Image

Archive for Exchanges

You Can Do 1031 Real Estate Exchanges

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Have you heard about 1031 real estate exchanges? It turns out they are a great way to save money on taxes. You may not realize this, but paying income taxes on the disposition of rental, business, or investment real estate is voluntary. You have another option!

Even people who have heard of 1031 real estate exchanges often don’t take advantage of them. Perhaps it’s because the name makes it sound like something too difficult to mess with. The truth is that the process is simple; don’t let the word “exchange” fool you.

The Basics of the 1031 Exchange

Here is what you need to know: the Section 1031 tax-deferred exchange is merely a sale and a purchase. It involves four parties: 1) the seller (you), 2) the buyer, 3) the seller of your new property, and 4) a qualified intermediary who knows how to qualify your sale and purchase as tax-deferred. The process requires only a few necessary steps:

  • Hire an intermediary.
  • When you sell to the buyer, the intermediary holds onto the money. Don’t touch the money yourself.
  • You then purchase your new property using the funds being held by the intermediary.
  • All of the taxes are deferred as long as you receive no cash and do not obtain debt relief!

Who Can Act as Intermediary

For your sale and purchase to qualify for tax-deferred status, your intermediary must be someone impartial who does not benefit from the exchange. Specifically, you cannot have had a business relationship with the person in the last two years[1]. That means the ordinary people you may think of to help with your finances—your attorney or accountant—won’t work.

Don’t get discouraged. Professional intermediaries are available who specifically handle these kinds of situations on a daily basis. You can do a quick online search for “1031 intermediary” and find plenty of candidates. Because they are fairly common, you can usually get a fairly good price (perhaps less than $500) on hiring an intermediary.

Tip: Be aware that like any purchase of services, hiring an intermediary does carry risk. They are a business, and although it’s not common, it is possible to come across dishonest intermediaries who steal their clients’ money. Be sure you check the company’s background. Also, intermediaries can go bankrupt. This would entirely throw off your sale and purchase if the funds from the first sale are missing. That means you won’t be able to complete the exchange. You’ll have to pay the taxes, and you won’t have the money from the sale—bad news all around.

Most professional intermediaries are legitimate companies that make their money through helping clients to save on taxes. However, you should always protect yourself and your investments. Make sure you go with a company with an established reputation, and check into options to protect your money, such as bonds or an insurance policy. Also, ask the intermediary if they offer some type of protection for your funds.

Time Limits on Making an Exchange

Okay, so most of this doesn’t sound too complicated. Don’t let the simple process make you get lax. Section 1031 sets hard, fast rules about how long you can take to complete an exchange. Be efficient; meet the deadlines. If you don’t, you lose out on your tax-deferred advantage, no exceptions or second chances. Here’s the information you need:

  • Start Date—The date on which you close the sale for the property you are selling triggers the “initial transfer date”. Once you have relinquished the property, the Section 1031 exchange officially begins.
  • Identify Date—Yes, you have a time limit on how long you can take to identify the property you intend to buy. You should formally identify your possible choices by the forty-fifth day after the initial transfer date[2]. Please note that this is not the date by which you must purchase the property; you merely need to have a few specific options picked out.
  • Close Date—The close date is not the day you close the sale on your new property. It is actually the date on which the exchange is fully completed and you have identified the new property title in your name. The closing of the exchange must be completed within whichever of the following two time frames is shorter[3]: 1) 180 days after the initial transfer date, or 2) the due date of your tax return.

Before you begin to panic, remember that you are allowed to extend the due date of your tax return. You may even be able to get the full 180 days by extending your return. So, if your exchange closes after October 17, file the extension to get more time to complete process.

Other options also exist to buy you a little time. When you know it may take a while to find a suitable replacement property, you can delay the start date. How? One way is to offer your potential buyer a triple net lease to occupy the property until you’re ready to close[4].

How to Prove Identification

You may have noticed that you need to formally identify a property by the forty-fifth day after initial transfer. Ugh, more paperwork, right? Fortunately, it’s easy enough to record your identification of a property. Just put down the earnest money, and you have your evidence that purchase of the replacement property is in process. If you haven’t put down earnest money, you’ll have to sign a document that you provide to the qualified intermediary[5].

