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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

Education is Key to Tax Savings

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 little-red-school-house1make 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.

school-booksI 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.

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Posted in 1031 Exchange Basics, Choosing a Qualified Intermediary, FAQs, Qualifying Properties, Tenants-in-Common, Test Your Exchange IQ

Beware of buying replacement property from related parties

Tuesday, July 14th, 2009 by Moore McLaughlin

United States Tax CourtIn Ocmulgee Fields, Inc. (2009), the United States Tax Court had another opportunity to consider whether a taxpayer can acquire replacement property from a related party in a 1031 like-kind exchange.  Relying on its prior decision in Teruya Brothers, Ltd. (2005), the court rejected the claimed like-kind exchange even though the replacement property had been acquired through a qualified intermediary.  The Tax Court indicated its belief that the basis shifting that occurs in a like-kind exchange is sufficient grounds to apply the anti-abuse rule in Code Section 1031(f)(4). The case is important because it highlights the potential tax risk in acquiring replacement property from a related party.

In general, Congress and the IRS have always cast a wary eye on transactions between related parties.  The Internal Revenue Code does not contain a blanket ban on such transactions.  However, many sections of the tax code apply special rules where Congress or the IRS suspects a greater potential for abuse.  In particular with section 1031, the IRS and the courts have generally held that an exchanger cannot purchase replacement property from a related party.  One exception is where the related party is also doing a 1031 exchange, and buying from an unrelated party.

Interestingly, however, the IRS and the courts have recently ruled on several occasions that an exchanger may sell the relinquished property to a related party without violating the letter or spirit of the related party rules under section 1031.

The moral of this case is to be aware of the relationships among all of the parties to an exchange and consult an experienced tax attorney when in doubt.  If you would like to know more about the recent cases, or related party exchanges, contact All States 1031 Exchange Facilitator, LLC owner F. Moore McLaughlin, Esq., CPA, CES at fmm@allstates1031.com or Alexandra L. Hart at ahart@allstates1031.com or by calling at 877-395-1031.

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Piling On: Foreclosure Sales Can Trigger Unexpected Tax

Thursday, November 15th, 2007 by Moore McLaughlin

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.

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Tax Planning Alert – Using Passive Activity Losses in a 1031 Exchange

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.

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