Get Flash to see this player.

(Listen Here 3:35 min)

Many people ask “Why do I have to assign my purchase agreement to my Qualified Intermediary?” Even more, they ask “Why do I have to give notice that I am assigning my contract to my intermediary to all of the other persons involved in the purchase agreement?” It seems intrusive to have to give everyone notice that you are doing and exchange. Why is it anyone’s business?

Old School Requirements

Let’s go back in time before the current Treasury regulations were in place. We would actually deed or transfer our property to the Intermediary. The Intermediary acted as a straw man, so that they became the seller of the relinquished property and the purchaser of the replacement property. So, your Intermediary actually went into title and then participated in the transfer or the purchase of the property.

Modern 1031 Tax Techniques Allows Mere Assignment

Thankfully, today, our Intermediaries do not have to legally take title. We can accomplish the same function by simply assigning to the Intermediary our rights in the relinquished property purchase agreement, or our rights in the replacement property purchase agreement, and that is deemed to be the same as if the Intermediary actually took our property from us, or received the replacement property for our benefit.

Faster, Cheaper…Direct Deeding for 1031 Exchanges

The benefit here is that we do not have to deed a property. We do not have to pay for extra recording fees, and we do not have to go through all of that extra hassle of actually deeding the intermediary into the chain of title. However, the Treasury regulations say that if you are going to have direct deeding, that is the exchanger deeds the relinquished property to the buyer, and the seller of the replacement property deeds the replacement property to the exchanger. Then, we have to give written notice of this assignment to the Intermediary to all of the other parties to the purchase agreement. Remember, in old common law, an assignment was never considered effective unless all of the parties to that agreement were given notice.

Why Would the IRS Adopt an Old Common Law Assignment Rule

And so, the Treasury regulations sort of adopted this old rule. And, I think that is perhaps so that unscrupulous folks can’t fabricate an exchange. They can’t say “You know that deal that we did back last year?  That was a 1031 exchange.” The way to catch them in that lie would be to say, “Well, show us where you gave written notice to the other parties of the purchase agreement.” If they can’t show, well then maybe it wasn’t a 1031 from the outset.

Get Flash to see this player.

(Listen Here 3:13 min)

Contract Deeds or Executor Contracts, basically installment sales, create a lot of questions. Here is one that I get a lot. I sold my property ten years ago on an installment sale, a Contract for Deed. And now, I am being paid off, and I am getting this balloon payment from the buyer. Question: Can I do a 1031 Exchange on this windfall of cash that I am receiving?

Understand the Timing -  When Did the Sale Take Place

 If you look at this transaction, it may appear that the sale is now occurring because when the balloon payment is given to the vendor, the deed will be delivered to the vendee. So, it feels like perhaps the sale is occurring now. But, for Federal Tax purposes, the sale probably occurred ten years ago when the Contract for Deed or the installment sale was entered into.

Who is Really the Owner of the Property

When a Contract for Deed is given, the purchaser or vendee is considered to be the equitable owner of the property. They probably bear the risk of loss if the property is destroyed. They probably bear the burden of paying the property taxes to the local property tax assessor. And, under the contract, they probably enjoy the possession, the exclusive use of the property. So, for Federal Tax Purposes, the Contract for Deed vendee probably acquired the property way back when the initial Contract for Deed was entered into. Now, when this windfall is coming in, we are not really selling the property anymore, we are just receiving payoff like any other lender who has loaned money to a purchaser.

Section 1031 Does Not Apply to “Evidence of Indebtedness”

When a Contract for Deed vendor holds that legal title, they don’t necessarily own the property anymore. They really own an enforcement mechanism. In the event of a default under the Contract for Deed, they can swoop in and cancel the Contract for Deed. This is an enforcement mechanism much like a mortgagee’s interest or bank’s interest in a mortgaged property. They are really a creditor, not so much a property owner for Federal Tax Purposes.

Get Flash to see this player.

(Listen Here 2:53 min)

A lot of people wonder, “Can I purchase my replacement property on a Contract for Deed?” As financing gets more and more challenging, seller arranged financing looks more appealing. So, if we can find a seller that will convey the property to us on a Contract for Deed, will that property work as a 1031 replacement property?

How Can This Work for a 1031 Exchange…
if I do Not have Full Legal Title?

The question might be lingering in the back of your mind. Yes, I know that I am the vendee, but I know that the vendor still has legal title. I also know that as a purchaser under a Contract for Deed, I don’t receive the actual deed until I am done making my payments. So, query whether this qualifies as a 1031 Exchange.

