1031 Exchange Strategies for the Long Term Investor

Section 1031 of the Internal Revenue Code is one of the most powerful wealth building tools available to investors. Section 1031 allows investors to defer payment of capital gains taxes on the sale/exchange of a business or investment property. 

The deferral of taxes means more purchasing power for the investor and the ability to more quickly build a better and larger investment portfolio. 

Building a Tax Snowball

Long term planning is crucial for investors planning a 1031 Exchange.  Although taxes can be deferred in an exchange they will not be forgotten.  The gain deferred in a properly structured 1031 Exchange will reduce the tax basis in the property acquired in the exchange. 

For example, let’s assume an investor with a $500K gain on the sale of a property can defer taxes by exchanging into a property with a net purchase price of $750K.  Generally, a property’s tax basis is the property’s net purchase price.  However, when exchanging, the gain will offset the basis, so in our example, the new basis is $250K.  A sale of the new property above $250K will result in a taxable event

If the investor has done several exchanges over the course of many years, they may face a large (and unexpected) tax liability when it is ultimately time to stop exchanging and “cash out”.  Therefore, it is of utmost importance that investors know how the tax laws work and plan appropriately.

Strategies for Avoiding Taxes over the Long Term

Proper planning can help minimize and potentially eliminate most taxes owed.  Investors can utilize two strategies to reduce their tax liability:

Convert To Primary Residence (Section 121 Strategy) - A 1031 Exchange investment property can be converted into a primary residence and upon disposition be eligible for the homeowners exemption.  This strategy can eliminate taxes on up to $500K of gain for married couples, or $250k for singles.  Converting an investment property into a primary residence can be tricky, so it is wise to consult with a tax advisor.  Although not a substitute for proper tax planning with an advisor, here are some helpful tips to consider.
Rental Income - Before being converted into a primary residence, the investment property should have reported rental income for at least 12 months so that the validity of the original 1031 Exchange is not challenged by the IRS.  12 months of rental activities should be considered a minimum, the more time held as a rental, the better.
Use and Ownership - Once converted into a primary residence the owner is not eligible for the homeowner’s exemption until the property has been owned for five years, and has been used by the owner as a primary residence for at least two out of the past five years.
Death (Estate Planning Strategy) - Upon death, owners of real property will pass the property on to heirs at a stepped-up tax basis.  With a new stepped-up basis, the capital gain earned during the decedent’s life is eliminated entirely.  A true death benefit provided by the tax code.  For estate planning purposes, many real estate investors choose to incorporate a “defer, defer, die” strategy.  Instead of cashing out and paying taxes, investors can 1031 exchange into easy to manage (or management free) properties that produce stable cash flow.  The property is held until the investor dies, leaving the asset to their heirs at a stepped up basis and eliminating the entire capital gains tax liability.

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Dealing with Seller Financing in a 1031 Exchange…

Investors who decide to carry a  note on the sale of their investment property have a few options  if they are also doing a 1031 Exchange.

1. Do not include the note in the exchange. If the note is not included in the exchange, taxes will be payable using the installment method of accounting.
2. Include the note in the exchange and defer taxes owed.

With option #2, investors have several alternatives for attempting to use the note as part of the exchange. It is important that Asset Exchange Company be named as the beneficiary of the note in order to avoid any constructive receipt issues.  The alternatives available include:

1. Use the note as consideration for the replacement property.
2. Replace the note with cash.

•     “Buy” the note with your own cash
•      Sell the note on the secondary market
•     Have the note paid off prior to close of escrow

Seller financing can be an attractive option in today’s market.

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My friend at Asset Exchange Company send me some interesting update that I thought you might be iterested in. They offer $499 Delayed Exchange Services and a Free 1031 Exchange Hotline: 877-471-1031 .

IRS Scrutiny into 1031 Exchanges…

If you are considering conducting a 1031 Exchange, make sure you work with Asset Exchange Company to ensure it is done right. The IRS is planning on increasing audits and enforcement of 1031 Exchanges by summer of 2008. 

