The Compounding Effect

The following post is a portion of an article written by Ronald Raitz and appearing in the Sept/Oct edition of Commercial Investment Real Estate, The official magazine of the CCIM.

When Albert Einstein was asked, “What is the most powerful force in the universe?” His reply was, “Compound interest.” People in the financial services industry understand the effects of compounding: For example, whether an investor starts funding an individual retirement account at age 20 or 40 results in a dramatically different retirement balance at age 59½. The simplest of illustrations — the “double the penny” example — further highlights the sometimes surprising benefits of compounding: A penny doubled every day for a month is worth only two cents on day two, but on day 31 it is worth $64 million. Compounding plus time can indeed produce impressive investment growth.

Potentially the most powerful benefit of a 1031 exchange, the compounding effect also is the most overlooked. The key to getting the highest compounding result is keeping all of the money working for the investor — not only now but also into the future. In an exchange, the amount of tax that otherwise would be paid is reinvested. The projected future value of the compounded yield on the deferred tax becomes very substantial over time.

Many real estate investors also add leverage, which significantly amplifies the compounding effect. For example, in 1988, an investor who possessed strong management skills sold a $1 million property that had a $200,000 basis. Without utilizing an exchange, the gain on the sale would have been $800,000 with approximately $200,000 in taxes due. After paying the taxes, there would have been approximately $800,000 after-tax cash to reinvest.

But the investor exchanged the property and bought a $1 million income-producing replacement property that was 85 percent occupied. He put $200,000 down — exactly the same amount he otherwise would not have had without the exchange. Two years later, after making necessary management adjustments, he increased the property’s occupancy to 94 percent and sold it for $1.4 million. The $200,000 that he put down on the property (money that would have been used to pay the recognized gain in 1988) added to the $400,000 he just made equals $600,000.

The investor did another exchange and put the $600,000 in proceeds down on a $2 million income property that had been under-managed and was at 83 percent occupancy. Three years later, after achieving 92 percent occupancy in the property, the investor sold it for $2.6 million. With the $600,000 he had put down plus the $600,000 he made on the sale, after only five years the $200,000 tax that was deferred had grown to $1.2 million. Alternatively, without the exchange strategy the investor would have had no compounding benefit from his investments because the initial $200,000 would have been paid to cover the tax obligation.

Compounding combined with leverage can build wealth very quickly. Over a 12-year period, this investor did five exchanges and turned the money that he otherwise would not have had ($200,000) into $4.8 million.

Many investors have developed exchange strategies that have enabled them to go from a modest net worth to a very high net worth in a 10- to 20-year time frame. Clearly, these real-life examples are achieved more easily when real estate is in an up cycle, but this does not negate the potential benefits of employing a 1031 exchange strategy and holding real estate through the down cycles. Over time, the investors still come out far ahead of where they otherwise would have been if they had sold, paid the tax, and gone into an alternative investment.

Since there are no restrictions on the number of exchanges a taxpayer can complete, this strategy can be used during the taxpayer’s entire lifetime. Although some investors eventually sell property that is acquired via an exchange and pay the tax, it is very common to never cash out and carry investments into the taxpayer’s estate. At that point, the estate receives a stepped-up basis and the tax consequence disappears.

Section 721 Exchange into an UPREIT

A REIT is a Real Estate Investment Trust whose stock is publically traded. An UPREIT is a real estate investment operating partnership in which the REIT is the general partner and real estate investors are limited partners. A Section 721 Exchange is the method by which real estate investors can transfer a real estate investment into an UPREIT tax-free (or tax-deferred). Internal Revenue Code Section 721 deals with contributions of real estate to an operating partnership in exchange for an interest in the partnership.

UPREITs use IRC §721 to acquire property from investors who want to exchange out of their real estate investment into an investment which is managed by professionals. Subsequently, at a point in time which is suitable for the investor, UPREIT partnership ownership units are exchanged for shares for publically traded stock in the REIT which are then sold on the securities market. The exchange of units of the UPREIT operating partnership for stock shares in the REIT is a taxable event. But this is done at the same time that the REIT stock shares are sold so at this time the investor is cashing out of all or part of his investment at capital gains rates. This arrangement provides professional management and liquidity to the real estate investor.

In order to contribute an investment property to an UPREIT, the property must meet the REIT's investment criteria which generally include a requirement for institutional-grade property. If the real estate investor's real estate is not institutional-grade, he can convert his real estate to institutional-grade real estate with a sale and exchange through IRC §1031 and replacement with an investment in a syndicated tenancy-in-common (TIC) investment. Then, the TIC investment can be contributed to the UPREIT in exchange for ownership units in the operating partnership of the UPREIT.

Insist your QI Hold Funds in a Segregated Exchange Account

Qualified Intermediaries (“QIs”) use a variety of ways to bank and invest funds they hold in escrow or trust for their 1031 Exchange clients. QIs have a fiduciary responsibility to hold client funds in a safe and liquid manner. At the present time there is no industry standard for how funds should be held by QIs or how funds should be invested. The most common ways are as follows -

Segregated Accounts – Many QIs, like 1031 Corporation, open separate bank accounts for each 1031 file that they open. The accounts are usually money market accounts which are under FDIC protection and are opened in the name of the QI as escrow holder for the client and include the client’s federal identification number. The accounts usually bear interest which is reported on year end Form 1099 to the client.

Pooled Accounts – Many QIs pool all of their client 1031 funds into one bank account or investment. This is the common way large QIs manage money they hold for their clients. Many smaller QIs also use this method of holding 1031 funds.

Several recent scandals and failures in the 1031 Exchange industry have occurred with QIs using pooled accounts. In some instances, the pooled accounts were invested in other companies owned by the owner of the Qualified Intermediary company. In other instances, the pooled accounts were reinvested in securitized investments which have lost value in the current financial “melt down.”

Land America is apparently the latest casualty of the Pooled Account type of QI. They are reported to be holding $290 million of client exchange funds invested in securitized investments called Auction Rate Securities. The securities have become illiquid and Land America is attempting to meet client obligations from other operating accounts.

Our recommendation is to always insist that your QI hold your 1031 funds in a segregated account subject to FDIC protection.

Acquiring a Leasehold Interest as Replacement Property

Section 1031 defines a leasehold interest with a term of 30 years or more as "like kind" to a fee interest in real estate. Renewal options under the lease are counted for purposes of determining if the lease has 30 years or more to run. Accordingly, a 30 year leasehold interest can be exchanged for a fee interest in real estate or vice versa, a fee interest in real estate can be exchanged for a 30 year leasehold interest.

Usually when a leasehold interest is sold or exchanged, the lease is an existing lease and there is significant value in the lease because of leasehold improvements which are present on the leasehold. When a leasehold interest is purchased as replacement property for an exchange, the value of the leasehold would normally be attributed to the value of the improvements which are on the leasehold. For income tax reporting, the taxpayer-lessee would continue paying rents after acquiring the leasehold including improvements. The purchase cost (or tax basis in an exchange) of the lease would be amortized over the period of the lease.

What if the lease is a newly created lease into which the taxpayer is entering? A taxpayer can transfer a fee interest for the receipt of a newly created 30 year lease. But in this case, it is important that the purchase price appear to be for the acquisition of a leasehold and related improvements and not merely as an advance payment of rent over the term of the lease. If the newly created lease was perceived to be an advance payment of rent 1031 exchange treatment has been denied under case law for the seller of the lease. But there have been exceptions under IRS Rulings.

