A Section 1031 Exchange May Be Helpful Even When a Property is Sold at a Loss

In today’s real estate market sellers often have to accept a sale price which is less than what was originally paid for a property. Sellers are often dismayed to learn that even if the property is sold at a “loss” or at a foreclosure sale, income taxes may be due.

A taxable gain on the sale of property can result even though a taxpayer sells the property for less than what was paid for it when it was purchased. Income taxes are due when a taxpayer sells property at a net sale price which exceeds the “tax basis” in the property as distinguished from what was paid for the property when it was acquired.

Tax basis is comprised of the following elements for a property which is purchased:

-Purchase price paid for the property.
-Plus improvements made to the property subsequent to the purchase.
-Minus any depreciation taken on the property after purchase.
-Minus any deferred gain from a 1031 exchange when the property was acquired (if any).

Since depreciation and deferred gain from a 1031 exchange decrease tax basis, gain can result even though the property is sold for less than what was paid for it. For example, if a property that is being sold for $400,000 was acquired a few years ago for $500,000 and currently has a tax basis of less than $400,000, a taxable gain will result on the sale. A 1031 Exchange can be utilized to defer the income taxes on this gain if the investor is going to reinvest the proceeds of the sale in to replacement real estate.

The gain on the sale of property is taxed at capital gains tax rates. The maximum long-term capital gains tax rates for property held for 12 months or longer can be summarized as follows:

-25% for the amount of the gain equal to depreciation taken on the property
-15% for the remainder of the gain (20% after January 1, 2011 unless new tax law extends the 15% rate)
-Plus a possible alternative minimum tax which often occurs when a large capital gain is reported
-Plus state income taxes which will be due on the sale

Talk to your tax advisor when you are anticipating a sale of your property. You may find that a 1031 exchange can save you taxes even if you are selling the property at a loss.

If you have any questions we can help with, contact us at 888-367-1031 or email us at 1031@1031cpas.com. Our Exchange Manual is also available, free of charge at www.1031cpas.com. 1031 Corporation is the Intermediary of choice for thousands of real estate professionals, CPAs and investors.

What Is The Tax Rate on Boot Received in a 1031 Exchange? (15% or 25%?)

When depreciable real estate is sold gain on the sale is taxed under the capital gains tax rules at a maximum of 25% to the extent of any depreciation taken on the property being sold. Gain in excess of the depreciation taken is taxed at a maximum rate of 15%. This depreciation is referred to as “Unrecaptured Section 1250 Depreciation". Accountants often refer to it as “25% Rate Gain.”

When depreciable real estate is exchanged and the taxpayer is reporting “boot” received on the exchange, accountants must decide if the boot is taxed at 15% or 25%. Accountants commonly think that the 25% rate must be used before any gain on the sale can be taxed at 15%. This is the way the capital gain rates are applied under the Installment Sale Rules and ordering structure of IRC §453.

However, there is no guidance issued by the IRS which applies to this issue in the case of boot being reported on an exchange of depreciable real estate. Also, Internal Revenue Reg. 1.168(i)-6 instructs taxpayers to carryover the cost and accumulated depreciation of the relinquished property to the depreciation schedule of the replacement property (referred to as “exchanged basis”).

Since the accumulated depreciation of the relinquished property is carried over to the depreciation schedule of the replacement property, isn’t it possible to argue that the 25% Rate Gain is also carried over to the replacement property and deferred until a cash-out of the replacement property?

This is certainly a taxpayer argument which is logical and has merit. And accordingly, taxpayers reporting boot on an exchange of depreciable real estate might wish to use this argument to limit the tax on boot received to 15%.

Taxpayers should always consult with their tax professional for guidance on issues such as this. See our Exchange Manual or call us at 888-367-1031 if we can help with any questions you may have about 1031 Exchanges.

Section 1245 Property Issues in 1031 Exchange

Many taxpayers don’t immediately recognize that the sale of Section 1245 property is subject to depreciation recapture at ordinary income tax rates. This can be a startling discover when their tax bill is calculated. Section 1245 property is subject to tax at ordinary rates to the extent of any gain on the sale and to the extent depreciation is recognized on the property since acquisition.

