Scottsdale AZ Real Estate | Bill Duffey | REMAX | Carefree, Cave Creek, Paradise Valley and North Phoenix - Homes, Land and Commercial Properties

RE/MAX Excalibur REALTOR®Bill Duffey, Scottsdale AZ 480-585-2904

Scottsdale / Carefree / Desert Mountain / Paradise Valley / Cave Creek / North Phoenix

1031 Exchange

or 1031 Reverse Exchange

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Be Careful - call me for a list of reputable Qualified Intermediaries

Daily Real Estate News  |  May 30, 2007 A Warning to Those Who Use 1031 Exchanges Investors using 1031 exchanges to defer capital-gains taxes on an investment property they have sold can run into trouble if the Internal Revenue Service-required qualified intermediary, known as a QI, has financial trouble. IRS regulations say that investors can’t touch the money from the sale of an investment property and must use a QI to manage the money while their search for a “like kind” property to invest in. The IRS doesn’t place restrictions on where the money is invested. In the past year, at least two independent QIs have allegedly misappropriated client funds. In one case, businessman Donald McGhan is accused of operating a Ponzi scheme with money in his care — he lost more than $95 million of customer proceeds. The 1031 Tax Group has filed for bankruptcy protection after its principals lost $151 million through bad investments and loans. The Federation of Exchange Accommodators, the qualified intermediaries' industry-trade group, says it has been working with states and the federal government to enhance oversight of the industry. Source: The Wall Street Journal, Peter Lattman and Kemba Dunham (05/26/07)

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Loophole

A loophole written into the U.S. tax code allows you and your clients to never pay capital gains taxes on a real estate sale, as long as the profits are reinvested into a similar property. But you can't fully enjoy all of the benefits it provides unless you know the rules--which are intimidating, to say the least. "The Tax-Free Exchange Loophole" explains what you need to know to get started. Get tips straight from the book in this month's book review at REALTOR® Magazine Online (10/15/2005).   SEE BELOW.

IRS Eases Rules (April 2005)
for Combining Home Sale Exclusions and 1031 Exchanges

The IRS recently issued a ruling further explaining the handling of real estate transactions involving both personal residences and investment property. Under this new ruling, your exclusion from capital gains tax can be maximized in transactions that involve both types of properties. Depending on the situation, the IRS will now allow you to use your entire exclusion for your personal residence. If you have any gain left over (above the maximum exclusions), then you can defer it through a tax-deferred exchange!

IRS code Section 121 lets you exclude $250,000 of gain if you file a single-return and up to $500,000 excluded if you file a joint-return when you sell your personal residence if you have lived there for two of the last five years.

IRS code Section 1031 applies to investment property and allows you to roll the gain from your Old Investment Property to your New Investment Property -- thereby defer paying the capital gains taxes. Remember, this is property you hold for investment or for business use.

Section 1031 applies to investment property, and Section 121 applies to your residence. What about property that is, or was both your residence and used for investment...? Since Section 121 applies if the property has been your residence for any two of the last five years -- this raises the question of what was it the other three years? (Assuming that you don't live in the property any more...) The obvious answer is that it was investment property, and that is where Section 121 and Section 1031 overlap.

For the last seven or eight years we've been writing articles and teaching classes about this overlap of the two tax code sections. Now there's an IRS ruling that verifies what we've been teaching. What the ruling effectively says is that when you have real estate that is a possible Section 121/1031 overlap, you get to maximize the tax free exclusion of Section 121 first, and then apply the remainder to Section 1031 exchange.

Here are two examples of how this new rule works. Fred and Sue are selling a house that they lived in for 24 months (years one and two). During years three and four they rented the house out (and lived somewhere else). Now Fred and Sue are selling the house at a gain of $600,000. How much of this gain is tax free under Section 121 and how much is rollover gain under Section 1031? Notice that the property was their residence half of the time, and was rental property the other half.

Your inclination would be to treat half the gain (just $300,000) as tax free under Section 121, and to roll the other half over via Section 1031. But under the new ruling you first apply as much of the gain as you need to maximize the Section 121 gain, with the balance applied to the Section 1031 gain. So in this case (Fred and Sue file a joint-return) that means that the gain to be excluded under Section 121 is $500,000! And the remaining $100,000 of gain could then be deferred using Section 1031 by doing an exchange.

Example Two: Fred and Sue have a one story house with a walk-out basement. They live up stairs, and the basement is their office. Their CPA has treated their office as half of the structure (with their residence being the other half). Again, they are selling their house at a gain of $600,000.

As in the above example, you first apply as much gain as necessary to maximize your Section 121 exclusion ($500,000), with the balance ($100,000) applied to the Section 1031 gain.

So, whether the property is currently both your residence and your office, or if the property was fully your residence for two years and then used for investment for the other time, you need to first fully allocate the appropriate gain as your personal residence, then you can apply any remaining gain to an exchange. In both of our examples, the schedule allocating the gain would look like Table 1.

