YOU DON'T HAVE TO BE RICH TO BE AUDITED BY IRS

The following is an excerpt from an article that appeared in the April 2009 issue of Smart Money--it confirms what I already knew--"The IRS's job is to enforce the tax laws enacted by Congress and to collect what's due.  Its primary weapon? the Audit, whose use has more than doubled since 2000, to surpass 1 percent of all returns, according to the Transactional Records Access Clearinghouse, a Syracuse University data-research organization.  The increase can be attributed to the rising number of so-called correspondence audits--those done through the mail asking for specific information rather than, say, investigating  your whole return...One way to get the IRS's audit sensors tingling:  claiming deductions much higher than are typical for your income level.  We'd share them with you, but the IRS keeps that information under wraps.  What's more clear: Big charitable donations have been getting a much closer look...To protect yourself, get a receipt for any donation you plan on deducting, and keep those receipts for seven years--unless it suspects you of outright fraud, that's how far back the IRS will go with an audit."

ARE THERE DIFFERENT TYPES OF SECTION 1031 EXCHANGES? THE SIMPLE ANSWER IS YES !!

The Federation of Exchange Accommodators explains:

What are the different types of exchanges?

• Simultaneous Exchange: The exchange of the relinquished property for the replacement property occurs at the same time.

• Delayed Exchange: This is the most common type of exchange. A Delayed Exchange occurs when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. A Delayed Exchange is subject to strict time limits, which are set forth in the Treasury Regulations.

• Build-to-Suit (Improvement or Construction) Exchange: This technique allows the taxpayer to build on, or make improvements to, the replacement property, using the exchange proceeds.

• Reverse Exchange: A situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000. These transactions are sometimes referred to as "parking arrangements" and may also be structured in ways which are outside the safe harbor.

• Personal Property Exchange: Exchanges are not limited to real property. Personal property can also be exchanged for other personal property of like-kind or like-class.

IN A SECTION 1031 EXCHANGE, HOW DO I DEFER ALL OF THE TAX?

Taxpayers are often confused about such issues as:  How do I make sure that the transaction is tax deferred in full?  By following just two simple rules, your transaction should meet the full-deferral rollover test of Section 1031.  They are:

#1--You must buy a replacement property of equal or greater value to the property sold in order to completely defer the applicable capital gains tax.  If you purchase a property of lesser value, you will be taxed on the difference; and

#2--You must use all of the cash proceeds from the sale of the relinquished property towards the purchase of your replacement property in order to completely defer capital gains tax.  If you do not use all of your proceeds on the purchase, you will be taxed on the difference. 

For more information on these and other basic rules on Section 1031 exchanges, go to our website at: www.liberty1031.com and then proceed to the section titled "Understanding 1031's".

IN A SECTION 1031 EXCHANGE, AM I ALLOWED TO KEEP SOME OF THE CASH?

I get asked this question all the time.  I have had clients want to use the proceeds for everything from paying off charge card bills, going on vacations, to buying themselves a Porsche automobile.   The answer to this question was delineated in one of the four rules of  what we in the Qualified Intermediary industry call the "Napkin Rule".  The part of the rule discussing use of proceeds says:  "Thou shalt use all of the proceeds from the sale of the relinquished property towards the purchase of the replacement property." 

OK--so what if you don't use all of the proceeds towards the purchase of the replacement property--will that invalidate your entire Section 1031 Tax Deferred Exchange?  The Answer is NO it won't--but you will be taxed on the portion of the proceeds that you kept and did not use towards the purchase of the replacement property--the rest of the proceeds that were used towards the purchase of the replacement property would not be taxed at this time as a result of Section 1031.  This type of transaction is called a "partial" exchange.

IN A SECTION 1031 EXCHANGE, UNCLE SAM IS YOUR PARTNER!!

Recently, one of Liberty  1031 Exchange Services' 1031 Business Development Consultants (BDC) described to me how he explains a Section 1031 tax deferred exchange to an investor who has no knowledge on the subject matter.  He starts out by saying, "Let me tell you about a real estate investment partner that I know of...he offers no monthly payments and he charges no interest, so you get an interest free loan. There is no balloon date or call date on this interest free loan.  In fact, he might not even require that you pay him back.....His name is UNCLE SAM!!!”

Our BDC, is correct because in a Section 1031 tax deferred exchange, UNCLE SAM (our Federal Government) allows you to defer the capital gains tax on the sale of your investment property. The Qualified Intermediary receives the funds from the sale of the relinquished property and uses the proceeds to purchase the replacement property selected by the taxpayer.  In many cases, the taxpayer will own his or her exchanged investment property at the time of his or her demise and may not owe any estate taxes, thereby having deferred and finally escaped the payment of any tax on the profits.  UNCLE SAM can be a great partner if you play by his rules (Section 1031).

HOW CAN I MAKE SURE THAT MY PROPERTY QUALIFIED FOR A SECTION 1031 EXCHANGE?

