Q:

Subject: Exchange Question

Yes, an exchange question…

I am debating 1031 vs cap gains, and wondering about the middle ground, a partial exchange.

I bought the property for 180 +20k improvements – 8300 in depreciation.

The selling price is 475k. Fees are 25k approx.

The state tax rate I believe is 9.3 in California as it is taxed at ordinary income.

The fed rate is 15% I think. At any rate I come up with a cap gains tax of 63k, ouch.

What if I purchased a 250k home with a 70k loan? What would my cap gains be reduced to?

Is that a good question?

A:

It’s impossible for anyone but your personal tax advisor to give you a precise figure on your possible taxes from the proposed partial exchange because it is not a simple calculation.  There are other factors that could affect your tax, such as capital losses, suspended passive losses, and carry forward investment interest.

From your figures, you are looking at a possible taxable gain of $200,000, representing the amount you are missing the target replacement price by (450-250).  The tax on that will include a 25% Federal tax on the depreciation recapture, in addition to the 15% rate on the additional gain.

To see whether a 1031 exchange with such a huge trade-down in value makes sense, have your tax person plug your numbers into his/her tax program to run the figures for you.

Good luck.

Kerry Kerstetter

 

Q:

Subject: Exchange Question

I have a piece of bare land (investment property) that I want to exchange for a floating home. I am being cautioned that this floating home, even if we use it for investment purposes, does not qualify for 1031 exchange because it is considered personal property and therefore not a like-to-like exchange. (This may be similar in principle to exchanging for a mobile home that is in a long-term (30 year) lease.)

The best argument we’ve heard thus far is that in California, there is a law on the books where for tax assessment purposes, floating homes are considered real property. I’m told 1031 respects state law over federal.  Further, I understand it is unlawful for a person to have to pay real property tax on personal property, therefore (sort of a “if a=b and b=c then a=c” thing) we feel we would have a good argument should we be audited.

Our title company, 1031 exchange agent and real estate agent all are comfortable with the transaction. Are we taking too much of a risk?

 

Thanks for your help!

A:

At first, I thought you were going to say that your exchange facilitator was refusing to accept the houseboat as a suitable like kind replacement property.  I agree that a permanently docked houseboat, such as you often see in places like Sausalito, which is taxed by the county as real property, would be appropriate like kind property as long as it will not be used be you personally and will be held for rental, business or investment purposes.

This is a similar situation to mobile homes.  RVs and other large living quarters that move around a lot would definitely be considered as personal property; while permanently mounted mobile homes that are taxed by the county as real property would meet that test for 1031 purposes.  

A boat that is not permanently moored, even with living facilities, would be considered personal property and not suitable replacement property for the disposal of land.

It sound like you are on the right track. 

Good luck.

Kerry Kerstetter

 

Transferees Debate Whether to Sell or Rent – Good look at some of the factors involved in deciding whether to hold onto a former residence or sell it off.  She includes the key factors that I often discuss:

tax free residence sales

1031 exchanges

tenants from hell, as illustrated in the movie, Pacific Heights

Q:

Subject: Want to Gift to each of our Daughters

 

Hi, Kerry,

We want to gift real property to one daughter (so they can build a home and be close to us) and we want to do the same for the other daughter (equity in the home they occupy) our rent house next door – total value to each approx $14,000. 

 

We have read about IRS “gift sharing”, but don’t really understand it.  Publication 950 & Form 709 and its instructions. 

 

Could split it into two different tax years if necessary – 2005 & 2006.    We would prefer not to complicate our taxes.  Can you please advise? 

 

Thanks,

A:

The current law allows each person to gift up to $11,000 to another individual per calendar year without the need for filing a gift tax return (709) or dipping into your lifetime gift and estate tax exclusion.  This means that you can give $11,000 to each daughter, and so can your husband, for a total of $22,000 to each daughter.  You could also gift up to $11,000 each to their spouses, effectively doubling that figure.

For jointly owned property, the gifting process is fairly straight forward.  The concept of gift splitting comes into play where there is property that is owned entirely by one spouse.  In those cases, you have the option of dividing the gift as if it had been made by both spouses, and thus doubling the tax free portion.  For example, if one of the properties that you want to gift to your daughter is worth $20,000 and is just in your name, you can choose to report it on Form 709 as if you gave $10,000 worth and your husband gave $10,000 worth.

Gifts can be split into multiple years through a variety of methods, such as gifting certain percentages each year or by selling the property to the kids and then forgiving the carryback loan in $11,000 increments.  If the properties are only worth $14,000 each, neither of those approaches seems necessary.  Your and your husband’s $22,000 annual exclusion is more than enough to cover the gifts in one calendar year.

I’m not sure how familiar you are with gifting; so I will mention a few common misconceptions I hear all the time.

