Revisiting Depreciation Recapture Issues When Cashing Out (Not 1031 Exchanging)

It is that time of year again when we field many questions regarding the reporting and tax treatment of 1031 Exchanges, or lack of 1031 Exchanges, on taxpayers income tax returns. 

There seems to be many more questions this year because many taxpayers just sold and cashed out rather than 1031 Exchanging again, and now have significant income tax liabilities. 

The one income tax issue involved with rental property that is often misunderstood is depreciation recapture.  Depreciation is mandatory if you buy and hold rental property or investment property, and the depreciation is deferred into the future upon sale of the rental property as long as you are structuring a 1031 Exchange transaction.  However, the depreciation will be recaptured upon sale if you are not 1031 Exchanging.

This is the reason that we have noticed an increase in depreciation recapture questions.  So, I thought that I would link to an discussion board post on depreciation recapture that will help explain the issue in greater detail.

1031 Tax Deferred Exchange of Internet Domain Names or URLs

I was speaking with a "Domainer" today and I thought this would be a good subject for my next blog post regarding 1031 Exchanges.  He was asking whether a Domainer could 1031 Exchange Internet domain names or website URL addresses for other Internet domain names or website URL addresses. 

What Is A Domainer?

First, you are probably asking yourself right about now what in the world is a "domainer" and what do they do.  I think you will be facinated by the technical definition.  I had to look it up for this post to make sure that I got it right, although I already had the general idea about domainers and domaining. 

Essentially, a domainer is someone that buys, sells, owns, and invests in Internet domain names or URL addresses for profit.  Domainers may buy and hold domain names/website URLs for sale or they may buy and position domain names/website URLs to product cash flow through a variety of strategies. 

Can You Defer Taxes On Sale of a Domain Name?

The question asked by this specific Domainer that called me was whether he could defer the payment of his capital gain taxes that resulted from the sale of an Internet domain name or URL address by buying (reinvesting in) another Internet domain name via a tax-deferred exchange. 

The short answer is yes.  The majority of taxpayers that are aware of 1031 Exchanges generally think that the strategy only applies only to real estate.  However, you can 1031 Exchange personal property, such as Internet domain names, as long as the Internet domain name was held for income production, investment or used in a trade or business. 

Domain names that are bought and held specifically for sale will not qualify for tax-deferred exchange treatment through a 1031 Exchange because they are treated as inventory in the Domainer's business and not as an asset used in the business or acquired and held for investment. 

Intent to Hold for Investment is Critical

The critical element in a 1031 Exchange of domain names is the Domainer's intent to hold the domain names for investment (as opposed to intent to hold as inventory for sale).  The sale and exchange of an Internet domain name that was acquired and held for investment or cash flow will qualify for 1031 Exchange treatment.  The sale of an Internet domain name that was merely bought and held with the intent to sell will not qualify for 1031 Exchange treatment. 

New Real Estate Blog and Discussion Board Launching

The Exeter Real Estate Blog has just been launched, and is looking for ideas for content.  Let us know what you would like to see in terms of content, discussion, and information.  Real estate will be discussed from all angles, including issues involved with buying, holding, managing, and selling real property. 

Still Time to Register for "Just Show Me The Money" Seminar This Week

There are still spaces left for this week's seminar entitled "Just Show Me The Money" in San Diego, California on Wednesday, January 27, 2010, but time is running out.  You still have time to register early this week if you are interested. 

The program will cover numerous ways for the small, closely held business to obtain financing either through debt financing or equity financing and the various ramifications from each.  Topics will include sources of capital as well as the amount of control that you might have to be prepared to give up with the various financing options. 

Just Show Me The Money Seminar on 1/27/2010 in San Diego

Do you own your own closely held business?  Are you having trouble obtaining financing (debt) or raising capital to expand your closely held business?  This is a common problem in today's new world where the debt and capital markets are still problematic. There are ways to raise money.  There are solutions.  But, you must be creative and think outside of the box.  You are invited to a seminar entitled "Just Show Me The Money."

