Foreclosure rates have increased dramatically recently, and the trend is expected to continue through the last quarter of 2007. Many foreclosed owners suffer a second indignity when they discover that they owe a substantial capital gains tax resulting from the foreclosure. The final straw comes when they learn that the gain could have been deferred through a 1031 exchange despite the fact that there was zero equity from the foreclosed property.

            When appreciated real estate is to be sold, many taxpayers are aware that they can defer income tax on the gain by entering into a like-kind exchange under Section 1031 of the internal Revenue Code. When real estate is to be foreclosed on, however, few taxpayers are aware that they too may need a 1031 exchange since they may have “phantom income” if the debt encumbering the foreclosed property exceeds the fair market value of the property.

            For income tax purposes, a foreclosure (and a deed in lieu of foreclosure) is treated as a sale despite the involuntary nature of the proceeding. Gain from the “sale” is equal to the amount realized over the adjusted basis of the property.

            With nonrecourse debt, the amount realized is equal to the outstanding amount of the nonrecourse debt, regardless of the current fair market value (”FMV”) of the asset (i.e. the “phantom gain”). When recourse debt is discharged through a foreclosure, the transaction is treated as (i) a sale of the real estate for its FMV (with gain equal to the difference between the FMV and adjusted basis) and (ii) cancellation of debt (”COD”) income, taxed at ordinary rates, for the amount of the debt relieved that exceeds the FMV. The tax code does provide some exceptions to recognition of COD income for insolvent and bankrupt taxpayers, in exchange for reduction of certain tax attributes.

            IRC § 1031 provides that no gain or loss will be recognized on the exchange of properly held for productive use in a trade or business or for investment if the property is exchanged for property of a like kind. The regulations which define the term “like kind real property” generally consider US real property to be of like kind to all other US real property. There is no requirement in the Code or the Regulations that a taxpayer must have equity in the property being transferred for the exchange to be valid.

            A taxpayer engaging in an otherwise valid like kind exchange will recognize gain if “boot” is received. Boot includes cash and the fair market value of any property other than qualifying like kind property. Boot also includes any relief from debt on the property-being sold, unless the taxpayer acquires a property with an equal amount of debt.

            If a foreclosure or deed in lieu of foreclosure is inevitable, then the real estate owner can opt to enter into a deferred exchange transferring the distressed property to a qualified intermediary (”QI”). The QI disposes of the property by allowing the lender to complete the foreclosure. The QI would receive no proceeds from the sale, and would therefore not be required to spend any funds on the replacement property. The replacement property would, however, need to have a FMV equal or greater than the foreclosed property, and debt equal to or greater than the debt on the foreclosed property in order to avoid the receipt of boot.

            Since it is doubtful that the real estate owner will be able to obtain 100% financing for the replacement property, it will be necessary for the owner to invest additional capital into the replacement property. The taxpayer and the QI would effectuate the purchase like a traditional exchange, with the exception being that the taxpayer would bring any required equity to the closing. The cost of expending additional capital, however, should be weighed against the tax resulting from the phantom income that would otherwise be due. In most cases, it makes sense to do the exchange. A taxpayer thinking about entering into this type of exchange should consult with a tax professional.

I am sure many of you have recently read articles telling of horror stories of Qualified Intermediaries running into the sunset with their clients money. It’s sad to say but it has happened. The Exchangors doing business with these companies either were misinformed about the security features offered by the companies or they did not ask any questions about what was happening with their funds.

Make sure your funds are in an INDIVIDUAL, DUAL SIGNATORY ACCOUNT and make sure that you are receiving monthly statements directly from the bank or that you can call and get the current balance on your account from the bank.

Ask if they are bonded and insured.

Ask if they are members of the FEA and if they have a Certified Exchange Specialist on staff.

Remember not to focus on the price of the exchange - You get what you pay for. If you want superior knowledge, protection and service, it’s going to cost you a reasonable fee but in the long run you are going to be thankful for the security in knowing your exchange was completed correctly and you have no worries.

The bitterness of poor quality remains long after the sweetness of low price is forgotten 

You have the right to know these things.

Click here to see all the security features that All States 1031 has to offer.

http://www.allstates1031.com/about-all-states-1031-exchange/security.php

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QUESTION - “My dad would like to exchange 80 acres of corn/soybean ground in Illinois for a piece of waterfront property in eastern Oregon. The property in Illinois is all corn, with some “natural/conservation” along the drainages. The property in Oregon is made up of three parcels. One parcel is natural sage brush, the other parcel has grape/apple/cherry orchard and a house.

My family would live in the house and continue to operate the orchard. In the future, my dad would retire and build on the parcel that is currently in sage brush.

Does this qualify as like-kind?? Other complications??

ANSWER- The answer to this question isn’t a simple one. The easy part of this is the actual real estate. If the property qualifies as investment property then it can be exchanged for other investment property. However, with the crops, or if there are assets, etc. with the property those types of things can be exchanged but not for real estate. Please contact us at 877-395-1031 to discuss the transaction further.

