Can You Do a 1031 Exchange With a Relative?

Are you allowed to do a 1031 exchange with a relative? Yes, you are. However, special rules do apply.

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There is a 2 year test that applies when you perform a 1031 exchange with a related party (a term defined for this context in the Internal Revenue Code). Under this test, if either you or your related party disposes of the property received in the exchange, then the 1031 non-recognition of gain or losses is disallowed.

However, if that occurs the gain or loss would be recognized in the year in which the disposition occurred, not when the exchange took place.

For example, in March 2015 you performed a 1031 exchange with your brother. You traded your brother your Chula Vista rental property for his Escondido rental property. Then, in August 2016 (without your knowledge) your brother sold the Chula Vista property. Even though you had no control over the fact that he sold the property, you did not satisfy the 2 year test so your exchange would be treated as a sale and would be taxable in 2016.

Exceptions

There are 3 exceptions to what otherwise could be a very harsh rule.  These exceptions are:

1. Dispositions that occur after the death of the taxpayer or the related person; 
2. Compulsory or involuntary conversions, if the exchange occurred before the threat or imminence of such conversion; or
3. Dispositions with respect to which it is established to the satisfaction of the Treasury Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

If you have questions about 1031 exchanges, please feel free to send me an e-mail.

Deferred 1031 Exchanges

All the 1031 exchanges that we have discussed so far have had the exchange of property occur simultaneously. However, it is possible, and in fact very common, for a property owner to relinquish his or her property and then subsequently receive a replacement property- even weeks or months later.

Two important requirements must be met in order for a deferred like-kind exchange to qualify for 1031 treatment:

   1) The replacement property must be identified within 45 days after the closing of the sale of the initial (relinquished) property; and

   2) The replacement property must be received within the earlier of 180 days of the closing of the sale of the initial (relinquished) property, or the extended due date of the taxpayer's tax return for the year in which the initial sale occurred.

In order to meet the 45-day identification requirement, you must identify and describe in an unambiguous manner the replacement property in a written document.  The written document must then be delivered to either the person obligated to transfer the replacement property or to any other person involved in the exchange.

As a precaution against identifying a property that is subsequently unable to be delivered to you (and thus not qualifying for Section 1031 treatment), you are allowed to identified more than one replacement property.  In fact, you are allowed to identify up to 3 replacement properties (without regard to their value) or any number of potential replacement properties as long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of the relinquished property.

In order to meet the 180-day receipt requirement, you must actually receive the replacement property within the time period and it must be substantially the same property identified.

A significant potential problem is when people intend to do a deferred 1031 exchange and sell their property, receive the funds, and then use those funds to purchase a replacement property. Unfortunately, that is not a 1031 exchange and will be treated as a sale.

If you or a disqualified person receives, or constructively receives, any cash or non-like-kind property prior to receiving the replacement property it transforms the transaction into a taxable event or partially taxable event depending on the amount received.  If the amount was equal to the full consideration of the relinquished property, then the transaction is treated as a sale.  If the amount received is less than full consideration, then the transaction is treated as a partially taxable exchange.

There are a group of people who are considered disqualified persons because they are viewed as your agent or as related-parties. This group includes your employees, attorney, accountant, banker, and real estate agent/broker.

There are a number of qualifying arrangements that can be made to work around this limitation. One of which is the use a qualified intermediary.  A qualified intermediary is someone who is not a disqualified person and enters into a written agreement with you.  Under that agreement, the qualified intermediary acquires the relinquished property from you and then transfers the relinquished property to a 3rd party.  The qualified intermediary will then acquire the replacement property and transfer it to you.

Here is an example of how a deferred 1031 exchange may look.

You own a rental property in Santee with a fair market value of $550,000, but you would like a rental property closer to your home in Vista. You find a qualified intermediary and enter into an exchange agreement to perform a 1031 exchange. You then find a buyer for your property in Santee. Instead of selling the property directly to the buyer, you transfer the property to the qualified intermediary. The qualified intermediary then sells the property to the buyer.

