Archive for the ‘Qualifying Properties’ Category
Monday, August 31st, 2009 by Moore McLaughlin
The 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.
Tags: 1031, 1031 exchange, All States, Certified Exchange Specialist, CES, investment, investment property, Moore McLaughlin, partnership exchange, partnership interest, QI, qualified intermediary, reverse 1031 exchange, reverse exchange
Posted in 1031 Exchange Basics, 1031 myths, FAQs, Qualifying Properties, Reverse Exchanges
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.
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.
Tags: 1031, 1031 exchange, 1031 myths, All States, commingle exchange security, construction exchange, exchange funds, gain, improvement exchange, investment, investment property, IRS, Moore McLaughlin, QI, qualified intermediary, qualifying property, reverse 1031 exchange, reverse exchange
Posted in 1031 Exchange Basics, 1031 myths, Choosing a Qualified Intermediary, FAQs, Qualifying Properties, Reverse Exchanges
Monday, August 17th, 2009 by Moore McLaughlin
According to Dan Hartman, Senior Mortgage Advisor, Province Mortgage Associates, Inc. located in Providence, Rhode Island, the FHA will 
issue new guidelines affecting condo lending. The new guidelines will be more favorable to allowing commercial space in the development, will reduce the minimum number of units required to just 2, and will permit phasing. These and other changes will have a positive impact of those seeking to do 1031 exchanges. Click here to read Dan’s full article.
While dealer property will not qualify for 1031 exchanges, many people own single condos that have been used to produce investment income, some people convert their primary residence to rental, and some people convert a vacation condo to rental. Remember that pure vacation homes, and second homes, do not qualify for 1031 exchange treatment. When buyers have more options for financing, they can more easily close on the condo of their choice. Alexandra Hart and I see many situations where a seller and a buyer want to close a deal, but the buyer is unable to secure financing. These new FHA guidelines could help condo buyers obtain financing more easily and close more deals.
Furthermore, the new lending guidelines may help finance a reverse or construction exchange. Reverse exchanges are increasingly popular in the current market when it takes an exchanger longer than expected to close on the sale of their relinquished property. In the meantime, the exchanger may need to act quickly to buy a replacement property that has just been reduced to a great price. Another great tool in the current market is the construction or improvement exchange. With a large inventory of short sale and foreclosure properties available, an exchanger may want to acquire a “rehab project” that is of a lesser value than their relinquished property. Instead of paying tax on the “buy down” difference, they can put that money towards improvements to their replacement property tax-free. Construction exchanges can also be used for demolition or if the exchanger wants to raw land and build a new structure.
If you are interested in learning more about these new FHA guidelines, or if you have any financing questions, please contact Dan Hartman directly at 401-263-8655 or by e-mail at DHartman@provincemai.com.
For more information about forward, reverse or construction 1031 exchanges or the types of property that qualify, please contact Alexandra L. Hart at 877-395-1031 ext. 217 or by e-mail at AHart@AllStates1031.com.
Tags: 1031, 1031 exchange, All States, construction exchange, convert, Dan Hartman, FHA Guidelines, improvement exchange, Inc., investment, investment property, Moore McLaughlin, primary residence, Province Mortgage Associates, QI, qualified intermediary, qualifying property, reverse 1031 exchange, reverse exchange, vacation home
Posted in 1031 Exchange Basics, Construction Exchanges, Qualifying Properties, Reverse Exchanges
Sunday, August 2nd, 2009 by Moore McLaughlin
The 1031 exchange is a powerful income tax savings and deferral tool. With proper planning and implementation, 1031 exchanges can be an integral part of estate tax planning. As with 1031 exchanges, anyone wishing to establish a well-thought out and properly considered estate plan is well advised to seek the services of a tax attorney who specializes in estate tax planning.
The primary reason why 1031 exchanges can be used so effectively in estate planning is because of the law that allows the heirs to receive a stepped-up basis in the assets transferred to them upon death. Capital gains are calculated based on the difference between the amount received from the sale of the asset and the seller’s adjusted tax basis. The seller’s adjusted tax basis is the amount paid for the asset originally, plus the cost of capital improvements, reduced by the amount of depreciation deductions taken over the years. If the amount received (including debt paid off or assumed) exceeds the adjusted tax basis, a capital gain results. A 1031 exchange allows the seller to avoid gain recognition, in part, by transferring the basis from the relinquished property to the replacement property. Then, if the replacement property is ever sold, the deferred gain may be recognized or deferred again with another 1031 exchange.