If the IRS viewed the purchase of the lease to be an advance payment of rent to the lessor (and the rental agreements required rents of more than $250,000), the Internal Revenue Code would require that the lessor and lessee both treat the payment as rent income and rent expense over the period of the lease and this would not be viewed as a “purchase” by the lessor. Accordingly, the possible application of this provision is an issue that taxpayers entering into a purchase of a newly-created lease should be concerned about in drafting the terms of the purchase.

As one can see, it is important that the purchase appear to be in the nature of the purchase of real estate vs. an advance payment of rent. For more information on Leasehold Interests as Replacement Property, please visit our website or call 1031 Corporation Exchange Professionals at 888-367-1031.

Banking your 1031 exchange in uncertain markets

There has been a great deal of turmoil in the financial markets and banking industry as several large and well known financial institutions have stumbled. With so much unease in the marketplace, and wondering who will be next in the news, I wanted to take a moment to talk about 1031 escrowed funds. During the exchange, the Qualified Intermediary you select has control of the funds. While they make accept your "input" into where the deposit is placed, it is ultimately up to them to determine where to place the money. It is important to know where the money is being banked. I wanted to spend a bit of time to discuss what is important and how 1031 Corporation - as a subsidiary of FirstBank deposits the funds.

Each account is segregated from all other exchange accounts. That means, the exchange we facilitate for you will have an account number that can be viewed 24/7 on FirstBank's website. You know exactly where the money is and when you awake to the sound of CNN talking about turmoil in the Asian stock exchange causing fears at 2 a.m., you can get online and view your account. Segregation is very important if there are issues with your Qualified Intermediary.

But what if there is an issue with the bank that your QI places the funds? It is worth checking to find out the stability, strength and customer service the bank provides - particularly in times of uncertainty. 1031 Corporation, as a subsidiary of FirstBank, deposits all client escrow accounts at FirstBank.

Here are some highlights of this respected institution.

Solid History FirstBank was founded in Lakewood, Colorado in 1963. It is employee owned with a long term focus. Over 100 officers and nearly 600 employees have more than 10 years of service with FirstBank.

Strong Financial Position FirstBank is viewed as "well capitalized" under regulatory guidelines. With assets totaling $9.2 billion and deposits of $7.8 billion, FirstBank continues to experience solid growth.

Record EarningsWhile others are reporting large losses, FistBank's net income was up to over $67 million thru the first half of 2008. This represents a 41% increase over the comparable period last year.

Unique FDIC Insurance Options While most banks can only insure up to $250,000 of your exchange funds, FirstBank's 26 separate bank charters make it possible to be insured for up to $6.5 million. No longer is there a need to "spread the risk" around by opening multiple accounts at various financial institutions.

No Subprime Involvement FirstBank does not originate, hold or purchase subprime mortgage loans or security. Continued focus on credit quality enables them to succeed in all ecomnomic cycles.

Open For Business With 126 branch location in three states (Colorado, Arizona and California) FirstBank serves more than 60,000 customers. Along with internet banking and 24 hour customer service, you can always speak to someone about your exchange account.

You should speak with your Qualified Intermediary and determine where your exchange funds are held. It is extremely important in these times of uncertainty!

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.

AMT Filers May Finally Get Some Needed Relief

The IRS has announced that it will suspend the collection of back taxes from tax filers that have a large AMT liability due to the sale of Incentive Stock Options. Congress is FINALLY working to approve legislation that would help taxpayers who exercised ISOs during the "Dot com" boom and subsequent bust cycle of 2000 and 2001.

Let's take an example to show this point. As part of his incentive package, a mid-level manager of Yahoo receives an option to purchase 1,000 shares of the company at a strike price of $40 a share back in 1999. Quickly, the stock rises and goes over $100 a share by the beginning of 2000. The employee decides to purchase his options at $40. But - rather than immediately sell the stock - he decides to hold on to the 1,000 shares.

Since the stock options are an Incentive Stock Option, the employee has to recognize the unrealized gain on the difference between the option price and the market price at the time the shares were optioned. This means that this mid-level manager now has to pay tax on the $60,000 gain ($100,000 value versus his actual cost of $40,000) - even though he has not sold the stock. Why? The ISO purchase places him in the Alternative Minimum Tax category. Not only that, but Mr. Yahoo Manager isn't eligible for the 15% long-term capital gains rate. He now has to pay 26% of income (or 28% - depending on his income). To make matters worse, this poor fella hasn't even sold the stock yet. He decided to keep it. So, he has to find the cash from other savings to pay the tax. Sound like a disincentive to hold company stock as an investment?

Being a dedicated employee, he hangs on to his stock while watching it fall off its high in January 2000. He becomes anxious but knows the stock will come back. So, when his tax bill comes due on April of 2001 - and this Yahoo employee realizes his tax bill - he realizes he now has to sell the shares to pay the tax. But there's a problem. The stock has declined to $10 a share! This AMT tax filer has watched his stock get decimated and now doesn't even have enough net proceeds from the sale to pay his Alternative Minimum Tax!

Under the provisions of what Congress is attempting to pass, taxpayers that were caught in this unfortunate predicament will not get their AMT completely relieved. However, they will be able to speed up the use of the AMT credits that were generated as a result of these transactions. This, in effect, will provide a "relief" of sorts on subsequent tax bills. Thus, the IRS has decided to hold off on collecting these back taxes until the AMT credit can be recognized.

Shared Tax Burden? Spread The Wealth

According to the most recent data from the IRS, the top 1% of filers are now bearing a record share of the income tax burden. In 2006, people with an adjusted gross income of more than $388,800 paid 39.9% of all federal income taxes while earning just 22% of the overall income. This is up from the 2005 data which showed the top "one-percenters" paying 39.4%.

The top 10% - which includes you if you earn more than $108,900 - pull in 47% of adjusted gross income but pay almost 71% of the total tax burden. The culprit? perhaps it is the Alternative Minimum Tax. In 2006, an estimated 3.8 million taxpayers were affected by the AMT and by 2007 that number is expected to grow to 23 million taxpayers.

It certainly doesn't appear that anyone has increased the number of tax breaks to the "wealthy". With record deficits and talk of increasing taxes, the only thing that appears to be increasing is their share of the overall tax burden.

On final interesting thing to note. The bottom 50% pay roughly 3% of the total income tax bill and the lowest income earners actually have a NEGATIVE income tax. Since their income is low enough to get the earned income credit, they qualify to get a refund on income AND payroll taxes.

The Rules of Boot in a 1031 Exchange

"Boot" is a term that you won't find in the Internal Revenue Code. But, if you talk to your accounting professional, you might find it is something he or she uses when discussing the tax consequences of a Section 1031 tax-deferred exchange. I use this short comparison in some of the courses we teach to describe boot..."two cowboys meet out on the range and decide to trade horses. One horse is worth more than the other, so the cowboy with the lesser valued horse, throws in his six shooter "to boot" in the trading of horses.

In modern times, Boot is basically any money or the fair market value of any non-like kind or "other property" received in an exchange. When talking about money, in this context, it should be understood that this includes cash or any cash equivalents - including any debt or obligation the taxpayer assumed by the other party or liabilities to which the property exchanged by the taxpayer is subjected. "Other property" is property that is not like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or "non-qualified property." "Other property" also includes such things as a promissory note received from a buyer (Seller Financing).

Any boot received is taxable (to the extent of exchange gain realized). This is fine when a selling taxpayer desires some cash - and is willing to pay some taxes. Otherwise, boot should be avoided to fully defer the gain in a 1031 Exchange. Boot can sometimes inadvertently appear at closing from a variety of factors. It is important for the exchanging party to understand what miscelaneous items can result in boot if taxable income is to be avoided.