Within 45 days, you find 3 properties that you may be interested in, and your provide their addresses to the qualified intermediary in a written document. After some negotiations with the sellers, you agree upon a purchase price of $600,000 for one of the properties. The qualified intermediary then goes into escrow with the seller to acquire the property, with you contributing an additional $50,000 cash to make the purchase as well as any exchange fees the qualified intermediary is charging you. After the qualified intermediary acquires the replacement property, it transfers the property to you completing the 1031 exchange.

If you would like to discuss deferred 1031 exchanges further, please send me an e-mail.

Whats Your Basis After a 1031 Exchange?

Over the past few weeks we have been discussing 1031 exchanges and the requirements that must be met in order to have a tax-deferred exchange of property. We also discussed boot, the taxable benefits that are received as part of a 1031 exchange.

So what happens when you sell the property you received in a 1031 exchange? How do you calculate your gain?

The gain is calculated by taking the sales price and subtracting from that amount your basis and the selling expenses (gain = proceeds - (basis + selling costs).

Generally, basis is your original purchase price plus the cost of capitalized improvements less the depreciation allowable over the years. But is it the original purchase price of the relinquished property or the replacement property? Do you factor in the capital improvements and depreciation on the relinquished property?

In order to determine what your basis is in the replacement property, you start with your adjusted basis in the relinquished property at the time of the exchange. By adjusted basis, I mean you start with the original purchase price and adjust that by any capital improvement and depreciation allowed.

Next, you increase your basis by: 

1. The amount of cash you paid to the other party;
2. The value of any other property given to the other party;
3. Any liabilities you assumed in the exchange; and
4. Any gain you recognize.

Finally, you decrease your basis by:

1. The amount of cash you are paid;
2. The value of any other property you receive;
3. Any liabilities assumed by the other party (that you are relieved of); and 
4. Any loss you recognize.

As you may have noticed, the adjustments to the basis is primarily boot.

Lets look at an example of how to calculate the basis of the replacement property.

Several years ago you purchased a property for $200,000. You paid $40,000 cash and financed the rest. Over the years you made $50,000 of capital improvements and have taken $30,000 of depreciation. You have also paid off $10,000 of the mortgage. Your property now has a fair market value of $500,000, and you enter into a 1031 exchange to acquire a property with a fair market value of $600,000. That property is subject to a mortgage of $200,000. You also agree to pay the other party $50,000 cash.

First, we have to determine what your basis in the relinquished property was. You purchased it for $200,000. We add to that amount the $50,000 of improvements and subtract the $30,000 of depreciation. That means your relinquished property had a basis of $220,000.

Next, we have to increase that basis by the cash you are paying to the other party and the debt you agreed to assume. That means you will be increasing the basis by $250,000 ($50,000 cash plus $200,000 liability assumed).

Finally, there was debt relief of $150,000. That means you decrease the basis by $150,000. That means your basis in the replacement property is $320,000.

If you have questions about this formula or about 1031 exchanges in general, please send me an e-mail.

What is Boot? Why Do I Have to Pay Taxes On It?

Over the last few posts, we discussed 1031 exchanges and how, if the requirements are met, they allow for tax-deferred exchanges of one property for another. I mentioned that even though the exchange of the property itself is tax-deferred, there may be other elements to the exchange that are taxable. Taxable benefits received as part of a 1031 exchange are referred to as boot.

Image from www.atlas1031.com

There are essentially two forms of boot. The first is any property received in the exchange that is not like-kind to the property relinquished. The most common form of this type of boot is cash, but it can be any type of property that is not like-kind.

For example, you own a rental property with a fair market value of $1.2 million. You are willing to exchange it for another rental property with a fair market value of $1 million, but you probably want to be compensated for the difference in values by receiving cash for $200,000. That cash is boot.

The second form of boot is debt relief. If the relinquished property is subject to debt and as part of the exchange you are relieved of that debt, you are treated as having received cash.

Lets say you own a commercial building with a fair market value of $1.5 million, but it has a mortgage of $500,000 attached to it. You exchange it for another property with a fair market value of $1.5 million. At first glance, it may look like there is no boot because nothing except for the rental properties were exchanged. However, you were relieved of $500,000 of debt and that is treated the same as if you had received that much in cash.

