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Archive for the ‘1031’ Category

Selling Residence To Controlled Entities

Posted by taxguru on June 23, 2006


Q-1:

Subject: RE: Sale of Personal Residence

Kerry,
 
I’m puzzling over this discussion.
 
I’m not sure when the questioner is assuming Sec 121 kicks in.
 
When is the property “sold” for purposes of Sec 121: when “sold” to the LLC for the note or when the units are sold by the LLC? For tax purposes the LLC is disregarded so is it possible to even “sell” to the LLC from the IRS point-of-view?  Would the answer be the same or different if an S-corp were used in that it is a unique “person” under the law?
 
In my case I am considering transferring my personal residence condo to an LLC or S-corp and converting to a rental and would want the liability protection of the LLC or S-corp; but how/when would it be reported to the IRS for purposes of Sec 121? Or would I lose the benefit of the Sec 121 exemption if I hold it for rental beyond three years after converting it to rental?
 
I’ve searched everywhere and this question is the closest I’ve come to a discussion about this scenario. I can’t find anything on the IRS site that seems to give a definitive response.
 
Thanks,


A-1:

The gist of that Q & A was to highlight the fact that the Section 121 exclusion is available to be used when a home is sold outright to a related party.  According to the IRS Pub quote, the only time it’s not available is when a remainder interest in the home is sold.

This means that a sale to a controlled C or S corp would be eligible for the Section 121 exclusion, assuming all of the normal conditions are met.

As always, you should be working with an experienced tax professional before setting up any of these kinds of transactions.

Good luck.

Kerry Kerstetter

Q-2:

Kerry,
 
Thank-you for your reply. You didn’t say but I take it from your reply that you don’t think that sale to an LLC would qualify for Sec 121 treatment; is that correct?
 
Can you recommend a tax professional in Denver, or anywhere, that is competent and can answer questions? I have tried to find one to discuss this with and have not been able to find anybody that knows what they are talking about. Or maybe they just want to deal with the easy and usual.
 
Twice I was referred to the related party rules that govern 1031 exchanges. When I pointed out I wasn’t looking at a 1031 exchange they both told me the rules still apply to my case. When I asked where in the regulations I could find that they just said its too complicated and I don’t want to get into it. In response to my questions I’ve been asked why I want to do it, told not to do it, sell it to a third party, etc. etc. but never just an answer to my questions. So I go hunting through IRS pubs and the internet trying to find answers.
 
I want to explore my options: where do I find someone who is competent and can answer questions?
 
Thanks,

A-2:

Actually, it was the opposite.  That sale to the LLC should qualify for the Sec. 121 tax free exclusion

There are obviously some gray aspects to this issue. For example, a sale to an LLC that is being reported on the owner’s Schedule C (disregarded entity) would probably not qualify; but a sale to an LLC that files its own 1065 or 1120 should be okay.

The rules for related parties are stricter for 1031 exchanges than they are for primary residence sales.

You will need to work directly with an experienced tax pro who can analyze your unique circumstances. I wish I could help; but I already have too many clients to take care of; so we are still trimming back on the difficult clients and are not accepting any new ones at this time. 

Unfortunately, we don’t have anyone to whom we could refer you. If you haven’t already done so, you should check out my tips on how to select the right tax preparer for you.

I wish I could be of more assistance; and I wish you the best of luck.  

Kerry Kerstetter

Posted in 1031 | Comments Off on Selling Residence To Controlled Entities

1031 With Low Equity

Posted by taxguru on June 10, 2006

 

Q:

Subject: 1031 Exchange Question

 Dear Sir:

    I wish to sell my house  in Los Angeles, which is an investment property now, and in which i have not lived for over 3 years, for about a million dollars in a few months, and then within 180 days i wish to have closed escrow on a 600,000 dollar property, planning in time to knock down the shabby building on it, but borrowing a million dollars to build 8 units where that shabby property was within the 180 day period of the sale of my original property. 
 
Question 1.  It I have bought the new cheaper property, and received the construction loan to build on the site where that shabby property is, within the 180 days of selling my original home, will this quality as a 1031 exchange?  Or is such a project not covered by the 1031 program since it would take more than 180 days to build the 8 units, or for any other reason?
 