The Question is…Who is the Owner for Federal Tax Purposes

The answer is probably because a Contract for Deed vendee receives the benefits and burdens of ownership. And, you want to make sure that your Contract for Deed is drafted so that it does give you the benefits and burdens of ownership because you bear the risk of loss of the property if destroyed, because you bear the obligation to pay the property taxes, because you have exclusive possession of the property. All of these factors really weigh on the side of you being the equitable owner of the property and the equivalent of the owner of a fee interest in real estate for Federal Tax purposes.

Put the Exchange Funds Down as the Down-Stoke…
If You’re the Owner

 So, you can purchase your replacement property on a Contract for Deed. In theory, you would take all of your proceeds, all of your net proceeds from your relinquished property and plunk that down as your down-payment. Then you would make incremental installment payments going forward until the Contract for Deed is satisfied at which time you would receive the deed for the property. However, in the interim, you are the equitable owner of the property, and that should be sufficient to complete your 1031 Exchange.

Get Flash to see this player.

(Listen Here 3:06 min)

Sometimes people want to do a 1031 Exchange into a property that they plan on immediately occupying as their home. And, they wonder to themselves – well, I know that I have to treat my replacement property as either business property, property used in my trade, or as investment property. Well, I hope that my personal residence goes up in value, so it must be an investment, right?

Recent 1031 Tax Court Case – on 1031 Property Exchange of Lake Cabin

In a case called Moore vs. The Commissioner of Internal Revenue, a similar question was put before the tax court. A person was trying to do a 1031 Exchange from a second home lake cabin into a bigger, better second home lake cabin. The taxpayer in the case said “Well, you know that this is a scarce commodity, and I anticipate that it will go up in value. I hope it goes up.” The taxpayer was trying to make the argument that, even though it was his second, his lake cabin that he never rented out, never advertised as a business property that it was held for investment, so that it should qualify for 1031.

Hoping For an Increase In Value on Your
“Personal Use” Property ≠ Investment

The tax court did not buy this argument. They said “Yes, everybody hopes that their primary residences and second homes go up in value. But, we really need to look at how you use the property to decipher what your intention was. Was your intention primarily to use the property for recreational and personal use? Or, was your intention to hold it for investment?”

1031 Lesson Learned – Do Not Hold Primarily for Personal Use

Under the facts of the Moore case, the taxpayer was found to primarily hold the property for personal use. So, getting back to our question, “Can I call my replacement property home/personal residence an investment, especially if I move into it immediately after I have completed my exchange?” The answer is probably, no. That would not qualify because your use as your home is antithetical, completely opposite to use in one’s business, use in one’s trade, or holding for investment.

Get Flash to see this player.

(Listen Here 4:49 min)

When you are doing a 1031 Exchange, you generally want to hit three benchmarks called the napkin test. These are generalities that typically bear out to be good indicators of whether or not all of the gains will be deferred in a 1031 Exchange. Here are the benchmarks.

Step One - Equal or Greater Value

One, you typically want to buy a replacement property of equal or greater value than the relinquished property that you gave up. So, we want to go up in value, and get a bigger, better property.

 Step Two - Equal or Greater Equity

Secondly, we want to take all of our net equity, all of our proceeds from the disposition, the sale of our relinquished property. Imagine a big stack of poker chips in front of your relinquished property. I want to slide all of those poker chips over into the replacement property. So, I am moving all of my equity from A to B. So, the second rule of thumb is I want to move all of my equity into the replacement property rather than taking any cash or chips off the table, which would be treated as taxable boot.

Step Three - Off-set Your Debt Relief

The last benchmark, the third thing that I am trying to juggle, is that to the extent that I am paying off mortgages and debt on the relinquished property, I need to offset that debt relief with either new debt taken out in conjunction with the replacement property. So, I could take out a new purchase money mortgage, or I could assume the seller’s existing mortgage that would satisfy my debt relief if I acquired a replacement property with at least an equivalent amount of debt. Or, alternatively, I can offset my debt relief by putting more of my own cash into the replacement property. Cash in will also offset debt relief.

Coming Up Short on “Sufficient Value”

 Well, here is where things get a little bit crazy. What if a person wants to acquire a replacement property that is not of sufficient value, but they are willing to gross up that price, fabricate, inflate the value of the price and report the transaction as if they acquired a replacement property of greater value. Let’s say that the real value of the property is $100,000, but the taxpayer grosses up the sale price to $150,000, so that they acquiring a replacement property of sufficient value. Suppose that they are buying from a friend who is willing to go along with it. Perhaps the friend is even willing to split the difference and to send back some of that inflated proceeds to the purchaser. They will give it back under the table. This is not acceptable. Filing a false or fraudulent tax return is a criminal offense. Knowing and willful attempts to evade or defeat income tax due is a crime.