The most common sources of boot include cash boot received during the exchange, debt reduction boot (from trading down in value) and sale proceeds being used to service costs at closing which are not closing expenses. We covered this recently in our article about Closing Costs and 1031 Exchange.

As a recap, the following are examples of some of the non-transaction costs which should be paid with cash brought to closing to avoid "boot":

rent prorata items

utility escrow charges

tenant security or damage deposits

loan acquisition costs

For complete information on the issue of boot, please look at the Rules of Boot section of our Exchange Manual found on the 1031 Corporation Exchange Professionals website.

Market Issues Threaten Investment Mortgage Options

Headlines today are filled with larger banks and mortgage companies in residential real estate lending rushing to raise capital, set aside loan reserves and just simply try to stay in business. Possible government intervention, investor nervousness and changes at Freddie Mac and Fannie Mae in a tightening underwriting market are threatening to topple the mortgage providers and the organizations themselves. While the previous cause for the foreclosure market has been focused on higher loan-to-value loans and faulty or aggressive underwriting, traditional real estate investors are now beginning to feeling the pinch as well.

Earlier this year, Freddie Mac sent an advisory letter to mortgage lenders specifying new product standards. The advisory, now implemented, requires individual real estate investors that obtain loans sold to Freddie to finance no more than four investment properties (previously Freddie capped the number of properties at ten). With Freddie and Fannie responsible for nearly half of the twelve trillion dollar mortgage market in America, many other underwriters have followed suit on the four-property limitation.

You can understand what this drastic change has meant for investment financing options. With the new requirement, real estate investors who already have more than four properties are now unable to refinance their existing loans. This is a potentially big problem for the many investors that have used adjustable rate or fixed initial rate mortgages. As cash flow is squeezed, the change may lead to even greater foreclosure numbers. Those mortgage companies that are continuing to finance investors with greater than four investment mortgages are naturally increasing their costs for providing a mortgage. The rising costs are impacting investment portfolios and dampening tax incentive strategies across the country.

Previously, tax-savvy investors were able to take a mortgage against their primary residence and invest the money in investment property. Many times, these mortgages were larger than $417,000 – the current minimum jumbo mortgage loan amount. The idea was that the return on investment from the property would be higher than the after tax deduction cost of the mortgage interest. However, as investors are forced to pay higher rates on these mortgages, the strategy becomes less attractive.

While real estate investors are definitely more limited today than in the past, they are not completely out of options. It is possible to bypass the four-property rule by taking out a line of credit - rather than a mortgage - at a local bank. Many of these are prime-base products and can possibly be a lower cost option today. Another option is to work with a local or regional lender (1031 Corporation’s parent, FirstBank, is one such option) that holds investment and jumbo mortgages "on their books" as investments and locally underwrites each loan.

Overall, the industry outlook is that the mortgage market is probably going to get tighter. With a hard fought and tight presidential election looming as well as a struggling national economy and financial markets, investor sentiment is that it will take a while for the mortgage market to improve. For investors, that means establishing - or keeping in touch with - strong, trusted local lenders and advisers that are in touch with the rapidly changing mortgage markets.

IRS Guidance and 1031 exchanges

Many times in this blog, we refer to different Internal Revenue Service publications that provide guidance on issues involving real estate and 1031 exchanges. The IRS provides a number of publications and written correspondence that provide guidance. These documents are essentially a translation of tax laws that Congress enacts. we often refer to these when consulting clients on 1031 exchanges. I've listed the top 5IRS publications we use - starting at the highest and moving down according to their "rank".

Regulation
Regulations are the highest form of guidance to new legislation. They are are issued by the IRS and Treasury to also address issues that arise with respect to existing Internal Revenue Code sections. Regulations interpret and give directions on complying with the law.

Revenue Ruling
A Revenue Ruling generally states an IRS position. It is an official interpretation of the Regulation Code or statute. It is, basically, how the IRS applies the law.

Revenue Procedure
A Revenue Procedure is an official statement affecting the duties or rights of taxpayers under the Code, statute, and/or regulations. A Revenue Procedure might provide return filing or other instructions concerning an IRS position. It may also provide a "safe harbor" umbrella with which a taxpayer can structure and complete a transaction.

Private Letter Ruling
A Private Letter Ruling, or PLR, is a statement written to a specific taxpayer that interprets/applies tax law to that taxpayer's specific set of facts. It is issued to establish the tax consequences of a particular transaction before the transaction is completed or before the filing of a taxpayer's return. To receive a PLR, a taxpayer must request a written response from the IRS. It is binding to that taxpayer's circumstances only if the taxpayer is fully and accurately describing the proposed transaction in the request and carries it out as described. It should be noted that while a PLR may provide guidance, it can not be relied on as precedent by other taxpayers or IRS personnel.

Technical Advice Memorandum
A Technical Advice Memorandum, or TAM, is guidance furnished by the Office of Chief Counsel in response to technical or procedural questions that develop during a proceeding. A request for a TAM generally comes from an exam of a taxpayer's return or a taxpayer's claim for a refund or credit. TAMs are issued on closed transactions and interpret the application of tax laws, treaties, regulations, Revenue Rulings or other precedents. The advice is deemed a final position of the IRS, but only with respect to the specific issue in the specific case in which the advice is issued.

There are, of course, many other additional publications and pronouncements that provide taxpayer guidance. Robert F. Reilly, CPA, CFA - in a two part article for the AICPA's Practicing CPA, detailed a number of these various publications. Part I covers publications presenting official IRS positions, IRS instructional publications, and announcements, notices, and news releases. While Part II covers advance rulings and determinations as well as new types of IRS pronouncements.

When seeking tax and litigation guidance, tax professionals (CPAs and attorneys) first consider statutory authority. When that is insufficient, they look to these official publications of the IRS as well as judicial precedent (Tax Court rulings)regarding the specific matter.

With respect to 1031 exchanges, your Qualified Intermediary should be monitoring various tax law updates and publications to have the most current weapons to provide you in your arsenal. 1031 Corporation Exchange Professionals has a full time CPA on staff and retains expert tax and real estate attorneys that constantly monitor and update like-kind exchange strategy. While we do not provide tax or legal advice, we can consult with you and your tax professionals and provide guidance as to the proper IRS publications and court case precedent in reviewing your individual exchange facts and circumstances. Further, this consultation is provided as a part of our services and no fee is paid unless an exchange is initiated.

Primary Residence Gain Exemption Rule Changing

Most homeowners are aware of the primary residence exclusion. It is a provision in the tax law that allows a homeowner to sell their primary residence and exempt the gain if certain conditions are met. The gain is available up to $250,000 - if you file your taxes individually - or $500,000 - if you file your taxes if married filing jointly. To be eligible, you must own the home and live in it - as a primary residence - for at least two of the last five years prior to the sale.

The law previously permitted you to convert a vacation, secondary residence or investment property into your principal residence, live in it for two years, sell it and take the full exclusion even though a portion of the gain might have been attributable to periods when the property was used as a vacation, second home or investment property.

This strategy was used for 1031 exchange investors to exempt up to $500,000 of deferred gain in an investment property. In 2004, the Jobs Creation Act made an additional requirement that if a 1031 exchange was involved, you had to own the property for a minimum of five years. thus you could rent a home out for three years, move in it for two and exempt the exclusionary gain.

The Housing Assistance Tax Act of 2008 changes all that. While many provisions within the new law assist struggling homeowners, a provision added takes away from the primary residence exemption rules.

