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Dispelling 1031 Myths, part 5

Monday, October 12th, 2009 by Moore McLaughlin

MermaidIn our continuing effort to help investors understand the rules of 1031 exchanges, we present two more common myths.  Avoiding these myths and misconceptions will allow investors to maxmimize the return on their investments by reducing the amount of taxes they pay.

Myth No. 9

I only have to reinvest my gain.  Or, I only have to reinvest my cash proceeds.

If Alexandra and I have heard this once, we have heard it a million times.  The general rule of 1031 exchanges is that the exchanger must buy a replacement property that is equal to or greater in value than the relinquished property.  The 1031 rules require the exchanger to reinvest their adjusted sales price, not just their gain or cash equity.  The reason is because Section 1031 requires an exchanger to receive like-kind property.  Luckily, all United States real estate is like-kind to all other United States real estate, regardless of the type or grade. Non-like kind property (called boot) typically consists of cash or debt relief.  To the extent that an exchanger trades down in value (i.e. buys a replacement property of less value than the relinquished property), than the exchanger receives boot, in the form of cash or debt relief equal to the amount of the trade down. Net boot received will always be taxed, to the extent of the taxpayer’s gain. However, often times, paying some tax is better than paying all the tax if no exchange is completed.

So, the easy rule to remember is for the exchanger to buy a replacement property or properties of equal or great value than their relinquished property or properties.  The good news, though, is that once these rules are understood, the exchanger realizes that he or she can trade down in value a little without blowing up the whole exchange.  Instead, a small amount of gain is recognized, while the balance of the gain is deferred.  Thus, the 1031 transaction is still worth doing. To learn more about partially tax-deferred exchanges or taking some cash at the closing, please click here.

Myth No. 10

I can exchange my primary residence tax-free under section 1031.

A primary residence does not qualify under section 1031.  In order for a property to qualify under section 1031, the property must be held for the productive use in a trade or business or held for investment.  Under these rules, a primary residence is held for personal use, therefore it is not deemed to be held for investment.  Thus, a primary residence generally does not qualify under Section 1031.

However, Section 121 provides for gain exclusion on the sale of a principal residence, if certain criteria are met.  If these criteria are satisfied, up to $250,000 of gain may be excluded (up to $500,000 for joint returns).  The basic rule of section 121 requires that the seller own and occupy the property as a primary residence for at least 2 out of the previous 5 years.  However, if the property was acquired as part of a previous 1031 exchange (and the taxpayer converted it from a rental property to their primary residence), than the taxpayer must own the property for 5 years and live there as a primary residence for at least 2 out of the 5 years before they may be eligible for the 121 exclusion. Furthermore, effective January 1, 2009, an amendment to the 121 exclusion will affect the amount of gain exclusion allowed for primary residences with a rental history (AKA “non-qualifying use”). In the event that the gain exceeds this exclusion amount, capital gain must be recognized and cannot be deferred even if a replacement primary residence is purchased.  If you are interested in learning more about the tax consequences of the sale of your home, you should consult an experienced tax attorney or CPA to learn more about section 121. It is especially important to consult with your tax advisor if your primary residence has or had an investment or business-use component (i.e. a home office or rental unit). Certain combination or consecutive use properties may allow for the combination of section 121 and section 1031, thereby maximizing the potential tax exclusion and deferral.

So, even for those lucky homeowners who say “…but my home is the best investment I ever made,” I say, “That may be true, but generally, it does not qualify under section 1031.” We continue dispelling as many 1031 myths as we can.  Stay tuned for more 1031 myths in the near future; or call us toll free at 877-395-1031 or contact Alexandra L. Hart by e-mail at ahart@allstates1031.com.

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Posted in 1031 Exchange Basics, 1031 myths, FAQs, Qualifying Properties

Dispelling 1031 Myths, part 4

Monday, September 28th, 2009 by Moore McLaughlin

Loch Ness MonsterAlexandra Hart and I are still amazed that we hear so many of the same myths and misconceptions every week about 1031 exchanges, what properties qualify and how exchanges work.  Unfortunately, many of the myths result in someone not exchanging when a 1031 would have saved a significant amount of taxes.  Here are two more myths that we hear as reasons not to do an exchange.

Myth No. 7

In order for a 1031 exchange to work, I have to find someone who has property I want and who wants my property.

Not true.  The IRS has allowed so-called delayed or deferred exchanges for many years.  For a number of years, no guidance existed on how to handle deferred exchanges.  In the late 1970’s, the Starker case held that a 1031 exchange did not have to be simultaneous.  Subsequently, the tax law was changed which allowed deferred exchanges, subject to certain limitations.