In a report issued last month, the Treasure inspector general for tax administration wrote: “There appears to be little IRS oversight of the capital gains (or losses) deferred through like-kind exchanges.”  The inspector general made three specific recommendations, all of which have been accepted by the IRS:

• The IRS should study tax reporting and compliance issues involved with like-kind exchanges. The IRS agreed to conduct research and complete the work by Aug. 15, 2008. Based on the outcome of this research, it appears likely that exchanges that take place this year will receive greater scrutiny.
• The IRS should provide better information and guidance to taxpayers on how to conduct a proper 1031 exchange. The IRS has agreed that by Jan. 15, 2008, it will provide more information on a number of publications and forms to help taxpayers understand how the exchange process works. Specifically, Publication 17, Your Federal Income Tax will be updated to specifically remind taxpayers that they must file Form 8824 with their returns if they have been involved in 1031 exchanges in the previous year.
• The IRS must provide clear guidance to taxpayers on the rules and regulations of like-kind exchanges with respect to second homes that were not used exclusively by owners.

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The information being provided is for consumers’ personal, non-commercial use and may not be used for any purpose other than to identify prospective properties consumers may be interested in purchasing.

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What is the Minimum Length of Ownership Required for a 1031 Exchange Property?

Unfortunately, there is no safe holding period for property to automatically qualify for a 1031 Exchange. Keep in mind, the properties only need to be “held for investment” to be eligible for an exchange. Length of ownership is only one factor the IRS looks at when determining if the properties were “held for investment”. Want to play it safe? Follow these general rules:

• Hold your properties for a minimum of two tax filings.
• Report all rental income from the property on each of your tax filings.
• Take any allowable deductions including depreciation.
• Keep all records (lease agreements, property management contracts, etc.)

 Tax Update: Private Mortgage Insurance (PMI)

Private Mortgage Insurance (PMI) is a premium paid by home buyers to lenders when the value of the home loan they receive exceeds 80% of the appraised value of the property. PMI is charged by lenders to account for the additional risk they take on when funding loans secured by less than the traditional 20% minimum owner’s equity.

Until recently, the cost of PMI was not a deductible expense for tax purposes. This despite the fact that PMI is essentially the same as interest paid on the loan it relates to. Mortgage interest is deductible for most homeowners. If interest is thought of as the payment to a lender to account for time value of money and the risk of default, then PMI does not seem much different. Why the tax code treated it differently was a source of confusion and anger for many owners caught in the PMI net. However, there is good news to report.

New tax legislation passed late in 2006 allows for the deduction of PMI premiums for property acquired during 2007. In order to receive the deduction, the premium must relate to the purchase, not refinance, of a principal residence. The premiums are deductible in the same manner as mortgage interest. The benefit phases out for single taxpayers who make over $50,000 and is completely phased out at $55,000. The deduction for married taxpayers filing jointly phases out at $100,000 with a complete phase out at $110,000. There is some confusion as to whether the deduction is discontinued at the end of 2007, but for now, qualifying taxpayers who purchase qualifying property in 2007 will be entitled to the additional deduction.

PMI is generally associated with purchases of principal residences, so it usually does not affect investors contemplating a 1031 Exchange. However, similar expenses relating to the acquisition of a loan should be paid for “out of pocket” rather than with the proceeds of a 1031 Exchange sale. Most other non-recurring closing costs can be paid for with exchange funds.
 

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Frequently Asked Questions - 1031 Exchange

Q: How long do I have to own a property before I can exchange it?

A: The longer the better. Unfortunately, there is no safe holding period for property to automatically qualify for an exchange. Keep in mind, the property only needs to be “held for investment or productive use in trade or business” for it to be eligible for an exchange. Time of ownership is only one factor the IRS looks at when determining if the property was “held for investment”. Some tax advisors recommend a minimum holding period of one year.

Q: Can I sell my duplex and purchase raw land?

A: Certainly. Properties involved in an exchange need to be “held for investment or productive use in trade or business”. Holding land for its future appreciation would be considered held for investment. Don’t get confused by the “like-kind” requirement. “Like-kind” can be any real property used for business or investment purposes within the U.S.

Q: Can I move into a rental property that was originally purchased as part of a 1031 Exchange?

A: Yes - but not right away. Keep in mind that the IRS will look at your “intent” in determining if your exchange is valid. If the IRS feels your original intent when the property was initially acquired was to use it as a primary residence, you may have your exchange disqualified. To play it safe, rent the property out for as long as possible before moving in.