Keep in mind that you’re allowed to identify up to three replacement properties regardless of fair market value, whether you’re selling one or multiple properties[6]. You can identify more than three new properties if the total fair market value of the properties does not exceed 200 percent of the fair market value of the properties you sold. The deadlines may be strict, but these rules allow plenty of flexibility in choosing new properties. Even better, the Section 1031 rules work for pretty much any real estate (rental buildings, vacant land, business facilities), as long as it’s domestic and not for personal use[7].

In fact, you can even build on vacant land or rehab a building with a build-out or construction exchange[8]. When identifying the replacement property, you simply include plans for the structure or build-out you will have constructed (make sure this is completed within the designated 180-day period). The qualified intermediary then pays out the funds to the contractor as work is completed.

All you have to remember to qualify for tax-deferral is that all of the proceeds from your original sale must be used to acquire a replacement property. Do not collect cash on the deal. Do not attempt to reduce your debt through the exchange. If the property you purchase is a fixer-upper and did not cost the full amount you sold the original property for, simply complete enough improvements (through your intermediary) within the 180 days in order to use up all the funds. Otherwise, you have all the same options for selling real estate that you normally would, including owner take-backs[9], also completed through the intermediary.

Special Rules about Buyers and Sellers

You may be wondering if certain individuals, like relatives, are excluded from taking part in the sale and purchase. The good news is you are allowed to make the exchange transaction with someone you are related to, but you will be disqualified for tax deferral if an exchanged property is sold again within the next two years[10]. This only applies in cases of siblings (full and half), parents, grandparents, spouse, and descendants (biological and adopted)[11]. Entities in which you own (directly or indirectly) more than fifty percent in value are also considered related parties for this purpose.

Selling a property is not always easy. You’ll be happy to know that Section 1031 also allows “reverse exchanges”[12]. This simply means your intermediary can buy the new property with money you put up in advance before you have sold your original property. Be aware: the 180-day time frame still applies, with the start date taking place once you close on the new property. You’ll need to sell your original property by then to avail the tax advantage.

If you’d like to take advantage of these tax savings, be sure to contact a knowledgeable intermediary who can ensure the correct process is followed. Special rules exist for particular types of property, such as those being converted to rental properties, so make sure you’re working with someone who has experience with your type of situation and understands all the details. The rules get more complicated when you start trying to exchange personal property (e.g., office equipment) or intangibles like a business personality. Keep it simple with real estate exchange to get maximum return for the least effort.

  1. Reg. Section 1.1031(k)-1(k). ↑
  2. IRC Section 1031(a)(3)(A). ↑
  3. IRC Section 1031(a)(3)(B); Reg. Section 1.1031(k)-1(d). ↑
  4. Private Letter Ruling 8118023. ↑
  5. Reg. Section 1.1031(k)-1(c)(2). ↑
  6. Reg. Section 1.1031(k)-1(c)(4)(i). ↑
  7. IRC Section 1031(h). ↑
  8. PLR 200842019. ↑
  9. IRC Section 453(f)(6). ↑
  10. IRC Section 1031(f)(1). ↑
  11. IRC Sections 1031(f)(3); 267(b); 707(b)(1). ↑
  12. Revenue Procedure 2000-37. ↑
Categories : Capital Gains, Exchanges, Rental Properties, Tax Planning

You Totaled Your Vehicle? Tax Benefits You Can Use

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Let’s face it; wrecking your vehicle is a bummer. But, don’t let moping about something that’s done and over with keep you from being smart about the situation moving forward. There’s no need for having a totaled vehicle and missing out on tax benefits.

Understanding Tax Law

Your particular business situation will determine exactly how the tax law views your totaled vehicle, also called an involuntary conversion. Both individuals and corporations, however, have to work with the same rules as far as the business part of the vehicle. The difference lies in the personal use part. For an individual, there is a personal casualty loss. For corporations, there is no personal part; it’s all business.

If you’re confused about which situation applies to you, look at the check made out by the insurance company. When you total your vehicle, they will keep the vehicle and give you a check for its pre-accident value. If the check is made out to you (because you are a Schedule C taxpayer and you own the vehicle), you will divide the money between business and personal use based on mileage for each. A check made out to the corporation is not divided. On the books, the vehicle belongs to the business.