Beginning on January 1, 2009, homeowners will now be required to pay tax on gains made from the sale of a second home, vacation or investment property the portion of time after that date that the home was not used as a primary residence. The amount taxed will be based on the portion of time that the house was not used as a primary residence. The rest of the gain remains eligible for the "up to $500,000" exclusion as long as the two out of five year usage and ownership tests are met. The new law thus reduces the exclusion to the ratio of time used as a principal residence to the total time of ownership.

For example, suppose a married couple filing a joint tax return purchases an investment property after January 1, 2009 and rents it for seven years. They then convert it into a primary residence for three years before selling it. In this situation, only 30% (3/10 years) of the gain would be eligible for the $500,000 exclusion and 70% 7/10 years) of the gain would be subject to tax. Quite a difference.

There is some good news. It is not retroactive. The period of investment use before 2009 is ignored. So is the period of time it is rented after you move out of the residence. Only periods of time it is rented before you made it your residence (after January 1, 2009) count. So, if you've owned an investment property for the past twenty years, move into it before January 1, 2009, and live in it for two years before you sell it, the entire gain remains eligible for the tax exclusion. So, too, is the primary residence that you lived in on January 1, 2009 but later rent out for two years before selling it. The entire gain is eligible for the exclusion.

The Act complicates deferred gains on 1031 exchanges and changes investor strategy for moving into an investment property. 1031 Corporation Exchange Professionals can provide guidance on the issue and, of course, you should speak with your tax advisor to ensure you fully understand your options.

Land Banking & 1031 Exchange

Land banking is not a new concept. It is described as the process of separating real estate activities by forming different business entities that perform investment functions while others complete development activities.

Let's say an investment group forms an LLC and purchases a tract of land for a long-term investment. Over the years, development moves closer to the land and the land increases in value. Perhaps the property is annexed into a municipality, the zoning is changed and a new four lane highway appears. The group decides that, rather than sell it "as is", they would further profit by taking the land through development of the parcel. But wait, they've held it for a long time and they realize that if they develop it, they will get taxed at ordinary tax rates instead of the long term capital gain rate - which is significantly lower. But what if they form a new entity to develop the property? Ah....land banking!

Thanks to a series of favorable court rulings over the past couple decades, owners can sell a property to a separate corporation they control. This corporation then develops the horizontal (and perhaps vertical) improvements and markets the land. By doing so, the former entity - in our example, the LLC - can potentially save significant tax liability on the appreciated value of the land when it is sold to the related corporation by classifying the investment as a long-term capital gain! Jim Walker, the senior tax partner of at the firm Rothgerber Johnson & Lyons LLP explains this process more fully in his article "Land Banking:" A Structured Approach to Capital Gains Planning.

So what would happen if the owners of the LLC decide ahead of the sale that they'd like to reinvest the proceeds of the land sale, to the related corporation, via a 1031 exchange rather than pay the 15% Fed cap gains tax (plus any applicable state or local tax) in order to fully defer the tax?

There is a special rule for exchanges between related parties which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years following the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs. Under this thinking, the development corporation would be compelled to hold the land purchased from the LLC for two years before reselling it.

Tax and exchange professionals have historically advised their clients to comply with the two year rule. However, three Private Letter Rulings (PLRs) released in 2007 say that the two year rule did not apply to a related party who purchased the relinquished property from the taxpayer. The legislative history of Section 1031 identifies several situations intended to qualify under this provision. It includes a non-tax avoidance exception that applies to transactions not involving the shifting of basis between properties.

The purpose of the rule is to prevent related parties from shifting basis from a high basis asset to a low basis asset in anticipation of the sale of the low basis asset that would reduce gain recognition. However, the exchanges in the three PLRs treated the exchanges as valid even though the related buyer voluntarily disposed the property it acquired within two years of the purchase. The rationale used in the 2007 Private Letter Rulings was that the exchanging taxpayer was the only entity that owned property before the exchange. The development corporation did not own property prior to the exchange. Thus, the subsequent disposal did not result in "basis shift" or "cashing out".

So is it possible to land bank a property separating the investment and development activities between entities and then subsequently have the investment entity exchange property? It would appear so - based on recent rulings. Clearly, one need get their legal and tax professional included early on in this process to ensure that you've structured a case that will stand up to potential audit. You also should use the services of a Qualified Intermediary that understands related party issues and knows how to properly process the exchange.

Closing costs deductions on 1031 Exchange

We are often asked this question. Or perhaps it is asked, “Do I have to replace the net sales price or full sales price of the property I am selling to fully defer my tax?” Unfortunately, very little guidance (and it is fairly dated) has been provided in determining the deduction of transactional costs from any realized and recognized gain. Internal Revenue Service Form 8824 provides for transactional costs that are referred to as “exchange expenses” that can be deducted. But what are transactional costs?

Exchange expenses are those expenses which result solely as a result of the sale or acquisition of property and other costs directly related to the sale or acquisition of real estate or in connection with the 1031 Exchange (transaction expenses). These may include: real estate commissions, closing or escrow fees, title insurance premiums, legal fees, transfer taxes as well as such items as notary fees, recording fees and even the fee paid to your Qualified Intermediary.

One thing is clear. Costs related to obtaining financing should not be deducted from the proceeds to determine the "net sale price." Other transactional items typically found on a closing statement are not exchange expenses and probably do not reduce the amount realized or recognized and are not added to the basis of the replacement property. Items such as property taxes, utility escrow deposits or charges, homeowners' association fees, hazard insurance premiums, tenant security deposits and prepaid rents are items to look for on a closing statement.

When completing your tax return and determining how to report closing cost deductions, it will be extremely helpful to have your settlement statement as well as a form such as 1031 Corporation's Form 8824 worksheet. Of course, a taxpayer should review their individual transaction and closing costs with their tax and/or legal advisors to determine whether costs related to the closing are exchange expenses or not.

Where Does Your Intermediary Put Your Exchange Funds?

We've spoke before of the need to fully investigate the Qualified Intermediary (QI) you, as an investor or a referring agent, choose. Some high profile cases have identified the need to deal with a QI you know and trust. Even that is sometimes not enough and you should really investigate the safety and security of the company you use.

As we've said before, the range of investments a Qualified Intermediary can make with your exchange funds is not currently regulated. Your QI can place your exchange funds in many different investment vehicles. Knowing how your exchange funds are protected is vital when selecting an intermediary partner. Most, but not all, QIs place your 1031 exchange proceeds in financial institution. Others choose to pool the funds and place them with an investment firm that offers short term liquidity such as overnight borrowing vehicles.

While we've previously explored the security features of bonding and making sure you deal with a firm that is financially stable and uses segregated accounts. However, we haven't discussed knowing the financial strength of the institution with which the Qualified Intermediary banks your funds. With recent news of bank capital calls, troubled financial institutions and even failures like Indy Mac, you should ask the question of where your funds are held.

Some of the questions you should ask include:

Are your exchange proceeds placed in a segregated account or are they pooled with other exchange client funds?

How well capitalized is the bank or financial firm your Qualified Intermediary uses?

Can you find information of the bank or investment firm?

Has there been any recent news about trouble such as capital calls, bad loans or subprime lending participation with the financial institution?

Does the bank or investment firm provide independent depositor insurance such as FDIC coverage?

Does your Qualified Intermediary offer the ability to split your exchange funds into multiple accounts to provide deposit insurance protection?

Our firm has always segregated funds and held them in a bank account. We are a subsidiary of FirstBank. They hold more than $9.2 billion in assets, have a low loan-to-deposit ratio of around 42% and are extremely well capitalized. Further, they are profitable today having a very low percentage of problem loans and have never participated in subprime mortgage lending. In fact, the health of the bank was just highlighted in both a Rocky Mountain News article and a Denver Post article. We also have the ability to split accounts into 26 separately chartered banks of the bank. This provides our clients with up to $6.5 million in FDIC insurance.

