In many areas of taxation, there are big differences in the financial consequences strictly based on how things are described, such as with this recent email I received.

Hi! I was reading your tax page. Can you answer a question? If you sell a secondary residence and buy a different secondary residence, is that done under a 1031? How do you prove a property is a secondary residence? I find a lot of info about rental for rental or sale of primary residences but I can’t find anything about sale of a secondary or part-time residence.

Thanks,

My reply:

Tax treatment for the sale all depends on what call the residence.

If you call it a “personal use” property, there is no way to avoid taxes on any gain on its sale. It does not qualify for a 1031 exchange. The best you can do is delay some of the taxes by carrying back as much of the sale price and reporting the gain on the installment method.

If you call the residence “investment” property, which you may have visited occasionally to maintain, it is eligible for a 1031 exchange and can be replaced with any investment, farm, rental or business real estate in the country, as described at www.tfec.com.

You would be well advised to consult with your personal tax advisor to see how much tax you are looking at and whether the property can be considered as an investment.

Normally, if there is a large gain from the sale of an asset, that proves it was a smart investment.

Good luck.

Kerry Kerstetter

For decades, I’ve used the phrase “swap ’til you drop” to explain the benefit of using 1031 exchanges to legally avoid taxes on sales of real estate. The drop part refers to the step up basis property receives in the hands of the heir. It essentially wipes out the accumulated profits at the time of death and is what I have always called the “ultimate escape from capital gains taxes.”

Because estate taxes are generally higher than capital gains taxes, for those whose estates are large enough to exceed the tax free threshold, there are often benefits to using lower step up values, when that is possible.

When it comes to the $250,000 per person tax free exclusion of gain from primary residence sales, I have been seeing a lot of confusion, such as this email I received yesterday.

Hi. I just came across your website. I have a question you might be able to answer. I have a client who’s husband died 6/25/03. She filed married joint for 2003 but for 2004 of course she will file single. She is selling their primary residence in 2004. Will she only be allowed the $250,000 maximum tax exclusion since she is single filing status for that year? Or do you know of any special rules about spouses of deceased taxpayers getting a longer period to sale principal residence and still claim the $500K. Please let me know if you know anything about this or if you know of a place I can research it. Thank you.

My response:

Noting that you are in Vacaville, I need to mention that if your client is also in California, the entire gain in the home prior to 6/25/03 has already been wiped out by the stepped up basis the widow receives. For community property, the entire cost basis is stepped up.

If your client is in a non-community property state, the husband’s half of the property is stepped up to half of the home’s FMV as of 6/25/03 and the widow’s half remains as it was before.

Your client will only have to worry about the appreciated value since 6/25/03, which can then be excluded on a pro-rated basis of $10,417 ($250,000 / 24 months) of tax free gain per month from 6/25/03 until the date of sale. The death is one of the circumstances that allows the use of the pro-rated exclusion.

You can see this explained on Pages 7 & 8 of IRS Publication 523, which covers home sales.

Good luck. I hope this helps.

You can see all of the rules for the sale of a residence by obtaining IRS’s Publication 523. This is available from the IRS website in downloadable PDF format and in browser friendly html.

I’ve added a section to the TFEC website on State rules regarding 1031 exchanges. It’s for my own benefit as well as the growing number of investors we are working with who are using this technique to transfer their real estate investments from one state to another without having to pay any taxes on their profits. In fact, even though we are located in Arkansas, more than half of the exchanges we handle have one or more legs in other states.

There is a big difference in the carryover basis and potential capital gains taxes between having the transfer take place as a gift or as an inheritance. Besides the issues covered in the following email exchange, another common misconception I’d like to dispel is that a gift doesn’t have a zero cost basis just because the recipient didn’t personally pay anything for it. That idea has come up in a few recent conversations with clients.

I received the following question:

I am an attorney in Kentucky. I have a question about your website. You said that if a gift of non cash is made and the item is a highly appreciated one, the fair market value is used as the cost basis for the gift. In a case with a piece of real property here in Kentucky, the FMV of the property when the donor acquired it was $60,000. The FMV right now is $149,332. Would this be a situation where the FMV of the property becomes the recipients’ basis. If so, can you please point me to some statutory authority on this please. Thank you very much, keep up the good work on the website.

My response:

There seems to be a misunderstanding regarding the basis issue.

When a gift is made of an appreciated asset, the gift tax (Form 709) is based on the item’s current fair market value. However, the cost basis of that item on the books of the recipient is the same as it was for the item’s previous owner (giftor/donor) plus any gift tax that was paid on that item. As I explain to people, this means that responsibility for the future capital gains taxes on that item is also transferred to the recipient (giftee/donee). In your example, the $60,000 cost basis would transfer to the recipient.