For a Proprietorship

Let’s do an example to see how you would divide the insurance money between personal and business use. In this example, you owned the vehicle for three years. During those three years, you drove it 20,000 miles for business and 5,000 miles for other uses. So, you have 80 percent business use from the time of purchase to the totaling of the vehicle.

You can now use that percentage to determine gain or loss on both a business and personal basis. Since a proprietorship is a Schedule C taxpayer, here’s what you need to know. 1) The business part will have either a taxable gain or a deductible loss. 2) For the personal part, you will pay taxes on any gain, but you cannot deduct a loss.

To clarify the personal casualty loss, you probably will not have a personal deduction if you had insurance. You see, by IRS rules you can deduct whichever is lower of your cost or the fair market value, minus the insurance proceeds. Since insurance will likely reimburse at fair market value minus your deductible, there will not be a personal casualty loss deduction.

Even if you have an insurance deductible, it is unlikely you will come out with a personal loss deduction. That’s because tax law includes these two additional rules regarding personal loss:

  1. The amount of each casualty loss is reduced by $100[1], and then
  2. Casualty losses are only allowed to the extent that they exceed ten percent of adjusted gross income[2].

If you think you might still have a personal loss to claim after these calculations, check with your tax advisor to be sure.

For a Corporation

Your corporation may own a vehicle that you use for both business and personal reasons. In that case, the corporation will assign a value to your personal use. That amount then goes on your W-2, or you will be responsible for reimbursing the corporation. Since you are a more than 5 percent shareholder, you are obligated by specific legal requirements regarding how your corporation determines this value.

Here’s how the example above plays out when the vehicle belongs to your corporation. As far as depreciation, gain, and loss purposes, the corporation owns 100 percent of the vehicle. So, all gains will be taxable, and any loss will be deductible.

Deferring Taxes

In either scenario, you can end up with some taxable gains. Usually, these gains come about because of depreciating the vehicle or expensing deductions claimed on it. When your gain comes from deductions, it’s called “recapture income”, which is taxed at the usual income tax rates. But, here’s a little secret: you can avoid those taxes!

Instead of claiming your totaled vehicle as a gain, you can replace it with other like-kind property. Tax law even allows for two years from the time of the wreck for you to make the replacement[3]. The details are covered under IRS Section 1031 on exchanges of business vehicles, which states that like-kind property for vehicles includes cars, light general-purpose trucks, and vehicles that share characteristics of the two former types (such as crossovers, SUV’s, vans, etc.).

All you have to do to defer the taxes is reinvest all of your insurance money into a new vehicle and properly document this on your tax return. That means if you wreck your SUV, you can take the $20,000 insurance money and replace your SUV with a car. If you don’t reinvest the full amount, you will have taxable income for the amount leftover[4]. So, if that new car only costs $16,000, you’ll have a taxable gain of $4,000. It works this way for both a proprietorship and a corporation.

Don’t Forget the Documentation

In order for your vehicle replacement to be accepted by the IRS (and to avoid taxes), be sure you attach a statement to your tax return (either the Form 1040 or the corporate return) that includes[5]:

  • Details of the wreck, including the date,
  • Amount of insurance reimbursement,
  • How you calculated the gain,
  • The replacement property purchased,
  • The amount of gain that is postponed,
  • The adjusted basis on the replacement vehicle (which is reduced by the deferral of gain), and
  • How much of the gain is taxable (again, if you invest the full reimbursement amount, there is no taxable gain).

So, in order to avoid those gain taxes, replace your vehicle with one of like-kind (which basically means for the same use) and document everything about your wreck, insurance reimbursement, and purchase of the new vehicle. For any business losses, deduct those immediately! Business loss deductions work the same way for a proprietorship or a corporation. You may not like knowing that you totaled your vehicle, but you can rest easy with the knowledge to set your finances straight in the aftermath.

  1. IRC Section 165(h)(1). ↑
  2. IRC Section 165(h)(2). ↑
  3. IRC Section 1033(a)(2). ↑
  4. IRC Section 1033(a)(2)(A). ↑
  5. IRS Pub. 547, Casualties, Disasters, and Thefts (2012), posted Nov. 29, 2012, p. 12. ↑
Categories : Business Expenses, Cars, Trucks & SUVs, Casualty Losses, Depreciation, Exchanges, Tax Planning

Are You a “Dealer” or “Investor” for Tax Purposes?