Section 1245 Property is generally depreciable personal property whether tangible (such as machinery, equipment, furniture and fixtures) or intangible (such as patents, copyrights, and subscription lists). However, real property can sometimes include Section 1245 Property subject to the same depreciation recapture rules. Some examples of real property which is also Section 1245 Property include –

• Cost segregated real property that includes components which are depreciated as personal property.
• Oil and gas storage tanks, grain storage bins, silos.
• Certain commercial real estate acquired between 1981 and 1986 which was depreciated using an accelerated method.

Section 1245 property that is a part of the sale of real estate, attributable to the realized gain and depreciation taken on Section 1245 property, will be taxed at ordinary income tax rates instead of the preferred capital gains tax rates (subject to previously non-recaptured section 1231 losses).

In a 1031 exchange of real estate, realized gains are deferred if qualifying replacement property is acquired and if there is no taxable “boot” received. However, if the real estate exchanged contained any Section 1245 Property, there will be a Section 1245 depreciation recapture unless the replacement real estate also includes Section 1245 Property of equal or greater value. Any “trade-down” in the Section 1245 Property will result in Section 1245 depreciation recapture taxed at ordinary income tax rates.

Taxpayers with Section 1245 property embedded in their real property should consult with their qualified legal and tax professionals on the potential recapture occurring when contemplating either a sale or exchange. If you’ve questions on the 1031 exchange of Section 1245 property, 1031 Corporation would be happy to consult with you and your tax professional. Give us a call at 888-367-1031.

Like Kind vehicles under Section 1031

A new private letter ruling (PLR 200912004) says that vehicles that share characteristics of both cars and light general purpose trucks - including SUVs, minivans, cargo vans and crossovers - are of "like kind" for section 1031 purposes.

The IRS observes that in the past few decades motor vehicles have evolved in a manner which blurs the distinction between cars and light-duty trucks.

The “safe harbor” for determining which vehicles are like-kind to each other has been by reference to the General Asset Classes found in Reg. §1.1031(a)-2(b)(2) or the Product Classes found in Sectors 31, 32 and 33 of the North American Industry Classification System (NAICS). Vehicles which are found in the same Asset Class or Product Class have been deemed to be like-kind.

PLR 200912004 observes that personal property exchanges can be like-kind for a 1031 Exchange even if they are not in the same Asset or Product Class and that no inference is to be drawn from the fact that properties are not in the same Asset or Product Class.

As noted above, the Asset and Product Classes are “safe harbors” and not the exclusive way to determine if personal property is like-kind.

Accordingly, cars, light general purpose trucks and vehicles that share characteristics of both cars and light general purpose trucks (13,000 lbs) (e.g., crossovers, sport utility vehicles, minivans, cargo vans and similar vehicles) are like-kind for 1031 Exchange purposes even though they are in different Asset or Product Classes.

Caveat: This opinion was issued as a private letter ruling, and therefore it cannot be cited as precedent, and the Service has the right to change its position on this matter without notice.

For more information on depreciable tangible personal property and like-kind exchanges, please visit our 1031 exchange website, www.1031cpas.com, or give 1031 Corporation a call at 888-367-1031.

IRS Form 8824 worksheet

If you've ever completed an exchange, you know how difficult it can be to complete the IRS 8824 Like Kind Exchange form. You may have searched high and low, tried unsuccessfully to use a couple worksheets and even read all the instructions in the IRS publication but still had difficulty figuring out the form and what goes where.

Well, we are here to help. Larry Jensen, 1031 Corporation's accounting professional with more than 25 years CPA partner experience and 18 years experience in the 1031 industry, has created an incredibly helpful 8824 worksheet that can assist you or your tax professional in preparing the Form 8824. You can find the form by clicking on that previous underlined link.

