Q:

Subject: Exchange Question

 

Can I payoff raw land I currently own with a 1031 exchange?

Q:

Subject: Exchange Question

 

Hi,

I am writing from Maryland. Last year I sold a piece of land in West Virginia to purchase a primary residence in Maryland. When I originally purchased the land 6 years ago my intent was to build a primary residence on it. I had some financial troubles and deferred building the house. My personal situation changed and I needed to buy a home in Maryland closer to family and work. I ended up selling the land and used every penny as a down payment on my new house which is worth about 10 times the price of what I sold the land for. It doesn’t seem fair that I have to pay capital gains tax, I never intended to keep the land as investment to make money. In addition, I paid out over $1800 in West Virginia property tax over 6 years.

Thank you,

A:

As I’m assuming your personal tax advisor has already told you, the fact that you didn’t originally intend to hold that land for appreciation purposes isn’t relevant.  All IRS cares about is how the property was actually used and the fact that you sold it for more than you bought it for.  You should have already been deducting the property taxes on Schedule A in the years in which they were paid.

It’s too late now to change the consequences for you; but for future reference, as well as for others in similar circumstances, there was a way in which you could have legally avoided taxes on the land sale.  I’m assuming that you didn’t bother to consult with a tax pro prior to selling the land, or else this idea would have been brought up.

While a 1031 exchange directly between an investment property and a primary residence is not legal, a two step approach is frequently used in situations similar to yours.  You could have used Sec. 1031 to reinvest the land proceeds into a rental house.  After renting the home out for a reasonable period of time, you could then convert it into your primary residence. 

I hope you have better luck next time, tax wise.

Kerry Kerstetter

 

IRS is issuing a clarification on how to best avoid taxes on homes that have been used as both a primary residence and business or rental.  Utilizing a combination of the Section 121 tax free exclusion and Section 1031 like kind exchange is not anywhere close to a new idea.  We have been doing just that for decades with tax and exchange clients, including long before 1997, with the old rules requiring a new residence to be purchased within a certain time frame and the measly once in a lifetime exclusion of $125,000 of gain per person or couple. This new ruling will just make those who feel uneasy about doing anything that is not explicitly spelled out for them a little more comfortable.

Q:

Kerry,

I ran across your website online and I like the way you think.  I have a tax question and I was wondering if you mind answering it.  It is my understanding that you do not pay taxes on borrowed money.  Well what if you know you are about to sell property and have a bundle of equity built in.  Traditionally this would be capital gains and we don’t like those so we would put the money into a tax deferred account (1031 exchange) but with a tax deferred exchange we are not allowed to touch one red dime—it must go towards the purchase of property.  What if I was to refinance this property pulling a portion of my equity out.  At this point it is equity and borrowed money.  Would I have to pay tax on this for the year as income or would it be considered borrowed money of which tax is not owed?

Thank you,

A:

While there have been occasional discussions about making cash taken out of a property’s equity in anticipation of an exchange taxable, those have never gotten very far.  As it stands, if you borrow money against your rental or investment property, the proceeds are not taxable as long as the refi is a completely separate event from the exchange transaction.

However, if you sell the property, and don’t do a 1031 exchange, the relief of debt (paying off the loan) is treated the same as cash proceeds.  Many people make the mistake of assuming that only the actual cash received is counted.

If you do a 1031 exchange after having refinanced, there will obviously be less cash to reinvest via your facilitator.  This means that the additional amount of the cost of the replacement property will have to be financed with a loan.  Basically, the loan on the new property should be at least as much as the loan on your old property.  As with any exchange, whatever you miss your target replacement price by will be taxable as boot.

Your personal tax advisor should be able to help you with more specifics for your situation.

Good luck.

Kerry Kerstetter

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Q:

I had a quick question about a 1031 exchange we are performing.  We sold a property in which we had a 50% share.  Those funds are being held by an intermediary right now.  We have located another property in which we will be tenants in common with four other people.
Now my question is at what point can we form an LLC to hold this new property? Could this be done before the close of escrow or do we have to wait a few months before we can do it?  What is the IRS’s stance on this topic?  The escrow agent is saying it should be done after the close of escrow.

Thank You,

A:

One of the basic requirements for a valid 1031 exchange is that the names on the title of the old and new properties are the same.

Thus, if you owned the previous property in your personal name, you need to take title to the new one in the same way.

Later, after the dust has settled and you have acquired the new property, you can then contribute it to an LLC if that is what you want to do. 

There are some possible twists to doing this that you will want to work out with your personal tax advisor, such as setting the property’s basis on the LLC’s books as the same as it was on your personal books.

I hope this helps.  To be honest, your exchange facilitator should have covered this with you as it is a basic component of 1031 exchanges.

Good luck.

Kerry Kerstetter

Treasury and IRS Announce Guidance On Like-Kind Home Exchanges – Formalizing the part of last October’s law that sets a five year waiting period for people to sell their homes tax free if the homes were acquired as part of a 1031 exchange. I discussed this new rule earlier, right after the law was signed, as well as in this follow-up.

Q:

Subject: primary residence held in LLC

Question:

If I have my primary residence placed in an LLC will there be any capital gains due when I sell it after living there 2 yrs or more??

A:

The tax free exclusion for gains from primary residence sales of up to $250,000 per person is only available for homes owned by individuals. 

Properties owned by other entities, such as corporations, partnerships and LLCs, are not eligible for any such tax free sale because only individuals (human beings) can have primary residences under the tax code. 

On the books of the other kinds of entities, the property is normally treated as an investment, business or rental property and the only way to defer taxation of any gain is via a 1031 like kind (aka Starker) exchange.

If you are serious about being involved with LLCs and real estate, you really should be working with a tax pro or you could easily find yourself owing a lot of unexpected taxes.

Good luck.

Kerry Kerstetter

 

Q:

I don’t know whether you respond to specific questions/individuals but in trying to do some research came across your site.  I have gotten two different responses to a tax question so thought I would give you a try.
I did a 1031 exchange this year–sold a condo I had rented for years and bought a home in a resort area in Delaware that will be rented on a weekly basis.  In order to rent this home it had to be fully furnished–can this furniture and everything purchased to set up the kitchen for use be deducted in one year as a Section 179 expense??  I am a real estate agent so I know all my losses this year are not limited and since I didn’t settle on this till June I did not have a lot of rental income on it.
Thanks for any insight you can give.

A:

It depends on how you are going to show the new rental property on your tax return.

If you are going to show it on Schedule E as a regular rental property, you can’t claim Section 179 for the furnishings.

However, if you show it on Schedule C as a short-term rental property (average stay of seven days or less), you will be able to use Section 179 for the furnishings. 

This special rule, which I usually call the “motel exception,” and many tax pros overlook, makes the activity not considered to be a passive one and thus not subject to those deductible loss limitations.  You do need to be actively involved in the operation of the property to be able to claim the losses. 

Another big benefit of this approach is to generate self employment losses on the rental Sch. C to offset self employment income from other business activities, such as real estate sales.

Good luck.  I hope this helps.

Kerry Kerstetter