WASHINGTON, DC, March 18, 2015 (GLOBE NEWSWIRE) — via PRWEB – The Section 1031 Like-Kind Exchange Coalition (“Coalition”) released an economic impact study today which concludes that repealing the like-kind exchange rules would slow economic growth, reduce GDP and hurt many U.S. small businesses.
The Ernst & Young study was commissioned in response to legislative proposals to repeal Section 1031, and concludes that the GDP reduction is driven primarily by decreased business investment. A repeal of Section 1031 would impose tax on investors across a wide spectrum of industries who, absent the tax, would continue their investment in real property and other capital assets. The industries most impacted by a repeal of Section 1031 include truck transportation, real estate, specialty construction and heavy construction.
The Coalition hosted a roll-out event featuring small business owners and industry professionals who described their experiences with like-kind exchanges and explained how a repeal would hurt their industries.
“Like-kind exchanges allow domestic businesses to efficiently expand and prosper, stimulating economic growth. Most importantly, exchanges are used by a wide array of businesses including farmers and ranchers, commercial real estate investors, construction companies, conservationists, trucking and transportation companies as well as small family owned businesses that invest in real estate and vehicles,” commented President of the Federation of Exchange Accommodators Mary Cunningham.
The Coalition is comprised of more than a dozen industry associations whose members represent of a diverse group of U.S. business owners and individuals.
I took a call from a new client last week describing a strategy that she had employed to lessen the tax burden to her heirs. Her goal was to liquidate her investments so her heirs would not be burdened by future management responsibilities and the sale of a dozen properties. Over the course of the preceding year, she sold two of her investment properties and pocketed the proceeds. Much to her surprise, her CPA advised her that this method resulted in a big fat tax bill! In her haste to unburden her heirs, she has transferred the tax to herself.
The reality is that had she not taken the step to liquate, her investments would be passed to her heirs at a stepped-up basis or at the then current market value, thereby negating capital gains tax altogether. In the end, her estate has been diminished!
The most important aspect is to understand the goals and objectives of the investor. As this client found out, while cash is always the gold standard, touching it can lead to unintended and expensive tax consequences. If the sale of investment assets leads only to cash, the long hard work of achieving equity can be diminished by over 30%. A strategy that utilizes a Section 1031 approach can keep all of the cash intact and tax deferred.Since the majority of her investment assets are in real estate, a Section 1031 Exchange will produce optimum tax relief.
After spending some time discussing the options, the client revealed that she wanted to relocate her investments to the three communities where her heirs were residing to make future management easier. Together, we created a stepped plan to liquidate one property at a time, this will spread out the timing issues and allow for a careful selection process for the replacement properties. As soon as she has a sale agreement on the first property, we will produce an Exchange Agreement to provide the net proceeds of the real property will be redirected to us as QI for the acquisition of “like-kind” new or Replacement Property. This can be any kind of real estate and located anywhere in the United States. In addition, it can be more than one piece of property. The value is exchanged, not the quantity, quality or character of the old or Relinquished Property.
The Replacement Property options are as varied as stand alone whole interest in real estate, partial interest, Tenancy-In-Common (TIC) interest, Umbrella Partnership Real Estate Investment Trust (UP-REIT), and subsurface real estate in the form of Oil and Gas Leases. A combination of any of these options will produce a diversified portfolio of income producing property. Remember, since the net tax effect on the investment owner could easily approach 30%, this savings significantly increases buying power of any one, or combination of these strategies.
Reinvestment of the assets will produce a steady stream of income, and they can be as passive or active as the soon to-be retired investment owner desires. The benefits are encased in what the cash can acquire and not the cash itself. The selling of an investment is typically the largest transaction in the investment owner’s career, failing to recognize the available tools, specifically the advantages of Section 1031, can have devastating effects on the investment owner’s future quality of life.
We are often asked if property can be exchanged and still provide some cash for other immediate needs? The short answer is yes, however, If you elect to take cash, it will be immediately subject to significant tax.
The very tax you are trying to avoid is triggered (up to the amount you touch) at the moment cash is received. This can prove to be a rather costly option as Federal capital gain rates can take a 23.8% swipe (depending on your income) and state tax (depending on where you live) will also be due. So although it is possible to take cash out at closing it is not recommended.
The first thing to remember if you want tax deferral is NEVER touch the cash. That includes never taking possession of the sale proceeds at the closing table or allowing your attorney or other agent to do so. All sale proceeds MUST be directed to your qualified intermediary (QI).
If you have cash left over after the QI funds the acquisition of your replacement property, it will paid over to you at the end of the exchange or 180 days, whichever comes first. That cash, known as “boot” will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain by both the state and federal government at the above mentioned rates.