Never Heard of a Zero Equity 1031 Tax Deferred Exchange?

You may be thinking "why in the world would I even need a 1031 Tax Deferred Exchange if I'm losing my rental property through a short sale transaction?"


The answer to that question is very easy, but may surprise many investors who are going through a short sale, foreclosure or deed-in-lieu of foreclosure transaction themselves. 

Short Sale Scenario

Our story begins with a real estate investor who has been buying and holding investment properties for the last five (5) years. The real estate investor refinances all of their investment properties about once every six to twelve months depending on how much they have increased in value in order to pull out the cash equity in the property and acquire more rental properties. He or she maintains the loan-to-value ratio as close (as high) to 100% as possible.  It was easy to do so with the easy credit markets.

Now, of course, the real estate markets have gone through a free fall and probably have a little bit more to drop. The real estate investor's total market value of his or her real estate portfolio has plunged significantly below what is owed on the portfolio.  Renters have been and may continue to move out and rental income drops to below costs, expenses and debt service. The investor is no longer able to service the debt servicing requirements because the cash flow has dropped so much.

They have no choice but to sell the property and complete a short-sale, unless they want to lose the property through a foreclosure (trustee's) sale.

Capital Gains

Let's say the real estate investor bought the real property for $100,000.00 (original cost basis) and that the real property progressively increased in value over the years to $500,000.00 (fair market value). The real estate investor was able to refinance over and over again and now has total outstanding debt of $450,000.00 (90% loan-to-value ratio).

The investment property market value has now dropped to $300,000.00. The real estate investor owes $150,000 more than what the real property is actually worth on the market today, so he or she decides that their ownly alternative is to sell the real estate for $300,000.00 and complete a short-sale.

Here's The Catch

The real estate investor sells the property for $300,000.00, but he or she has a $100,000.00 cost basis, which translates into a $200,000.00 CAPITAL GAIN.

They are still going to owe capital gain taxes on the $200,000 capital gain (profit) even though they have sold the real property and have NO EQUITY in the real estate. Investors often get equity and capital gain or profit confused.

ZERO EQUITY 1031 EXCHANGE™

There is a possible solution, which is to defer the payment of the real estate investor's depreciation recapture taxes and capital gain taxes by structuring and completing a Zero Equity 1031 Exchange™ (the phrase was coined and trademarked by Exeter 1031 Exchange Services, LLC in April 2009).

The Structure Is Actually Quite Easy

It works like any other 1031 Tax Deferred Exchange transaction except that the real estate investor has no equity or cash position left in the real estate in order to structure the 1031 Tax Deferred Exchange.  There is no cash proceeds for the 1031 Tax Deferred Exchange Qualified Intermediary to receive and hold as part of the 1031 Exchange transaction.

The challenge for the real estate investor is to find a way to acquire and finance like-kind replacement property as part of the 1031 Tax Deferred Exchange.  Structuring the Zero Equity 1031 Exchange is the easy party, but locating and buying suitable replacement property as part of the Zero Equity 1031 Exchange is the near impossible part.

However, the Zero Equity 1031 Exchange does allow the real estate investor to sell his or her troubled investment property, complete a short-sale AND structure a 1031 Tax Deferred Exchange in order to defer the payment of the capital gain taxes. 

It works well with transactions structured pursuant to a deed-in-lieu of foreclosure, too.  It gets a little more complicated when you are going to actually lose the property through a foreclosure.  You can contact me for assistance.  I would be happy to discuss this in greater detail with you.

San Diego Leading Economic Indicators Unchanged for November 2009

January 7, 2010 -- The University of San Diego's Index of Leading Economic Indicators for San Diego County was unchanged in November. Two of the components--consumer confidence and the outlook for the national economy--were up sharply during the month, and there was also a small increase in help wanted advertising. On the downside, local stock prices took a big tumble during the month. Building permits and initial claims for unemployment were also negative, but there were only slight declines in those components.

