Contract exchanges (A Contract Exchange is the tax-deferred exchange of: The Buyer’s ownership in a Sales Contract on real property, for different real property, or for a contract or option on different real property; or the Option Holder’s exchange of an Option to purchase real property, for different real property, or for an option or contract on different real property. Essentially, a contract exchange is an exchange of an open option to purchase, or an open Sales Contract, rather than an exchange of the underlying real estate itself.) have recently become a hot topic among tax professionals, because many investors desire to cash in on the built in gains from the real estate market. Now, sensing possible dwindling future returns over the paper appreciation already earned, real estate investors want to lock in the gains from their hot investments such as condominium development contracts, and move into less high-flying, high-risk real estate holdings.
A “Contract Exchange ” is the tax-deferred exchange of:
-The Buyer’s ownership in a Sales Contract on real property, for different real property, or for a contract or option on different real property; or
-The Option Holder’s exchange of an Option to purchase real property, for different real property, or for an option or contract on different real property. Essentially, a contract exchange is an exchange of an open option to purchase, or an open Sales Contract, rather than an exchange of the underlying real estate itself.
Why do a Contract Exchange? You might ask, why not just close on the property, and then exchange the underlying real estate for replacement property? There are several advantages of exchanging the pre-closing contract itself. The primary reason to enter into a contract exchange is to lock in existing gains while avoiding the tax bite from entirely “cashing out”. Another very important reason to conduct a contract exchange is to avoid the risks, costs and time delays from conducting multiple closings.
Actually closing on an Option or Pre-closing Contract requires that the investor execute extra contracts, get extra approvals, and raise funds in most circumstances when he or she would otherwise not be required if the investor merely exchanged his Option or Pre-closing contract directly for the replacement property.
Simplify the Process and Save Money. When an option or pre-closing contract is exchanged for a full interest in the replacement property, there is no need to raise the necessary funds to exercise the option, or to close and take title on the acquisition of the relinquished property. If the taxpayer will be financing the transactions, by exchanging the option or pre-closing contract for the replacement property, he or she will not need to obtain a mortgage on the relinquished property in order to pay the purchase price for the relinquished property. Instead, the taxpayer would merely apply the funds from the sale of the option directly to the downpayment on the replacement property, and complete the transaction in a one-step closing.
EXAMPLE: Option or Pre-closing Contract Value = $100,000 Exercise Price of Option, or Purchase Price for Relinquished Property = $400,000 Relinquished Property value = $500,000
A. Taxpayer exercises option or closes on the acquisition of the relinquished property, then exchanges the relinquished property for replacement property. The taxpayer must:
1. obtain a loan for $400,000 in order to finance the exercise of the option or pay the purchase price to acquire the relinquished property;
2. pay loan origination fees, application fees, or points to obtain the mortgage, plus wait for the mortgage company’s approval of the transaction;
3. close on the purchase of the relinquished property, file and record a deed on the relinquished property; and pay the following fees: attorney’s, title, documentation, insurance, recording fee and transfer taxes;
4. record the mortgage on the relinquished property;
5. pay off the mortgage at closing on the sale of the relinquished property, and incur all of the other closing costs on the sale of the relinquished property;
6. use the remaining proceeds from the sale of the relinquished property ($100,000 less the costs, taxes, expenses and fees described in items 1 through 5 above) as the initial downpayment on the replacement property, which must equal or exceed the $500,000 value of the relinquished property.
B. Same example as item A above, but rather than closing on the acquisition of the relinquished property, the taxpayer sells his option or pre-closing contract and reinvests its proceeds directly into replacement property. The taxpayer must:
1. Close on the sale of the option or the pre-closing contract, without the necessity of paying recording, documentary stamps, legal fees, title insurance or other fees, or transfer taxes; then
2. apply the full proceeds from the sale of the option to the initial downpayment on the replacement property, which must also equal or exceed the $500,000 value of the relinquished property. With pre-closing contracts the developer might require taxpayer to pay a “transfer fee”.
Avoiding Risks and Problems of Ownership. Closing on the real property not only entails time, costs, and additional steps, it also imposes risks. Such risks include:
-What if there is a problem with title to the property?
-What if the property becomes damaged in between closings?
-What if permits or zoning problems are discovered after signing the Executory Contract or buying the Option, but before closing?
-What if the developer or seller goes bankrupt in between the time the Option is purchased or the Executory Contract is signed, but before all the closings are completed?
-What if the property fails inspection or undiscovered defects exist?
-What if the lender refuses to loan on the property because the extra appraisal does not meet its minimum?
Each of these problems is substantially eliminated with a contract exchange, because the taxpayer never takes title to the underlying property in a contract exchange.
