InvestmentAnalysis 1031 PDF

Investment Analysis &
1031 Exchanges
Investment Analysis & §1031 Exchanges 1

NOTICE
NOTHING IN THIS SEMINAR OR OUTLINE SHOULD BE CONSTRUED AS LEGAL OR

TAX ADVICE. THE COURSE MATERIALS ARE INTENDED TO BE USED FOR
EDUCATIONAL PURPOSES ONLY AND ARE NOT INTENDED TO BE RELIED UPON AS
TAX ADVICE OR USED TO DETERMINE ANY TAX IN A PARTICULAR
TRANSACTION. THE COURSE MATERIALS MERELY PROVIDE AN OVERVIEW OF
SOME OF THE SIGNIFICANT ISSUES RELATING TO THE SUBJECT MATTER OF THE
PRESENTATION. ACCORDINGLY, PARTICIPANTS AND OTHERS SHOULD SEEK
LEGAL AND OR TAX ADVICE GUIDANCE FROM A COMPETENT ADVISOR WITH
REGARD TO ANY SUCH TRANSACTION.

TABLE OF CONTENTS
I. Investments.....................................................................................................................7
A. Investing Defined
B. Why People Invest
C. Why Specialize in Small Rental Properties?
D. Comparing Investments
II. Investment Real Estate................................................................................................... 11

A. What is Investment Real Estate?
B. Five Major Advantages of Investment Real Estate
III. Real Estate Cash Flow Concepts..................................................................................13

A. Standard Cash Flow Model
B. Calculating Before-Tax Cash Flow
C. Case Study #1
IV. Tax Aspects of Cash Flow.............................................................................................22

A. Before-Tax Cash Flow versus Real Estate Taxable Income
B. After-Tax Cash Flow
C. Tax Aspects of Cash-Flow Definitions
D. Passive Losses
E. Real Estate Investor versus Real Estate Dealer
F. Case Study #2
V. Common Uses of Cash Flow Analysis ...........................................................................34

A. Determining the Value of Investment Property
B. Gross Rent Multiplier and Capitalization Rate Method
C. Cash on Cash
D. Debt Coverage Ratio
E. Case study #3
F. Making Changes
VI. Accurate Data ................................................................................................................42

A. The Software Advantage
B. Obtaining Accurate Data
C. Important Questions to Ask
D. Putting it All Together
E. Case Study #4

VII. Marketing Investment Property.................................................................................49
A. Marketing Material
B. Property Data Sheet
C. APOD
VIII. Understanding Investor Goals ..................................................................................53

A. Diversification
B. What Investors Want to Know
C. The Real Estate Professional’s Task
IX. Types of Non-Recognition Transfers ...........................................................................55

A. Overview of IRC §1031, Exchange of Property Held for Investment
B. Overview of IRC §1033, Involuntary Conversions
C. Overview of IRC §121, Exclusion of Gain from Sale of Principal Residence
D. Overview of Treasury Decision 9152 – Reduced Maximum Exclusion of Gain
X. History of IRC Section 1031........................................................................................... 88
XI. Exchange Terminology .................................................................................................95

A. Actual Receipt
B. Basis and Adjusted Basis
C. Boot (Cash Boot and Mortgage Boot)
D. Constructive Receipt
E. Direct Deeding
F. Disqualified Person
G. Exchange Period
H. Identification Period
I. Like-Kind Property
J. Qualified Intermediary
K. Realized Gain vs. Recognized Gain
L. Relinquished Property
M. Replacement Property
N. Sequential Deeding
XII. “Like-Kind” Property Issues ......................................................................................104

A. Stock in Trade/Dealer Property
B. Partnership Issues
C. Holding Period Issues
D. Second/Vacation Homes
E. Tenant-in-Common Interests
F. Revenue Procedure 2002-22

G. Special Situations
(i) Conversion From/To a Rental to a Residence
(ii) Split Treatment Transactions
(iii) Personal Property Exchanges
XIII. Tenant-in-Common Programs/Fractional Ownership ..........................................117

A. Why Consider TIC Ownership?
B. Who Should Consider TIC Ownership?
C. What is a Tenant-in-Common (TIC) Ownership?
D. TIC Ownership and 1031 Exchanges
E. Forms of TIC Property Management
F. Advantages of TIC Ownership Program
G. Limitations of TIC Ownership Program
H. Overview of the TIC Ownership Program
I. TIC Ownership – Real Estate or Security?
J. What to Look for with TIC Ownership
XIV. Exchange Requirements.............................................................................................159

A. Exchange Requirement
B. Property Requirement
C. Qualifying Purpose Requirement
D. Like-Kind Requirement
XV. Section 1031 Exchange Documentation .....................................................................173
XVI. Section 1031 Formats and Variations.......................................................................176

A. The Two-Party Trade (Swap)
B. The Three-Party Exchange
C. The Delayed Exchange
D. Section 1.1031(k)-1: Treatment of Deferred Exchanges
(i) Overview
(ii) Identification and Receipt Requirements
(iii) Identification of Replacement Property before end of the ID Period
(iiii) Safe Harbors
-----(1) In General
-----(2) Security or Guarantee Arrangements
-----(3) Qualified Escrow Accounts and Qualified Trusts
-----(4) Qualified Intermediary
-----(5) Interest and Growth Factors
-----(6) Additional Restrictions of Safe Harbors
-----(7) Items Disregarded in Applying Safe Harbors

E. The Multiple Property Exchange
F. Overview of Parking Arrangements
(i) Revenue Procedure 2000-37
G. The Improvement Exchange
(i) Improvement Structure
(ii) Identification Requirements
(iii) Goods and Services to be Produced
(iv) Construction on Land Already Owned by the Taxpayer
H. The Reverse Exchange
(i) Replacement Property “Parked”
(ii) Relinquished Property “Parked”
I. The Reverse/Improvement Exchange
J. Non-Safe Harbor “Parking Arrangements”
XVII. The Exchange Equation............................................................................................229

A. Requirements for a Fully Deferred Exchange
XVIII. The Benefits of an Exchange ..................................................................................233

A. Calculating Taxable Gain
B. Reporting Requirements – IRS Form 8824
XIX. Important Issues and Recent Developments ............................................................237

A. Cost Segregation Studies
B. Related Party Exchanges
C. Exchange Entity and LLC Issues
D. Combining Exchanges and Installment Sales
E. Refinancing Prior to or After an Exchange
F. Treatment of Selling Expenses in an Exchange
G. Non-Tax Motives for Exchanging/Estate Planning
H. Recent Developments
Form 8824 .............................................................................................................................290

I. Investment

A. Investing Defined
Whenever an individual places surplus funds in the bank or stock market, or purchases real estate
for speculation, he or she has made an investment decision. There is a wide variety of investment
vehicles available. Each type of investment has unique characteristics that may be desirable to
one investor yet undesirable to another. Investors may even evaluate each investment differently.
Each investment may also exhibit different risk levels, and the return or yield on an investment
should be commensurate with the amount of risk associated with it.
B. Why People Invest
People invest to obtain the financial independence necessary to achieve their goals. Achieving
financial success usually takes time, careful planning, and the assistance of other professionals.
Most people invest for the following reasons:
• To generate additional income

• To acquire wealth for their retirement
• To accumulate for their children’s education
• To acquire prestige in the community
• To create an estate for their heirs
• To obtain financial independence
C. Common Investment Vehicles
• Saving accounts and certificates of deposit

• Stocks and mutual funds
• Real estate
• Partnership interests
• Bonds and bond funds
• Mortgages/trust deeds
• Collectibles/art

D. Why Specialize in Small Rental Properties?
Less Competition: Very few residential real estate professionals specialize in small rental
properties. Commercial real estate professionals also rarely go after
small residential rental properties.
Easier to Finance: Financing for up to four units is similar to single-family-home

financing.
Easier to Manage: Tenants tend to stay longer in smaller apartment complexes. (Properties
with high turnover rates require more maintenance and can be
management-intensive.)
Easier Entry: Small rental properties cost less to acquire. (Smaller price equals
smaller down payment.) First-time investors are often more
comfortable investing in small rental properties. Many of your existing
and past clients fall into this category.
Better Liquidity: More often than not, smaller, less-expensive investment properties can
be sold more quickly than larger investment properties.
E. Comparing Investments
Let’s take a moment to determine the before-tax wealth accumulation potential of three types of
investments.
Savings: If we invest $40,000 in a certificate of deposit (CD) at 5%, compounded

daily, our investment will grow to $84,675 in fifteen years.
Stocks & Bonds: If we invest $40,000 in a mutual fund growing at 10% annually, our
investment will grow to $176,090 in fifteen years.
Real Estate: If we invest $40,000 (20% down) in a $200,000 real estate investment,
appreciating at 5% annually, in fifteen years the value of the property will
grow from $200,000 to $415,785. Assuming a 15-year fully amortized loan
was used to purchase the property, let’s take a look at the future net equity
potential of this investment.
Future value of property in 15 years $415,785

– 7% overall cost of sale $29,105
– Loan balance $0
= Net proceeds from sale before tax $386,680

Review: In the above examples we determined that if we invested $40,000 for 15 years, we
would be able to accumulate wealth (before tax) in the following amounts:
1) Certificate of deposit $84,675

2) Mutual fund $176,090
3) Real estate $386,680
Comparison of Investments
Which is the better investment for your client? Answer: It depends on your client’s:
• Need for liquidity

• Risk tolerance
• Yield requirements
• Desire for cash flow vs. equity growth

II. Investment Analysis

A. What Is Investment Real Estate?
Investment real estate is any type of real estate held for investment except an
investor’s personal residence or second home.
B. Five Major Advantages of Investment Real Estate
First Advantage: Income from Cash Flow

Second Advantage: Equity from Loan Pay-Down
Third Advantage: Equity from Appreciation
Fourth Advantage: Tax Savings
Fifth Advantage: Higher Leverage

III. Real Estate Cash Flow Concepts

A. Standard Cash Flow Model
Many different real estate professionals use the standard cash flow model. It can be used to
analyze all sorts of investments, from small residential to large commercial properties. Properties
can be analyzed on a before-tax and after-tax basis. We will begin with the first nine lines of the
cash flow model to determine the before-tax cash flow of an investment property. Later we will
learn about the tax aspects of cash flow in order to calculate after-tax cash flow.

B. Calculating Before-Tax Cash Flow
In Simple Terms:
Income
- Expenses
= Net Operating Income
- Annual Debt Service
= Before-Tax Cash Flow
Net Operating Income is the single most Before-Tax Cash Flow: If financing is used to
important number in investment analysis. It obtain an investment property, we must subtract
is used by appraisers to determine value. It the annual debt service from Net Operating
is used by lenders to determine the amount Income to arrive at our Before-Tax Cash Flow. (If
they will lend. It is the amount of money there is no mortgage, Before-Tax Cash Flow ends
available to pay the mortgage and up being equal to Net Operating Income.)
ultimately determines whether you'll have a
positive or negative cash flow.
Detailed Breakdown:
Before-Tax Cash Flow
1. GROSS SCHEDULED INCOME $
2. – Vacancy & Uncollected Rents – $
3. = EFFECTIVE RENTAL INCOME = $
4. + Other Income + $
5. = GROSS OPERATING INCOME = $
6. – Annual Operating Expenses – $
7. = NET OPERATING INCOME = $
8. – Annual Debt Service – $
9. = BEFORE-TAX CASH FLOW = $

C. Case Study #1
Four-Plex Rental Property

A four-plex rental property is listed for $200,000. It has two 1bd/1ba units rented at $550 per month
and two 2bd/2ba units rented at $640 per month. The average vacancy in the area is reported to be 5%.
The current owner averages an additional $418 per year from laundry machines. 80% financing is
available at 7.75% on a 30-year fixed-rate loan with monthly payments of $1,146.26. Annual operating
expenses are as follows:
Taxes $2,200
Insurance $1,000
Property Management $2,204
Repairs & Maintenance $1,400
Utilities:
Electricity $600
Sewer & Water $800
Total Utilities: $1,400
Services:
Garbage $550
Landscaping $800
Total Services: $1,350
Annual Operating Expenses $9,554
Question: What is the first year’s cash flow before tax?

2. – Vacancy & Uncollected Rents – $___________
4. + Other Income + $___________
6. – Annual Operating Expenses – $___________
8. – Annual Debt Service – $___________

Line-by-Line Breakdown
Line 1: Gross Scheduled Income (GSI) is the maximum amount of annual rent you would
receive if the property were 100 percent occupied all year.
Typical Unit Mix
Case study information: Two units are

rented at $550 per month and two units are
rented at $640 per month.
2 units X $550 = $1,100

+ 2 units X $640 = $1,280
= Total Monthly = $2,380
$2,380 X 12 months = $28,560
Gross Scheduled Income = $28,560
Line 2: Vacancy & Uncollected Rents represent an estimate of rental income that will be lost
because portions of the property are not rented, or because existing tenants fail to pay rent. When
expressed as a percentage, it is called the vacancy factor. When expressed as a dollar amount, it
is referred to as the vacancy loss.
Case study information: The average vacancy in the area is reported to be 5%.
Formula: Gross Scheduled Income x Vacancy Factor = Vacancy Loss
Gross Scheduled Income $28,560 x .05 = $1,428
Vacancy Loss = $1,428

Line 3: Effective Rental Income is obtained by subtracting Vacancies & Uncollected Rents
from Gross Scheduled Income. It represents the actual amount of money collected in rents for
the year.
Review
GROSS SCHEDULED INCOME
- Vacancy & Uncollected Rents
= EFFECTIVE RENTAL INCOME
Effective Rental Income = $27,132
Line 4: Other Income refers to income from sources other than rents. Other income can have a
significant effect on cash-flow analysis. Sources of other income include:
• Laundry machines
• Rental application fees
• Storage fees
• Parking fees
• Vending machine income
• Late fees paid by tenants
Case study information: The current

owner averages an additional $418 per
year from laundry machines.
Other Income = $418
Line 5: Gross Operating Income (GOI) is obtained by adding Other Income to Effective
Rental Income. Gross operating income is the total income investors are able to deposit in their
property’s operating account (the property’s checking account). Gross operating income is the
total actual income received from operations.
Review
EFFECTIVE RENTAL INCOME

+ Other Income
= GROSS OPERATING INCOME
Gross Operating Income = $27,550

Line 6: Annual Operating Expenses are the costs involved in running the property.
• Property tax • Utilities

• Insurance • Services (garbage, janitorial, pool, elevator,
• Property management lawn, etc.)
• Maintenance and repair • Other expenses
**Loan payments are not considered an annual operating expense. Loan payments are a financial
cost to an owner who chooses to borrow rather than pay cash. Also, operating expenses do not
include cash outlays for major improvements. These outlays, called capital additions, must be
placed on a cost-recovery or depreciation schedule and deducted over time.
Case study information: Simplified

Annual expenses are as follows:
Taxes $2,200
Insurance $1,000
Property Management $2,204
Repairs & Maintenance $1,400
Utilities:
Electricity $600
Sewer & Water $800
Total Utilities $1,400
Services:
Garbage $550
Landscaping $800
Total Services $1,350
Annual Operating Expenses $9,554
Annual Operating Expenses = $9,554

Line 7: Net Operating Income (NOI) is obtained by subtracting Annual Operating Expenses
from Gross Operating Income.
GROSS OPERATING INCOME

- Annual Operating Epenses
= NET OPERATING INCOME
Let’s Review
Net Operating Income (NOI) = $17,996
Line 8: Annual Debt Service (ADS) is the total of all monthly loan payments (principal and
interest) paid throughout the year on all mortgages.
Case Study Information:
A four-plex rental property is listed for
$200,000 with 80% financing available at
7.75% on a 30-year fixed-rate loan with
monthly payments of $1,146.26
Monthly payment of $1,146.26 X 12 months = $13,755.12 = ADS

Line 9: Before-Tax Cash Flow is obtained by subtracting Annual Debt Service from Net
Operating Income.
DETAILED SIMPLIFIED
Income
Minus
Expenses
Equals
Net Operating Income
Minus
Annual Debt Service
Equals
Cash Flow Before Tax

$ 4,240.88

IV. Tax Aspects of Cash Flow

In Case Study #1 we used the first nine lines of the cash flow model to determine the Before-Tax
Cash Flow for an investment property. As we study the Tax Aspects of Cash Flow (lines 10
through 17), we will build upon the answers from Case Study #1.

1. GROSS SCHEDULED INCOME $ 28,560.00
2. – Vacancy & Uncollected Rents – $ 1,428
3. = EFFECTIVE RENTAL INCOME = $ 27,132.00
4. + Other Income + $ 418.00
5. = GROSS OPERATING INCOME = $ 27,550.00
6. – Annual Operating Expenses – $ 9554.00
7. = NET OPERATING INCOME = $ 17,966.00
8. – Annual Debt Service – $ 13,755.12
9. = BEFORE-TAX CASH FLOW = $ 4,240.88
Tax Aspects of Cash Flow
10. NET OPERATING INCOME (LINE 7) $

11. - Interest (Mortgage 1) - $
13. - Points Amortization - $
14. - Cost Recovery (Depreciation) - $____________
15. = REAL ESTATE TAXABLE INCOME = $
16. x Investor’s Marginal Tax Rate x %___________
17. = TAX LIABILITY OR (SAVINGS) = $
After-Tax Cash Flow
18. BEFORE-TAX CASH FLOW (LINE 9) $
19. - Tax Liability or (Savings) (line 17) - $____________ + or (-)
20. = AFTER-TAX CASH FLOW = $

A. The Difference
The only difference between before- and after-tax cash flow is the investor’s tax liability (or
potential tax savings).

- Tax Liability (Savings)
= After-Tax Cash Flow
How is Tax Liability (Savings) Calculated?
The deductions for cost recovery (depreciation), mortgage interest, and points amortization
benefit an investor by allowing them to ‘D.I.P.’ into the IRS’s pocket and pay tax on a
lower amount called Real Estate Taxable Income. To calculate Real Estate Taxable
Income, we go back to line 7 of the cash flow model and take a detour at Net Operating
Income.
Line 7: NET OPERATING INCOME
NET OPERATING INCOME NET OPERATING INCOME
- Annual Debt Service - Cost Recovery (Depreciation)
= BEFORE-TAX CASH FLOW - Mortgage Interest
- Points Amortization
= REAL ESTATE TAXABLE INCOME
An investor’s marginal tax rate is applied to Real Estate Taxable Income to determine Tax
Liability (or Savings).
After-Tax Cash Flow

Real Estate Taxable Income is multiplied by the investor’s Marginal Tax Rate to arrive at the
investor’s Tax Liability (or Savings). Once the tax liability (or savings) is determined, it is then
deducted from Before-Tax Cash Flow to determine the After-Tax Cash Flow for the investment.
Line 7: NET OPERATING INCOME
NET OPERATING INCOME NET OPERATING INCOME
- Annual Debt Service - Cost Recovery (Depreciation)
= BEFORE-TAX CASH FLOW - Mortgage Interest
- Points Amortization
= REAL ESTATE TAXABLE INCOME
X Marginal Tax Rate
= TAX LIABILITY (SAVINGS)
BEFORE-TAX CASH FLOW
- Tax Liability ( Savings)
= AFTER-TAX CASH FLOW
Note: It is important to watch your sign convention when adding and subtracting negative
numbers. Subtracting a negative number is the same as adding the number
Tax Aspects of Cash Flow Definitions
Cost Recovery (Depreciation)
The deductions for operating expenses and interest require the property owner to pay first, then deduct.
But with cost recovery (formerly called depreciation), you can deduct a non-cash expenditure.
Remember, always recommend that your client consult his or her own tax professional to determine
his or her specific tax issues.
• Only buildings and improvements can be depreciated, not land.

• The cost recovery period is 27.5 years for residential investment properties and 39
years for nonresidential investment properties. Mid-month convention applies. *
• Movable business property (also known as personal property), such as appliances and
carpets, has a cost recovery period of five or seven years.
To estimate annual cost recovery (depreciation) for a residential rental, you must first
determine the property’s cost basis.
• Sales price plus capitalized closing costs equals cost basis. (Loan points are not
included in capitalized closing costs.)
• Once you arrive at the cost basis for a property, the next step is to allocate the cost
basis between land and improvements. Typically, an investor will use either the
assessor’s records or the allocations on the appraisal to determine the percentage
allocation between land and improvements.
• Once you have determined the improvement allocation of the cost basis, divide this
number by 27 ½ years to estimate 12 months depreciation.
* Regardless of the actual closing date, the Tax Reform Act of 1984 requires that
taxpayers use the 15th of the month as the date of acquisition or disposition when
calculating cost recovery deductions. This is known as the mid-month convention and
allows a maximum of 11½ months of cost recovery in the year of acquisition and
disposition. This act applies to real estate placed in service after June 22, 1984
(excepting low-income housing).
Example: In this example we will assign 80% of the basis at acquisition to improvements and
assume this investment property was purchased in January.
Sales Price $540,000

+ Capitalized Closing Costs $10,000
= Basis at Acquisition $550,000
$550,000 X 80% = $440,000 Improvement Allocation
$440,000 / 27.5 = $16,000 Annual Cost Recovery
Mid-month Convention
$16,000 Annual Cost Recovery / 12 = $1,333.33 Monthly Cost Recovery
$1,333.33 X 11.5 Months = $15,333.33 Cost recovery in the year of acquisition

Cost Recovery Practice Problem
Ignoring mid-month convention, what is 12 months’ cost recovery for a residential rental
property selling for $200,000 with $2,400 in capitalized closing costs? The allocation for land is
20% of the cost basis.
Answer________________________
Interest Deduction Rules
• Interest paid on rental property loans is deducted from rental income, whereas
homeowner’s mortgage interest is deducted from personal income. Only the interest
portion of a mortgage loan is deductible.
• There is no limit to the amount of interest a rental property owner may deduct against
rental income, whereas homeowners can only deduct interest on the first $1.1 million
borrowed.
• Finally, there are limitations regarding interest deductions for refinancing. If a rental
property owner refinances and pulls out cash, that cash must be spent for a business
purpose in order for the interest on it to be deductible. This situation is covered by a
complex section of the tax code called the Tracer Rule (T.D.8145). While these regulations
generally do not concern an agent making a sale, a buyer should be aware of them and
consult a tax professional if he or she is considering refinancing.
Interest Deduction Practice Problem
If the first-year annual debt service for an investment property is calculated to be

$13,755.12 with $1,404.30 going towards principal, how much interest would be paid?
Answer ________________________
Amortization of Loan Points

If points are paid when obtaining financing for investment property, they are amortized over the term
of the loan. The term of a loan can differ from the amortization period. For instance, if a purchase loan
is amortized over 30 years but has a due date or term of 5 years, the points paid on this loan would be
amortized over 5 years.
Points Amortization Practice Problem
If one point is paid on a $160,000 loan amortized over 30 years with a due date or term of 30
years, what is the annual points amortization for this investment property?
Answer

Tax Aspects of Cash Flow Example: If we use the NOI from Case Study #1 and the answers
from the last three practice problems, we can calculate the following Real Estate Taxable
Income:

10. NET OPERATING INCOME (LINE 7) $ 17,996.00
11. - Cost Recovery (Depreciation) - $ 5,888.00
12. - Interest (Mortgage 1) - $ 12,350.82
14. - Points Amortization - $ 53.33
15. = REAL ESTATE TAXABLE INCOME = ($ 296.15)
If the Real Estate Taxable Income for this example had been a positive number, we would
multiply it by the investor’s marginal tax rate to determine the investor’s tax liability (how much
tax would be owed) and enter that number on line 17 of the cash flow model.
Since the Real Estate Taxable Income in this example is negative, there is no income to pay tax
on, and therefore no tax liability. But there is a potential tax savings, which is determined by
multiplying the Real Estate Taxable Income by the investor’s marginal tax rate. The resulting
potential tax savings is entered on line 17 in brackets ( ).
Note: It is important to use brackets ( ) in cash-flow analysis to indicate a negative number. This
will help you to keep track of your sign convention when subtracting negative numbers. On line
17 in the example below you will notice brackets around the word (Savings). When the number
on line 17 is negative, it is a potential tax savings. When the number is positive, it represents the
investor’s tax liability for this investment.
Example: Suppose an investor who is in the 28% tax bracket owns this property. When we
multiply ($296.15) times 28% we arrive at ($82.92). Again, since line 17 is a negative number,
it indicates there is a potential tax savings instead of a tax liability.

16. x Investor’s Marginal Tax Rate x % 28
17. = TAX LIABILITY OR (SAVINGS) = ($ 82.92)

B. After-Tax Cash Flow
The final step in completing the standard cash flow model is to subtract the tax liability or
(savings) from before-tax cash flow. Take a moment and complete lines 18, 19, and 20 below.

2. – Vacancy & Uncollected Rents – $ 1,428
4. + Other Income + $ 418.00
6. – Annual Operating Expenses – $ 9554.00
13. - Interest (Mortgage 2) - $ 0
16. x Investor’s Marginal Tax Rate x % 28%
17. = TAX LIABILITY OR (SAVINGS) = ($ 82.92)
After-Tax Cash Flow

C. Potential Tax Savings
In the previous section, it was mentioned that a negative number on line 17 represented a
potential tax savings. The rules governing whether or not the tax savings can be used fall under
the passive loss rules and require an investor to meet certain guidelines in order to receive the
full benefit of the passive loss deduction.
D. Passive Losses
(1) What Is Passive Loss?
To understand passive loss, we must first define passive income. For tax purposes, there are
three types of income: active, portfolio, and passive.
• Active income consists of wages, salaries, tips, etc., plus income from activities in
which the taxpayer materially participates.
• Portfolio income is income from interest, dividends, and royalties.
• Passive income results from any of three types of passive activity: rental activity,
limited business interests, and activities in which the taxpayer does not materially
participate.
Most income from real estate investments is passive income. Passive loss results when all
deductions related to a property—operating expenses, depreciation, mortgage interest, and points
amortization—exceed the property’s income for the year.
For income tax reporting, passive loss is determined by combining all income and losses from
passive sources for the year. Therefore, a loss from one property can offset income from another.
(2) How Can Passive Losses Be Used to Reduce Taxes?
Passive losses can be used to offset passive income. If a passive loss cannot be fully used in the
year it is generated, it can be carried forward to offset passive income in future years. At the time
of sale of a property, any unused passive loss from that property may be used to offset the capital
gain from the sale.
Under the current tax law, passive losses cannot ordinarily be used to offset active or portfolio
income. However, up to $25,000 of passive loss can be so used if certain conditions are met.
They are:
• The investor must own 10% or more of the investment.
• The investor must actively participate in managing the investment (this does not
preclude the use of a professional property management company).

• The investor’s adjusted gross income (before applying passive losses) must not exceed
$100,000 for the full deduction to be taken. If income exceeds $100,000, the $25,000
exemption is reduced by one dollar for every two dollars of income over $100,000.
Exception for Real Estate Professionals
If an investor materially participates in rental activities and spends at least 50% of his total
working time in real property trades or businesses, for a total of at least 750 hours per year, he
can deduct passive losses against his active or portfolio income up to the full amount of that
income. Only one spouse must meet the test for a joint income tax filing.
Real Property Trade or Business: A business with respect to which real property is developed
or redeveloped, constructed or reconstructed, acquired, converted, rented or leased, operated or
managed, or brokered.
Caution!
This is only a brief summary of the tax laws relating to passive losses. The regulations are quite
complex, and a potential investor should consult accounting and tax professionals before making
an investment decision based on passive loss potential. A real estate professional should avoid
giving specific advice in these areas.
E. Real Estate Investor vs. Real Estate Dealer
We have assumed the owner of rental property is classified by the IRS as a real estate investor
rather than as a real estate “dealer.” A dealer in real estate primarily holds property for resale to
customers in the ordinary course of business. A real estate investor typically holds property for
personal investment, not as inventory to be resold to customers. A real estate dealer is not
allowed the same income tax benefits available to investors. A dealer is not allowed:
1) long-term capital gains tax treatment when selling (all profits are taxed as ordinary
income);
2) the ability to perform an IRC Section 1031 tax-deferred exchange;
3) the ability to receive IRC Section 453 installment sale treatment;
4) depreciation deductions.
Listed below are some factors the IRS may review to determine whether the intent was to hold
the property for personal investment or for resale to customers. The burden of substantiating the
investment intent lies with the property owner. The items below are not an exhaustive list, but
are useful indicators:

• the nature and purpose of the acquisition of the property and the duration of
ownership
• the extent and nature of the taxpayer's efforts to sell the property
• the number, extent, continuity, and substantiality of the sales
• the use of a business office for the sale of the property
• the character and degree of supervision or control exercised by the taxpayer over
any representative selling the property
• the time and effort the taxpayer habitually devoted to the sales
A Visual Look at Mortgage Interest and Cost Recovery Deductions
The effects of mortgage interest and cost recovery on Cash Flow After Tax (AT)
Cost recovery ends at 27.5 years Loan pays off at 30 years

F. Case Study #2
A single-family home is listed for $150,000. It has three bedrooms and two baths and rents for
$950 per month. The average vacancy in the area is reported to be 5%. There is no other income
associated with this property. Property taxes will be reassessed at 1.2% of sales price per year.
Fire insurance has been quoted at $500 per year. The purchaser will personally manage the
property. Maintenance is expected to cost $800 per year. The buyer will obtain 75% financing at
5.875% fixed rate amortized over 30 years with monthly P&I payments of $665.48. Mortgage
interest for year one will be $6,571.70. Buyer will pay one point for this loan (points
amortization will be $37.50 per year). Cost recovery will be $3,959.66 in year one due to mid-
month convention. The investor is a real estate professional in the 28% tax bracket.

4. + Other Income + $___________

After-Tax Cash Flow


V. Common Uses of Cash Flow Analysis

There are many uses for the information represented in the Before-Tax Cash Flow model. Of
particular interest are Gross Scheduled Income (line 1), Net Operating Income (line 7), Annual
Debt Service (line 8), and Before-Tax Cash Flow (line 9). We will discuss common uses for
these line items in this chapter.

4. + Other Income + $___________
A. Determining the Value of Investment Property
Two commonly used methods of determining the value of an investment property are the Gross
Rent Multiplier (GRM) method and the Income Capitalization or Cap Rate method.
B. Gross Rent Multiplier (GRM)
The GRM method of determining investment value is quick and easy because it only uses
the information from line one of the cash flow model.
Calculating the Gross Rent Multiplier of an Investment
To calculate the Gross Rent Multiplier (GRM) for an investment property that is offered for sale,
divide the asking price by the first year Gross Scheduled Income (GSI).
Asking Price = GRM

GSI
Example:

For this example we will use an investment property listed for $200,000 with a Gross Scheduled
Income (GSI) of $28,560. If this property were purchased at the list price, it would have a Gross
Rent Multiplier (GRM) of 7.
Asking Price= GRM $200,000 = 7.00

GSI $28,560
Using the Gross Rent Multiplier to Determine the Value of an Investment Property
The value of an investment property can be determined by multiplying a specific gross rent
multiplier by the properties expected first-year gross scheduled income.
First-year GSI x GRM = Value of investment property
The gross rent multiplier used in evaluating investment property is typically derived from
comparable property’s in the marketplace and may be adjusted by the investor to reflect his or
her specific requirements.
Example:
Suppose a potential buyer’s gross rent multiplier (GRM) requirement is 6.75. (This means the
investor will pay no more than 6.75 times the gross scheduled rent to purchase an investment
property.) The property the buyer is considering has an estimated first-year gross scheduled
income of $28,560. The investment value, or the amount this investor would be willing to pay
for this property, is:
$28,560 x 6.75 = $192,780
Note: Once the Gross Scheduled Income for an investment property has been determined, we
can make the following assumptions:
1) The higher the asking price, the higher the GRM.

2) Sellers generally try to list and sell their properties at the highest possible GRM.
3) Buyers typically try to purchase investment properties at the lowest possible GRM.
The lower the GRM, the more attractive the investment becomes.
Pros and Cons of Using a Gross Rent Multiplier:
Pros: The gross rent multiplier is a convenient tool because of its simplicity.
Cons: The usefulness of the gross rent multiplier is limited by the fact that it does not take into
account vacancy and uncollected rent, operating expenses, debt service, tax impact, or income
past the first year.
Capitalization Rate (Cap Rate)

Many appraisers and investors use a cap rate along with the first-year Net Operating Income
(line 7) of an investment property to establish its value (price). A cap rate is the ratio between the
first-year net operating income (NOI) and the purchase price of the property. Cap rates are
market-specific and can vary from neighborhood to neighborhood or even street to street. They
are affected by the principles of supply and demand and can vary significantly according to
perceived risk. In addition, different investor’s may have different cap rate requirements. If you
are trying to determine the appropriate cap rate for a specific marketplace, contact a real estate
appraiser or real estate professional who is familiar with the marketplace.
Determining the Cap Rate of an Investment
We can use the following formula to solve for the cap rate of an investment property, when the
net operating income is known and the price is fixed.
NOI = Cap Rate

Purchase Price
Example: Suppose an investment property is listed for $200,000 with an estimated first-year
NOI of $17,966. If this property were purchased at the list price, the cap rate for this investment
would be 9%.
NOI = Cap Rate $17,996 = .09 or 9%

Purchase Price $200,000
Using a Cap Rate to Determine Investment Value
The cap rate used in evaluating investment property is typically derived from comparable
properties in the marketplace and may be adjusted by the investor to reflect his or her specific
requirements. The following formula can be used to solve for the investment value of a property
when the net operating income is known and the cap rate is set:
NOI = Investment Value (Price)

Cap Rate
Example: Suppose a potential buyer is looking at a property listed for $200,000 with an
estimated first-year NOI of $17,996. After looking at the cap rates of similar properties, the
buyer has decided on a cap rate requirement of 9.25%. We can use the investor’s cap rate and the
property’s first-year NOI to determine the property’s Investment Value (the price the investor
would be willing to pay).
NOI = Investment Value $17,996 = $ 194,551

Cap Rate 9.25%
Note: Once the Net Operating Income for an investment property has been determined, we can
make the following assumptions:

1) The lower the cap rate, the higher the sales price.
2) The higher the cap rate, the lower the sales price.
3) Sellers want buyers to accept the lowest possible cap rate.
4) From the buyer’s point of view, the higher the cap rate, the more attractive the
investment becomes.
Pros and Cons of Using a Capitalization Rate (Cap Rate):
Pros: The main advantage of using a cap rate is its simplicity. It also accounts for vacancy and
operating expenses.
Cons: The reliability of using a cap rate is limited because it only looks at a one-year forecast
and does not take into consideration any financing or tax implications.
Discussion: Now that we have learned to determine the value of an investment property using a
Gross Rent Multiplier and Cap Rate, let's discuss the following:
1. If the price of a property is increased, how does this affect GRM and Cap Rate?
2. If you were able to lower the operating expenses of an investment property, how would
this affect GRM and Cap Rate?
C. Cash on Cash
Another measurement of investment performance is called Cash on Cash (C/C). This involves
comparing an investor’s initial investment to the potential before-tax cash flow an investment
property is likely to produce. Let’s assume the investor’s initial investment is $44,000 ($40,000
down plus $2,400 in closing costs plus $1,600 for points). We will also assume the property
produces a first-year before-tax cash flow of $4,240.88.
Before-tax cash flow = % Return $4,240.88 (cash) = .0964 or 9.64%

Initial investment $44,000 (on cash)
Discussion: What if the potential investor for this property had a cash on cash requirement of
10%? How could this be achieved?
Pros and Cons of Using Cash on Cash:
Pros: Cash on Cash takes into consideration vacancy and uncollected rent, operating expenses,
and debt service.
Cons: Cash on Cash does not take into consideration anything past a first-year forecast. It does
not take into account tax considerations.

D. Debt Coverage Ratio (DCR)
Another use for the before-tax cash flow model is determining the Debt Coverage Ratio for an
investment property. When lenders provide financing for apartment complexes with five units or
more, they generally use a debt coverage ratio as a lending guideline.
Formula: Debt Coverage Ratio (DCR) is determined by dividing Net Operating Income (NOI)
by the Annual Debt Service (ADS). Remember, annual debt service is the total principal and
interest for all mortgages.
Net Operating Income = Debt Coverage Ratio or NOI = DCR

Annual Debt Service ADS
Example:
From Case Study #1, observe the following Before-Tax Cash Flow model and the Debt
Coverage Ratio derived from lines 7 and 8.

2. – Vacancy & Uncollected Rents – $_ 1,428.00
4. + Other Income + $_ 418.00
6. – Annual Operating Expenses – $ 9,554.00
$17,996.00 (NOI) = 1.31 DCR

$13,755.12 (ADS)

Understanding Debt Coverage Ratios
To understand DCR, let’s look at a break-even property. A property with NOI of $5,000 and
ADS of $5,000 would break even and have a DCR of 1.0 (one point zero).
$5,000 NOI = 1.0 DCR

$5,000 ADS
The Before-Tax Cash Flow for this investment property would be zero, which would not
generally be acceptable to a lender. Because income and expenses vary from month to month,
lenders reduce their risk by making loans where the ADS is less than the NOI.
Lenders typically like to see Debt Coverage Ratios between 1.1 and 1.3 for low-risk properties.
Solve for ADS: Let’s assume that an investment property has NOI of $5,000 and the lender’s
minimum DCR requirement is 1.2. We can divide the NOI by the DCR to solve for the
maximum ADS the lender will allow.
NOI = ADS $5,000 = $4,167

DCR 1.2
You can divide the ADS in this example by 12 to arrive at the monthly Principal and Interest
allowed by the lender. Enter this monthly amount into your financial calculator along with the
appropriate interest rate and amortization period, and then solve for loan amount. This will
determine the maximum loan you can obtain from this particular lender.
Bottom Line: Lenders want to make sure that the income produced by the property is more than
enough to pay the mortgage (ADS). A higher DCR means there is less risk in making the loan.
An aggressive lender may only require a DCR of 1.1, while other lenders have DCR
requirements as high as 1.25 or more.
Solve for Maximum Loan Amount
You can divide the ADS in this example by 12 to arrive at the maximum monthly Principal and
Interest allowed by the lender. Enter this monthly amount into your financial calculator along
with the appropriate interest rate and amortization period, and then solve for loan amount. This
will determine the maximum loan you can obtain from this particular lender.
$5,000 (NOI) = $4,167 (Maximum ADS) $4,167 = $347.25 (Maximum Monthly P&I)
1.2 (DCR) 12 Months

E. Case Study #3:
Use this before-tax cash flow model to answer the questions below.
Saint James Apartments
What is the before-tax cash flow for this investment? ___________

(Bottom line of the before-tax cash flow model)
1) What is the gross rent multiplier for this investment? __________

(Purchase price divided by gross scheduled income)
2) What is the capitalization rate for this investment? ___________

Net Operating Income (NOI) = Cap Rate
Purchase Price
3) What is the cash on cash return on this investment? ____________

Before-tax cash flow = % Return
Initial investment
4) What is the debt coverage ratio for this investment? ____________

Net Operating Income = Debt Coverage Ratio
Annual Debt Service

VI. Accurate Data

A. The Software Advantage
There are numerous software packages available to assist you with real estate investment
analysis, including those available as part of your Multiple Listing Service.
There are several advantages of using software as opposed to using pencil, paper, and calculator.
The main advantages are:
1. Speed: Data can be entered quickly, and most calculations take place automatically.
2. Flexibility: When data is changed, all related data is automatically recalculated.
3. Accuracy: Because calculations take place automatically, fewer keystrokes are needed,
leaving less opportunity for human error.
4. Printed Reports: Computer-generated reports look more professional than handwritten

reports.
Making Changes
In Case Study #3 we used the Before-Tax Cash Flow model to calculate the following statistics:
1. Gross Rent Multiplier

2. Cap Rate
3. Cash on Cash
4. Debt Coverage Ratio
Discussion: What would happen to the Before-Tax Cash Flow model and the resulting statistics
if you changed the first line of the cash flow model—Gross Scheduled Income?
Any change in the data used in the cash flow model requires you to redo all the calculations
following your change.