You should expect the same level of security and safety in your 1031 exchange funds. After all, it's your money they are holding. If your Qualified Intermediary can not answer these simple questions of where the money is held, or the answers aren't sufficient to provide you peace of mind, it's time to look for a new QI.

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.

Mutual Irrigation Ditch, Reservoir or Irrigation Company Stock

With the recent passage of the Food and Energy Security Act of 2007 (commonly referred to as the Farm Bill), mutual irrigation ditch, reservoir or irrigation stock (“ditch stock”) MAY now be considered like-kind to a fee interest in real estate.

Section 1031 clearly spells out that corporate stock, bonds and notes are not eligible for a like kind exchange. However, the recently passed Farm Bill amends section 1031 to exclude mutual irrigation ditch, reservoir or irrigation company stock from “stocks, bonds, or notes”. With this passage, these water rights may now be eligible for a 1031 exchange - depending on state statute and previous court rulings.

Mutual irrigation ditch, reservoir or irrigation stock is generally considered to be a water right which is used on farm land to irrigate crops. Water, as a mineral, is generally considered to be an interest in real estate. As an interest in real estate, it is generally considered to be like-kind to a fee interest in real estate. Farm land which is sold or exchanged sometimes includes ditch stock that has benefits and value to the sale of that land. Particularly in the western United States, these water rights are critical to the ongoing production ability of the property and are typically sold with the real estate.

In order to qualify, the new law clearly indicates that such ditch stock has to be recognized as real property, or an interest in real property, in the state in which the corporation is located. Recognition can be by the highest court of the state or by applicable state statute. Mutual irrigation ditch companies are organized under separate sections of state statutes and ditch stock has been recognized as an interest in real property by the District Court of Colorado and other court cases. However, ditch stock in other states may or may not qualify.

Exchange clients should be familiar of the state laws and court rulings in the state their exchange property is located. Of course, they should also discuss their circumstances with a knowledgeable real estate attorney or qualified tax professional before embarking on an exchange of water rights. A Qualified Intermediary that is familiar with the special closing and exchange-related issues involving ditch and water stock should also be consulted and engaged to ensure the exchange is completed properly. To learn more about this topic, please consult our 1031 Exchange Manual or give 1031 Corporation Exchange Professionals a call at 888-367-1031.

Transferable Development Rights are 1031 Like Kind to Real Estate

Transferable Development Rights (TDRs) are a relatively modern land use planning tool that are encountered in many jurisdictions. Where they are authorized, governments can grant TDRs in order to limit or to entirely prevent development in special zoning districts. When properly structured, governments can accomplish these land use goals without having to pay for what might otherwise constitute costly partial – or even total – condemnations. TDR programs can also be used to reduce political and legal opposition to a restrictive zoning plan. In a TDR program, a governmental entity grants owners of property in the special use zone TDRs in exchange for either voluntary or compulsory new restrictions on the development of property within the zone. These TDRs can be sold on the open market to owners of other real property in a receiving zone, permitting development of the property in the receiving zone beyond what would otherwise have been permitted.

In a recent IRS Letter Ruling (2008-05012), a taxpayer proposed to sell a fee interest in relinquished property and use the proceeds to acquire TDRs. Those TDRs would be used to enhance construction on property the taxpayer already owned within a designated receiving zone. The taxpayer sought a ruling that the TDRs were like-kind to a fee interest in real property.

The IRS ruled that the TDRs could be like-kind to a fee interest under section 1031, despite the fact that the taxpayer intended to use the them to enhance real property it already owned, as long as the TDRs were acquired in an arm’s length transaction. They cited a prior Revenue Ruling from 1968 that said a leasehold with more than 30 years left to run on the property the taxpayer already owned was like-kind to a fee interest under section 1031 as long as the taxpayer acquired the leasehold in an arm’s length transaction.

Next, relying almost entirely on their classification under state and local law, the ruling held that the TDRs are like-kind to a fee interest in real property. While TDRs may not be treated identically to real property for all purposes, they are treated like real property in a number of important ways including: a) the fact that their grant is not discretionary; b) they appear to be permanent; c) they are transferred in a manner similar to the transfer of a deed or an easement; and d) they are recorded and indexed against the granting and receiving sites. Further, the state where the taxpayer was located had a tax statute and transfer tax provisions that seemed to define TDRs as real estate.

Because TDR programs vary considerably from one state to another, it is by no means certain that the laws of a particular jurisdiction will comply sufficiently with the standards presented in this letter ruling. As is always the case with private letter rulings, the ruling itself cannot be cited as precedent, and the IRS has the right to rule differently on subsequent occasions. However, the ruling is useful for the purpose of demonstrating the current thinking on this important subject. To receive a copy of the PLR involving TDRs, give us a call at 888-367-1031 or send us a message at 1031@1031cpas.com.

Family Limited Partnerships

In managing federal estate taxes, the use of Family Limited Partnerships (FLPs) has proven to be a beneficial planning technique. During the last two decades, FLPs gained popularity. They also attracted the attention of the Internal Revenue Service (IRS).

Due to the FLPs extraordinary tax benefits, the IRS has audited many FLPs. But this IRS challenge should not be viewed as their demise. Rather, IRS audits reveal proper FLP use and maintenance.

Benefits of the FLP
An FLP is a powerful estate planning tool that can help reduce future taxes. This tool may be very handy as estate taxes may soon be at an all time historic high. For those who pass away after 2010, the tax law would impose a steep estate tax or "death tax" burden of up to 55% of ranch value!

Using an FLP can help ease this tax burden. Through an FLP, a senior family member can reduce the estate tax and keep control of the family operation.

An FLP is often formed by a member of the senior generation who transfers family assets to the partnership in exchange for both general and limited partnership interests. Some or all of the limited partnership interests are then gifted to the junior generation. The general partner need not own a majority of the partnership interests. In fact, the general partner can own only 1 or 2% of the partnership, with the remaining interests owned by the limited partners.

This structure produces several advantages:

The senior family member can gift limited partnership interests to junior family members at less than the full fair market value of the underlying assets.

The use of the partnership entity allows a senior family member to shift some of the form and ranch income and future appreciation to other members of the family.

The senior family member retains management and control while transferring away limited ownership interests.

The senior family member can also place restrictions within the partnership agreement that ensure continuous family ownership.

At death, the senior family member's estate tax bill may be reduced since only the value of the decedent's partnership interest will be taxed.

IRS Scrutiny: Potential Concerns with the FLP
The IRS has taken a more aggressive stance regarding FLPs. Over the past several years, the IRS has had success in attacking FLPs with the most common problems being:

Failure to Follow Formalities. FLPs are required to have Partnership Agreements that must be followed. Although FLPs have far fewer formalities than corporations, the partners should have regular meetings, take minutes, and treat the entity with the formality expected of a non-family business.

Inadequate Valuation Reports. The IRS is often critical of both the quality and content of the family's valuation appraisals. To avoid the IRS attention, the family should retain accredited appraisers experienced with the requirements of estate tax appraisals.

Non-business Assets or Activities. FLPs are business entities and are not meant for personal use. The family homestead should not be placed into an FLP, nor should normal family expenses (utilities, clothing, educational expenses, etc.) be paid from the FLP.

Other "red flags" include commingling FLP and personal income, preparing FLP financial records after death and forming "deathbed" FLPs.

FLPs need annual care and regular maintenance. With this care, FLPs can achieve substantial federal estate and gift tax savings. For farm and ranch families with large illiquid estates, FLPs can be a very beneficial tax savings tool.