Section 1031 contains no fixed amount of time needed to qualify a transaction for tax-deferred status.  Instead, Section 1031 requires that the taxpayer have the intent to have held the relinquished property for either an investment purpose or a business purpose at the time of the exchange to avoid a taxable exchange.  The taxpayer must also intend to hold the replacement property as an investment or be used in a trade or business (business purpose).

The case law on Section 1031 follows a line of precedence where courts will attempt to determine what the taxpayer's original intent was at the time he sold his relinquished property and purchased his replacement property.  The court applies a “facts and circumstances” test to objectively measure whether the taxpayer had a bona fide intention to hold each property as investment or business property at the time of the exchange. The taxpayer’s actions, written and oral communications, and tax filings, constitute evidence for examination if the Internal Revenue Service challenges the tax-deferred status of the exchange. 

For a more thorough discussion on this subject go to our website:  www.liberty1031.com and look up recent articles written on this subject.

MIXED USE SECTION 1031 EXCHANGES

Invariably, when I give a seminar or speech on 1031 exchanges, a question on mixed use exchanges is queried. 

What is a mixed use?  Pretend my last name is McDonald.  Further pretend that I am a farmer. AND on my farm--E- I, E- I - O, --ENOUGH of the nursery rhyme--but if I had a farm and I lived in the farm house, but farmed the surrounding land, I would have a mixed use property.  The farm house would be my personal residence and the surrounding farm land would be property that I used in my trade or business (in this case, farming) or was being held as an investment. 

I could sell the property and use both sections 121 and 1031 of the Internal Revenue Code (IRC).  How does that work you ask?  Under section 121 of the Internal Revenue Code(IRC), a taxpayer can sell their personal residence, and if they lived in the personal residence 2 of the last 5 years, up to $250,000 of profit per person or up to $500,000 per married couple, can be received TAX FREE.  That of course is presuming that the personal residence (in this case the farm house) went up that much in increased equity.  The remaining portion of the sales price could be allocated to the farm land, which would qualify for a Section 1031 exchange. 

Let me give you an example.  Mr. and Mrs. McDonald (the taxpayers) purchase a farm for $300,000 in 2001.  It has a farmhouse on it and 50 acres of farm land.  The farmhouse is valued at $200,000 and the land is valued at $100,000 (that of course equals $300,000).  In 2009 they agree to sell the farmhouse and the 50 acres for $1,100,000.  If they can justify the value of the farmhouse at $700,000, they could receive the profit on the farmhouse TAX FREE(sales price of farmhouse $700,000 less original purchase price of $200,000 equals a TAX FREE PROFIT of $500,000 under IRC Section 121). 

The farm land which was originally purchased for $100,000 is now worth $400,000, so there was a profit of $300,000 on the land.  The taxpayer could transact a  IRC Section 1031 exchange on the $400,000 of land and purchase another real estate investment for $400,000 or more.  If taxpayers did that, they would defer any and all taxes that would be due on the sale of the farm land (that of course is covered under IRC Section 1031). 

It's a convoluted example--but WOW--what a way to save money, pay no tax on the personal residence profit and defer paying tax on all of the other profit. I'll say it again, acting as the Qualified Intermediary on a Section 1031 exchange is a wonderful job--the client is always happy because you have helped him/her save payment of taxes and, in some cases, they will never pay any tax.

NON-TAX REASONS TO DO A SECTION 1031 EXCHANGE--PART 2

Here are some additional (we gave you 7 other reasons in our previous blog) Non-Tax Reasons a Taxpayer will want to do a Section 1031 Tax Deferred Exchange:

8. The Taxpayer decided to relocate to another state and would like to have all of their investments within a reasonable distance from where they live.   This becomes especially important to the Taxpayer who must manage and oversee their investments personally.

9. Consolidation is an important concern to many of our clients.   They own a number of investment properties and managed them for a number of years.  They have decided that it would be better to own fewer, but more expensive investments.   This could decrease the Management responsibilities, as a larger/more expensive property is more conducive for hiring a management company to take care of the investment.

10. Multiplication and Leverage--no I'm not talking about 3 x 3 = 9.  Many Taxpayers are hoping that through their investments, their net worth will appreciate.  For example:  A Taxpayer who owns a piece of property valued at $500 that will appreciate 10% in a year, will have an investment worth $550 at the end of the first year (appreciation of $50 that year).  A Taxpayer who exchanges that $500 (I am presuming there is no debt on the property to make this example easy to understand) for a $2,000 investment (that would be 25% down--$500--with the remaining $1,500 in borrowed money) would have at a 10% appreciation factor, a $200 appreciation that year.  We know which is more--$200 is more than $50.  So through multiplication and Leverage--the Taxpayer's net worth can appreciate at a much quicker pace.

11. Reduced Management Responsibilities--I know I have intimated this reason above, but it is a very important reason that many Taxpayers transact a 1031 exchange.  They exchange the property they presently own and replace it with one with less management headaches, or replace it with a property that they don't have to manage at all, such as a Tenant-in-Common type of property--that is professionally managed by others.