B. Obtaining Accurate Data
Obviously, your cash-flow analysis will only be as accurate as the information you plug into the
cash flow model. Current information on a property’s income and expenses may be available
from the following sources:
• The property manager’s records

• Copies of the current lease and rental agreements
• A copy of the owner’s Schedule E (rental property income tax schedule)
• The owner’s personal records
C. Important Questions to Ask
Gross Scheduled Income
• What are the current rents, according to the lease and rental agreements?
• Are these market rents?
• How long do these agreements run?
• Are the tenants prompt payers?
• When were rents last increased?
• What did the owner report as rental income on his Schedule E?
• If there is a property manager, what do his records show as collected rents?
Vacancy & Uncollected Rents
• What is the current vacancy factor for the property?

• What is the current market or submarket vacancy factor?
• What is a reasonable forecast for future vacancies?
• Is the property competitive, or does it need to be upgraded?
Other Income
• Are the laundry and vending machines owned by (a) the property owner or (b) an
outside vendor?
• If (a), how long will the machines last, and how much will it cost to replace them?
• If (b), what are the contract terms?
• Are parking fees charged for extra or large vehicles?

Annual Operating Expenses
Annual expenses should be broken down into categories. This will assist a buyer and his or her
tax professional to properly analyze the property. In addition it makes it easy to enter the
expenses on a Schedule E at tax time. The following is a typical breakdown of annual expenses:
Advertising Services (garbage, gardening,

Cleaning and maintenance pest, pool, landscaping, etc.)
Leasing commissions Supplies
Property insurance Taxes
Legal and other professional fees Utilities
Management fees Other
Repairs
Annual Debt Service
Remember to include only principal and interest payments; taxes and insurance have already
been accounted for under operating expenses.
D. Putting It All Together
So far we have learned to:
• Gather accurate data

• Calculate Before- and After-Tax Cash Flow
• Use a Gross Rent Multiplier to determine the value of a property
• Use Cap Rate to determine the value of an investment property
• Calculate Cash on Cash
• Calculate a Debt Coverage Ratio

Review
To reinforce what we have learned so far, we will utilize the entire cash flow model while
completing Case Study #4 to answer the following questions:
• What is the total initial investment?

• What is the before-tax cash flow?
• What is the gross rent multiplier for this investment?
• What is the capitalization rate for this investment?
• What is the cash on cash return on this investment?
• What is the debt coverage ratio for this investment?
• What is the after-tax cash flow?
Instructions: Complete the entire cash flow model for Case Study #4 and then answer the
questions on the page immediately following Case Study #4.

E. Case Study #4
A ten-unit property is listed for $465,000. It has five 1bd/1ba units rented at $500/month and five
2bd/1ba units rented for $600/month. The average vacancy in the area is reported to be 5%.
$1,100 per year in other income is expected. Property taxes will be 1.2% of sales price/year.
Insurance will cost $1,800/year. Property management will cost 7% of Gross Operating Income.
Maintenance averages $2,500/year. Total utilities will cost $2,600/year. Total services will cost
$5,000/year. Buyer will pay one point for 80% financing at 7.5% fixed rate amortized over 30
years with annual principal and interest payments totaling $31,212.94. Closing costs will be
1.5% of sales price. Mortgage interest for year one will be $27,783.71. Annual points
amortization will be $124. Cost recovery will be $13,158.09 due to mid-month convention, an
80% allocation of basis for improvements, and a cost recovery period of 27.5 years. The investor
is a real estate professional in the 28% tax bracket.

4. + Other Income + $___________
After-Tax Cash Flow

Case Study #4 Questions
What is the total initial investment?________________

(Down payment plus closing costs plus points)
What is the before-tax cash flow? ________________

(Line 9 of the cash flow model)
What is the gross rent multiplier for this investment? __________

(Purchase price divided by gross scheduled income)
What is the capitalization rate for this investment? ___________

Net Operating Income (NOI) = Cap Rate
Purchase Price
What is the cash on cash return on this investment? ____________

Before-tax cash flow = % Return
Initial investment
What is the debt coverage ratio for this investment? ____________

Net Operating Income = Debt Coverage Ratio
Annual Debt Service
What is the after-tax cash flow for this investment? _____________
(Bottom line of the after-tax cash flow model)

VII. Marketing Investment Property

A. Marketing Material
Actual vs. Proforma: It should be noted in any marketing material whether you are using actual
income and expense information or proforma income and expenses. (A proforma is an
opinion/estimate of the potential income and expenses a new owner will experience.) There are
many different types of reports or statements used for marketing investment properties. Two
very common types are a Property Data Sheet and an APOD (Annual Property Operating Data).
B. Property Data Sheet
A property data sheet often includes financial statistics and a scaled-down operating statement.
Examples of data are reflected below:
• Address • Number of gas and electric meters

• Name of complex • Size of lot
• Number of units • Roof type
• Unit mix (size, number • Number of stories
of bedrooms & baths, rents) • Capitalization rate
• Age • Gross rent multiplier
• Date of last renovation • Pictures of the property
C. Annual Property Operating Data (APOD) Sheet
An annual property operating data sheet is a detailed cash flow statement based on estimated
income and expenses for the next twelve-month period. It includes proposed financing figures
and a potential before-tax cash flow. It may also, for the purpose of calculating potential cost
recovery (depreciation), show the allocation of value between land, improvements, and personal
property. The information contained in this report can be used by investors and their financial
advisors to determine the suitability of an investment.
EXAMPLES: On the following two pages you will find examples of a Property Data Sheet and
an Annual Property Operating Data (APOD) Sheet.

John Smith (800) 555-5000 Office
Company
5555 Main Street (800) 555-5010 Direct
Logo Any Town, USA (800) 555-5011 Fax
jsmith@realty.com
Four-Plex
1234 Exchange Street

Any Town, USA
Property Information
Price $200,000 Number of Units 4

Price per Unit $50,000 Year Built 1980
Rentable Sq Ft 3,600 Year Renovated 1995
Price per Sq Ft $56 Number of Buildings 1
Taxes $2,200 Number of Stories 2
Insurance $1,000 Parking Spaces 6
Roof Comp Zoning Multi-Res
# Electric Meters: 5 # Gas Meters: 4 Land Area 70 x 150
Amenities and Features Unit Mix
Well-maintained property in good location. # Units Actual Rent Proforma Rent

Two of the tenants have lived here for more of Type Beds Baths Sq Ft $Rent Sq Ft $Rent Sq Ft
than 5 years. Laundry machines are leased
with 50% of revenue going to owner. 4 2 1 900 $595 $0.66 $625 $0.69
Laundry is all electric on separate meter
along with common-area lighting.
Actual Operating Statement Proforma Operating Statement

Gross Scheduled Income $28,560 Gross Scheduled Income $30,000
- Vacancy Loss (5%) $1,428 - Vacancy Loss (5%) $1,500
+ Other Income $418 + Other Income $418
= Gross Operating Income $27,550 = Gross Operating Income $28,918
- Annual Operating Expenses $9,554 - Annual Operating Expenses $9,756
= Net Operating Income $17,996 = Net Operating Income $19,162
Cap Rate:9.0% Gross Rent Multiplier: 7.00 Cap Rate:9.58%Gross Rent Multiplier: 6.67
Annual Expenses per Unit $2388.50 Annual Expenses Per Unit $2,439.00
This document is an informational summary for review by prospective investors/principals and/or their representatives. Although the information
contained herein has been prepared by (Company Name) or has been furnished by sources deemed reliable, none of such information has been
verified and no representation, either expressed or implied, is made to the accuracy thereof. All information contained herein is further subject to
correction, modification, or withdrawal without further notice. This information is confidential in nature, and should not be reproduced in whole
or in part without the express written permission of (Company Name).

Annual Property Operating Data
Prepared for _________________________ Date Prepared ______________________
Purchase Price _________________________ Down Payment ______________________
Property Name _________________________ + Closing Costs ______________________
Location _________________________ + Loan Points ______________________
Number Units/Size _________________________ = Initial Investment ______________________
Proposed Financing
Assessed/Appraised Values 1 Mortgage 2nd Mortgage
st
Loan Amount _______________________

Land _________________________ Interest Rate _______________________
+ Improvements _________________________ Amortization Period _______________________
+ Personal Property_________________________ Loan Term (Due) _______________________
= Total _________________________ Monthly Payment _______________________
Annual Debt Service _______________________
ANNUAL FIGURES COMMENTS
1 GROSS SCHEDULED INCOME ___________ ___________________________

2 - Vacancy and Uncollected Rent ___________ ___________________________
3 = EFFECTIVE RENTAL INCOME ___________ ___________________________
4 + Other Income ___________ ___________________________
5 = GROSS OPERATING INCOME ___________ ___________________________
OPERATING EXPENSES: ___________________________
6 Real Estate Taxes ___________ ___________________________
7 Property Insurance ___________ ___________________________
8 Property Management ___________ ___________________________
UTILITIES: (gas, electric, sewer & water, etc.) ___________________________
9 __________________ ___________ ___________________________
10 __________________ ___________ ___________________________
11 __________________ ___________ ___________________________
12 __________________ ___________ ___________________________
SERVICES: (garbage, landscaping, janitorial, etc.) ___________________________
13 __________________ ___________ ___________________________
14 __________________ ___________ ___________________________
15 __________________ ___________ ___________________________
16 __________________ ___________ ___________________________
OTHER EXPENSES: ___________________________
17 __________________ ___________ ___________________________
18 __________________ ___________ ___________________________
19 __________________ ___________ ___________________________
20 __________________ ___________ ___________________________
21 __________________ ___________ ___________________________
22 - TOTAL OPERATING EXPENSES ___________ ______________________
23 = NET OPERATING INCOME ___________ ______________________
24 - Annual Debt Service ___________ ___________________________
25 - Capital Additions ___________ ______________________
26 = CASH FLOW BEFORE TAX ___________ ___________________________
Prepared by ___________________________________________
• The figures contained in this report, while obtained from sources deemed reliable, are estimates, not guaranteed. Investors should seek legal
and tax advice before making a decision to purchase investment real estate.

VIII. UNDERSTANDING INVESTOR GOALS

A. Diversification
The key to successful investing is a balanced portfolio. Most financial advisors recommend that
investors have adequate insurance, some liquid savings, some fixed-return instruments, and some
investments with equity growth potential. Within these categories, a diversification of
investments can protect the investor if the market drops in one area of his or her investment
portfolio. Real estate, as one element of an investment portfolio, offers the potential for equity
growth as well as monthly cash flow.
B. What Investors Want to Know
• How much do I need to invest to realize my goals?

• What kind of return can I make on my investment?
• When do I receive this return?
C. The Real Estate Professional’s Task
The real estate professional’s task is to help provide investors with the information they need to
make a decision. Investors must decide for themselves whether or not an investment in real
estate is right for them. A real estate professional should not necessarily express an opinion
about an investment unless the client asks for it, and should never press a client to make a certain
decision. In addition, a real estate professional should encourage the client to seek professional
tax and legal advice before choosing real estate as an investment.

I. Introduction to IRC §1031, §1033, §121

A. Overview of IRC §1031. Exchange of Property Held for Investment
Under Internal Revenue Code Section 1031, no gain or loss is recognized on the exchange of
property held for productive use in a trade or business or for investment if that property is
exchanged solely for property of a like kind which is to be held either for productive use in a
trade or business or for investment. Section 1031(a) provides:
(a) Non-recognition of gain or loss from exchanges solely in kind
(1) In general.
No gain or loss shall be recognized on the exchange of property held for productive
use in a trade or business or for investment if such property is exchanged solely for
property of like kind which is to be held either for productive use in a trade or
business or for investment.
(2) Exception. This subsection shall not apply to any exchange of -
(A) stock in trade or other property held primarily for sale,
(B) stocks, bonds, or notes,
(C) other securities or evidences of indebtedness or interest,
(D) interests in a partnership,
(E) certificates of trust or beneficial interests, or
(F) choses in action.
[REMAINDER OF STATUTE OMITTED]

B. Overview of IRC §1033, Involuntary Conversions
(a) General rule. If property (as a result of its destruction in whole or in part, theft, seizure, or
requisition or condemnation or threat or imminence thereof) is compulsorily or
involuntarily converted—
(1) Conversion into similar property. Into property similar or related in service or use to
the property so converted, no gain shall be recognized.
(2) Conversion into money. Into money or into property not similar or related in service
or use to the converted property, the gain (if any) shall be recognized except to the
extent hereinafter provided in this paragraph:
(A) Non-recognition of gain. If the taxpayer during the period specified in

subparagraph (B) , for the purpose of replacing the property so converted,
purchases other property similar or related in service or use to the property so
converted, or purchases stock in the acquisition of control of a corporation
owning such other property, at the election of the taxpayer the gain shall be
recognized only to the extent that the amount realized upon such conversion
(regardless of whether such amount is received in one or more taxable years)
exceeds the cost of such other property or such stock. Such election shall be
made at such time and in such manner as the Secretary may by regulations
prescribe. For purposes of this paragraph —
(i) no property or stock acquired before the disposition of the converted property
shall be considered to have been acquired for the purpose of replacing such
converted property unless held by the taxpayer on the date of such
disposition; and
(ii) the taxpayer shall be considered to have purchased property or stock only if,
but for the provisions of subsection (b) of this section, the unadjusted basis of
such property or stock would be its cost within the meaning of section 1012.
(B) Period within which property must be replaced. The period referred to in
subparagraph (A) shall be the period beginning with the date of the disposition of
the converted property, or the earliest date of the threat or imminence of
requisition or condemnation of the converted property, whichever is the earlier,
and ending—
(i) 2 years after the close of the first taxable year in which any part of the gain
upon the conversion is realized, or
(ii) subject to such terms and conditions as may be specified by the Secretary, at
the close of such later date as the Secretary may designate on application by

the taxpayer. Such application shall be made at such time and in such manner
as the Secretary may by regulations prescribe.
(C) Time for assessment of deficiency attributable to gain upon conversion.

[OMITTED]
(E) Definitions. For purposes of this paragraph —
(i) Control. The term “control” means the ownership of stock possessing at least
80 percent of the total combined voting power of all classes of stock entitled
to vote and at least 80 percent of the total number of shares of all other
classes of stock of the corporation.
(ii) Disposition of the converted property. The term “disposition of the converted
property” means the destruction, theft, seizure, requisition, or condemnation
of the converted property, or the sale or exchange of such property under
threat or imminence of requisition or condemnation.
(b) Basis of property acquired through involuntary conversion.
(1) Conversions described in subsection (a) (1). If the property was acquired as the
result of a compulsory or involuntary conversion described in subsection (a) (1), the
basis shall be the same as in the case of the property so converted—
(A) decreased in the amount of any money received by the taxpayer which was not
expended in accordance with the provisions of law (applicable to the year in
which such conversion was made) determining the taxable status of the gain or
loss upon such conversion, and
(B) increased in the amount of gain or decreased in the amount of loss to the taxpayer
recognized upon such conversion under the law applicable to the year in which
such conversion was made.
(2) Conversions described in subsection (a) (2). In the case of property purchased by the
taxpayer in a transaction described in subsection (a)(2) which resulted in the non-
recognition of any part of the gain realized as the result of a compulsory or
involuntary conversion, the basis shall be the cost of such property decreased in the
amount of the gain not so recognized; and if the property purchased consists of more
than 1 piece of property, the basis determined under this sentence shall be allocated to
the purchased properties in proportion to their respective costs.
(3) Property held by corporation the stock of which is replacement property.
(A) In general. If the basis of stock in a corporation is decreased under paragraph (2) ,
an amount equal to such decrease shall also be applied to reduce the basis of

property held by the corporation at the time the taxpayer acquired control (as
defined in subsection (a)(2)(E) ) of such corporation.
(B) Limitation. Subparagraph (A) shall not apply to the extent that it would (but for
this subparagraph) require a reduction in the aggregate adjusted bases of the
property of the corporation below the taxpayer's adjusted basis of the stock in the
corporation (determined immediately after such basis is decreased under
paragraph (2) ).
(C) Allocation of basis reduction. The decrease required under subparagraph (A) shall
be allocated—
(i) first to property which is similar or related in service or use to the converted
property,
(ii) second to depreciable property (as defined in section 1017(b) (3) (B)) not
described in clause (i), and
(iii) then to other property.
(D) Special rules.
(i) Reduction not to exceed adjusted basis of property. No reduction in the basis
of any property under this paragraph shall exceed the adjusted basis of such
property (determined without regard to such reduction).
(ii) Allocation of reduction among properties. If more than 1 property is

described in a clause of subparagraph (C), the reduction under this paragraph
shall be allocated among such property in proportion to the adjusted bases of
such property (as so determined).
(c) Property sold pursuant to reclamation laws. [OMITTED]
(d) Livestock destroyed by disease. [OMITTED]
(e) Livestock sold on account of drought, flood, or other weather-related conditions.

[OMITTED]
(f) Replacement of livestock with other farm property in certain cases. [OMITTED]
(g) Condemnation of real property held for productive use in trade or business or for
investment.
(1) Special rule. For purposes of subsection (a) , if real property (not including stock
in trade or other property held primarily for sale) held for productive use in trade

or business or for investment is (as the result of its seizure, requisition, or
condemnation, or threat or imminence thereof) compulsorily or involuntarily
converted, property of a like kind to be held either for productive use in trade or
business or for investment shall be treated as property similar or related in service
or use to the property so converted.
(2) Limitation. Paragraph (1) shall not apply to the purchase of stock in the
acquisition of control of a corporation described in subsection (a) (2) (A).
(3) Election to treat outdoor advertising displays as real property. [OMITTED]
(h) Special rules for property damaged by Presidentially declared disasters.
(1) Principal residences. If the taxpayer's principal residence or any of its contents is
compulsorily or involuntarily converted as a result of a Presidentially declared
disaster—
(A) Treatment of insurance proceeds.
(i) Exclusion for unscheduled personal property. No gain shall be recognized

by reason of the receipt of any insurance proceeds for personal property
which was part of such contents and which was not scheduled property
for purposes of such insurance.
(ii) Other proceeds treated as common fund. In the case of any insurance
proceeds (not described in clause (i)) for such residence or contents—
(I) such proceeds shall be treated as received for the conversion of a

single item of property, and
(II) any property which is similar or related in service or use to the

residence so converted (or contents thereof) shall be treated for
purposes of subsection (a) (2) as property similar or related in service
or use to such single item of property.
(B) Extension of replacement period. Subsection (a)(2)(B) shall be applied with

respect to any property so converted by substituting “4 years” for “2 years”.
(2) Trade or business and investment property. If a taxpayer's property held for
productive use in a trade or business or for investment is compulsorily or
involuntarily converted as a result of a Presidentially declared disaster, tangible
property of a type held for productive use in a trade or business shall be treated
for purposes of subsection (a) as property similar or related in service or use to
the property so converted.

(3) Presidentially declared disaster. For purposes of this subsection , the term
“Presidentially declared disaster” means any disaster which, with respect to the
area in which the property is located, resulted in a subsequent determination by
the President that such area warrants assistance by the Federal Government under
the Robert T. Stafford Disaster Relief and Emergency Assistance Act.
(4) Principal residence. For purposes of this subsection, the term “principal
residence” has the same meaning as when used in section 121, except that such
term shall include a residence not treated as a principal residence solely because
the taxpayer does not own the residence.
(i) Replacement property must be acquired from unrelated person in certain cases.
(1) In general. If the property which is involuntarily converted is held by a taxpayer to

which this subsection applies, subsection (a) shall not apply if the replacement
property or stock is acquired from a related person. The preceding sentence shall
not apply to the extent that the related person acquired the replacement property
or stock from an unrelated person during the period applicable under subsection
(a)(2)(B).
(2) Taxpayers to which subsection applies. This subsection shall apply to—
(A) a C corporation,
(B) a partnership in which 1 or more C corporations own, directly or indirectly

(determined in accordance with section 707(b) (3)), more than 50 percent of
the capital interest, or profits interest, in such partnership at the time of the
involuntary conversion, and
(C) any other taxpayer if, with respect to property which is involuntarily
converted during the taxable year, the aggregate of the amount of realized
gain on such property on which there is realized gain exceeds $100,000.
In the case of a partnership, subparagraph (C) shall apply with respect to the
partnership and with respect to each partner. A similar rule shall apply in the
case of an S corporation and its shareholders.
(3) Related person. For purposes of this subsection , a person is related to another
person if the person bears a relationship to the other person described in section
267(b) or 707(b)(1).
[REMAINDER OF STATUTE OMITTED]

C. Overview of IRC §121. Exclusion of Gain from Sale of Principal Residence
(a) Exclusion Gross income shall not include gain from the sale or exchange of property if,
during the 5-year period ending on the date of the sale or exchange, such property has
been owned and used by the taxpayer as the taxpayer's principal residence for periods
aggregating 2 years or more.
(b) Limitations
(1) In general
The amount of gain excluded from gross income under subsection
(A) with respect to any sale or exchange shall not exceed $250,000.
(2) Special rules for joint returns
In the case of a husband and wife who make a joint return for the taxable year of the
sale or exchange of the property -
(A) $500,000 Limitation for certain joint returns Paragraph (1) shall be applied by
substituting ''$500,000'' for ''$250,000'' if -
(i) either spouse meets the ownership requirements of subsection (a) with
respect to such property;
(ii) both spouses meet the use requirements of subsection (a) with respect to
such property; and
(iii) neither spouse is ineligible for the benefits of subsection (a) with respect to
such property by reason of paragraph (3).

(3) Application to only 1 sale or exchange every 2 years
(A) In general Subsection (a) shall not apply to any sale or exchange by the taxpayer
if, during the 2-year period ending on the date of such sale or, there was any other
sale or exchange by the taxpayer to which subsection (a) applied.
(B) Pre-May 7, 1997, sales not taken into account in Subparagraph (A) shall be
applied without regard to any sale or exchange before May 7, 1997.
(c) Exclusion for taxpayers failing to meet certain requirements
(1) In general
In the case of a sale or exchange to which this subsection applies, the ownership and
use requirements of subsection (a), and subsection (b)(3), shall not apply; but the
dollar limitation under paragraph (1) or (2) of subsection (b),whichever is applicable,
shall be equal to -
(A) the amount which bears the same ratio to such limitation (determined without
regard to this paragraph) as
(B) (i) the shorter of -
(i) the aggregate periods, during the 5-year period ending on the date of such sale
or exchange, such property has been owned and used by the taxpayer as
the taxpayer's principal residence; or

(ii) the period after the date of the most recent prior sale or exchange by the
taxpayer to which subsection (a) applied and before the date of such sale
or exchange, bears to (ii) 2 years.
(2) Sales and exchanges to which subsection applies
This subsection shall apply to any sale or exchange if -
(A) subsection (a) would not (but for this subsection) apply to such sale or exchange
by reason of -
(i) a failure to meet the ownership and use requirements of subsection (a), or
(ii) subsection (b)(3), and (B) such sale or exchange is by reason of a change in
place of employment, health, or, to the extent provided in regulations,
unforeseen circumstances.

D. Overview of TD 9152 – Reduced Maximum Exclusion of Gain from a Sale or
Exchange of Principal Residence
Explanation and Summary of Comments
1. Facts and Circumstances Test
Under section 121(a), a taxpayer may exclude up to $250,000 ($500,000 for certain joint
returns) of gain realized on the sale or exchange of the taxpayer’s principal residence if
the taxpayer owned and used the property as the taxpayer’s principal residence for at
least two years during the five-year period ending on the date of the sale or exchange.
Section 121(b)(3) allows the taxpayer to apply the maximum exclusion to only one sale
or exchange during the two-year period ending on the date of the sale or exchange.
Section 121(c) provides that a taxpayer who fails to meet any of the conditions by reason
of a change in place of employment, health, or, to the extent provided in regulations,
unforeseen circumstances, may be entitled to exclusion in a reduced maximum amount.
The temporary regulations provide, as a general definition, that a sale or exchange is by
reason of a change in place of employment, health, or unforeseen circumstances only if
the taxpayer’s primary reason for the sale or exchange is a change in place of
employment, health, or unforeseen circumstances. The temporary regulations provide
factors that may be relevant in determining the taxpayer’s primary reason for the sale or
exchange. One commentator asserted that the factors are beyond Congressional intent,
unnecessary, and overbroad. The final regulations retain the list of factors because it is
helpful in determining the taxpayer’s primary reason for the sale or exchange. For each of
the three grounds for claiming a reduced maximum exclusion, the temporary regulations

provide a general definition and one or more safe harbors. Under the temporary
regulations, if a safe harbor applies, the taxpayer’s “primary reason” for the sale or
exchange is deemed to be change in place of employment, health, or unforeseen
circumstances. For greater simplicity, the final regulations delete the primary reason test
from the safe harbors and provide that, if a safe harbor applies, the sale or exchange is
deemed to be “by reason of” a change in place of employment, health, or unforeseen
circumstances. If a safe harbor does not apply, the taxpayer may be eligible to claim a
reduced maximum exclusion if the taxpayer establishes, based on the facts and
circumstances, that the taxpayer’s primary reason for the sale or exchange is a change in
place of employment, health, or unforeseen circumstances.
2. Unforeseen Circumstances
The temporary regulations provide that a sale or exchange is by reason of unforeseen
circumstances if the primary reason for the sale or exchange is the occurrence of an event
that the taxpayer does not anticipate before purchasing and occupying the residence. One
commentator asserted that this definition is beyond Congressional intent and would allow
any circumstance giving rise to the sale or exchange of property to qualify for a reduced
maximum exclusion. The final regulations revise the definition of a sale or exchange by
reason of unforeseen circumstances from “an event that the taxpayer did not anticipate”
to “an event that the taxpayer could not reasonably have anticipated” before purchasing
and occupying the residence. Additionally, the final regulations clarify that a sale or
exchange by reason of unforeseen circumstances (other than a sale or exchange within a
safe harbor) does not qualify for the reduced maximum exclusion if the primary reason

for the sale or exchange is a preference for a different residence or an improvement in
financial circumstances. The final regulations provide additional examples illustrating the
application of the reduced maximum exclusion rules to situations outside of the
unforeseen circumstances safe harbors. Under the temporary regulations, a taxpayer’s
primary reason for the sale or exchange is deemed to be unforeseen circumstances if one
of the following safe harbor events occurs during the taxpayer’s ownership and use of the
property: (1) involuntary conversion of the residence, (2) a natural or man-made disaster
or act of war or terrorism resulting in a casualty to the residence, and (3) in the case of a
qualified individual, (a) death, (b) the cessation of employment as a result of which the
individual is eligible for unemployment compensation, (c) a change in employment or
self-employment status that results in the taxpayer’s inability to pay housing costs and
reasonable basic living expenses for the taxpayer’s household, (d) divorce or legal
separation under a decree of divorce or separate maintenance, (e) multiple births resulting
from the same pregnancy, or (f) an event determined by the Commissioner to be an
unforeseen circumstance. A taxpayer who does not qualify for a safe harbor may
demonstrate that, under the facts and circumstances, the primary reason for the sale or
exchange is unforeseen circumstances. Commentators suggested that marriage,
bankruptcy of the taxpayer’s employer not resulting in the loss of the taxpayer’s
employment, and the adoption of a family member should be additional unforeseen
circumstances safe harbors that qualify for the reduced maximum exclusion. The final
regulations do not adopt these comments. Marriage and adoption are voluntary events
that typically lack the degree of unforeseeability common in the other unforeseen
circumstances safe harbors, and bankruptcy of the taxpayer’s employer unaccompanied

by a change in employment status of the taxpayer does not impact the taxpayer’s current
ability to pay housing costs. However, these events may still qualify for the reduced
maximum exclusion under the facts and circumstances test if, as a result of such an event,
the taxpayer’s primary reason for the sale or exchange is a change in place of
employment, health, or unforeseen circumstances. For purposes of the reduced maximum
exclusion by reason of unforeseen circumstances, the temporary regulations provide that
a qualified individual includes the taxpayer, the taxpayer’s spouse, a co-owner of the
residence, and a person whose principal place of abode is in the same household as the
taxpayer. A commentator suggested that the unforeseen circumstances exception should
be limited to events involving only the taxpayer and the taxpayer’s spouse. The
commentator stated that, under this narrower exception, a safe harbor for death would be
unnecessary because little, if any, gain would result as a consequence of the step-up in
basis provisions of the Code. The commentator also asserted that the safe harbor for
involuntary conversions is redundant and unnecessary because section 1033 already
provides for non-recognition of gain in such circumstances. The final regulations do not
adopt these comments. The inclusion in the safe harbors of events affecting co-owners
and co-inhabitants is appropriate because these events may affect the taxpayer’s ability to
pay housing costs. The involuntary conversion safe harbor is also appropriate, as both the
non-recognition provisions of section 1033 and the exclusion provisions of section 121
may apply to a conversion of property. See section 121(d) (5). The temporary regulations
provide that unforeseen circumstances include events determined by the Commissioner to
be unforeseen circumstances to the extent provided in published guidance of general
applicability or in a ruling directed to a specific taxpayer. The final regulations clarify

that taxpayers may rely on only those determinations made by the Commissioner in
published guidance of general applicability. A ruling directed to a specific taxpayer does
not establish a safe harbor of general applicability.
3. Health Exception
The temporary regulations provide that a sale or exchange of a residence is by reason of
health if the primary reason for the sale or exchange is to obtain, provide, or facilitate the
diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified
individual, or to obtain or provide medical or personal care for a qualified individual
suffering from a disease, illness, or injury. A sale or exchange that is merely beneficial to
the general health or well-being of the individual is not a sale or exchange by reason of
health. This definition is based on the definition of medical care under section 213. A
commentator suggested eliminating the term diagnosis from the definition of sale or
exchange by reason of health because taxpayers rarely would sell a residence merely to
obtain a diagnosis of a disease, illness, or injury. The final regulations do not adopt this
suggestion because, while such sales are likely to be uncommon, they may occur. In
addition, retaining diagnosis in the general definition of sale or exchange by reason of
health maintains uniformity with the definition of medical care under section 213 and
reduces complexity.
4. Statute of Limitations
A commentator suggested that the regulations should clarify that, under section 6501, the
statute of limitations on assessments arising from the use of the exclusion begins to run
from the filing date for the year of the sale or exchange. The final regulations do not

address this issue because the issue is well-settled by statute and rules regarding the
statute of limitations on assessments are outside the scope of these regulations.
5. Military Exception
Numerous commentators suggested that members of the uniformed services should be
accorded a special exception to the use requirement because they are often required to be
away from home for extended periods of time and unable to use a property as their
principal residence for at least two years during the five-year period prior to a sale or
exchange. The final regulations reflect enactment of the Military Family Tax Relief Act
of 2003 Public Law 108–121, section 101 (117 Stat. 1335) (MFTRA). The MFTRA
amends section 121 to provide that a taxpayer serving (or whose spouse is serving) on
qualified official extended duty as a member of the uniformed services or Foreign
Service may elect to suspend the running of the 5-year period for up to 10 years. The
election may be made with respect to only one property at a time. The taxpayer makes an
election by filing a return for the taxable year of the sale or exchange of the taxpayer’s
principal residence that does not include the resulting gain in the taxpayer’s gross
income. A taxpayer who would qualify to exclude gain under section 121 as a result of
the amendments made by the MFTRA but is barred by operation of any law or rule of
law may nonetheless claim a refund or credit of an overpayment of tax if the taxpayer
files the claim before November 11, 2004.
6. Effective Dates
Section 1.121–3 of the final regulations, relating to the reduced maximum exclusion,
applies to sales and exchanges on or after August 13, 2004. For sales or exchanges before

August 13, 2004, and on or after May 7, 1997, taxpayers may elect to apply the rules
retroactively in accordance with §1.121–4(j) and will be afforded audit protection in
accordance with §1.121–4(k). Section 1.121–5 of the final regulations, relating to the
suspension of the 5-year period for certain members of the uniformed services and
Foreign Service, applies to sales and exchanges on or after May 7, 1997.
Special Analysis
It has been determined that this Treasury decision is not a significant regulatory action as
defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It
also has been determined that section 553(b) of the Administrative Procedure Act (5
U.S.C. chapter 5) does not apply to these regulations, and because these regulations do
not impose a collection of information on small entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the notice of
proposed rulemaking preceding these regulations was submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact on small
businesses.
Drafting Information
The principal author of these regulations is Sara Paige Shepherd, Office of Associate
Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS
and Treasury Department participated in the development of the regulations.
*****

Adoption of Amendments to the Regulations
Accordingly, 26 CFR Part 1 is amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.121–3 is amended by:
1. Adding paragraphs (b), (c), (d), (e), and (f).
2. Removing paragraphs (h), (i), (j), and (k).
3. Re-designating paragraph (l) as paragraph (h) and revising it.
The revisions and additions read as follows:
§1.121–3 Reduced maximum exclusion for taxpayers failing to meet certain
requirements.
*****
(b) Primary reason for sale or exchange.
In order for a taxpayer to claim a reduced maximum exclusion under section 121(c), the
sale or exchange must be by reason of a change in place of employment, health, or
unforeseen circumstances. If a safe harbor described in this section applies, a sale or
exchange is deemed to be by reason of a change in place of employment, health, or
unforeseen circumstances. If a safe harbor described in this section does not apply, a
sale or exchange is by reason of a change in place of employment, health, or unforeseen

circumstances only if the primary reason for the sale or exchange is a change in place
of employment (within the meaning of paragraph (c) of this section), health (within the
meaning of paragraph (d) of this section), or unforeseen circumstances (within the
meaning of paragraph (e) of this section). Whether the requirements of this section are
satisfied depends upon all the facts and circumstances. Factors that may be relevant in
determining the taxpayer’s primary reason for the sale or exchange include (but are not
limited to) the extent to which—
(1) The sale or exchange and the circumstances giving rise to the sale or exchange are
proximate in time;
(2) The suitability of the property as the taxpayer’s principal residence materially
changes;
(3) The taxpayer’s financial ability to maintain the property is materially impaired;
(4) The taxpayer uses the property as the taxpayer’s residence during the period of the
taxpayer’s ownership of the property;
(5) The circumstances giving rise to the sale or exchange are not reasonably foreseeable
when the taxpayer begins using the property as the taxpayer’s principal residence;
and
(6) The circumstances giving rise to the sale or exchange occur during the period of the
taxpayer’s ownership and use of the property as the taxpayer’s principal residence.
(c) Sale or exchange by reason of a change in place of employment—

(1) In general. A sale or exchange is by reason of a change in place of employment if,
in the case of a qualified individual described in paragraph (f) of this section, the
primary reason for the sale or exchange is a change in the location of the
individual’s employment.
(2) Distance safe harbor. A sale or exchange is deemed to be by reason of a change in
place of employment (within the meaning of paragraph (c) (1) of this section)
if—
(i) The change in place of employment occurs during the period of the taxpayer’s
ownership and use of the property as the taxpayer’s principal residence; and
(ii) The qualified individual’s new place of employment is at least 50 miles farther
from the residence sold or exchanged than was the former place of employment,
or, if there was no former place of employment, the distance between the
qualified individual’s new place of employment and the residence sold or
exchanged is at least 50 miles.
(3) Employment. For purposes of this paragraph (c), employment includes the
commencement of employment with a new employer, the continuation of
employment with the same employer, and the commencement or continuation of
self-employment.
(4) Examples. The following examples illustrate the rules of this paragraph (c):
Example 1. A is unemployed and owns a townhouse that she has owned and used as
her principal residence since 2003. In 2004 A obtains a job that is 54 miles from her

townhouse, and she sells the townhouse. Because the distance between A’s new
place of employment and the townhouse is at least 50 miles, the sale is within the
safe harbor of paragraph (c) (2) of this section and A is entitled to claim a reduced
maximum exclusion under section 121(c)(2).
Example 2. B is an officer in the United States Air Force stationed in Florida. B
purchases a house in Florida in 2002. In May 2003, B moves out of his house to
take a 3-year assignment in Germany. B sells his house in January 2004. Because
B’s new place of employment in Germany is at least 50 miles farther from the
residence sold than is B’s former place of employment in Florida, the sale is within
the safe harbor of paragraph (c)(2) of this section and B is entitled to claim a
reduced maximum exclusion under section 121(c)(2).
Example 3. C is employed by Employer R at R’s Philadelphia office. C purchases a
house in February 2002 that is 35 miles from R’s Philadelphia office. In May 2003,
C begins a temporary assignment at R’s Wilmington office that is 72 miles from
C’s house, and moves out of the house. In June 2005, C is assigned to work in R’s
London office. C sells her house in August 2005 as a result of the assignment to
London. The sale of the house is not within the safe harbor of paragraph (c) (2) of
this section by reason of the change in place of employment from Philadelphia to
Wilmington because the Wilmington office is not 50 miles farther from C’s house
than is the Philadelphia office. Furthermore, the sale is not within the safe harbor by
reason of the change in place of employment to London because C is not using the
house as her principal residence when she moves to London. However, C is entitled

to claim a reduced maximum exclusion under section 121(c) (2) because, under the
facts and circumstances, the primary reason for the sale is the change in C’s place
of employment.
Example 4. In July 2003 D, who works as an emergency medicine physician, buys a
condominium that is 5 miles from her place of employment and uses it as her
principal residence. In February 2004, D obtains a job that is located 51 miles from
D’s condominium. D may be called in to work unscheduled hours and, when called,
must be able to arrive at work quickly. Because of the demands of the new job, D
sells her condominium and buys a townhouse that is 4 miles from her new place of
employment. Because D’s new place of employment is only 46 miles farther from
the condominium than is D’s former place of employment, the sale is not within the
safe harbor of paragraph (c)(2) of this section. However, D is entitled to claim a
reduced maximum exclusion under section 121(c) (2) because, under the facts and
circumstances, the primary reason for the sale is the change in D’s place of
employment.
(d) Sale or exchange by reason of health—
(1) In general. A sale or exchange is by reason of health if the primary reason for the sale
or exchange is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or
treatment of disease, illness, or injury of a qualified individual described in paragraph
(f) of this section, or to obtain or provide medical or personal care for a qualified
individual suffering from a disease, illness, or injury. A sale or exchange that is

merely beneficial to the general health or well-being of an individual is not a sale or
exchange by reason of health.
(2) Physician’s recommendation safe harbor. A sale or exchange is deemed to be by
reason of health if a physician (as defined in section 213(d) (4)) recommends a
change of residence for reasons of health (as defined in paragraph (d)(1) of this
section).
(3) Examples. The following examples illustrate the rules of this paragraph (d):
Example 1. In 2003, A buys a house that she uses as her principal residence. A is
injured in an accident and is unable to care for herself. A sells her house in 2004 and
moves in with her daughter so that the daughter can provide the care that A requires
as a result of her injury. Because, under the facts and circumstances, the primary
reason for the sale of A’s house is A’s health, A is entitled to claim a reduced
maximum exclusion under section 121(c) (2).
Example 2. H’s father has a chronic disease. In 2003, H and W purchase a house that
they use as their principal residence. In 2004, H and W sell their house in order to
move into the house of H’s father so that they can provide the care he requires as a
result of his disease. Because, under the facts and circumstances, the primary reason
for the sale of their house is the health of H’s father, H and W are entitled to claim a
reduced maximum exclusion under section 121(c)(2).
Example 3. H and W purchase a house in 2003 that they use as their principal
residence. Their son suffers from a chronic illness that requires regular medical care.