There is a big difference between legally deferring your taxes in a proper 1031 Exchange and stretching the truth to fabricating the value of your replacement property.

Do Not Do the Crime

Section 7201 says that any person who willfully attempts to evade or defeat any tax imposed by this title, or the payment thereof, shall in addition to other penalties provided by law, be guilty of a felony. And, upon conviction thereof, shall be imprisoned not more than five years. Or they may be fined not more than $250,000 for individuals or both together with the costs of prosecution.

Get Flash to see this player.

(Listen Here 6:01 min)

Today’s podcast is highlighting some of the changes that came from the American Recovery and Reinvestment Act of 2009 – otherwise known as the Tax Stimulus Package. In particular, we are going to be talking about Section 25A, which is the Hope Scholarship Credit. Remember, a tax credit is like a negative tax. It offsets dollar for dollar your liability to the government, and it is better than a deduction.

Old Section 25A on Steroids

Here are some of the enhancements for tax years 2009 and 2010. This has been entitled by the government, The American Opportunity Tax Credit. But, it is really just an enhancement of Section 25A, which is for the Hope Scholarship Credit. Under the old Hope Credit, you were able to take a credit for one hundred per cent of the first $1,200 expended for tuition and related expenses. Then you were able to take a credit for fifty per cent of the next $1,200. So, the maximum credit under the old rule was $1,800.

The New Rule is Better

You get to take one hundred per cent of the first $2,000 and then twenty five per cent of the next $4,000 that is expended for tuition and related expenses. (That’s a total $2,500 tax exclusion) By the way, that now includes “course materials”. So, it is a broader definition for what we can spend our money on. Under the old Hope Credit, you were only allowed to take this exclusion for the first two years of Post Secondary Education. The new version allows us to take it for up to four years. So it is a broadening to include four years of Post Secondary Education. Thus, if you are on the four year plan, you should be able to cover all four years of college.

More People Qualify

Another enhancement is that they have expanded the range of people who qualify to take this credit. Under the old rule, there was a phase out. If you made two much money, the credit was no longer available to you. Those phase outs started around $50,000 for single filers and $100,000 for joint filers. Under the new rule, those phase outs have been raised. So, a person making $80,000 (Adjusted Gross Income or AGI) for single filers and $160,000 (AGI) for joint filers is where the phase outs now start to kick in. Under the new rule, if your income for a single filer equals $90,000 (AGI) or $180,000 (AGI) for a joint filer, then you are phased out from taking these credits.

If Child Claims Exclusion – They Must Provide 50% Support

One thing that continues, though, is that if a child is going to take this credit for themselves, they have to provide for more than fifty per cent of their own support. So, unfortunately, if Mom and Dad are providing for more than fifty per cent of a child’s support, that child won’t be able to take this tax credit.

This Credit keeps Getting Better

One interesting facet of this new legislation is that this credit applies against the alternative minimum tax (AMT).

And Partially Refundable

What if you have very little income, and you have very little tax liability because of the low income, and you get this credit? Can you take the credit? Normally, a credit offsets your tax liability dollar for dollar. But, what if the amount of your credit exceeds the amount of your tax liability or your debt to the government? This is a unique tax credit in that it is refundable or partially refundable. Forty per cent of this credit can be paid to you as a refund if the amount of your credit exceeds the amount of your income tax liability. So, as an example, let’s say that if I have zero tax liability for 2009, but I fully qualify for one-hundred percent of this credit. That means that forty percent of the $2,500 credit will be paid to me as a refund. Remember, forty percent times $2,500 equals $1,000 of cash in my pocket because up to forty per cent of this tax credit is refundable.

This is a Good Deal for Taxpayers

In summary, the old Section 25A Hope Credit was a good deal for taxpayers. The new version under the American Recovery Act and Reinvestment of 2009 is even better. It has expanded definitions of what we can spend money on, and it has expanded the range of taxpayers who can qualify because of a lengthened phase out period, and we can use it for more than two years. We can use it for four years of Post Secondary Education expenses. This is a wonderful tax incentive. It is designed to stimulate the economy and encourage education.

Get Flash to see this player.

(Listen Here 5:05 min)

Part Two - The Death Question

Section 102 of the internal revenue code says that an heir (beneficiary who inherits property) that receives property as a “gift, bequest, devise, or inheritance” takes that property tax-free.  It states “Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance”.