Of course if you have questions about the worksheet or a question about completing your like kind exchange reporting, feel free to give us a call at 888-367-1031. The phone call is free and the complimentary guidance he can provide might prove invaluable. Just remember to use 1031 Corporation Exchange Professionals next time....the instructions, worksheet and all your reporting requirements come neatly bound after your exchange is complete. Sure makes tax time a lot easier for you and your accounting professional!

Oh, one more thing....if you haven't already done so...tomorrow is not only Saturday, it's Valentine's Day....don't forget your honey. If you do forget, well...we can't help you out with that!

Aircraft Exchanges

If you have used an aircraft for trade or business purposes, a 1031 exchange of aircraft could save you thousands of dollars on the sale and replacement. Chances are you have depreciated the aircraft, perhaps even completely. The aircraft may be worth more today than when you purchased it. If you sell it without doing a 1031 Exchange, you may be taxed not only on any gain from the sale, but also on the depreciation recapture. Section 1031 of the Internal Revenue Code provides for the deferral of gain, provided certain requirements are met.

Things You Need to Know About 1031 Exchanges of Aircraft:

1. Both the old and new aircraft must be used for trade, business or investment. The old and new aircraft must both be used for trade, business or investment activities to qualify for a 1031 exchange. Personal use aircraft do not qualify.

2. The aircraft exchanged must be like kind. Aircraft are generally like kind to any other aircraft under the General Asset Classes or the Standard Industrial Classification (SIC) guidelines. In general, all aircraft and helicopters (except those used in commercial or contract carrying of passengers or freight) are treated as like kind. Commercial or charter aircraft and helicopters used for transporting passengers and cargo in scheduled air transportation, are similarly treated as like-kind to one another.

3. You have 45 days from the date of closing on the old aircraft to identify a list of aircraft from which you will purchase the new aircraft. From the date of closing, you have 180 days to close on one or more of the aircraft from your 45-day list.

4. You cannot have actual or constructive control of any of the proceeds received from the sale of the old aircraft. By law, all money is held by a Qualified Intermediary (also referred to as an Accommodator or Facilitator). 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 new aircraft is purchased.

5. The titleholder on the old aircraft must be the same titleholder on the new aircraft. One aircraft can be exchanged for two or more replacement aircraft or vice versa.

6. The replacement aircraft must be equal or greater in value to the relinquished aircraft to avoid taxable boot, and all exchange cash must be reinvested in the replacement aircraft.

Aircraft owners can realize the benefits available through the 1031 Exchange process. A team of professional consultants is critical to ensure the necessary steps to complete your exchange properly are followed and comply with current Section 1031 tax law.

Selecting a knowledgeable and experienced Qualified Intermediary that is familiar with aircraft exchanges is of particular importance given the complexities of the exchange.

Oil, Gas and Mineral Interest 1031 Exchanges

It would seem to make sense that you could exchange a working or royalty interest for another working or royalty interest as part of a 1031 Exchange. But, did you know that you can also exchange a working or royalty interest for other real estate? For example, if you sell a working interest, you could replace it with another working interest, a royalty interest, or ownership in an office building, apartment building, or other real estate.

However, oil, gas and mineral interest exchanges are tricky. For example, if you sell a working interest and retain the royalty interests or surface rights, the IRS may disallow your exchange. This is because production payments do not qualify for a 1031 Exchange.

The sale of working interests often involves the sale of related equipment. Keep in mind that transfers of equipment require the equipment to be treated as a separate personal property exchange. Personal property exchanges are a different animal than real estate exchanges.

Also note that any costs incurred to drill and develop the gas or mineral site must be recaptured to the extent that you do not re-acquire qualified natural resource property. In other words, if you sell a working interest in a gas well and buy an office building, you would have to "recapture" the Intangible Drilling Costs (IDC) costs you had previously deducted.

If you have questions about Oil, Gas or Mineral interests and how they relate to 1031 exchanges, please contact 1031 Corporation Exchange Professionals at 888-367-1031.

Depreciation using Cost Segregation

The following information was graciously provided by Jeff Pinkerton of U.S. Cost Segregation.

You may be able to easily take cash out of the investment properties you currently own. It's actually quite easy.