Later that year their son begins a new treatment that is available at a hospital 100
miles away from their residence. In 2004, H and W sell their house so that they can
be closer to the hospital to facilitate their son’s treatment. Because, under the facts
and circumstances, the primary reason for the sale is to facilitate the treatment of their
son’s chronic illness, H and W are entitled to claim a reduced maximum exclusion
under section 121(c)(2).
Example 4. B, who has chronic asthma, purchases a house in Minnesota in 2003 that
he uses as his principal residence. B’s doctor tells B that moving to a warm, dry
climate would mitigate B’s asthma symptoms. In 2004, B sells his house and moves
to Arizona to relieve his asthma symptoms. The sale is within the safe harbor of
paragraph (d) (2) of this section and B is entitled to claim a reduced maximum
exclusion under section 121(c) (2).
Example 5. In 2003, H and W purchase a house in Michigan that they use as their
principal residence. H’s doctor tells H that he should get more outdoor exercise, but
H is not suffering from any disease that can be treated or mitigated by outdoor
exercise. In 2004, H and W sell their house and move to Florida so that H can
increase his general level of exercise by playing golf year-round. Because the sale of
the house is merely beneficial to H’s general health, the sale of the house is not by
reason of H’s health. H and W are not entitled to claim a reduced maximum exclusion
under section 121(c) (2).
(e) Sale or exchange by reason of unforeseen circumstances—

(1) In general. A sale or exchange is by reason of unforeseen circumstances if the primary
reason for the sale or exchange is the occurrence of an event that the taxpayer could
not reasonably have anticipated before purchasing and occupying the residence. A sale
or exchange by reason of unforeseen circumstances (other than a sale or exchange
deemed to be by reason of unforeseen circumstances under paragraph (e) (2) or (3) of
this section) does not qualify for the reduced maximum exclusion if the primary reason
for the sale or exchange is a preference for a different residence or an improvement in
financial circumstances.
(2) Specific event safe harbors. A sale or exchange is deemed to be by reason of
unforeseen circumstances (within the meaning of paragraph (e)(1) of this section) if
any of the events specified in paragraphs (e)(2)(i) through (iii) of this section occur
during the period of the taxpayer’s ownership and use of the residence as the
taxpayer’s principal residence:
(i) The involuntary conversion of the residence.
(ii) Natural or man-made disasters or acts of war or terrorism resulting in a casualty to
the residence (without regard to deductibility under section 165(h)). (iii) In the
case of a qualified individual described in paragraph (f) of this section—
(A) Death;
(B) The cessation of employment as a result of which the qualified individual is
eligible for unemployment compensation (as defined in section 85(b));

(C) A change in employment or self-employment status that results in the
taxpayer’s inability to pay housing costs and reasonable basic living expenses
for the taxpayer’s household (including amounts for food, clothing, medical
expenses, taxes, transportation, court-ordered payments, and expenses
reasonably necessary to the production of income, but not for the maintenance
of an affluent or luxurious standard of living);
(D) Divorce or legal separation under a decree of divorce or separate
maintenance;
-Or -
(E) Multiple births resulting from the same pregnancy.
(3) Designation of additional events as unforeseen circumstances. The Commissioner may
designate other events or situations as unforeseen circumstances in published
guidance of general applicability and may issue rulings addressed to specific
taxpayers identifying other events or situations as unforeseen circumstances with
regard to those taxpayers (see §601.601(d)(2) of this chapter).
(4) Examples. The following examples illustrate the rules of this paragraph (e):
Example 1. In 2003, A buys a house in California. After A begins to use the house as
her principal residence, an earthquake causes damage to A’s house. A sells the house
in 2004. The sale is within the safe harbor of paragraph (e) (2) (ii) of this section and
A is entitled to claim a reduced maximum exclusion under section 121(c) (2).

Example 2. H works as a teacher and W works as a pilot. In 2003, H and W buy a
house that they use as their principal residence. Later that year W is furloughed from
her job for six months. H and W are unable to pay their mortgage and reasonable basic
living expenses for their household during the period W is furloughed. H and W sell
their house in 2004. The sale is within the safe harbor of paragraph (e) (2) (iii) (C) of
this section and H and W are entitled to claim a reduced maximum exclusion under
section 121(c) (2).
Example 3. In 2003, H and W buy a two-bedroom condominium that they use as their
principal residence. In 2004, W gives birth to twins and H and W sell their
condominium and buy a four-bedroom house. The sale is within the safe harbor of
paragraph (e) (2) (iii) (E) of this section, and H and W are entitled to claim a reduced
Example 4. In 2003, B buys a condominium in a high-rise building and uses it as his
principal residence. B’s monthly condominium fee is $X. Three months after B moves
into the condominium, the condominium association replaces the building’s roof and
heating system. Six months later, B’s monthly condominium fee doubles in order to
pay for the repairs. B sells the condominium in 2004 because he is unable to afford the
new condominium fee along with a monthly mortgage payment. The safe harbors of
paragraph (e) (2) of this section do not apply. However, under the facts and
circumstances, the primary reason for the sale, the doubling of the condominium fee,
is an unforeseen circumstance because B could not reasonably have anticipated that
the condominium fee would double at the time he purchased and occupied the

property. Consequently, the sale of the condominium is by reason of unforeseen
circumstances and B is entitled to claim a reduced maximum exclusion under section
121(c) (2).
Example 5. In 2003, C buys a house that he uses as his principal residence. The
property is located on a heavily traveled road. C sells the property in 2004 because C
is disturbed by the traffic. The safe harbors of paragraph (e) (2) of this section do not
apply. Under the facts and circumstances, the primary reason for the sale, the traffic, is
not an unforeseen circumstance because C could reasonably have anticipated the
traffic at the time he purchased and occupied the house. Consequently, the sale of the
house is not by reason of unforeseen circumstances and C is not entitled to claim a
reduced maximum exclusion under section 121(c) (2).
Example 6. In 2003, D and her fiancé E buy a house and live in it as their principal
residence. In 2004, D and E cancel their wedding plans and E moves out of the house.
Because D cannot afford to make the monthly mortgage payments alone, D and E sell
the house in 2004. The safe harbors of paragraph (e) (2) of this section do not apply.
However, under the facts and circumstances, the primary reason for the sale, the
broken engagement, is an unforeseen circumstance because D and E could not
reasonably have anticipated the broken engagement at the time they purchased and
occupied the house. Consequently, the sale is by reason of unforeseen circumstances
and D and E are each entitled to claim a reduced maximum exclusion under section
121(c)(2).

Example 7. In 2003, F buys a small condominium that she uses as her principal
residence. In 2005, F receives a promotion and a large increase in her salary. F sells
the condominium in 2004 and purchases a house because she can now afford the
house. The safe harbors of paragraph (e) (2) of this section do not apply. Under the
facts and circumstances, the primary reason for the sale of the house, F’s salary
increase, is an improvement in F’s financial circumstances. Under paragraph (e)(1) of
this section, an improvement in financial circumstances, even if the result of
unforeseen circumstances, does not qualify for the reduced maximum exclusion by
reason of unforeseen circumstances under section 121(c)(2).
Example 8. In April 2003, G buys a house that he uses as his principal residence. G
sells his house in October 2004 because the house has greatly appreciated in value,
mortgage rates have substantially decreased, and G can afford a bigger house. The safe
harbors of paragraph (e) (2) of this section do not apply. Under the facts and
circumstances, the primary reasons for the sale of the house, the changes in G’s house
value and in the mortgage rates, are an improvement in G’s financial circumstances.
Under paragraph (e)(1) of this section, an improvement in financial circumstances,
even if the result of unforeseen circumstances, does not qualify for the reduced
maximum exclusion by reason of unforeseen circumstances under section 121(c)(2).
Example 9. H works as a police officer for City X. In 2003, H buys a condominium
that he uses as his principal residence. In 2004, H is assigned to City X’s K–9 unit and
is required to care for the police service dog at his home. Because H’s condominium
association does not permit H to have a dog in his condominium, in 2004 he sells the

condominium and buys a house. The safe harbors of paragraph (e) (2) of this section
do not apply. However, under the facts and circumstances, the primary reason for the
sale, H’s assignment to the K–9 unit, is an unforeseen circumstance because H could
not reasonably have anticipated his assignment to the K–9 unit at the time he
purchased and occupied the condominium. Consequently, the sale of the condominium
is by reason of unforeseen circumstances and H is entitled to claim a reduced
Example 10. In 2003, J buys a small house that she uses as her principal residence.
After J wins the lottery, she sells the small house in 2004 and buys a bigger, more
expensive house. The safe harbors of paragraph (e) (2) of this section do not apply.
Under the facts and circumstances, the primary reason for the sale of the house,
winning the lottery, is an improvement in J’s financial circumstances. Under
paragraph (e) (1) of this section, an improvement in financial circumstances, even if
the result of unforeseen circumstances, does not qualify for the reduced maximum
exclusion under section 121(c) (2).
(f) Qualified individual. For purposes of this section, qualified individual means—
(1) The taxpayer;
(2) The taxpayer’s spouse;
(3) A co-owner of the residence;
(4) A person whose principal place of abode is in the same household as the taxpayer;
-Or -

(5) For purposes of paragraph (d) of this section, a person bearing a relationship specified
in sections 152(a)(1) through 152(a)(8) (without regard to qualification as a
dependent) to a qualified individual described in paragraphs (f)(1) through (4) of this
section, or a descendant of the taxpayer’s grandparent.
*****
(h) Effective dates. Paragraphs (a) and (g) of this section are applicable for sales and
exchanges on or after December 24, 2002. Paragraphs (b) through (f) of this section are
applicable for sales and exchanges on or after August 13, 2004.

§1.121–3T [Removed]
Par. 3. Section 1.121–3T is removed. Par. 4. Section 1.121–5 is added to read as follows:
§1.121–5 Suspension of 5-year period for certain members of the uniformed services and
Foreign Service.
(a) In general. Under section 121(d)(9), a taxpayer who is serving (or whose spouse is
serving) on qualified official extended duty as a member of the uniformed services or
Foreign Service of the United States may elect to suspend the running of the 5-year
period of ownership and use during such service but for not more than 10 years. The
election does not suspend the running of the 5-year period for any period during which
the running of the 5-year period with respect to any other property of the taxpayer is
suspended by an election under section 121(d)(9).
(b) Manner of making election. The taxpayer makes the election under section 121(d)(9) and
this section by filing a return for the taxable year of the sale or exchange of the
taxpayer’s principal residence that does not include the gain in the taxpayer’s gross
income.
(c) Application of election to closed years. A taxpayer who would otherwise qualify under
§§1.121–1 through 1.121–4 to exclude gain from a sale or exchange of a principal
residence on or after May 7, 1997, may elect to apply section 121(d) (9) and this section
for any years for which a claim for refund is barred by operation of any law or rule of law
by filing an amended return before November 11, 2004. (d) Example. The provisions of
this section are illustrated by the following example: Example. B purchases a house in

Virginia in 2003 that he uses as his principal residence for 3 years. For 8 years, from
2006 through 2014, B serves on qualified official extended duty as a member of the
Foreign Service of the United States in Brazil. In 2015, B sells the house. B did not use
the house as his principal residence for 2 of the 5 years preceding the sale. Under section
121(d) (9) and this section, however, B may elect to suspend the running of the 5-year
period of ownership and use during his 8-year period of service with the Foreign Service
in Brazil. If B makes the election, the 8-year period is not counted in determining
whether B used the house for 2 of the 5 years preceding the sale. Therefore, B may
exclude the gain from the sale of the house under section 121.

II. History of IRC §1031

A. The Revenue Act of 1918
(a) First income tax law to be enacted
(b) Gain or loss must be recognized and taxed accordingly on any disposition of property
including like-kind exchanges.
B. The Revenue Act of 1921-Congress Creates IRC §202(c)
(a) No gain or loss had to be recognized on any exchange of "like-kind" property, Non-"like-
kind" exchanges also qualified for deferral unless the property acquired in the exchange
had a "readily realizable market value". Under this code section, stock and bond traders
could utilize an exchange to avoid tax. This resulted in taxpayers deferring gains by
exchanging appreciated stocks and recognizing losses on others by selling in a taxable
transaction.
(b) Rationale. The rationale for permitting deferral was: (1) continuity of investment (e.g., no
cash liquidity to pay tax), and (2) administrative convenience (avoids need to value non-cash
consideration (e.g., horse trades)).
C. The Revenue Act of 1924 Eliminates Non "Like Kind" Exchanges
D. The Revenue Act of 1928 Section Number Changed to IRC Section 112(b) (1)

E. Mercantile Trust Co. of Baltimore et. al. v. Commissioner (1935)
(a) Board of Tax Appeals approved the first exchange involving the use of an intermediary to
hold cash.
(b) The "cash in lieu of" clause was first upheld to not invalidate the exchange.
F. 1954 - Congress Amended Tax Code to Present Description and Code Section
G. The Famous Starker Tax Court Cases
T.J. Starker and his son, Bruce, sold Timberland to Crown Zellerback, Inc. who gave them
exchange credits instead of cash. Over the next several years, T.J. and Bruce identified
property that Crown Zellerback purchased for them and then deeded the properties to them
for the exchange credits on their books until all of the credits were used up.
(a) 1975 Starker I, "Bruce and Elizabeth" - ($73,500 exchange value credit) heard in Ninth
Circuit Court.
(i.) First notice to the investment community of the validity of non-simultaneous
exchanges.
(ii.) The "growth factor" was introduced and allowed as interest income.
(iii.) Exchange was held to be valid.
(b) 1977 Starker II ("T.J."-$1.5 million exchange value credit)
(i.) Ownership issues (12 properties purchased: 9 to T.J., 2 to his daughter, one of which
T.J. used as a personal residence).

(ii.) Growth factor and "disguised interest" must be treated as interest income.
(iii.) Same District Court reverses Starker I and invalidates all of T.J.’s exchanges.
(c) 1979 Starker III (Appeal of Starker II)
(i) Ninth Circuit Court of Appeals (11 Western States only) reversed the Starker II
decision.
(ii) "Simultaneity" not requirement; the creation of the "delayed" exchange.
H. Deficit Reduction Act of 1984 Congress codifies the "delayed" exchange.
(a) 45 day/180 day rule added.
(b) Congress specifically approves non-simultaneous (or “delayed”) exchanges
(c) Section 1031(a) (2) is amended to disallow exchanges of partnerships interests.

I. Tax Reform of 1986
In 1986, Congress overhauled the tax system. Changes to relating to real estate transactions
included:
(a) Elimination of preferential capital gain treatment. Capital gains rates taxed at same rate as
ordinary income
(b) Enactment of "passive loss" and "at risk" rules to discourage tax shelters.
(c) Real estate depreciation limited to “straight line” as opposed to accelerated depreciation.
Current recovery period is 39 years for improved commercial real estate and 27.5 years for
improved residential real estate.
J. The Revenue Reconciliation Act of 1989
(a) Must now exchange properties only within the United States and it's territories Taxpayer
can no longer perform international exchanging.
(b) Allowed for related party exchanges. However, a two year holding period for both
parties is required. (Related parties include members of a family including brothers and
sisters (whether by whole or half blood), spouses, ancestors and lineal descendants.
Special rules apply to corporations, trusts, partnerships, etc. The above amendments were
retroactive to July l0, 1989.)

K. Treasury Issues Proposed Regulations in 1990
(a) Effective July 2, l990
(b) Clarification of 45-day identification and 180-day exchange period rules actual and
constructive receipt issues & rules (Safe Harbors).
(c) Clarified that general and limited partnership interests in entities owning real property
were not like kind and could not be sold or acquired as part of 1031 exchange.
(d) Clarification of related party issues. §1031 exchanges involving related parties, as
defined in Code Section 267(b) pose serious implications to §1031 exchanges. The most
common scenarios and implications of the related party rules are:
(1) The exchanging party sells to a related party. In this scenario the related party
must hold the property for a minimum of two years; otherwise the exchange will be
invalidated.
(2) The exchanging party acquires property from the related party.
A taxpayer should generally not purchase a replacement property from a related
party. In Private Revenue Ruling 9748006, the IRS disallowed tax deferral to a
taxpayer who purchased his mother’s property
(3) The exchanging party trades property with a related party. Both parties must hold the
property acquired for two years following the exchange.

L. Final Regulations Adopted
(a) Effective June 10, l99l
(b) Very few changes to proposed rules and regulations
(c) Clarification of simultaneous exchanges and improvement exchanges
(d) Clarification of "disqualified person" as an Intermediary
M. 1997 Tax Relief Act
(a) Although there was an attempt to dramatically alter Code Section 1031, the final result
was no change to the code.
(b) Act amended Section 1031 to provide that foreign personal property is not like kind to
domestic personal property.
N. Jobs and Growth Tax Relief Reconciliation Act of 2003
(a) Reduced capital gain taxes to a maximum of 15%, retroactive to May 6, 2003.

III. Exchange Terminology

A. Actual Receipt -- “Actual receipt” means the taxpayer’s actual receipt of proceeds resulting
from a sale of relinquished property in an exchange under Section 1031 (compare
“constructive receipt”).
B. Basis and Adjusted Basis -- “Basis” generally refers to the amount invested by the taxpayer
in the property determined with reference to Internal Revenue Code Section 1012. The
original “cost basis” means the amount invested by the taxpayer at the time the property was
initially purchased. “Adjusted basis” means the original cost basis, adjusted through the date
of sale in accordance with certain basis adjustment rules set forth in the Internal Revenue
Code and Treasury Regulations. Generally speaking, the adjustments to basis include adding
to the original cost basis the value of capital improvements made by the taxpayer during the
period the property was owned by the taxpayer, and by subtracting the accumulated
depreciation taken by the taxpayer over the same period. The resulting “adjusted basis” is
used to determine the capital gain recognized by the taxpayer on a sale or other disposition of
the property.
Example: Original Purchase Price (Basis) $300,000
Add: Capital Improvement s +50,000
Less: Depreciation -150,000
Equals: Adjusted Basis $200,000

C. Boot -- “Boot” means cash or other “non like-kind” property actually or constructively
received by the taxpayer as consideration for the sale of the prroperty relinquished in a 1031
exchange. “Boot” received by the taxpayer is taxable to the extent of the taxpayer’s potential
gain in the property. “Cash boot” means sale proceeds actually or constructively received by
the taxpayer. “Mortgage boot” refers to a reduction in the taxpayer’s mortgage liabilities on
the purchase of replacement property. “Mortgage boot” usually occurs when the taxpayer
acquires replacement property of a lesser value than the net sale price of the property
relinquished in the exchange.
D. Constructive Receipt – The doctrine of constructive receipt in the context of a 1031
exchange applies where the taxpayer does not actually receive boot, but would, on demand,
have the right to receive such boot. Where applicable, the taxpayer is deemed to be in receipt
of the sums subject to his or her control.
E. Direct Deeding -- In the context of a 1031 exchange involving a Qualified Intermediary,
“direct deeding” refers the transfer of title from the exchanging taxpayer to the buyer of the
relinquished property and, likewise, a deed from the seller of the replacement property to the
exchanging taxpayer. The Regulations under Section 1031 provide for direct deeding if the
taxpayer has executed an assignment of their purchase agreement to the Qualified
Intermediary and if the other party to the transaction (buyer in the sale of the relinquished
property or seller in the purchase of a replacement property) is notified in writing that the
exchanger has assigned the purchase agreement to the Qualified Intermediary before the
property is transferred.

F. Disqualified Person – Treasury Regulation Section 1.1031(b)-2(a) defines a “disqualified
person” as a person who is the agent of the taxpayer at the time of the transaction. A person
who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker
or real estate agent or broker within the two-year period ending on the date of the transfer of
the first of the relinquished properties is treated as an agent of the taxpayer at the time of the
transaction. However, certain past services are not be taken into account, including routine
financial, title insurance, escrow or trust services for the taxpayer by a financial institution,
title insurance company, or escrow company, See Treas. Reg. §1.1031(k)-1(k)(2).
G. Exchange Agreement -- A written agreement between the taxpayer and the Qualified
Intermediary which outlines the Qualified Intermediary’s obligations to transfer the
relinquished property to the buyer and the replacement property to the taxpayer, subject to
certain requirements specified in the Internal Revenue Code and Treasury Regulations. Of
particular importance, the exchange agreement must be signed by the taxpayer before the
closing of a sale of any relinquished property and must limit the taxpayer’s rights to receive,
pledge, borrow or otherwise obtain the benefits of the money or other property before the end
of the exchange period. Without a qualified exchange agreement, a taxpayer will be deemed
to be in constructive receipt of the proceeds resulting from the sale of relinquished property,
even if the taxpayer fully intends to do an exchange and has not taken possession of the funds
from the closing agent.

H. Exchange Period -- The exchange period begins on the date the relinquished property is
transferred to the buyer and ends by the earliest of either: 180 calendar days after closing on
the sale of the relinquished property or the due date for filing the tax return for the year in
which the relinquished property was sold (unless a filing-extension has been obtained).
I. Identification Period -- The identification period in a delayed exchange begins on the date the
taxpayer transfers the relinquished property and ends at midnight on the 45th calendar day
thereafter. To qualify for a §1031 tax deferred exchange, the tax code requires identifying
replacement property: 1) In a written document signed by the Taxpayer; 2) Hand delivered,
mailed, telecopied, or otherwise sent; 3) Before the end of the identitication period to; 4)
Either the person obligated to transfer the replacement property to the Taxpayer [generally the
“Qualified Intermediary”] or any other person involved in the exchange other than the
taxpayer or a disqualified person. The replacement property must be unambiguously described
(i.e. legal description, street address or distinquishable name). The type of property should be
described in a personal property exchange.
J. Like-Kind Property -- Any property held for productive use in a trade or business exchanged
for any other property held for productive use in a trade or business. Real property that
qualifies for a 1031 exchange must be “held for productive use in a trade or business or for
investment.” Both the relinquished and replacement properties must be considered “like-kind”
to qualify for tax deferral. IRC Section 1031 does not limit “like-kind” property to certain
types of real estate. The term refers to the nature or character of the property, rather than its
grade or quality. Real property must be exchanged for “like-kind” real property. “The fact
that any real estate involved is improved or unimproved is not material, for that fact relates

only to the grade or quality of the property and not to its kind or class. Unproductive real
estate held by one other than a dealer for future use or future realization of the increment in
value is held for investment and not primarily for sale.”
Real property is not considered “like-kind” to personal property.
Examples of real property exchanges include:
(1) Unimproved for improved property
(2) Fee for a leasehold with 30+ years to run
(3) Commercial building for vacant land
(4) Duplex for commercial property
(5) Single family rental for an apartment
(6) Industrial property for rental resort property
Personal property that qualifies for a 1031 exchange must be “held for productive use in a
trade or business or for investment.” In general, qualifying properties must both be in the
same General Asset Class or within the same Product Class. The North American Standard
Industrial Classification Manual provides categories for General Asset Classes of
depreciable tangible personal property.
Examples of qualifying personal property exchanges include:
(1) Mexican gold coins for Austrian gold coins
(2) Aircraft for aircraft

(3) Restaurant equipment for restaurant equipment
(4) Computer for computers
K. Qualified Intermediary
What is a Qualified Intermediary?
In most circumstances, the use of a “Qualified Intermediary” is required to successfully
complete an IRC Section 1031 tax deferred exchange. The entity that facilitates an exchange
(sometimes referred to as an accommodator or facilitator) is referred to as a Qualified
Intermediary in the Treasury Regulation §1031.1031(k)-1(g) (4) (iii) as follows:
A Qualified Intermediary (“QI”) is a person who:
(1) Is not the taxpayer or a disqualified person;
(2) Enters into a written agreement with the taxpayer (the “Exchange Agreement”) under
which the QI:
• Acquires the relinquished property from the taxpayer;
• Transfers the relinquished property;
• Acquires the replacement property;
• Transfers the replacement property to the taxpayer.
(3) The Exchange Agreement must expressly limit the taxpayer’s rights to receive, pledge,
borrow, or otherwise obtain benefits of money or other property held by the QI. (See
Treasury Regulations §1031.1031(k)-1(g) (4) (i).)
The use of an experienced QI can significantly reduce the complexity of an exchange by
assuring the proper execution of required documentation. The QI industry is not regulated
nationally. Consequently, the careful selection of the QI is essential to ensure the highest

levels of expertise and security of funds.
Asset Preservation, Inc. (API) provides Qualified Intermediary services in conformity with
the Internal Revenue Code and Treasury Regulations. API:
• Coordinates with each taxpayer’s attorney and/or tax advisor, forwards exchange
transaction documentation as needed so that the IRC §1031 rules and regulations are
thoroughly understood;
• Prepares the necessary exchange documentation - Exchange Agreement, Assignment
Agreement (s), Notice of Assignment (s), Qualified Exchange Account Form, Security of
Funds Instrument and instructions to each Closing Officer and oversees each closing to
assist in proper §1031 procedures;
• Facilitates the exchange of the relinquished property for replacement property by serving
as a conduit for proceeds resulting from the sale of the relinquished property and
applying such proceeds to the purchase of the replacement property for the taxpayer;
• Holds and protects exchange proceeds on behalf of the Exchanger until funds are needed
to purchase the replacement property;
• Provides guidance, information and critical timelines throughout the entire exchange.

L. Realized Gain vs. Recognized Gain – The term “realized gain” refers to the tax gain
generated by a potentially taxable disposition of property by a taxpayer. While a disposition
of property is generally a realization event, realized gain is not always recognized and taxed
currently. In other words, “realized gain” may or may not be “recognized.” In a taxable
sale, realized gain is recognized and generates a current tax liability. In a tax deferred
transaction permitted under the Internal Revenue Code (such as an exchange of property held
for investment under Section 1031), realized gain is transferred to the replacement property
and recognition is deferred until a later taxable disposition of the replacement property.
M. Relinquished Property – The term “relinquished property” refers to the property being
transferred by an exchanger to a third party in an exchange transaction.
N. Replacement Property -- The term “replacement property” refers to the property being
acquired by an exchanger from a third party to complete an exchange transaction.
O. Sequential Deeding – The term “sequential deeding” in the context of an exchange refers to
the qualified intermediary’s acquisition of record title for purposes of transferring
relinquished property from the exchanger to the third-party buyer, or to the intermediary’s
acquisition of record title to replacement property from a third party seller for purposes of
transferring title to the exchanger to complete an exchange. Although sequential deeding can
be used in a delayed exchange, it is most often seen in “parking arrangement” transaction.
(Compare, “Direct Deeding” supra)

IV. “Like-Kind” Property Issues

A. Stock in Trade/Dealer Property Issues
Section 1031(a)(1) provides that no gain or loss shall be recognized on the exchange of
property held for productive use in a trade or business or for investment if such property is
exchanged solely for property of like kind which is to be held either for productive use in a
trade or business or for investment. Section 1031(a) (2) provides that Section 1031(a) (1)
does not apply to “stock in trade or other property held primarily for sale.” Stock in trade
describes property which is included in the inventory of a dealer and is held for sale to
customers in the ordinary course of business. The gain on the sale of dealer property is taxed
as ordinary income.
To qualify for a §1031 exchange, a taxpayer must be able to substantiate their investment
intent, especially if the taxpayer is in the business of selling property such as a developer.
Listed below are some factors the IRS may review to determine whether or not the taxpayer’s
primary intent was to hold the property for investment. The factors listed below are not
exhaustive, but provide factors the courts have used to divine the taxpayer's true intent.
• The purpose for which the property was initially acquired.
• The purpose for which the property was subsequently held.
• The purpose for which the property was being held at the time of sale.
• The extent of advertising, promotion of other active efforts used in soliciting buyers
for the sale of the property.
• The listing of property with brokers.
• The extent to which improvements, if any, were made to the property.
• The frequency, number and continuity of sales.

• The extent and nature of the transaction.
• The ordinary course of business of the taxpayer
B. Partnership Issues
A partnership may exchange property for other property of "like-kind." However, IRC Section
1031(a)(2)(D) specifically prohibits exchanges of partnership interests. This means that a
taxpayer cannot buy into or sell interests in a partnership and qualify for a §1031 exchange.
The rationale is that a partnership interest [along with a real estate investment trust (REIT)
share] itself is personal property and thus is not "like-kind" with real property. Given these
facts, what alternatives are available to taxpayers?
First, taxpayers owning a property together must determine if they really own the property in
a true "partnership." Often, taxpayers who own property with others may consider the other
individuals their "partners" even though they hold title as an undivided interest and don't file a
partnership tax return, thus they are merely "co-owners”. The test is, "do the owners hold title
as "tenants-in-common”?
One option is that the entire partnership stays intact and exchanges the relinquished property
for a replacement property. After the partnership closes on the replacement property, the
property can be refinanced and the proceeds are distributed to the partner who wants to cash
out.
Another alternative is that the partnership has a valid election out of subchapter K under IRC
§761. The partner seeking to cash out sells their undivided interest and the other partner
exchanges their tenancy-in-common interest for a replacement property. (Note: There are

risks associated with partnership issues that must be discussed with a legal and/or tax
advisor.)
Advance planning is important, as the greater the period of time between the election out of
the partnership and the exchange, the better. The election out of the partnership to the
individuals as an undivided interest shortly before closing on the relinquished property leaves
open the possibility that the exchange would be invalidated because the property was not
held as an undivided interest long enough to be considered "held for investment." If the
entire partnership will be exchanging, it is preferable that the Partnership Agreement mention
that they are holding the property "for investment or use in a trade or business."

C. Holding Period Issues
IRC §1031 states that property “held for productive use in a trade or business or for
investment” must be exchanged for like-kind property. There is much confusion and
misinformation among real estate taxpayers on the issue of what is viewed as “held for
investment.” The reason is that neither the IRS nor the Regulations provide a comprehensive
definition of the phrase “held for investment.” (The regulations do state, however, that
unproductive real estate held by a non-dealer for future use or future appreciation, is held for
investment.)
There is no safe holding period for property to automatically qualify as being “held for
investment.” Time is only one factor at which the IRS looks in determining the taxpayer’s
intent for both the relinquished and replacement properties. The IRS may look at all the facts
and circumstances of a taxpayer’s situation to determine the taxpayer’s true intent for both
properties involved in an exchange.
In one private letter ruling (PLR 8429039), the IRS stated that a minimum holding period of
two years would be sufficient. Although a private letter ruling does not establish legal
precedent for all taxpayers, there are many advisors who believe two years is a conservative
holding period, provided no other significant factors contradict the investment intent.
Other advisors recommend that taxpayers hold property for a minimum of at least twelve
months. The reason for this is twofold: (1) A holding period of 12 or more months means the
taxpayer will usually reflect it as an investment property in two tax filing years. (2) In 1989,
Congress had proposed a one year holding period for both the relinquished and replacement -

properties. Although this proposal was never incorporated into the tax code, some believe it
represents a reasonable minimum guideline.
The taxpayer’s “intent” in holding both the relinquished and replacement properties is the
central issue. Each taxpayer and their advisors should be able to substantiate properties
relinquished and acquired in a tax deferred exchange were “held for investment.”

D. Second/Vacation Homes
Many tax/legal advisors believe it is possible to perform an exchange on a vacation property
which still can be considered “held for investment.” In Private Letter Ruling (PLR) 8103117,
the IRS did allow for tax deferral when a property owner intended to acquire property for
personal enjoyment and as an investment. As stated in this PLR, “...the house and lot you
acquire in this trade will be held for the same purposes as the properties exchanged: to
provide for personal enjoyment and to make a sound real estate investment.” It appears, in
this instance, that “personal enjoyment” of a property does not prevent a property owner from
benefiting from a tax deferred exchange.
There are no regulations, statutes, or court cases which give a definitive answer on the
exchange of vacation/2nd homes. Each exchange must be reviewed on a case-by-case basis.
To qualify for an exchange, the property owner should be able to support that the property
was “held for investment.”
Reg. 1.1031(a)-1(b) states in the definition of “like-kind” that “unproductive real estate held
by one other than a dealer for future use or future realization of the increment in value is held
for investment and not primarily for sale.” It appears that even property owners who have
never rented their vacation property but can substantiate that they acquired and held the
property because they expected it to increase in value (a wise investment decision) may
qualify for a §1031 tax deferred exchange. IRC §165 and IRC §280, which address when
losses may be deducted on vacation homes, may provide additional guidance to taxpayers.
(a) What about a Timeshare?
There are generally two types of timeshares that can be purchased by a taxpayer:

(1) The first variation was widely promoted in the 1970’s and 1980’s and generally
consists of a right to use a type of unit at a particular location for a specified period
of time. These are generally considered personal property and are not eligible for
§1031 tax deferral.
(2) The other variation has become more popular in the past 10-15 years and generally
consists of a taxpayer purchasing legal title, not merely rights to use a property, to
a specific unit for a specified period of time. This second variation is generally
considered real property and may qualify for §1031 tax deferral.
Even if the timeshare owner has title to a real property interest, they should be able to
support that the primary intent for holding the timeshare is for investment purposes. In
Dewey vs. Commissioner, the IRS did not allow §1031 tax deferral because they
determined the taxpayer’s primary purpose for a two-week timeshare purchase was
personal enjoyment and not for investment purposes. As with any §1031 exchange, the
taxpayer should be able to substantiate that the primary intent for holding the property was
either for investment or business purposes.