Of course, there could be boot going both ways in the transaction. In that case, there are rules that allows certain types of boot to be offset by other boot, leaving you with "net boot." These offsetting rules are:

1. Cash paid to the other party offsets cash received.
2. Cash paid to the other party offsets any mortgage (debt) relief.
3. Mortgage (debt) assumption offsets mortgage (debt) relief.
4. Exchange expenses offsets cash received.
5. Mortgage (debt) assumption does not offset cash received.

Furthermore, just because you have boot does not necessarily mean that it will be subject to tax. Boot is only taxable to the extent that there is gain. For 1031 exchanges, the amount of gain recognized is equal to the lesser of: 1) the amount of gain realized in the exchange; or 2) the value of the boot received.

Lets look at another example. Several years ago you purchased a rental property in San Diego for $700,000. The property now has a fair market value of $800,000 with a mortgage of $200,000. You enter into a 1031 exchange and receive a property with a fair market value of $500,000 with no debt and cash of $100,000.

If you had sold the original property in a traditional sale, you would have had a gain of $100,000 ($800,000 value less $700,000 purchase price). Because you did a 1031 exchange instead, you received a like-kind property with a fair market value of $500,000 and boot of $300,000 ($200,000 of debt relief and $100,000 cash). In this case, you would not be required to recognize all $300,000 of boot, only the $100,000 of gain that you would have recognized in a traditional sale.

Lets look at the same scenario, except that you had purchased the property for only $200,000. In this case, if you had sold the property you would realize a gain of $600,000. However, in a 1031 exchange you only have to recognize $300,000 of gain because that is the amount of boot you received.

If you have any questions about 1031 exchanges and boot, please feel free to send me an e-mail.

Can I Take Advantage of a 1031 Exchange?

As we discussed in the last blog post, a 1031 exchange is a tax-deferred, like-kind exchange of property held for productive use or investment for another property held for productive use or investment. In English, it allows you to trade one property for another property without paying income taxes at that time.

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As you can imagine, this is a major benefit to taxpayers because it means that you can defer paying thousands of dollars (or far more) in taxes for years. Obviously, such a beneficial tax code provision is going to have very strict requirements that must be met in order to utilize it.

The first requirement is that the property that you are disposing of must have been held for productive use in a trade or business or for investment.  This means that it cannot be personal use property, such as your principal residence or a vacation home.

The second requirement is that the property that you are acquiring must be used either in a trade or business or for investment. How the other party used the property is irrelevant, the test is how you will use the property. The basic idea is that if you are going to be allowed to defer taxes from the "sale" of the relinquished property, you have to use the replacement property in a similar manner.

The next requirement is that the property cannot be: inventory, stock, bonds, notes or other evidence of indebtedness, interests in a partnership, certificates of trusts or beneficial interests, or choses in action.

Finally, the replacement property must be of a "like kind" to the property relinquished. All real estate located in the United States, whether it is improved or unimproved, is considered to be like-kind to other real estate located in the United States. However, real estate located in the United States is not like-kind to real estate outside of the United States.

Unlike with real estate, not all personal property (e.g., equipment, furniture, etc.) is considered to be like-kind to other personal property.  In order to be like-kind, the personal property must be in the same asset class (and if livestock, must be the same gender).  In addition, as with real estate, personal property located in the United States is not like-kind to personal property outside of the United States.

There are additional timing requirements that must be met if the property exchange does not occur simultaneously, but we will discuss that further in a future blog post.

If you would like to know if your transaction would qualify under Section 1031, please send me an e-mail.

What is a 1031 Exchange?

If you own rental real estate, you are probably concerned about the tax hit you will take when you sell one property to invest in another property. If you talk to realtors or tax professionals about it, they would probably suggest that you consider a Section 1031 exchange.

So, what then is a 1031 exchange? It is a tax-deferred, like-kind exchange of one investment for another investment.

The Hasbro game Monopoly actually provides a great conceptual basis for how a 1031 exchange is intended to work.

Early in the game, you will use your cash to buy various properties. Eventually, one of the other players will acquire a property that you need and is not willing to sell it to you for cash (or you may not have enough cash on hand to buy it). Instead, the other player suggests trading his property for one of yours.

When this trade happens, you do not have to pay the bank for the difference in value between your property and the other player's property. It is simply a trade between the two players.