You're probably depreciating those properties at 27.5 years (if residential) or 39 years (if commercial). There is a section of the IRS code that allows you to depreciate certain assets within that building at 15 or 7 or even 5 years. That faster depreciation means more of a tax writeoff which means less taxes. You can even go back in time and recapture this 'lost' depreciation that you haven't been taking.

The technique is called cost segregation analysis and has been a part of the tax law for the past decade. This analysis needs to be performed by a qualified engineering firm, which identifies and "costs out" those assets which qualify for faster depreciation. For example, carpet, electrical for computer equipment and decorative elements can be depreciated over 5 years. Site utilities, paving and landscaping can be depreciated over 15 years.

Imagine you purchased a 15 year old four-plex five years ago and paid $500,000 for it. Assume 20% of that went to land, that means you are depreciating $400,000 over 27.5 years (that's 3.6% per year). But of that $400,000 you paid for the building itself, how much went to the carpet? To the plumbing and kitchen fixtures? To the interior non-load bearing walls?

The answer, of course, is "I don't know". Cost segregation analysis answers those questions and provides data your CPA can use to apply the deductions you've been missing. Extra deductions means less taxes. In fact, it's common that 25% of the assets in an apartment can be depreciated more rapidly. Compare that with the 3.6% you're depreciating now and you can see how this technique can benefit you.

Further, leasehold improvements have even a more profound impact. Typically about 50% of those assets are amenable to accelerated depreciation. This means that you can write off the cost of the original carpet that came with the building, as well as the new carpet you installed. Similarly the new cabinets, the new bathroom and the new electrical wiring and so forth.

This is a time-tested and IRS-accepted method of helping improve your cash flow.

For more information, contact Jeff at 303.694.3924 or visit their website at U.S. Cost Segregation Services.

Tired of Being a Landlord Yet You Don’t Want a Big Tax Bill?

Anyone who has owned investment real estate, whether a student rental, a small apartment building, an office building or a strip retail center, knows that two of the most demanding aspects of being a landlord is dealing with tenants and maintaining property. For many, being a real estate investor appears a Catch-22: you want out, but to get out you must give away all or most of what you have worked for. One of the best strategies for freeing yourself of landlord hassles while deferring taxes is 1031 Exchanging into an Absolute-Net-Leased property in which the tenant maintains the building.

1031 Exchange. The IRS Code allows you to exchange one real estate investment asset for another while deferring the gain and depreciation recapture on the sale of the first property. With 15% federal capital gains tax, state taxes and the recapture of depreciation, the potential for deferring taxes is huge...particularly if you have held the property for many years. On the sale of an investment property that has been held long enough to generate significant appreciation while a significant amount of depreciation has been taken, it is not unusual for 30% to 40% of the proceeds from the sale to be paid in taxes if the seller does not 1031 exchange into another property.

The IRS Code says properties eligible for a tax-deferred exchange must be like-kind. For real estate held for investment, that gives you a lot of latitude. An apartment building you own in California can be exchanged for an office building in Colorado. Raw land can be exchanged for a fully-developed building. Your 100% ownership in the building you are selling can be divided into two or three properties to create diversification. As long as the exchange is done properly the options for tax-deferred investments are limitless.

Replacement Property. Locating and securing your 1031 replacement property must be done swiftly, skillfully and knowledgeably. The replacement property must be identified in writing within 45 days of the sale of your relinquished property. Then, the closing on the purchase of the second property must occur within 180 days of the sale of the relinquished property. The process of selecting your replacement property should begin as soon as you know you have a solid buyer for your replacement property. You do not want to wait until day 44 to begin looking, or you are likely to come up empty handed.

If you are looking to let go of the hassles associated with being a landlord, then you should focus search on Absolute Net-Leased properties. Such properties can be purchased as fractional interests (also known as Tenant-In-Common, or TIC, interests) or as ‘whole’ properties. TIC interests are available in large retail centers, multi-family housing, luxury private student housing and office buildings. Generally, you will need a minimum of $150,000 in cash and meet certain accreditation requirements in order to buy into a TIC.

