Tuesday, December 30, 2008

Can a Relative Live in My Rental or Investment Property?

This is actually a fairly common question. Can a taxpayer sell rental or investment property and acquire another rental or investment property through a 1031 tax deferred exchange and still qualify for tax deferred exchange treatment if a relative lives in the newly acquired property? The answer is fairly straight forward.

Treat it as Rental or Investment Property
The key is that the acquired property must be rental or investment property or used in your trade or business in order to qualify as like kind property. So, as long as the related party is paying the taxpayer fair market rent just like any other tenant would pay, it will qualify as like kind replacement property for tax deferred exchange treatment.

Risk of Being Recharacterized as a Second Home
There will be risk that the acquired property would be recharacterized or reclassified as a second home or vacation home instead of rental or investment property if the related party does not pay fair market rent to the taxpayer.

Vacation Property or Second Home
It is possible for a property held and used as your vacation property or your second home to qualify for tax deferred exchange treatment. It depends on a number of factors. The IRS also provided certain "Safe Harbors" for situations like this. I just recently posted a blog on this subject.

Monday, December 29, 2008

Trading Equal or Up in Value in a 1031 Exchange

Reinvest Total Investment Amount
This seems like a relatively straight forward issue, but it can get confusing for many investors. The concept is simple. Congress wants to make sure that investors trade equal or up in value (i.e. they stay fully invested) if they are going to be able to defer the payment of their capital gain taxes.

Most Investors Trade Way Up In Value
The actual required calculation for trading equal or up in value is not generally an issue because most investors are trading significantly up in value. However, some investors are not interested in expanding their real estate holdings, but do want to make sure that they defer all of their income taxes. Other investors are simply misinformed as to what trading equal or up in value means.

It's Not Just Reinvesting Your Equity
First, trading equal or up in value does not mean just reinvesting all of your cash, equity or capital gain in the property. The investor must do that also, but it is based on the net sales price and not just the investor's equity or capital gain in the property.

The two (2) rules are as follows:
  1. Trade equal or up in value based upon the net sales price of the relinquished property; and
  2. Reinvest 100% of the net cash proceeds from the sale of the relinquished property.

It is technically based on your net sales price, so if you want to cut the reinvestment as close as possible, you can calculate your reinvestment by taking your gross sales price and subtracting your routine closing costs to arrive at your net sales price. The next sales price is the correct amount of value that you must reinvest in your like-kind replacement property.

Friday, December 26, 2008

Backdating the Identification Form in Your 1031 Exchange

You are probably very familiar with the 45 day identification period if you have ever completed a 1031 exchange transaction. The taxpayer must identify in writing the potential replacement properties that they are considering buying as part of their 1031 exchange transaction, and the identification must be made with in 45 calendar days of the closing of the relinquished (sale) property.

45 Day Period Moves Fast
The 45 day identification period moves very quickly. In fact, it is only six weekends, which is not a lot of time to search for suitable like-kind replacement properties for your 1031 exchange. Taxpayers should start looking for replacement property well before they have closed on their relinquished properties to help minimize the stress involved with the 45 day ID period.

It is not surprising that many taxpayers may get a little stressed out during the 45 day identification process and time period. O.K. That might be an understatement in certain cases, especially as the taxpayer gets to the end of his or her identificatio period.

Backdating or Altering the Identification Form
Actually, my favorite question is "what is your position on the 45 day period?" I can't actually say this, but I really want to respond with "Are you kidding me?" The 45 day identification requirement is contained with the Internal Revenue Services, the Treasury Regulations and in numerous IRS rulings and court decisions. I think it is just about as clear as it can be that you must identify no later than midnight of the 45th day. There is no gray area here.

"But, ABC Exchange Company will allow me to backdate my identification form." "Nobody ever gets caught." These are some of my favorate follow-up comments that we get after we inform them that there is no flexibility with the 45 day identification requirement, even though we wish there were.

It's Tax Fraud; Pure and Simple
I realize that the IRS has been very loose in its enforcement of this area, but it will happen at somepoint in time. The act of backdating, altering or amending your identification form after the end of yoru 45 day identification period is tax fraud. There is no gray area.

I don't know about you, but I certainly do not want to be the poster boy for the IRS when they decide to actually prosecute some of these cases.

It is the same as the mortgage fraud was going on for years, which is part of the reason we are n the mess that we are in now. Clients used to respond all the time that no one ever gets caught if they say it was owner occupied when in fact it was rental property. We would still warn them. Well, the FBI is investigating and prosecuting those who lied right now. Its fraud, period.

Do you really want to take the chance that you might be the one that gets caught? More importantly, do you really want to work with a 1031 exchange company that is routinely breaking the law? I would prefer that they be around for a long time so that they are there for me if I get audited. Just my two cents.

