Q:

Subject:  1031 Exchange

Back in 2005 we sold a vacant property and had a gain of $130K and bought a $180K house using a 1031 exchange..  We have had it for a rental for 4 years. 

Due to our financial situation, we have to sell our primary residence at a loss of $40K and move into our 1031 rental house and make it our residence house.
 
Do we have to pay taxes on the original deferred gain on our rental house?    .

A:

Converting a business asset to personal use is not a taxable event, so no tax will be due for the year of the conversion.

However, down the road when you sell this property, you will need to possibly pay tax on some of the gain.  The law was recently changed to require a five year look-back period.  If you occupy the home as your primary residence for a full five years before selling it, you will be allowed to exclude up to $500,000 of profit on its sale.  If you sell the home after less than five years of personal occupancy, the tax free gain will be prorated according to the amount of time it was used as a primary residence.

Your own personal professional tax advisor should be able to explain this to you in more specifics for your unique circumstances.

Good luck.

Kerry Kerstetter

Q:

Subject:  Exchange Question

can I exchange a retail business for another retail business?

A:

It is a little trickier than just selling one business and reinvesting into another one.

When a business is sold, the sale price is allocated between the different assets being transferred, such as real estate, fixtures, equipment, goodwill, inventory and covenant not to compete.

The profits from some of those assets can be deferred via a Section 1031 exchange if that portion of the proceeds is used to acquire like kind assets of equal or higher value within the statutory 180 day reinvestment period.

For example, if $100,000 of your sale price was allocated to the business real estate, you could defer the gain on your original real estate by acquiring $100,000 or more of new (to you) investment or business real property.

The like kind rules and definitions are also a little tricky.  Real estate has the widest scope of like kind status, with any kind of investment or income producing property being eligible on both sides of the exchange.  Equipment and fixtures have to be the same kind.

Goodwill in one business cannot be classified as like kind for goodwill in any other business; so it is not possible to defer any of that profit.

Same thing for a covenant not to compete.  That will be taxable income as it is received and cannot be exchanged tax free for anything else.

This is why, if you are considering reinvesting business sale proceeds into another business, it is critical that you work with your own professional tax advisor ASAP to have the gains and possible taxes calculate for each type of asset involved and to assist you in negotiating the allocation with the buyer of your old business and seller of your new one.  The allocations you use must be reported consistently on everyone’s books.

This is a quick and dirty answer to your questions   Your own personal professional tax advisor should be able to give you more specific advice with your actual figures.

Good luck.

 Kerry Kerstetter 
 

As a means of saving huge amounts on taxes, 1031 exchanges of real estate have always been in the cross-hairs of our rulers looking to generate more tax revenue.  Rather than completely repeal Section 1031, the more likely approach is to whittle away at its usage.  I recently came across two such attempts that are in the works.

Federal regarding farm land:   1031 Proposal In The Farm Bill Update

In California, a frequently proposed idea has resurfaced, to disallow referral of gain on the disposal of Calif. property when the replacement property is not also in Calif.  Some other states have already implemented this kind of restriction, and if Calif does this, we can only expect many more states to follow.

We recently received the following news item in an email from Wachovia Exchange Services: 

Hello friends,

I recently received some information about California that might interest some of you.  Hopefully, we will never see this proposal get
enacted.  And I would hate to think that it might give any other states the same idea.

California, like a number of states, is faced with a severe budget shortfall. The legislature is therefore looking at a number of proposals
to raise revenues and reduce expenditures. As part of this effort, the California Legislative Administrative Office has proposed a revenue
raiser wherein an exchange of California property for out-of-state commercial property would not be eligible for deferral as a like-kind
exchange.

California currently has a claw-back regime where California property is exchanged for non-California property. In such case, while the gain is deferred, if the replacement property is subsequently sold, the deferred gain is subject to California tax. The reason for the proposal is the administrative difficulty in taxing the gains once the property has left the state.

This is just a proposal at this time; however, it should be noted that California has a history of non-conformity with the federal tax rules,
so it would not be out of character for it to have different rules for like-kind exchanges.