This is quite different from how the basis is affected when items pass through inheritance. The fair market value at the time of death is used for estate and probate purposes, and it also becomes the basis on the heir’s books. The capital gain that had accumulated during the previous owner’s lifetime is literally wiped off the books. This stepped up basis for the heirs makes this one of the biggest tax saving opportunities available and is why gifting appreciated assets is not normally the best strategy.

This is also why the “swap ’til you drop” strategy of continuously using 1031 exchanges normally means that the accumulated gains are never subject to capital gains taxes. It has always bugged me to hear people say that they want to just sell their highly appreciated assets and pay the taxes so they won’t burden their kids with that responsibility. The exact opposite is true.

For decedents leaving an estate under the taxable threshold (currently $1,500,000), this means the gain is never taxed. For those whose estates are large enough to require an estate tax, there is a trade-off between wanting a high or low valuation on the estate tax return (Form 706) because of the normally higher estate tax rates.

I hope this clears things up.

There is a tendency on the part of some people to not want to bother with new things or to avoid even discussing issues with which they are not extremely familiar. In the worlds of consulting and most any business relationship, this is a disservice to the clients, as well as a potential liability to the advisor.

When we moved here to the Ozarks almost eleven years ago, not surprisingly, there were hundreds of differences in all kinds of things from what we had been used to in the Bay Area. Many of those differences were obviously part of the reason we had decided to relocate.

As we met and interacted with more and more people, we noticed that many of the things that had been common knowledge back in the Bay Area were practically unknown here in the Ozarks. We knew that we were moving from the highest tech part of the country (my main office was in Fremont, CA – part of the extended Silicon Valley) to one of the least technically up to date areas (high tech was having an answering machine). It was also a running joke in this area that they were happy to be twenty years behind the rest of the country because when the world ended in places like the PRC, there would be another 20 years to prepare for it here in the Ozarks. There was a general attitude by many that there was no need to learn about new things because everyone had gotten along just fine without them.

I will be the very first to admit that it is impossible for anyone to know absolutely everything about a topic, especially something that is constantly changing as much as the world of taxes. However, it is extremely important to be aware of at least the existence of new developments. When we financial professionals are working with clients, they expect us to know more than they do and to catch the signals for money saving opportunities that may apply to them.

After moving here, we started encountering people and hearing story after story about people having to pay huge amounts of taxes from the sales of their properties. The influx of people to the Ozarks from the PRC and the Chicago area had drastically driven up prices, resulting in huge profits for people who had often paid almost nothing for their properties.

When we would ask why those people hadn’t done Section 1031 (aka Starker) tax deferred exchanges so they could avoid those huge taxes, we discovered that almost none of the tax and real estate professionals had ever heard of 1031 exchanges. To them, that was some new fangled thing for big city folks and had no application here in the Ozarks. In the meantime, their clients were needlessly paying hundreds of thousands of dollars of taxes.

Again, it’s a product of the environment that back in the PRC, most tax and real estate pros knew about 1031s and would broach the idea when a client may be a good candidate for one. The famous Starker case was in 1978, and the official blessing of delayed exchanges was given by our rulers in DC in 1984; so it had been around long enough to become part of the collective knowledge. There were even scores of exchange accommodation companies to handle the paperwork and funds for clients.

Here in the Ozarks, the existence of 1031 exchanges was almost completely unknown by tax or real estate pros. Many of them weren’t even interested in learning about them and were unconcerned that they weren’t helping their clients save huge amounts of taxes. As I toured around Arkansas, Oklahoma and Missouri, speaking to groups of CPAs and Realtors, I explained the mutual benefits of helping their clients save on their taxes.

I also explained that, as more of their clients learned about 1031 exchanges after the fact, they would become extremely angry that they weren’t told about 1031s by either their tax or real estate pro before thy had sold their properties. The reaction to such news is handled in one of two ways. The old style from this part of the country is to slough it off and chalk it up to experience (“we’ll know better for next time”). The other response is to blame someone and take legal action for the fact that they weren’t informed of ways to save taxes. Besides the huge amounts of money people from California and Illinois were bringing to the Ozarks, they were also bringing their knee jerk reflex to sue anyone for any reason. I lost track of the number of people wanting to know if they could sue their tax and real estate pros for not telling them about 1031 exchanges. Having been the victim of nuisance lawsuits myself, I did not want to add to the massive volume of litigation and encouraged everyone to consider this a learning experience, although they had very good cases of negligence against their advisors.