Denise Hoffman is a senior associate with the law firm Rothgerber Johnson and Lyons LLP. If you or your family has questions concerning Family Limited Partnerships, please call Denise at 303-628-9523 or contact her by e-mail at dhoffman@rothgerber.com.

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.

FDIC Insurance on 1031 Exchange Funds

So you are considering a 1031 exchange and you have selected a Qualified Intermediary (QI) to facilitate your exchange. The property you are selling is under contract and the closing is next week. You have begun the search for suitable replacement property but have not yet found anything appropriate. The money from your sale, it appears, is going to be held by the Qualified Intermediary for some time. But what will that QI do with the funds while you await the need for those proceeds in a replacement property purchase? How do you know your funds are secure?

The range of investments a Qualified Intermediary can make with your exchange funds is not currently regulated. Therefore, the funds can be accounted for and placed in many different investment vehicles. Knowing how your exchange funds are protected is vital when selecting a intermediary partner. While we've previously explored the security features of bonding and making sure you deal with a firm that is financially stable and uses segregated accounts, we haven't discussed the issue of Federal Deposit Insurance as a security vehicle when discussing 1031 exchange funds.

Many larger Qualified Intermediaries co-mingle client funds into one investment account. They do this to maximize the return on investment for the QI firm. From there, the funds may be invested with a brokerage or depository institution. Other QI firms segregate each client's funds into a separate account held at a commercial bank. While many of these brokerage accounts can be just as secure in the instruments they invest, it certainly pays to investigate whether your funds are co-mingled or segregated and exactly where and what the funds are being invested.

Okay, now you've determined that it is in your best interest to use a Qualified Intermediary that is depositing the funds into a segregated account at a commercial bank. But your exchange proceeds are more than $250,000. The amount you receive exceeds the amount of FDIC insurance and you are concerned with the added protection this level of insurance would provide. So, now what?

Some Qualified Intermediaries, including our firm, provide the ability to open multiple exchange accounts to the same client under separate bank charters. What this allows is the ability to increase the overall FDIC insurance coverage to the number of institutions times $250,000 at each charter. For example, 1031 Corporation Exchange Professionals is a subsidiary of FirstBank. With 26 separate charters in Colorado, Arizona and California, 1031 Corporation has the capacity to open multiple accounts and extend the FDIC coverage for any one exchange client up to $6.5 million.

Selecting a Qualified Intermediary that only uses segregated accounts banked at a financially solid, commercial bank (and further - owned by a larger financial parent) are important safety features to consider. Still, having a government-sponsored insurance, like the one the FDIC provides, for the amount of your exchange can certainly add an extra layer of confidence that your funds are secure.

Revoking an Inadvertent Opt-Out from Installment Method in a Failed 1031 Exchange

An interesting private letter ruling was just released that dealt with an installment sale as it relates to a 1031 exchange. In this case, a taxpayer sold real estate property as part of a planned exchange. However, they were unable to find suitable replacement property within the 180 day exchange period, and the exchange was not completed. The exchange was started in one calendar year and the 180 day period expired in the next year. This failed exchange qualified as an installment sale because the taxpayer did not have receipt of any portion of the sales proceeds in the year that the property was sold.

However, a slight problem occurred. Apparently, the taxpayer’s accountant failed to recognize that the transaction qualified as an installment sale and he reported the gain from the property sale on the tax return for the year the exchange started. Declaring the income on the taxpayer’s tax return amounted to an option to opt out of the installment method. Otherwise, the taxpayer would have been permitted to defer the tax payment on the proceeds from this transaction until the return year that the exchange funds were received.

A section of the Treasury regulations provides that an election to opt out of installment sale treatment is irrevocable, and that “An election may be revoked only with the consent of the Internal Revenue Service.”

When the taxpayer learned of the accountant’s error, it applied to the IRS for consent to revoke its "opt-out" election. The IRS was satisfied that the election to pay the taxes in the first year was inadvertent and the result of the accountant’s oversight - rather than hindsight by the taxpayer or some attempt to avoid taxes. Therefore, the taxpayer was permitted to revoke its election out of the installment method and defer the tax payment on the proceeds until the second filing year.

This reflects both the possibility of deferring capital gains tax over a calendar year on an exchange started late in the year as well as the ability to amend or revise taxes for something inadvertently overlooked by an unknowing accounting professional.

There is also another option for investors of failed exchanges called a Structured Sale Transaction. We'll write about that option next so stay tuned.

1031 Exchange Partnership Issues

Investment real estate is commonly owned by multiple owners in a partnership or by multiple owners as tenants in common to an undivided interest in the underlying real property. An exchange of a tenant-in-common interest in real estate poses no problems and is eligible for 1031 Exchange treatment. However, an exchange of an interest in a partnership is not permitted under the Code and Regulations. Careful forward planning is required to ensure a successful 1031 exchange where partnership issues are involved.

If a partnership owns property and desires to sell and exchange it, the partnership is the entity or party to the like kind exchange. Since the partnership will take title to the replacement property, no issues are apparent during the exchange period. However, if the partners wish to split up immediately after the exchange, the "held for" requirement may not be met on the replacement property. The partnership would need to retain ownership of the new property for an unspecified period of time (one year is commonly thought to be sufficient) to meet this qualification. Once sufficient time has passed, the partnership can then dissolve and distribute the property - through deed to individual properties or tenant-in-common ownership - to the former partners.

If a partnership wishes to exchange property but one or more of the partners want to "cash-out" or go their separate way(s), it is common for the partnership to split out the ownership before the sale. The partnership distributes tenancy-in-common title to the individual partners who wish to proceed in separate directions. The partnership (and its remaining partners) would then proceed with an exchange of the remaining ownership in the name of the partnership.

Frequently, individual partners desire to end the partnership relationship when the owned property sells. They would prefer to take their share of the partnership sale proceeds and buy qualifying 1031 replacement property in their own names. Far too frequently, the partnership gives each individual their undivided tenant-in-common interest in the old property just days or hours before closing. The plan is for each partner to take ownership in his or her name and individually complete a 1031 exchange. This lack of planning presents problems. The entire exchange could fail since the partnership could be seen as the selling entity that did not take title to qualifying replacement property. The individual owners have not met the "held for" requirement as they only owned the property in their individual names for a short period of time.

If partners wish to discontinue the partnership, sell the property and go their separate ways - with either the cash or a 1031 Exchange - it is necessary for the individual partners to receive deed to the property from the partnership in advance of the sale of the property. This is done through a distribution of property from the partnership to its individual partners. The partners are then generally required to hold the property as tenants in common for an unspecified period of time (decent interval of time) in order to comply with the "held-for" requirement of a 1031 Exchange that requires a taxpayer to have "held" qualifying property for business or investment purposes prior to the exchange.

The services of a tax professional are essential for tax planning purposes. An experienced Qualified Intermediary is also needed to ensure a successful exchange structure where partnership and co-ownership real estate interests are involved. To view more on partnership issues or other issues related to 1031 exchanges, take a look at this 1031 Exchange Manual or give us a call at 888-367-1031.

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.

What Does a Home Inspector Look For?

A couple months back, we mentioned a number of items that you can do to get your house ready for sale. So, you've been good enough to get the property under contract and a closing date has been scheduled. Now, if you can just pass the inspection without a number of concessions or issues to scramble to fix before closing.

Well, the following items reflect areas of your home that are typically looked at by a certified home inspector (ASHI®… American Society of Home Inspectors). In some instances, if not given proper attention prior to the inspection, they may become issues to be resolved as a result of the Inspection Condition of the contract and could potentially cost more in time and money. Take a minute to review this checklist. It would be wise to go ahead and make any necessary corrections now.