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Tax law is forever classifying people and making structures that either create benefits or disadvantages on your tax return. Part of getting the most from your return is about understanding the definitions of the IRS. Two that seem very similar, but have distinctly different consequences on your taxes, are real estate dealer and real estate investor.

What’s the Downside of Each?

We’ll start by discussing the disadvantages. That’s right—there is no golden choice when trying to figure out if you classify as a dealer or an investor. In either case, there will be some disadvantages.

As a real estate dealer:

  • Your profits are taxed at both the ordinary income rates (up to 35 percent) AND the self-employment rates (up to 14.13 percent).[1]
  • You may not depreciate property that you are holding with the intention of selling.
  • You may not use the tax-favored installment method to report dispositions of your property.
  • And, you may not use the Section 1031 exchange to defer taxes on properties you hold as a dealer.

As a real estate investor:

  • You are subject to the net capital losses limit of $3,000 (applied after gains are offset against losses).
  • You must treat selling expenses as a reduction in sales proceeds, which means those expenses produce benefits at the capital-gains tax rates only.

Admittedly, the dealer gets the lesser deal when it comes to disadvantages. The investor does get to depreciate property, is allowed to sell using the tax-favored installment method, and may choose to use a Section 1031 exchange, thereby deferring taxes on a disposition.

What about the Up Side?

Every coin has a heads and a tails. And, it’s the same with tax designations. Both dealers and investors gain some advantages from their respective positions.

Advantages for real estate dealers include:

  • You are treated as a business and may treat most expenses as ordinary business deductions (advertising, commissions, legal fees, real estate sales, etc.).
  • Your property sale losses are not limited capital loss cap of $3,000 that limits investor properties.
  • Your losses are deducted as ordinary losses.
  • You get to deduct the entire loss (either immediately or using the net operating loss rules to deduct it over time—these rules allow you to carry back your losses up to five years and forward up to twenty years).

Advantages for real estate investors include:

  • Your sales profits are taxed at 15 percent or less, a tax-favored capital gains rate.
  • You are not subject to the self-employment tax.

Practical Application

So, what does all this mean for you and your business? Let’s run through some example numbers. For the example, we’ll say you have a $90,000 profit from a property sale. Based on the tax rates mentioned above, your taxes as a dealer could be as high as $36,370.[2] Your taxes as an investor might be as high as $13, 500.

You can clearly see that having your properties qualify as investment sales generates a considerable tax savings—potentially $22,870!

However, depending upon your business structure and activities, it may not be possible to define all of your property sales as investment sales. No problem. The IRS has no qualms with an individual taxpayer acting as part dealer and part investor. You read that right; you can balance the pros and cons of each situation. It’s simply a matter of taking each property on a case-by-case basis.[3]

Not so fast. You may think the IRS is giving you some kind of free gift by allowing this pick and choose method, but it’s not quite as unstructured as all that. You will be required to make a clear distinction in your record books. You didn’t think the IRS was going to let you off without documentation, did you? And, this means you must decide before-hand which route you’re going with each property sale. You cannot simply go back over your sales at tax time and assign designations. You will have to establish what your intent was with the sale—dealer sale or investment sale.

Tips on Documentation

Good documentation of your purpose and activities helps you to establish your case with the IRS. You should determine, and make note of, your intent for the property throughout the process:

  • When you purchase the property;
  • During your ownership; and
  • At the time you sell it.

If you keep records throughout the process (not just at the time of sale) it gives your case credibility. It’s important to keep in mind, however, that if your return is challenged in court, they will likely examine the sale when they rule on whether you acted as a real estate dealer or real estate investor on a particular property.[4] None of this means that your purpose may not change between the time you buy a property and sell it, but at least you will be prepared to understand and plan for such a scenario.

The All Important Point-of-Sale

Important: The point-of-sale is the most critical part of the process in determining your investor or dealer status. It’s often the deciding factor in IRS decisions. Although a single piece of real estate can have features of both dealer and investor property, it can only be treated as one or the other. Take a look at the characteristics of each from a tax standpoint.