Now deferred exchanges are the norm.  We very rarely see direct swaps of property, although they are certainly allowed.  Most exchanges are effected by exchangers who sell their relinquished property to an unrelated third-party buyer and then purchase the replacement property from someone who is unrelated to either the exchanger or the buyer of the relinquished property.  In fact, in many cases neither the buyer of the relinquished property nor the seller of the replacement property are doing 1031 exchanges.  Although, in many cases they are.

The deferred exchanges must meet several simple rules.  The exchanger must acquire the replacement property within the earlier of 180 days from the sale of the relinquished property or the due date of the tax return (including extensions).  The exchanger must identify the potential replacement properties within 45 days from the sale of the relinquished property.  And, lastly, the exchanger should use a qualified intermediary (QI) or other safe harbor to avoid receipt of the sales proceeds from the sale of the relinquished property.  Following these rules, and a few others, will ensure a valid 1031 exchange.

Myth No. 8

If I fail to identify property within 45 days or if I fail to acquire sufficient replacement property during the exchange period, I will lose my money or be hit with severe penalties by the IRS.

Failure of an exchange results in no penalties and you will not lose your money.  An exchanger who fails to identify any property during the 45-day identification period will have his or her exchange proceeds returned on Day 46.  Likewise, an exchanger who fails to acquire any property during the exchange period will receive the exchanges funds on Day 181.  Please click here to read more about at what points during the exchange period the exchanger is allowed to get their money back.  The only economic loss is the fee charged by the intermediary, which is typcially minimal compared to the potential tax savings.

A failed 1031 exchange is treated merely as a sale of the relinquished property, subject to whatever taxes would have been imposed had a 1031 exchange not been attempted.  Even better, the exchange that begins in one tax year and fails in the subsequent tax year is treated as an installment sale with the possibility of significant tax deferral.  Click here for more information on the tax treatement of a failed exchange.

In any event, once sellers become aware of these realities, most realize that they have nothing to fear from a failed exchange and decide to enter into the exchange to preserve the right to defer taxes.

Stay tuned for more posts exposing the myths of 1031 exchanges that keep investors from saving taxes.

For more information on 1031 exchanges, contact Moore McLaughlin by e-mail at fmm@allstates1031.com or Alexandra L. Hart at ahart@allstates1031.com or by call toll-free at 877-395-1031.

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Posted in 1031 Exchange Basics, 1031 myths, FAQs, Test Your Exchange IQ

Dispelling 1031 Myths, part 3

Monday, August 31st, 2009 by Moore McLaughlin

UnicornThe following are two additional myths that trip up investors and cause them to pay more taxes than they should.  This post is a continuation of my previous posts where I am trying to help investors understand the power of 1031 exchanges and not fall into certain misunderstandings.

 Myth No. 5

 I can’t do a 1031 exchange because I am purchasing the Replacement Property and I haven’t sold my Relinquished property yet.

A reverse exchange is the “flip side” of a deferred exchange, where an investor directly or indirectly acquires a like kind replacement property before disposing of a relinquished property. Once the replacement property is acquired, the investor has 180 days from that date to close on the sale of their relinquished property (or until the due date of their tax return, including extensions). In the current real estate market, owners of real estate often face the prospect of losing the opportunity to acquire a desirable replacement property when the seller of such property is unwilling or unable to wait while the investor completes the disposition of a relinquished property. Sellers in today’s market may have a hard time estimating how many days their relinquished property will be listed on the market for sale before the deal will actually close. Furthermore, it is taking buyers more time than usual to secure financing and get to the closing table. However, in the meantime, perhaps the seller has found the perfect replacement property, or a property that has just been reduced and now the price is right and they need to act quickly. Or perhaps a business owner who is relocating may desire to purchase their new office space before selling their current office space to accommodate a smooth transition of employees and daily operations. A reverse exchange is perfect for these scenarios.

 On October 2, 2000 the Internal Revenue Service (”IRS”) issued Revenue Procedure 2000-37 providing guidance on structuring reverse exchanges to avoid IRS challenge.  The Revenue Procedure describes a safe harbor for reverse exchanges if certain requirements are met.  All States 1031 has been a leader in structuring and implementing reverse exchanges, and has formed an affiliated company, All States Reverse Exchange Facilitator, LLC, to handle the high volume of transactions. Taxpayers contemplating a reverse exchange also need to consider their financing options in advance. It is important to note that if a taxpayer wishes to defer taxes with a reverse exchange, they must contact a Qualified Intermediary like All States 1031 before they close on the purchase of their replacement property. Anyone considering the purchase or sale of investment property is encouraged to call Alexandra L. Hart at All States 1031 toll free at (877) 395-1031 for a complimentary consultation.  Planning ahead is the best way to ensure a seamless 1031 exchange, so call today!