12. Exchange out of a property they own a partial interest in--and exchange into a property they will own just by themselves.  That way they no longer have to get an approval to do anything to or with the property from their "co-owner."

13. Estate Planning is a major reason Taxpayers should do an exchange.  Although this blog is titled Non-Tax Reasons--I just had to sneak this one in because, if done correctly, most Taxpayers will pay NO tax when doing a Section 1031 exchange and at the Taxpayers’ demise, their heirs will receive these assets at a stepped up basis-and it's very likely that there will be no estate taxes.   Isn't this a wonderful world--That's why I love being the Qualified Intermediary--I can make my client, the Taxpayer, happy as well as their heirs.

FOR A MORE THOROUGH BREAKDOWN OF THESE AND OTHER BENEFITS GO TO OUR WEBSITE:  www.liberty1031.com

NON-TAX REASONS TO DO A SECTION 1031 EXCHANGE--PART 1

The majority of my bloggers are aware that doing a Section 1031 tax deferred exchange allows  Taxpayers the privilege of not having to pay their federal capital gains taxes, depreciation recapture taxes and state income taxes (if any) on the property they held for investment or on the property that they used in their trade or business.  Whew--that was a long sentence. 

So deferral of payment of taxes is a major reason astute Taxpayers use Section 1031 of the Internal Revenue Code.  But there are numerous Non-Tax reasons to do a 1031 exchange.  I will cover some of these reasons in this blog and will continue with more reasons in the next blog.  Let's begin.  Non-Tax reasons to do a Section 1031 Exchange:

1. Taxpayers may want to sell a property that they have fully depreciated and exchange into a more expensive property that can be depreciated.

2. Taxpayers may want to exchange a property that is not producing income into a piece of property that does produce an income stream.  The typical example would be the exchanging of a piece of raw acreage into a replacement property, such as an office building that produces a positive cash flow.   A lot of retirees do this type of exchange, because they are looking for that income stream in their retirement years.

3. Taxpayers' "Property of Their Dreams," becomes available and so they exchange an investment property they are not particularly fond of for the "Property of Their Dreams."

4. Taxpayers exchange a property that is not producing a satisfactory cash flow for another that will produce a higher cash flow.

5. Taxpayers want to diversify their investments.  They might own one large property.  They could sell the property (relinquish it) and purchase (replace) with numerous investment properties.   They may want to diversify because they would like to have properties in various different states so that if one state has an economic problem, the rest of their assets are not affected.  Or they might want to own different types of property.  For example they could exchange a large office building and replace it with a small strip shopping center, an office condominium, and other property--all being different types of real estate.  Remember--the property sold (relinquished) must be "like kind" to the property purchased (replaced).   In the case of Real Estate, all real estate is "like kind" to any other type of real estate.

6. The Taxpayers may want to exchange a property that is not appreciating at the rate they would like for another property that has a better possibility for increased appreciation.

7. The Taxpayers may decide to do a 1031 exchange because the present property they own may be harder to sell in the future and the replacement property may be easier to dispose of in the future.

REMEMBER:  IT IS IMPORTANT TO HIRE AN INDEPENDENT QUALIFIED INTERMEDIARY WHO IS KNOWLEDGEABLE IN THE ENTIRE 1031 EXCHANGE PROCESS.  We will continue with more Non-Tax Reasons for a 1031 exchange in our next blog.

ONE OF OUR SECTION 1031 EXCHANGE CORRDINATORS HAS A FATHER THAT.........

Most of you bloggers know that an Exchange Coordinator (EC) is the person in our office who handles all of the paperwork on the Section 1031 exchange.  They are highly trained and experienced individuals.  In fact, in our office, the EC must have been a real estate paralegal for at least 5 years before we even interview them for an EC position.  I believe we are the only Qualified Intermediary Company in the Section 1031 industry that has this strict hiring requirement.  Now that I've given you the experience factor, one of our EC's asked me to solve a problem for which she had no resolution.  She tried to solve it, but couldn't come up with a satisfactory answer. It involved her father.  Her father built a spec home and wondered whether he would be able to do a 1031 exchange.   

She told her father, correctly by the way, that she didn't think he would qualify because most developers or builders who build or renovate and then sell, would be considered to be “dealers”, because they held the property primarily for the purpose of reselling it.   That of course would not qualify for a Section 1031 exchange, because you must hold the property for investment purposes or for use in the trade or business.  It can't be inventory or primarily held for sale.  

If this were to go to through the court system, the main test would be:  What was your intent?  If you can prove that you are an investor and not a dealer then, of course, you can pursue the 1031 avenue or, at least, pay capital gains taxes.  If you are a dealer and this is a business, then no matter how long you held the property, it would be taxed as ordinary income. Ordinary income, of course, is taxed at a higher rate.