Don’t forget to factor in existing debt!
Besides taking cash, one of the main ways people get into trouble with 1031 transactions is failing to consider their existing loans. Mortgage loans or other debt on the property you relinquish, and any debt on the replacement property must be replaced with new debt. If you don’t receive cash back but your liability goes down, that too will be treated as income to you just like cash. For example, suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. This will be treated as if you have $100,000 of gain (classified as “mortgage boot”) and it will be taxed at the same rate as cash proceeds.
The bullet proof test for 100% tax deferral is to always go even or up in value and replace the old debt with new debt or cash. Not sure, just ask, our goal is to keep you tax deferred!
We have conditioned our clients to expect that state capital gains tax can be deferred along with the federal tax exposure by utilizing Section 1031 for their exchanges. It is true, most states will honor the deferral as long as the gain is being rolled into the new property.
However, you should be aware that not all states recognize Section 1031 in the same manner as the Federal Tax Code. Recognizing the subtleties can be the difference between tax deferral in future years or tax liability. Increasingly, our clients have become tax savvy and have begun selecting their replacement properties in states that have the most favorable tax treatment. A few tax hungry states have begun instituting a “clawback” provision that entitles the taxing authority in the departing state to go after the tax it would have otherwise collected if the exchanger eventually “cashes out”.
The State of California has enacted legislation that will go into effect on January 1, 2014 that will require an exchangor departing the state to file an annual information return, regardless of the taxpayer’s state of residency. The purpose of the filing is to to be sure that the deferred state tax is still applicable and that the taxpayer has not in a subsequent year “cashed-out” thereby denying the deferred state tax.
Unfortunately, California is just the latest state to enact the “clawback”. Massachusetts, Montana and Oregon also have indicated that they will pursue taxpayers who received deferrals and later cash out. These three states have not made it clear how they will monitor and collect but as budgets continue to be strained, expect that there will be no hiding places left!
A recent client was contacted by a qualified land trust to acquire the development rights to his 500 acre tract of forest/meadow land. The property had long been identified by the conservation community as a key wildlife migration path to adjoining protected property. Our client had been approached numerous times but resisted a sale that would trigger tax and negate his ability to continue to enjoy the property. The land trust had successfully acquired similar property and encouraged our client to seek advice about how he could utilize Section 1031 to meet their mutual goals.
When he contacted us, we explained the real estate concept known as the “bundle of rights” that lends itself to the sale of one individual right without disturbing the remaining rights. We tend to think of real estate as the physical land and any and all structures attached thereto, however, it is much more. It is often described as a bundle of sticks and each stick represents individual rights; for example, the right to lease, to mortgage, to ditch, to develop, to farm, to bequeath, to grant rights of way, surface or sub-surface rights, etc. If you own all of the rights inherent with the land, your ownership is described as being “fee simple” or without limitations or restrictions. If you own less than the whole, you hold a partial interest and any deeded rights will be described in the chain of title. The sale of any one or combination of these rights can leave the underlying land intact from a physical standpoint. However, the sale of any of the rights require that it be properly accounted for and taxed.
Knowing that our client did not desire to sell his whole ownership we discussed how the sale of the development rights would allow the parcel to remain intact, restrict his future use, but would provide a path to exchange the value for other real estate. He was surprised to learn that a partial interest in real estate is “like-kind” to any real property. The possibility of converting one of the “rights” for an asset that would allow him to acquire other property was the deciding factor for him to proceed with an exchange.
The first step was to have the property appraised so that the development rights could be quantified by a disinterested third party. It was determined that the whole parcel was valued at $950,000 and the development rights accounted for $500,000 of the total value. The trust agreed to acquire a conservation easement protecting the property for future generations and raised the $500,000.
Knowing that he had limited time select his replacement property, he contemplated numerous combinations ultimately deciding to acquire income producing property. Once the closing was scheduled, our client had a maximum of 45 days to identify the property(ies) he wanted to purchase with his exchange funds and up to 180 days to make the acquisitions. Because the transaction was facilitated by a Qualified Intermediary as a Section 1031 Exchange, no state or federal tax was paid.
He continues to enjoy his 500 acre parcel and reap the benefits on the ownership of three new investment properties.
Vacation homes can be a source of great pleasure during their ownership; the reality of how they are treated for tax purposes happens once you decide to sell the property. You may have determined that the cottage at the beach or condo slope side at the mountain is your “investment” property, however, the truth is, not for tax purposes!