However, if the replacement property is owned by the exchanger upon the exchanger’s death, then the heirs get to “step up” the basis to the property’s fair market value as of the date of death. If the heirs sell the property the next day, no gain is recognized because the basis of the property was increased to an amount equal to the fair market value. In this instance, the gain that was deferred by the 1031 exchange is permanently avoided.
Exchangers are sometimes confronted with the decision of whether to sell a property and take back a promissory note, i.e. seller financing. In such a case, the seller would recognize the capital gain over time, as payments are made under the terms of the promissory note. The downside to this plan, from an estate tax perspective, is that the heirs do not get to step up the basis in the promissory note. As a result, the entire amount of gain must be recognized at some point in the future as payments are received.
Most seniors and retirees look at an asset as merely a producer of an income stream, whether payments under a note, net rent from an investment property, or stock dividends. Many times, these seniors and retirees are looking for an income stream that is generated without any effort on their part. They’ve put in their time over the years and are looking for passive income.
A 1031 exchange is the perfect solution because of the IRS definition of real estate and the development of tenant-in-common (TIC) investments 
and the proliferation of single-tenant triple-net lease properties. I’ve worked with many people in this exact situation and they come to realize that they can enjoy a greater stream of income by reinvesting all of their sales proceeds, not just the net after taxes. 1031 exchanges all investors to achieve a higher reinvestment capital through the power of tax deferral. furthermore, distributions from TIC investments are often times easier to split up amongst heirs than leaving behind a physical piece of real estate, especially one that requires hands-on management.
To learn more about estate tax planning, click here.
To learn more about various types of passive investments that qualify for 1031 exchange replacement property, click here.
For more information about estate planning, contact F. Moore McLaughlin, Esq, CPA, CES(r) at 401-421-5115 x212 or by e-mail at mmclaughlinquinn@mclaughlinquinn.com.
Tags: 1031, 1031 exchange, All States, capital gains tax, Certified Exchange Specialist, CES, CPA, estate planning, estate tax planning, investment, investment property, Moore McLaughlin, QI, qualified intermediary, qualifying property, tax attorney, Tenant In Common, TIC
Posted in 1031 Exchange Basics, FAQs, Qualifying Properties, Tenants-in-Common
Tuesday, July 21st, 2009 by Moore McLaughlin
Everyone from the greatest tax attorney on down knows that the Internal Revenue Code is complicated and impossible to understand. I’ve always maintained that the easiest way to achieve true tax simplification is to pass a law requiring everyone in Congress and the President to prepare their own tax returns, by hand, and be subjected to a line-by-line audit. I guarantee that the tax code would be shortened and made easier to understand. I’m not sure that would be so great for tax attorneys, but I’m sure it would be good for America.
Since we know this will never happen, we are left with trying to understand the laws as they are currently written. Fortunately, a few of us 
make our living understanding and applying the tax laws in ways to help our clients. I have been teaching tax law to CPAs, attorneys, real estate brokers, real estate and other investors, and anyone who will listen since I began practicing law over 17 years ago. I believed then, and I believe even more strongly now, that those who are better educated about how the tax laws work have a decided advantage over those who don’t. Seeking an experienced professional is certainly a wise move, but the client who has more than a mere passing knowledge of the tax laws will, in the long run, be more successful than his or her peers who lack a solid understanding. Remembering that it is not what you make, but what you keep that is important.
All of this brings me to the topic of 1031 exchanges. 1031 exchanges are a very powerful tool, in the right hands. While in many respects 1031 exchanges are very simple, and should scare no one, certain complex nuances can be exploited to save even more taxes when used properly. Alexandra Hart and I spend a good portion of our work time educating investors and their professionals about basic and not-so-basic aspects of 1031 exchanges and debunking the most common myths and misunderstandings about 1031 exchanges. We send out monthly educational newsletters to further educate exchangors and their advisors.