In the real world, you may acquire various investment properties throughout your life. At some point in your life, you may reach a point where you want to sell one of your investment properties and purchase another investment property. Without Section 1031, the owner of each property would have to pay income taxes on their individual gains from the sale of the properties. However, Section 1031 allows each landowner to simply trade their properties like they would in a game of Monopoly while deferring paying any taxes until the eventual sale (not 1031 exchange) of a property occurs.

Of course, few trades are this easy either in Monopoly or real life. In Monopoly, if the two properties do not have exactly the same value to both players, then the player with the more valuable property may demand money in addition to the property. While there are no consequences to that in the game, in real life the receipt of cash in a 1031 exchange is referred to as "boot" and is taxable. Even beyond the difference in values between the properties, few trades in the real world are as simple as they are in a game of Monopoly because many properties are burdened with mortgages which can have tax consequences. Furthermore, in the real world it can be difficult to find two landowners who are willing to trade properties, so to make a 1031 exchange work a qualified intermediary may have to be used to work around this problem.

Over the next few posts, we will discuss the formal requirements of a Section 1031 exchange, taxable transactions connected to a 1031 exchange, your basis in the new property, and transactions involving qualified intermediaries. In the meantime, if you would like to discuss 1031 exchanges or any other tax issue please send me an e-mail.

Are Real Estate Professional Affected by the Passive Loss Rules?

Over the past few blog posts we have been discussing what passive activities are, and how they can affect your taxes. Specifically, we discussed how all real estate investments are automatically considered to be passive activities, and that passive activity losses cannot be deducted against ordinary income. Instead, passive activity losses can only be used to offset passive activity income (which is taxed like ordinary income). We also discussed that certain investors who actively participate in the real estate activity are allowed to deduct up to $25,000 of losses as a special allowance, but that the special allowance begins to phase out if the investor has more than $100,000 of income from all sources. But what about real estate professionals? Real estate professionals are not simply investors who may own one or two rental properties, they spend most of their time involved in real estate and their income is typically very dependent on their real estate activities. Are real estate professionals limited to the same $25,000 special allowance that other real estate investors are limited to?

No, the Internal Revenue Code specifies that real estate professionals are exempt from the passive activity rules (for their real estate investments).

Who is a Real Estate Professional?

There are two requirements that must be met in order to qualify as a real estate professional for tax purposes:

1) More than one half (1/2) of the personal services you perform in all trades or businesses must be performed in real estate trades or businesses in which you materially participate (see the material participation rules here). The purpose of this rule is to ensure that only people who spend more time with real estate than other trades or businesses qualify.

2) You must perform more than 750 hours of services during the year in real estate trades or businesses in which you materially participate. This rule prevents casual investors who are not involved in other trades or businesses from claiming to be real estate professionals.

To be clear, there are a number of real estate activities that can qualify- it is not simply limited to rental activities. The Internal Revenue Code specifically lists the following activities that qualify as a real estate trade or business:

• Real property development;
• Redevelopment;
• Construction;
• Reconstruction;
• Acquisition;
• Conversion;
• Rental;
• Operation;
• Management;
• Leasing; and
• Brokerage.

Therefore, if you are a real estate professional, the passive activity rules do not apply to your real estate activities.  You are entitled to deduct those any losses from those activities against your ordinary income.

If you have questions about whether you qualify as a real estate professional, how the passive activity rules operate, or any other tax question please send me an e-mail.

How Do I Know If My Business is a Passive Activity?

In the last post, I discussed the consequences of having your business be classified as a passive activity.  As I mentioned, any trade or business activity in which you do not materially participate is a passive activity to you.  But how do you know if you have materially participated?

Image borrowed from www.123rf.com

Luckily for you, there are 7 tests that answer this question, and you only need to "pass" one of them to avoid the "passive activity" treatment.

The material participation tests are:

1) You participated in the activity for more than 500 hours.  In general, any work you do for the business counts, unless it is the type of work not customarily done by the owner of that type of activity or your main reason for doing that work is simply to reach 500 hours.

2) Your participation was substantially all the participation in the activity of all individuals for the year, including participation of employees.  In other words, if you essentially run the business by yourself you do not have to worry about the number of hours you actually worked.