Thursday, December 25, 2008

Merry Christmas

Twas the night before Christmas and all through the house not a creature was stirring...not even your 1031 exchange Qualified Intermediary!

Have a very Merry Christmas!

Wednesday, December 24, 2008

Two Party Swaps: Concurrent 1031 Exchanges

These type of 1031 exchanges are not that common, but they do happen on occassion. This post was triggered by a recent call that I received. The caller said that he wanted this other person's investment property and coincidentally the other person wanted an investment property that he had. He wanted to know if they merely "swapped" properties if that would qualify as a tax-deferred exchange.

Classic Two Party Swap

This is a classic two party swap or concurrent 1031 exchange. You might also hear it referred to as a simultaneous 1031 exchange. It is actually the most basic type of tax-deferred exchange or 1031 exchange and is the structure often used years ago before the current delayed exchange was allowed by the courts through the Starker cases.

You have two investors that simply want each other's investment property. This tax-deferred exchange is often over complicated by the parties involved when it should be a relatively straight forward tax-deferred exchange.

Concurrent Recording of Deeds

The procedures to complete this tax-deferred exchange are very simple. The two parties simply draw up deeds for each of their properties granting the property to the other party. The two deeds are then recorded concurrently or simultaneously, and you have accomplished the two party swap.

Property Market Values

This assumes of course that both properties are worth the same amount. One party may owe the other party a cash payment in order to "equalize" the values if the properties are not equal value. The party that receives the cash payment will recognize tax on the cash portion received or he or can set up a delayed tax-deferred exchange with a Qualified Intermediary or Accommodator.

Professional Qualified Intermediary

The use of a professional Qualified Intermediary is not generally needed when you are structuring a classic two party swap. However, you must make sure that everything is structured and recorded concurrently.

Investors often retain a professional Qualified Intermediary in order to make sure that the necessary steps are taken to protect the tax-deferred exchange transaction. This will ensure that the proper tax-deferred exchange documentation is completed accurately and there is no accidental error that could invalidate the tax-deferred exchange.

You might also want to review some of the blog posts on this subject on the Exeter Discussion Board.

Consult with Tax Advisor

Both parties should of course consult their tax advisor before proceeding with a two party swap in order to ensure that the values are correct. Any complication due to property market value or outstanding debt, etc., can be dealt with before recording the deeds.

Tuesday, December 23, 2008

Does My Vacation Property Qualify for 1031 Exchange Treatment?

I can't tell you how many debates I have listened to or participated in regarding vacation homes or vacation property and whether it does or does not qualify for 1031 exchange treatment. The arguments were always the same. Would the IRS consider the property held for personal use or held for investment?

The more the vacation property or second home is held and used as investment property the better you were, and the more that you used the property for personal use the less likely it was that it would qualify for 1031 exchange treatment.

Moore vs. Commissioner
There was a court decision in Moore vs. Commissioner that held that a vacation home or vacation property must be primarily held for investment and not primarily held for personal use or enjoyment in order to qualify for 1031 exchange treatment.

Revenue Procedure 2008-16
The Internal Revenue Service issued Rev. Proc. 2008-16, which addressed this issue very well. It was in fact a very generous ruling in favor of the taxpayer. We updated our extensive article regarding the qualifications of a vacation property or second home and whether it qualifies for 1031 exchange treatment.

Safe Harbor Ruling
However, the Rev. Proc. only provides certain safe harbors. This means that if you fall within the safe harbors you will qualify for 1031 exchange treatment. But, it also means that if you fall outside of the safe harbors it does NOT mean that you do not qualify. It just means that you can not take advantage of the safe harbor provisions, but you must be extra careful when proceeding with your 1031 exchange going forward.

Strategic Thoughts
Vacation properties or second homes that fall outside of the Rev. Proc. may still qualify for 1031 exchange treatment. Taxpayers merely have to be more diligent in their planning to ensure a successful 1031 exchange.

Here are some thoughts that you may wish to consider:
  • Rent out the vacation property or second home as much as possible.
  • Put the vacation property or second home in a rental pool.
  • Limit your personal use of the property to less than 14 days per year if at all possible.
  • Don't use the property for any personal use in the year in which you will sell the property.
  • Treat and report the property as investment property for income tax purposes, including depreciation (the IRS will tax you later on deprecation recapture whether you depreciated the property or not).
  • Always charge fair market rental rates when you rent the vacation property or second home to your relatives and friends that use the property and make sure that you report this on your income tax return.
  • The best of all solutions is to cease all personal use for at least 12 months before the sale and rent the property for 100% of that time. This way it is well documented that you are holding it for investment purposes and are collecting rent and paying taxes as investment property.
You can easily structure the sale of your vacation property or second home so that it will qualify for 1031 tax deferred exchange treatment if you follow the above suggestions and leave plenty of time to do so.