First, there is no deduction on your income tax returns for gifts made.  This balances out with the fact that the recipients do not have to pay any income tax on gifts that they receive.

While the gift amounts are based on the fair market values of the property at the time of the gift, the basis that the recipients will have to use to determine any capital gain or loss if they ever sell the property is the same basis as you and your husband had in the property.  For appreciated property, this means that you are also literally transferring your capital gain to the recipients.  This isn’t necessarily a bad thing.  If they are going to live in the property for at least two years, they will be able to utilize the tax free exclusion of up to $250,000 per person of gain from primary residence sales.  Even if they don’t live there, they will still be able to utilize a 1031 exchange to defer the taxation on the gain if they so choose.

Documenting the carryover basis that your daughters receive in the property can be done in a number of ways.  If Form 709 is filed with IRS to report the gift, the property’s basis has to be shown.  If the gift is under the $11,000 threshold and you choose not to file the 709, you should provide your daughters with a statement of the property’s basis so they can have it for their records.  It will come in very handy down the road when they sell the property.

I hope this clarifies the  gifting process for you.  Let us now if you want to set up a phone appointment to discuss any of this in more detail.

Kerry

Follow-Up:

Appreciate your response, Kerry. Thank you.  We will deed one acre, value of $14,000, to our daughter & son-in-law this week.

 

Have a great week!  

Reply:

I’m glad to see that the info was useful to you.

In addition to the deed, be sure to give your daughter & son-in-law the cost basis of the property so they will have that available if they ever sell it.

Kerry

Q:

Subject: Exchange Question

 

Dear Sir,

 

Can I exchange my business in England for a similar business in California? As I am taxed on my worldwide income I should also have all the benefits which are available to all US residents.I am a US citizen

A:

Using 1031 like kind exchange rules for business sales is extremely complicated and is something that you will need to consult with a tax pro on.

This is due to the fact that when a business is sold, the price needs to be allocated between the different components involved, such as equipment, real estate, inventory, goodwill and covenant not to compete.  With each of those items, you will need to determine whether it is even eligible for a 1031 exchange, and if so, what constitutes eligible like kind replacement property. 

One thing that is in the tax code that may mess up your plans has to do with real estate.  United States real estate must be replaced with United States real estate.  Likewise, British real estate would need to be replaced with British real estate.  California real estate is not like kind for British real estate.

You didn’t specify exactly how the sale will be structured.  The above refers to the sale of business assets.  Another complication could cause problems for you if you are selling a corporation by selling off its stock.  This would automatically make it ineligible for a 1031 exchange.

There are plenty of ways to minimize your tax bite.  However, the only way to do so effectively is by working with a tax pro.

Good luck.

Kerry Kerstetter

 

The June issue of the online Journal of Accountancy also has an interesting look by Philip Witmer and Claudia Kelley at the decision process of whether it makes more financial sense to rent out a former residence or just sell it.  The authors have even included a fairly detailed Excel spreadsheet to help quantify the projections. 

I doubt if I will be using it much because it relies too heavily for my comfort on assumptions of such unknowable factors as future interest and appreciation rates.  Anyone who claims to have a crystal ball that can accurately predict such things should be avoided like the plague. 

What’s much more important in this kind of decision is whether you can stomach being a landlord and avoid getting a tenant who uses the movie Pacific Heights as his game-plan to steal property, as we had back in the Bay Area.

This article is still quite useful because they do address that point, as well as the very critical aspect of  losing the ability to use the Section 121 tax free sale rule after having been out of the home for three years.  They do mention that a Section 1031 like kind tax deferred exchange would most likely be a good move in those cases.

Q:

Subject: Exchange Question

Dear Sir or Madam:

I want to do a partial 1031 exchange. I am selling a relinquished rental property at $550K with a present mortgage of $285K in Virginia, and buying a replacement rental property at $275K with $0 mortgage in Florida. I am expecting an equity of approx. $240K from the relinquished property which I will fully invest into the replacement property and add $35K from my other sources. My net adjusted basis is $0 since the property has been fully depreciated.  I am trying to determine what percentage of my total tax (Federal and State Capital Gains, and Recapture of Depreciation will I be able to defer)?  My Recaptured depreciation tax is approximated at $22K; my Federal Capital Gains at $67K, and my Virginia Capital Gains at $30K if I do no exchange at all.  I have the following questions:

-Will I defer any Capital Gains in such a partial 1031 Exchange?

-If I do the above partial 1031 Exchange — what approximate amount will I pay Federal and State capital gains on and what amount will I have to pay recaptured depreciation on?

 

In summary, I am trying to determine if such a partial 1031 Exchange will defer any taxes for me. 