In order for vacation property to qualify as “investment” property, personal use is limited. The guidance provides that personal use cannot exceed the greater of fourteen calendar days or 10% of the days actually rented to others. It can also be used during periods of repair of maintenance without limitation as long as you maintain good records. If you rent to family members it will count against your personal use days if they have a direct lineal relationship (mother, father siblings, and grandparents). This can be avoided by renting to your in-law and not your brother or sister but the rent must be deemed to be market rent.
If this sounds like too much record keeping to avoid falling astray of the regulations, then consider a period of compliance before sale. For instance, you have owned and freely used your vacation property for the past five years but now want to spend time in another locale. The way to accomplish having your personal use property deemed to be investment property is to suspend your free access to no more than the limitations outlined above. In plain terms, stop using it for at least two years. Offer the property for rent by using a management company. This will help in clarifying your rental intent and the record keeping becomes someone else’s problem. Don’t forget to inform your tax preparer to report the property on your Schedule E and review IRS Publication 527 for additional details.
Now you are free to go ahead and sell the vacation property and acquire new vacation/rental property in another location. Since your property has been converted to “investment” property by virtue of your abandonment of personal use, upon sale, the property will qualify for a Section 1031 Exchange. Once you exchange, the new property must be rented to others for the next two years. You can make limited use as previously described and then convert it back to personal use after the lock out period.
While all of this sounds tedious, it can bring significant tax savings, thereby allowing you to use all of your proceeds for the next purchase, not 20-40% less. If you consider that some family properties are now in the third and further generation of ownership, the tax basis is generally so low that the tax impact is monumental. A planning strategy is key to your success and future enjoyment!
Solid Rock Realty Advisors, LLC
2020 Charlotte Street, Suite 14
Bozeman, MT 59718
406-582-1265 Office
800-517-1031 Toll-Free
800-249-1033 Fax
The IRC Section 1031 Exchange is one of the most powerful tax saving and wealth building tools available for people selling highly appreciated real estate. A properly structured 1031 exchange allows a family selling a farm or ranch to sell land, to reinvest the proceeds in other “like-kind” real estate, and to defer capital gain taxes.
To quote the tax code, IRC Section 1031 (a)(1) states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Effective January 1, 2013, capital gains tax rates have increased, making tax-saving strategies such as the 1031 Exchange and Charitable Remainder Trust even more advantageous. In addition to higher capital gain tax rates, there is a new 3.8 percent healthcare tax on investment income including income from the sale of real estate.
There are many potential benefits for a taxpayer who successfully executes a 1031 exchange. Some of these include:
Tax Deferral (Immediate & Indefinite)
In a properly executed 1031 exchange, capital gain taxes are deferred and transferred to replacement property. Tax is not due until the taxpayer sells the replacement property without utilizing a 1031 Exchange. Since there is no limit to the number of exchanges a taxpayer can complete, it is possible to defer the payment of tax indefinitely.
The 1031 exchange is commonly referred to as a tax “deferred” exchange, implying that taxes are not eliminated, only deferred until the replacement property is later sold in a taxable transaction. However, it is possible to potentially eliminate capital gain taxes altogether on the sale of property by exchanging into and holding property until death. Under current tax law, heirs of a descendant’s property receive a “step-up” in basis of the property’s tax basis to its fair market value upon death. This step-up in basis could conceivably enable the heirs to inherit property and then sell the property for fair market value soon after the decedent’s death and pay little or no tax. Thus, by employing the 1031 exchange until death, it may be possible to not only defer taxes on the sale of property, but permanently eliminate them. Some refer to this strategy as “swap until you drop”.
Improvement in Return on Investment (ROI)
A typical farm or ranch has a very low cash flow rate of return. By selling and exchanging land into other types of commercial real estate, a family may be able to greatly increase their annual cash flow rate of return.
Consolidation or Diversification
Real estate investors who have accumulated multiple properties may eventually decide to consolidate their properties into one or a small number of larger assets. Conversely, as is the case with most farm and ranch families, one large real estate asset can be exchanged into multiple properties. Exchanging into different types of properties and in different geographic locations can be an effective risk reduction strategy.
Elimination of Active Management of the Investment
Operating a farm or ranch involves a lot of hard work. Exchanging farm and ranch land into other passive real estate investments or into properties that are professionally managed, may enable a family to free themselves of the day-to-day activities of running their farm or ranch. Ironically, an agricultural family can often sell their place and increase their income without having to work as hard for it.
Wealth Building
The greatest potential benefit from using a 1031 exchange may be the ability to preserve all of the equity in the relinquished property. Deferring taxes on a sale allows the seller to reinvest the full sales proceeds, undiluted by tax. The ability to invest the money that would have gone to taxes in additional real estate may enable a family to grow wealth and generate more income for retirement.