As I toured the area and spread the word about the value of exchanges, I was trying to motivate people to start up exchange accommodation services. I even offered to provide the forms that I had developed as owner of an exchange company back in the Bay Area, Realty Arrangements, Inc. (RAI). It was too new a concept for this area and nobody wanted to get into this service. I constantly heard “you’re so smart, why don’t you do it.” I discussed this idea with the CPA to whom I had sold RAI, Doug Heimforth. I had signed a non-competition agreement which I didn’t want to violate, so I asked him about having a branch office of RAI here in the Ozarks. He decided it would be easier all around for us to just start up our own new company out here; which is how Sherry’s Tax Free Exchange Corporation was born.

The motivation for this longer than expected piece was my seeing the issue of suing CPAs and Realtors for not informing clients about 1031 exchanges in some of the Q&A boards I occasionally check on the web, such as this one. The desire to force tax advisors to pay for their failures to alert clients about tax saving options is still very strong.

As I would explain in my speeches and seminars to CPAs and Realtors, they don’t all have to become experts on the details of 1031 exchanges. There are far too many tax issues to become an expert in every one of them. However, they should at least be aware of the signs that indicate a 1031 might be beneficial for their clients. When they detect any of these signs, they should refer their clients to consult with someone who can dig in and analyze and advise on the specifics of their situation.

It won’t always be the case that a 1031 exchange is the best move. On at least half the cases I consult on, we come to a mutual conclusion that a 1031 exchange would not be appropriate, for various reasons. While the end result may be the same, this is actually quite different than my arbitrarily making the conclusion, or completely ignoring the possibility, without even discussing it with the client.

Keep your own wits about you when investing.

Medicare Using Blimp in Ad Campaign

Uncle Sam Spends $32 Million to Promote New Currency – It’s always struck me as odd when monopolies waste money advertising their products and services (i.e. utiltities, Post Office, etc). It’s not as if there are other types of currency we could be using than the bills produced by our government. They have a term for alternatives – counterfeiting.

Taxes and hard work – A familiar theme that bears repeating as often as possible, to counteract the lies told by the Left. Lower tax rates motivate people to work more and higher rates make them work less.

Why The National Debt Matters To You

Americans Stake Claims in a Baja Land Rush – There’s nothing wrong with this, especially as the PRC is swallowed up by Mexico. One thing to remember – property in Mexico (or any other country) is not considered to be suitable like-kind as an eligible replacement for USA real estate under Section 1031. This means that investors who want to sell off USA real estate and reinvest into Mexican property will have an additional expense; the capital gains taxes that could be avoided by replacing with USA property.

Abusive shelters targeted by IRS

Calendar Showcases Accountants’ Inner Wild Child – You can see more about this calendar from the Louisiana Society of CPAs on their website.

States Try to Poach California Businesses – That shouldn’t be very difficult. The whole recall circus was a huge commercial for Anywhere But California to operate a business.

Dian Brown sells property – More on the lingering fallout from the looting and collapse of Harrison Abstract.

We have discovered that Ms. Brown wasn’t just fast and loose with the escrow funds. She was very loose on how to handle 1031 exchanges. Sherry’s company, Tax Free Exchange Corporation, has had to recently bail out a number of former clients of Ms. Brown’s who are in the middle of doing 1031 exchanges. While we weren’t surprised that she had copied her documents from ours, as many others in this area have, we have been appalled at how terrible her application of the rules for 1031 exchanges had been. We are having to educate her former clients on the proper 1031 procedures, as if they had never heard of it, even though many claim to have done 1031s with Dian Brown. They need to keep their fingers crossed that their tax returns aren’t examined by IRS, because their sloppy “1031” exchanges won’t stand up to much close scrutiny.

I’ve posted a new article on how to properly refinance property to pull out tax free cash without jeopardizing a Section 1031 tax free exchange.

They are trying to freeze many of Dian Brown’s assets and are having a hearing today (7/21) to discuss it. She and her attorney are still trying to claim that her personal assets should be exempt from any action since the problems were with her corporation. This is a ridiculous argument that will hopefully be tossed out by the judge. It’s been reported that Brown admitted transferring $400,000 of client money from the corporate accounts to her personal accounts. That makes an easy connection to why her personal assets should be frozen ASAP and used to pay off her victims.

The news accounts of this case have given the impression that all funds held by Harrison Abstract have been frozen since the end of June. I just learned from some clients whose funds were part of this mess that their money was released after pressure was exerted by a Harrison bank and it was explained that there may be additional damages due to the failure to complete a 1031 exchange. Hopefully, other people who had their money in Harrison Abstract’s account when everything was frozen will also be able to close their deals without having to wait months or years.

Based on some recent email exchanges, I’ve updated some of the FAQs regarding 1031 exchanges on TFEC’s website:

Dealing with property owned in a partnership

Reverse exchanges