 

Thank you much,

A:

 As you describe the situation, you would save some capital gains taxes by doing a partial 1031 exchange. 

However, the taxes you will be saving will be the lowest taxes and not just half of the total possible. 

Whenever you do a partial exchange by missing the reinvestment target price, the first taxes that will be payable will be the most expensive ones, which are generally on the depreciation recapture.  After all of those have been picked up, will you get into the lower long term capital gains rates, which are the ones you would reduce under your proposed scenario.

If you need to know exactly how much tax you will save by doing a partial exchange, your personal tax advisor should be able to plug the applicable numbers in for you.

Good luck.

Kerry Kerstetter

Q:

Subject: Exchange Question

An individual sells a rental producing property (Schedule E) and has identified a rental income property but it is taxable as an S Corp of which he is currently a 22.5% shareholder.  The majority shareholder of 55% will sell his interest within the 180 day limit.

 

Will this qualify as a 1031 exchange?

 

Thank you

A:

From the way you described the situation, there would not be a valid 1031 exchange.  It sounds as if you will be disposing of a rental property that you own in your own name.  The replacement that you are proposing sounds like a purchase of stock in the S corp that owns a rental property. 

A valid 1031 exchange requires like kind properties, which is real estate for real estate.  Corporate stock is considered to be personal property, regardless of what assets it owns.

If I misunderstood the details here, please give me a better explanation of the actual ownership of the properties involved. 

Kerry Kerstetter

My interpretation of this transaction must have been right, because I received the following reply.

Thanks for getting back to me.

 

Q:

Kerry,

Outstanding website! I have a slight variation on the 1031 Holding Period question.

We moved from the East Coast to the Midwest in 2000. At that time, we decided to rent out our East Coast condo. We rented it out until we sold it in 2004 and did a 1031 Exchange due to the huge appreciation. In August 2005, we will have rented out the replacement property for 1 year (actually 10.5 months with 1.5 months needed to get it rented).

Is there substantial risk in moving into this property at this point? (I’ve come across the 1-year vs. 2-year arguments). Since we have another house in this same town that we are currently living in, we thought of simply moving into the replacement property and turning our existing home into a rental. It’s slightly smaller and in an area easier to rent out. Does having consistent rental property income on a tax form look better?

Thank you very much,

A:

There is no hard and fast rule or law regarding how long you have to use the replacement property as rental before you can convert it into your own residence without voiding out the 1031 exchange.  What is critical is that, at the time of the acquisition, the intended use of the property was for rental and there was no preconceived plan to convert it into personal use. 

The problems with these kinds of situations arise when the taxpayers are blabbermouths and go around telling everyone of their plan to acquire replacement 1031 property with the goal of converting it to personal use.  As I’ve said many times, if that is your ultimate plan, keep it to yourself.  Telling others about it will come back to bite you in the butt if IRS were to ever look into it.

As I’ve mentioned on several occasions, the only current hard and fast time requirement has to do with how long you must own the property in order to qualify for the Section 121 tax free exclusion of up to $250,000 per person.  That is five years, starting from when you acquired the home in the 1031 process.  

If there is no documentation showing that you had a plan back in 2004 to ultimately move into the new rental home, and everything shows that such a decision came well after that time, you should be okay to do that.

I hope this helps you understand the rules. Good luck.

Kerry Kerstetter

 

Q:

I have a question that I have gotten many different answers on.  I bought my 1st investment property on March 15th (it was a pre-construction home and that is the date of the closing).  I am selling the property and it will be closing on May 4th.  I was told that 6 weeks is too short of a time period to hold a property to be exchanged.   I was told also that it could be done, but it is a very high risk and if you get caught there are penalties to pay.

I also am considering starting a small business (C corp) to funnel the sale through the corporation and then I can also re-invest the money and claim some expenses.  I am new at this and could use some advice. 

Thanks in advance for any info you can give me.  I live in the state of Florida and the investment property is also in Florida.

Thank You,

A:

There is no minimum holding period for property that is involved in a 1031 exchange.

What is a potential concern is if you start doing a lot of rapid purchases and sales and you or your corporation do nothing but that.  That would make you a real estate dealer, with the properties considered to be inventory.  Dealers are not allowed to use any of the tax saving techniques that investors can, such  as Section 1031, installment sales, or the special lower capital gains tax rates.  In addition, profits are subject to the additional 15.3% self employment tax.  There is no statutory explicit number of deals that will classify someone as a dealer.  It is a very gray area in taxation and should be addressed with a tax pro who knows how to avoid the dealer tag.

Using a corporation has a lot of tax saving potential.  However, it is not a do-it-yourself area.  You need to consult with a tax pro who understands how to best utilize them in order to avoid the common and very costly mistakes that people constantly make when going it alone.

Good luck.

Kerry Kerstetter