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

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

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

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

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

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

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

Research Study Points to Investment Opportunity?

Recently I received a report from Marcus & Millichap's Research Services that I found quite interesting. In the report, they point to the very real potential of further increases in homeowner delinquency rates and further declines in homeownership rates.

They estimate more than six million current homeowners owe more on their home than they are worth. Assuming no additional declines in value nearly all of them will need at least five years to just to get back to break even on their value. U.S. homeownership rate currently sits at just over 67% which is down about 2% over the highs we saw a couple years back. However, once you take into account the upside-down homeowners, the effective homeownership rate is nearly 6% lower. Markets we've all heard about - Phoenix, Miami and Las Vegas - have been hit the hardest and the biggest gap in homeownership exists.

So what does this mean for investors? M & M points out that apartment owners will be the group that benefits the most from the increase in residential defaults projected as prior homeowners become renters. According to their findings, cccupancy rates are likely to improve in late 2010 and 2011 as economic recovery gains traction. They do point out that many bank-owned homes will elevate rental competition as investors scoop up good deals and this will limit rental gains for the next 12 to 24 months. Long term, they believe, the expanded renter pool (which will also benefit from the growing echo boomer population) should contribute to increased rent growth.

I also thought it interesting that they believe the retail market might actually benefit from the increased defaults on home mortgages. They theorize that, as a portion of cash is freed up from prior larger mortgage payments, retail sales will increase. They do indicate that they continue to believe relatively modest job growth (triggered by early signs of a recovery) will cause retail fundamentals to lag the broader commercial market.

It will be interesting to see how the summer and fall months (with many political races also occuring) will impact these predictions. Talking with a number of real estate professionals, there is a real sense that the homebuyer tax credits did, indeed, provide a boost to the housing recovery (or stabilization). In addition, as some of the temporary government census jobs are dismissed, it will be interesting to see if the economy has yet gained enough traction to offset these lost positions.

So what's an investor to do? Sell now? Hang tight? Add to their portfolio? Exchange to re-position their real estate assets? While opinions vary, many experienced investors and financial profesionals believe there are winners to be had in the present economic environment. It is up to you to determine whether those opportunities exist in apartments, rental homes, retail or some other category. With just as many opinions on the direction of the economy and the impacts on real estate, this is an individual question that demands consultation with a trusted real estate expert (or a few!), reflection on your own personal finacial situation and risk tolerance and, of course, the help of a solid tax professional.

If you determine that re-position your portfolio fits your situation, you have a great advantage in the taxation question with a 1031 exchange. The professionals at 1031 Corporation would love to speak with you about the opportunies that exist to exchange your present real estate assets for ones that may position you to take advantage of future recovery. Give us a free, no obligation call today at 888-367-1031.

Leasehold Interests and 1031 Exchanges Frequently Asked Questions

A leasehold interest with a term of 30 years or more is like-kind to a fee interest in real estate (Reg. §1.1031(a)-1(c)(2)). 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.

Leasehold interests with less than 30 years remaining under the lease are not like-kind to a fee interest in real estate. But, they can qualify as like-kind to other leasehold interests with either 30 years remaining under the lease or less than 30 years.

What is the difference between a lease and a leasehold interest?

A Leasehold Interest is an interest in real estate which is acquired and possessed by a person who is the lessee of the property under the terms of a lease. The Lessor is the owner of the property. The Leasehold Interest might be bare land or land with improvements. Sometimes the leasehold improvements are in place when the lease is executed and sometimes the improvements are constructed by the lessee after the lease is executed.

A Lease is the legal instrument documenting the terms and number of years of possession by the lessee.

What is the tax basis of a leasehold interest acquired as replacement property in a 1031 Exchange?

Tax basis is the purchase cost of obtaining the lease minus the deferred gain resulting from the exchange. If improvements are constructed on the leasehold, tax basis will include the cost of such construction or improvements.

How is the tax basis of a leasehold interest depreciated?

The tax basis of a leasehold interest is amortized over the number of years the lease has to run, including options for renewal of the lease.

If I exchange bare land for a 30 year lease of a commercial building, I can amortize the tax basis attributable to the bare land over 30 years?

Yes, the tax basis of the leasehold interest is amortized over the life of the lease, including options for lease renewal.

What if the term of the lease is for 30 years plus an option to renew for an additional 30 years (60 years in total)? Am I required to amortize a commercial office building which ordinarily could be depreciated over 39 years over 60 years?

The building can be depreciated over the ;">MACRS recovery period (39 years in this case) if the life of the lease, including renewal options is longer than the MACRS recovery period (Reg. §1.178-1(b)(3)). The cost basis allocable to the land would be amortized over the life of the lease, including renewal options.

What if the term of the lease is for 20 years plus an option to renew for an additional 20 years (40 years in total) and I do not intend to exercise the renewal option?

Amortization of the tax basis of the lease over 20 years is possible if the taxpayer can establish that is “more probable than not” that the lease will not be renewed, extended or continued (Reg. §1.178-1(b)(2).