Consider the following example: A Montana couple sells land for $5 million with a cost basis of $1 million. Assuming 2013 tax rates (23.9 percent combined federal and state capital gains tax and 3.8 percent Medicare Surtax), they will pay approximately $1,246,000 in taxes.
If this same couple were to do a 1031 exchange on the full $5 million sale, this $1,246,000 tax cost could be invested in additional real estate. Assuming the real estate grew at an average annual compound rate of 7 percent (income plus appreciation), in 20 years this $1,246,000 would be worth approximately $4.8 million.
Not only would this couple benefit from the additional income the real estate would generate while they are alive, if they hold the property until they die and if real estate continues to receive a step up in basis upon death, they could potentially pass close to $5 million more to their heirs!
There are complex rules and strict time parameters for completing a successful 1031 exchange. For more information, request our Wealth Guide on 1031 exchanges by calling 406-582-1264.
Chris Nolt is the owner of Solid Rock Wealth Management and Solid Rock Realty Advisors, LLC, sister companies dedicated to working with families selling a farm or ranch and transitioning into retirement. For more information, call 406-582-1264 or visit: http://www.solidrockwealth.com and http://www.solidrockproperty.com
Securities and advisory services offered through Independent Financial Group, LLC (IFG), a registered broker dealer and investment advisor, member FINRA/SIPC. IFG, Solid Rock Wealth Management and Solid Rock Realty Advisors, LLC are not affiliated entities. This material was created to provide accurate and reliable information on the subjects covered. It is not, however, intended to provide specific tax or legal advice, nor is it an offer to buy or sell securities. Tax information can be sourced at irs.gov or your state’s revenue dept. website. Because individuals’ situations and objectives vary, this information is not intended to indicate suitability for any particular individual. IRC Section 1031 exchange and IRC Section 664 charitable remainder trust are complex tax codes and the service of an appropriate tax or legal professional should be sought regarding your individual situation.
Edmund & Wheeler, Inc. is pleased to announce that Chris Brown of Stowe VT has joined our team as an Exchange Specialist. Edmund & Wheeler, Inc. provides capital gains tax deferral services for owners who sell and replace like kind real and personal property under Section 1031 of the IRS tax code. In the past year Edmund & Wheeler has expanded its service model to include expanded training, consulting & replacement property strategies to its core services of being a Qualified Intermediary for Section 1031 Exchanges.
Chris Brown has over 16 years of entrepreneurial real estate investment, development and advisory experience. This includes ownership of a niche New England real estate advisory firm specializing in §1031 exchange replacement property solutions and private equity real estate ventures.
Michael Coyle, owner of Edmund & Wheeler, Inc. states; “ We are so happy to have Chris join our team. Our expanded service model requires us to have strong consulting, communication, coordination, and financial analysis skills. Chris’ background brings to us a broader range of experience in replacement property strategies. Chris has been working with real estate investors in designing and implementing complex replacement property strategies uniquely matched to their needs. Our expanded service model requires us to provide training and consulting to our clients and their advisors. Chris brings excellent communication and collaboration skills to these tasks. Chris maintains a VT Real Estate Sales Person license and Series 22 and 65 Security licenses, allowing him to refer clients to the full range of replacement options, including securitized forms of replacement properties. Our exchange clients are seeking a broader array of replacement property options beyond wholly-owned & managed real estate and our services are tuned to allow our clients to examine all strategies and on a national scale”.
For more information you can visit www.section1031.com or call 603-444-0020.
Doing business with related parties can be accomplished but it takes some additional planning and due diligence. Holding periods are carefully monitored both before and after an exchange takes place. The reasoning behind the restrictions is due to the opportunity to shift tax basis with closely held entities or families thereby creating tax avoidance.
Section 1031(f) provides special rules for property exchanges between related parties. A taxpayer exchanging like-kind property with a related person cannot use the provisions of 1031 if, within 2 years of the date of the last transfer, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The taxpayer takes any gain or loss into account in the taxable year in which the disposition occurs. The two year rule is in essence a “safe harbor”.
For purposes of Section 1031(f), the term “related person” means any person bearing a relationship to the taxpayer described in Sections 267(b) or 707(b)(1). Plainly said, related parties include, but are not limited to, immediate family members, such as brothers, sisters, spouses, ancestors and lineal descendants’. However, related parties do not include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.
Corporations, limited liability companies or partnerships in which more than 50% of the stock, membership interests or partnership interests, or more than 50% of the capital interests or profit interests, is owned by the taxpayer is considered to be a related party.