One of the basic areas where we educate investors deals with what types of properties qualify for 1031 exchanges. Once people learn that they can exchange a three-family rental for a commercial building, or raw land for improved land, or property in Rhode Island for property in Florida, they start to see the unlimited possibilities. We educate exchangors about the time constraints set forth for 1031 exchanges. Exchangors who understand these rules make better decisions about which properties to pursue. Alexandra spends many hours each week speaking with CPAs explaining how to calculate the tax a client would owe without the exchange and how to compare it to the tax savings of doing the exchange.
We also explain the possibilities of investing in tenant-in-common arrangements, whereby a small investor can leverage his or her exchange proceeds into a larger, more profitable, and easier-to-manage property, all within the rules of section 1031. Again, education is the key. These investors are more informed and geneally make smarter investment decisions.
I encourage everyone who is interested in exchanging to read, read and read, and ask questions. As a caveat, make sure you ask the right people, not your brother, your neighbor, or your friend from the gym (unless these people are trained in 1031 exchanges). Visit our website at www.allstates1031.com to read the many articles I have written. Continue checking this blog. Call or e-mail me or Alexandra or request our free 1031 exchange guide and start the education process early to give yourself the best chance for a successful 1031 exchange.
Tags: 1031, 1031 exchange, All States, Certified Exchange Specialist, CES, investment, investment property, IRS, Moore McLaughlin, QI, qualified intermediary, qualifying property, Tenant In Common, TIC
Posted in 1031 Exchange Basics, Choosing a Qualified Intermediary, FAQs, Qualifying Properties, Tenants-in-Common, Test Your Exchange IQ
Monday, July 6th, 2009 by Moore McLaughlin
I have read some recent posts on various websites proclaiming that 1031 exchanges are dead among Baby Boomers. As Mark Twain wrote from London after reading his own obituary, “The reports of my death are greatly exaggerated.” In fact, the baby boomers may be the demographic group that uses 1031 exchanges most frequently. The reasons are fairly obvious. Wealth is not accumulated overnight, usually. It takes time. The older you are, the more time you have had to accumulate wealth. Plus, those with wealth tend to have better tax and investment advisors who can teach them all the tricks.
But, most importantly, many baby boomers have undertaken extensive and appropriate estate planning and therefore understand the value of 1031 exchanges in an integrated estate plan. Exchangors can acquire the replacement property or properties and hold them until death. At this point, their heirs receive a stepped-up basis in the property and the capital gains tax has been completely avoided.
Some promoters are pitching a new product called a deferred sales trust. Looking beyond whether these types of structures actually achieve the touted tax results, and whether the funds are truly safe, and whether the return on the investment is reasonable, the tax results, especially compared to 1031 exchanges, must be analyzed. The premise behind the deferred sales trust is that the taxpayer sells the property and effectively receives an installment obligation, thereby allowing the gain to be recognized in future tax years when the payments are received. Two important tax consequences result from this structure.
First, as gain is recognized in subsequent years, the tax is imposed on these gains based on the tax rates in effect at the time. Since long-term capital gains rates are at historic lows right now, there is no where to go but up. So, a present value tax calculation should include the possibility that tax rates will increase. In Rhode Island, the tax rates on long-term capital gains recently increased from 1.67% to 9.9%, effective beginning in 2010. For federal tax purposes, President Obama campaigned on a pledge of higher taxes. As a result, the tax bite on an installment sale will not be insignificant.
Second, payments under installment sale notes are generally treated as income in respect of a decedent when received by the estate of a decedent. No step-up in basis is allowed. Thus, the estate or the heirs will pay the income tax. Not the case with 1031 exchange replacement property. Replacement property received by an estate or heirs steps-up the basis to its current fair market value. If the heirs or the estate sells the property at that value, no tax results. Not the case with installment sale notes.
Another important feature of 1031 exchanges for baby boomers, and other real estate investors, is the ability to exchange into qualifying replacement properties that require little or no active owner involvement. Many Tenant-In-Common investments are available whereby exchangors can buy a fractional interest in a property and have the property professionally managed for them. Single-tenant triple-net properties are also available, as are shopping malls with triple-net tenants. An exchangor should consult with a professional in searching for the various options that are available. Or, visit the Property Exchange web page sponsored for free by All States 1031 Exchange Facilitator, LLC.