 Myth No. 6

 My partners don’t want to exchange, so I’m going to exchange my partnership interest.

 Exchanges of partnership interests generally do not qualify for non-recognition treatment under IRC § 1031.  Therefore, when partners want to end their relationship, they cannot each exchange out of their partnership interests into another partnership interest or real property under IRC § 1031. Such transactions can be structured as 1031 exchanges, however, by converting the partnership interest into a real property interest. Once the partners dissolve their partnership and hold the property as tenants in common, they can each defer taxes with their own 1031 exchange(s), or some partners can take cash at closing and pay tax on their portion. The various structures include partnership split-ups, split-offs, buy-outs and formations. Such transactions are often referred to as “drop & swaps” or “swap & drops.” Structuring these transactions is not without tax risk, and requires the advice of an experienced tax professional. When partners are selling investment property and no longer want to stay in the partnership, the key to structuring a successful exchange is to plan ahead. Once the partnership has signed a legal contract to sell, it may be too late to structure a 1031 exchange, since the name on the contract should not be the partnership entity, unless the partnership is staying together to buy the replacement property. However, with proper planning, it is possible for each partner to get exactly what they want out of the sale. The owner of All States 1031, F. Moore McLaughlin, IV, Esq., CPA, CES®, is a licensed tax attorney and nationally recognized educational speaker on this subject. To start planning ahead for a partnership exchange, please call Attorney McLaughlin toll free at (877) 395-1031 for a complimentary consultation.

Educate yourself and don’t fall for these common myths. 

Check back for more posts dispelling other myths about 1031 exchanges.  In the meantime, click here for more 1031 myths or contact me or Alexandra L. Hart at 877-395-1031 or by e-mail fmm@allstates1031.com or ahart@allstates1031.com.

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Posted in 1031 Exchange Basics, 1031 myths, FAQs, Qualifying Properties, Reverse Exchanges

Dispelling 1031 Myths, part 2

Thursday, August 20th, 2009 by Moore McLaughlin

The following is a continuation from a previous post regarding some common myths surrounding 1031 exchanges.  Taxpayers who understand the rules of section 1031 and do not fall for the many myths will save more taxes and see better returns from their investments.  Here are two more of the tops myths that Alexandra and I hear daily.Bigfoot

Myth No. 3

 I heard that 1031 exchanges are only for the big investors.

 Actually, anyone who owns investment property should consider a §1031 exchange before selling.  The property size and value do not matter when considering a 1031 exchange. All that matters is the gain and the tax consequences. It’s fair to assume that about a quarter of the gain will go to the IRS in taxes if no exchange is completed. If the property has a low basis or has appreciated in value, the owner should seriously consider a 1031 exchange before selling. IRS code section 1031 is the only legal way to defer taxes on the sale of investment or business-use property. Currently, real estate sales are taxed at the 15% federal long-term capital gains tax rate, plus the state tax rate, plus 25% tax on any depreciation deductions taken. Furthermore, with tax rates rising steeply, it gives investors an even greater reason to do a 1031 exchange and defer that tax. The more taxes that are deferred, the more money the investor can retain to work for them in their next investment. Whether they are selling a small rental unit or an office building, they can simply pay the gain and throw away their hard earned money, or effectuate a §1031 exchange, preserving their capital and building their wealth. Any investor should consult a tax adviser who is familiar with §1031 exchanges to determine the most beneficial strategy.

 Myth No. 4

 I’ll just have my attorney hold the sales proceeds in escrow while I look for Replacement Property.

IRS regulations specifically exclude the investor’s agent, broker, attorney, accountant, most family members and other related parties or agents who have acted on the investor’s behalf within the previous two years from acting as the exchange facilitator or Qualified Intermediary (QI) for a tax-deferred exchange. To ensure compliance with the latest IRS regulations and updates, the investor should choose a well established full-time Qualified Intermediary, not someone who merely “dabbles” in exchanges. Generally, companies who are exclusively devoted to structuring and facilitating 1031 exchanges have streamlined the process and offer the most competitive fees. Typically, the fee for a QI can range from $750 - $7,500, depending on the QI and the complexity of the exchange. Furthermore, the QI should have instituted financial safeguards such as a fidelity bond and insurance to protect the sales proceeds during the exchange. Ideally, the QI will set up a separately segregated dual signatory exchange account for each exchange client, not a co-mingled or sub-account. Furthermore, sale proceeds should be deposited in a liquid money market account at a stable financial institution or back to ensure preservation of principal and liquidity of funds. Click here to learn about how All States 1031 secures clients’ funds. Finally, be sure to ask the QI certain due diligence questions to make sure that the owners and operators of the company have a comprehensive understanding of the tax code, preferably with tax attorneys, CPAs, and Certified Exchange Specialists® on staff.