QUESTION - “Can I identify a replacement property and purchase it and before I sell the intitial investment property and still use a 1031 tax exchange? I have a piece of property that i want to divest, but I want to purchase another piece quickly and I don’t know how long it will take me to sell my current property. ”

ANSWER- The answer is Yes! You can buy first and sell later by using a Reverse Exchange. It is a complicated transaction that requires your QI to take title to your replacement property and hold it until you sell your Relinquished property. We have done many, many of these types of exchanges. We have a few articles as well that you can read about doing a reverse exchange the links are below.

http://www.allstates1031.com/reverse-exchanges/reverse-exchanges.php

http://www.allstates1031.com/news-events/articles/All-States-1031-Reverse-Exchange.pdf

If you have “closed” on your sale then you are too late. By “closed” I mean you have received the proceeds from the sale.

At All States 1031 we can initiate your exchange in minutes. You can call us from the closing table and we can get you started right away. We don’t prefer this method but we can and will do it for you at no additional cost to our normal fees. Š

This entry is for your questions. Post anything you like. If you have questions on exchanging or on your transaction or questions on what qualifies post it here and one of our experts will give you all the information you are looking for right away. Responses will be no more than 24 hours. If you have an emergency and need to speak to someone right now Call us at 877-395-1031 or email us at Exchange@allstates1031.com.

In a typical investment property sale, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date or through proper tax planning, eliminated. Section 1031 of the Internal Revenue Code 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.

For example:

Exchangor X sells property A in MA (a 3 family rental). X paid $200,000 for A when it was purchased 9 years ago. X is selling A for $500,000. X has a capital gain of $300,000 that he would have to realize and pay capital gains tax on without the section 1031 exchange. The approximate amount of tax X would pay on the sale is 15% for federal and 5% state which is $90,000. X buys a ranch in NM for $500,000. Completes his exchange and pays $0.

By entering into a section 1031 exchange with a Qualified Intermediary, such as All States 1031, X now has $90,000 that he can use to reinvest rather than handing it over Uncle Sam. Good deal right?

Owners of rental property who are not “real estate professionals” and whose income is over $100,000 may have suspended passive activity losses. These owners should be aware of the treatment of these suspended losses if they are contemplating a 1031 exchange.

Passive Activities

Prior to 1986, a taxpayer could generally deduct losses in full from rental activities and trades or businesses regardless of his or her participation. This gave rise to significant numbers of tax shelters that allowed taxpayers to deduct non-economic losses against wages and investment income. The Tax Reform Act of 1986, added IRC § 469, which limits the taxpayer’s ability to deduct losses from businesses in which he or she does not materially participate and from rental activities.

In general, losses generated by passive activities can only be used to offset income generated by passive activities. The rental of real estate is considered a passive activity. There are some exceptions to the general rule including the following:

A. $25,000 Deduction: Rental real estate losses up to $25,000 may be deducted by an individual whose modified adjusted gross income (MAGI) is less than $100,000. To qualify for this offset, the taxpayer must actively participate (make management decisions), own at least 10 percent and not be a limited partner. The $25,000 exception is phased out at the rate of 50 cents for every dollar of MAGI over $100,000. Therefore, when MAGI exceeds $150,000, the $25,000 offset is not allowed.

B. Real Estate Professionals: A real estate professional may be able to deduct all current rental real estate losses regardless of how high his MAGI might be. To deduct losses without limit, the taxpayer must spend more than half of his time in real property businesses and work more than 750 hours a year and materially participate (works on a regular, continuous and substantial basis in operations) in each separate rental real estate activity.

So what happens to the losses if the real estate owner is not a real estate professional and the $25,000 deduction is phased out? The real estate owner has suspended passive activity losses (“PALs”) that can be carried forward indefinitely until there is passive income or an entire disposition in a fully taxable transaction.

1031 Exchanges and Passive Activity Losses

If a real estate owner disposes of his entire interest in a passive activity to an unrelated person in a fully taxable transaction, he may offset any gain with all passive activity losses allocable to the activity, not limited by the PAL rules. A fully taxable transaction is one in which all realized gain is recognized.

If the owner has substantial PALs that would offset the bulk of his gain, then the owner would better off selling the property outright and not doing a 1031 exchange. If the owner, however, has a substantial unrealized gain, his best option would be to do a 1031 exchange, using the PALs to offset boot recognized in the exchange. Alternatively, the owner could exchange the property to defer the gain and continue to carryforward the PALs until they can be used.

How or when is boot recognized in an exchange? The two most common examples are cash received at the closing of the property being sold or cash received at the end of the exchange because the real estate owner purchased a less expensive property. An example illustrates how this would work. A real estate owner decides to sell his rental property for $500,000. He has a tax basis of $100,000 and $50,000 of suspended passive activity losses. If he simply sold the property outright, his $400,000 gain would be reduced by the $50,000 of PALs, leaving him with a $350,000 taxable gain. If he opted to do a 1031 exchange, he could arrange to receive $50,000 at the closing, exchange the rest and fully defer the gain. The $50,000 cash boot would be taxable, but it would be reduced by the $50,000 in PALs resulting in no gain being recognized.

Real estate owners with significant PALs should consult with their tax advisors before doing an exchange.