HARP – On This. . .

PREDICTION:  Tax rates will rise, and property values will increase.

IRC Section 1031 allows sellers of qualifying real estate to exchange it for like-kind real estate and defer payment of taxes. . . possibly forever.

WHAT IS A TAX-DEFERRED EXCHANGE?

Section 1031 of the Internal Revenue Code allows any real estate in the USA held for investment or for use in the taxpayer’s trade or business to be exchanged for other like-kind property without payment of federal income taxes. Most states tax codes provide likewise. There are technical rules for completing the exchange, but it is a straightforward process with clear-cut rules expressly authorized by law.

Taxes that can be deferred include all capital gains taxes, all depreciation recapture taxes, all passive-investment taxes (so called “Obamacare taxes”), and, in most cases, state income taxes. In many circumstances, these taxes can add up to in excess of 30%. Instead of paying taxes, why not reinvest those funds as equity in another like-kind property instead, and continue to receive an investment return on those funds?

HOW IS LIKE-KIND PROPERTY DEFINED?

• A concept that is often misunderstood is “like-kind” property. The definition is much broader and simpler that some might expect. Basically, any real estate located in the USA and held for investment or for use in the taxpayer’s trade or business can be exchanged for any other USA real estate held for investment or for use in the taxpayer’s trade or business without paying taxes. That means, for example:

The physical use of the real estate is not what makes it like-kind; rather, all real estate located in the USA is like-kind to all other real estate located in the USA. Likewise, foreign real estate is like-kind to other foreign real estate, but it is not like-kind to USA real estate. The condition is that (i) the real estate being sold must have been held for investment or for use in the taxpayer’s trade or business, and not held primarily for resale, and (ii) the real estate being acquired must likewise be acquired for investment purposes or for use in the taxpayer’s trade or business and not primarily for resale.

ARE THERE TIME CONSTRAINTS?

At the time of closing, the taxpayer does not need to know exactly what property will replace the property being sold. The taxpayer has 45 days to identify potential replacement property, and up to 180 days after closing to acquire the replacement property. A key, however, is that the selling taxpayer cannot come into physical or constructive possession of the sale proceeds during the exchange period. To satisfy this condition, the seller will designate a qualified intermediary to hold the funds under an exchange trust agreement. This can be done quickly, often within a day or two before closing if necessary. Although the seller/taxpayer does not have the right to access the funds during the exchange period, the seller/taxpayer does have the right to direct the qualified intermediary to apply the funds toward the taxpayer’s purchase of any replacement property which is identified by the taxpayer during the 45-day identification period.

For all taxes to be deferred, the entire sale proceeds of the real estate being sold must be used to acquire the replacement property. For this purpose, “sale proceeds” includes all cash received at closing and any mortgage indebtedness that was paid off.

INCIDENTAL PERSONAL PROPERTY

Prior to January 1, 2018 tax-deferred exchanges of certain personal property were also permitted. The 2017 Tax Cuts and Jobs Act, effective January 1, 2018, ended this practice and limited tax-deferred like-kind exchanges to only real property. This raised concerns as to whether certain personal property commonly incidental to a sale of commercial property, such as appliances, carpeting, HVAC systems, security systems, Wi-Fi systems, trade fixtures, etc. would disqualify an exchange for tax deferral, or constitute taxable “boot”.

Under Final Regulations published by the Treasury Department effective December 2, 2020, personal property that is incidental to real property acquired in an exchange will be disregarded and may therefore be included as part of the tax-deferred exchange. Personal property is considered “incidental” in commercial transactions if (a) it is the type of personal property typically transferred together with real property, and (b) the aggregate fair market value of the personal property transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement real property received in exchange.   

ADVANTAGES AND DISADVANTAGES

There are many advantages and not many disadvantages to structuring a sale as a tax-deferred exchange. The rules are technical but not very difficult to apply. It has virtually no impact on the buyer and provides extraordinary benefits to the seller.

For a real estate lawyer, besides providing a great service to your clients, an exchange provides a direct lead-in to the next transaction with an opportunity to handle the purchase of replacement property of equal or greater value that must close within 180 days.

Our tax code provides this benefit; it is up to real estate professionals to take advantage.

Thanks for listening . . .

Kymn

These are troubled times. The COVID pandemic is crushing some segments of the commercial real estate industry, including particularly retail and restaurants.

In COVID-19 lease negotiations, I usually represent commercial landlords. When representing commercial tenants, knowing the challenges landlords face is useful.  Commercial tenants should recognize that when seeking rental abatements, or other rent relief, they are proposing to shift the financial burden of COVID from tenant to the landlord. Landlords may want to help; but they may be unable to do so and preserve ownership of their property.

The good news is, there appears to be light at the end of the COVID tunnel. Vaccines are here. The bad news is, we have a long recovery ahead for small businesses and commercial landlords.

The idea that most commercial landlords are “rich people”, large corporations, or REITS who can better weather the financial storm brought by COVID is not true. Most landlords rely on timely payment of rent to pay their mortgages and other expenses of ownership. And, unlike commercial tenants, landlords did not receive direct relief under the federal CARES Act. The forgivable PPP loans to small businesses allow commercial tenants to use up to 40% of the loan proceeds to pay rent. This was designed to help small businesses survive, and to indirectly help commercial landlords by giving commercial tenants funds to help pay rent. Frequently, commercial tenants have ignored this aspect of the PPP loan program.

Strategically, tenants make a mistake when they approach their landlord with a sense of entitlement, and demand rent relief. COVID-19 is not the fault of the landlord any more than it is the fault of the tenant.  At a minimum, when asking the landlord for rent relief, a commercial tenant should be prepared to certify to landlord that tenant has suspended distributions to tenant’s owners and investors. The landlord is not the tenant’s business partner. Why should a landlord take a financial hit to enable a tenant to continue to pay tenant’s owners and investors?  Landlords have their own financial challenges.   

 Except in rare occasions where the lease terms provide otherwise, commercial tenants are not automatically “entitled” to rent relief because of COVID-19. It is not a right.  If a commercial tenant needs COVID rent relief, it must be willing to be financially transparent and able to make a compelling case to landlord as to how the landlord will benefit by granting the requested relief.  Even a compelling case may not be enough if landlord’s mortgage payments, real estate taxes, insurance, utilities, and necessary third-party vendor obligations cannot be paid or abated. Tenants need to provide information to landlord to enable the landlord to likewise make a compelling case to its lender and critical third-party vendors. 

Plausible workout strategies may include:

(a) temporary deferral of monthly base rent to be repaid later, with or without interest; or

(b) temporary abatement of monthly base rent in exchange for an extension of the current lease term.

Abatement is a forgiveness of rent. Deferral merely postpones the due date. A landlord will typically need corresponding relief from its lender to help fund the abatement or deferral, and to suspend applicable loan covenants.

Often the best solution is a partial rent abatement (say, for example, a 25% to 50% base rent abatement for a short period) in exchange for extending the term of the lease at full rent. This helps give commercial tenants the rent relief they need in these difficult times, while preserving the value of the property for the landlord – and collateral value for its lender.

Finding a solution that preserves the tenant as a viable occupant and preserves the value of the property for the landlord and its lender is the surest route to avoiding costly and catastrophic litigation.     

Thanks for listening,

Kymn