Q: Do I have to reinvest ALL of my cash (equity)?

A: No. However, any cash (equity) that is not reinvested in real estate will be taxable (and is known as cash boot). The general rule of thumb if you don’t want to pay any taxes is to reinvest all of your cash and purchase a property equal or greater in value.

Q: How long do I have to complete my exchange?

A: 180 days. However, also keep in mind you will be required to identify your potential replacement properties on day 45 of your exchange. Your timeline starts when you close escrow on the property you are selling.

Q: Does my Realtor need to do anything special since I am exchanging?

A: Your Realtor should make sure the sales contract is assignable. Asset Exchange Company can provide the necessary language for the contract.

Q: How do I get my exchange started?

A: Call Asset Exchange Company at 877-471-1031 as soon as you’ve opened escrow. We’ll draft up an exchange agreement and coordinate with you and your escrow company to facilitate the exchange.

Q: What are their fees?

A: $499 for a standard one for one delayed exchange.

Q: Do you handle Reverse 1031 Exchanges?

A: Yes. Asset Exchange Company can accommodate Reverse 1031 Exchanges. We also handle multi-property exchanges, construction and improvement exchanges and reverse construction/improvement exchanges.

Q: Does your company have an Attorney or a CPA on staff?

A: Both. When you work with Asset Exchange Company, your transaction is handled from start to finish by an attorney and a CPA. You can consult with the attorney/CPA as much as necessary at no additional fee.

Q: What distinguishes Asset Exchange Company?

A: Hard work - and we like what we do. Asset Exchange Company wants to be the resource for all your 1031 Exchange needs. We work hard for our clients, we are responsive and we offer great rates.
  
 
 
 
 

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TREASURY REPORT: LIKE-KIND EXCHANGES REQUIRE OVERSIGHT TO ENSURE TAXPAYER COMPLIANCE

The September 17, 2007  Report ( reference number: 2007-30-172 )  indicates the Treasury is concerned taxpayers performing 1031 exchanges are underreporting gain because there is little IRS oversight of 1031 at the present time. The Report has three recommendations that the IRS has agreed to pursue:

1) The IRS will study compliance and reporting issues involving 1031 tax deferred exchanges from tax returns selected by the National Research Program. As a result of this study, the IRS anticipates recommending target audit areas for exchanges by the end of summer in 2008.

2) By January 2008, the IRS will be revising their information on the IRS website and in a number of IRS forms and publications to provide additional guidance regarding the need for taxpayers performing 1031 exchanges to file Form 8824.

3) The IRS will be offering more guidance on 1031 exchanges of second and vacation homes that are not used exclusively by the taxpayer. The IRS is concerned that some may have been encouraging taxpayers to exchange non-qualifying second or vacation homes.

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The information being provided is for consumers’ personal, non-commercial use and may not be used for any purpose other than to identify prospective properties consumers may be interested in purchasing.

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Holding Requirements…

How long do I have to own my relinquished and replacement properties before they qualify for 1031 Exchange?

Want the easy answer?  The longer the better. Unfortunately, there is no safe holding period for property to automatically qualify for a 1031 Exchange. Keep in mind, the properties only need to be “held for investment” to be eligible for an exchange. Time of ownership is only one factor the IRS looks at when determining if the properties were held for investment.

In one private letter ruling (PLR 8429039), the IRS stated that a minimum holding period of two years would be sufficient.

Although a private letter ruling does not establish legal precedent for all investors, there are many advisors who believe two years is a conservative holding period, provided no other significant factors contradict the investment intent.
Other advisors recommend that Exchangers hold property for a minimum of at least twelve months. The reason for this is twofold:
(1) A holding period of 12 or more months means the investor will usually reflect it as an investment property in two tax filing years.
(2) In 1989, Congress proposed a one year holding period for both the relinquished and replacement properties. Although this proposal was never incorporated into the tax code, some believe it represents a reasonable minimum guideline.
Unfortunately, there is no easy answer as to how long a property must be held for it to qualify for an exchange, so make sure the intent when the property is acquired, is to hold it for investment purposes.  To be safe, hold it for as long as possible!

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