Question 2.  I bought my original home long time ago for 275,000, and i invested 100,000 dollars in renovating it.  But now I owe 540,000 on this property since i refinanced it in the interim.   If i sell this original house for a million dollars, satisfying all relevant 1031 exchange requirements,  are these following steps  the steps which would occur in this transaction?  First, the 540,000 loan is paid back, and then my net return now  due to me after the sale of my original home, which should probably be a million dollars minus the 540,000  ( and also minus  real estate commissions), is put into the new building or real estate project, plus a new loan is obtained for whatever additional moneys are needed to get into the new building or real estate project, keeping in mind that the new project would need to exceed the one million dollar value of the original building?
 
I thank you in advance for your answers to these 2 questions, and any helpful further thoughts which you may have on my planned project.  I will also keep you in mind for all my 1031 exchange needs, including conveyances, and facilitations.
Sincerely,

A:

You really need to be working on this kind of plan with your own personal professional tax advisor who can look at your actual figures.  In fact, we always advise people contemplating a 1031 exchange to have their tax advisors do the calculations on the tax effect of a full cash sale in order to see if an exchange makes economic sense.

With the brief description that you gave, it will probably be worthwhile to look into an exchange. One of the issues that you need to discuss with your personal tax advisor is the adjusted cost basis of the original property.  If you did take out equity via a mortgage, and did not use that money to make capital improvements, it is very likely that the current loan balance is much higher than the cost basis, especially after reducing the basis for depreciation.

In regard to the rules for reinvesting the exchange proceeds, it isn’t required that the new property be completely finished within the 180 days.  You just have to spend, via cash and debt, an amount equal to or higher than the net proceeds within the 180 days.  With unfinished construction projects, you need to be very careful in regard to prepaying the contractor because there have been plenty of cases where the contractor disappears without finishing the job.   

Good luck.

Kerry Kerstetter

 

Posted in 1031 | Comments Off on 1031 With Low Equity

Cash Received From 1031 Exchange

Posted by taxguru on June 8, 2006

 

Q:

If I intentionally left $10,000 out of the reinvestment leg of my 1031 exchange, is my only downside the paying of the tax on that $10,000?

A:

First, if you were wondering whether holding out any cash would nullify the 1031 exchange, that would not be the case.  The only real issue is how much, if any, of the case held back would be taxable.

As Sherry said, the taxability of any cash taken out of the exchange isn’t a cut & dried answer.  It hinges on the numbers involved, as worked out on the 8824 worksheet, which we have posted on our website for downloading.

From a simplistic viewpoint, if there is no debt involved in the new purchase, and you end up with cash, that will generally be taxable.

If there is debt taken on the new property, any cash received on the deal is generally only taxable to the extent it exceeds the exchange expenses, which are the total closing costs from all of the exchange legs.

The tax rate on any taxable boot (cash) will be based on a number of factors.  If there was depreciation recapture on the old property, it will be taxed first at the special 25% Federal rate.  Next is the capital gain, which is taxed at ordinary tax rates if the original property was held less than 12 months or the special  long term capital gain (LTCG) rates (5% and/or 15%) if the property was owned for more than a year.  Arkansas tax will also be applicable to any taxable gain.  This is usually 5% for LTCG and 7% for other types.

I hope this helps you understand the issue.  Your own personal tax advisor should be able to more precisely calculate any potential tax for your particular situation.

Kerry  

Posted in 1031 | Comments Off on Cash Received From 1031 Exchange

Exchange Worksheet

Posted by taxguru on May 5, 2006

 

Q:

Subject: Exchange Question
 
Dear Tax Guru:
 
One of my clients did a 1031 exchange during 2005, and I want to make sure I’m handling the accounting for the transaction correctly.  There was a cash boot paid for the new property.  I would like to know the specifics of the needed entry for book and tax purposes.  Any guidance you can provide would be greatly appreciated. 
 
Sincerely,

A:

You generally want the books to match the 8824 for the exchange.  If your tax prep program doesn’t produce detailed worksheet for exchanges, as Lacerte just started doing a few years ago, you can use a manual or computerized worksheet. 

CFS’s TaxTools program has some excellent 1031 exchange worksheets that I often use to double-check the Lacerte 8824.

Several years ago, I posted a manual worksheet on TFEC’s website that is also very useful.