For these reasons, as well as many others, the 1031 exchange often makes more sense than the deferred sales trust. In any event, consult with a tax attorney, preferably one who is also a CPA and a Certified Exchange Specialist, who can explain the differences and help you decide which option makes the most sense for a particular person and scenario.
Tags: 1031, 1031 exchange, All States, baby boomers, capital gains tax, Certified Exchange Specialist, CES, deferred sales trust, estate planning, estate tax, FEA, Federation of Exchange Accommodators, installment sale, installment sale note, investment, investment property, Moore McLaughlin, promissory note, QI, qualified intermediary, Rhode Island, trust
Posted in 1031 Exchange Basics, 1031 News, Qualifying Properties, Tenants-in-Common
Monday, June 8th, 2009 by Alexandra Hart
As an exchange consultant, I receive the same sad phone call at least once a month: “I just sold my investment property and I’d like to do a 1031 exchange.” Unfortunately, once the closing has happened and the seller receives the proceeds- it’s too late to do a 1031 exchange. They will be stuck paying the tax that they could have deferred (if they had just called me earlier). Generally, that’s about 25% (or more) of their gain going to the IRS instead of giving themselves a higher reinvestment capital by deferring the tax. The same is true for buyers- if they want to defer taxes with a reverse 1031 exchange, they must get in touch with a Qualified Intermediary (QI) like All States 1031 prior to the closing.
In fact, I get calls literally from the closing table: “I’m at the closing- is it too late to do a 1031 exchange?” No- it’s not too late to do a 1031 exchange! I can draft the necessary 1031 documents very quickly and it is still possible to defer taxes at that point with a 1031 exchange (and still close on time!). Planning ahead is the best way to ensure a seamless 1031 exchange. Often times, I receive calls from people who are merely thinking about selling their investment property. I am happy to answer any questions or give complimentary consultations. The more time someone has to plan ahead, the better they will fully understand all of the 1031 rules and the exchange process.
For example, many exchangers think that 45 days to identify potential replacement properties is not enough time. This “exchange clock” starts ticking once the exchanger sells their relinquished property. However, if the exchanger plans ahead, they can start looking for potential replacement properties before they even sell, therefore giving them much longer than 45 days to make such an important decision. I’ve seen many organized exchangers coordinate their sale closing and purchase closing to be within days of each other- that way they don’t even have to worry about the 45 or 180 day time limits.
If you are considering buying or selling investment property, or for more tips on planning ahead for a 1031 exchange, please call me toll free at (877) 395-1031 extension 217 or e-mail me at AHart@AllStates1031.com
Tags: 1031, 1031 advice, 1031 consultant, 1031 exchange, 1031 Facilitator, 1031 Intermediary, 1031 tips, 180 days, 45 days, Add new tag, capital gain tax, capital gains tax, complimentary 1031 consultation, exchange advice, exchange consultant, exchange consultation, Exchange Facilitator, exchange time lines, exchange tips, like kind exchange, planning ahead, QI, qualified intermediary, real estate excahnge, reverse exchange, tax deferred exchange, tax free exchange, time limits
Posted in 1031 Exchange Basics, Choosing a Qualified Intermediary, FAQs, Qualifying Properties
Monday, June 18th, 2007 by Moore McLaughlin
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.
Tags: 1031, 1031 exchange, All States, crops, farm, investment property, qualifying property
Posted in 1031 Exchange Basics, FAQs, Qualifying Properties
Monday, June 18th, 2007 by Moore McLaughlin
QUESTION - “Can I identify a replacement property and purchase it before I sell my original investment property and still use a 1031 tax exchange? I have a piece of property that I want to sell, 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 Qualified Intermediary 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.
Tags: 1031, All States, reverse 1031 exchange, reverse exchange
Posted in 1031 Exchange Basics, Choosing a Qualified Intermediary, FAQs, Qualifying Properties, Test Your Exchange IQ
Thursday, January 18th, 2007 by Moore McLaughlin
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.
Tags: 1031, 1031 exchange, 469, All States, boot, investment, investment property, IRS, PALs, passive activity losses, QI, qualified intermediary, real estate professionals, tax advisors
Posted in 1031 Exchange Basics, Qualifying Properties, Test Your Exchange IQ