E. Special Situations
(a) Conversion from Rental to a Residence
An increasingly popular strategy is to initially complete a tax deferred exchange and at
a later date convert the rental property to a primary residence. After the taxpayer has
lived in the primary residence for at least two of the past five years, they qualify for
the tax exclusion benefits of Section 121.
On October 22, 2004, President Bush signed into law corporate and foreign tax
legislation that also contained a provision affecting IRC §1031. Under this provision,
an Exchanger who performs an IRC §1031 tax deferred exchange into a rental house
as replacement property and later the rental house is converted into the Exchanger’s
principal residence, is not allowed to exclude gain under the principal residence
exclusion rules of IRC §121 unless the sale occurs at least five years after the closing
date of the replacement property purchase. The Conference Agreement on H.R. 4520
includes the following provision to amend §121(d):
Sec. 840. Recognition of gain from the sale of a principal residence acquired in a
like-kind exchange within 5 years of sale. (10) PROPERTY ACQUIRED IN LIKE-
KIND EXCHANGE -- If a taxpayer acquired property in an exchange to which section
1031 applied, subsection (a) shall not apply to the sale or exchange of such property if
it occurs during the 5-year period beginning with the date of the acquisition of such
property.
The change to IRC §121 is effective for principal residence sales occurring on or after
October 22, 2004 and all investors who previously acquired their current residence

through a §1031 exchange within the past three years will now have to wait at least
two more years before selling their residence to exclude the gain. This assumes they
meet the two out of five year principal residence test.
The result of this additional requirement to IRC §121 is that an investor exchanging
into a rental house, which is later converted to a principal residence, will have to wait
a minimum of five years to exclude capital gain under IRC §121(subject to the
maximum exclusion restrictions of $500,000, married filed jointly; $250,000 filing as
a single). Also note that the Exchanger must acquire the replacement property with the
intent to hold it for investment. There is no defined “holding period” as to how long a
property must be held to be considered held for investment.
An Example
An Exchanger completes an exchange for a rental home that is held for investment and
rents the property out for two years. The exchanger decides to move into their former
rental house and live in it as their principal residence. Under the new law, the
Exchanger will have to wait for at least three more years before selling the principal
residence and excluding gain under IRC §121.
(b) Split Treatment Transaction
A taxpayer selling a duplex, triplex or fourplex, where the owner lives in one unit
and rents out the remaining units, can use two tax code sections and receive
excellent tax advantages. The unit where the taxpayer lives is considered their
primary residence and can qualify for exclusion of capital gain taxes under IRC

Section 121 the deferral of the capital gain taxes associated with the remainder of the
multi-family property under IRC Section 1031.
A good accountant is generally needed to determine the value allocated to the
residence portion and to the remaining units held for investment. A tax professional
may use factors such as the square footage or the quality and value of improvements
to each unit in determining what percentage is considered the primary residence and
what percentage is allocated to the exchange portion.
(c) Personal Property Exchanges
Internal Revenue Code Section 1031 allows taxpayers to exchange either “like-kind”
real or personal property for other “like-kind” real or personal property. Although
the rules for “like-kind” real estate are fairly broad, the rules to exchange personal
property for “like-kind” or “like-class” specify that a taxpayer can only receive tax
deferral if the sale of personal property is exchanged for the purchase of personal
property that falls within the same Product Class or General Asset Class. Product
and General Asset Classes, as described in the North American Standard Industrial
Classification (NASIC) Manual, were developed for use in the classification of
establishments and products by the type of activity for which they are engaged.
Depreciable tangible personal property is exchanged for property of “like-kind” if it
is exchanged for property of “like-class”.
(a) Office furniture, fixtures, and equipment;
(b) Information systems (computers);

(c) Data handling equipment, except computers;
(d) Airplanes and helicopters;
(e) Automobiles and taxis;
(f) Buses;
(g) Light general-purpose trucks;
(h) Heavy general-purpose trucks;
(i) Railroad cars and locomotives;
(j) Tractor units for use over-the-road;
(k) Trailers and trailer-mounted containers;
(l) Vessels, barges, tugs, and similar water transportation equipment;
(m) Industrial steam and electric generation and distribution systems.
Another aspect of personal property exchanges that differs from real property
exchanges is that certain items of the sale transaction, such as “goodwill” “covenants
not to compete” and “inventory” does not qualify for tax deferral under IRC Section
1031. Thus, these items may not be attributed to the value of the sale for the
exchange and the capital gain or loss must be recognized by the taxpayer.
There are also many transactions that involve the sale of both real property and
personal property, such as the sale of hotels, restaurants, and gas stations, wherein
the taxpayer owns both the land and the personal property. In this case, the taxpayer

can allocate the proceeds specifically for real property and personal property and
purchase “like-kind” property with the respective funds. In a complex combined
real and personal property exchange, it is important to maximize potential tax
deferral benefits in advance.

V. TENANT-IN-COMMMON
PROGRAMS/FRACTIONAL OWNERSHIP

A. Why Consider TIC Ownership
The current real estate market contains many investors with large amounts of appreciation in
their properties. Many of these investors would like to sell their properties. Some of them
would like to sell and buy more property. Some of them would like to sell and eliminate the
management responsibilities. And all of them would like to avoid taxation.
Previously, many of these investors have used 1031 tax deferred exchanges to help them
defer current taxation when they sold their real estate. Some real estate investors who want
to sell their highly appreciated properties and avoid taxation by using a 1031 tax deferred
exchange are finding it very difficult to locate a good replacement property.
The lack of inventory for quality real estate that is available as replacement properties has
caused some real estate investors to either pay unnecessary taxes when they sell their
properties or to not sell at all, therefore, decreasing their flexibility in attaining their goals.
Many of these investors are looking for options that will allow them to sell their properties,
avoid current taxation, and find suitable replacement properties.

B. Who Should Consider TIC Ownership?
Many real estate investors could benefit from owning real estate in a TIC structure.
Examples of real estate investors who could benefit from a TIC include people who want to:
(a) Sell their properties and avoid current taxation.
(b) Sell their properties and avoid depreciation recapture.
(c) Sell their properties and use a 1031 tax deferred exchange.
(d) Reduce the time, effort, and stress of locating quality replacement property.
(e) Eliminate the need to name a specific individual property on their own within 45 days.
(f) Own institutional grade commercial property.
(g) Benefit from the knowledge and experience of real estate experts.
(h) Increase their depreciation deductions on their real estate.
(i) Increase the tax efficiency on their real estate income.
(j) Reduce the liability of financing their real estate individually.
(k) Eliminate day-to-day management responsibilities of owning real estate.
(l) Diversify their real estate holdings to minimize risk.
(m) Maximize the cash flow from their real estate investments.
(n) Receive estate tax planning benefits.

(o) Have the ability to sell property for fair market value without having to increase the
asking price to factor in taxes that will have to be paid.
(p) Provide a steady and reliable income stream from an institutional grade commercial
property.
(q) Receive income from their real estate on a tax-advantaged basis.
(r) Increase the tax basis on new properties purchased.
(s) TIC ownership may provide many of these benefits to real estate investors.

C. What is a Tenant-in-Common (TIC) Ownership?
Tenant-in-Common (TIC) ownership is the co-ownership of a property or properties, by two
or more investors. Each TIC owner owns an undivided fractional interest in the real estate
and receives their proportionate share of net income, tax benefits, and appreciation.
Title to the investment property is held by each TIC owner rather than by a corporation,
limited liability company (LLC) or partnership. Each owner receives a trust deed or warranty
deed for their ownership percentage. Each owner also has title insurance for their ownership
percentage. TIC ownership programs can involve up to 35 unrelated TIC investors.
Essentially, a TIC owner has the same rights, benefits and risks as a single owner of
property, but their share in the property is generally equal to the percentage of their equity
participation.
Most TIC ownership programs consist of institutional-grade properties, such as apartment
communities, industrial properties, office buildings, shopping centers and
warehouse/distribution properties ranging from $5 million to over $100 million in value. For
many real estate investors who have “done it themselves”, they have never had access to this
institutional grade real estate that has historically been reserved for pension funds, insurance
companies, and other large institutional investors. Now literally everyone can own this type
of high quality real estate.
The minimum investment commitment varies depending on the type of property, the total
amount of equity being raised, and the number of TIC ownership investors. Although there is

no standard minimum investment, many TIC ownership investments start at $100,000 and
can accommodate $10,000,000 or more per individual investor.
In most TIC ownership programs, the provider makes the day-to-day decisions allowed under
the management agreement or master lease. The TIC owners make the major decisions such
as approving of rejecting leases, refinancing or a potential sale. Unanimous approval by the
owners is required for all major decisions relating to the property. In short, TIC owners make
all of the big decisions regarding the property while a professional management team handles
the day-to-day activities and management of the property.

D. TIC Ownership and 1031 Exchanges
TIC ownership of real estate has been used for many years. Though not a well known
ownership structure, it was generally employed by smaller group of investors who owned a
property together. In 2002, the IRS issued Revenue Procedure 2002-22 and TIC ownership
has become increasingly popular with many real estate investors. TIC popularity is
evidenced by the growth in TIC equity from $100 Million in 2001 to $2 Billion in 2004.
Properly structured TIC ownership can be an acceptable property to use as a replacement
property in a 1031 tax deferred exchange. This simply means that real estate investors who
want to sell their properties, and avoid current taxation by using a 1031 exchange, now have
additional replacement properties to choose from in the form of TIC properties. TIC
ownership provides a pre-packaged 1031 exchange replacement property solution.
Today, one of the most difficult issues real estate owners have to deal with is finding
replacement property to complete a 1031 exchange. Real estate investors can sell their
individually owned properties, and even their jointly owned properties, and transfer their
gain tax deferred with a 1031 exchange using a TIC property as the replacement property.
TIC ownership can be thought of as “Real Estate By The Slice”:

Buy Fractional Interest
Of TIC Property With
$500,000 Of Equity
Sell Individually
Owned Property With
$500,000 Of Equity

E. Forms of TIC Property Management
TIC properties are managed on a day-to-day basis as outlined in a Master Lease or a
Management Agreement.
A Master Lease agreement provides that the TIC owners act as the landlord of the property.
The TIC owners are considered the Master Lessor and they receive the rent from the Master
Lessee. The TIC owners receive a fixed rent amount with annual increases. The Master
Lessee then subleases the property out to the ultimate tenants of the property. The Master
Lessee retains all net property income above the fixed rent amounts paid to the TIC owners.
TIC TIC TIC TIC TIC

Owner Owner Owner Owner Owner
Master
Lessee
TIC Sponsor
Property

TIC owners agree to allow an affiliate of the TIC sponsor to manage the property for a specified
period of time. The Management Company will receive management fees for overseeing the day-
to-day management of the property. The TIC owners will usually receive 100% of the net rent.
TIC TIC TIC TIC TIC

Owner Owner Owner Owner Owner
Propert
Master
Agreement
TIC Sponsor

F. Advantages of TIC Ownership Program
TIC ownership can provide these advantages:
(a) Provides A Viable Source Of 1031 Replacement Property: Many real estate owners
who sell their real estate are finding it more and more difficult to locate quality
replacemenmt properties to enable them to complete a 1031 exchange. TIC ownership
creates an additional form of real estate inventory for 1031 replacement properties.
(b) Elimination Of Management: Many real estate investors, especially the Baby Boomers,
no longer desire the day-to-day burdens and responsibilitites of being a landlord and do
not want to be involved in active property management. Most TIC ownership programs
have professional management which may have extensive experience and a successful
track record in all phases of owning, mananging and operating institutional grade
commercial real estate.
(c) Superior Institutional Grade Commercial Property: Provides investors the ability to
acquire commercial or “Class A” properties, which in many cases are leased to national
credit tenants. These types of properties have normally only been available to pension
funds, insurance companies, and other institutions. Most of the leases are long-term to
top quality tenants.
(d) Increase The Tax Efficiency Of Real Estate: Real estate investors are able to defer
capital gain and depreciation recapture taxes by enacting a 1031 exchange and using a
TIC as the replacement property. In addition, TIC owners will usually receive an
increased basis for depreciation and the benefits of deductible non-recourse mortgage

interest when they invest in the TIC, maximizing their net after-tax cash flow.
(e) Diversification and Risk Reduction: Real estate investors can now own institutional
grade commercial property to diversify their real estate portfolio. Because of the low
minimum equity requirements, investors can diversify by purchasing a portfolio that
consists of TIC ownership programs in different locations. This provides flexibilty with
a variety of property types, tenants, industries, etc.
(f) Flexibility for §1031 Exchanges: Provide the flexibility to meet the equity reinvestment
and debt requirement needed for full tax deferral, and thus avoid taxable “boot”, in a
1031 exchange.
(g) Flexible Investments: As little as $100,000 of equity can qualify for a TIC and an
individual program could accept as much as $20,000,000 from a single investor for
institutional grade commercial properties.
(h) Maximize Tax Deferral Certainty: TIC ownership provides the highest probabilitiy that
a seller will be able to complete a 1031 exchange. The property has been approved for
financing, all inspections and projections are complete, and there is no actual individual
seller of the replacement property.
(i) Maximize Monthly Cash Flow: Properties across the United States have appreciated
significantly in the last 10 years. In many areas rent income has not kept pace with the
tremendous appreciation. Many real estate investors are currently only receiving 2%-
4% cash flow based on their equity.
(j) Appreciaition Opportunities: TIC owners are able to participate in the appreciation the

investment grade commercial property experiences. In most TIC programs, the TIC
investors receive the majority, if not all, of the appreciation.
(k) Pre-Packaged Financing: Companies that structure TIC ownership programs generally
acquire the property, arrange financing, perform due diligence and then fully manage
the properties. Ordinarily the debt is non-recourse which is another benefit to investors
because personal guarantees are not required.
(l) Back-up Property within the 45-Day Identification Period: Some investors performing
an exchange have difficulty identifying and closing on replacement property within the
45-day “identification period”. A fractional interest in a TIC ownership property may
help an investor who is exchanging meet their identification requirements near the end
of the 45-day identification period.
(m) Stepped Up Basis At Death: TIC assets that are passed on to beneficiaries receive a full
step up in basis when the original TIC owner passes away. This simply means that
capital gain taxes will be forgiven after death.

G. Limitations of TIC Ownership Program
TIC ownership is “Actual Real Estate Ownership”. The main difference on the surface is
that instead of owning an entire property, a TIC owner will usually own a “Fractional
Interest” of the property. TIC owners face the same basic risks that all other real estate
owners face such as market risk, economic risk, location risk, and legal risk. While TIC
ownership can provide a real estate investor with tremendous benefits, it is very important
to understand the limitations and risks of TIC ownership such as:
(a) Lack Of Liquidity: TIC investors must understand that they are indeed investing in real
estate and the TIC transaction should be viewed as a long term commitment. A TIC
owner does not have a large group of ready and willing buyers for their TIC ownership
interest waiting for them if they decide they want to sell their TIC interest before the
TIC property is ultimately sold. Currently there is no secondary market for TIC
ownership interests, although some experts believe that a secondary market will evolve
over time. Some TIC sponsors may help a TIC owner sell their interest to the other TIC
owners or to an outsider. If current liquidity is mandatory, a special transaction known
as an “UPREIT” under IRC section 721 should be investigated.
(b) Exit Strategy: Presently, without a secondary TIC market, there is no defined exit
strategy for TIC programs other than the ultimate sale of the TIC property. Many TIC
sponsors believe that they will hold a property for a minimum of 3 years and a
maximum of 10 years before selling the property.
(c) Lack of Experience: Most real estate investors have never even heard about TIC
ownership. The majority of professionals from the financial industry, the real estate

industry, the accounting industry, and the legal industry do not fully understand what a
TIC is and how it can benefit their clients. The majority of real estate owners do not
have much experience in commercial real estate and may not be fully aware of the risks
involved with commercial property ownership. Many real estate owners find that
investing in their first TIC makes them feel the same way they felt when they invested in
their first piece of real estate.
(d) Rate of Return: There is no guarantee that a TIC will provide a higher rate of return than
other real estate or non-real estate invetsments. In fact there is no guarantee that the TIC
will make any money at all, similar to almost every other investment that an individual
investor would consider.
(e) Co-Owners: Every TIC investor is locked into a long-term business relationship with
many co-owners who have not known each other previously. Co-owners will have to
agree, in most cases unanimously, to all major decisions affecting the TIC property. This
means that major decisions regarding the property will almost always be made for
business and economic reasons rather than for emotional reasons.
(f) Capital Call: TIC ownership is actual real estate ownership. If there is major work that’s
needs to be done on the TIC property, or if a major tenant moves out, there could be a
capital call placed to all TIC owners, that is not covered by the capital reserve that is
maintained for the property. This means that each TIC owner could be required to put
more money into the deal. This need for capital is identical to an owner of an individual
property having to pay for a new roof or subsidizing the operating cash flow while they
are trying to get a new renter in. Most TIC programs have an amount set aside in their

operating budget to cover what the sponsor views as anticipated future costs.
(g) Short-Term Debt Structure: To take advantage of current low short-term interest rates,
some sponsors are securing short-term financing, such as five-year loans. If the TIC
property has not sold within the 5 year time period, the property will have to be
refinanced, or the rate on the loan will adjust to current market rates. Most people believe
that interest rates will be higher 5 years from now. Higher future interest rates in the future
may force the investors to accept a lower overall rate of return.
(h) Costs and Fees: Often there are many fees involved in the sale of TIC ownership
programs. Some of these are obvious such as the fees to the registered representative and
others involved in the acquisition, packaging, distribution and sales processes. Other
costs include property management and liquidation.
(i) Estate Taxes: While it is true that a TIC ownership interest will receive a ‘Step Up In
Basis” when a TIC owner passes away, it is also true that just like any other real estate,
the value of the TIC interest will be included in the estate of the decedant if not properly
planned.

H. Overview of the TIC Ownership Industry
A real estate sponsor locates an investment property and prepares an investment offering
through a Private Placement Memorandum (PPM). Broker/dealers conduct the due diligence
on the investment offering and execute an agreement to sell the TIC investment to qualified
investors, generally “accredited investors”, through its registered representatives. The
investors, and their legal and/or tax advisors; review the PPM to make a determination of the
merits of the TIC ownership investment. Interested investors then submit applications to
participate in the TIC ownership investment through their registered representatives and
brokers/dealers to the sponsors.
Terminology
(a) Accredited Investor: Defined in Rule 501 of Regulation D and encompasses a list of
criteria including an individual whose net worth exceeds $1 million or a person with
income exceeding $200,000 in each of the two most recent years or joint income with a
spouse exceeding $300,000 for those years and a reasonable expectation of the same
income level in the current year.
(b) Broker/Dealer: An individual or firm that is in the business of buying in and selling
securities. Brokers/dealers are registered with the Securities and Exchange Commission
(SEC).
(c) Due Diligence: The practice of investigting a potential investment.
(d) National Association of Securities Dealers (NASD): A self-regulatory securities industy
organization responsible for the operation and regulation of the stock market and for

conducting regulatory reviews of members’ business activities.
(e) Registered Representative: An individual who is licensed to sell securities and has the
legal power of an agent and has passed the Series 7 and Series 63 examinations.
(f) Regulation D Offering: A safe harbor exemption for TIC ownership investments where
investors must be qualified as accredited investors.
(g) Securities and Exchange Commission: The primary Federal regulatory agency of the
securities industry, who promotes full disclosure and protect investors against fraudulent
practices in the securities markets.
(h) Sponsor: The provider of the TIC ownership real estate. The sponsor arranges for the
financing and purchase of the TIC ownership property.

I. TIC Ownership – Real Estate or a Security?
Along with the tremendous popularity TIC ownership has gained over the last few years,
there is also a tremendous amount of confusion as to whether TIC ownership is a securities
transaction or a real estate transaction. A securities transaction must be handled by a licensed
registered representative of a broker dealer while a real estate transaction must be handled by
a licensed real estate professional.
The TIC industry’s trade association is the Tenant-In-Common Association (Website:
www.ticassoc.org). Most of the TIC ownership sponsors who belong to TICA treat their TIC
ownership programs as a security.
While TIC ownership is considered an investment in real estate, the actual transaction is
primarily viewed as a securities transaction, meaning that the people promoting the purchase
of a TIC ownership property must have the necessary securities license.
A landmark case dates back to 1946 in the SEC v. Howey. Howey and others argued in court
that the fractional interests of their orange grove was not a security, and instead was real
property. This court case has created what is often called the “Howey Test”, which helps to
make clear whether a regulatory body, such as the SEC, will view an investment as a
securities transaction. The test has three prongs:
(a) An investment of money in a common enterprise.
(b) The investment is made with the expectation of return.
(c) The return is based on the entrepreneurial efforts of another.

If all three “prongs” are met it is generally thought that the transaction will be viewed as a
security transaction.
In 2000, a major TIC sponsor asked the SEC to issue a “no action” letter that would state the
TIC offered by the specific sponsor was not a security and that the SEC would not take action
against the sponsor for this treatment. The SEC responded to the request for a “no action”
letter this way:
“Based on the facts presented, the Division disagrees with your view that the real estate
interests described in your letter are not securities within the meaning of Section 2(a)(1) of
the Securities Act of 1933. As a result, the Division is unable to assure you that it would
not recommend enforcement action to the Commission unless the offer and sale of the real
interests are registered under the Section Act or exempt from registration.”
It is important to note that the response from the SEC is specific to the TIC sponsor who
made the request. It is an often used example that TIC transactions will probably be viewed
as securities transactions.
The most conservative view is that TIC transactions should be treated as a security and only
offered and sold by licensed security representatives.
In November, 2004, the Commercial Legislation and Regulatory Subcommittee of the
National Association of Realtors met to discuss this issue.
According to a January 2005 article in TIC Monthly, Joe Price, Vice President and head of the
NASD’s corporate financing department, said. “We need to let members know that all the
NASD rules that would normally apply to the sale of securities apply to the sale of TIC’s.”

J. What to Look for with TIC Ownership
It is important for each TIC investor to remember that they are purchasing a fractional
ownership interest in a commercial property. Owning real estate generally involves
opportunities for significant investment benefits such as cash flow, appreciation, tax
benefits, and wealth leverage. Owning real estate also carries corresponding risks such as
market conditions, tenant turnover, failure for tenants to pay rent, competing real estate
projects and management competence or lack of experience, etc.
In addition, many PPM’s specifically state that the TIC sponsor does not warrant or
represent that the structure of their program will necessarily qualify as “like-kind”
replacement property for investors completing 1031 tax deferred exchanges.
The investor and the investor’s legal and tax advisors should review all pertinent aspects of
the TIC property being acquired and the offerring sponsor. Some of the areas that should be
reviewed include:
(a) What is the structure of ownership?
(b) What is the projected income flow?
(c) Is the projected income flow reasonable and realistic?
(d) What is the condition of the TIC property?
(e) Will the TIC be operated by a Master Lease or a Management Agreement?
(f) What are the fees being charged?
(g) Is the TIC property located in an area acceptable to the investor?

(h) Who are the proposed tenants of the property?
(i) How long are the leases?
(j) What types of rent escalators are in place?
(k) How much reserves are set aside?
(l) What are the requirements for a capital call?
(m) Does it appear to be a joint venture or partnership or does it appear to have attributes of
true TIC ownership? (Note: An interest in a partnership is specifically excluded from
tax deferral under §1031.)
(n) Does it appear to be roughly in compliance with the parameters of Revenue Procedure
2002-22?
(o) What is the experience and track record of the property manager?
(p) What is the experience and track record of the sponsor?
(q) What are the aspects of the particular investment (type of property, vacancy rates,
tenant mix, market conditions, etc.)?

K. Overview of Revenue Procedure 2002-22
In the 1990’s and into the 2000’s, there was much debate as to whether a TIC ownership
structure was actually a TIC, thus qualifying as a replacement property for 1031 exchange
purposes, or whether the TIC was actually another business entity such as a partnership that
would not qualify as a replacement property for 1031 exchange purposes. In March 2002 the
IRS released Revenue Procedure 2002-22, often referred to as “The Rev. Proc.”. It was hoped
that the IRS would clarify this issue and create a “Safe Harbor” for qualifying TIC programs
to be certified as acceptable replacement properties for 1031 exchanges.
Instead of specifying what would and wouldn’t qualify as an acceptable replacement property,
in “The Rev. Proc.”, the IRS stated what information was needed and what conditions had to
be met for the IRS to consider a request for a ruling that a TIC was indeed a “fractional
interest in rental real property”. This means that instead of creating a "Safe Harbor" for TIC
transactions, the IRS merely provided guidance that takes the form of advance ruling
requirements. Although it is not a statement of substantive law, the advance ruling
requirements are likely to become a “litmus test” for many sponsors of TIC ownership
replacement property programs.

Information to be Submitted
“The Rev. Proc.” states that the IRS "ordinarily" will not consider a request for a ruling
without the proper information. “The Rev. Proc.” Includes two main areas of data
requirements in Section 5 and Section 6 of “The Rev. Proc.”. However, even if Sections 5 and
6 are satisfied, the IRS may decline to issue a ruling "whenever warranted by the facts and
circumstances of a particular case and whenever appropriate in the interest of sound tax
administration."
Section 5 outlines the information to be submitted, including information on each co-owner
and the property. In addition, the ruling request must contain a complete statement of all the
facts relating to the TIC ownership, including those relating to promoting, financing and
managing the property. All of the following information must be included to the extent related
to the property:
(a) The name, taxpayer identification number and percentage interest of each co-owner;
(b) The name, taxpayer identification number, ownership of, and any relationship among, all
persons involved in the acquisition, sale, lease and other use of the property, including
the sponsor, lessee, manager, and lender;
(c) A full description of the property;
(d) A representation that each of the co-owners holds title as tenants in common under local
law;
(e) Promotional documents relating to the sale of the TIC interests;

(f) Financing documents;
(g) Agreements among the co-owners;
(h) Any lease agreement;
(i) Purchase and sale agreement;
(j) Any property management or brokerage agreement; and
(k) Any other relevant information, for example, any call and put options.
All materials submitted to the IRS must contain applicable exhibits, attachments and
amendments. However, much of the required information may only be known at the end of
an offering, when the sponsor is ready to acquire the property, close the loan and sell
interests to investors. It is unlikely that many sponsors will be able to keep a transaction open
long enough to obtain a ruling.
Conditions for Obtaining Rules
The IRS ordinarily will not consider a request for a ruling unless the conditions described in
Section 6 are satisfied. However, where the conditions in Section 6 are not satisfied, the IRS still
may consider a ruling request "where the facts and circumstances clearly establish that such a
ruling is appropriate." The conditions are summarized below:
(a) Tenants In Common Ownership. Each of the co-owners must hold title to the property (either
directly or through a disregarded entity) as a tenant in common under local law.
(b) Number of Co-Owners. The number of co-owners must be limited to no more than 35
persons (a husband and wife are treated as a single person).

(c) No Treatment of Co-Owners as an Entity. The co-owners may not file a partnership tax
return or otherwise hold themselves out as a partnership or other form of entity.
(d) Co-Ownership Agreement. The co-owners may enter into a limited co-ownership agreement
that may run with the land. This agreement may provide that a co-owner must offer the
interest for sale at fair market value before exercising any right of partition. In addition, the
agreement may provide for majority voting on certain issues.
(e) Voting. The co-owners must retain their voting rights as described below. Unanimous
approval is required for any sale, lease or re-lease of a portion or all of the property, any
negotiations or re-negotiations of indebtedness secured by the property, the hiring of any
manager, or the negotiation of any management contract (or any extension or renewal of such
contract). However, for all other actions, the co-owners may agree to be bound by a vote of
more than 50% of the co-owners. A co-owner who has consented to an action in this matter
may provide the manager with a power of attorney to execute specific documents with
respect to that action.
(f) Restrictions on Alienation. In general, each co-owner must have the right to transfer,
partition, and encumber their interest in the property without the agreement or approval of
any person. However, restrictions that are required by a lender and that are consistent with
customary commercial lending practice are not prohibited. The co-owners or the sponsor
may have a right of first refusal and a co-owner may agree to offer an interest for sale to the
other co-owners or the sponsor at fair market value before exercising any right to partition.

(g) Sharing Proceeds and Liabilities Upon Sale of Property. If the property is sold, any debt
secured by the property must be satisfied and the remaining proceeds distributed to the co-
owners.
(h) Proportionate Sharing of Profits and Losses. Each co-owner must share in all revenue and all
costs in proportion to their interests in the property. Neither the other co-owners, the sponsor,
nor the manager may advance funds to a co-owner to meet expenses associated with the
property, unless the advance is recourse and is not for a period exceeding 31 days.
(i) Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by the
property in proportion to their undivided interests in the property.
(j) Options. A co-owner may issue an option to purchase his interest, provided the exercised
price reflects fair market value of the property determined as of the time the option is
exercised. A co-owner may not acquire an option to sell the interest (put option) to the
sponsor, the lessee, another co-owner or the lender or any person related to such parties.
(k) No Business Activities. The activities of the co-owners must be limited to those customarily
performed in connection with the maintenance and repair of rental real estate.
(l) Management and Brokerage Agreements. The co-owners may enter into management or
brokerage agreements, which must be renewable no less frequently than annually. The
manager or broker may be a sponsor or co-owner (or a related party), but may not be a
lessee. The management agreement may authorize the manager to maintain common bank
accounts for the collection and deposit of rents and to offset expenses associated with the
property against any revenues before dispersing each co-owner’s share of net revenues. In

addition, the management agreement may authorize the manager to take certain actions on
behalf of the owners (subject to the voting regime described above in Paragraph 5). The
manager may not be paid a fee based in whole or in part on the income or profits derived
from the property and the fees may not exceed the fair market value of the manager¹s service
based upon comparable fees paid to unrelated parties for similar services.
(m) Leasing Agreements. All leasing agreements must be bona fide leases for federal tax
purposes.
(n) Loan Agreements. The lender may not be a related person to any co-owner, the sponsor, the
manager, or any lessee of the property.
(o) Payments to Sponsor. The amount of any payment to the sponsor for the acquisition of the
co-ownership interest and services must reflect the fair market value of the interest acquired
and the services rendered. This means that such payments and fees may not depend, in whole
or in part, on the income or profits derived from the property (i.e., no back-end or carried
interest is permitted).
Many professionals in the TIC industry believe that future IRS rulings will further clarify the
requirements to ensure favorable tax treatment of a TIC program. Most TIC sponsors have
adapted their programs to conform to the conditions stated in Revenue Procedure 2002-22.
Investors must seek the advice of knowledgeable tax and/or legal advisors who can
thoroughly scrutinize all aspects of a particular TIC ownership investment.

SECTION 1. PURPOSE
This revenue procedure specifies the conditions under which the Internal Revenue Service
will consider a request for a ruling that an undivided fractional interest in rental real property
(other than a mineral property as defined in section 614) is not an interest in a business entity,
within the meaning of 301.7701-2(a) of the Procedure and Administration Regulations. This
revenue procedure supersedes Rev. Proc. 2000-46, 2002-2 C.B. 438, which provides that the
Service will not issue advance rulings or determination letters on the questions of whether an
undivided fractional interest in real property is an interest in an entity that is not eligible for
tax-free exchange under ¹ 1031(a)(1) of the Internal Revenue Code and whether
arrangements where taxpayers acquire undivided fractional interests in real property
constitute separate entities for federal tax purposes under 7701. This revenue procedure also
modifies Rev. Proc. 2002-3, 2002-1 I.R.B. 117, by removing these issues from the list of
subjects on which the Service will not rule. Requests for advance rulings described in Rev.
Proc. 2000-46 that are not covered by this revenue procedure, such as rulings concerning
mineral property, will be considered under procedures set forth in Rev. Proc. 2002-1, 2002-1
I.R.B. 1 (or its successor).

SECTION 2. BACKGROUND
Section 301.7701-1(a)(1) provides that whether an organization is an entity separate from its
owners for federal tax purposes is a matter of federal law and does not depend on whether the
entity is recognized as an entity under local law. Section 301.7701-1(a) (2) provides that a
joint venture or other contractual arrangement may create a separate entity for federal tax
purposes if the participants carry on a trade, business, financial operation, or venture and
divide the profits from, but the mere co-ownership of property that is maintained, kept in
repair, and rented or leased does not constitute a separate entity for federal tax purposes.
Section 301.7701-2(a) provides that a business entity is any entity recognized for federal tax
purposes (including an entity with a single owner that may be disregarded as an entity
separate from its owner under 301.7701-3) that is not properly classified as a trust under
301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code. A
business entity with two or more members is classified for federal tax purposes as either a
corporation or a partnership.
Section 761(a) provides that the term a partnership includes a syndicate, group, pool, joint
venture, or other unincorporated organization through or by means of which any business,
financial operation, or venture is carried on, and that is not a corporation or a trust or estate.
Section 1.761-1(a) of the Income Tax Regulations provides that the term partnership means a
partnership as determined under 301.7701-1, 301.7701-2, and 301.7701-3. The central
characteristic of a tenancy in common, one of the traditional concurrent estates in land, is that
each owner is deemed to own individually a physically undivided part of the entire parcel of
property. Each tenant in common is entitled to share with the other tenants the possession of
the whole parcel and has the associated rights to a proportionate share of rents or profits from

the property, to transfer the interest, and to demand a partition of the property. These rights
generally provide a tenant in common the benefits of ownership of the property within the
constraint that no rights may be exercised to the detriment of the other tenants in common. 7
Richard R. Powell, Powell on Real Property 50.01-50.07 (Michael Allan Wolf ed., 2000).
Rev. Rul. 75-374, 1975-2 C.B. 261, concludes that a two-person co-ownership of an
apartment building that was rented to tenants did not constitute a partnership for federal tax
purposes. In the revenue ruling, the co-owners employed an agent to manage the apartments
on their behalf; the agent collected rents, paid property taxes, insurance premiums, repair and
maintenance expenses, and provided the tenants with customary services, such as heat, air
conditioning, trash removal, unattended parking, and maintenance of public areas. The ruling
concludes that the agent’s activities in providing customary services to the tenants, although
imputed to the co-owners, were not sufficiently extensive to cause the co-ownership to be
characterized as a partnership. See also Rev. Rul. 79-77, 1979-1 C.B. 448, which did not find
a business entity where three individuals transferred ownership of a commercial building
subject to a net lease to a trust with the three individuals as beneficiaries.
Where a sponsor packages co-ownership interests for sale by acquiring property, negotiating a
master lease on the property, and arranging for financing, the courts have looked at the
relationships not only among the co-owners, but also between the sponsor (or persons related
to the sponsor) and the co-owners in determining whether the co-ownership gives rise to a
partnership. For example, in Bergford v. Commissioner, 12
F.3d 166 (9th Cir. 1993), seventy-eight taxpayers purchased a co-ownership interests in
computer equipment that was subject to a 7-year net lease. As part of the purchase, the co-
owners authorized the manager to arrange financing and refinancing, purchase and lease the

equipment, collect rents and apply those rents to the notes used to finance the equipment,
prepare statements, and advance funds to participants on an interest-free basis to meet cash
flow. The agreement allowed the co-owners to decide by majority vote whether to sell or lease
the equipment at the end of the lease. Absent a majority vote, the manager could make that
decision. In addition, the manager was entitled to a remarketing fee of 10 percent of the
equipments selling price or lease rental whether or not a co-owner terminated the agreement
or the manager performed any remarketing. A co-owner could assign an interest in the co-
ownership only after fulfilling numerous conditions and obtaining the managers consent. The
court held that the co-ownership arrangement constituted a partnership for federal tax
purposes. Among the factors that influenced the courts decision were the limitations on the
co-owners ability to sell, lease, or encumber either the co-ownership interest or the underlying
property, and the manager=s effective participation in both profits (through the remarketing
fee) and losses (through the advances). Bergford, 12 F.3d at 169-170. Accord Bussing v.
Commissioner, 88 T.C. 449 (1987), 89 T.C. 1050 (1987); Alhouse v. Commissioner, T.C.
Memo. 1991-652. Under 1.761-1(a) and 301.7701-1 through 301.7701-3, a federal tax
partnership does not include mere co-ownership of property where the owner’s activities are
limited to keeping the property maintained, in repair, rented or leased. However, as the above
authorities demonstrate, a partnership for federal tax purposes is broader in scope than the
common law meaning of partnership and may include groups not classified by state law as
partnerships. Bergford, 12 F.3d at 169. Where the parties to a venture join together capital or
services with the intent of conducting a business or enterprise and of sharing the profits and
losses from the venture, a partnership (or other business entity) is created. Bussing, 88 T.C. at
460. Furthermore, where the economic benefits to the individual participants are not

derivative of their co-ownership, but rather come from their joint relationship toward a
common goal, the co-ownership arrangement will be characterized as a partnership (or other
business entity) for federal tax purposes. Bergford, 12 F.3d at 169.
SECTION 3. SCOPE
This revenue procedure applies to co-ownership of rental real property (other than mineral
interests) (the Property) in an arrangement classified under local law as a tenancy-in-common.
This revenue procedure provides guidelines for requesting advance rulings solely to assist
taxpayers in preparing ruling requests and the Service in issuing advance ruling letters as
promptly as practicable. The guidelines set forth in this revenue procedure are not intended to
be substantive rules and are not to be used for audit purposes.