‘Whole’ Absolute Net-Leased properties are often the separately-owned pad sites of larger retail centers. It could be the real estate for a Jack-in-the-Box, a Big-O Tire Store, Blockbuster Video or a Starbucks. One of the classic Absolute-Net-Leased properties for the larger buyer is the real estate for a Walgreens Pharmacy. In general, you will need $500,000 or more in cash to purchase a quality ‘whole’ Absolute-Net-Leased property.

Where to find Expertise. The 1031 Exchange is the ideal tool to move from a management-intensive property into an Absolute Net-Leased property. While you do not personally need to have all the answers, you need to know where to find them. Two essential members of your team are: (1) an investment real estate broker who can provide you with and help you evaluate various TIC and ‘whole’ replacement property options, and (2) a top-notch Exchange Qualified Intermediary, QI for short. With the right expertise, you can preserve your hard-earned equity, establish a predictable and reliable cash flow, and free yourself from getting the call when the toilet is not working.

The above article was graciously provided by Mark Casey. Mark is president of Casey Partners, Ltd. a real estate brokerage and consulting firm headquartered in Boulder. Mark holds a Master of Business Administration (MBA) from the University of Virginia. and is a member of Commercial Brokers of Boulder and the Denver Metro Commercial Association of Realtors (DMCAR). Casey Partners can be reached by calling 303-665-6000 or email info@caseypartners.com.

Recapture Rules for GO Zone Property in an Exchange

The IRS recently released Notice 2008-25 that provides depreciation recapture guidelines for Gulf Coast area property damaged by hurricanes Katrina, Rita and Wilma in 2005. The Gulf Opportunity Zone Act of 2005 provided a first year depreciation bonus on qualified rehabilitation expenditures of "GO Zone property". However, the sale of GO Zone property is subject to recapture of the bonus depreciation under various conditions, including certain 1031 Exchanges.

The rules are fairly technical but essentially this is what it comes down to:

There is no recapture if the replacement property is GO Zone property in the hands of the taxpayer.

There is recapture if the replacement property isn't GO Zone property in the hands of the taxpayer and isn't substantially (80%) used in the GO Zone or in the active conduct of a trade or business by the taxpayer in the GO Zone.

There is no recapture if the replacement property isn't GO Zone property in the hands of the taxpayer but is substantially used in the GO Zone and in the active conduct of a trade or business by the taxpayer in the GO Zone.

To read more about the guidelines as outlined in the Notice, please read about the GO Zone Property Recapture Rules on our website.

More Related Party Exchange Guidance

Who are related parties? Related parties include –

• Members of a family (including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal descendants).
• An individual and a corporation, partnership or LLC when the individual owns, directly or indirectly with family members, more than 50% of the ownership of each corporation, partnership or LLC.
• Two corporations, partnerships or LLCs when the same person or owners own, directly or indirectly with family members, more than 50% of the ownership of each corporation, partnership or LLC.

If a related party is used in this fashion, it is preferable to use a party or entity which already exists that is not just a shell entity set up to do this transaction (with the entity disappearing after the relinquished property is sold). The related party should bear the benefits and burdens of ownership of the relinquished property and not be merely acting as the taxpayer’s agent. The purchase price of the relinquished property should be fair market value.

When the property is resold by the related party, the gain or loss may be short term if the property has been held for less than 12 months by the related party. So, care should be taken to price the sale to the related party at the expected property sales price.

Potential ordinary income from sale to a related party. Sale of depreciable property to a related party. Under IRC §1239(a) any gain from the sale of depreciable property to a related party is ordinary income rather than capital gain. In the context of a 1031 Exchange, if there is any boot to be reported by the taxpayer from a sale of the relinquished property to a related party, the boot will be taxed as ordinary income.

Sale of property to a corporation by a shareholder. Under case law, if a shareholder sells his property to a related party corporation (51% or more of ownership) and if a subsequent resale by the corporation would be treated as ordinary income by the corporation, the gain on the sale by the shareholder to his corporation will also be ordinary income (and not capital gain). However, even if the related party is a corporation, only boot received by the taxpayer will be taxed as ordinary income. Just to be on the safe side, it is better for the related party or entity to be a person, LLC or partnership and not a corporation.