Two last things we want to bring to your attention: (1) You must recapture the depreciation you have taken after May of 1997; and (2) In our discussion above we assumed that you would roll over the remaining gain from these examples using Section 1031. In fact, you may decide not to do an exchange and therefore must treat the remaining $100,000 gain as recognized and pay taxes on it.

This new ruling is a great gift from the government to every taxpayer who has property that is part personal residence and part investment -- whether it's because you have an office in your home, or because you've treated it as both an investment and as your primary residence over the last five years.

CLICK HERE>> http://www.expert1031.com/1031facts/articles/crej040605.html for the full article and to see the Table referred to in the article.

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Recommended by the National Association of Realtors:

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Daily Real Estate News  |  May 30, 2007 A Warning to Those Who Use 1031 Exchanges Investors using 1031 exchanges to defer capital-gains taxes on an investment property they have sold can run into trouble if the Internal Revenue Service-required qualified intermediary, known as a QI, has financial trouble. IRS regulations say that investors can’t touch the money from the sale of an investment property and must use a QI to manage the money while their search for a “like kind” property to invest in. The IRS doesn’t place restrictions on where the money is invested. In the past year, at least two independent QIs have allegedly misappropriated client funds. In one case, businessman Donald McGhan is accused of operating a Ponzi scheme with money in his care — he lost more than $95 million of customer proceeds. The 1031 Tax Group has filed for bankruptcy protection after its principals lost $151 million through bad investments and loans. The Federation of Exchange Accommodators, the qualified intermediaries' industry-trade group, says it has been working with states and the federal government to enhance oversight of the industry. Source: The Wall Street Journal, Peter Lattman and Kemba Dunham (05/26/07)

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Watch who you pick - and make sure they are insured!

(none of my clients used this firm, just so you know)

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   ASSET PRESERVATION, INC.

* They are assured by Stewart Title, one of the largest Title companies in the country. 

Through a "Letter of Assurance," Stewart Title Company provides a Third Party Guarantee (a safe harbor under the 1991 Treasury Rules and Regulations), that "assures" the performance of API. Stewart Title Company is a wholly owned subsidiary of Stewart Information Services Corporation (NYSE: STC).

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Real Estate Flip Deals Have a Catch

(September 14, 2005) --   Real estate investors who quickly buy and resell properties, while declaring the transactions under section 1031 of the Internal Revenue Service Code, could find themselves being audited.

In these "like-kind" exchanges, investors can defer capital-gains taxes when they sell a business or investment property by sinking the profits into a comparable property right away. However, they cannot use the proceeds to purchase a primary residence or vacation home.

Moreover, the profits must be put into an escrow account, not taken as cash. Naive investors also risk being taxed at a rate of 35 percent, as those looking to qualify for the capital-gains tax rate of 15 percent must hold onto their properties for at least one year.

Experts urge amateurs to speak with a CPA or tax attorney to ensure that they understand the rules prior to making a real estate investment.

A recent study by First American Real Estate Solutions, meanwhile, shows why flipping has become so popular. Those who flipped properties in Las Vegas, Miami, and Orange County, Calif., within three to six months of purchase between 1999 and June 2005 achieved a rate of return that exceeded the market appreciation rate by 20 percent to 40 percent.

Source: Wall Street Journal (09/14/05); DeBaise, Colleen
 

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1031 Exchange

In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

A Qualified Intermediary (QI) is the professional provider of the mandatory mechanics of an exchange. The use of a QI, as an independent party to facilitate a tax-deferred exchange, is a safe harbor established by the Treasury Regulations. Sometimes QI's are referred to as "accommodators" or "exchange facilitators."  I have a list that I use for my clients.

When the taxpayer engages the services of a QI, pursuant to an exchange agreement, the IRS does not consider the taxpayer to be in receipt of the funds. The sale proceeds go directly to the QI, who holds them until they are needed to acquire the replacement property. The QI then delivers the funds directly to the closing agent who deeds the property directly to the taxpayer.

Without a QI, and pursuant to an exchange agreement, the IRS may not define a transaction as an exchange, thereby making it ineligible for tax deferment status.

Under normal circumstances, when you sell a property you have to pay tax on the gain. Gain is caused by taking depreciation deductions for tax purposes or by the property appreciating in value during its ownership.

A Section 1031 tax deferred exchange, named for the Internal Revenue Code Section it refers to (also known as a Starker Exchange, Tax Free Exchange, or Like-Kind exchange), allows an exception to the capital gains tax. When you sell your business or investment real estate, replace it with a different business or investment property, and complete an exchange, you can defer payment of the capital gains tax normally required on these sales.

If your plans include using the money from the sale of a business or investment property to buy more of the same, a 1031 Exchange provides greater proceeds for your next investment-more than you could gain through the re-investment of after-tax proceeds.

A 1031 Exchange is not a tax loophole. It is a section of the Internal Revenue Code, written by Congress, to allow anyone who meets all the requirements to sell their property and defer paying taxes on the gain.