Disposition (Sale) to a Related Party
It is clear that a taxpayer can dispose of (sell) his or her relinquished property to a related party and acquire like-kind replacement property from a non-related party without violating the related party rules and guidelines. The related party must hold the relinquished property acquired from the taxpayer for a minimum of two (2) years, and the taxpayer must hold the replacement property acquired as part of the 1031 Exchange for a minimum of two (2) years in order to qualify for tax-deferred treatment.
Acquisition (Purchase) from a Related Party
However, it appears that you may not be able to dispose of (sell) relinquished property to a non-related party and acquire like-kind replacement property from a related party without recognizing depreciation recapture and capital gain income tax liabilities.
However, you are generally entitled to defer income tax liabilities when you purchase property from a related party and your related party is also completing their own 1031 Exchange transaction using the sales proceeds from your purchase of the related party’s property, or if you can prove that the transaction did not result in an income tax basis swap (tax avoidance).
We hear this troubling refrain too often. It seems that many accountants and attorneys will tell their clients that a Section 1031 exchange is cumbersome and just delaying the inevitable. Some advise that the tax rates today are the cheapest you will ever see, “It’s easier to just pay the tax” they say. In far too many cases, this is terrible advice and costs their clients dearly.
What many investors (and sadly, their advisors) don’t realize is that the capital gains rates upon selling their real estate holdings is not “just 15%”. On January 1, 2013 Uncle Sam rang in the New Year with a capital gains rate increase to 20% for high wage earners, with an additional tax of 3.8% added into the mix to fund the President’s health care initiatives. Your state also wants their slice to the tune of as high as 13.3% depending on where you call home. Oh, and don’t forget you still have depreciation recapture which gets you for 25% of the depreciation off the top. Didn’t take depreciation? Doesn’t matter, the IRS will figure out what you should have taken then zap you for 25% of that number.
Now that you have run your numbers (and picked your jaw up off the floor) you may see things in a different light. It is so important to make sure you to understand the ramifications of your sale BEFORE your sale. Unless you have offsetting losses, you might be very surprised at the check you will have to write to the IRS. Section 1031 has some strict time requirements, so the time to start considering 1031 is not 3 days before your closing. If you have already closed, it’s too late.
As the word Exchange implies, you must purchase replacement property so the next step is to understand what your replacement options are. This is where things typically get a little confusing for our clients. The often repeated myth says that a “like-kind” exchange is just that, exchanging an office building or condo into another office building or condo. Believing this definition causes many real estate investors to dismiss the utility of 1031 because they just don’t want to own another three family apartment building, or another strip mall renting to Joe’s Pizza and FiFi’s Pet shop.
The reality is that you can exchange anything that is classified as real estate for anything that is classified real estate in the 50 US states. That means you can exchange the raw land you have been holding for years in Rhode Island for rental property on the Cape. Or, you can exchange your current office for a condo in Ft. Myers, rent it for a couple of years and then convert it to your personal residence or vacation home without triggering tax!
The following is a real-world example from our files:
Our client was a dentist in Boston who had been practicing for years in a 1600 square foot office condo that he owned. When the time came to relocate his practice to Maine and bring his son on board, he was blown away at the amount of capital gains tax he was responsible for upon the sale.
Luckily, this dentist had an attorney that had worked with us before and suggested he give our office a call. As it turns out, this dentist wanted to build a new office building for his practice, and already had plans for a new 6,000 square foot building.
He used a little known exchange strategy called a Build-to-Suit or Improvement Exchange whereby we set up a special purpose entity for him, purchased the land and built the building. When the building was complete, he sold his Boston property and exchanged into the new building. The numbers where almost identical and he completed the exchange and paid zero capital gains (FED / STATE / Depreciation recapture). What is eye opening about this transaction is that he was planning to sell his building, pay his taxes (over $340,000) and THEN build his new building. He won, as do most all of our clients.
One of the important aspects of the exchange process is to not only understand 1031 and the rules, but to understand the options that you have using proceeds from an exchange. Not only do first time clients often misunderstand the code or the process, they also don’t understand how it is possible to turn real estate into an income producing vehicle while paying zero capital gains tax.
Section 1031 is one of the few remaining tools provided by the Government that favors the real estate investor. Our company has been facilitating Section 1031 exchanges for over 30 years. Many of our clients are not professional real estate investors and initially don’t fully understand Section 1031 and its many uses. Please call or drop us a line, we love to answer questions and spread the word about the power of Section 1031.
We have conditioned our clients to expect that state capital gains tax can be deferred along with the federal tax exposure by utilizing Section 1031 for their exchanges. It is true, most states will honor the deferral as long as the gain is being rolled into the new property.
Section 1031 for Investors & Professionals 