Good luck.  I hope this helps.

Kerry Kerstetter

 

Posted in 1031 | Comments Off on Exchange Worksheet

Converting 1031 Property

Posted by taxguru on April 20, 2006

 

Q-1:

Subject: Investment Property HARD & FAST RULE

 

Good Evening …..

I came across your website tonite while doing some searches for a real estate property question I have.   It is a question that I simply cannot find the answer to.

I apologize if you do not accept questions, but figured I would give it a shot….

The Big Question:

I own 2 condos. 

They are both rented.

I would like to buy a home and eventually live in it myself.  Right now I am living with and caring for a sick uncle.

I would prefer not to get hit with the Cap Gains Tax from selling investment property.

Could I sell the condos, buy the home, rent out the home  — so it is basically selling investment property to purchase another investment property.

Then, after a year or so, move into the home (after the tenants are gone)  —- would this allow me to avoid the Cap Gains Taxes ??

Thank you so much for your time and I would be deeply indebted for any help you could provide…..

 

A-1:

With 1031’s it’s investment property for investment property.  Not primary residence.  Here’s the link on my website that explains about primary residences.

First of all you need to get with your tax person to figure your best avenue.  If he/she suggests a 1031 you need a1031 accommodator to do your paperwork.  You CAN NOT do this yourself.  Your tax returns have to show your acquisition/purchase property as investment property.

If you decide a year or two down the road you don’t want to rent it out anymore, you can convert the acquisition/purchase property into a primary residence.

IRS can drop a deal if they feel your intent was to make the acquisition/purchase property a primary residence from the start & you’d have to pay the capital gains taxes.

Hope this helps.

Sherry Lee Kerstetter, President

Tax Free Exchange Corporation

 

Q-2:

Thank you Sherry Lee for your rapid response and information…
 
I guess what you’re saying is the IRS does not have a hard and fast rule when it comes to turning an investment property into the owner’s primary residence….??
 
I have to admit that surprises me.  So if a landlord were to decide he did not want to rent out his property anymore and moved in there is no way to know if the IRS will come looking for Cap Gains Taxes ?    What if the property had been rented for 10 years ?  Certainly the IRS would not say “we think this was your plan from the start and we want our $$”  or would they ?? 
 
I would think there would have to be some guidelines for this type of situation — no ???
  
Thanks again Sherry Lee and any more info would be greatly appreciated….   🙂

A-2:

The issue of converting a 1031 replacement property into a personal use residence has been a gray area for decades.  We in the tax practitioner community have been begging IRS for decades to give us a definite time period after which a conversion won’t be challenged.  IRS refuses to do so because they want to reserve the right to second guess anyone. 

There was a slight step in the direction of defining safe time periods in 2004, when our rulers in DC specifically required people living in converted 1031 property to own it for at least five full years prior to sale if they want to use the $250,000 per person tax free exclusion of gain, as I described in this blog post.

Obviously, the longer time that elapses between the exchange and the conversion to personal use, the less likely IRS will challenge it as pre-planned.  The cases that are most suspect are the conversions that occur in less than 12 months, as well as any that can be identified as preconceived.

They key is to have plenty of documentation of your intention to use the replacement property for rental, business or investment purposes.  Any plan to eventually convert it to personal use should be kept to yourself  If you blab that to a lot of people, there is a chance that one of them may be jealous of your 1031 tax savings and try to make trouble for you by telling IRS about your preconceived plans.  The culture of envy and hating anyone else who has more than you is widespread in this country.

I hope this helps.  You should also be working with a tax pro who understands these rules and they apply to real life people.

Good luck.

Kerry Kerstetter

Q-3:

Thank you Kerry and Sherry for the info and your expertise.

I can see how it can get very complicated….

I wonder , in your opinions, do you think if I purchase a home under the 1031 Replacement Property Rule, rent it out for 2 full years, and then moved in — would this be fairly safe from IRS suspicions ??

I get the feeling that every case is different in this situation and there are certainly no “definites” …

Thank you !!!


A-3:

We’ve been doing 1031’s all over the USA for over 25 years & IRS has never challenged a case from us.

There is no guarantees & the laws can change from now until then.

We can just advise you on what we know to date.