3) You participated in the activity for more than 100 hours during the year, and you participated at least as much as any other individual.

4) You participate in multiple trade or business activities, each for at least 100 hours, and combined they add up to more than 500 hours.  However, each activity in this grouping must be (if looked at individually) a passive activity.

5) You materially participated in the activity for at least 5 of the last 10 years.

6) You materially participated in a personal service activity for at least 3 years (regardless of how many years ago that was).  For these purposes, personal service activities include activities in the fields of health, law, accounting, or consulting, or any other activity for which your personal skills/services (not capital) is the primary income-producing factor.

7) An evaluation of the "facts and circumstances".  This is the least certain of all the material participation tests because you have to evaluate your situation and make a decision as to whether you materially participated, and hope that the IRS agrees.

If you satisfy any one of these tests, then you materially participated in your trade or business and are entitled to deduct the losses against your other income.

Please keep in mind that your real-estate related activities are considered to be passive activities regardless of whether your materially participated in them.  However, there are two exceptions that we will be discussing in the next blog posts.

If you have any questions about the passive activity rules and how they affect you, please send me an e-mail.

What Do You Mean My Investment is a Passive Activity?

Has anyone ever told you that your investment in a business or in real estate is a passive activity?  Do you know what that means?  Don't worry, most people don't.

Before 1986, investors would create tax shelters for themselves by putting their money into investments that would generate tax losses but no actual economic losses. For example, they may invest in a rental property and then would rent the property to a tenant for an amount equal to the monthly expenses. The investors would then have no net cash inflow or outflow, but would be able to depreciate the property and claim a tax loss.


Congress eventually caught on to the games that investors were playing with the Tax Code as it existed back then, and as a response invented the passive activity rules.

Under the passive activity rules, there are two types of passive activities.  The first type of passive activity are trade or business activities in which you do not materially participate.  In the next blog post we will discuss how this is determined.  The second type of passive activity are rental activities (although there are two exceptions that will be discussed in future blog posts).

The income and gains on passive activities will continue to be taxed just like any other ordinary income and gains. However, the losses on passive activities are not deductible but instead can only be used to offset passive activity income.  The passive activities losses are deferred until they can either offset passive activity income or the underlying investment is completely disposed of (e.g., sold).

In addition to not being able to deduct passive activity losses against your active income, the passive activity income is subject to the 3.8% Medicare Surtax.

Do you think you might have a "passive activity" investment?  If you would like to discuss whether it truly is a passive activity and how that affects your taxes, please send me an e-mail.

What is an IRA?

Everyone keeps telling you that you need to save for your retirement, but your company does not have a 401(k).  What are you supposed to do?  You can contribute to an Individual Retirement Account (IRA)!

 

The advice that everyone is giving you is right, you need to make sure you save for your own retirement.  One estimate projected that the Social Security trust fund will be exhausted by 2037 if not sooner.  I discussed this and provided advice for your retirement savings plan in Plan for Your Retirement: No One Else Will.

 

If your employer does not provide a company 401(k) plan, you will want to talk to your financial advisor about establishing an IRA.  But what is an IRA?

There are 2 basic types of IRAs:

 

1) Traditional IRA

 

Qualified contributions to a Traditional IRA help to reduce your taxes because they are tax-deductible.  Contributions to a Traditional IRA are one the few ways in which you can actually reduce your tax bill after the year ends.  The governments allows you to make a contribution up until April 15th of the following year, and to take the deduction in the preceding year.

 

The amount you are allowed to contribute to a Traditional IRA changes frequently as it is adjusted for inflation, but in 2013 you are allowed to make a contribution up to $5,500, or $6,500 if you are age 50 or over.

 

Once invested into a Traditional IRA, all of the funds grow without being taxed.  You will not be taxed until you withdraw the funds! 

 

There are a few basic requirements in order to make a contribution to a Traditional IRA:

• The contributor must be an individual (not a trust, company, etc.)
• You must be under the age of 70.5
• You must have sufficient earned income or compensation (at least as much as you contribute to your IRA)

 

Be careful though.  The ability to make a tax-deductible contribution phases out based upon whether or not your employer provides a company retirement plan, your tax filing status, and your income level. 