Don’t fall for these common myths.  You will save money in the long-run and be a smarter investor.

Check back for more posts dispelling other myths about 1031 exchanges.  In the meantime, click here for more 1031 myths or contact me or Alexandra Hart at 877-395-1031 or by e-mail fmm@allstates1031.com or ahart@allstates1031.com.

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Posted in 1031 Exchange Basics, 1031 myths, Choosing a Qualified Intermediary, FAQs, Qualifying Properties, Reverse Exchanges

Dispelling 1031 Myths, part 1

Monday, August 10th, 2009 by Moore McLaughlin

ufoOver the next few posts, I will be dispelling many of the common myths surrounding 1031 exchanges.  The confusion and misunderstandings caused by the myths has resulted in many taxpayers paying more taxes than they should.  By paying the excess taxes, the non-exchangers have reduced the amount that they can reinvest, thereby needlessly reducing their income.

Myth No. 1

I sold a single-family rental property, thus I must buy a single-family rental property.

Alexandra and I hear this all the time.  Similarly, we hear “I can only trade raw land for raw land” or “multi-family for multi-family” or “Massachusetts property for Massachusetts property.”  In actuality, Section 1031 requires an exchange of “like-kind” property.  When dealing with real estate, “like-kind” is defined as any interest in real property.  Therefore, an exchanger can trade a single-family rental property for a commercial building.  Raw land can be exchanged for developed land.  Massachusetts real estate can be exchanged for Florida real estate.

Fractional interests can be exchanged for fee simple (or undivided) interests.  Likewise, fee simple interests can be exchanged for tenants-in-common interests.  Often times we see exchangers selling fee simple interests in Rhode Island property and buying TICs in other states.

Conservation easements, development rights, air rights and other intangible real estate rights can qualify as real property and be exchanged for fee simple interests, TICs and other real estate investments.

In summary, real estate is broadly defined.  Tax courts look to local law in determining if an interest is “real property”.  If the interest is real property, then the exchanger has a very wide array of options

Myth No. 2

My property is not worth enough for the trouble of a 1031 exchange.

Nothing could be further from the truth.  First of all, 1031 exchanges are very easy, especially with All States 1031 Exchange Facilitator, LLC.  We handle all the paperwork to satisfy the stringent requirements of the IRS and hold your hand throughout the entire process.  Our experience and knowledge of the tax law and the 1031 exchange process allows us to simply everything for you.

Second, the key in determining the value of the 1031 exchange is to look at the amount of taxes that will be deferred, not the selling price of the relinquished property.  The amount of the tax that will be deferred is based on the amount of gain that will be recognized if you do not complete an exchange.  Your CPA or other tax return preparer can help you with the exact calculation or use our capital gains calculator to determine an estimate of your tax.  In any event, even for a low selling price, a taxpayer who has owned the property for many years or who otherwise has a low adjusted tax basis may be staring at a large tax bill.  the other component of determining your tax is the tax rate.  The federal long-term capital gains rate is currently 15%.  However, under several proposals, this rate could increase to 20%, 28% or higher.  Don’t forget that any depreciation you have taken gets taxed at 25% currently.  And, for some of you, various states will impose taxes.  For example, Rhode Island just increased its tax on long-term capital gains from 1.67% to 9.9%.  By exchanging real estate in a 1031 exchange, all of these taxes can be deferred, and the tax money reinvested in your new property.

So, even a relatively low selling price of $300,000 by a person with an adjusted tax basis of $100,000 could result in a tax of over $50,000.  Instead of sending that money to the government, why not reinvest it and reap the rewards of the larger investment?

In summary, understand the facts of 1031 exchanges and don’t fall for these common myths.  You will save money in the long-run and be a smarter investor.

Check back for more posts dispelling other myths about 1031 exchanges.  In the meantime, click here for more 1031 myths or contact me or Alexandra Hart at 877-395-1031 or by e-mail fmm@allstates1031.com or ahart@allstates1031.com.

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Posted in 1031 Exchange Basics, 1031 myths, FAQs, Tenants-in-Common