You can read Section 102 at: http://www2.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000102—-000-.html

Basis of an Heir

The question then becomes, what if your heir then sells the property that they received as an “inheritance” from you? What is the heir’s basis for calculating his or her gain?  Will the heir have any tax liability?

At present, Section 1014 of the internal revenue code allows your heirs to take your property with a “stepped up basis” [roughly Fair Market Value (FMV)] of the property at the time of your death) so they would not necessarily take over your low basis in the property.  However, the tax code in this area may change, so you need to talk about this with your CPA or your accountant.  Under current Section 1014(a) the general rule applied to property an heir receives from a decedent is that the heir's basis equals the fair market value of the property at the time the decedent dies.  Because of Section 1014, any appreciation of the affected property that occurred during the decedent's lifetime may never be taxed. The current operation of this code section provides an incentive for taxpayers to defer taxes throughout one’s lifetime until death.  One strategy that people refer to with 1031 exchanges is called “Defer, Defer, Defer,…Die”.  The idea is that one never recognizes any gains during one’s lifetime, but instead continually defers the recognition of gain (compounding and building wealth tax-free) until they die.

Section 1014(f) says that this section shall not apply to decedents who die after December 31, 2009.  This “sunset provision” came from the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).  According to EGTRRA, Section 1014 will be terminated. EGTRRA replaces Section 1014 with a modified “carryover basis” rule, under which the property will receive a basis equal to the lesser of the adjusted basis of the property in the hands of the decedent, or the fair market value of the property on the date of the decedent's death. So, your heirs would probably take over your low basis, and they would need to continue to defer the taxes by utilizing 1031 tax exchanges. The good news is that they could also continue the strategy of “Deferring, Deferring,  Deferring,…Dying”… generation after generation.

You can read Section 1014 at http://www2.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00001014—-000-.html

Get Flash to see this player.

(Listen Here 4:25 min)

Many people ask me questions along the lines of  “Over the years, I have invested a large amount of money into an investment property. How does this affect my taxes  if I sell the property or if I die?.”

First, I would like to talk about the sale vs. 1031 exchange part of the question, and then I would like to go into the ramifications of dying while owning the property.

Part One  - Selling ~ The 1031 Question

Section 1031 is a very “taxpayer friendly” provision of the internal revenue code.  It gives you a way to “sell” your investment property without having to recognize the gains.  This defers your taxes.  I just posted a video that you can watch on 1031 exchanges of collector coins at: http://www.youtube.com/watch?v=dgJmxbdPxRw  (click on this link)

There are some rules and regulations that you must follow in order to get this tax deferral.  One of the key rules is that your property must have been “held for investment or for use in your trade or business”.  I have some good information on this at: http://www.youtube.com/watch?v=AIolirun-88   (click on this link)

The other major requirement is that you have to re-invest your proceeds into “like-kind property”.  If you have watched the two videos (see hyper links above) then you have probably picked up that certain property held for investment can be exchanged for certain other like-kind coins that will be held for investment.

In a delayed exchange using a qualified intermediary, your proceeds from the sale must be invested in a like kind property within 180 days of the sale. Also, your replacement property must be identified within 45 days. 

Remember, 1031 exchanges are governed under the United States Tax Code which specifies that if an asset (such as a collector coin, real estate, business equipment, aircraft, race horses or agricultural equipment) is sold, and the proceeds of the sale are then reinvested in an asset of a like-kind, then no capital gain or loss is recognized. This  allows the deferment of capital gains taxes that would otherwise have been due on the first sale. You can read this code section at: http://www2.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00001031—-000-.html

Remember, both your relinquished property and your replacement property must be held either for investment or for productive use in a trade or business.

Why is a 1031 Tax Exchange Good For You?
Time Value of Money

The key benefit is that your capital gains tax liability that would otherwise become due is deferred under Section 1031 of the code. The main value to investors is that as long as your money continues to be re-invested (over and over again) in other qualifying like-kind property, your portfolio can continue to grow in value (without taxation).

Get Flash to see this player.

(Listen Here 4:57 min)

Normally in a 1031 exchange, you defer all of your capital gains (both from appreciation in value and depreciation deductions taken over the years) by acquiring a like-kind replacement of equal of more value; and equal of more equity.

In Tax Law – Nobody Wants Surprises

There are some situations when the relinquished property will have some tax complications (snakes in the grass) that could cause you to unexpectedly  recognize gain.  To make matters worse, the surprise gains could be characterized as ordinary income and taxed at higher rates than mere capital gains rates.

What Do You Need to Check Out?