 

2) Roth IRA

 

The principal difference between Traditional IRAs and Roth IRAs are that with Traditional IRAs the contributions are tax-free while with Roth IRAs the distributions are tax-free.

 

In 2013, you are allowed to make a contribution up to $5,500 or $6,500 if you are age 50 or over.  However, the contribution limitation changes based upon your tax filing status and your income level.

 

Once invested into a Roth IRA, all the funds grow tax-free.  Furthermore, all of the distributions are tax-free provided that you are over the age of 59 1/2 and have had the Roth IRA account for at least 5 years.

 

Again, there are a few basic requirements in order to make a contribution to a Roth IRA:

• The contributor must be an individual (not a trust, company, etc.)
• You must have sufficient earned income or compensation (at least as much as you contribute to your IRA).

 

You will notice that unlike with Traditional IRAs, there is no age restriction on being able to contribute to a Roth IRA.

 

Of course these are only the 2 most basic types of IRAs.  You may want to discuss non-deductible IRAs, SEP IRAs, and SIMPLE IRAs with a financial advisor to determine what type of IRA makes the most sense for your situation.  If you need a referral to a great financial advisor, please do not hesitate to ask me.

 

If you have any tax questions that I can answer, please send me an e-mail.

 

Please feel free to leave your feedback below.

 

The Value of Rental Real Estate



 

Like most people, I want to be financially successful.  As a tax practitioner with a number of financially successful clients, I have the unique ability to see what traits they have in common.  One particular trait stands out to me: they diversify their investments among stocks, bonds, and rental real estate.

 

What makes rental real estate an attractive investment to the wealthy?

 

It could be the simple business model.  Person A needs a place to live.  Person B owns an extra house.  Person A pays Person B to live there.

 

It could be that it is a tangible investment.  An investment simply feels more real if you can see it before your eyes.

 

Or it could be that the investor expects the property value to rise and wants to finance the property through others paying rent.

 

In addition to all those reason, I think the tax incentives that the government gives rental property owners is a big factor. 

 

 

There are a number of tax advantages to owning rental real estate.

• Depreciation.  When you are renting out real estate, you are entitled to depreciate the full value of the building over a number of years (how many depends on whether it is a residential or non-residential property).  This means that you can depreciate both the amount of cash you paid plus the amount that you borrowed on the property.  Note: Only the building is depreciable, not the value of the land.
• Expenses are deductible.  All the expenses you incur in renting the property are deductible.  This includes mortgage interest, property taxes, a property manager, HOA fees, utilities, etc.  Of particular value is the mortgage interest deduction.  As I mentioned above, you are already allowed to depreciate the mortgage, but this deduction allows you to deduct the interest paid as well.
• Capital Gains.  When you eventually sell the property, assuming that you purchased as a rental and operated it in that manner, any gain will be taxed at capital gains rates which are significantly lower than ordinary income tax rates.

Taking advantage of these incentives means that in some years investors may have a positive cash flow but little to no taxable income.

There are some limitations on these benefits.  Because of tax games that were played in the 1980s, Congress has categorized all rental income as "passive income" and only allows passive losses to offset passive income.  There are two exceptions. 

The first is for real estate professionals, which we will not discuss here.  The second exception allows individuals to deduct up to $25,000 of rental losses if they actively participated in the real estate activity.  This exception phased out for individuals with modified adjusted gross incomes of greater than $100,000.

Some successful investors choose to participate in real estate investment groups instead of purchasing properties themselves.  In addition to all the tax benefits, this lets the investors avoid the traditional landlord responsibilities, gives them access to professionals to select the best investments, and allows them to invest smaller amounts.  For example, I know of one San Diego-based real estate investment group that allows investors to join for as low as $10,000.  This is significantly less than the 20-30% downpayment that a bank may require to finance a rental property.

I would love to get your feedback and answer any questions you may have.  If you want to ask me a question privately, please send me an e-mail.

Also, please let me know if you would like a referral to any of the following professionals:

• Real Estate Agent
• Property Manager
• Mortgage Broker
• Home Owners Insurance Agent
• Real Estate Investment Group