  • Real Estate Dealer—First off, dealer property is held with the intention of being to customers in the ordinary fashion of business or trade.[5] If you buy and sell many properties throughout the year, you are likely a dealer regarding those properties.[6] Unfortunately, the IRS has not established any set number for determining dealer status, so it’s all about making your case. In fact, number is only one factor, and in previous rulings:
  1. A company earned dealer status with only one sale because it had already agreed on sale to a third party prior to purchasing the property itself;[7]
  2. A taxpayer, Mr. Goldberg, did not earn dealer status even with 90 home sales in a year.[8] In his case, the homes were built for rentals and used as such prior to the time of sale.

However, in the majority of cases, more sales equal dealer properties. In addition to the influence of the number of properties sold, real estate that you subdivide also has an increased chance of achieving dealer status,[9] except under Section 1237.[10] Removing a lien can also make a property more salable under the ordinary processes of business[11] (recall that dealer property is sold in the ordinary course of business).

Several other traits indicate a dealer business transaction over investment actions. They include active marketing and sales activities,[12] property held for a short period of time (indicating the intention to turn over the property for profit),[13] generally making your living as a dealer,[14] regularly buying and selling real estate for your own account,[15] and buying property with the proceeds from another property.[16]

  • Real Estate Investor—In contrast to dealer property, investor property is held with the intention of producing rental income[17] or appreciating in value. This means that investor properties are typically held for longer periods of time[18] and are not often sold, unlike the quick turnover of a dealer property.[19] Other situations in which a court may rule your property is an investor property include acquiring the real estate by inheritance,[20] dissolution of a trust,[21] or a mortgage foreclosure.[22] It’s even possible for you to make improvements to such property prior to selling it and still retain investor status.[23] [24] Just don’t put the proceeds into more real estate or subdivide the property[25] if you want to maintain that status.

If you don’t make clear in your documentation which type of property sale you are making, the IRS will make the decision based on their interpretation, and that is not the best situation for you! So, look at those characteristics above again. Since you’re going to know at the outset what your purpose is with each property, you can make sure to include as many of the appropriate features as possible well before the sale.

  1. The usual self-employment tax rate times the Schedule SE adjustment. ↑
  2. Assuming the real estate profits were your only income. ↑
  3. Tollis v Commr., T.C. Memo 1993-63. ↑
  4. Sanders v U.S., 740 F2d 886. ↑
  5. IRC Section 1221(a)(1). ↑
  6. Sanders v U.S., 740 F2d 886; Suburban Realty Co. v U.S., 615 F2d 171. ↑
  7. S & H, Inc., v Commr., 78 T.C. 234. ↑
  8. S & H, Inc., v Commr., 78 T.C. 234. ↑
  9. Revenue Ruling 57-565 ↑
  10. IRC Section 1237. ↑
  11. Miller v Commr., T.C. Memo 1962-198. ↑
  12. Hancock v Commr., T.C. Memo 1999-336. ↑
  13. Stanley, Inc. v Schuster, aff’d per curiam 421 F2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert den 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969). ↑
  14. Suburban Realty Co. v U.S., 615 F2d 171. ↑
  15. Armstrong v Commr., 41 T.C.M. 524, T.C. Memo 1980-548. ↑
  16. Mathews v Commr., 315 F2d 101. ↑
  17. Planned Communities, Inc., v Commr., 41 T.C.M. 552. ↑
  18. Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3. ↑
  19. Rymer v Commr., T.C. Memo 1986-534. ↑
  20. Estate of Mundy v Commr., 36 T.C. 703. ↑
  21. U.S. v Rosbrook, 318 F2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963). ↑
  22. Cebrian v U.S., 181 F Supp 412, 420 (Ct Cl 1960). ↑
  23. Yunker v Commr., 256 F2d 130, 1 AFTR2d 1559 (6th Cir. 1958). ↑
  24. Metz v Commr., 14 T.C.M. 1166. ↑
  25. U.S. v Winthrop, 417 F2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969). ↑
Categories : Audits, Business Expenses, Capital Gains, Depreciation, Exchanges, Investments, Land, Leases, Passive Income & Losses, Receipts, Records, Rental Properties, Self-employment Tax, Tax Planning

Tax Topics