SECTION 4. GUIDELINES FOR SUBMITTING RULING REQUESTS
The Service ordinarily will not consider a request for a ruling under this revenue procedure
unless the information described in section 5 of this revenue procedure is included in the
ruling request and the conditions described in section 6 of this revenue procedure are satisfied.
Even if sections 5 and 6 of this revenue procedure are satisfied, however, the Service may
decline to issue a ruling under this revenue procedure whenever warranted by the facts and
circumstances of a particular case and whenever appropriate in the interest of sound tax
administration. Where multiple parcels of property owned by the co-owners are leased to a
single tenant pursuant to a single lease agreement and any debt of one or more co-owners is
secured by all of the parcels, the Service will generally treat all of the parcels as a single
property. In such a case, the Service will generally not consider a ruling request under this
revenue procedure unless: (1) each co-owners percentage interest in each parcel is identical to
that co-owners percentage interest in every other parcel, (2) each co-owner’s percentage
interests in the parcels cannot be separated and traded independently, and (3) the parcels of
property are properly viewed as a single business unit. The Service will generally treat
contiguous parcels as comprising a single business unit. Even if the parcels are not
contiguous, however, the Service may treat multiple parcels as comprising a single business
unit where there is a close connection between the business use of one parcel and the business
use of another parcel. For example, an office building and a garage that services the tenants of
the office building may be treated as a single business unit even if the office building and the
garage are not contiguous. For purposes of this revenue procedure, the following definitions
apply. The term a “co-owner” means any person that owns an interest in the Property as a
tenant in common. The term a sponsor means any person who divides a single interest in the

property into multiple co-ownership interests for the purpose of offering those interests for
sale. The term a related person means a person bearing a relationship described in 267(b) or
707(b)(1), except that in applying 267(b) or 707(b)(1), the co-ownership will be treated as a
partnership and each co-owner will be treated as a partner. The term a disregarded entity
means an entity that is disregarded as an entity separate from its owner for federal tax
purposes. Examples of disregarded entities include qualified REIT subsidiaries (within the
meaning of 856(i) (2)), qualified subchapter S subsidiaries (within the meaning of 1361(b) (3)
(B)), and business entities that have only one owner and do not elect to be classified as
corporations. The term a blanket lien means any mortgage or trust deed that is recorded
against the property as a whole.
SECTION 5. INFORMATION TO BE SUBMITTED
.01 Section 8 of Rev. Proc. 2002-1 outlines general requirements concerning the information
to be submitted as part of a ruling request, including advance rulings under this revenue
procedure. For example, any ruling request must contain a complete statement of all facts
relating to the co-ownership, including those relating to promoting, financing, and managing
the Property. Among the information to be included are the items of information specified in
this revenue procedure; therefore, the ruling request must provide all items of information and
conditions specified below and in section 6 of this revenue procedure, or at least account for
all of the items. For example, if a co-ownership arrangement has no brokerage agreement
permitted in section 6.12 of this revenue procedure, the ruling request should so state.
Furthermore, merely submitting documents and supplementary materials required by section
5.02 of this revenue procedure does not satisfy all of the information requirements contained
in section 5.02 of this revenue procedure or in section 8 of Rev. Proc. 2002-1; all material

facts in the documents submitted must be explained in the ruling request and may not be
merely incorporated by reference. All submitted documents and supplementary materials must
contain applicable exhibits, attachments, and amendments. The ruling request must identify
and explain any information or documents required in section 5 of this revenue procedure that
are not included and any conditions in section 6 of this revenue procedure that are or are not
satisfied.
.02 Required General Information and Copies of Documents and Supplementary Materials.
Generally the following information and copies of documents and materials must be
submitted with the ruling request:
(1) The name, taxpayer identification number, and percentage fractional interest in Property of
each co-owner;
(2) The name, taxpayer identification number, ownership of, and any relationship among, all
persons involved in the acquisition, sale, lease and other use of
Property, including the sponsor, lessee, manager, and lender;
(3) A full description of the Property;
(4) A representation that each of the co-owners holds title to the Property (including each of
multiple parcels of property treated as a single Property under this revenue procedure) as a
tenant in common under local law;
(5) All promotional documents relating to the sale of fractional interests in the Property;
(6) All lending agreements relating to the Property;
(7) All agreements among the co-owners relating to the Property;
(8) Any lease agreement relating to the Property;
(9) Any purchase and sale agreement relating to the Property;

(10) Any property management or brokerage agreement relating to the Property; and
(11) Any other agreement relating to the Property not specified in this section, including
agreements relating to any debt secured by the Property (such as guarantees or indemnity
agreements) and any call and put options relating to the Property.
SECTION 6. CONDITIONS FOR OBTAINING RULINGS
The Service ordinarily will not consider a request for a ruling under this revenue procedure
unless the conditions described below are satisfied. Nevertheless, where the conditions
described below are not satisfied, the Service may consider a request for a ruling under this
revenue procedure where the facts and circumstances clearly establish that such a ruling is
appropriate.
.01 Tenancy in Common Ownership. Each of the co-owners must hold title to the Property
(either directly or through a disregarded entity) as a tenant in common under local law.
Thus, title to the Property as a whole may not be held by an entity recognized under local
law.
.02 Number of Co-Owners. The number of co-owners must be limited to no more than 35
persons. For this purpose, a person. is defined as in 7701(a) (1), except that a husband and
wife are treated as a single person and all persons who acquire interests from a co-owner
by inheritance are treated as a single person.
.03 No Treatment of Co-Ownership as an Entity. The co-ownership may not file a partnership
or corporate tax return, conduct business under a common name, execute an agreement
identifying any or all of the co-owners as partners, shareholders, or members of a business
entity, or otherwise hold itself out as a partnership or other form of business entity (nor
may the co-owners hold themselves out as partners, shareholders, or members of a

business entity). The Service generally will not issue a ruling under this revenue
procedure if the co-owners held interests in the Property through a partnership or
corporation immediately prior to the formation of the co-ownership.
.04 Co-Ownership Agreement. The co-owners may enter into a limited co-ownership
agreement that may run with the land. For example, a co-ownership agreement may
provide that a co-owner must offer the co-ownership interest for sale to the other co-
owners, the sponsor, or the lessee at fair market value (determined as of the time the
partition right is exercised) before exercising any right to partition (see section
6.06 of this revenue procedure for conditions relating to restrictions on alienation); or that
certain actions on behalf of the co-ownership require the vote of co-owners holding more
than 50 percent of the undivided interests in the Property (see section 6.05 of this revenue
procedure for conditions relating to voting).
.05 Voting. The co-owners must retain the right to approve the hiring of any manager, the sale
or other disposition of the Property, any leases of a portion or all of the Property, or the
creation or modification of a blanket lien. Any sale, lease, or re-lease of a portion or all of
the Property, any negotiation or renegotiation of indebtedness secured by a blanket lien,
the hiring of any manager, or the negotiation of any management contract (or any
extension or renewal of such contract) must be by unanimous approval of the co-owners.
For all other actions on behalf of the co-ownership, the co-owners may agree to be bound
by the vote of those holding more than 50 percent of the undivided interests in the
Property. A co-owner who has consented to an action in conformance with this section
6.05 may provide the manager or other person a power of attorney to execute a specific

document with respect to that action, but may not provide the manager or other person
with a global power of attorney.
.06 Restrictions on Alienation. In general, each co-owner must have the rights to transfer,
partition, and encumber the co-owners undivided interest in the Property without the
agreement or approval of any person. However, restrictions on the right to transfer,
partition, or encumber interests in the Property that are required by a lender and that are
consistent with customary commercial lending practices are not prohibited. See section
6.14 of this revenue procedure for restrictions on who may be a lender.
Moreover, the co-owners, the sponsor, or the lessee may have a right of first offer (the right to
have the first opportunity to offer to purchase the co-ownership interest) with respect to
any co-owners exercise of the right to transfer the co-ownership interest in the Property. In
addition, a co-owner may agree to offer the co-ownership interest for sale to the other co-
owners, the sponsor, or the lessee at fair market value (determined as of the time the
partition right is exercised) before exercising any right to partition.
.07 Sharing Proceeds and Liabilities upon Sale of Property. If the Property is sold, any debt
secured by a blanket lien must be satisfied and the remaining sales proceeds must be
distributed to the co-owners.
.08 Proportionate Sharing of Profits and Losses. Each co-owner must share in all revenues
generated by the Property and all costs associated with the Property in proportion to the
co-owners undivided interest in the Property. Neither the other co-owners, nor the
sponsor, nor the manager may advance funds to a co-owner to meet expenses associated
with the co-ownership interest, unless the advance is recourse to the co-owner (and, where

the co-owner is a disregarded entity, the owner of the co-owner) and is not for a period
exceeding 31 days.
.09 Proportionate Sharing of Debt. The co-owners must share in any indebtedness secured by
a blanket lien in proportion to their undivided interests.
.10 Options. A co-owner may issue an option to purchase the co-owners undivided interest
(call option), provided that the exercise price for the call option reflects the fair market
value of the Property determined as of the time the option is exercised.
For this purpose, the fair market value of an undivided interest in the Property is equal to
the co-owners percentage interest in the Property multiplied by the fair market value of the
Property as a whole. A co-owner may not acquire an option to sell the co-owners
undivided interest (put option) to the sponsor, the lessee, another co-owner, or the lender,
or any person related to the sponsor, the lessee, another co-owner, or the lender.
.11 No Business Activities. The co-owners activities must be limited to those customarily
performed in connection with the maintenance and repair of rental real property
(customary activities). See Rev. Rul. 75-374, 1975-2 C.B. 261. Activities will be treated
as customary activities for this purpose if the activities would not prevent an amount
received by an organization described in ¹ 511(a)(2) from qualifying as rent under
512(b)(3)(A) and the regulations there under. In determining the co-owners activities, all
activities of the co-owners, their agents, and any persons related to the co-owners with
respect to the Property will be taken into account, whether or not those activities are
performed by the co-owners in their capacities as co-owners. For example, if the sponsor
or a lessee is a co-owner, then all of the activities of the sponsor or lessee (or any person
related to the sponsor or lessee) with respect to the Property will be taken into account in

determining whether the co-owners activities are customary activities. However, activities
of a co-owner or a related person with respect to the Property (other than in the co-owners
capacity as a co-owner) will not be taken into account if the co-owner owns an undivided
interest in the Property for less than 6 months.
.12 Management and Brokerage Agreements. The co-owners may enter into management or
brokerage agreements, which must be renewable no less frequently than annually, with an
agent, who may be the sponsor or a co-owner (or any person related to the sponsor or a
co-owner), but who may not be a lessee. The management agreement may authorize the
manager to maintain a common bank account for the collection and deposit of rents and to
offset expenses associated with the Property against any revenues before disbursing each
co-owners share of net revenues. In all events, however, the manager must disburse to the
co-owners their shares of net revenues within 3 months from the date of receipt of those
revenues. The management agreement may also authorize the manager to prepare
statements for the co-owners showing their shares of revenue and costs from the Property.
In addition, the management agreement may authorize the manager to obtain or modify
insurance on the Property, and to negotiate modifications of the terms of any lease or any
indebtedness encumbering the Property, subject to the approval of the co-owners. (See
section 6.05 of this revenue procedure for conditions relating to the approval of lease and
debt modifications.) The determination of any fees paid by the co-ownership to the
manager must not depend in whole or in part on the income or profits derived by any
person from the Property and may not exceed the fair market value of the manager’s
services. Any fee paid by the co-ownership to a broker must be comparable to fees paid by
unrelated parties to brokers for similar services.

.13 Leasing Agreements. All leasing arrangements must be bona fide leases for federal tax
purposes. Rents paid by a lessee must reflect the fair market value for the use of the
Property. The determination of the amount of the rent must not depend, in whole or in
part, on the income or profits derived by any person from the Property leased (other than
an amount based on a fixed percentage or percentages of receipts or sales). See section
856(d) (2) (A) and the regulations there under. Thus, for example, the amount of rent paid
by a lessee may not be based on a percentage of net income from the Property, cash flow,
increases in equity, or similar arrangements.
.14 Loan Agreements. The lender with respect to any debt that encumbers the Property or
with respect to any debt incurred to acquire an undivided interest in the Property may not
be a related person to any co-owner, the sponsor, the manager, or any lessee of the
Property.
.15 Payments to Sponsor. Except as otherwise provided in this revenue procedure, the amount
of any payment to the sponsor for the acquisition of the co-ownership interest (and the
amount of any fees paid to the sponsor for services) must reflect the fair market value of
the acquired co-ownership interest (or the services rendered) and may not depend, in
whole or in part, on the income or profits derived by any person from the Property.

VI. Exchange Requirements

IRC §1031 states:
“No gain or loss shall be recognized on the exchange of property held for productive use in
a trade or business or for investment if such property is exchanged solely for property of
like-kind which is to be held either for productive use in a trade or business or for
investment,” IRC §1031(a)(1).
To qualify for non-recognition treatment, the following requirements must be met:
(a) An exchange is required;
(b) Qualifying real or personal property must be exchanged;
(c) Property must be held for productive use in a trade or business or for investment
purposes;
(d) The relinquished property must be like-kind with the replacement property.

A. Exchange Requirement
Prior to the 1991 Regulations, common wisdom was that the taxpayer needed to evidence
intent to exchange at each step of the process. The offered and completed Purchase and Sale
agreement evidenced the so-called “contract for actual exchange” by including clear intent to
exchange. Since the 1991 Regulations, the fact that an actual exchange took place is given
more weight than the prior evidence of intent to exchange. As such, exchanges are often first
contemplated and then actually undertaken just prior to the close of the sales transaction.
Although an intent to exchange is not a requirement, the taxpayer’s intent at the time of the
exchange is important, Starker v. United States, 602 F.2d 1341 (CA9 1979). A sale is the
transfer of property for money, whereas an exchange necessitates the transfer of property for
property, Reg §1.1031(k)-1(a). A sale of property followed by the subsequent purchase of
like-kind replacement property does not qualify for the non-recognition of gain provided for
under IRC §1031, Meadows v. Comm., TC Memo 1981-417.
Prior to the enactment of IRC §1031(a) (3) in 1984, which allowed delayed exchanges, Tax
Reform Act of 1984, Pub. L. No. 98-369, 98 Stat 494, the Internal Revenue Service viewed an
exchange as a reciprocal transfer of property, which must take place simultaneously. The
position was rejected in Starker v. United States, Starker v. United States, 602 F.2d 1341
(1979). The addition of subsection (a) (3) to IRC §1031 in 1984 was in response to the
decision in the Starker case.

“Last Minute” Exchanges are Possible
Even if no language was included, many taxpayers contact a Qualified Intermediary just
minutes before closing on their transaction and successfully convert a sale into an exchange.
In most situations, a successful exchange can be accomplished as long as the Qualified
Intermediary is contacted prior to closing and all necessary exchange documents are
executed before closing.
The Rescission Agreement Option
In today’s environment with relatively few taxpayers aware of the flexibility afforded by an
exchange, taxpayers often learn of a tax deferred exchange after closing on the sale of the
sales property. Sometimes the taxpayer, due to poor planning or erroneous advice,
structures an ineffective or “broken” exchange. A valid exchange may be saved using the
doctrine of rescission. Under this doctrine the taxpayer and the Buyer of the relinquished
property would agree to rescind their transaction, put each other in their original positions
and complete their transaction all over again.
An early and often cited case in support of this doctrine is Penn v. Robertson, 115 F.2d 167
(4th Cir. 1940). Since then there have been numerous cases and IRS Private Letter Rulings
that have generally upheld the doctrine for tax purposes. Typical requirements are:

• The rescission transaction must occur between the original parties to the transaction;
• The rescission must restore the parties to their original positions with no further
obligations; and
• The rescission must occur within the same tax period as the original transaction.
There are many practical considerations such as lenders and real estate fees that work to restrict
the use of the rescission doctrine. However in the right circumstances, it may allow the taxpayer
a fresh start to do an exchange.

B. Property Requirement
Real property must be exchanged for like-kind real property held for productive use in a
trade or business or for investment purposes. Personal property of a like class are
considered to “like kind” for purposes of IRC §1031(a) (1). Personal property that is like
kind will also qualify for 1031 purposes even if they are not of like class. Property excluded
from non-recognition treatment includes the following:
(a) Stock in trade or other property held primarily for sale,
(b) Stocks, bonds or notes,
(c) Other securities or evidences of indebtedness or interest,
(d) Interests in a partnership,
(e) Certificates of trust or beneficial interests,
(f) Choses in action, IRC §1031(a) (2).
For the purposes of IRC §1031(a) (2) (D), “an interest in a partnership which has in effect a
valid election under IRC §761(a) to be excluded from the application of all of subchapter K
shall be treated as an interest in each of the assets of the such partnership and not as an
interest in a partnership,” Tax Reform Act of 1984, Pub. L. No. 98-369, 98 Stat.494.

C. Qualifying Use Requirement
The taxpayer must hold the property for productive use in a trade or business or for
investment. This qualifying property must be exchanged for property to be held for either of
these two uses. A taxpayer’s personal residence does not qualify for tax deferral under IRC
§1031.
There is no safe harbor holding period for property to automatically qualify as being held for
qualified use. Section 11601 of HR 3150, 100th Cong., 1st Sess. (1989), would have required
that the relinquished and replacement property be held for at least one year before and after
the exchange to qualify for non-recognition treatment under IRC §1031. This addition was
not included in the Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 1031-239, 103
Stat. 2106. Time is only one factor the IRS looks at in determining the taxpayer’s intent for
both the relinquished and replacement properties. In one private letter ruling, the IRS did
state that a minimum holding period of two years would be sufficient for the qualified use
test, Ltr Rul 8429039.

D. Like-Kind Requirement
Real property is not like-kind to personal property, Rev. Rul 59-229, 1959 CB 180. The
determination of whether property is real or personal is generally determined by state law,
Aquilino v. U.S., 363 US 509, 4 L. Ed. 2d 1365, 1371, 80 S. Ct. 1277, 1285 (1960). There are
exceptions to determination under state law, such as treating a lease of 30 years or more as
real property for purposes of IRC §1031, regardless of how the lease is treated under state
law, Reg §1.1031(a)-1(c). The words “like-kind” refer to the nature or character of the
property and not to its grade or quality, Reg §1.l1031 (a)-1(b).
(a) Real Property
The definition of real estate, which can be exchanged under the tax code, is extremely
broad. Many Revenue Rulings and Private Letter Rulings have addressed the wide
range of qualifying like-kind real property. Examples of real property transactions held
to be like-kind include:
(1)Unimproved real property for unimproved real property, Reg §1.1031(a)-1(b);
Barker v. Comm., 74 TC 555 (1980);
(2) Commercial building for lots, Burkhard Inc. Co. v U.S., 102 F.2d 642 (CCA9
1938);
(3) An easement for a fee interest, Rev. Rul 72-549, 1972-2 CB 472;
(4) Real estate in a city for a ranch or farm, Reg §1.1031(a)-1(c); Rutland v. Comm., TC
Memo 1977-8.

(b) Personal Property
Although IRC §1033 specifically addresses involuntary conversions, which provides
for the non-recognition of gain when proceeds are reinvested in property which is
similar or related in service or use to the property involuntarily converted, Reg.
§1.1033(a)-1(a), this standard probably provides a closer guideline for determining
whether personal property is like-kind under IRC §1031. Examples of personal
property exchanges include:
(1) Livestock for livestock, provided the livestock are held for the production of income
and not primarily for sale, Rutherford v. Comm., TC Memo 1978-505; Wylie v.
United States, 68.1 USTC 9286 (ND Tex 1968);
(2) Mexican gold coins for Austrian gold coins, Rev Rul 76-214, 1976-1 CB 218.
The Regulations provide a more detailed analysis of the permitted exchanges of
personal property by addressing the classifications of qualifying property as described
below:
(a) Introduction. Section 1.1031(a)-1(b) provides that the non-recognition rules of
section 1031 do not apply to an exchange of one kind or class of property for
property of a different kind or class. This section contains additional rules for
determining whether personal property has been exchanged for property of a like-
kind or like-class. Personal properties of a like-class are considered to be of a
“like-kind” for purposes of section 1031. In addition, an exchange of properties of
a like-kind may qualify under section 1031 regardless of whether the properties

are also of a like-class. In determining whether exchanged properties are of a like-
kind, no inference is to be drawn from the fact that the properties are not of a like-
class. Under paragraph (b) of this section, depreciable tangible personal properties
are of a like-class if they are either within the same General Asset Class (as
defined in paragraph (b)(2) of this section) or within the same Product Class (as
defined in paragraph (b)(3) of this section). Paragraph (c) of this section provides
rules for exchanges of intangible personal property and non-depreciable personal
property.
(b) Depreciable Tangible Personal Property—
(1) General Rule. Depreciable tangible personal property is exchanged for
property of a “like-kind” under section 1031 if the property is exchanged for
property of a like-kind or like-class. Depreciable tangible personal property
is of a like-class to other depreciable tangible personal property if the
exchanged properties are either within the same General Asset Class or
within the same Product Class. A single property may not be classified
within more than one General Asset Class or within more than one Product
Class. In addition, property classified within any General Asset Class may
not be classified within a Product Class. A property’s General Asset Class or
Product Class is determined as of the date of the exchanges:
(2) General Asset Classes. Except as provided in paragraphs (b)(4) and (b)(5) of
this section, property within a General Asset Class consists of depreciable
tangible personal property described in one of asset classes 00.11 through

00.28 and 00.4 of Rev. Proc. 87-56, 1987-2 C.B. 674. These General Asset
Classes describe types of depreciable tangible personal property that
frequently are used in many businesses. The General Asset Classes are as
follows:
(a) Office furniture, fixtures, and equipment (asset class 00.11),
(b) Information systems (computers and peripheral equipment) (asset class
00.12),
(c) Data handling equipment, except computers (asset class 00.13),
(d) Airplanes (airframes and engines), except those used in commercial or
contract carrying of passengers or freight, and all helicopters (airframes
and engines) (asset class 00.21),
(e) Automobiles, taxis (asset class 00.22),
(f) Buses (asset class 00.23),
(g) Light general-purpose trucks (asset class 00.241),
(h) Heavy general-purpose trucks (asset class 00.242),
(i) Railroad cars and locomotives, except those owned by railroad
transportation companies (asset class 00.25),
(j) Tractor units for use over-the-road (asset class 00.26),
(k) Trailers and trailer-mounted containers (asset class 00.27),

(l) Vessels, barges, tugs, and similar water-transportation equipment, except
those used in marine construction (asset class 00.28), and
(m) Industrial steam and electric generation and/or distribution systems (asset
class 00.4).
(3) Product Classes. Except as provided in paragraphs (b) (4) and (b) (5) of this
section, property within a Product Class consists of depreciable tangible
personal property that is listed in a 4-digit product class within Division D of
the Standard Industrial Classification codes, set forth in Executive Office of
the President, Office of Management and Budget, Standard Industrial
Classification Manual (1987) (SIC Manual). Copies of the SIC Manual may
be obtained from the National Technical Information Service, an agency of
the U.S. Department of Commerce. Division D of the SIC Manual contains a
listing of manufactured products and equipment. For this purpose, any 4-digit
product class ending in a “9” (i.e., a miscellaneous category) will not be
considered a Product Class. If a property is listed in more than one product
class, the property is treated as listed in any one of those product classes. A
property’s 4-digit product classification is referred to as the property’s “SIC
Code.”
(4) Modifications of Rev. Proc. 87-56 and SIC Manual. The asset classes of Rev.
Proc. 87-56 and the product classes of the NASIC Manual may be updated or
otherwise modified from time to time. In the event Rev. Proc. 87-56 is
modified, the General Asset Classes will follow the modification, and the

modification will be effective for exchanges occurring on or after the date the
modification is published in the Internal Revenue Bulletin, unless otherwise
provided. Similarly, in the event the NASIC Manual is modified, the Product
Classes will follow the modification, and the modification will be effective for
exchanges occurring on or after the effective date of the modification.
However, taxpayers may rely on the unmodified NASIC manual for
exchanges occurring during the one-year period following the effective date
of the modification. The NASIC Manual generally is modified every five
years, in years ending in a 2 or 7 (e.g., 1987 and 1992). The effective date of
the modified SIC Manual is announced in the FEDERAL REGISTER and
generally is January 1 of the year the SIC Manual is modified.
(5) Modified Classification Through Published Guidance. The Commissioner
may, by guidance published in the Internal Revenue Bulletin, supplement the
guidance provided in this section relating to classification of properties. For
example, the Commissioner may determine not to follow, in whole or in part,
any modification of Rev. Proc. 87-56 or the NASIC Manual. The
Commissioner may also determine that two types of property that are listed in
separate product classes each ending in a “9” are of a like-class, or that a type
of property that has a NASIC Code is of a like-class to a type of property that
does not have a NASIC Code.
(6) No Inference Outside of Section 1031. The rules provided in this section
concerning the use of Rev. Proc. 87-56 and the SIC manual are limited to

exchanges under section 1031. No inference is intended with respect to the
classification of property for other purposes, such as depreciation.
(7) General Rule. An exchange of intangible personal property of non-depreciable
personal property qualifies for non-recognition of gain or loss under section
1031 only if the exchanged properties are of a like-kind. No like-classes are
provided for these properties. Whether intangible personal property is of a
like-kind to other intangible personal property generally depends on the nature
or character of the rights involved (e.g., a patent or a copyright) and also on
the nature or character of the underlying property to which the intangible
personal property relates.
(8) Goodwill and Going Concern Value. The goodwill or going concern value of
a business is not of a like-kind to the goodwill or going concern value of
another business.

VII. Section 1031 Exchange Documentation

Proper documentation is critical to a valid exchange. The documents prepared by the Qualified
Intermediary are paramount to the exchange, and must be executed prior to closing on the
relinquished property. Backseat to the Qualified Intermediary documents, but very important,
are the documents prepared by the closing entity. The standard closing documents used in any
given area of the country are used in a §1031 tax deferred exchange. However, there are minor
changes to reflect the exchange transaction as compared to a sale transaction.
Qualified Intermediary:
(a) Exchange Agreement
(b) Assignment Agreement
(c) Notice of Assignment
(d) Account Set-Up Forms
(e) Security of Funds Instrument

Closing Entity:
(a) Settlement Forms which should reflect a Section 1031 tax deferred exchange.
These typically show the Qualified Intermediary as the seller (i.e. XYZ, Inc. as
Qualified Intermediary for John R. Smith)
(b) FRPTA (and state withholding forms where applicable)
(c) 1099 Form
(d) Other documents common to the area

VIII. Section 1031 Formats and Variations

A. The Two-Party Trade (Swap)
(a) The original exchange format. (Validated by Congress in 1921)
(b) Two parties trade (or swap) deeds and must "balance equities"
(c) In an analysis, you must "test" for tax deferral one party at a time
(d) In this format (Two-Party Exchange) you do not need a "Qualified Intermediary"
(e) A Qualified Intermediary may be employed when the equities are not equal
Facts:
Party A is trading their primary residence for Party B’s single family home. The value of
their primary residence is $175,000, with a loan balance of $100,000, therefore an equity
equal to $75,000.
Party B is trading their rental, for Party A’s single family residence. The value of their rental
is $200,000 cash, a loan balance of $125,000, therefore an equity of $75,000.

PARTY A PARTY B
Trade of Deeds
Single Family Home Single Family Home
Once the facts are present, it is important to analyze each party’s situation and apply the
appropriate tax section. In this case Party A is using IRC §121 and Party B, IRC §1031.

B. The Three-Party Exchange (Alderson vs. Commissioner – 1963) Facts:
(a) Alderson had a buyer for their property which had been held for investment.
(b) Alderson found a "like-kind" property to acquire, also to be held for investment.
(c) Alderson knew they could not sell and immediately purchase because that would have
resulted in 100% capital gain tax recognition.
(d) Alderson structured the transaction which required the buyers "participation" in their
exchange.
(e) The buyer agreed to an assignment of the contract between Alderson and the seller of
the new property.
(f) Buyer took title to Alderson’s new property and then traded it for Alderson’s property.
PARTY A PARTY B
ALDERSON
DEED (Exchanger)
DEED
BUYER DEED SELLER
Single Family Home Single Family Home

(a) Buyers with proper guidance should not "participate" in this format due to the liability
of going on title to a property they have no interest in
(b) Taxpayers must put faith in the performance of another party to complete a valid
exchange
(c) A much easier, safer and more reliable approach can be taken which does not require
any "participation" nor does it have to close simultaneously

C. The Delayed Exchange
The delayed exchange format was validated at the Federal level in 1984. This variation is the
most common exchange format because it provides taxpayers the flexibility of 45 calendar
days to “identify” and a maximum of 180 calendar (or day the tax return is due) to complete
the transactions.
DIRECT DIRECT
DEED Taxpayer DEED
Qualified
Buyer Intermediary $ Seller
$
Identification Period Total Exchange Period

0 45 180
Days Days
45-Day Identification Period:
A maximum of 45 calendar days to identify potential replacement property (s) in accordance
with the rules of identification.
180-Day Exchange Period:
(a) 180 days or day tax return is due
(b) Calendar days
(c) No extensions available

Identification Rules:
(a) Three Property Rule: The Taxpayer may identify a maximum of three (3) replacement
properties without regard to the fair market value of the properties.
(b) Two Hundred Percent Rule: The Taxpayer may identify any number of properties, so long
as the aggregate fair market value of the identified properties does not exceed two hundred
percent (200%) of the aggregate fair market value of the relinquished properties.
(c) Ninety Five Percent Rule: The Taxpayer may identify any number of properties without
regard to the aggregate fair market value so long as taxpayer receives ninety five percent
(95%) of the aggregate fair market value of all identified replacement properties.
Highlights of a Valid Delayed Exchange
(a) Consult with an experienced “Qualified Intermediary”, (Q.I.), and their own tax/legal
advisors prior to closing the sale of the relinquished property.
(b) Ensure that the “Sale Contract” is “assignable” and that the buyer is made aware of such
assignment in writing. It is common to show the seller as “John Doe and/or assignee.”
(c) The exchange contract language should accomplish three objectives: A) Intent to effect
a §1031 tax deferred exchange. B) Release the buyer from any liabilities or costs
resulting in the exchange; C) Notify the buyer in writing of assignment.
Contracts Should be Assignable
It is important, however, that the Purchase and Sale Agreements for both properties be
assignable. In order to structure a typical exchange transaction, the Qualified Intermediary

must be assigned in as the Seller of the relinquished property and also as the Buyer of the
replacement property.
A taxpayer should review the contract to confirm they are not prohibited from assigning their
position as either a “Seller” or “Buyer” to a Qualified Intermediary. When a typical exchange
is structured with a Qualified Intermediary, it is shown as the Seller on the Settlement
Statement instead of the taxpayer. The language below is satisfactory in establishing the
taxpayer’s intent to perform a tax deferred exchange and releases the other parties from costs
or liabilities as a result of the exchange:
Sale of Relinquished Property
Buyer is aware that Seller intends to perform an IRC Section 1031 tax deferred
exchange. Seller requests Buyer’s cooperation in such an exchange and agrees to
hold Buyer harmless from any and all claims, costs, liabilities, or delays in time
resulting from such an exchange. Buyer agrees to an assignment of this contract
by the Seller.”
Purchase of Replacement Property
Seller is aware that Buyer intends to perform an IRC Section 1031 tax deferred
exchange. Buyer requests Seller’s cooperation in such an exchange and agrees to
hold Seller harmless from any and all claims, costs, liabilities , or delays in time
resulting from such an exchange. Seller agrees to an assignment of this contract
by the Buyer.”

The Qualified Intermediary’s exchange agreement must be executed prior to closing the
sale.
(a) The Qualified Intermediary should oversee the closing to ensure that the closing
properly reflects the §1031 exchange.
(b) The taxpayer must identify the property(s) to be acquired in accordance with the “Rules
of Identification”.
(c) The taxpayer must close on the new property by the 180th calendar day (or their tax
filing date – whichever is earlier) from the close of the relinquished property sale.

What Not to Do in a Delayed Exchange
(a) Christensen vs. Comm. (April 10, 1998)
What Happened: The Christensen’s filed their tax return on April 15 and acquired
replacement property within 180 days, but this purchase closed after they had already
filed their tax return. The Tax Court cited failure to comply with the deadlines,
specifically the requirement to complete the exchange within 180 days orthe tax filing
date, whichever is earlier, as the reason tax deferral was not allowed.
(b) Knight vs. Comm. (March 16, 1998)
What Happened: On day 179, the Knight’s purchase of their replacement property fell
apart. The Knight’s acquired another property after the 180th day and argued they made
a “good faith” attempt to meet the time requirements. The Tax Court denied the
exchange because the tax code clearly allows only a maximum of 180 days to complete
the exchange.
(a) Dobrich vs. Comm. (October 20, 1997)
What Were They Thinking?
In the Tax Court case, Dobrich vs. Commissioner (October 20, 1997), the taxpayers
committed tax fraud by falsifying the date property was identified. The taxpayers
misrepresented to the IRS that they had properly identified replacement property by
back-dating documents in an attempt to reflect that an “oral identification” had been
made. They tried to fabricate their identification and created false documents to attempt
to substantiate their claim. The Court found evidence of the Dobrich’s intent to defraud

and ruled that they were liable for a Section 6663 fraud penalty. In addition, the taxpayer
pleads guilty to a criminal charge of causing the delivery of false documents to the IRS.
Ultimately, the taxpayers were liable for the $2.2 million in capital gain taxes they were
attempting to defer….plus an additional 75% fraud penalty of an additional $1.6 million!
The bottom line: Every taxpayer should make sure that they properly identify replacement
property within the 45 calendar day identification timeline - period.

D. SECTION 1.1031(k)-l. TREATMENT OF DEFERRED EXCHANGES
(a) Overview. This section provides rules for the application of section 1031 and the
regulations there under in the case of a "deferred exchange." For purposes of section
1031 and this section, a deferred exchange is defined as an exchange in which, pursuant
to an agreement, the taxpayer transfers property held for productive use in a trade or
business or for investment (the "relinquished property") and subsequently receives
property to be held either for productive use in a trade or business or for investment (the
"replacement property"). In the case of a deferred exchange, if the requirements set forth
in paragraphs (b), (c), and (d) of this section (relating to identification and receipt of
replacement property) are not satisfied, the replacement property received by the
taxpayer will be treated as property which is not of a like kind to the relinquished
property. In order to constitute a deferred exchange, the transaction must be an exchange
(i.e., a transfer of property for property, as distinguished from a transfer of property for
money). For example, a sale of property followed by a purchase of property of a like
kind does not qualify for non-recognition of gain or loss under section 1031 regardless of
whether the identification and receipt requirements of section 1031 (a)(3) and paragraphs
(b), (c), and (d) of this section are satisfied. The transfer of relinquished property in a
deferred exchange is not within the provisions of section 1031 (a) if, as part of the
consideration, the taxpayer receives money or property which does not meet the
requirements of section 1031 (a), but the transfer, if otherwise qualified, will be within
the provisions of either section 1031 (b) or (c). See Section 1. 1031 (a)-l (a) (2). In
addition, in the case of a transfer of relinquished property in a deferred exchange, gain or
loss may be recognized if the taxpayer actually or constructively receives money or

property which does not meet the requirements of section 1031 (a) before the taxpayer
actually receives like-kind replacement property. If the taxpayer actually or
constructively receives money or property which does not meet the requirements of
section 1031 (a) in the full amount of the consideration for the relinquished property, the
transaction will constitute a sale, and not a deferred exchange, even though the taxpayer
may ultimately receive like-kind replacement property. For purposes of this section,
property which does not meet the requirements of section 1031 (a) (whether by being
described in section 1031 (a) (2) or otherwise) is referred to as "other property." For rules
regarding actual and constructive receipt, and safe harbors there from, see paragraphs (f)
and (g), respectively, of this section. For rules regarding the determination of gain or loss
recognized and the basis of property received in a deferred exchange, see paragraph 0) of
this section.
(b) Identification and Receipt Requirements
(1) In General. In the case of a deferred exchange, any replacement property received by
the taxpayer will be treated as property which is not of a like kind to the relinquished
property if-
(i) The replacement property is not "identified" before the end of the "identification
period," or
(ii) The identified replacement property is not received before the end of the "exchange
period."
(iii) Identification of Replacement Property before the end of the Identification Period

(iv) The identification period begins on the date the taxpayer transfers the relinquished
property and ends at midnight on the 45th day thereafter.
(v) The exchange period begins on the date the taxpayer transfers the relinquished
property and ends at midnight on the earlier of the 180th day thereafter or the due
date (including extensions) for the taxpayers return of the tax imposed by chapter 1
of subtitle A of the Code for the taxable year in which the transfer of the
relinquished property occurs.
(vi) If, as part of the same deferred exchange, the taxpayer transfers more than one
relinquished property and the relinquished properties are transferred on different
dates, the identification period and the exchange period are determined by reference
to the earliest date on which any of the properties are transferred.
(1) In Gerneral. For purposes of paragraph (b)(1)(i) of this section (relating to the
identification requirement), replacement property is identified before the end of the
identification period only if the requirements of this paragraph (c) are satisfied with
respect to the replacement property. However, any replacement property that is
received by the taxpayer before the end of the identification period will in all events be
treated as identified before the end of the identification period.
(2) Manner of Identifying Replacement Property. Replacement property is identified only if
it is designated as replacement property in a written document signed by the taxpayer
and hand delivered, mailed, telecopied, or otherwise sent before the end of the
identification period to either--

(i)The person obligated to transfer the replacement property to the taxpayer (regardless
of whether that person is a disqualified person as defined in paragraph (k) of this
section); or
(ii) Any other person involved in the exchange other than the taxpayer or a disqualified
person (as defined in paragraph (k) of this section).
Examples of persons involved in the exchange include any of the parties to the
exchange, an intermediary, an escrow agent, and a title company. An identification of
replacement property made in a written agreement for the exchange of properties signed
by all parties thereto before the end of the identification period will be treated as
satisfying the requirements of this paragraph (c)(2).
(3) Description of Replacement Property. Replacement property is identified only if it is
unambiguously described in the written document or agreement. Real property generally
is unambiguously described if it is described by a legal description, street address, or
distinguishable name (e.g., the Mayfair Apartment Building). Personal property
generally is unambiguously described if it is described by a specific description of the
particular type of property. For example, a truck generally is unambiguously described if
it is described by a specific make, model, and year.
(4) Alternative and Multiple Properties.
(A) The taxpayer may identify more than one replacement property. Regardless of the
number of relinquished properties transferred by the taxpayer as part of the same

deferred exchange, the maximum number of replacement properties that the taxpayer
may identify is--
(i) Three properties without regard to the fair market values of the properties (the
"3-property rule"), or
(ii) Any number of properties as long as their aggregate fair market value as of the
end of the identification period does not exceed 200 percent of the aggregate fair
market value of all the relinquished properties as of the date the relinquished
properties were transferred by the taxpayer (the "200-percent rule").
(iii) If, as of the end of the identification period, the taxpayer has identified more
properties as replacement properties than permitted by paragraph (c) (4) (i) of
this section, the taxpayer is treated as if no replacement property had been
identified. The preceding sentence will not apply, however, and an identification
satisfying the requirements of paragraph (c) (4) (i) of this section will be
considered made, with respect to--
(A) Any replacement property received by the taxpayer before the end of the
identification period, and
(B) Any replacement property identified before the end of the identification period and
received before the end of the exchange period, but only if the taxpayer receives
before the end of the exchange period identified replacement property the fair
market value of which is at least 95 percent of the aggregate fair market value of all
identified replacement properties (the "95-percent rule").