If you would like further information about 1031 exchanges between related parties, further guidance is available on our website at our Related Party Rules section.

The Tax Rules for Sale of A Personal Residence

The Taxpayer Relief Act of 1997 brought sweeping changes to the tax rules applicable to the sale of a personal residence. Gone are all of the old rules, including the two-year rollover requirement and the once-in-a-lifetime 55-year old $125,000 tax-free gain rule. These rules were completely repealed.

Effective For Sales After May 6, 1997, The Rules Are -

A $500,000 tax-free gain for married-joint filers and a $250,000 for single persons. However, any depreciation taken on the residence after May 6, 1997 is subject to tax at the capital gains tax rates (maximum of 25% capital gains tax rate).

1st Two-Year Rule - Must live in residence for any two out of prior 5 years.

2nd Two-Year Rule - A second home sale within a two year period is not eligible for this exclusion.. Can only use this exclusion once in any two year period.

Except for the 2-Year Rules, no limit on number of times this exclusion is available.

A residence which was originally acquired as replacement property in a 1031 Exchange must be owned for five years as well as lived in for two out of those five years to qualify (American Jobs Creation Act of 2004).

A prorata exclusion is available for taxpayers for sales which are less than two years apart, or for failure to meet either of the two-year rules due to change of employment, health or other reasons specified by Treasury Regulations. For instance, one year residence or 2nd sale after one year = 50% of the above referenced exclusion.

A rental property converted to a personal residence and sold after May 6, 1997 is eligible for this exclusion subject to the two-year rules. Only the depreciation taken on the property after May 6, 1997 is taxable even though the property was partially or fully depreciated prior to May 6, 1997 before it was converted to a personal residence.

Taxpayers with a gain exceeding these exclusion amounts get no relief and must pay tax on the excess amount at the maximum capital gain tax rate; 15% generally except for the 25% maximum rate applicable to any depreciation taken on the residence after May 6, 1997.

There are a number of 1031 exchange strategies that investors can use in conjuction with the primary residence rules. For a sample of one such option, visit additional primary residence strategy guidelines on 1031 Exchanges.

Possible relief for clients of bankrupt 1031 exchange companies

The IRS recently indicated that it is contemplating tax relief, in some form, for taxpayers have who have not able to complete their like-kind exchange because they used a qualified intermediary (QI) that went bankrupt. In many cases, clients of these bankrupt 1031 exchange companies have not only lost the principal held by the accommodator, they are now subject to capital gains tax and depreciation recapture because they failed to complete their exchange.

In a letter to Representative Barney Frank, a client of a bankrupt 1031 exchange provider requested that the issue of an extension of the period to complete a 1031 like-kind exchange be exteneded. The IRS responded to Rep. Frank that Code Sec. 1031 does not provide for an extension of the statutory replacement period. They also noted that the law only authorizes it to postpone deadlines for Presidentially-declared disasters or terrorist or military actions. However, the Qualified Intermediary that declared bankruptcy action is not subject to one of the events covered under a disaster. Thus, the IRS indicated it does not have the authority to suspend or extend a statutorily mandated due date.

The IRS also said that because of the number of QI businesses that have experienced financial difficulties resulting in bankruptcy filings, the are considering action to provide some type of relief. The nature of that relief was not specified.

The IRS has expressed a willingness to help homeowners that have been subject to foreclosure. While some form of relief for taxpayers for clients of bankrupt QIs is possible from the IRS, there is also the possibility that Representative Frank or other legislators may work to provide statutory relief. Unfortunately, this doesn't get the principal back. That is up to the bankruptcy proceedings - a slow and often times frustrating and disappointing process for these "creditors".

The issue of selecting a competent and secure Qualified Intermediary is highlighted by these recent failures of exchange providers. We focused on What to Look for in a Qualified Intermediary, a couple weeks back. I would encourage you to please review that article along with other references on our linked websites to the right for further guidance.