Lengthen Your Holding Period. The words “held for” are a key element of the definition of property qualifying for exchange under Code Section 1031. Property acquired for an exchange that is not “held for” the prescribed purpose cannot be exchanged tax free. How long one must “hold” property before an exchange is uncertain. Most tax attorneys believe that the taxpayer should hold each exchange property for a minimum of one year. Utilizing a contract exchange has a big advantage in that the date of acquisition of the contract is the date that it was signed. If the taxpayer were to instead close on the underlying property, his holding period would re-start at the date of closing. If the property is a residence, then the taxpayer would be required to demonstrate his intent to hold the underlying real estate for investment or business use, typically by renting the property until the required period of at least a year was met prior to the exchange.
A contract exchange bypasses this requirement. By exchanging the contract rather than the underlying property, there is no need to endure the risks and headaches in serving as a landlord, and the clock starts ticking for satisfying the holding period on the date that the contract was signed.
What does the Tax Code Say?
Pre-closing Contracts. Exchanges of options and pre-closing contracts are not a heavily litigated issue, so there are not an overwhelming number of court cases to serve as precedent when analyzing whether a particular contract exchange is permissible. The primary issue to be decided is: whether the pre-closing contract or option is an interest in real property, or alternatively, is it a mere “intangible asset” similar to other contract rights such as an insurance contract, or an employment contract. Under Code Section 1031, all qualifying exchanges must involve two or more assets that are considered “like-kind” to each other. “Like-kind” has been interpreted in an expansive manner when real estate is involved—a taxpayer can swap undeveloped raw land for an office building, a 30 year lease in a development project, an apartment complex or a vacation home. Concerning personal property, or intangible property, the law is much stricter. For example, a male breeding cow cannot be exchanged under §1031 for a female cow.
With respect to a pre-closing contract, there are a number of cases referred to as “bundle of rights” cases that generally treat pre-closing contracts as equivalent to real estate. They are predicated on the idea that ownership of real property is really ownership of a “bundle” of rights with respect to that real estate: the right to use the property, the right to exclude others, the right to collect rents, the right to sell the property, the right to the underlying minerals, oil and natural resources on the property. A pre-closing contract is treated as one of these rights—the right to obtain full ownership by paying the purchase price, and thus these cases permit exchanges of pre-closing contracts.
Options. Options have much less authority one way or another. The best authority on options is contained in Internal Revenue Service Field Service Advice Memorandum 1995-12. A Field Service Memorandum (FSA) is not binding on the Internal Revenue Service for any taxpayer other than the one involved in the specific ruling, and cannot be cited as precedent by other taxpayers. While other taxpayers may not rely on the decision to serve as precedent, when the Internal Revenue Service issues a Field Service Advice Memorandum (FSA), a Private Letter Ruling (PLR), or a Technical Advice Memorandum, such rulings do give taxpayers an indication of how the IRS will likely treat future transactions with similar fact patterns.
FSA 1995-12 involved an exchange of an option on property A, for the full ownership interest in property B. The IRS Assistant Chief Counsel’s Opinion stated the following:
“Your doubt as to the applicability of section 1031 apparently centers upon whether exchanging land for an option to acquire land constitutes a like kind exchange. We do not view that as the disqualifying aspect…. While at its root the transaction appears to involve the exchange of land for an option to acquire land, it would be contrary to Service position to challenge nonrecognition of the swap on that basis…
Field Service Advice Memorandum 1995-12 is the only guidance one way or the other that explicitly addresses whether an option to acquire real property may be exchanged in a qualified Code Section 1031 for a full fee-simple interest in replacement property. In cases where the IRS “changes it mind” on such issues, they often release bulletins indicating that they will not continue to follow their previous rulings with respect to future transactions. As of the date of printing for this article, the Internal Revenue Service has not issued any bulletins retracting FSA 1995-12 with respect to future transactions, so it has served as in effect for over 10 years.
Since unexercised options have fewer of the incidents of ownership in real property than do pre-closing contracts, the fact that the Internal Revenue Service considers option exchanges acceptable under §1031 significantly bolsters the case that pre-closing contracts qualify as like-kind to real property.
Conclusion. Taxpayers who have held contracts on property in hot markets for more than a very short time, or options to purchase real estate that have gone up substantially, may wish to use a contract exchange to lock-in their appreciation. The process of closing on the property, or exercising their options and buying the real estate is not only more costly and full of risk than exchanging the option or pre-closing contract, it also will cause serious delay and extend the holding period to the point where the gains the taxpayer wishes to lock-in may no longer be there. If the taxpayer is serious about eliminating downside risk in this volatile market, a contract exchange may be the only way to go other than biting the bullet and paying the tax.
While contract exchanges are “cutting-edge” law that lacks the long history of traditional exchanges, there are strong legal arguments that they are permissible, and there is no significant contrary authority that would disqualify contract exchanges from being entitled to the benefits of Code Section 1031 qualification.
(Again, we want to stress the fact, to talk to Your tax professionals before making any descissions.)
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