For this purpose, the fair market value of each identified replacement property is
determined as of the earlier of the date the property is received by the taxpayer or the
last day of the exchange period.
(i) For purposes of applying the-3-property rule, the 200-percent rule, and the 95-
percent rule, all identifications of replacement property, other than
identifications of replacement property that have been revoked in the manner
provided in paragraph (c)(6) of this section, are taken into account.
(5) Incidental Property Disregarded.
Solely for purposes of applying this paragraph (c), property that is incidental to a larger
item of property is not treated as property that is separate from the larger item of
property.
Property is incidental to a larger item of property if--
(A) In standard commercial transactions, the property is typically transferred together
with the larger item of property, and
(B) The aggregate fair market value of all of the incidental property does not exceed 15
percent of the aggregate fair market value of the larger item of property.
Revocation of Identification. An identification of replacement property may be revoked at
any time before the end of the identification period. An identification of replacement
property is revoked only if the revocation is made in a written document signed by the
taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the
identification period to the person to whom the identification of the replacement property

was sent. An identification of replacement property that is made in a written agreement for
the exchange of properties is treated as revoked only if the revocation is made in a written
amendment to the agreement or in a written document signed by the taxpayer and hand
delivered, mailed, telecopied, or otherwise sent before the end of the identification period
to all of the parties to the agreement.
(d) Safe Harbors
(1) In General. Paragraphs (g)(2) through (g)(5) of this section set forth four safe harbors
the use of which will result in a determination that the taxpayer is not in actual or
constructive receipt of money or other property for purposes of section 1031 and this
section. More than one safe harbor can be used in the same deferred exchange, but
the terms and conditions of each must be separately satisfied. For purposes of the
safe harbor rules, the term “taxpayer” does not include a person or entity utilized in a
safe harbor (e.g., a qualified intermediary). See paragraph (g) (8), EXAMPLE 3(v),
of this section.
(2) Security and Guarantee Arrangements.
(i) In the case of a deferred exchange, the determination of whether the taxpayer is in
actual or constructive receipt of money or other property before the taxpayer
actually receives like-kind replacement property will be made without regard to
the fact that the obligation of the taxpayer's transferee to transfer the replacement
property to the taxpayer is or may be secured or guaranteed by one or more of the
following-

(A) A mortgage, deed of trust, or other security interest in property (other than
cash or a cash equivalent),
(B) A standby letter of credit which satisfies all of the requirements of Section
15A.453-1 (b) (3) (iii) and which may not be drawn upon in the absence of a
default of the transferee's obligation to transfer like-kind replacement
property to the taxpayer, or
(C) A guarantee of a third party.
(ii) Paragraph (g) (2) (i) of this section ceases to apply at the time the taxpayer has an
immediate ability or unrestricted right to receive money or other property
pursuant to the security or guarantee arrangement.
(3) Qualified Escrow Accounts and Qualified Trusts.
(i) In the case of a deferred exchange, the determination of whether the taxpayer is in
actual or constructive receipt of money or other property before the taxpayer
actually receives like-kind replacement property will be made without regard to
the fact that the obligation of the taxpayer's transferee to transfer the replacement
property to the taxpayer is or may be secured by cash or a cash equivalent if the
cash or cash equivalent is held in a qualified escrow account or in a qualified
trust.
(ii) A qualified escrow account is an escrow account wherein--
(A) The escrow holder is not the taxpayer or a disqualified person (as defined in
paragraph (k) of this section), and

(B) The escrow agreement expressly limits the taxpayer's rights to receive,
pledge, borrow, or otherwise obtain the benefits of the cash or cash
equivalent held in the escrow account as provided in paragraph (g)(6) of this
section.
(iii) A qualified trust is a trust wherein--
(A) The trustee is not the taxpayer or a disqualified person (as defined in
paragraph (k) of this section, except that for this purpose the relationship
between the taxpayer and the trustee created by the qualified trust will not be
considered a relationship under section 267(b)), and
(B) The trust agreement expressly limits the taxpayer's rights to receive,
pledge, borrow, or otherwise obtain the benefits of the cash or cash
equivalent held by the trustee as provided in paragraph (g)(6) of this
section.
(iv) Paragraph (g)(3)(i) of this section ceases to apply at the time the taxpayer has an
immediate ability or unrestricted right to receive, pledge, borrow, or otherwise
obtain the benefits of the cash or cash equivalent held in the qualified escrow
account or qualified trust. Rights conferred upon the taxpayer under state law to
terminate or dismiss the escrow holder of a qualified escrow account or the
trustee of a qualified trust is disregarded for this purpose.

(v) A taxpayer may receive money or other property directly from a party to the
exchange, but not from a qualified escrow account or a qualified trust, without
affecting the application of paragraph (g) (3) (i) of this section.
(4) QUALIFIED INTERMEDIARIES.
(i) In the case of a taxpayer's transfer of relinquished property involving a qualified
intermediary, the qualified intermediary is not considered the agent of the
taxpayer for purposes of section 1031 (a). In such a case, the taxpayer's
transfer of relinquished property and subsequent receipt of like-kind
replacement property is treated as an exchange, and the determination of
whether the taxpayer is in actual or constructive receipt of money or other
property before the taxpayer actually receives like-kind replacement property
is made as if the qualified intermediary is not the agent of the taxpayer.
(ii) Paragraph (g)(4)(i) of this section applies only if the agreement between the
taxpayer and the qualified intermediary expressly limits the taxpayer's rights to
receive, pledge, borrow, or otherwise obtain the benefits of money or other
property held by the qualified intermediary as provided in paragraph (g)(6) of
this section.
(iii) A qualified intermediary is a person who--
(A) Is not the taxpayer or a disqualified person (as defined in paragraph (k) of
this section), and

(B) Enters into a written agreement with the taxpayer (the "exchange
agreement") and, as required by the exchange agreement, acquires the
relinquished property from the taxpayer, transfers the relinquished property,
acquires the replacement property, and transfers the replacement property to
the taxpayer.
(iv) Regardless of whether an intermediary acquires and transfers property under
general tax principals, solely for purposes of paragraph (g) (4) (iii) (B) of this
section-
(A) An intermediary is treated as acquiring and transferring property if the
intermediary acquires and transfers legal title to that property,
(B) An intermediary is treated as acquiring and transferring the relinquished
property if the intermediary (either on its own behalf or as the agent of any
party to the transaction) enters into an agreement with a person other than the
taxpayer for the transfer of the relinquished property to that person and,
pursuant to that agreement, the relinquished property is transferred to that
person, and
(C) An intermediary is treated as acquiring and transferring replacement property
if the intermediary (either on its own behalf or as the agent of any party to
the transaction) enters into an agreement with the owner of the replacement
property for the transfer of that property and, pursuant to that agreement, the
replacement property is transferred to the taxpayer.

i. Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section,
an intermediary is treated as entering into an agreement if the rights of a
party to the agreement are assigned to the intermediary and all parties to
that agreement are notified in writing of the assignment on or before the
date of the relevant transfer of property, For example, if a taxpayer enters
into an agreement for the transfer of relinquished property and thereafter
assigns its rights in that agreement to an intermediary and all parties to
that agreement are notified in writing of the assignment on or before the
date of the transfer of the relinquished property, the intermediary is treated
as entering into that agreement. If the relinquished property is transferred
pursuant to that agreement, the intermediary is treated as having acquired
and transferred the relinquished property.
(ii) Paragraph (g)(4)(i) of this section ceases to apply at the time the taxpayer
has an immediate ability or unrestricted right to receive, pledge, borrow,
or otherwise obtain the benefits of money or other property held by the
qualified intermediary. Rights conferred upon the taxpayer under state
law to terminate or dismiss the qualified intermediary are disregarded for
this purpose.
(iii) A taxpayer may receive money or other property directly from a party to
the transaction other than the qualified intermediary without affecting the
application of paragraph (g) (4) (i) of this section.

(5) Interest and Growth Factors. In the case of a deferred exchange, the determination of
whether the taxpayer is in actual or constructive receipt of money or other property
before the taxpayer actually receives the like-kind replacement property will be
made without regard to the fact that the taxpayer is or may be entitled to receive any
interest or growth factor with respect to the deferred exchange. The preceding
sentence applies only if the agreement pursuant to which the taxpayer is or may be
entitled to the interest or growth factor expressly limits the taxpayer's rights to
receive the interest or growth factor as provided in paragraph (g)(6) of this section.
For additional rules concerning interest or growth factors, see paragraph (h) of this
section.
(6) Additional Restrictions on Safe Harbors Under Paragraphs (g) (3) through (g) (5).
(i) An agreement limits a taxpayers rights as provided in this paragraph (g) (6) only
if the agreement provides that the taxpayer has no rights, except as provided in
paragraph (g) (6) (ii) and (g) (6) (iii) of this section, to receive, pledge, borrow, or
otherwise obtain the benefits of money or other property before the end of the
exchange period.
(ii) The agreement may provide that if the taxpayer has not identified replacement
property by the end of the identification period, the taxpayer may have rights to
receive, pledge, borrow, or otherwise obtain the benefits of money or other
property at any time after the end of the identification period.

(iii) The agreement may provide that if the taxpayer has identified replacement
property, the taxpayer may have rights to receive, pledge, borrow, or otherwise
obtain the benefits of money or other property upon or after—
(A) The receipt by the taxpayer of all of the replacement property to which the
taxpayer is entitled under the exchange agreement, or
(B) The occurrence after the end of the identification period of a material and
substantial contingency that—
(1) Relates to the deferred exchange,
(2) Is provided for in writing, and
(3) Is beyond the control of the taxpayer and of any disqualified person (as
defined in paragraph (k) of this section), other than the person obligated
to transfer the replacement property to the taxpayer.
(7) Items Disregarded in Applying Safe Harbors Under Paragraphs (g) (3) through (g)
(5).
In determining whether a safe harbor under paragraphs (g) (3) through (g) (5) of this
section ceases to apply and whether the taxpayers rights to receive, pledge, borrow,
or otherwise obtain the benefits of money or other property are expressly limited as
provided in paragraph (g) (6) of this section, the taxpayers receipt of or right to
receive any of the following items will be disregarded—

(i) Items that a seller may receive as a consequence of the disposition of property and
that are not included in the amount realized from the disposition of property;
(ii) Transactional items that relate to the disposition of the relinquished property or
to the acquisition of the replacement property and appear under local standards in
the typical closing statements as the responsibility of a buyer or seller (e.g.,
commissions, prorated taxes, recording or transfer taxes, and title company fees).

E. The Multi-Property Exchange
Real estate investors may take advantage of the tax code to exchange several properties into
one replacement property. However, two basic rules can make planning for such an exchange
challenging:
• The 45-day identification and 180-day exchange completion periods start when the first
of several sales in the same exchange close.
• If several sales are grouped in the same exchange, the identification rules permit listing
only 3 properties of unlimited value - or - more than 3 properties whose combined values
do not exceed 200% of the value of properties being sold.
If the goal is to exchange several properties into one or more replacement properties, the
Exchanger must consider the prospect of completing all of the sales and then the purchase
within a 180-day window. The first question is to decide whether there is an advantage to
having only one exchange or is it better to attempt to break the sales and purchases into
different exchanges. Two or more separate exchanges will provide more flexibility than one
exchange in terms of identification lists and exchange periods. However, there may be
practical limitations in purchasing a single replacement property in separate purchases.
Care must also be taken to establish two or more exchange transactions. The separate
exchanges must clearly be reflected in the property sale agreements, separate exchange
agreements and closing arrangements. If one replacement property is selected for two
exchanges, the separate identification notices of both exchanges should specify only the
fractional interest of the replacement property that will be purchased for the respective
exchange.

Successful Exchangers have sold multiple properties in the same exchange using a variety of
strategies:
• Delay closing on the first few properties to sell until the remainder of sales can be
agreed to and closed within a short period. Leases to eventual purchasers can be
structured.
• Tie up the desired replacement property with an option to purchase (with or without a
lease) until sales of the relinquished properties can be negotiated and closed at roughly
the same time.
• If all else fails, a reverse exchange can be structured so that the replacement property
can be purchased by the Intermediary for the Exchanger prior to selling any of the
relinquished properties. However, financing and other considerations often make a
reverse exchange a more costly choice.
A well-planned exchange of several properties into one replacement property can achieve a
variety of investment objectives. A thorough understanding of the §1031 rules is critical to a
successful exchange.

Taxpayer
Sold 3 Properties
DEED
DEED DEED
DEED
Buyer #1
Buyer #2
$ Qualified
Intermediary Seller
Buyer #3 $
$
0 45 180
EXAMPLE – SELLING THREE RELINQUISHED PROPERTIES AND CONSOLIDATING
INTO ONE REPLACEMENT PROPERTY
FACTS: In this example, the Exchanger is selling three smaller relinquished properties and
anticipates exchanging into one larger replacement property.
ANALYSIS: The time period for selling the two remaining relinquished properties – and also
closing on the purchase of the replacement property is the earlier of 180 calendar days, or the
Exchanger’s tax filing date, whichever is earlier, from the closing date of the first relinquished
property sale.
PRACTICAL APPLICATION: Exchanger’s may want to postpone the actual closing date on the
first relinquished property under contract for more than the customary time in the marketplace
because the exchange period begins when the first property closes, not when it is under contract.
In addition, the Exchanger should have the 2nd and 3rd relinquished properties priced where they
anticipate closing on these two remaining relinquished property sales within the exchange
period.

Taxpayer
DEED Purchases 3 Properties
DEED
DEED
Seller #1
DEED
$
Qualified Seller #2
$
Buyer $
Intermediary
$ Seller #3
EXAMPLE – SELLING ONE RELINQUISHED PROPERTY AND
DIVERSIFYING INTO THREE SMALLER REPLACEMENT PROPERTIES
FACTS: In this example, the Exchanger is selling one larger relinquished property and
anticipates exchanging into three smaller replacement properties.
ANALYSIS: The Exchanger has a maximum of 180 calendar days, or the Exchanger’s tax filing
date, whichever is earlier, to close on all three replacement properties.
PRACTICAL APPLICATION: The Exchanger should probably begin the process of narrowing
the spectrum of desired replacement properties prior to closing on their relinquished property
sale. The Exchanger may also want to begin making offers on potential replacement properties
before closing on their sale in an effort to line up the exact replacement properties. There are no
extensions of the 45/180 day periods, so it is preferable to begin locating the replacement
property as soon as possible.

F. An Overview of Parking Arrangements
Prior to the release of Revenue Procedure 2000-37, (the “Rev. Proc.”) many taxpayers were
reluctant to proceed with reverse or improvement exchange variations – both of which
required the Qualified Intermediary to be “parked” on title to either the replacement or
relinquished property. One of the primary concerns was the problem of “constructive
ownership.” Many tax and legal advisors were concerned that the taxpayer was both
responsible for, and entitled to, the burdens and benefits of ownership while legal title was
held by the Qualified Intermediary. If the taxpayer retained all the benefits and burdens of
ownership, and only legal title was “parked”, the structure could be collapsed because the IRS
would look at the taxpayer as actually owning both the relinquished property and replacement
property at the same time. In addition, there were many potential problems such as the
management of the “parked” property, loan arrangements, advances to fund the purchase of
the replacement property, puts and calls, and which entity was entitled to receive the tax
benefits of ownership while the property was “parked.”
(a) Revenue Procedure 2000-37
Finally, the IRS has provided guidance for parking arrangements. As a result, taxpayers can
now work with an experienced Qualified Intermediary and confidently proceed with a wider
array of exchange alternatives. Revenue Procedure 2000-37, enacted on September 15, 2000,
applies to exchanges where title to either a relinquished or replacement property is “parked”
with the Qualified Intermediary. The revenue procedure creates a “safe harbor” for
transactions that are within the following parameters:

1) Title to either the relinquished or the replacement property must be parked with the
“Exchange Accommodation Titleholder” (EAT);
2) The EAT must hold legal title, referred to as the “Qualified Indicia of Ownership”
(QIO);
3) The taxpayer and the EAT must enter into a written agreement known as the
“Qualified Exchange Accommodation Arrangement” (QEAA) within five days of the
EAT’s purchase of the “parked” property;
4) The taxpayer must have a “bona fide intent” that the parked property will either be
the relinquished or replacement property in an exchange;
5) The EAT cannot be the taxpayer or a “disqualified person”;
6) The EAT must report the property on its income tax return;
7) The taxpayer must identify the relinquished property within 45 calendar days;
8) The taxpayer must complete the exchange within 180 calendar days from the date the
property is transferred to the EAT.
(b) Revenue Procedure 2000-37: Permissible Agreements

Revenue Procedure 2000-37 provided for the following permissible agreements regardless of
whether or not they contain terms which may typically destroy an arms-length relationship
between the EAT and the taxpayer:
The EAT may act as both the Qualified Intermediary and the EAT provided the taxpayer may
guarantee all or part of the obligations of the EAT including debt and incurred expenses;
1) The taxpayer may loan or advance funds to the EAT;
2) The EAT may lease the property to the taxpayer;
3) The EAT may enter into a management agreement with the taxpayer;
4) The taxpayer may act as contractor and/or supervisor with respect to the property;
5) EAT and taxpayer may enter into agreements using puts and calls at fixed or formula
prices for subsequent dispositions, provided that they satisfy the Qualified Intermediary
safe harbor provisions in Section 1.1031(k)-1(g)(4).
The safe harbor and permissible agreements cited above provide the taxpayer with much
needed clarification and guidance on many issues that have concerned tax and legal
advisors who have reviewed “parked” arrangements in the past. For the most part, the
requirements of Rev. Proc. 2000-37 provide taxpayers great latitude in these transactions.
However, the Rev. Proc. did narrow the time requirements considerably and this may
create problems on larger commercial exchanges. Obtaining the necessary approvals and
construction improvements within the 180-day time limit can be challenging when
proceeding with an improvement exchange on commercial property.

G. Reverse Exchanges
A “reverse exchange” involves the acquisition of the replacement property prior to closing
on the sale of the relinquished property.
Benefits of a Reverse Exchange
Often taxpayers may need to perform a reverse exchange in a “seller’s market” where
recently listed properties are quickly under contract with a buyer. The need for a §1031
reverse exchange arises when circumstances require that the replacement property be
acquired before closing on the relinquished property. This exchange variation is of great
interest to real estate taxpayers because it provides a fully tax deferred method when an
excellent purchase opportunity presents itself.
This exchange format can enable a taxpayer to immediately purchase a replacement property,
which may be beneficial under market conditions where property is only on the market for a
short period of time. Prior to the release of Revenue Procedure 2000-37 on September 15,
2000, many legal and tax advisors viewed both the reverse and improvement formats as more
aggressive and potentially open to more attack from the IRS.
One way to avoid the reverse exchange is to delay the “closing” of the new replacement
property in some manner. Some typical strategies to delay the closing include:
• Extend the closing period in the Purchase and Sale Agreement on the acquisition of
the replacement property. This method is preferred, however, an additional non-
refundable earnest money deposit may be demanded by the seller.

• Obtain an option to purchase on the replacement property. This option will later be
assigned to the Qualified Intermediary prior to exercising the option.
• Negotiate a lease option. This alternative often solves the seller’s problem of
servicing the debt until the property is closed. The lease payment provides cash flow
to the Lessor.
• In instances where the closing cannot be delayed, taxpayers can either have the
“replacement property parked” or the “relinquished property parked”. These methods
avoid the “pure” reverse exchange, which involves owning both relinquished and
replacement properties at the same time. The “pure” reverse exchange is never
advisable and clearly disallowed under Revenue Procedure 2004-51. The two reverse
methods discussed below are used when it is not possible to delay the closing.

(a) Replacement Property “Parked” Transactions
There are two ways to adhere to the Revenue Procedure requirements. One alternative is
“parking” title of the replacement property with the Exchange Accommodation
Titleholder (EAT) (sometimes referred to as the “exchange last” option) which involves
the following steps:
STEP 1 – “EAT” purchase OF replacement property
(A) Taxpayer advances/loans funds to the EAT.
(B) EAT purchases the replacement property.
(C) Seller deeds the replacement property to the EAT.
(D) EAT leases the replacement property to the taxpayer.
EXCHANGER
$ LEASE
DEED
EAT SELLER
$

STEP 2 – Sale of relinquished property and exchange of the replacement property to the
Taxpayer
(A) Relinquished property is transferred to the EAT in exchange for the replacement
property to the taxpayer.
(B) Payoff of the original advance/loan from the taxpayer from sale proceeds.
DEED
EXCHANGER
$ DEED
BUYER $ EAT
Positives of the Replacement Property “Parked”
• Can proceed without advancing the amount equal to the equity in the relinquished
property;
• A deferred exchange may follow this format;
• Allows for multiple relinquished properties.
Disadvantages of the Replacement Property “Parked”
• Lender may have issues loaning to an EAT; as the note to the EAT will be non-recourse.
• Additional costs associated; including, but not limited to: title insurance, transfer taxes,
recording changes, etc.

STEP 1 – Replacement property purchase
SALE PRICE PURCHASE PRICE
Value $400,000 $800,000

Debt $200,000 $700,000
Equity $200,000 $100,000
EXCHANGER
$100,000 - Exchanger
$700,000 - Loan LEASE
DEED
EAT SELLER
$800,000
A. Exchanger advances/loans $100,000 funds to the EAT.
B. EAT purchases the replacement property for $800,000 consisting of the Exchanger’s
$100,000 loan plus $700,000 in financing.
Lender Issues:
• Will the lender want to loan to the Exchanger when EAT is on title?
• Loan is non-recourse
• Lender can ask for a personal guarantee from the Exchanger
Debt/Equity Issues:
• Equity and debt don’t need to be equal at the time of purchase
• At the later relinquished property sale, $100,000 can be repaid to the Exchanger and the
remaining $100,000 can be used to pay down the note, thus matching the equities.

STEP 2 – Relinquished property sale/transfer of replacement property
EXCHANGER
DEED
$100,000
DEED LENDER
$100,000
BUYER EAT
$200,000
A. Relinquished property is sold to the Buyer for $400,000. The EAT receives $200,000 net
proceeds from the sale.
B. $100,000 is forwarded to the Exchanger (to pay off the loan for the original $100,000
used by the EAT to purchase the replacement property.)
C. The remaining $100,000 in net equity is used to pay down the $700,000 loan used to
purchase the replacement property.
D. The replacement property is transferred back to the Exchanger. The replacement property
value is $800,000, consisting of $600,000 debt and $200,000 equity.

(b) Relinquished Property “Parked” Transactions
The second alternative is “parking” title to the relinquished property with the EAT
(sometimes referred to as the “exchange first” option) which involves the following
steps:
STEP 1 – Exchange of Relinquished Property for the Replacement Property
(A) Taxpayer deeds the relinquished property to the EAT according to the QEAA.
(B) Simultaneously, the taxpayer and the EAT enter into an Exchange Agreement.
(C) Taxpayer advances/loans funds to the EAT for the acquisition of the
replacement property.
(D) The replacement property is deeded directly to the taxpayer in compliance with
the Exchange Agreement.
(E) EAT leases the relinquished property to the taxpayer.

EXCHANGER
DEED
$200,000 LEASE DEED
$200,000
EXCHANGER SELLER
A. Exchanger loans $200,000 to the EAT.
B. EAT purchases the replacement property for $800,000 with terms of $200,000 equity and
$600,000 debt.
C. The replacement property is deeded to the Exchanger and the relinquished property is
deeded to the EAT.
D. EAT leases the relinquished property to the Exchanger.
Lender Issues:
• Lender provides loan if the Exchanger is on title to the replacement property.
Debt/Equity Issues:
• For a fully deferred exchange, the equity and debt must be the same or greater at the time
of the replacement property purchase by the EAT.

STEP 2 – Sale of Relinquished Property
(A) Taxpayer locates purchaser for replacement property and enters into a contract.
(B) Taxpayer assigns contract to EAT and EAT sells relinquished property to Buyer.
(C) EAT receives proceeds from sale and pays off advance/loan from taxpayer.
Positives of the Relinquished Property “Parked”
• If conventional financing is involved in acquiring the replacement property, it is much
easier to loan to the taxpayer since they will immediately be on title to the replacement
property;
• Less expensive transfer taxes for the relinquished property transfer.
Negatives of the Relinquished Property “Parked”
The equity and debt in the replacement property need to match to avoid boot issues;
The transfer to the EAT could increase the County Property Tax valuation; in certain areas.
There are potential lender issues with “Due on Sale” clauses and/or prepayment penalties
with the relinquished property.

EXCHANGER
$200,000
DEED
BUYER EAT
$200,000
STEP 2 – Eat Sale of Relinquished Property
A. EAT sells the relinquished property to Buyer.
B. EAT forwards $200,000 net equity to Exchanger to pay off loan.

H. The Improvement Exchange
The improvement exchange allows a taxpayer, through the use of a Qualified Intermediary,
to make improvements on a replacement property using exchange equity. In other words, a
taxpayer can maximize investment opportunities using tax-free dollars while building or
improving new investment property. This type of exchange is also referred to as a
“construction” or “build-to-suit” exchange.
(a) Benefits of the Improvement Exchange
Improvement exchanges offer taxpayers a wide array of benefits which often result in a
better investment than properties readily available on the open market. The ability to
refurbish, add capital improvements, or build from the ground up, while using tax
deferred dollars, can create tremendous investment opportunities. Due to the additional
options provided by this variation and because the 1991 Treasury Regulations established
specific parameters for improvements to be produced, improvement exchanges continue
to become more common.
Another benefit is that the new replacement property does not necessarily have to be fully
completed within the 180 day exchange period. A certificate of occupancy is not
required.

(b) Requirements of an Improvement Exchange
A taxpayer must meet three basic requirements in order to defer all of their gain in the
improvement exchange format. The taxpayer must;
(1) spend the entire exchange equity on completed improvements or down payment by
the 180th day,
(2) receive substantially the same property they identified by the 45th day, and
(3) the replacement property must be of equal or greater value at the time of transfer to
the taxpayer. The final value of the replacement property is the combination of the
original purchase price plus the capital improvements made to the property. [Note:
The improvements need to be in place prior to taxpayer taking title to the replacement
property.]
(c) When Can the Improvement Exchange be Used
The property to be acquired in the exchange is not of equal or greater value to property
which is being relinquished. In this case, the improvement exchange can eliminate a
taxable situation by adding capital improvements to an existing property.
(1) To build a new investment from the ground-up. This example maximizes the
investment opportunity in a given area by enabling a taxpayer to build their own
property. You don’t have to be subject to property currently on the market and to
the seller’s terms. Taxpayer can build a new property.

(2) The new investment is of equal or greater value, but it needs refurbishments. Utilize
the improvement exchange to refurbish the new property while again using tax-free
dollars.
(d) Potential Obstacles
The main obstacle in this type of §1031 exchange occurs when there is a lender involved.
This is true because, throughout the improvement process, the Qualified Intermediary or
an Accommodator is holding title to the property. This can be overcome in most cases
and a succesful exchange can be completed.

STEP 1 – Sale of Relinquished Property/Purchase of Replacement Property
DEED
EXCHANGER
DEED
BUYER $
EAT/QI SELLER
$
STEP 2 – Improvements to Replacement Property
DEED
EXCHANGER
EAT/QI
0 45 180
SCENARIO: Exchanger is selling a $1,000,000 (free and clear) automobile dealership and
wants to build a new and larger automotive dealership in a growing part of the town. The new
dealership, both land and improvements will be worth $2,000,000 at completion and will consist
of $930,000 equity and $1,030,000 financing with a local lender. The $930,000 net equity must
be reinvested in “like-kind” real property within the 180-day exchange period. The Exchanger
will complete the remainder of the improvements after the exchange is completed and they are
back on title to the land and a partially completed building.

Relinquished Property Sale Replacement Property Purchase
Sales Price $1,000,000 Lot Purchase (Cash) $600,000

Debt $0
Cost of Sale )
$70,000
Net Equity $930,000 Draw #1 (site work) $100,000
Draw #2 (foundation) $230,000
Exchange Value = $930,000
(e) Identification Requirements

The rules for the identification and receipt of the replacement property are more specific
and are defined in the Regulations below:
“(e) SPECIAL RULES FOR IDENTIFICATION AND RECEIPT OF REPLACEMENT
PROPERTY TO BE PRODUCED—
(1) In General. A transfer of relinquished property in a deferred exchange will not fail to
qualify for non-recognition of gain or loss under section 1031 merely because the
replacement property is not in existence or is being produced at the time the property
is identified as replacement property. For purposes of this paragraph (e), the terms
“produced” and “production” have the same meanings as provided in section
263A(g)(1) and the regulations there under.
(2) IDENTIFICATION OF REPLACEMENT PROPERTY TO BE PRODUCED.
(i) In the case of replacement property that is to be produced, the replacement
property must be identified as provided in paragraph (c) of this section (relating to
identification of replacement property). For example, if the identified replacement
property consists of improved real property where the improvements are to be

constructed, the description of the replacement property satisfies the requirements
of paragraph (c) (3) of this section (relating to description of replacement property)
if a legal description is provided for the underlying land and as much detail is
provided regarding construction of the improvements as is practicable at the time
the identification is made.
(ii) For purposes of paragraphs (c)(4)(i)(B) and (c)(5) of this section (relating to the
200-percent rule and incidental property), the fair market value of replacement
property that is to be produced is its estimated fair market value as of the date it is
expected to be received by the taxpayer.
(3) RECEIPT OF REPLACEMENT PROPERTY TO BE PRODUCED.
(i) For purposes of paragraph (d)(1)(ii) of this section (relating to receipt of the
identified replacement property), in determining whether the replacement property
received by the taxpayer is substantially the same property as identified where the
identified replacement property is property to be produced, variations due to usual
or typical production changes are not taken into account. However, if substantial
changes are made in the property to be produced, the replacement property
received will not be considered to be substantially the same property as identified.
(ii) If the identified replacement property is personal property to be produced, the
replacement property received will not be considered to be substantially the same
property as identified unless production of the replacement property received is
completed on or before the date the property is received by the taxpayer.

(iii) If the identified replacement property is real property to be produced and the
production of the property is not completed on or before the date the taxpayer
receives the property, the property received will be considered to be substantially
the same property as identified only if, had production been completed on or
before the date the taxpayer receives the replacement property, the property
received would have been considered to be substantially the same property as
identified. Even so, the property received is considered to be substantially the
same property as identified only to the extent the property received constitutes real
property under local law.
(4) ADDITIONAL RULES. The transfer of relinquished property is not within the
provisions of section 1031(a) if the relinquished property is transferred in exchange
for services (including production services). Thus, any additional production
occurring with respect to the replacement property after the property is received by
the taxpayer will not be treated as the receipt of property of a like-kind.”
I. The Reverse/Improvement Exchange
This variation combines the reverse with the improvement exchange. Essentially, the
replacement property is purchased first and improvements are made to this property within
the 180 day exchange period. This variation is often used by owner-users or other taxpayers
desiring to construct a property to their exact specifications.

J. “Parked” Arrangements Outside the Revenue Procedure
There is a certain amount of disagreement among tax and legal advisors as to how non safe
harbor parking arrangements should be structured in order to qualify for tax deferral.
Two recent adverse authorities, DeCleene v. Commissioner (DeCleene), and Technical
Advice Memorandum 200039005 (TAM 200039005) may provide some clues about how not
to structure non safe harbor reverse exchanges. The DeCleene case is a recently issued
decision dealing with an improvement exchange. In DeCleene, the Tax Court determined that
the entity parked on title to the property did not possess the “benefits and burdens of
ownership” of the property while the improvements were being constructed.
In TAM 200039005, the determination was that without any safe harbor applying, the issue of
the Qualified Intermediary’s agency status was relevant. In this TAM, the IRS concluded that
the Qualified Intermediary had no independent role in the transaction and was considered the
taxpayer’s agent. As a result, the taxpayer was deemed to have acquired the replacement
property with the Qualified Intermediary’s acquisition of title, thus not qualifying for tax
deferral under IRC Section 1031.
The IRS is willing to consider transactions outside the safe harbor of the Rev. Proc. A non
safe harbor private letter ruling (PLR 200111205) was issued that permitted an “exchange
last” parking arrangement between a commercial real estate owner and a subsidiary of an
exchange intermediary company. The PLR provides a road map for structuring transactions
outside the safe harbor, if the fact pattern provided in the PLR is the same as the intended
transaction. The PLR emphasizes the concept of “integration” of the transactions (sale of

relinquished property and the acquisition of the replacement property) and that the
Accommodator not be the agent of the taxpayer.
Based upon the situations cited above, a taxpayer opting to perform a “parked” property
exchange outside the safe harbor provided by Rev. Proc. 2000-37 should definitely seek the
expertise of knowledgeable advisors. In addition, they should attempt to structure an
exchange where the Qualified Intermediary possesses sufficient “benefits and burdens of
ownership” to avoid being considered an agent of the taxpayer. Although not an exhaustive
list, some issues to consider would be: 1) Does the QI have risk of loss or gain associated with
the transaction? 2) Does the QI use some of their own funds in the transaction? 3) Can the
taxpayer substantiate that the QI is truly a fourth-party principal operating at an arms-length
distance?
Issues to Consider with any “Parked” Exchange
Every reverse or improvement exchange involves an EAT “parking” title to either the
relinquished or replacement property. As a result, the EAT incurs liability for being on the
chain of title. It is essential that all parties to the transaction insulate themselves from any
liability that might arise. For maximum liability protection, the EAT should create a separate
special purpose entity such as a limited liability company (LLC) to isolate the taxpayer from
liability issues. The EAT should make sure the LLC complies with state and federal
registration and filing requirements. A taxpayer contemplating a “parked” property exchange
should find out how many reverse or improvement exchanges the company has handled prior
to the issuance of Rev. Proc. 2000-37, as it’s important to verify that the staff handling these
transactions thoroughly understands the many pitfalls to avoid. Lastly, it would be prudent for

the EAT to provide the taxpayer with a written assurance regarding the property while it is
being held under the QEAA.

IX. THE EXCHANGE EQUATION

A. Requirements for a Fully Deferred Exchange
Whenever property is sold, it is important to make the distinction between realized gain
and recognized gain. Realized gain is defined as the net sale price minus the adjusted tax
basis. Recognized gain is the taxable portion of the realized gain. The common objective
in a tax deferred exchange is disposing of a property containing significant realized gain
and acquiring a “like-kind” replacement property so there is no recognized gain. In
order to defer all capital gain taxes, a taxpayer must “balance the exchange” by acquiring
replacement property that is the same or of greater value as the relinquished property,
reinvest all the net equity and replace any debt on the relinquished property with debt on
the replacement property (although a reduction in debt can be offset with additional
cash). The taxpayer can quickly calculate whether there will be recognized gain based on
the following principals:
(a) Taxable “boot” is defined as non like-kind property the taxpayer may receive as part
of an exchange. “Cash boot” is the receipt of cash and “mortgage boot” (also referred
to as debt relief) is a reduction in the taxpayer’s mortgage liabilities on a replacement
property. Generally, capital gain income is recognized (and therefore taxable) to the
extent there is boot.

(b) For a fully deferred exchange, a taxpayer must reinvest all net equity and acquire
property with the same or greater debt. Compare the relinquished property with the
replacement property in terms of:
(1) Value
(2) Net Equity (after deducting costs of sale)
(3) Debt
Relinquished Replacement Boot

Value $ 900,000 $ 1,200,000
Example 1
-Debt $ 300,000 $ 630,000 $0

-Cost of Sale $ 30,000
Net Equity $ 570,000 $ 570,000 $0
Total Boot $0
The Exchanger acquired property of greater value, reinvesting all net equity and increasing the
debt on the replacement property.
Analysis: This results in no boot.

Value $ 900,000 $ 800,000
Example 2
-Debt $ 300,000 $ 260,000 $ 40,000

Net Equity $ 540,000 $ 440,000 $ 100,000
Total Boot $ 140,000
The Exchanger acquired property of a lower value, keeps $100,000 of the net equity and
acquired a replacement property with $40,000 less debt.
Analysis: This results in a total of $140,000 in boot.
($40,000 (mortgage boot) + $100,000 (cash boot) = $140,000)

m
pl

Value $ 900,000 $ 800,000
-Debt $ 300,000 $ 260,000 $ 40,000
Net Equity $ 540,000 $ 540,000 $0
Total Boot $ 40,000
The Exchanger acquired property of a lower value, reinvesting all net equity, but has less debt in
the replacement property.
Analysis: This results in $40,000 in mortgage boot.

X. The Benefits of an Exchange

A. Calculating Taxable Gain
The benefits of IRC Section 1031 exchanges can be tremendous. Investment property
owners are often able to defer many thousands of dollars in capital gain taxes, both at
federal and state levels. If the requirements of a valid 1031 exchange are met, capital gain
recognition will be deferred until the taxpayer chooses to recognize it. This essentially
results in a long-term, interest-free loan from the IRS.
An Example
1. CALCULATE NET ADJUSTED BASIS
Original Purchase Price (Basis) $500,000
plus Capital Improvement + $50,000
minus Depreciation - $150,000
equals Net Adjusted Basis $400,000
2. CALCULATE CAPITAL GAIN
Sales Price $1,200,000
minus Net Adjusted Basis - $400,000
minus Cost of Sale - $80,000
equals CAPITAL GAIN $720,000

3. CALCULATE CAPITAL GAIN TAX DUE
Recaptured Depreciation (25%) $37,500
plus Federal Capital Gain (15%) + $85,500
plus State Tax (CA 9.3%) + $66,960
TOTAL TAX DUE $189,960
4. CALCULATE AFTER-TAX EQUITY
Sales Price $1,200,000
less Cost of Sale - $80,000
less Loan Balances - $300,000
equals GROSS EQUITY $820,000
minus Capital Gain Taxes Due $189,960
equals AFTER-TAX EQUITY $630,040

5. ANALYZE REINVESTMENT - SALE
After-Tax Equity x 4 = $2,520,160
6. ANALYZE REINVESTMENT – EXCHANGE
Gross Equity = Net Equity $820,000
Gross Equity x 4 = $3,280,000
Note: 25% x $150,000 = $37,500 15% x $570,000 = $85,500 9.30% x $720,000 = $66,960
B. Reporting Requirements – IRS Form 8824
IRS Form 8824 must be completed each time a taxpayer performs a tax deferred
exchange. See the appendix for this form.

XI. Important Issues and Recent Developments

A. Cost Segregation Studies
A cost segregation study is a powerful strategy that allows investors, who have constructed,
purchased, remodeled or expanded virtually any type of commercial real property to improve
their rate of return by deferring income taxes to a later tax period. By accelerating
depreciation deductions and deferring federal and state income taxes, the property owner is
able to increase the profitability of their investments.
A cost segregation study is an accounting and engineering-based analysis and reclassification
of the real and personal property contained in an investment property. Real property is
assigned a 27.5-year or 39-year straight depreciation deduction under the Modified
Accelerated Cost Recovery System (MACRS). However, land improvements and personal
property can have significantly more advantageous depreciation (“cost recovery”) periods.
Tax savings are generated by properly reclassifying shorter asset lives (5, 7, and 15-year
depreciation schedules) for assets that were otherwise lumped in with the property’s
acquisition or construction costs. Without a cost segregation study, the cost basis of the
shorter-life assets are typically undifferentiated from the construction costs or purchase price
and are reflected at the longer 27.5 and 39-year depreciation periods.