Understanding an Exchange

All relinquished (old) and replacement (new) property must be vacant land, rental property or property used for trade, business or investment. The property must be held for at least a year and a day to qualify for a 1031 Exchange. If the properties meet these requirements, you may exchange any real estate for any other type of real estate.

• You cannot have actual or constructive control of any of the proceeds received from the sale of the old property. By law, all money is held by a Qualified Intermediary (also referred to as an Accommodator or Facilitator - I have a list of them that I use and they charge a reasonable rate - hundreds, not thousands, of dollars). You cannot have an associate or employee, your attorney, broker or CPA hold the proceeds, nor can you leave the proceeds in escrow until the second property is purchased.
• You have 45 days from the date of closing on the old property to identify a list of properties, from which you will purchase the new property.
• From the date of closing, you have 180 days to close on one or more of the properties from your 45-day list.
• The titleholder on the old property must be the same titleholder on the new property.
• You must reinvest all cash proceeds from the sale, and purchase a new property or properties of equal or greater value, in order to avoid taxation on the gains.

1031 Reverse Exchange

When Would I Consider a Reverse Exchange?

If you find a property you would like to acquire before you sell your current property, a Reverse 1031 Exchange can save you thousands of dollars in capital gains tax.

The IRS issued Revenue Procedure 2000-37 (Rev Proc) in September 2000 that gives taxpayers guidance on Reverse 1031 Exchanges. A “Safe Harbor” Reverse introduces a new entity into the reverse process-an Exchange Accommodation Titleholder (EAT). An EAT is a single member limited liability company (LLC) established by a Qualified Intermediary (QI) for use specifically in a reverse exchange. The EAT takes title to, or parks, a property for the taxpayer and holds it until the taxpayer is able to sell the old property. Rev Proc places a time restraint on the taxpayer-the EAT must convey the title on or before 180 days from the date of the EAT’s purchase. When the EAT parks the new property, Rev Proc requires the taxpayer to identify their old property on or before 45 days from the EAT’s purchase. I have reverse exchange specialists that  will guide you through this process.

Rev Proc also refers to the fact that some reverse exchanges will fall outside of the “Safe Harbor.” A “Non-Safe Harbor” Reverse will follow the guidelines outlined in Rev Proc, with the exception of the 180 day requirement. Typically, construction exchanges fall into this category because they require more time to complete the exchange.

Before the reverse process begins, I will review with the two types of reverse exchanges so you have the information necessary to select the reverse exchange that is best suited to your needs.

Reverse Exchange Timeline

Purchase - Contract Stage

• Negotiate your purchase contract for the new property. The Buyer on the contract should be you "and/or assigns."
• Include language in the contract to establish your intent to do a tax-deferred exchange.
• Select a title or escrow company and/or closing agent to handle the closing of the transaction. Notify them that you are participating in a Reverse 1031 Exchange.

Purchase - Financing Stage

• Negotiate a loan with your lender on behalf of the EAT. The loan is usually secured by the new property.
• The EAT signs the Note and the Deed of Trust. Your lender may require you to guarantee the loan. Sometimes the lender also takes a security interest in your old property. Be sure that there is an assumption clause in the Deed of Trust allowing you to assume the loan made to the EAT.
• Negotiate with your lender for a clause that allows re-amortization of the loan if there is a single substantial pay down on the loan in excess of a stated percentage.

Purchase - Closing Stage

Inform me when you have a signed purchase contract. Information needed includes:

1. A copy of the contract
2. The phone number, name and reference number for the closing agent or title company
3. Your mailing address, phone and fax numbers
4. Sale price of the property being purchased

The purchase closes, and the title to the property is recorded in the name of the EAT. If possible, one of our representatives will be present at closing to obtain signatures on the QEAA and other documents.

Identify the Relinquished Property

You have exactly 45 days (including Sundays and holidays) from the closing of the new property to identify the property you are going to sell. You have 180 days from the date of closing to close on your sale in order to be within the "Safe Harbor" provided by Rev Proc.

We will send you a notice with the closing date of the new property, the expiration date of the 45-day identification period, the expiration date of the 180-day closing date, and a form to notify us of the location of the relinquished (old) property to be sold.

You must mail or fax the Property Identification Form before midnight of the 45th day from the closing of the new property.

Sale - Contract Stage

• Negotiate the contract to sell the old property.
• Include language in the contract to establish your intent to do a tax-deferred exchange.
• Identify a title company or closing agent to handle the closing of the transaction.

Sale - Closing Stage
Inform us when you have a signed sales contract. Information needed includes:

1. A copy of the contract
2. The phone number, name and reference number for the closing agent or title company
3. Sale price of the property being sold

The sale proceeds are transferred to the intermediary to hold until you purchase the new property.

Transfer the Replacement Property

Federal Laws:

http://www.irs.gov/faqs/faq-kw180.html

http://www.irs.gov/businesses/small/industries/article/0,,id=98491,00.html

http://www4.law.cornell.edu/uscode/26/1031.html

(letter on file)

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