Here are some things to check out with your CPA, accountant or tax attorney:

Tax Credits

When Congress wants to encourage investors to do something…they provide tax incentives.  One of the most effective tax incentive is to offer tax credits.  Tax credits are more valuable than mere deductions because they off-set your tax liability dollar-for-dollar. The problem is that tax credits on your relinquished property for either  “rehabilitation expenditures” under Section 47; or from “low income housing” under Section 42 may be recaptured. Both of these Tax Code Sections allow for recapture of the amount of the tax credits.  It is always prudent to check with your accountant BEFORE you sell…just to make sure you do not have any problems with old tax credits.

Special Recapture for Rapid Deprecation

If you were able to take rapid deprecation under Section 179 or you qualified for bonus deprecation for investment in the Gulf Opportunity (GO) Zone areas impacted by hurricanes Katrina, Rita, and Wilma, then you need to check into the recapture provisions of those specific programs if your property ceases to be Qualified GO Zone Property.

Section 1245 Gain

Cost segregation engineering studies are often used by property owner to peel out those components of a piece of real estate that can be more rapidly deprecated.  A typical commercial building is deprecated over 39 years.  That is a long deprecation schedule.  A multi-family apartment building can be deprecated over 27.5 years.  Certain components of real-estate can be re-classified and more rapidly deprecated over a 5..10..15 year schedule. Those components can cause you to have recapture, unless you are mindful and when you buy your replacement property you buy qualifying property that matches up component for component with those Cost Segregation properties that were more rapidly deprecated.

Conclusion

Be on the look out for recapture that could spoil your 1031 exchange.  Talk to your CPA or tax advisor and have them run a projection to make sure that there are not any snakes lying in the grass…waiting to give you the tax bite.

Get Flash to see this player.

(Listen Here 4:26 min)

Cars and trucks are getting more like-kind. The IRS recently issued a private letter ruling (LTR 200912004) specifically to a tax-payer that was a rental car company that conducted ongoing 1031 like-kind exchange programs. So, every time they disposed of their old rental cars, those were the disposition of “relinquished properties”. Every time they brought in new cars into their rental fleet, those were the “replacement properties”. This was an ongoing cycle, a program of exchanges that had been incorporated into their business model to have the most efficient (tax neutral sale) disposition of their properties. This particular taxpayer had a conundrum, because appreciable personal property such as rental cars are broken into different asset classes.

Cars and Trucks…Depreciable Tangible Personal Property are
 Normally Only Considered Like-Class to
Other Depreciable Tangible Personal Property in
the SAME *General Asset Class*

There are thirteen different “general asset classes” set out in Rev. Proc. 87-56. Two of those asset classes are applicable to this taxpayer’s property. Asset class 00.241 is for general purpose light duty trucks, while asset class 00.22 is for cars and taxis. Depreciable tangible personal property is of a like-class to other depreciable tangible personal property if the exchanged properties are either within the same General Asset Class or within the same (North American Industry Classification System – NAICS) Product Class. The conundrum that this taxpayer had is that since these general assets had been created, the car industry has morphed, and we now have ‘crossover vehicles’ and ‘sport utility vehicles’ and little ‘minivans’. There are cars that look like trucks, and trucks that look like cars, and it is hard to determine whether these automobiles and light duty trucks and crossovers (in the middle) are like-kind. Especially if they are in separate general asset classes.

Throw Out the Mumbo Gumbo “General Asset Classes”

Alright, this private letter ruling from the Internal Revenue Service is very taxpayer friendly because this acknowledges that the industry has changed, and that the regulation of automobiles has changed. The IRS basically said “Look, even though these items are not in the same general asset class, they can still be considered like-kind”. So, this private letter ruling is taxpayer friendly in that it acknowledges that the car industry has changed, and it gives the taxpayer the ability to exchange an SUV for a car… a light duty truck that is less than thirteen thousand pounds in weight for another automobile or SUV or minivan that is in that same general ‘genre of automobile’.

1031 Exchanges Just Got Easier

This private letter ruling is good for the U.S. automobile leasing industry. It is good for consumers, and it is good for America because Section 1031 stimulates economic growth by allowing business owners and investors to move their capital to the most advantageous replacement property. It also minimizes a drag that normally would occur from income tax and capital gains taxes. Section 1031 helps the automobile leasing industry, and it can help other investors and business owners also. Section 1031 is broader than just real estate. We can see in this private letter ruling that automobiles, light duty trucks and minivans all quality for 1031 treatment if they are exchanged for other like-kind property that will also be used in their trade or business of the taxpayer.