Benefits
• Accelerate the cost recovery of many personal property assets
• Reduce income taxes
• Reduce property and sales taxes
• Increase cash flow
Summary
• Cost segregation allows the property owners to accelerate depreciation deductions.
• A cost segregation study is an accounting and engineering based analysis that identifies
Section 1245 personal property that qualifies for more advantageous depreciation
deductions.
• A cost segregation study does not change the amount of deduction available, but when
the deductions are available to the property owner.
An Example
Assume: $3.825 million property
Federal tax rate: 35%
State tax rate: 5%
Discount rate: 8%

Asset Classes Asset Original Original Allocation Allocation
Classes Life Allocation Allocation After CSS After CSS %
Personal Property 5 year 0 0% $9,360 0.3%
Personal Property 7 year 0 0% $567,021 14.8%
Land Improvements 15 year 0 0% $378,848 9.9%
Real Property 39 years $3,825,000 100% $2,869,771 75%
Total 100% $3,825,000 100%
Deferred Taxes, Year 1: $35,422
Deferred Taxes, Years 1-5: $192,334
NPV of Taxes Deferred: $164,388

(a) Who Should Consider a Cost Segregation Study?
Any property owner who has:
• Built a new building
• Purchased a new building
• Expanded or remodeled an existing facility
• Paid for leasehold improvements or build-outs
• Has unclaimed depreciation benefits that go back to anytime up to January 1, 1987

(b) History of Cost Segregation
1962 Investment tax credit (ITC) enacted
• Creates the distinction between “Section 38” (ITC eligible) property and
“non-Section 38” property (not eligible for ITC).
1969 ITC repealed
1971 ITC reinstated
1975 Whiteco Industries v. Commissioner – Established six criteria:
1) Is the property capable of being moved and has it in fact been moved?
2) Is the property designed or constructed to remain permanently in place?
3) Are there circumstances that tend to show the expected or intended length of
affixation (i.e. are there circumstances which show that the property may or
will have to be moved?)
4) How substantial a job is removal of the property and how time-consuming is
it? Is it readily removable?
5) How much damage with the property sustain upon its removal?
6) What is the manner of affixation of the property to the land?

1981 Accelerated Cost Recovery System (“ACRS”)
• Section 38 property was assigned a 5-year recovery period and a 150%
declining balance method.
• Non-Section 38 property was assigned a 1-year recovery period and a 175%
declining balance method.
1986 Investment tax credit repealed
• No distinction between Section 38 and non-Section 38 property.
1986 Modified Accelerated Cost Recovery System (“MACRS”)
• Real property recovery periods changed to 27.5 and 31.5-year straight line for
non-residential rental and commercial real property.
1997 Hospital Corporation of America and Sub. v. Commissioner
• Tax court concludes that tests developed for differentiating property for
purposes of the investment tax credit are applicable to HCA in deciding
whether assets constitute tangible personal property.
1999 Action on Decision 1999-008
• The IRS acquiesces in part to HCA in regards to the concept that the
investment tax credit analysis (i.e. cost segregation) does have continued
viability under ACRS and MACRS.
1999 Legal Memorandum 199921045

• Performing a cost segregation study requires IRS prior consent by filing Form
3115, Application for Change in Accounting Method.
2002 Revenue Procedure 2002-9
• Automatic IRS consent of change from one method of depreciation to another
• 3115 Form must be filed with current year return, including extensions
• No automatic review process
• No filing fee
2002 Revenue Procedure 2002-19
• Beneficial Section 481(a) adjustments are taken into account in the year of
change rather than being spread over four years.
2003 Jobs and Growth Tax Act of 2003
• 50% “bonus depreciation” (expires December 31, 2004)
• Applies to 20-year (or less) property and certain leasehold improvements
• First year expensing election under Section 179 increased from $24,000 to
$100,000
(b) Summary of Cost Segregation History
1) Accelerated Method and Shorter Recovery Period

• Moving tangible personal property assets from a longer life (27.5, 31.5 or 39-
year property)
• Changing from straight line method to calculating expense using double
declining balance method
2) No Amended Returns
• Filing Form 3115, Application for Change in Accounting Method, eliminates
the need for amending tax returns from prior years.
3) Automatic Approval
• The filing of Form 3115 is automatically approved and a filing fee is not
required.
4) Immediate Benefits
• The adjustment generated by a cost segregation study for existing assets can be
recognized in the current year (Section 481(a))

5) Bonus Depreciation
• Property moved from 27.5 or 39-years to 20-year (or less) may qualify for 30%
or 50% bonus depreciation
• Limited time period for this bonus depreciation (expires on December 31,
2004)
6) Section 179 Expense
• Top amount increased to $100,000 (from $24,000)
7) Net Operating Loss
• Should the result of a completed cost segregation study be a NOL, the carry
back can be taken to the previous two years.
Typical Tax Savings
Although every project is different, property owners typically see an immediate savings of
15% - 45% by reclassifying assets from real property depreciated over 27.5 or 39 years to
personal property depreciated over 5 or 7 years or land improvements over 15 years.

Examples of typical savings are as follows:
Project Type Percentage Savings
Apartments 25% - 30%
Automobile Dealers 30% - 35%
Banks 40% - 45%
Hotels 25% - 30%
Grocery Stores 35% - 40%
Offices 15% - 20%
Manufacturing Buildings 35% - 50%
Medical Facilities 30% - 35%
Restaurants 35% - 40%
Retail Buildings 25% - 35%
Warehouses 15% - 20%

(c) Cost Segregation Study Methods
1. Invoice Review Method
Method:
• Property owner provides tax professional with construction cost information or

separate invoices
Limitations:
• Construction costs are often not detailed sufficiently
• Does not necessarily incorporate last-minute changes made to plans
• Restricted to a review of the available construction information
Result:
• This method does not result in maximum depreciation deductions
2. Engineering-Based Approach
Method:
• Requires blueprints and architect specifications; The pricing of personal property

and takeoffs are obtained from the blueprints.
Limitations:
• The specifications may be inaccurate and may not be complete
Result:
• This method does not result in maximum depreciation deductions

3. Combination of Site Visit, Engineering-Based Approach and Invoice Review
Approach
Result:
• The combination of all three approaches does maximize the available
depreciation deductions
• The site visit by an engineer who is an expert is analyzing all aspects of a
building is critical to accomplish two objectives:
1) Thoroughly study all aspects of the building and
2) Prepare precise costing of personal and real property based upon exact
measurements and using accepted industry standard resources in the industry.
• The engineering-based approach uncovers areas where the depreciation benefits
are buried in a summary of construction information.
• The invoice-based approach is used in areas where adequate cost detail has been
provided.

(iv) Analysis and Documentation
• Capitalized Cost
• Administrative and engineering costs
• Capitalized interest
• Equipment and Services
• Direct “hard” costs (physical components of the building such as concrete, framing,
drywall, carpet, wall coverings, electrical items such as lights and electric panels,
plumbing and mechanical components such as heating and A/C units)
• Indirect “soft” costs (can be as high as 15-20% of the total construction costs;
architectural fees, engineering fees, permits and zoning costs, general contractor costs)
• Work papers with quantity takeoffs and final report showing properly cross referenced
supporting documents

(e) The Cost Segregation Study Process
1) Review existing building drawings and construction documents where there have been
significant capital improvements to identify assets that may qualify for accelerated
depreciation.
2) Obtain and review copies of approved contractor pay requests, change orders and
miscellaneous invoices in order to segregate the costs into their correct asset
classifications.
3) Interview site managers to gain a better understanding of the property.
4) Where significant capital improvements have been made, interview the general
contractor and review the construction plans. In the event the contractor is not able to
provide this information, the cost of these improvements will be determined utilizing
nationally recognized cost estimating guides.
5) Review and allocate indirect project costs, such as architectural fees, contractor’s
general conditions, engineering fees, permits, etc.
6) Visit the property to verify all qualifying personal property and land improvement
assets have been identified.
7) Analyze, estimate and allocate costs among appropriate multi-functioning assets.
8) Analyze and review applicable tax laws differentiating personal from real property.
9) Analyze MACRS class lives and respective recovery periods and assign appropriate
class life categories to specific assets.

10) Prepare a written report which includes project asset classifications and descriptions,
allocation of project related fees and services, and construction cost spreadsheets
separating the assets into the following categories: A) personal property (5 to 7-year tax
life), B) land improvement property (15-year tax life and C) residential or commercial
real property (27.5/39-year tax life). In addition, references to court cases, revenue
rulings, tax citations and photographs to support the positions taken regarding the
identification of personal and land improvement assets will be provided.

B. Related Party Exchanges
The related party rules were enacted to prevent related parties from “cashing out” of an
investment and avoiding tax if either party’s property is disposed of within two years of the
exchange. In addition, Section 1031(f) states that the Internal Revenue Service reserves the
right to invalidate any exchange in which the taxpayer can’t prove that the “exchange” did
not have a principal purpose of avoiding taxes that would otherwise be due or avoiding the
purposes of the related party rules.
Section 1031(f)(4) of the Code adds special rules for transactions between related persons.
For purposes of Section 1031(f), the term “related person” means any person bearing a
relationship to the Taxpayer described in Section 267(b) or 707(b)(1). Essentially, Section
1031(f) denies tax deferral when related parties perform an exchange of low basis property
for high basis property in anticipation of the sale of the high basis property. The rationale for
Section 1031(f) is that if a related party exchange is followed shortly thereafter by a
disposition of the property, the related parties have essentially “cashed out” of the
investment and the original exchange should not receive tax deferred treatment. The IRS
tends to look at the related parties as a single economic unit and tax deferred exchange
treatment will be disallowed if it is a part of a transaction or series of transactions structured
to avoid the purposes of the related party provisions.

1.Who is a Related Party?
A related party is any person or entity bearing a relationship with the taxpayer. Although not
an exhaustive definition, this includes:
A) Family members such as brothers, sisters, spouses, ancestors and lineal descendents.
(Stepparents, uncles, in-laws, cousins, nephews and ex-spouses are not considered
related.)
B) A corporation or partnership in which more than 50% of the stock or more than 50%
of the capital interest is owned by the taxpayer.
An expanded definition includes:
1. Family members (siblings, spouse, ancestors, and lineal descendants);
2. An individual and a corporation , where more than 10 percent of the stock is owned
directly or indirectly by or for such individual;
3. Two corporations that are part of the same control group;
4. A grantor and a fiduciary of the same trust;
5. A fiduciary and a beneficiary of the same trust;
6. A fiduciary of a trust and the fiduciary or beneficiares of another trust where the same
person is the grantor of both trusts;
7. A fiduciary of a trust and a corporation more that 10 percent in value of the outstanding
stock of which is owned, directly or indirectly, by or for the trust or by the grantor of
the trust;

8. A person and an IRC §501 organization, if the organization is contolled by the person
or his family;
9. A corporation and a partnership if the same persons own more the 10 percent in value
of the outstandking stock of the corporation and more than 10 percent of capital interest
or profits interest in the partnership;
10. An S Corporation and another S Corporation or a C Corporation if the same persons
own more than 10 percent of the value of the outstanding stock of each corporation;
11. A partnership and a person owning, directly or indirectly, more than 10 percent of the
capital interest, or profits interest, in such partnership;
12. Two partnerships in which the same persons own, directly or indirectly, more than 10
percent capital interests or profits interests;
13. An executor of an estate and the beneficiaries of the estate.
Although it is important to consult with tax or legal advisors before attempting any exchange
with a related party, some guidelines exist which are useful in analyzing related party
exchanges.
(b) Simultaneous Exchange
When related parties directly swap with each other, both parties must hold the property
acquired for two years following the exchange. If either party disposes of their property
within the two-year holding period, then the capital gain tax will need to be recognized.

(c) Delayed – Selling to a Related Party
A taxpayer can sell to a related party, but the related party must hold the property for a
minimum of two years or the exchange will be invalidated.
Delayed – Purchasing from a Related Party
A taxpayer should generally not purchase a replacement property from a related party. In
Private Revenue Ruling 9748006, the IRS disallowed tax deferral to a taxpayer who
purchased his mother’s property. Revenue Ruling 2002-83 also denied tax deferral treatment
to an Taxpayer using a Qualified Intermediary to ultimately purchase replacement property
from a related party.
A conservative guideline to observe is: “If the buyer and seller are related, and one of the
parties ends up with the property and the other ends up with the cash, the exchange may be
disallowed.”

Related Party Exchanges - Review of Legal Developments
TERUYA BROTHERS V. COMM. (2005)
The U.S. Tax Court held that a company could not defer gain under §1031 on its exchange
of properties through a Qualified Intermediary that sold them and then later bought
replacement properties from a party related to the exchanger because the company could not
demonstrate that tax avoidance was not a principal purpose of the transaction.
The Section §1031 rules say that if someone exchanges with a related party, and the related
party sells the property within two years, the transaction is disqualified from the tax deferral
benefits of Section §1031.
PLR 2004-40002
This private letter ruling is important in that it validated a situation where related parties
exchanged with each other where both performed a §1031 exchange and never cashed out of
their investment.
Partnership A owned Building 1 and Partnership B owned Building 2. Partnership A and
Partnership B are considered related persons under IRC Section §1031(f) (3). Partnership A
had entered into a purchase and sale agreement to sell Building 1 to an unrelated third party
and then purchase Building 2 from Partnership B in a §1031 exchange. Partnership B is also
interested in doing a §1031 exchange on the sale of Building B as its relinquished property.
Partnership B’s replacement property is owned by a completely unrelated seller. Partnership
A and Partnership B hire the same Qualified Intermediary to prepare all needed exchange
documents. Partnerships A and B both represent they will not sell Building 2 or Partnership
B’s replacement property within 2 years from their acquisition in a §1031 exchange.

The IRS ruled that neither IRC §1031(f) (1) nor §1031(f) (4), with the tax avoidance
structuring exception, apply since neither of the related persons are cashing out their
investment and both partnerships are seeking to acquire like-kind replacement properties
under IRC §1031.
TAM 102519-97: IRS ruled that an individual is not entitled to tax deferred treatment when
purchasing a replacement property owned by a related party, even though a Qualified
Intermediary (QI) purchased the replacement property.
TAM 200126007: IRS denies tax deferred treatment when Taxpayer wanted to sell
residential property with a low basis and exchange for replacement property owned by a
party related to the Taxpayer. The IRS felt this transaction involved “basis shifting” and a
cashing out of the investment by an exchange between related parties.
FSA 199931002: Taxpayer should not exchange into a property owned by a related party
when transferring the relinquished property to an unrelated party.
FSA 2001137003: Taxpayer can acquire a replacement property from a related party if the
Taxpayer and the related party are involved in a ‘swap’ and each hold their property for at
least two years.
Revenue Ruling 2002-83
Revenue Ruling 2002-83 addresses the situation where an Taxpayer transfers a relinquished
property to a QI in exchange for a replacement property owned by a related party. The

Revenue Ruling specifies that an Taxpayer, under the facts shown below, is not entitled to
nonrecognition treatment under Section 1031(a) if, as part of the transaction, the related
party received cash or other non-like-kind property for the replacement property.
Facts:
• Taxpayer A wants tax deferral under IRC Section 1031;
• B is an entity related to Taxpayer A;
• C wants to buy A’s property.
The Issue:
• Taxpayer transfers low basis relinquished property to QI;
• QI sells relinquished property to C for cash;
• QI acquires high-basis replacement property from B, transfer this property to A and
pays B the cash received from C.
Result: Tax Deferred Treatment Denied
In essence, the Taxpayer A, enters into a like-kind exchange with QI, an unrelated thiry-
party. The problem is that the end result is the same as if Taxpayer A had exchanged
property with B followed by a sale from B to C.

C. Exchange Entity and LLC Issues
Generally in a §1031 tax deferred exchange, an Taxpayer should take title to the replacement
property in the same manner they held title on the relinquished property. In most cases, the
entity initiating the exchange must be the same entity concluding the exchange. Some examples
are reflected below:
• If a wife relinquishes, than the wife acquires;
• Smith LLC relinquishes, Smith LLC acquires;
• Gemco Corp. relinquishes, Gemco Corp. acquires;
• Durst Partnership relinquishes, Durst Partnership acquires.
SOME EXCEPTIONS TO THE GENERAL RULE
• Partnerships and Limited Liability Companies (LLC’s): An Taxpayer who elects taxation as a
sole proprietorship can hold the relinquished property as an individual but acquire the
replacement property as a single-member, single-asset LLC. This provides the benefit of
liability protection and also can help the satisfy the ‘single asset entity’ requirements that many
lenders impose on replacement property purchases. The IRS has also ruled that a limited
liability company with two members will be considered a single member limited liability
company if the sole role of one of the members is to prevent the other member from placing
the LLC into bankruptcy and that the limited role member had no interest in LLC profits or
losses nor any management rights other than the limited right regarding bankruptcy.

• Grantor Trusts: A Taxpayer can acquire a replacement property in a revocable living trust or
“grantor” trust for estate planning purposes.
• Death of a Taxpayer: If the Taxpayer dies during the exchange, the Taxpayer’s estate may
complete the exchange.
Sometimes a business consideration, lender requirement or the Taxpayer’s liability issues can
make it difficult to keep the vesting entity the same throughout the exchange. For this reason,
it is important that Taxpayers review the entire exchange transaction with their legal and/or
tax advisors before closing on the sale of the relinquished property. Some problem areas:
If a wife, as the only Taxpayer, is relying on the husband’s income to qualify for replacement
property financing, the lender may require that the husband appear on the deed. This could
have an impact on the wife’s exchange.
Most lenders are wary about lending to trustees. An Taxpayer who relinquishes property in a
trust but needs to obtain conventional financing for the purchase may have difficulty
obtaining a loan because lenders prefer loaning to an individual.
Sometimes an Taxpayer may relinquish a property in one entity such as multi-member LLC,
corporation or partnership but want to acquire a replacement property in a different entity.
This would disqualify the exchange.
A partnership may exchange its relinquished property for a "like-kind" replacement property,
however, section 1031(a)(2)(D) of the tax code specifically prohibits a partner from
exchanging their interest in one partnership for an interest in another partnership. With the
prohibition of exchanging a partnership interest, what alternatives are available to taxpayers?

Example 1:
Situation: A partnership is dissolving and one partner wants to exchange, while the
remaining partner seeks to cash out. Option A: The partnership distributes the relinquished
property to the partners as tenants-in-common prior to close of escrow. The partner seeking
to cash out “sells” their undivided interest in the relinquished property to the buyer. The
other partner, “exchanges” their tenancy-in-common interest in the relinquished property for
a replacement property. Option B: The partnership exchanges the relinquished property for
the replacement property, which is then distributed to the taxpayer and cash is distributed to
the other partner.
Example 2:
The taxpayer exchanges the relinquished property for a tenancy-in-common interest in the
replacement property which is then contributed into a partnership into which another partner
contributes cash.
An exchange similar to Example 1A was approved by the Tax Court in Bolker v.
Commissioner, 181 TC 782 (1983), aff’d 760 F2d 1039 (CA9 1985). A corporation
distributed the relinquished property to it’s sole shareholder who then exchanged it for the
replacement property. The Court determined that since the taxpayer never intended “to
liquidate the investment or use it for personal pursuits”, he did hold the relinquished property
for a proper purpose.
The Tax Court also approved an exchange similar to Example 1B. In Maloney v.
Commissioner, 93TC 89 (1989), a corporation performed an exchange and then distributed it

to the shareholders. The Tax Court determined that the replacement property was held for
investment after the liquidation, even though the replacement property was now held by the
shareholders rather than by the corporation. Both Bolker and Maloney involved distributions
by a liquidating corporation rather than by a partnership, however, the rationale should apply
equally to the distribution from a partnership. An exchange similar to Example 2 was
approved by both Courts in Magneson v. Commissioner (9th Cir 1985) 753 F2d 1490,
because, “the new property is substantially a continuation of the old investment still
unliquidated”.
A Few Suggestions:
(1) The greater the period of time between the exchange and the contribution or distribution,
the better.
(2) The Partnership Agreement should recite that taxpayer is holding the property in
question "for investment or in a trade or business”.
(3) The substance of the transaction should parallel the Exchange Agreement.

D. Combining Exchanges and Installment Sales
When a Taxpayer elects to carry-back a Note on the relinquished property (the sale or Phase
I Property), there are basically two options for treatment of the Note:
(1) Do not include the Note in the exchange and pay any taxes that may be due. The
Taxpayer would receive the Note as the Beneficiary at the closing and pay taxes on
this portion of the capital gain under the Installment method (§453).
(2) Include the Note in the exchange by initially showing the “Qualified Intermediary”
as the Beneficiary and possibly defer the capital gain taxes.
In option number (1), the Taxpayer is electing to take the Installment method per Code
Section 453. The Note is made payable to the Taxpayer and is received by the Taxpayer
at the closing of the relinquished property. The drawback to this method is the capital
gain tax could become due in one lump sum if the Note allows for prepayments or if a
balloon payment is required. In option number (2), the Taxpayer has four different
alternatives for attempting to use the Note as part of the tax deferred exchange. In order
to avoid “constructive or actual receipt” by the Taxpayer, the QI is named as the
Beneficiary on the Note.
Use the Note Towards the Down Payment on the Replacement Property
The Seller of the replacement property accepts the Note as partial payment towards the
purchase price. In this scenario, the Note is assigned to the Seller by the QI and delivered
to the Seller at closing.

Taxpayer or a Related Party Purchases Note From the Qualified Intermediary
Essentially, the Taxpayer purchases the note from the Qualified Intermediary. The
purchase may include discounting the note to represent its fair market value at the time of
purchase. The sale of the note to the Taxpayer takes place during the exchange period,
thus allowing Asset Preservation, Inc. to use the note proceeds towards the replacement
property.
The Payer Pays Off the Note Prior to Closing on the Replacement Property
The Note is actually paid off during the exchange. This works only on short-term Notes
due within the 180 day exchange period. The Payer pays off the Note directly to the QI,
the holder of the Note. The QI adds the payoff proceeds to the existing proceeds in the
Qualified Exchange Account. When the replacement property is ready to close, all
proceeds are delivered to the closing officer.
Selling the Note on the Secondary Market
The Taxpayer finds an taxpayer willing to purchase the Note, thereby replacing the Note
with cash. The cash proceeds are added to the existing cash in the Qualified Exchange
Account for purchasing the replacement property. Typically the Note will need to be sold
at a discount, often anywhere from 15% – 30%. If the Note is discounted, the discounted
amount May be considered a selling expense. If the Taxpayer chooses option (2) and then
is unsuccessful with any of the four alternatives shown above, the QI will assign the Note
back to the Taxpayer. The Taxpayer has all the tax benefits of the installment method in

Code §453 as shown under option (1) available. Many Taxpayers choose option (2)
because it allows for several alternatives of tax deferral, without penalizing the Taxpayer.
E. Refinancing Issues
Many real estate taxpayers never consider an exchange because they mistakenly believe their
equity must always remain tied up in real estate. Believe it or not, an taxpayer can exchange
into a more desirable property, thus preserving all their equity — and then refinance the
replacement property to obtain cash. The cash received from the refinance of the replacement
property can then be used for whatever the taxpayer chooses.
A real estate taxpayer should not refinance the relinquished property and shortly thereafter
perform a tax deferred exchange, unless it can be established that the debt incurred prior to the
exchange had “independent economic substance.” If the Taxpayer cannot support they had a
valid business reason incurring addition debt prior to the sale, the IRS could easily
characterize this as a “step transaction” (where they determine the steps leading up to the
exchange show the taxpayer’s original intent was merely to obtain the cash in an attempt to
avoid the reinvestment rules of IRC § 1031.) For example, in Private Letter Ruling 8434015,
the IRS ruled that cash proceeds refinanced immediately prior to closing an exchange
constituted taxable boot.
In most circumstances, an attorney or CPA will recommend refinancing the replacement
property after completing the exchange transaction. Any refinancing should be done later and
off the replacement property closing statement.

Given the IRS's position with respect to increasing debt prior to an exchange in order to
receive tax-free cash, a cautious taxpayer will:
(a) Increase the debt on the relinquished property before listing the property for sale or
entering into a contract to sell or exchange the property. The taxpayer can also support
its tax position by having an independent business reason for the debt increase, such as
some immediate need for the cash.
(b) Increase the debt on the replacement property after closing of the exchange, as this
appears less risky than doing so on the relinquished property prior to closing.
(c) Not take excess financing proceeds out at closing of the replacement property. Any
refinancing should be done later and off the replacement property closing statement.

F. Treatment of Selling Expenses
A frequently asked question is “What expenses can be deducted from the exchange proceeds
without resulting in a tax consequence?” Although the IRS has not published a complete list
of qualifying expenses, there are some rulings that provide general parameters. Brokerage
commissions can be deducted from the exchange proceeds (Revenue Ruling 72-456). Other
transactional costs may also be able to be deducted if they are paid in connection with the
exchange. (Letter Ruling 8328011).
Transactional costs that are referred to as “exchange expenses” on Form 8824 are not
specifically listed but should generally include costs that are:
(a) A direct cost of selling real property, which typically include:
Real estate commissions
Title insurance premiums
Closing or escrow fees
Legal fees
Transfer taxes and Notary fees
Recording fees
- or -
(b) Costs specifically related to the fact the transaction is an exchange such as the
Qualified Intermediary fees.

Although not a complete list, the costs related to obtaining the loan should not be
deducted from the proceeds. These and other “non-exchange expenses” include:
Mortage points and assumption fees
Credit reports
Lender’s title insurance
Prorated mortgage insurance
Loan fees and loan application fees
Property taxes
Utility charges
Association fees
Hazard insurance
Credits for lease deposits
Prepaid rents and security deposits

G. Non-Tax Motives for Exchanging/Estate Planning
(a) leverage
(b) diversification
(c) consolidation
(d) cash flow
(e) management relief
(f) increased depreciation
(g) estate planning
Examples of typical exchanges include:
(1) Non-income producing raw land sold and income producing rental
property acquired. Taxpayer also benefits from "depreciation" which they did not
have on the raw land.
(2) Multiple management intensive properties sold and one larger professionally
managed property acquired.
(3) Sell one property and acquire multiple properties for investment diversification.
One can diversify not only by property type, but also by location.

Relinquished Property Replacement Property Benefit
Non-income producing land Triple Net Leased Property Cash flow
High-equity property Highly leveraged property Leverage
Multiple Rental Single user commercial Management relief
Commercial property Industrial and apartments Diversification
Multiple property types Single property type Consolidation
In addition to the deferral of capital gain taxes, there are many underlying reasons an
taxpayer would want to exchange one property for another. These are some of the typical
non-tax motives for performing an exchange:
• Exchange from depreciated property to higher value property that can be depreciated.
• Exchange from property that cannot be refinanced, such as land, to improved property
that will support a new loan thereby gaining the ability to obtain cash.
• Exchanging from non-income land to improved property to create cash flow.
• Exchange from already appreciated property, such as an apartment, to a high cash flow
property, such as a retail center, to generate needed cash flow.
• Exchange from cash flow property to property with faster appreciation for clients who do
not need cash but wish to build their estate.

• Exchange for a property or properties that may be easier to sell in the coming years.
• Exchange to meet the location requirements of a client who has moved across the country
or one who simply wishes to invest in a different part of the city.
• Exchange to fit the lifestyle of a client, for example, a retiree may exchange for a
property requiring reduced management in order to travel more.
• Exchange from several smaller properties into a larger one to consolidate the benefits of
ownership, or exchange from a larger property to several smaller ones to divide an estate
among children or for retirement reasons.
• Exchange to a property an taxpayer can use in her own profession, for example, a doctor
may exchange out of rental houses into a medical building she can use for her practice.
• Exchange out of a partial interest in one property to a full interest in another.
• Exchange into a singe family rental property that will initially be held for investment. At
a later date the taxpayer may decide to move into this property and convert it into their
primary residence. Under current tax laws, after the taxpayer has lived in the property as
their primary residence for 2 out of 5 years, they are eligible for the tax exclusion
benefits available under IRC Section 121.
• Exchange into a rental property at a resort location that is desirable and where property
values typically appreciate well in good economic times.
• Exchange out of a management intensive ranch or farm operation for a lower
management burden of an apartment complex with an on-site property manager.

• Exchange depreciated equipment or vehicles for similar new equipment or vehicles.
H. Recent Legislation
De Cleene vs. Commissioner, 115 TC 34 (Nov. 17, 2000)
In this case a parking arrangement was used for an improvement exchange. The
documentation was inadequate and the arrangement was such that the exchange
accommodation titleholder was relieved of any risk from being the ”owner” of the property
and was clearly the agent of the taxpayer. The exchange was disallowed. Interpretation: In
parking arrangements which are outside the safe harbor of Rev. Proc. 2000-37, it is
important that the entity holding the parked property hold the benefits and burdens of
ownership to the greatest extent possible.
Bundren vs. Commissioner TC Memo 2001-2 (Jan. 5, 2001)
In this case the taxpayer had owned a house (Property A) which he had used as his personal
residence for twelve years. He then moved out and converted it to a rental for 4 months and
then used it as relinquished property in an exchange for another residence (Property B)
which he used as a rental for 20 months. He then sold B without doing another exchange.
The issue in the case is what the taxpayer’s basis in Property B is at the time of sale (and
therefore what was there gain or loss from that sale). The court generally upheld the IRS’
position in the case as to basis. But what is strange about this case is that the IRS agreed
with the taxpayer during the case that taxpayer had done a valid tax deferred exchange when
he swapped Property A for Property B, even though he had only rented out the property for

4 months. So the court did not address this issue. This result does not mean it is safe to hold
property for only 4 months and then use it in an exchange.
TAM 2000-35005 (May 11, 2000)
IRS rules that an FCC Radio License is like-kind to an FCC Television License. Upon
review of the personal property regulations under IRC Section 1031, the TAM states that the
licenses are intangible personal property and that a like-kind determination depends on (1)
the nature and character of the rights involved and (2) the nature and character of the
underlying property to which the licenses relate.
PLR 2000-40017 (June 30, 2000)
A like-kind ruling, this time finding that real property located in the United States is like-
kind to real property located in the U.S. Virgin Islands. Only applies to U.S. Virgin Islands.
PLR 2000-41027 (July 19, 2000)
Another like-kind case, finding that outdoor advertising signs will be treated as real property
for federal income tax purposes and thus are like kind to other real property, if taxpayer
makes the proper election under IRC Code Section 1033(g)(3) on his tax return for the year
of the exchange.

Field Service Advice 2000-48021 (August 29, 2000)
In this matter the taxpayer attempts to do a related-party exchange by selling various parcels
of property to his children in return for a promissory note from the children to the taxpayer,
which note is to be held by an escrow agent. An exchange agreement was entered into
between taxpayer, the children and the escrow agent, which placed some restrictions on the
exchange proceeds. Later, the children paid off the note by paying money to taxpayer’s
attorney, and the taxpayer used the money to acquire the replacement property by direct
deed from its seller. There were many deficiencies in this arrangement which caused the IRS
to disallow it as an exchange: (1) the taxpayer was ruled to be in constructive receipt of
exchange proceeds when the children paid off the note by paying the money to the
taxpayer’s attorney (who is, of course, taxpayer’s agent); (2) the exchange agreement
contained inadequate restrictions on the taxpayer’s access to exchange proceeds because it
allowed the taxpayer to “reject” a purchase contract for replacement property, then
immediately receive the exchange proceeds before expiration of the exchange period; (3) no
assignments of the rights to purchase the replacement property were entered into between
taxpayer and escrow agent; and (4) the taxpayer did not sign his ID letter. Also, the children
sold some of the real property they received from taxpayer before holding it for 2 years.
This would have doomed even a well-structured exchange.

Rev. Proc. 2000-46 (October 12, 2000)
IRS issues a letter stating that until further notice, it will not make any rulings concerning
the question of whether “tenancy-in-common arrangements” will be treated as valid
purchases of real property or as partnership interests (thus ineligible as replacement property
under Section 1031(a) 1).
PLR 200111025 (Dec. 8, 2000)
This ruling concerns a non-safe-harbor reverse exchange transaction. Facts: taxpayer owned
rural land for a long time. A non-profit conservation organization entered into an option to
buy the land, for use as a preserve. The option was exercised by the buyer, but there were
many contingencies to closing (which would substantially delay the closing) such as, before
the buyer could close the purchase, an election would have to be held in which voters would
have to approve a bond issue to finance purchase of the land. Taxpayer wanted to do a
reverse exchange to acquire replacement property before the closing of the sale of the land.
The taxpayer entered into an exchange accommodation arrangement, probably with a QI.
The arrangement closely followed the requirements of Rev. Proc. 2000-37, which governs
parking arrangements, and the documentation was well structured. However, the period that
the accommodation titleholder was holding the property exceeded 180 days, which put the
transaction outside the limits of the Rev. Proc. (Also, the facts occurred before the Rev.
Proc. came into effect.) The IRS stated that in order to do a successful non-Rev.-Proc.
reverse exchange, three requirements must be met: (1) the taxpayer must demonstrate his
intent to do an exchange of like-kind property; (2) the steps in the various transfers in the
exchange must be part of an “integrated plan” to exchange; and (3) the party holding the

property must not be the taxpayer’s agent. The first 2 requirements clearly had been fulfilled
because of the good documentation of the reverse exchange. The IRS analyzed the agency
question and found that, due to good formalities that were observed in the arrangement; the
accommodator was not the taxpayer’s agent. Thus the reverse exchange was upheld. This
ruling is probably in conflict with the DeCleene, above, which concentrates much more on
the transfer of the benefits and burdens of ownership to the accommodator than on the
agency question. It is questionable how much this ruling can be relied on in determining
what is required to do non-Rev. Proc. parking arrangements because: (1) DeCleene is an
appeals court case, and much more powerful as precedent in future cases than an IRS ruling;
(2) the facts were very favorable to the taxpayer (selling land to be used as a nature
preserve) and (3) the person who wrote this PLR is no longer working in the IRS department
that handles 1031 exchanges. Many in the QI industry believe that it is still important that
the benefits and burdens of ownership be transferred as far as possible to the accommodator
in order to do this type of exchange.
PLR 200118023 (Jan. 31, 2001)
In this ruling a QI company formed a single asset limited liability company (LLC) to serve
as the qualified intermediary and to hold replacement property to be improved in an
improvement exchange. In forming the LLC, the QI company became the sole member
(owner) of the LLC. The LLC acquired like-kind replacement property and the
improvements were constructed on it. When the time came to transfer the improved property
on to the taxpayer to complete the exchange, the QI transferred its ownership of the entire
LLC, including the improved property held by the LLC, to the taxpayer. The issue here was

whether transferring this LLC to the taxpayer would be treated as receipt of the replacement
property by the taxpayer. The IRS ruled that transferring the LLC itself was a permissible
way of transferring the replacement property to the taxpayer. This ruling is favorable
because it simplifies the process of doing parking arrangements and it sometimes will save a
taxpayer from having to pay transfer taxes more than once when doing an exchange
involving a parking arrangement.
TAM 200130001 (March 1, 2001)
Taxpayers here enter into a complex series of transactions by which they attempt to combine
the sale of 3 relinquished properties for the ultimate purchase of 1 replacement property in a
delayed exchange. But the IRS rules that there is no exchange due to the failure to observe
some basic formalities required by the Treasury Regulations for delayed exchanges: (1) no
written notices of assignment of the 3 contracts for the sale of the relinquished properties
were given to the purchasers (direct deeding was used so this was required); (2) there was
no requirement in the exchange agreements that like-kind property be exchanged; and (3)
the exchange agreements contained no express limitation on the taxpayers’ access to have
access to the exchange proceeds during the exchange. These violations threw the transaction
outside the safe harbor for delayed exchanges. The exchange was disallowed.
TAM 200126007 (March 22, 2001)
This TAM is further proof that taxpayers who do exchanges in which they purchase
replacement property from related parties may be in for trouble with the IRS. Taxpayer did
two separate simultaneous exchanges in which he sold real property to third parties and used
the proceeds to acquire investment real property from a related party. The taxpayer held the

property acquired from the related party for 2 years as required by the IRS code. But the
effect of these exchanges was to shift taxpayer’s low basis in the properties he relinquished
to the replacement properties he acquired from related party. Looking at the taxpayer and
the related party as a single unit, the exchange had the effect of reducing the unit’s
investment in real property and reducing the related party’s level of debt. The IRS explicitly
stated that it believes that the intent of IRC Section 1031(f) (re: related parties) was to treat
the related parties as a single economic unit, and that if the exchange, looked at from this
point of view, caused any basis shifting, “cashing out” of an investment, or any net deferral
of gain or acceleration of losses, then the exchange would be disallowed. The only
exceptions to this would be in case of death, certain involuntary conversions, and situations
where the IRS finds there was no intent to avoid taxes (very limited). The IRS also stated
that the use of an intermediary in this kind of related party exchange would not help at all.
The exchange will still be disallowed. The net effect is that, except in rare circumstances,
the IRS will challenge exchanges in which the taxpayer buys from a related party.
PLR 200151017 (September 17, 2001)
This ruling deals with an entity merger mid-exchange which did not affect the validity of the
tax deferred exchange.
PLR 200211016 (December 10, 2001)
Taxpayer requested an extension of the 180-day exchange period because they believed
their situation was analogous to events the allow suspension provided under Section
6503(b). (Note: A State Agency had taken possession of the Intermediary and appointed a

receiver who froze all assets of the Intermediary, including the proceeds of the taxpayer.)
The request was denied.
PLR 200211016 (March 15, 2002)
After Taxpayer’s intermediary received the proceeds from Taxpayer’s sale of real property,
a state agency took control of the intermediary and a judge confirmed the appointment of a
receiver and froze all assets of the intermediary, including Taxpayer’s proceeds. Taxpayer
identified like-kind replacement property, but was unable to close on it within the 180-day
exchange period (under IRC Section 1031(a) (3) (B)) because the proceeds remained frozen.
Taxpayer requested a ruling suspending running of the exchange period during the
receivership, arguing that the situation was analogous to the events that trigger the
suspension provided under IRC Section 6503(b) (extending the limitation on the period in
which the IRS can collect tax due while a taxpayer’s assets are under a court’s control). IRS
rules that nothing in the language of Section 6503(b) or case law interpreting this provision
supports suspension of the 180-day exchange period, and denies the request for extension.
David Dobrich v. Comm., TCM 1997-447
The taxpayers did not identify their intended replacement property to anyone involved in the
exchange. Further, the taxpayers did not even discuss the properties that were eventually
acquired with the exchange proceeds with the Qualified Intermediary, the real estate brokers
or the owners of the replacement properties. Approximately 3 months after the expiration of
the 45-day Identification Period, the taxpayers and the real estate brokers for the
replacement properties created letters purporting to identify such properties and backdated

the letters to before the 45-day deadline. The taxpayers pled guilty to violating IRC Section
7202 and causing fraudulent identification.
Definition of a Disqualified Person (January 31, 2002)
Additional clarification to the definition of the term of “disqualified person” in response to
changes in the federal banking law.
Private Letter Ruling 2002-40049 (July 1, 2002)
The three PLR’s have similar fact patterns and involve the leasing of motor vehicles. The
Qualified Intermediary treats each vehicle as a separate transaction. The the buyers fo the
vehicles are auto dealers, bidders and lessess. The taxpayer transfer security deposits under
the lease to the Qualified Intermediary before the exchange. The Qualified Intermediary also
is the buying entity for non-replacement property vehicles for the taxpayers. These services
are considered to be within the routine financial services definition.
The taxpayer is a subsidiary of an equipment manufacturer and is in the business of leasing
equipment. The exchange program is with the Qualified Intermediary who also serves as a
collection agent for the taxpayer under the equipment leases.

