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Part 2 Of Pay Or Play
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Part Two of Pay or Play – Ways to Avoid Capital Gains with 1031 Exchanges.

By John Dietz - Email Editor

Date : September 9, 2008

Dear Valued Reader,

The other day I got a phone call from an individual, Bill N., who had a piece of real estate that he wanted to sell. He had bought the property for $200K, it was now worth about $2 million, and he had a loan against it for $600,000. Now he wanted to sell the property, and surprise, surprise, he didn’t want to pay any taxes.

Immediately upon getting these calls, I get all excited and start thinking of all the weird exotic tools we can use to save this guy some taxes, charitable remainder trusts, structured settlements, term investment trusts, etc. . . . The challenge with these tools is that they require a lot of pre-planning in order to “keep it legal”, and with that additional pre-planning comes confusion for the client as well as higher fees for the tax advisor.

As with so many prior situations, after running through the pros and cons of the various strategies available and how I can dazzle Bill N. with my brilliant knowledge of the tax code, I told Bill N. that probably the best tool he had available to him was something called a 1031 exchange. Funny thing is, Bill N. sounded a bit disappointed that I mentioned something so pedestrian to him.

So what exactly is a “1031”, sometimes referred to as a “Starker Exchange?”

Under section 1031 of the tax code,

A property owner, who holds property for “the productive use in a trade or business or for investment”, is allowed to defer paying any capital gains taxes if such property owner, in accordance with the provisions and requirements of Section 1031, sells such property and identifies like-kind property within 45 days and acquires the other like-kind property within 180 days.

The players in a 1031 like-kind exchange are:

  • the Exchanger and
  • the Qualified Intermediary (QI).

The basic 1031 exchange works similar to this.

  • An investor owns real estate (called the “exchanger”) and wants to avoid the current federal 15 percent capital gains tax on the appreciation of the property, and the 25% rate on the recaptured depreciation. Once you factor in the state income taxes, in many cases taxes could eat away almost 30% percent of your profit. The original property being sold is called the “relinquished property.”
  • The exchanger transfers title of the relinquished property to the Qualified Intermediary just prior to the sale and the QI becomes the seller and receives the proceeds. When the exchanger identifies replacement property, the QI purchases it and transfers the title to the exchanger.
  • The exchanger has 45 days from the date of closing on the relinquished property to identify like-kind property and then has 180 days to close on the “replacement property.”

The game “rules and conditions” and the typical like-kind exchange (sometimes called a Starker Exchange) offered under IRC 1031:

  • The exchanged property must have been held for investment purposes. In recent years a number of people were “flipping” properties in a couple of months. They also used section 1031 to defer the taxes on the profits; those exchanges aren’t going to hold up on audit.
  • Swapped property must be exchanged for similar or like-kind property. Like-kind is a very broad definition, if it is real estate, it can be exchanged for real estate. Thus raw land can be exchanged for an apartment complex and vice versa.
  • Identification of the replacement property must be in writing within 45 days. You can identify up to three properties within the guidelines. If identifying unlimited multiple properties, they commutatively cannot exceed 200 percent of the fair market of the relinquished property.
  • Closing of the replacement property must be within 180 days, although an extension may be filed.

Word of Caution –

  • If the exchange fails, you do the wrong thing or you do not follow the rules, you will pay the capital gains taxes!

Words of Advice –

  • Do not neglect any paperwork. This is a transaction where you have to dot your I’s and cross your T’s. Everything must be declared in writing and qualified by midnight on the day of the deadline.
  • Do not take receipt of the money – EVER.
  • Do use a known and experienced Qualified Intermediary. The fee the intermediary charges the exchanger is typically very little, normally less than a thousand dollars. The way the intermediary makes the bulk of its profit is by earning the interest on the money generated from the proceeds of your sale. In recent years, a number of qualified intermediaries have gone out of business and taken millions of dollars from investors.

Working with IRC Section 121 in Wealth Building –

One way to have your cake and eat it too is to combine the tax deferral of section 1031 with the completely tax free provisions of section 121 of the Internal Revenue Code.

The way this works is to exchange your current property into a new investment property. Keep in mind that in order for your exchange to meet the code provisions, the new property must be for investment purposes, and can not be a new personal residence. . . yet.

Let me give you a personal example. Mrs. H. who lives in Florida, owns a number of rental properties. If she were to sell those properties right now, she would lose a lot of reinvestment capital due to the taxes she would have to pay.

With one property she has in California, she is thinking of exchanging into a property located in Arizona and renting the property out. So long as she does things correctly, she will owe no taxes on the exchange.

As I said, she lives in Florida now, but she might move to Arizona in the future. If she moves to Arizona a couple years after the exchange took place, she could now move into the “new” Arizona property as a personal residence.

The key is that the property she “exchanged” into was originally investment property. After two years she can move into that property, and use it as her primary residence.

Then, so long as she lives there for the next five years (while the normal period is 2 of the last five years, under a change to section 121, if the property was acquired from a 1031, Congress increased the time period to 5 years), the first $250,000 is not subject to taxes. If she were married, then she would have a $500,000 exclusion.

It may sound like a lot of work, but the work is wealth building. It allows a family to move up to larger, nicer real estate, defer capital gains and in conjunction with other estate planning vehicles can be very valuable even for a couple whose children have finished college and now want to recover from the college debt burden or lack of cash flow there of.

Different types of exchanges –

Reverse Exchange

The IRS has recently issued Revenue Procedure 2000-37, which allows a taxpayer to perform a “reverse exchange.” A reverse exchange allows a taxpayer to acquire replacement property before selling the relinquished property. This may generate options when the market is seller driven.

There are different qualifications and the paperwork is much more stringent. Again you have to use an expert Qualified Intermediary.

1033 Exchanges

A 1033 exchange with properties that have been seized, condemned, or destroyed by uncontrollable forces. Qualifications include, (the list is not comprehensive):

  • condemnation of a property outside of a taxpayers control
  • eminent domain property
  • does not require a Qualified Intermediary
  • two years are allotted to find the replacement property into a 1033 exchange.

We coined it pay or play because a 1031 is difficult to achieve, yet it is a very valuable tool. Wealth building is a diligent and steady process for most, but the good news is Wealth Building and Asset Protection do work!

With help from Tim Berry, JD.

Until next time,

John

John Dietz
TrustMakers.com

 

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ABOUT THIS EDITOR:

John Dietz is a strategic advisor at Trustmakers.com with a passion for client solutions that can encompass your business, your real estate, and your personal assets. Mr. Dietz serves to educate you on the latest in asset protection planning.

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