Deferred Sales Trust to the Rescue
However, for those who do not have time to properly structure the sale of your vacation property or second home for 1031 tax deferred exchange treatment, you may wish to consider the Deferred Sales Trust as a tax deferred solution on the sale of your property. Property does not have to be investment property in order to take advantage of the Deferred Sales Trust.

Monday, December 22, 2008

Selling an Easement on Your Property for a Billboard

Sale of an Easement
You own real estate and someone approaches you with a special request. They would like to buy an easement on your property so that they can put up a billboard for advertisements. The offer is attractive, and you really want to accept, but you are worried about the income tax consequences and contact your tax advisor for guidance.

Is It a Sale of a Real Estate Interest?
This is where a little creative thinking can go a long way. The sale of an easement on your real property is generally considered a partial sale of real estate because you are granting a right of way on your real property to someone else. You need to verify that the sale of an easement is considered to be a sale of a real property interest in the state in which the subject property is located.

1031 Tax Deferred Exchange
It is considered to be a sale of real estate in most states, so the sale of the easement can be structured as a sale of real estate and therefore will qualify for 1031 exchange treatment. You can sell the easement or right of way and set-up a 1031 exchange and buy replacement property in order to defer the payment of your captial gain taxes from the sale of the easement.

You might even want to approach one of these outdoor advertising vendors with the idea. It might be a great strategy to generate some liquid cash that can be reinvested tax deferred through a 1031 exchange into investment property that produces monthly cash flow.

Tax Deferred Investment Solutions
The 1031 exchange does, of course, require that you reinvest in replacement property. You may not wish to buy replacement property through a 1031 exchange when you sell an easement to your real property. In this case, you would need to decide if you wish to cash out and pay the taxes in the current year or look for ways to defer the payment of the taxes over a period of time. Certain taxpayers may wish to look at the Deferred Sales Trust as an alternative strategy to the 1031 exchange transaction.

Sunday, December 21, 2008

Can I Buy More Than One Property in My 1031 Exchange?

There is a common misconception that taxpayers who are completing a 1031 exchange can only sell one relinquished property and buy one replacement property, and nothing could be further from the truth. One of the benefits of the 1031 exchange is the ability to use the 1031 exchange strategy to diversify or consolidate your investment portfolio.

Diversification Strategy
Generally, younger investors are trying to trade up in value by selling one relinquished property and buy two or more replacement properties. This will usually provide them with more units, more cash flow and better diversification (risk management).

Consolidation Strategy
The opposite of the diversification strategy is the consolidation strategy. This is often implemented by taxpayers that are apporaching retirement or are in retirement and are tired of the property management headaches involved with owning investment property. It is a very effective life simplification strategy by selling more than one relinquished property and buying fewer replacement properties or properties that are easy to maintain and manage.

Tax Deferred Solution
1031 exchanges allow taxpayers to reposition or rebalance their investment portfolios by selling and buying one or more properties without having to pay depreciation recapture taxes and capital gain taxes. The only downside is that it does require that you buy replacement property in order to defer the payment of your income taxes.

Taxpayers that are not interested in buying more investment properties will need to look for other tax deferral solutions. They might want to consider the Deferred Sales Trust.

Saturday, December 20, 2008

Can I Change the Property that I have Identified in My 1031 Exchange

The 1031 exchange requires that you sell an exchange property (relinquished property) and acquire other property (replacement property in order to defer the payment of your capital gain taxes.

Replacement Property Identification
The 1031 exchange process requires that you identify the replacement property or properties that yu are going to acquire as your replacement property within your 1031 exchange. The identification must be made within 45 days from the date that you sold and closed on the sale of your exchange or relinquished property.

Changing Identified Property
The question that comes up all the time is can I change the replacement properties that I have already identified as part of my 1031 exchange. The answer is: It depends.

You can change your mind and revoke your identified properties at any time as long as you are still within your 45 calendar day identification period. Simply contact your 1031 exchange Qualified Intermediary and find out how they want you to revoke the identification that you already provided them with. I would recommend that you make a complete revocation of your previous identification even if you do not want to revoke all of the properties and then make a completely new identification on a separate identication form. This keeps the entire process nice and clean.

However, you can not change your mind and revoke your replacement property identification if you are outside of your 45 day identification period. You can only change your mind during the 45 day ID period, but not after the 45 ID period has past.

Beware of Changing Your Mind After the 45 Day Period
There are those 1031 exchange Qualified Intermediaries that allow you to amend, alter or change your identification period after the 45 day period. I get the comment all the time: It doesn't matter; THEY let me do it. Actually, they are allowing YOU to commit TAX FRAUD. I know that it is tempting, but it is tax fraud none the less.