See our Exchange Manual or give us a call us at 888-367-1031 if we can help with any questions you may have about 1031 Exchanges.

Reverse & Improvement Exchange Financing

Reverse 1031 exchanges involve the purchase of Replacement Property prior to the sale of the property being sold (the Relinquished Property) in a like kind exchange. Since you are not able to own a Replacement Property prior to selling a Relinquished Property, a taxpayer arranges for an Exchange Accommodation Titleholder (EAT) (usually the Qualified Intermediary) to take and hold title to replacement property until they find a buyer for his or her relinquished property.

Reverse Exchanges are also common where a taxpayer wants to acquire a property and construct improvements (an (Improvement Exchange) on it before taking title to the property as replacement property for an exchange. This is necessary if the value of the improvements is important for replacing with property of equal or greater value in order to avoid a taxable “trade-down.”

One question that naturally arises is the financing of the Replacement Property. Since the taxpayer's equity is tied up in the property not yet sold, how does one go about financing the purchase of the Replacement Property? Having the Qualified Intermediary (and EAT) owned by a bank helps....a lot.

See, the trouble is, the property is not in your name yet. So, secondary financing providers have issue with lending to an entity that isn't signing on the loan. If you want to finance 100% of the purchase price and wait to pay the loan down and amortize the loan after your relinquished property sells, most lenders are going to say it is impossible. Further, what happens when the property sells. The proceeds from that sale can't be assigned to the loan since they need to go to the Qualified Intermediary for 1031 exchange purposes.

1031 Corporation has the answers to these questions. As a bank-owned Qualified Intermediary, we can assist with Reverse and Improvement Exchange Financing through FirstBank's 130+ office locations throughout Colorado, Arizona and California. Since we are owned by a bank, we are very familiar with reverse exchange financing issues and can work with our bank officers. Having a Qualified Intermediary subsidiary, the bank officers are familiar with the terms and conditions of Reverse Exchange Financing and can work with you to provide this "bridge" in financing. In fact, FirstBank has a program that allows for long-term commercial financing at the time of Replacement property purchase. They even include a one-time assumption of the loan and waive any prepayment penalty for the Relinquished Property sale proceeds.

Call us today at 888-367-1031 if you are working through the mechanics of Reverse Exchange Financing or if you are having difficulty financing the purchase of your 1031 Exchange Replacement Property. We are uniquely positioned to assist you and would be happy to help expain the process in detail.

Estate Tax 2010

Many older taxpayers work to move wealth they've generated in their lifetimes from one generation to another while minimizing tax liability through estate planning. Intergenerational transfers of wealth have a significant impact on the economy and many believe that the estate tax generates costs to taxpayers, the economy and the environment that far exceed any potential benefits that it might arguably produce. Still, the political landscape today seems to indicate estate taxes are here to stay.

When dealing with estate planning, many older generation taxpayers deed property into a family partnership or LLC. Children receive an ownership percentage "gift" each year that transfers ownership over time. The parents that have acquired the real estate are able to continue to take income from the property but their heirs receive the property without estate tax (up to $1 million in lifetime gift tax exemption). If property is sold, the LLC can utilize a 1031 exchange to sell the investment property and allow the real estate portfolio to grow tax deferred. When the parents pass on, the children then have an ownership in the investment property outside the estate.

If there is not time to do this advance planning, the heirs are subject to an estate tax. This tax had been getting less concerning for many taxpayers due to the Bush tax cuts in 2001 that increased the exemption amount and reduced the tax rate. The tax was set to expire in 2010. It was expected that Congress would re-visit the estate tax before the end of 2009 and put some structure in place. They did not. Because of a limited time circumstance confusion reigns in the current estate tax landscape.

Both the estate tax and the generation-skipping transfer tax (on assets given to grandchildren) were repealed at the end of 2009. If Congress and the President do nothing, both taxes are scheduled to return in 2011 at the unfavorable rates that applied in 2001. The amount that is exempt from each of these taxes will then be $1 million and the tax on the rest will be 55%. Most tax writers do not want this to happen and talks on the estate tax are already underway.

Congress is talking about reinstating the estate tax retroactively to January 1st, 2010 and reviving the "date of death" value for inherited assets. Given the size of some estates, like the one of billionaire Dan Duncan, some are likely to challenge the retroactive imposition of the estate tax and there is a long shot that a proposal gaining ground may give estate a choice in 2010. However, there are past court cases that suggest restoring the tax this way is perfectly legal and could be upheld. Of course, the sooner Congress acts, the fewer number of large estates likely to bring such cases and the less chance these heirs will have to call the tax unconstitutional.

Members of the House of Representatives generally support a proposed $3.5 million exemption and a 45% rate on estates. There is growing support in the Senate for a $5.0 million exemption and a 35% top tax rate. We'll see, in the coming weeks and months, how this plays out and we'll certainly do our best to keep you posted of any news.

By conferring with your tax professional, and utilizing the tools of estate planning and 1031 exchanges together, one can minimize the effects of capital gains taxes on investment property. If you have are considering selling your investment property and want to defer capital gains tax using the tools of a 1031 exchange, please contact the professionals at 1031 Corporation. We have years of experience and work with accounting professionals to structure an exchange to minimize the tax impact on your investment assets. Give us a call today at 888-367-1031.