Good Luck.
Sherry

 

Posted in 1031 | Comments Off on Converting 1031 Property

Payoff of Installment Note

Posted by taxguru on April 16, 2006

 

Q:

Subject: Installment Sale Income
 
I have found your insight helpful.  I was hoping you would be able to help me.
  
Purchased investment property 05/2004 secured by a bank loan.  In 9/2004, I borrowed funds from father’s trust to pay off the bank loan.  I am a trustee on the trust account.  Payments were made to the trust account until 2/2005.
 
Another investment property was sold in 2002.  The Installment Sale Income, Form 6252, was used for this transaction, and since 2002 I have recieved interest income from this property.  In 2/2005, I transferred my interests in this property to father/trust in return for relief of debt to the trust.
 
It is my understanding that this Installment Sale Income, since it was disposed of, will be taxed as capital gains.  However, because the “gain” was used to purchase like property, is it a wash?  If a gain, how is the gain reported?
 
I asked my accountant and he has not gotten back to me.  I want to be sure I know what questions to ask and know what needs to happen.
 
Thanks.

A:

The proper time to research the tax consequences of an installment note payoff is before you receive the payoff.  Once that is done, it’s too late to do anything about it.

A common misconception is that using proceeds from an installment note payoff to invest into new property can save on the tax bite.  That is flat out wrong.  It has no effect.

A 1031 exchange involves like kind properties.  Real property can only be exchanged for other real property. An installment note, even though originally arising from the sale of real property, is itself considered to be personal property.  Personal property is not like kind for real property.

There are ways to delay taxation on installment note payoffs by substituting new borrowers and/or collateral. It is similar to re-loaning the money.  However, this all has to be set up beforehand, with no actual payment received.  Once you receive the payoff, it is a taxable event.  What you do with the money, including loaning it to someone else or buying new property, will have no effect on the taxation of the note payoff.

Good luck.  I hope you will be more careful next time you are faced with this kind of situation. 
 
Kerry Kerstetter

 

Posted in 1031 | Comments Off on Payoff of Installment Note

Selling residence received via 1031 exchange

Posted by taxguru on April 15, 2006

 

Q-1:

Subject: Home Sale
 
Kerry,
 
My understanding regarding the $250,000/person exclusion for a primary residence home sale that had been acquired in a like-kind exchange is:
 
1. Home must be a rental for at least 12 months prior to becoming a primary residence.
2. Home must be occupied a total of 2 years in a 5 year period and have six “facts and circumstances” to establish primary residency (fed/state tax filing, voter registration, auto registration, bills and correspondence, local bank and social/religious affiliations).
3. Home can’t be sold before 5 years of ownership.
 
Questions:
 
1. If the home value is $750,000 and our exclusion is $500,000 as husband/wife, is there $250,000 capital gains only or is there also deferred gain from the exchange due?
 
2. Is there depreciation recapture tax due upon sale of the house?
 
Thanks,

A-1:

Items 1 and 2 in your summary aren’t actually as cut and dried as you imply. 

There is no statutory safe time frame for a 1031 replacement property to be used as rental before it can be safely be converted to personal usage without jeopardizing the 1031 exchange.  It is still a matter of intent at the time of the acquisition and is based on the facts and circumstances

Proving use as a primary residence is also not just a certain number of items,  It is based on the overall facts and circumstances, where obviously the more factors that make your case, the better off you will be in regard to defending your position against any IRS challenge.

The Section 121 tax free exclusion is up to $500,000 of profit for a married couple.  The key factor is the home’s adjusted cost basis.  If you were to sell your home for $750,000 with no selling expenses, and your cost basis was somehow zero (very unlikely), you would have $250,000 of taxable long term capital gain.  Each time you do a 1031 exchange, you are required to report the adjust basis of the new replacement property on Form 8824.  If done properly, this basis will generally be the latest property’s acquisition price less the cumulative deferred gains from all of the earlier properties.

Depreciation that you claimed (or could have claimed) after May 6, 1997 is subject to recapture and taxable at the special Federal rate of 25%.  With 1031 properties, this actually means that you need to trace back the depreciation on all of the previous properties that have been rolled into the one you are now selling; not just what you took on the current property. 

This can obviously get fairly complicated, which is why you need to be working with a tax pro who has experience in this area.