November’s unchanged reading broke a string of seven consecutive increases for the USD Index. There is no change though in the previously reported outlook for 2010. The first few months of the year may be weak, with the local unemployment rate edging up to approach 11 percent. Things will improve in the second half of the year, with a net overall gain of between 3,000 to 5,000 jobs for the year.

An improving housing market will boost employment in construction, while research and development and health services will remain relatively strong. Rebounding local and national economies will stabilize employment in retailing and in the leisure and hospitality sector. However, job losses are expected to continue in manufacturing, which has lost jobs in 10 of the last 11 years.

Wealth & Legacy Seminar Series Announced for January 2010

The Center for Wealth & Legacy Studies™ is committed to helping successful business owners, especially those working or involved within the real estate profession or community, as well as their families 'pass forward' their financial success (wealth) along with their core family values, virtues, ethics and morals that helped to creat their financial wealth in the first place.

The Center for Wealth & Legacy Studies brings together an incredible diversity of professionals with significant experience and expertise in the wealth and legacy fields to identify and address the financial (wealth) and legacy issues facing each and every business owner and family member in today's complex and ever evolving world. The Center's goals and objectives are to instill hope and provide a specific roadmap for continued success throughout the generations to come.

Wealth & Legacy Seminar Series

The Center for Wealth & Legacy Studies delivers this information to business owners and families through various seminars and webinars, including their quarterly Wealth & Legacy Seminar Series offered originally in San Diego, California, and now offered in Las Vegas, Nevada as of January 2010. In fact, early bird registration numbers for the two Wealth & Legacy Seminars are already off to a really great start.

The Center for Wealth & Legacy Studies's first seminar to be held in the City of Las Vegas, Nevada Wealth & Legacy Seminar is scheduled for Wednesday, January 20, 2010, and its next San Diego, California Wealth & Legacy Seminar in the Series is scheduled to be held on Wednesday, January 27, 2010.

You can also view the next three or four seminars in the series with a brief sneak peak as to the topics to be addressed on the home page of each website. The cost is absolutey negligible ($40.00 for you, and you can invite two (2) guests at only $20.00 each). This is especially inexpensive when you look at the caliber of the speakers and the quality of the topics that will be presented. The bulk of the costs are covered by our sponsors. You can also view our prior seminars to see what we have brought to the table so far.

Partner Buying Me Out. Can I 1031 Exchange Into Other Real Estate?

Three (3) investors own an investment property together.  They own the property as tenants-in-common, or co-owners, are each individually on recorded title to the property, and each report their own individual interest in the real property on their own income tax return.

Partner To Buy Out Remaining Partners

One of the partners now wants to buy the other two (2) co-owners of the real property out so that he or she now owns all of the property.  The two (2) partners will agree to be bought out as long as they do not have any income tax liability because of the sale.

Can Remaining Partners Structure 1031 Exchange?

The question is whether the two (2) partners that are being bought out can structure and complete a 1031 Exchange in order to defer their capital gain taxes into the purchase of another property. 

Generally, the answer is yes, because they each own a tenant-in-common interest in the real estate, are each individually on recorded title and each treats and reports their interest in the real property on their own income tax returns. 

The two (2) remaining partners can each decide individually to cash out, to structure a 1031 Exchange and go their separate ways, or to 1031 Exchange into the same replacement property and remain co-investors in the new property. 

Beware Of The Partnership Interest

This was a nice clean question and answer scenario.  It was a brief discussion that I had on the phone today.  There are numerous issues here that could change the answer to the question, so you should always have your legal or tax advisor review your specific situation.

The biggest area of concern is when an individual does not own an individual interest in the real estate, but actually owns and treats their ownership as an interest in a partnership. 

Welcome To The New Year - 2010

The Exeter Learning Institute welcomes you into the New Year - 2010.  We look forward to a much more prosperous year, and to assisting you with your tax deferred and tax exclusion strategies. 

May you and your family have a very happy, healthy and prosperous New Year!