1031 Regulatory Reform Legislation

Recently the topic of financial regulatory reform has been a hot item in the news. I recently became aware that there is a paper circulating in Washington with a proposed national regulatory bill concerning the Qualified Intermediary industry. The author of this proposal has been running moving around the Capital attempting to put provisions in place that, had they been in place, reportedly would have "prevented the loss of over $770 million of exchangers' funds that has occurred at the hands of QIs which currently operate in an environment that is subject to little or no regulation and oversight at the state level."

Seven states, thus far, have adopted 1031 legislation in an attempt to protect consumers. Those provisions, if adopted by all states, or at the national level, would have, perhaps, prevented or reduced many losses from unscrupulous Qualified Intermediaries. It should be said that, like many laws, people that are crooks will break the law.

One of the provisions that the author of this latest proposal is suggesting, though, is detrimental to the public. It would not allow a bank-owned Qualified Intermediary from depositing the exchange client proceeds into the parent bank. The proposal says that the "depository bank, escrow holder, or trustee holding exchange funds must unrelated to, and independent of, the QI". The pitch is that the bank which owns or controls the QI could then "place its financial interests above those of the exchanger".

This proposal would have the effect of eliminating banks (and their exchange facilitator affiliates) from the exchange facilitator business. This requirement would also negatively impact title insurance company-affiliated exchange facilitators who may wish to use a related escrow or trust company to provide qualified escrow or qualified trust services to provide greater protection to taxpayers.

Despite the fact that banks are already regulated by a state or federal financial regulator (and are subject to more oversight and controls than non-bank exchange facilitators), this proposal seeks to eliminate some of the safest and financially strongest exchange facilitators from the industry. Given that not a single loss has occurred as a result of bank failure, and there has never been any loss of exchange funds that were held in a bank-related QI, there is no history that would warrant this provision.

The national trade association of Qualified Intermediaries, the FEA, has been a strong supporter of federal regulation of its industry to require prudent funds management standards and other protections for its clients. In 2007, the FEA petitioned the FTC for regulatory oversight and submitted to it a comprehensive draft regulation. The FTC denied the petition, saying that the burdens of regulation outweighed the need, and that there was no evidence of pervasive fraud throughout the industry.

The FEA has since been actively involved in passing state legislation to regulate exchange facilitators. The FEA is supportive of legislation or regulations which provide protections for all taxpayers utilizing exchange facilitators and which do not competitively disadvantage any legitimate business model. It is my personal opinion that working with the FEA, and not against its efforts, would best serve the consumer and the industry as a whole.

For the record, 1031 Corporation is owned by FirstBank. We also individually segregate accounts. Please visit our website for a free exchange manual or contact us at 888-367-1031.

1031 Corporation Exchange Professionals Celebrates 20 Years

On April 27, 1990, company founder Larry Jensen CPA, formed 1031 Corporation Exchange Professionals to assist a taxpayer with an exchange of real estate under the provisions of Code Section 1031. There were few or no Qualified Intermediaries in Colorado at the time and it was difficult for taxpayers to implement a qualifying exchange under IRC §1031. Mr. Jensen felt that 1031 Corporation could be helpful as a facilitator.

In 1991, the IRS issued the “Safe Harbor” Regulations establishing a greater market for this type of service. 1031 Corporation was already established and began to market exchange services locally. Many of the clients, Corporation worked with in the early years were unacquainted with a “1031 Exchange.” 1031 Corporation quickly became a leader in introducing tax professionals, Realtors, title companies and attorneys to the simplified tax-deferred exchange procedures on the sale and purchase of real and personal property investments.

Over the years, because of its commitment to provide friendly, professional service, 1031 Corporation grew from its humble beginnings. With increased knowledge from tax and real estate professionals, repeat and referred client business and a growing real estate market, 1031 Corporation developed into one of the nation’s leading exchange intermediaries. In the 20 years of business, 1031 Corporation has facilitated thousands of exchange transactions ranging from the simple real property exchange to the complex, multiple asset exchange.

In 2006, recognizing that clients deserve assured safety of their exchange funds and competent professional services, 1031 Corporation became a subsidiary of FirstBank. With it’s extensive reputation of friendly customer service, safety and security, FirstBank and 1031 Corporation were a natural fit. As Colorado’s largest locally-owned bank - with over $10 billion in assets and 130 branches in Colorado, Arizona and California – FirstBank continues to expand 1031 Corporation’s exchange services nationwide.

Since 1991, 1031 Corporation and its staff of Certified Exchange Specialists have assisted clients with leading-edge services and consultation that continues today. As we celebrate our 20th anniversary, 1031 Corporation Exchange Professionals wishes to thanks all of our clients, and business partners for the confidence they have placed in our services over the years. We pledge to continue serving our clients at the highest level of competence and expectations.

Please give us a call at 888-367-1031 or visit our website if we can be of any assistance.