Q:

Subject: Exchange Question

Will I invalidate the 1031 exchange if I don’t use all the money held in escrow to buy replacement property? 

A:

Not reinvesting the full amount of your disposal leg proceeds won’t invalidate the 1031 exchange if everything else has been done properly.

However, it will, in most cases, not allow you to roll all of the gain from the original property into your replacement property.  The actual calculation for the Form 8824 worksheet is a little messy; but the quick and dirty way to look at is that the unreinvested funds will be taxable in the year that you receive them.  For example, if your disposal leg happened in 2007 and the 180 day reinvestment period expires in 2008, and you are sent the remainder of the funds in 2008, the taxable portion of the gain will be shown on your 2007 tax return as a deferred installment sale, with the actual gain subject to tax on your 2008 tax return.  If both ends of the exchange happened inside the same tax year, the unreinvested potion will be subject to tax on that year’s tax return.

The tax rate that the unreinvested funds will be hit with will be the highest rate applicable to the property’s disposal.  This normally works out to be the 25% Federal depreciation recapture rate, plus the comparable state rate, if you or the property are located in a taxable state.

I hope you’re picking up on the fact that the actual tax calculations are very tricky and are not something you should even think about attempting on your own.  The services of an experienced professional tax  preparer will more than pay for themselves in a case like this.

Good luck.  I hope this helps.

Kerry Kerstetter

Courtesy of the most recent email bulletin from ACAT.

If you are considering a like-kind exchange (also known as a Section 1031 or Starker exchange), you need to review the IRS regulations that apply…and do it right.

Like-kind exchanges allow investors to defer taxes when they dispose of property they currently own and replace it with similar property.  However, the Internal Revenue Service plans to increase audits and enforcement of these exchanges beginning mid-2008.

Usually when a business or investment property is sold, the seller must pay tax on any profit.  The tax varies depending on the type of income and the current tax rate.  For example, if you purchased land for $100,000 and sold it for $200,000, you could expect to owe $15,000 federal income tax on the transaction, assuming a current capital gains tax rate of 15%.

With a like-kind exchange, it is possible to purchase property for $100,000, sell it for $200,000, buy another like-kind property for at least $200,000, and avoid income taxes on that sale.  But you have to follow the IRS rules precisely, and this requires planning prior to the transaction.

First, the property sold and the replacement property must be “like-kind.”  IRS rules and regulations offer guidance to help determine what qualifies as like-kind property.  For example, you can exchange a single-family home for an office building, or an apartment complex for a shopping center. But you can’t exchange your home for an oil well and you can’t exchange real property for a business. 

Second, many like-kind exchanges will require the assistance of a qualified intermediary in order to comply with all of the requirements for a tax-free exchange.  You can usually find a qualified intermediary in your area by checking the Yellow Page listings under “Title Companies.”

All like-kind exchanges must be reported to IRS by filing Form 8824 with your federal income tax return.

Sounds confusing?  Studies by the IRS and the Government Accounting Office have found consumers don’t understand the rules.  But help is on the way.

The IRS has updated Publication 17 “Your Federal Income Tax” to better tell taxpayers about like-kind exchanges.  Additional information about the like-kind exchange process is found in IRS Publication 544 “Sales and Other Dispositions of Assets,” and in the instructions for Form 8824.

There are significant savings you can realize. But the best advice is to get your accountant involved at every step.

This information is provided as a public service, and should not be construed as individual accounting or tax planning advice.  For information on how these general principles apply to your situation, please consult an accounting or tax professional.

IRS Steps Up Scrutiny On Popular Tax Strategy – Thanks to an alert reader for the heads up on this article about upcoming IRS scrutiny of 1031 exchanges.  A big stumbling block for IRS will be in educating its agents on the proper application of 1031 rules, especially the fact that different kinds of real estate qualify as like kind.  I’ve lost track of the number of IRS agents I’ve had to train on this and other 1031 related issues.