Good luck.

Kerry Kerstetter

Q-2:

Thank you for your response Kerry.
 
As I understand you, all depreciation claimed after May 6, 1997 is subject to recapture and taxable at the special Federal rate of 25% WHEN I SELL THE HOUSE AS MY PRINCIPAL RESIDENCE. Right?
 
thanks,

A-2:

That is correct, plus any gain in excess of the $500,000 maximum exclusion for a couple.

Kerry

 

Posted in 1031 | Comments Off on Selling residence received via 1031 exchange

Home Gain Above Exclusion LImit

Posted by taxguru on April 14, 2006

 

Q-1:

Subject: sale of residence Tax Relief Act of 1997
 
I was just reading your page on the sale of residence.
 
If I read it correctly, there is no more deferral of gains on a sale of a residence. The only thing is a $250K exclusion. But what about the taxpayer that sells a residence with more than a $250 gain, and wants to buy another residence. He’s screwed. Under the old rules he could defer the gain, but under this new rule he can exclude $250, but the remaining $1 million is taxable. This isn’t tax relief.
 
Did I read this correctly?

A-1:

You read that correctly.

As with most things in life, the tax code is based on trade-offs.  The multiple exclusion of gain was considered to be worth more than the previous gain deferral rule.

As for bumping up the amount of excludable gain, which hasn’t changed one bit since the law was enacted in 1997, there is little to zero chance of that happening. Our society has an insidious under-tone of envy and hating the evil rich is a full time task for the DemonRats and their propagandists in the media.  This means that expecting any sympathy for having to pay tax on profits above $250,000 is a waste of time.

Obviously, the “fair” thing would be to allow people to choose between the tax free exclusion or the gain deferral by reinvesting into a more expensive home. Unfortunately, as I always have to point out, the concept of “tax fairness” is a huge oxymoron in this country.

If your sale hasn’t already closed, you should work with a tax pro to see if there is another way around having to pay tax on your gain.  One common strategy is to convert the home to rental and dispose of it as a 1031 exchange for new rental property or properties and then later on, convert one of the replacement homes to personal use.  The rules for this are tricky; so working with an experienced tax pro is critical.

Good luck.

Kerry Kerstetter

Q-2:

Mr. Kerstetter,
 
Thanks for your response. I was thinking the same thing, regarding a conversion and 1031 exchange. I guess you could refinance before you convert, to pull out some equity, then use that cash to help you buy another residence.
 
The problem I’m thinking of is my old mother’s residence that has much more than a $250K gain in it. Maybe I could convince her to sell it now, and exclude $250K of gain. It would seem to be better than the estate selling the property at her death and have the entire gain be taxable. She could rent it back if she wanted to stay there.

A-2:

You and your mother really should be working with estate planning CPA and attorney to work out the best game plan for her. 

Depending on the size of her estate, it is entirely possible that her residence would not be taxable.  Under current law, the heirs receive the property at its stepped up market value as of the date of death.  This means that the heirs can literally turn around and sell the property shortly after and their is no gain.  The only real potential tax to worry about is the estate tax, if the net estate is more than the excluded amount for the year in which she passes away. I have the current schedule of those exemptions on my website

If our rulers don’t get off their butts and address the estate tax issue in the next few years, there will be a change in the step-up limits for estates created in 2010 and beyond; so no estate plan is perfect for long-term.

A good tax advisor could even help you come up with other options to take advantage of the current tax laws.  One I have seen used is to sell the home now, with a large carry-back of the sales price.  After deducting the $250,000 tax free exclusion, the remaining gain is reported on the installment plan, taxable as payments are received.  That also allows for additional estate and income tax planning opportunities if the note receivable is left to the buyer of the property, such as a child. 

There are several options available, which any experienced tax pro should be able to work with you on.

Good luck.

Kerry Kerstetter

Follow-Up:

Thanks for the info. I had forgotten about the stepped up basis. I must be losing it in my old age. For 18 yrs I was a Revenue Agent.
 
She set up a family trust, so she’s in pretty good shape that way. The only problem is the exclusion amount, which she is probably a little under right now, but might exceed before the next exclusion kicks in, especially if real estate prices continue increasing.
 
Thanks a lot for your help.