Add downspout extensions of 4” flexible tubing 5’ from the house to control basement seepage.

Maintain a positive grade of dirt approximately 3’ away from the foundation to direct water away from the house.

Check flashing around chimney, vent pipes and eves for leaks and caulk with roofing cement.

Clean all gutters and check alignment. Replace rusted out sections.

Power wash exterior siding and decks.

Clean masonry stoops and walks and paint handrails with rustoleum.

Caulk windows and door thresholds with a silicone/latex caulk.

Freshly paint the front door, windows, trim and shutter for curb appeal.

Put down fresh bark/rock and add flowers to brighten up the front yard.

Repair floor squeaks by screwing the sub-floor to the joist.

Have the furnace and air conditioning unit(s) serviced by a licensed contractor; check for gas leaks, heat exchanger problems… Get a written report.

Repair leaky faucets, loose toilets, plumbing leaks, and re-caulk the tub/shower with a silicone tub and tile caulk.

Clean ashes from the fireplace and check the firebrick for cracks and the condition of the flue and damper. Have a chimney sweep clean the area if there is more than 1/3” of creosote.

Patch cosmetic sheet rock cracks with spackling compound. Touch-up paint.

Check windows for proper operation.

In crawl spaces add 6 mil polyethylene over exposed dirt as a vapor barrier and radon gas deterrent.

Check all exhaust fans, whole house fans, ceiling fans and attic fans for operation.

These tips could save you a more costly "find" by the inspector or, worse yet, give your buyer a reason to delay closing or back out of the contract.

For more tips or to find a home inspector in your area there are three organizations that you might find helpful The American Society of Home Inspectors, The National Association of Certified Home Inspectors or The National Association of Home Inspectors.

Related party exchange IRS rulings confirms past guidance

Two new Private Letter Rulings have been released that follow the pattern of recent previous rulings on Related Party Exchanges. The recent rulings holds consistent with previous answers that the taxpayer may acquire replacement property from a related party if the related party is also doing an exchange into a replacement property.

The taxpayers intend to sell property to an unrelated party and acquire replacement property from a related entity. The related party will then use the sale proceeds to acquire another property. The letters indicate that both the taxpayer and related party will use a Qualified Intermediary to complete their exchange and both will hold their replacement property they buy for at least two years.

A 1031 exchange is not allowed if it is part of a transaction, or series of transactions, structured to transfer a low cost basis from one entity to another or if one of the two parties is cashing out of their investment. In both cases, the IRS held that receipt of limited cash boot by the related party would not invalidate the exchange under §1031. Both parties will end up owning property that is like kind to the property they sold.

The full Revenue Procedure Rulings are available by clicking PLR 200820017 and PLR 200820025.

Possible capital gains tax increase on the horizon?

Recently, the Wall Street Journal released an article discussing a recent phenomena we've seen in the exchange business. The article, written by Dale Arden is titled Property Investors Fear Gains-Tax Rise, Shift 1031 Strategy. It discussed the idea that real estate investors are not using 1031 exchanges as a strategy in light of the possibility that a new administration will raise capital gains tax rates. Instead, they are taking advantage of, what is perceived as the lowest capital gains tax rate, the 15% long-term capital gains tax.

We discussed this a couple months back in an entry titled, AMT, Capital Gains and the Time Value of Money. The answer to the question really comes down to whether it is financially better to pay a 15% tax rate or pay a 20% or 25% rate when the property is sold some years out. Central to the analysis of this is the assumptions made. When will the replacement property be sold and at what level of appreciation? The longer the hold period and the greater the appreciation, the more likelihood that it may still make sense to defer the gain and pay the tax later. That, of course, assumes there is a capital gains tax that is higher at the date you defer than today. After all, they could go up only to be reduced at some later date before you eventually cash out and pay the tax. Betting on politics...now that is a tricky game!

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.

Senate Estate Tax Alternative Hearings Expected to Yield No Action

Last week, the Senate Finance Committee met to discuss "Alternatives to the Current Federal Estate Tax System". This was the second of three hearings scheduled. Issues surrounding the possible administrative burdens to the Internal Revenue Service and the role of government in estate taxation. Also discussed were the complaince with budgetary rules and precautions to a new estate taxation system. Members reviewed the accessions tax and comprehensive inheritance tax.

Despite adding amendments to the Senate budget resolution and these three scheduled hearings, experts believe that it is unlikely there will be any substantive movement on the estate tax issue this year. More likely, the issue could be addressed next year before the 2010 one year full repeal and reversion to pre-2001 law that would occur in 2011.

IRS 1031 Exchange Fact Sheet

On March 5th, the IRS released a new ‘Fact Sheet’ (#21 in the Tax Gap Series) on 1031 exchanges. The information contained it in is fairly basic and doesn't provide anything too earth shattering to those who've done exchanges. It does note the incidental increase in Qualified Intermediary bankruptcies. It does also mention taxpayers need to be wary of schemes involving non-qualifying exchanges of vacation or second homes and 'promotors' that allow constructive receipt or refer to a 1031 exchange as "tax-free".

Finally, they make mention a very important aspect...consult with a tax professional for additional assistance. In combination with a good qualified intermediary, a real estate attorney tax or accounting professional and professional real estate agent should be included early on to ensure the exchange is structured properly and legitimately processed.

To see the full the full IRS Fact Sheet, see the Like Kind Exchange Fact Sheet located on our website.

Tax Cuts Explained - Economics 101

We haven't posted for a couple weeks and there is much to report. However, today, I wanted to post the following that I received in an email. I think it is appropriate for a Friday...

Because it's the election season, let's put tax cuts in terms everyone can understand. Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that's what they decided to do.

The ten men drank in the bar every day and seemed quite happy with the arrangement until one day the owner threw them a curved ball (or is that a curved beer!). "Because you are all such good customers," he said, "I'm going to reduce the cost of your daily beer by $20."

Drinks for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his 'fair share?'

They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer.

So, the bar owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay. And so:

The fifth man, like the first four, now paid nothing (100% savings).

The sixth now paid $2 instead of $3 (33% savings).

The seventh now paid $5 instead of $7 (28% savings).

The eighth now paid $9 instead of $12 (25% savings).

The ninth now paid $14 instead of $18 (22% savings).

The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant the men began to compare their savings.

"I only got a dollar out of the $20," declared the sixth man. He pointed to the tenth man, "but he got $10!"

"Yeah, that's right," exclaimed the fifth man. "I only saved a dollar too. It's unfair that he got ten times more than I!"

"That's true!" shouted the seventh man. "Why should he get $10 back when I got only two? The wealthy get all the breaks!"

"Wait a minute," yelled the first four men in unison. "We didn't get anything at all. The system exploits the poor!"

The nine men surrounded the tenth man and beat him up. The next night the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our Tax System works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

David R. Kamerschen, Ph.D.
Professor of Economics
University of Georgia

For those who understand, no explanation is needed.


For those who do not understand, no explanation is possible.

New Guidance on exchanges of Vacation Homes

Just issued, hot of the press, is a new IRS Revenue Procedure (Rev Proc 2008-16) providing a safe harbor for exchanges of vacation homes held for investment purposes. This has long been an area where guidance, for exchange purposes has been sought. So, this recent Procedure ruling is quite a hot topic around our office.

In order to qualify as a "held for investment" property under the Revenue Procedure safe harbor guidelines, the relinquished (vacation property sold in a 1031 exchange) and replacement property (vacation property purchased in an exchange) must meet three basic guidelines:

The property must be held for at least twenty four months before and after the exchange.