Field Service Advise 2002-44010 (July 22, 2002)
This involveds a failed attempt to create a new tax basis with a shorter life for depreciation
proposed through a series of sales and leasebacks of aircraft. The taxpayer did not file Form
8824 and the other entity involved in the transactions did not report them in the way the
taxpayer did.
Private Letter Ruling 2002-51008 (September 11, 2002)
This PLR involved a reasonably complicated safe harbor reverse exchange along with
improvements to be built on the replacement property. In addition, the replacement property
includes a lessee’s interest in land leased on a long-term basis from a city. The taxpayer
would like to move an existing business from the relinquished property to the replacement
property. The IRS approved this transaction as qualifying for both the reverse and Qualified
Intermediary safe harbors. The IRS noted in regards to the related party issue by stating,
“Since both [taxpayer] and the related parties continue to be invested in the exchange
properties, and are not otherwise cashing out of their interst, Section 1031(f)(1) is not a
concern for this transaction unles and until [taxpayer] or the related parties dispose of their
interests in the exchanged property with two years after the last trnsfer that was part of the
exchange.”
Revenue Ruling 2002-83 (November 25, 2002)
The fact pattern presented in this ruling dealt with an attempt to shift basis as the low basis
property is being exchanging within the greater related person economic unit and the high
basis property is being transferred outside the economic unit to a buyer. Although a

Qualified Intermediary was involved, the IRS reinterates their position stated in previous
PLRs. And although this position is not inconsisten with previous positions
Revenue Procedure 2003-39 (May 7, 2003)
Three safe harbors are created for taxpayers in ongoing exchange programs for personal
property: 1) Replacement property received within 45 calendar days of the sale of the
relinquished property or any other replacement property identified can be matched to the
relinquished property before the due date of the taxpayer’s tax return. 2) The requirement
that the taxpayer transfer money or other property to a Qualified Intermediary can be
satisfied by the balance held in a joint bank acount between between the Qualified
Intermediary and the taxpayer so long as the balance equals or exceeds the amont of
proceeds from the sale of the relinquished properties.
3) Their will be no disqualification of the Qualified Intermediary if the Qualified
Intermediary sells relinquished properties that are not matched with replacement properties
or pays or receives proceeds in connection with unmatched properties or acuiris unmatchd
replacement properties. In addition, this revenue procedure discsses the abilty of the
taxpayer to enter into a master assignments of agreements to sell/purchase property
combined with the taxpayer’s written notice to third parties of this assignment.
Revenue Ruling 2003-56 (May, 9, 2003)
This ruling is a clarification of the technical partnership income tax impact when a delayed
exchange covers two tax years. The IRS will suspend the resolution of partnershp liabilty
changes until after the exchange has been completed. If there is a net increase in partnership

liabilities, then the increase is accounted for in the year of the receipt of the replacement
property. If there is a net decrease in partnershp liabilities, the decrease is taken into account
in the year of transfer of the relinquished property.
Rev. Rul. 2004-86, 2004-33 IRB
A new revenue ruling explains when interests in a multi-owner Delaware statutory trust
(DST) formed to hold rental real property may or may not be treated as qualifying property
in a tax-deferred like-kind exchange for real property.
Background. The Delaware Statutory Trust Act (Act) provides that a Delaware statutory
trust (DST) is an unincorporated association recognized as an entity separate from its
owners. A DST is created by executing a governing instrument and filing an executed
certificate of trust. A DST is very different from a traditional trust and is given much more
flexibility in how to design its relationships, duties and powers of its trustees and
beneficiaries.
Code Sec. 1031(a)(1) provides that no gain or loss is recognized on the exchange of
property held for productive use in a trade or business or for investment if such property is
exchanged solely for property of like kind that is to be held either for productive use in a
trade or business or for investment. Code Sec. 1031(a) doesn't apply to any exchange of
stocks, bonds or notes, other securities or evidences of indebtedness or interest, interests in a
partnership, or certificates of trust or beneficial interests. (Code Sec. 1031(a) (2))
DST ruling. In Rev Rul 2004-86, IRS concluded that a DST (formed to hold rental real
property) is classified, for federal tax purposes, as a partnership or a corporation if the

trustee has the power to dispose of the property and acquire new property, renegotiate or
enter into leases, renegotiate or refinance debt, invest cash to profit from market
fluctuations, or make more than non-structural modifications to the property.
Rev. Proc. 2004-51, 2004-23 IRB (July 24, 2004)
1. Purpose
This revenue procedure modifies sections 1 and 4 of Rev. Proc. 2000-37, 2000-2 C.B.
308, to provide that Rev. Proc. 2000-37 does not apply if the taxpayer owns the property
intended to qualify as replacement property before initiating a qualified exchange
accommodation arrangement (QEAA).
2. Background
.01 Section 1031(a) provides that no gain or loss is recognized on the exchange of
property held for productive use in a trade or business or for investment if the property
is exchanged solely for property of like kind that is to be held either for productive use
in a trade or business or for investment.
.02 Section 1031(a) (3) allows taxpayers to structure deferred like-kind exchanges.
Under § 1031(a)(3), property may be treated as like-kind property if it is (A) identified
as property to be received in the exchange (replacement property) on or before the day
that is 45 days after the date on which the taxpayer transfers the property relinquished
in the exchange (relinquished property), and (B) received before the earlier of the date
that is 180 days after the date on which the taxpayer transfers the relinquished property,
or the due date (determined with regard to extensions) for the transferor's federal

income tax return for the taxable year in which the transfer of the relinquished property
occurs.
.03 Rev. Proc. 2000-37 addresses “parking” transactions. See sections 2.05 and 2.06 of
Rev. Proc. 2000-37. Parking transactions typically are designed to “park” the desired
replacement property with an accommodation party until such time as the taxpayer
arranges for the transfer of the relinquished property to the ultimate transferee in a
simultaneous or deferred exchange. Once such a transfer is arranged, the taxpayer
transfers the relinquished property to the accommodation party in exchange for the
replacement property, and the accommodation party transfers the relinquished property
to the ultimate transferee. In other situations, an accommodation party may acquire the
desired replacement property on behalf of the taxpayer and immediately exchange that
property with the taxpayer for the relinquished property, thereafter holding the
relinquished property until the taxpayer arranges for a transfer of the property to the
ultimate transferee. Rev. Proc. 2000-37 provides procedures for qualifying parking
transactions as like-kind exchanges in situations in which the taxpayer has a genuine
intent to accomplish a like-kind exchange at the time that the taxpayer arranges for the
acquisition of the replacement property and actually accomplishes the exchange within
a short time thereafter.
.04 Section 4.01 of Rev. Proc. 2000-37 provides that the Internal Revenue Service will
not challenge the qualification of property held in a QEAA “as either 'replacement
property' or 'relinquished property' (as defined in § 1.1031(k)-1(a)) for purposes of §
1031 and the regulations thereunder, or the treatment of the exchange accommodation

titleholder as the beneficial owner of such property....” Thus, taxpayers are not required
to establish that the exchange accommodation titleholder bears the economic benefits
and burdens of ownership and is the “owner” of the property. The Service and Treasury
Department are aware that some taxpayers have interpreted this language to permit a
taxpayer to treat as a like-kind exchange a transaction in which the taxpayer transfers
property to an exchange accommodation titleholder and receives that same property as
replacement property in a purported exchange for other property of the taxpayer.
.05 An exchange of real estate owned by a taxpayer for improvements on land owned
by the same taxpayer does not meet the requirements of § 1031. See DeCleene v.
Commissioner, 115 T.C. 457 (2000); Bloomington Coca-Cola Bottling Co. v.
Commissioner, 189 F.2d 14 (7th Cir. 1951). Moreover, Rev. Rul. 67-255, 1967-2 C.B.
270, holds that a building constructed on land owned by a taxpayer is not of a like kind
to involuntarily converted land of the same taxpayer. Rev. Proc. 2000-37 does not
abrogate the statutory requirement of § 1031 that the transaction be an exchange of like-
kind properties.
.06 The Service and Treasury Department are continuing to study parking transactions,
including transactions in which a person related to the taxpayer transfers a leasehold in
land to an accommodation party and the accommodation party makes improvements to
the land and transfers the leasehold with the improvements to the taxpayer in exchange
for other real estate.

3. Scope
This revenue procedure applies to taxpayers applying the safe harbor rules set forth in
Rev. Proc. 2000-37 in structuring like-kind exchanges.
4. Application
.01 Section 1 of Rev. Proc. 2000-37 is modified to read as follows:
SECTION 1. PURPOSE
This revenue procedure provides a safe harbor under which the Internal Revenue Service will
treat an exchange accommodation titleholder as the beneficial owner of property for federal
income tax purposes if the property is held in a “qualified exchange accommodation
arrangement” (QEAA), as defined in section 4.02 of this revenue procedure.
.02 Section 4.01 of Rev. Proc. 2000-37 is modified to read as follows:
SECTION 4. QUALIFIED EXCHANGE ACCOMMODATION ARRANGEMENTS
.01 In general. The Service will treat an exchange accommodation titleholder as the beneficial
owner of property for federal income tax purposes if the property is held in a QEAA. Property
held in a QEAA may, therefore, qualify as either “replacement property” or “relinquished
property” (as defined in § 1.1031(k)-1(a)) in a tax-deferred like-kind exchange if the exchange
otherwise meets the requirements for deferral of gain or loss under § 1031 and the regulations
thereunder.
.03 Section 4.05 is added to Rev. Proc. 2000-37 to read as follows:

.05 Limitation. This revenue procedure does not apply to replacement property held in a QEAA
if the property is owned by the taxpayer within the 180-day period ending on the date of transfer
of qualified indicia of ownership of the property to an exchange accommodation titleholder.
Private Letter Ruling 2004-40002
The IRS rules that IRC Section 1031(f) (1) – the tax avoidance structuring exception - does not
apply in a related party exchange since neither of the related persons are cashing out of their
investments. This is the first favorable PLR to confirm this belief held by many in the industry.

5
TLS, have you I.R.S. SPECIFICATIONS TO BE REMOVED BEFORE PRINTING
transmitted all R Action Date Signature
text files for this INSTRUCTIONS TO PRINTERS
cycle update? FORM 8824, PAGE 1 of 6.
MARGINS: TOP 13mm (1⁄2 "), CENTER SIDES. PRINTS: HEAD TO HEAD O.K. to print
PAPER: WHITE WRITING, SUB. 20. INK: BLACK
FLAT SIZE: 216 mm (81⁄2 ") 279 mm (11")
Date PERFORATE: (NONE) Revised proofs
DO NOT PRINT — DO NOT PRINT — DO NOT PRINT — DO NOT PRINT requested
OMB No. 1545-1190

Like-Kind Exchanges
Form 8824 (and section 1043 conflict-of-interest sales) 2005
Department of the Treasury Attachment
䊳 Attach to your tax return.
Internal Revenue Service Sequence No. 109
Name(s) shown on tax return Identifying number
Part I Information on the Like-Kind Exchange
Note: If the property described on line 1 or line 2 is real or personal property located outside the United States, indicate the country.
1 Description of like-kind property given up 䊳
2 Description of like-kind property received 䊳
3 Date like-kind property given up was originally acquired (month, day, year) 3 / /
4 Date you actually transferred your property to other party (month, day, year) 4 / /
5 Date like-kind property you received was identified by written notice to another party (month,
day, year). See instructions for 45-day written notice requirement 5 / /
6 Date you actually received the like-kind property from other party (month, day, year). See instructions 6 / /
7 Was the exchange of the property given up or received made with a related party, either directly or indirectly
(such as through an intermediary)? See instructions. If “Yes,” complete Part II. If “No,” go to Part III Yes No
Part II Related Party Exchange Information
8 Name of related party Relationship to you Related party’s identifying number
Address (no., street, and apt., room, or suite no., city or town, state, and ZIP code)
9 During this tax year (and before the date that is 2 years after the last transfer of property that was part of the
exchange), did the related party directly or indirectly (such as through an intermediary) sell or dispose of any
part of the like-kind property received from you in the exchange? Yes No
10 During this tax year (and before the date that is 2 years after the last transfer of property that was part of the
exchange), did you sell or dispose of any part of the like-kind property you received? Yes No
If both lines 9 and 10 are “No” and this is the year of the exchange, go to Part III. If both lines 9 and 10 are “No” and this is not the
year of the exchange, stop here. If either line 9 or line 10 is “Yes,” complete Part III and report on this year’s tax return the deferred
gain or (loss) from line 24 unless one of the exceptions on line 11 applies.
11 If one of the exceptions below applies to the disposition, check the applicable box:
a The disposition was after the death of either of the related parties.
b The disposition was an involuntary conversion, and the threat of conversion occurred after the exchange.
c You can establish to the satisfaction of the IRS that neither the exchange nor the disposition had tax avoidance as its
principal purpose. If this box is checked, attach an explanation (see instructions).
For Paperwork Reduction Act Notice, see page 5. Cat. No. 12311A Form 8824 (2005)
5
I.R.S. SPECIFICATIONS TO BE REMOVED BEFORE PRINTING
INSTRUCTIONS TO PRINTER
FORM 8824, PAGE 2 of 6
MARGINS: TOP 13 mm (1⁄2 "), CENTER SIDES. PRINTS: HEAD TO HEAD
FLAT SIZE: 216 mm (81⁄2 ") 279 mm (11")
PERFORATE: (NONE)
DO NOT PRINT — DO NOT PRINT — DO NOT PRINT — DO NOT PRINT
Form 8824 (2005) Page 2

Name(s) shown on tax return. Do not enter name and social security number if shown on other side. Your social security number
Part III Realized Gain or (Loss), Recognized Gain, and Basis of Like-Kind Property Received
Caution: If you transferred and received (a) more than one group of like-kind properties or (b) cash or other (not like-kind) property,
see Reporting of multi-asset exchanges in the instructions.
Note: Complete lines 12 through 14 only if you gave up property that was not like-kind. Otherwise, go to line 15.
12 Fair market value (FMV) of other property given up 12
13 Adjusted basis of other property given up 13
14 Gain or (loss) recognized on other property given up. Subtract line 13 from line 12. Report the
gain or (loss) in the same manner as if the exchange had been a sale 14
Caution: If the property given up was used previously or partly as a home, see Property used
as home in the instructions.
15 Cash received, FMV of other property received, plus net liabilities assumed by other party, reduced
(but not below zero) by any exchange expenses you incurred (see instructions) 15
16 FMV of like-kind property you received 16
17 Add lines 15 and 16 17
18 Adjusted basis of like-kind property you gave up, net amounts paid to other party, plus any
exchange expenses not used on line 15 (see instructions) 18
19 Realized gain or (loss). Subtract line 18 from line 17 19
20 Enter the smaller of line 15 or line 19, but not less than zero 20
21 Ordinary income under recapture rules. Enter here and on Form 4797, line 16 (see instructions) 21
22 Subtract line 21 from line 20. If zero or less, enter -0-. If more than zero, enter here and on Schedule
D or Form 4797, unless the installment method applies (see instructions) 22
23 Recognized gain. Add lines 21 and 22 23
24 Deferred gain or (loss). Subtract line 23 from line 19. If a related party exchange, see instructions 24
25 Basis of like-kind property received. Subtract line 15 from the sum of lines 18 and 23 25
Part IV Deferral of Gain From Section 1043 Conflict-of-Interest Sales
Note: This part is to be used only by officers or employees of the executive branch of the Federal Government for reporting
nonrecognition of gain under section 1043 on the sale of property to comply with the conflict-of-interest requirements. This part
can be used only if the cost of the replacement property is more than the basis of the divested property.
26 Enter the number from the upper right corner of your certificate of divestiture. (Do not attach a
copy of your certificate. Keep the certificate with your records.) 䊳 –
27 Description of divested property 䊳
28 Description of replacement property 䊳
29 Date divested property was sold (month, day, year) 29 / /
30 Sales price of divested property (see instructions) 30
31 Basis of divested property 31
32 Realized gain. Subtract line 31 from line 30 32

33 Cost of replacement property purchased within 60 days after date
of sale 33
34 Subtract line 33 from line 30. If zero or less, enter -0- 34
35 Ordinary income under recapture rules. Enter here and on Form 4797, line 10 (see instructions) 35
36 Subtract line 35 from line 34. If zero or less, enter -0-. If more than zero, enter here and on
Schedule D or Form 4797 (see instructions) 36
37 Deferred gain. Subtract the sum of lines 35 and 36 from line 32 37
38 Basis of replacement property. Subtract line 37 from line 33 38

Form 8824 (2005)
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Form 8824 (2005) Page 3

Deferred exchanges. A deferred exchange 1. Subtract line 18 from line 17. Subtract
General Instructions occurs when the property received in the the amount of the exclusion from the
Section references are to the Internal exchange is received after the transfer of result. Enter that result on line 19. On the
Revenue Code unless otherwise noted. the property given up. For a deferred dotted line next to line 19, enter “Section
exchange to qualify as like-kind, you must 121 exclusion” and the amount of the
Purpose of Form comply with the 45-day written notice and exclusion.
Use Parts I, II, and III of Form 8824 to receipt requirements explained in the 2. On line 20, enter the smaller of:
report each exchange of business or instructions for lines 5 and 6. a. Line 15 minus the exclusion, or
investment property for property of a like
Multi-asset exchanges. A multi-asset b. Line 19.
kind. Certain members of the executive
exchange involves the transfer and receipt Do not enter less than zero.
branch of the Federal Government use Part
of more than one group of like-kind 3. Subtract line 15 from the sum of lines
IV to elect to defer gain on
properties. For example, an exchange of 18 and 23. Add the amount of your
conflict-of-interest sales.
land, vehicles, and cash for land and exclusion to the result. Enter that sum on
Multiple exchanges. If you made more vehicles is a multi-asset exchange. An
than one like-kind exchange, you may file line 25.
exchange of land, vehicles, and cash for
only a summary Form 8824 and attach Property used partly as home. If the
land only is not a multi-asset exchange.
your own statement showing all the property given up was used partly as a
The transfer or receipt of multiple
information requested on Form 8824 for home, you will need to use two separate
properties within one like-kind group is
each exchange. Include your name and Forms 8824 as worksheets—one for the
also a multi-asset exchange. Special rules
identifying number at the top of each page part of the property used as a home and
apply when figuring the amount of gain
of the statement. On the summary Form one for the part used for business or
recognized and your basis in properties
8824, enter only your name and identifying investment. Fill out only lines 15 through
received in a multi-asset exchange. For
number, “Summary” on line 1, the total 25 of each worksheet Form 8824. On the
details, see Regulations section 1.1031(j)-1.
recognized gain from all exchanges on line worksheet Form 8824 for the part of the
23, and the total basis of all like-kind Reporting of multi-asset exchanges. If property used as a home, follow steps (1)
property received on line 25. you transferred and received (a) more than through (3) above, except that instead of
one group of like-kind properties or following step (2), enter the amount from
When To File (b) cash or other (not like-kind) property, line 19 on line 20. On the worksheet Form
do not complete lines 12 through 18 of 8824 for the part of the property used for
If during the current tax year you Form 8824. Instead, attach your own business or investment, follow steps (1)
transferred property to another party in a statement showing how you figured the through (3) above only if you can exclude
like-kind exchange, you must file Form realized and recognized gain, and enter the at least part of any gain from the exchange
8824 with your tax return for that year. correct amount on lines 19 through 25. of that part of the property; otherwise,
Also file Form 8824 for the 2 years Report any recognized gains on Schedule complete the form according to its
following the year of a related party D; Form 4797, Sales of Business Property; instructions. Enter the combined amounts
exchange (see the instructions for line 7 on or Form 6252, Installment Sale Income, from lines 15 through 25 of both worksheet
page 4). whichever applies. Forms 8824 on the Form 8824 you file. Do
Exchanges using a qualified exchange not file either worksheet Form 8824.
Like-Kind Exchanges accommodation arrangement (QEAA). If More information. For details, see Rev.
Generally, if you exchange business or property is transferred to an exchange Proc. 2005-14 on page 528 of Internal
investment property solely for business or accommodation titleholder (EAT) and held Revenue Bulletin 2005-7 at
investment property of a like kind, no gain in a QEAA, the EAT may be treated as the www.irs.gov/irb/2005-07_IRB/ar10.html.
or loss is recognized under section 1031. beneficial owner of the property, the Additional information. For more
If, as part of the exchange, you also property transferred from the EAT to you information on like-kind exchanges, see
receive other (not like-kind) property or may be treated as property you received in section 1031 and its regulations and Pub.
money, gain is recognized to the extent of an exchange, and the property you 544.
the other property and money received, transferred to the EAT may be treated as
but a loss is not recognized. property you gave up in an exchange. This
Section 1031 does not apply to may be true even if the property you are to Specific Instructions
exchanges of inventory, stocks, bonds, receive is transferred to the EAT before Lines 1 and 2. For real property, enter the
notes, other securities or evidence of you transfer the property you are giving up. address and type of property. For personal
indebtedness, or certain other assets. See However, the property transferred to you property, enter a short description. For
section 1031(a)(2). In addition, section 1031 may not be treated as property received in property located outside the United States,
does not apply to certain exchanges an exchange if you previously owned it include the country.
involving tax-exempt use property subject within 180 days of its transfer to the EAT.
Line 5. Enter on line 5 the date of the
to a lease. See section 470(e)(4). For details, see Rev. Proc. 2000-37 as
written notice that identifies the like-kind
modified by Rev. Proc. 2004-51. Rev.
Like-kind property. Properties are of like property you received in a deferred
Proc. 2000-37 is on page 308 of Internal
kind if they are of the same nature or exchange. To comply with the 45-day
Revenue Bulletin 2000-40 at
character, even if they differ in grade or written notice requirement, the following
www.irs.gov/pub/irs-irbs/irb00-40.pdf. Rev.
quality. Personal properties of a like class conditions must be met.
Proc. 2004-51 is on page 294 of Internal
are like-kind properties. However, livestock Revenue Bulletin 2004-33 at 1. The like-kind property you receive in a
of different sexes are not like-kind www.irs.gov/irb/2004-33_IRB/ar13.html. deferred exchange must be designated in
properties. Also, personal property used writing as replacement property either in a
predominantly in the United States and Property used as home. If the property document you signed or in a written
personal property used predominantly given up was owned and used as your agreement signed by all parties to the
outside the United States are not like-kind home during the 5-year period ending on exchange.
properties. See Pub. 544, Sales and Other the date of the exchange, you may be able
2. The document or agreement must
Dispositions of Assets, for more details. to exclude part or all of any gain figured on
describe the replacement property in a
Form 8824. For details on the exclusion
Real properties generally are of like kind, clear and recognizable manner. Real
(including how to figure the amount of the
regardless of whether they are improved or property should be described using a legal
exclusion), see Pub. 523, Selling Your
unimproved. However, real property in the description, street address, or
Home. Fill out Form 8824 according to its
United States and real property outside the distinguishable name (for example,
instructions, with these exceptions:
United States are not like-kind properties. “Mayfair Apartment Building”).
5
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Form 8824 (2005) Page 4

3. No later than 45 days after the date Report the deferred gain or (loss) from line ● A nonrecourse liability generally is
you transferred the property you gave up: 24 on this year’s tax return as if the exchange treated as assumed by the party receiving
a. You must send, fax, or hand deliver had been a sale. the property subject to the liability.
the document you signed to the person An exchange structured to avoid the However, if an owner of other assets
required to transfer the replacement related party rules is not a like-kind subject to the same liability agrees with the
property to you (including a disqualified exchange. Do not report it on Form 8824. party receiving the property to, and is
person) or to another person involved in Instead, you should report the disposition of expected to, satisfy part or all of the
the exchange (other than a disqualified the property given up as if the exchange liability, the amount treated as assumed is
person), or had been a sale. See section 1031(f)(4). reduced by the smaller of (a) the amount of
b. All parties to the exchange must sign Such an exchange includes the transfer of the liability that the owner of the other
the written agreement designating the property you gave up to a qualifed assets has agreed to and is expected to
replacement property. intermediary in exchange for property you satisfy or (b) the FMV of those other
Generally, a disqualified person is either received that was formerly owned by a assets.
your agent at the time of the transaction or related party if the related party received Line 18. Include on line 18 the sum of:
a person related to you. For more details, cash or other (not like-kind) property for the ● The adjusted basis of the like-kind
see Regulations section 1.1031(k)-1(k). property you received, and you used the property you gave up,
qualified intermediary to avoid the
Note. If you received the replacement ● Exchange expenses, if any (except for
application of the related party rules. See
property before the end of the 45-day expenses used to reduce the amount
Rev. Rul. 2002-83 for more details. You can
period, you automatically are treated as reported on line 15), and
find Rev. Rul. 2002-83 on page 927 of
having met the 45-day written notice
Internal Revenue Bulletin 2002-49 at ● Net amount paid to the other party—the
requirement. In this case, enter on line 5 excess, if any, of the total of (a) any
www.irs.gov/pub/irs-irbs/irb02-49.pdf.
the date you received the replacement liabilities you assumed, (b) cash you paid
property. Line 11c. If you believe that you can to the other party, and (c) the FMV of the
establish to the satisfaction of the IRS that other (not like-kind) property you gave up
Line 6. Enter on line 6 the date you tax avoidance was not a principal purpose
received the like-kind property from the over any liabilities assumed by the other
of both the exchange and the disposition, party.
other party. attach an explanation. Generally, tax See Regulations section 1.1031(d)-2 and
The property must be received by the avoidance will not be seen as a principal the following example for figuring amounts
earlier of the following dates. purpose in the case of: to enter on lines 15 and 18.
● The 180th day after the date you ● A disposition of property in a Example. A owns an apartment house
transferred the property given up in the nonrecognition transaction, with an FMV of $220,000, an adjusted
exchange. ● An exchange in which the related parties basis of $100,000, and subject to a
● The due date (including extensions) of derive no tax advantage from the shifting mortgage of $80,000. B owns an
your tax return for the year in which you of basis between the exchanged apartment house with an FMV of $250,000,
transferred the property given up. properties, or an adjusted basis of $175,000, and subject
Line 7. Special rules apply to like-kind ● An exchange of undivided interests in to a mortgage of $150,000.
exchanges made with related parties, different properties that results in each A transfers his apartment house to B
either directly or indirectly. A related party related party holding either the entire and receives in exchange B’s apartment
includes your spouse, child, grandchild, interest in a single property or a larger house plus $40,000 cash. A assumes the
parent, grandparent, brother, sister, or a undivided interest in any of the properties. mortgage on the apartment house received
related corporation, S corporation, Lines 12, 13, and 14. If you gave up other from B, and B assumes the mortgage on
partnership, trust, or estate. See section property in addition to the like-kind the apartment house received from A.
1031(f). property, enter the fair market value (FMV) A enters on line 15 only the $40,000
An exchange made indirectly with a and the adjusted basis of the other cash received from B. The $80,000 of
related party includes: property on lines 12 and 13, respectively. liabilities assumed by B is not included
● An exchange made with a related party The gain or (loss) from this property is because it does not exceed the $150,000
through an intermediary (such as a figured on line 14 and must be reported on of liabilities A assumed. A enters $170,000
qualified intermediary or an exchange your return. Report gain or (loss) as if the on line 18—the $100,000 adjusted basis,
accommodation titleholder, as defined in exchange were a sale. plus the $70,000 excess of the liabilities A
Pub. 544), or Line 15. Include on line 15 the sum of: assumed over the liabilities assumed by B
● An exchange made by a disregarded ($150,000 - $80,000).
● Any cash paid to you by the other party,
entity (such as a single member limited B enters $30,000 on line 15—the excess
● The FMV of other (not like-kind) property
liability company) if you or a related party of the $150,000 of liabilities assumed by A
you received, if any, and
owned that entity. over the total ($120,000) of the $80,000 of
● Net liabilities assumed by the other liabilities B assumed and the $40,000 cash
If the related party (either directly or party—the excess, if any, of liabilities
indirectly) or you dispose of the property B paid. B enters on line 18 only the
(including mortgages) assumed by the adjusted basis of $175,000 because the
received in an exchange before the date other party over the total of (a) any
that is 2 years after the last transfer of total of the $80,000 of liabilities B assumed
liabilities you assumed, (b) cash you paid and the $40,000 cash B paid does not
property from the exchange, the deferred to the other party, and (c) the FMV of the
gain or (loss) from line 24 must be reported exceed the $150,000 of liabilities assumed
other (not like-kind) property you gave up. by A.
on your return for the year of disposition Reduce the sum of the above amounts
(unless an exception on line 11 applies). (but not below zero) by any exchange Line 21. If you disposed of section 1245,
If you are filing this form for 1 of the 2 expenses you incurred. See the example 1250, 1252, 1254, or 1255 property (see
years following the year of the exchange, on this page. the instructions for Part III of Form 4797),
complete Parts I and II. If both lines 9 and you may be required to recapture as
The following rules apply in determining ordinary income part or all of the realized
10 are “No,” stop. the amount of liability treated as assumed. gain (line 19). Figure the amount to enter
If either line 9 or line 10 is “Yes,” and an ● A recourse liability (or portion thereof) is on line 21 as follows:
exception on line 11 applies, check the treated as assumed by the party receiving
applicable box on line 11, attach any the property if that party has agreed to and Section 1245 property. Enter the smaller
required explanation, and stop. If no line is expected to satisfy the liability (or of:
11 exceptions apply, complete Part III. portion thereof). It does not matter whether 1. The total adjustments for deductions
the party transferring the property has (whether for the same or other property)
been relieved of the liability. allowed or allowable to you or any other
4
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FLAT SIZE: 216 mm (81⁄2 ") 279 mm (11")
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Form 8824 (2005) Page 5

person for depreciation or amortization (up Line 25. The amount on line 25 is your 3. Report the amount from line 35 on
to the amount of gain shown on line 19), or basis in the like-kind property you received Form 4797, line 10, column (g). In column
2. The gain shown on line 20, if any, plus in the exchange. Your basis in other (a), write “From Form 8824, line 35.” Do
the FMV of non-section 1245 like-kind property received in the exchange, if any, is not complete columns (b) through (f).
property received. its FMV. Line 36. If you sold a capital asset, enter
Section 1250 property. Enter the smaller any capital gain from line 36 on Schedule
Section 1043 D. If you sold property used in a trade or
of:
1. The gain you would have had to Conflict-of-Interest Sales business (or any other asset for which the
report as ordinary income because of (Part IV) gain is treated as ordinary income), report
additional depreciation if you had sold the the gain on Form 4797, line 2 or line 10,
property (see the Form 4797 instructions If you sell property at a gain according to a column (g). In column (a), write “From Form
for line 26), or certificate of divestiture issued by the 8824, line 36.” Do not complete columns
Office of Government Ethics (OGE) and (b) through (f).
2. The larger of:
purchase replacement property (permitted
a. The gain shown on line 20, if any, or property), you may elect to defer part or all Paperwork Reduction Act Notice. We
b. The excess, if any, of the gain in of the realized gain. You must recognize ask for the information on this form to
item (1) above over the FMV of the section gain on the sale only to the extent that the carry out the Internal Revenue laws of the
1250 property received. amount realized on the sale is more than United States. You are required to give us
Section 1252, 1254, and 1255 property. the cost of replacement property the information. We need it to ensure that
The rules for these types of property are purchased within 60 days after the sale. you are complying with these laws and to
similar to those for section 1245 property. (You also must recognize any ordinary allow us to figure and collect the right
See Regulations section 1.1252-2(d) and income recapture.) Permitted property is amount of tax.
Temporary Regulations section any obligation of the United States or any You are not required to provide the
16A.1255-2(c) for details. If the installment diversified investment fund approved by information requested on a form that is
method applies to this exchange: the OGE. subject to the Paperwork Reduction Act
1. See section 453(f)(6) to determine the If the property you sold was unless the form displays a valid OMB
installment sale income taxable for this control number. Books or records relating
year and report it on Form 6252. TIP stock you acquired by exercising
a statutory stock option, you may to a form or its instructions must be
2. Enter on Form 6252, line 25 or 36, the be treated as meeting the retained as long as their contents may
section 1252, 1254, or 1255 recapture holding periods that apply to such stock, become material in the administration of
amount you figured on Form 8824, line 21. regardless of how long you actually held the any Internal Revenue law. Generally, tax
Do not enter more than the amount shown stock. This may benefit you if you do not returns and return information are
on Form 6252, line 24 or 35. defer your entire gain, because it may allow confidential, as required by section 6103.
you to treat the gain as a capital gain The time needed to complete and file
3. Also enter this amount on Form 4797,
instead of ordinary income. For details, see this form will vary depending on individual
line 15.
section 421(d) or Pub. 525. circumstances. The estimated burden for
4. If all the ordinary income is not individual taxpayers filing this form is
recaptured this year, report in future years Complete Part IV of Form 8824 only if the
cost of the replacement property is more approved under OMB control number
on Form 6252 the ordinary income up to the 1545-0074 and is included in the estimates
taxable installment sale income, until it is all than the basis of the divested property and
you elect to defer the gain. Otherwise, shown in the instructions for their individual
reported. income tax return. The estimated burden
report the sale on Schedule D or Form
Line 22. Report a gain from the exchange 4797, whichever applies. for all other taxpayers who file this form is
of property used in a trade or business shown below.
Your basis in the replacement property is
(and other noncapital assets) on Form Recordkeeping 1 hr., 38 min.
reduced by the amount of the deferred gain.
4797, line 5 or line 16. Report a gain from
If you made more than one purchase of Learning about the
the exchange of capital assets according
replacement property, reduce your basis in law or the form 27 min.
to the Schedule D instructions for your
the replacement property in the order you Preparing the form 59 min.
return. Be sure to use the date of the
acquired it.
exchange as the date for reporting the Copying, assembling, and
gain. If the installment method applies to Line 30. Enter the amount you received sending the form to the IRS 33 min.
this exchange, see section 453(f)(6) to from the sale of the divested property, If you have comments concerning the
determine the installment sale income minus any selling expenses. accuracy of these time estimates or
taxable for this year and report it on Form Line 35. Follow these steps to determine suggestions for making this form simpler,
6252. the amount to enter. we would be happy to hear from you. See
Line 24. If line 19 is a loss, enter it on 1. Use Part III of Form 4797 as a the instructions for the tax return with
line 24. Otherwise, subtract the amount on worksheet to figure ordinary income under which this form is filed.
line 23 from the amount on line 19 and the recapture rules.
enter the result. For exchanges with related 2. Enter on Form 8824, line 35, the
parties, see the instructions for line 7 on amount from Form 4797, line 31. Do not
page 4. attach the Form 4797 used as a worksheet
to your return.

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Investment Analysis &

Investment Analysis & §1031 Exchanges 1

NOTHING IN THIS SEMINAR OR OUTLINE SHOULD BE CONSTRUED AS LEGAL OR

Investment Analysis & §1031 Exchanges 2

II. Investment Real Estate................................................................................................... 11

III. Real Estate Cash Flow Concepts..................................................................................13

IV. Tax Aspects of Cash Flow.............................................................................................22

V. Common Uses of Cash Flow Analysis ...........................................................................34

VI. Accurate Data ................................................................................................................42

Investment Analysis & §1031 Exchanges 3

VIII. Understanding Investor Goals ..................................................................................53

IX. Types of Non-Recognition Transfers ...........................................................................55

X. History of IRC Section 1031........................................................................................... 88

XI. Exchange Terminology .................................................................................................95

XII. “Like-Kind” Property Issues ......................................................................................104

Investment Analysis & §1031 Exchanges 4

XIII. Tenant-in-Common Programs/Fractional Ownership ..........................................117

XIV. Exchange Requirements.............................................................................................159

XV. Section 1031 Exchange Documentation .....................................................................173

XVI. Section 1031 Formats and Variations.......................................................................176

Investment Analysis & §1031 Exchanges 5

XVII. The Exchange Equation............................................................................................229

XVIII. The Benefits of an Exchange ..................................................................................233

XIX. Important Issues and Recent Developments ............................................................237

Form 8824 .............................................................................................................................290

Investment Analysis & §1031 Exchanges 6

Investment Analysis & §1031 Exchanges 7

should be commensurate with the amount of risk associated with it.

B. Why People Invest

Most people invest for the following reasons:

• To generate additional income

C. Common Investment Vehicles

• Saving accounts and certificates of deposit

Investment Analysis & §1031 Exchanges 8

Easier to Finance: Financing for up to four units is similar to single-family-home

Savings: If we invest $40,000 in a certificate of deposit (CD) at 5%, compounded

Future value of property in 15 years $415,785

Investment Analysis & §1031 Exchanges 9

1) Certificate of deposit $84,675

• Need for liquidity

Investment Analysis & §1031 Exchanges 10

Investment Analysis & §1031 Exchanges 11

B. Five Major Advantages of Investment Real Estate

First Advantage: Income from Cash Flow

Fifth Advantage: Higher Leverage

Investment Analysis & §1031 Exchanges 12

Investment Analysis & §1031 Exchanges 13

Investment Analysis & §1031 Exchanges 14

Before-Tax Cash Flow

1. GROSS SCHEDULED INCOME $

2. – Vacancy & Uncollected Rents – $

3. = EFFECTIVE RENTAL INCOME = $

5. = GROSS OPERATING INCOME = $

6. – Annual Operating Expenses – $

7. = NET OPERATING INCOME = $

8. – Annual Debt Service – $

9. = BEFORE-TAX CASH FLOW = $

Investment Analysis & §1031 Exchanges 15

Four-Plex Rental Property

Question: What is the first year’s cash flow before tax?

Before-Tax Cash Flow

Investment Analysis & §1031 Exchanges 16

Typical Unit Mix