 

Posted in 1031 | Comments Off on Home Gain Above Exclusion LImit

Selling Mixed Use Home

Posted by taxguru on April 11, 2006

 

Q-1:

Subject: Particular Capital Gains situation

Hello.

From 2002 to end of 2005 I rented 2 of the 3 rooms of my house. I have always lived in one room myself.

I would like to sell the home in 2006 (this year) but first I would like to estimate the capital gains tax.

Is it true that I cannot simply claim the home (my only property) as my primary residence and thereby take advantage of the $250,000 capital gains exclusion?

Must I pro-rata the rental as a portion of the home and in that way avail of some of the $250,000 capital gains exclusion.

If pro-rata were the route to take how could it be calculated, particularly since I do not rent rooms in 2006?

Thank you

A-1:

There are to many possible scenarios involved here for me to make any suggestions.

You need to work with your personal professional tax advisor to work out the best way to handle the sale of mixed use property. 

Good luck.

Kerry Kerstetter

Q-2:

Kerry Kerstetter,

Thank you for the quick reply.

There is only one scenario. I am selling the house this year but lived in it for 10 years and rented out rooms for the last 4.
I will just ask one question then, in case you would have an opportunity to re-visit this.
Can I claim some of the $250,000 or is it an all or nothing situation?

Thank you

A-2:

It is actually much more complicated than you understand.

At a bare minimum, you will have to recapture depreciation claimed since May 6, 1997.

From the way you described it, this sounds very much like a tri-plex, where two-thirds of the units were rented out and you occupied one-third as your primary residence.  Under that scenario, you would need to report the sale on your tax return as if it were a sale of two different kinds of properties.  Two-thirds of the sales price would be shown on Form 4797 as sale of rental property, with appropriate figures for the cost basis and depreciation. 

The other one-third of the sales price would be shown on Schedule D, using the appropriate cost basis for that portion of the house.  The gain on that sale would be eligible for the exclusion of up to $250,000 of profit.

If you were to wait to sell the home until more than two full years after your tenants left, the sale could be shown as one sale of a primary residence, with the full gain eligible for the $250,000 exclusion, except for post 5/6/97 depreciation.

Another issue to discus with your personal tax advisor is the possible taxes on the sale of the rental two-thirds and whether you want to do a Section 1031 like kind tax deferred exchange on that portion, which would require you to reinvest into new business, rental or investment real estate within 180 days.  You can see the rules for that on www.tfec.com.

I hope I made my point that there are several factors to analyze, and you need to do it with a qualified professional tax advisor or you could very easily make a very expensive mistake.

Good luck.

Kerry 

Follow-Up:

Kerry,
Thank you sincerely for putting your time into this.

 

Posted in 1031 | Comments Off on Selling Mixed Use Home

Using Exchange Proceeds

Posted by taxguru on March 19, 2006

 

Q:

Subject: Exchange Question

Hello,
 
 I own with another family member (50/50) some open land that is being developed.
 
When it sells I expect cap. gains of about 250k.  If there is a mortgage lein against the property does that loan reduce the net cap. gains?  is the loan a cost?
 
or do I pay off the bank and then the IRS
 
otherwise would do an exchange or TIC
 
Thank you,

A:

You and the co-owner of that property are looking at some huge tax bills if you don’t start working with a professional tax advisor to work out the best plan for your circumstances.

Paying off loans against the property will have no affect on the taxable gain.  Debt relief is considered the same as receiving cash in the eyes of the IRS.

If you are planning to do a 1031 exchange, you will need to reinvest a total amount equal to or higher than the net sales price, which will be close to the cash proceeds plus the debt relief.  While for most exchanges, this means that you will need to take on an equal or higher loan balance on the new property as you had on your old one, there are ways to have less debt if you invest more cash from other sources. 

If you and the co-owner have the current property in your individual names, you each have the option of doing a 1031 exchange on your share of the sale price regardless of what the other owner chooses to do.  If the property’s title is in the name of a corporation, LLC or partnership, either that entity will have to do an exchange or you will need to have the property’s title transferred into your individual names first.

Again, any experienced professional tax advisor can help you work out the actual numbers for your situation.

Good luck.

Kerry Kerstetter

 

Posted in 1031 | Comments Off on Using Exchange Proceeds