Within this 24 month period, the vacation home properties must meet meet the following requirements:

1) The vacation home must be rented to another person at fair market value for fourteen or more days, and;

2) Personal use must not exceed fourteen days or ten percent of the time the property is rented at fair market value.

To read more about this exciting (okay...we admit, we are easily excited...) IRS Revenue Procedure ruling and obtain a more complete discussion on this topic, please see Safe Harbor for Exchanges of Vacation Homes.

When you visit, be sure to look around for related information on primary and vacation property rules as they relate to 1031 exchanges.

Conservation Credits and Development Rights are Like-Kind to Real Estate

Recent Private Letter Rulings have ruled that conservation easement credits and tranferable development rights are like kind to a fee interest in real estate.

PLR 200649028 regarding Conservation Easement Credits dealt with the question of whether future development restrictions conveyed by a taxpayer under a state conservation program would qualify as being like kind to a fee interest in real estate. In this case, a county issued "credits" to a taxpayer for a conservation easement. The credits were sold to a buyer and the taxpayer used the money to purchase replacement real estate - all with the assistance of a Qualified Intermediary. The IRS ruled that the credits represented an interest in real estate for both the seller and the buyer.

PLR 200805012 held that Transferable Development Rights ("TDR"s) are a qualifying interest in real estate which is like kind to a fee interest in real estate if they are considered real estate under state law. In this case, the taxpayer proposed to sell (exchange) real estate and replace with the purchase of TDRs. Another interesting aspect of this ruling is that the TDRs were to be used to construct improvements on a property already owned by the taxpayer. The IRS ruled that the TDRs were like kind to a fee interest real estate. It is unclear whether the IRS condoned the use of the proceeds for improvements on property the taxpayer already owned as replacement property.

These rulings are useful for purposes of demonstrating the current thinking of the IRS on these issues. However, taxpayer beware! Private Letter Rulings are specific to that taxpayer's question. The IRS has the right to rule differently on subsequent occasions. Also, conservation programs can vary significantly from state to state. The assistance of a tax professional, real estate attorney and qualified intermediary is essential when determining how best to structure your conservation easement or development rights exchange.

Staging your home for a quick sale

The market is slow, there are a ton of homes available in your neighborhood and you are competing against everyone - or so it seems. How do you get your home to stand out and sell a bit quicker?

A recent phenomenom is staging your home before marketing the property. What is staging? Basically it is making your home appear in top form for sale. Here are some tips to consider that should help your home show well.

FIRST IMPRESSIONS: An inviting exterior, or “curb appeal” invites a view of the interior. In the summer, keep the lawn trimmed and sidewalks edged, flower beds cultivated, bushes and trees pruned. In the winter, make sure snow is removed from walks and driveways and that the yard is free and clear of refuse. Check the gutters and downspouts for debris and make sure there aren't any leaks. Fix, paint, or wash railings, steps, front door and screens.

WALLS AND WINDOWS: Make sure all windows, window coverings, carpets and flooring are clean. Replace dirty or torn window screens. Touch up picture frame pinholes on the walls and clean or repaint kickboard scuff marks. Reduce or remove the number of personal photographs and frames.

FIX AND CLEAN: Make sure all door knobs and hinges work well and fix those sticking drawers and doors. Stop leaking faucets and tighten all fittings and handles. If necessary, replace worn or dated hardware. Clean and change filters on the furnace and air conditioning unit.

STORAGE SPACE: Store all unnecessary items and rearrange or, better yet, remove some furniture to “enlarge” rooms. Keep hallways and stairs free of clutter. Clear out the attic and basement and store off site. Storage and closet spaces don't look as large when they are filled! Having clothes hung neatly, shoes organized and other articles neatly placed will make your closets appear big and inviting.

LIGHTS: Replace all burned out bulbs and repair any faulty or worn out switches. Clean or replace dated and worn light fixtures.

KITCHENS SELL: Keep counter space clear of appliances. Clean and clear the refrigerator, stove and oven. Bake cookies or bread just before showings.

BEDROOMS: Arrange them neatly. Don't forget to safely store jewelry and personal items. Vacumn floors and rugs and make sure the beds are neatly made.

SPARKLING BATHROOMS: Keep countertop(s), sink(s), tub, watercloset and shower clean. Put away personal items - brushes, bottles and prescription medications.

GARAGES: Straighten up the tools and arrange stored goods on the shelves. Clean garage floors of oil spots and stains and make sure there is enough room to park the car.

TAKE ONE LAST LOOK AROUND! Before showing, tidy everything up one last time. Wash any dirty dishes, put clothes away and straighten up loose papers. Open the curtains and turn the lights on to give your home the best lighting.

Use these tidying tips and clutter-busting ideas and you may just find an edge over the competition that will get that home under contract a bit quicker.

Banks as a 1031 Exchange Qualified Intermediary

A couple months ago, we talked about the need to select your Qualified Intermediary (QI) carefully. Highly publicized failures of a couple larger intermediaries further highlight the need to select an exchange facilitator with security in mind. Banks are increasingly becoming involved in providing the services of a 1031 Exchange Qualified Intermediary.

If you think about it, it makes sense since that’s what banks do – hold money on your behalf. Exchanges typically result in sales proceeds being held until replacement property can be purchased and the exchange completed. There is a level of trust that is necessary for an investor to trust his exchange funds. Banks fulfill that needed role.

But what if you have an existing relationship with the bank? Does this disqualify your bank from being your Exchange Facilitator? According to a couple recent IRS rulings the answer is, no, they are NOT disqualified. In fact, your bank may be the safest and most prudent choice as your Qualified Intermediary.

Two recently released, nearly identical IRS Private Letter Rulings (200803003 and 200803014) involved exchange companies that were wholly-subsidiaries of a bank group. In these two cases, the banks provided investment advisory brokerage, private planning, insurance, trust, and retail banking services. In some instances, these subsidiaries would provide banking services to customers who also use the exchange services of the bank-owned Qualified Intermediary.

The IRS ruled that the provision of these types of services would not result in the Exchange Facilitator, or QI, being deemed a disqualified person under section 1031 of the Internal Revenue Code. Applying the factors put forth in a Supreme Court case (National Carbide Corp. v. Commissioner), the IRS held that insurance services did not create an agency relationship between the bank subsidiary and the exchanger.

Trust services - including principal and income accounting, fiduciary income tax services, distribution and valuation services, charitable trust services, bill payment, probate related services, and discretionary investment and asset management services - by an affiliate of the QI did not create an agency relationship. These were considered routine trust services that are not taken into account when determining whether the Qualified Intermediary is a disqualified person.

The IRS also ruled that routine banking services such as: consumer and small business lending, home financing, retirement and custodial services, check writing, direct deposit, online bill payment, and fee-refunded ATM transactions by an affiliate or by the QI itself, did not create an agency relationship. These services are considered routine financial services that are not taken into account when determining whether the QI is a disqualified person.

So can your bank also serve as your Qualified Intermediary? Based on these two Private Letter Rulings, it is pretty clear that, in most every case, your bank can accommodate your exchange. Given the increased safety and security they provide, the strict regulatory oversight they are under and the financial strength they possess, it seems prudent that a bank-owned Qualified Intermediary is a good place to start your 1031 exchange.

1031 Corporation Exchange Professionals is a subsidiary of FirstBank Holding Company - an $8.6 billion dollar bank with more than 120 retail locations in Colorado, Arizona and California. 1031 Corporation has been in business since 1990 and is a member of the Federation of Exchange Accommodators and the Denver Better Business Bureau.

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.