make up a tax package for the client but am unsure which tax document I must send.

Thanks for your help.

A:

In regard to the exchange accommodation services, there are no official IRS tax forms that need to be provided to any of the parties involved in the exchange.

If you are also handling the closing as the escrow agent, you do need to prepare the 1099-S with the gross selling price to be sent to IRS and to the seller.

The 8824 is completed by the exchanger’s tax preparer from the settlement statements from all of the exchange legs, disposal and replacement. 

I hope this is what you needed.

Kerry Kerstetter

Q:

Subject: Primary residence

Tax guru:

What if you have more than $500,000 gain on your primary residence?

Is it fully taxable?

Can you do a 1031?

Do you have to reinvest at a higher level for your primary residence?

If you can help…

Thanks

A:

If you are married and have a gain of more than $500,000 on your home sale, the excess is taxable as long term capital gain.  There is no reinvestment opportunity for residences; so whether or not you buy a new home is completely irrelevant.

1031 exchanges are not allowed for personal use property.

However, a common strategy in situations such as yours is to convert the home into a rental and later dispose of it via a 1031 exchange.  This makes the disposal ineligible for the Section 121 tax free exclusion.  You would also be required to reinvest the proceeds into other business, rental or investment real estate; and not directly into a new personal residence.

There are obviously a lot of pros and cons to the various strategies available to you.  You definitely need to consult with a tax pro who understands these kinds of real estate transactions.

Good luck.

Kerry Kerstetter