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Archive for the ‘Taxes’ Category

With the upcoming holiday rapidly approaching, we should all start thinking about what we’re thankful for. You know, just in case someone at the dinner table puts us on the spot.

I’ve previously told you about the beauty of Roth IRAs.

To quickly recap: They give most working Americans the ability to sock away money, watch it grow, and never have to pay another cent in taxes on any of the funds as long as certain conditions are met.

And unlike regular IRA accounts — which are taxed at withdrawal time — you do not have to begin taking minimum distributions at age 70 ½.

In fact, so long as you have earned income (or alimony) you can continue making contributions for the rest of your life.

And here is perhaps the best feature of Roth IRAs, one that I rarely hear mentioned (even by financial professionals) …

You Can Use a Roth IRA to Pass
Along Massive Wealth to Your Heirs

Let me explain how it works …

Because you are not required to take minimum distributions, you can leave every single penny of your Roth IRA intact for your designated beneficiary. That’s great.

Even better is the fact that your heir will face a choice upon your death: Either withdraw the whole amount by December 31 of the fifth year after your death OR begin receiving minimum distributions based on his or her life expectancy.

Under either choice, all the proceeds should be tax-free (with the exception of estate taxes).

Here’s an example:

Say you leave your Roth IRA to your son who is 53 at the time of your death.

If your son decides to take minimum distributions, the IRS will use its actuarial tables (available in IRS pub. 590) to figure out roughly how long your son is likely to live.

Then the IRS will divide the value of your account by that number (31.4 in 2008) to arrive at a dollar amount for yearly distribution.

In the case of a $100,000 portfolio, your son would have to withdraw $3,289 in 2009 ($100,000/30.4).

Important: While your son is taking those minimum distributions, the value of his inherited investment account can continue to rise!

I’m sure you can see the appeal of this approach, especially since you’re well aware of the effect of compounding.

A Roth IRA is a great way to pass along wealth to your heirs!
A Roth IRA is a great way to pass along wealth to your heirs!

Think about what would happen if you loaded up that Roth IRA with stocks that steadily increase their dividends. And imagine what would happen if you were reinvesting those dividends back into more shares!

You’d be combining complete tax efficiency with multiple layers of compounding interest. Heck, with enough time, you could leave behind a nest egg that was rising faster than the rate of your heir’s mandatory withdrawals!

That brings me to another point. While this strategy would be great for a son or daughter, it would be even better for a grandchild or a great-grandchild.

After all, those minimum distributions are calculated on the recipient’s age. The lower the number, the less money coming out every year and thus the longer the account can grow.

Obviously, the lynchpin in this whole plan is absolute agreement on the part of the original account owner and the beneficiary on opting for taking the minimum distribution route.

But if you have an heir you can count on, I consider this one of the smartest moves you can possibly make.

If you’re eligible for a Roth IRA, take advantage. And even if most of your money is currently in a regular IRA account, it may very well be worth your while to roll it into a Roth.

Although you’ll take a big tax hit in the process, if your goal is leaving that money to someone far younger, the Roth could still prove the smarter wealth builder over the long haul. That’s definitely something to be thankful for!

Best wishes,

 

Bridges to Hope Foundation Newsletter and Blog

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How to deduct mortgage interest, points on taxes
Are you in the market for a mortgage loan? Whether the loan is to buy a new home or to refinance your existing mortgage, you must shop around. Contact a number of mortgage lenders. Get rate quotes for a fixed 30-year mortgage as well as for adjustable-rate loans.

Find out what the monthly payment will be for each type of loan, but then before you make your final decision, plug in the amount of the mortgage interest that you will be able to deduct.

How do you do this? Let’s look at this example. You find a house that you want to buy and sign a contract for $475,000. You have been saving money for a long time in order to buy your first house, and plan to put down 20 percent ($95,000) and get a loan in the amount of $380,000.

One lender is prepared to lend you this money at 6.5 percent for 30 years, and the monthly payments (exclusive of real estate taxes and insurance) will be $2,402. Another lender has offered you a 5-year adjustable-rate mortgage (ARM) starting at 5.75 percent. This will require a monthly payment of $2,218.

The difference is $184 per month or more than $2,200 per year. Since you are married, file a joint tax return and your taxable income is between $128,500 and $195,800, you know that you are in the 28 percent tax bracket for income tax purposes. Oversimplified, that means that every dollar you pay in mortgage interest can be reduced by 28 percent. So now, after doing the math, the difference between the two types of mortgages is only $132 per month (or $1,584 per year).

It is important to take into consideration the tax deductions available to homeowners when considering what kind of mortgage to get. If you plan to stay in the house for a long period of time, you may be willing to accept the fixed 30-year loan, rather than be subjected to a potentially steep increase five years from now when your ARM will adjust.

It is this very issue that is one of the primary causes of the current “mortgage meltdown” confronting our nation’s homeowners. Many consumers opted for a 100 percent interest-only (or adjustable-rate mortgage) two or three years ago and now have been told that their monthly payment will dramatically increase. These homeowners cannot afford the new payment, and since property values have declined in many parts of the country, they are unable to refinance to get a better mortgage rate.

Let’s look at several interest deductions that can save you money while preparing your 2007 income tax return:

1. Mortgage insurance premiums: If you are able to put down 20 percent or more as a down payment on your home, should you go into default and the home has to be foreclosed, most lenders are comfortable that there will be sufficient equity so that they will not lose any money.

However, if you are unable — or unwilling — to put down a lot of money and want a larger loan, there are two things that lenders can do. They can require that you put down only 5 or 10 percent and give you two loans: one for 80 percent and a second trust for the 10 or 15 percent difference.

Alternatively, they can require that you obtain private mortgage insurance. This is coverage — which the homeowner pays for — to compensate the lender should there be a shortfall between the amount of the money received at a foreclosure sale and the loan balance.

There is also governmental mortgage insurance provided by the Federal Housing Administration (FHA); the Veteran’s Administration (VA), called a funding fee; and the Rural Housing Service, called a guarantee fee.

If you entered into a transaction after Jan. 1, 2007, that included some form of mortgage insurance, you may have the right to deduct these insurance payments as home mortgage interest. However, there are some restrictions. First, the insurance must be in connection with home acquisition debt. This means that the loan is secured either by your principal residence or a vacation home that is not rented out for more than 14 days a year.

The insurance contract must have been issued after Jan. 1, 2007. The deduction is reduced by 10 percent for each $1,000 that the adjusted gross income (AGI) exceeds $100,000 (or $50,000 if you file an individual tax return). If your AGI is more than $109,000 ($54,500 if filing separately) then you cannot take advantage of this deduction.

If you sold your house last year — or refinanced it — thereby cancelling the mortgage insurance, unless the insurance was provided by the VA or the Rural Housing Service, you cannot claim a deduction for the unamortized balance of the premium.

2. Mortgage interest: Interest on mortgage loans on a first or second home is fully deductible, subject to the following limitations: acquisition loans up to $1 million, and home-equity loans up to $100,000. If you are married, but file separately, the limits are split in half.

The concept of “acquisition loan” is often difficult to understand. To qualify for such a loan, you must buy, construct or substantially improve your home. If you refinance for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use all of the excess to improve your home or treat it as a home-equity loan.

This can best be understood by an example: You want to take advantage of current mortgage rates, which are still quite low, and refinance your existing $250,000 loan. Your house is assessed for tax purposes at $750,000.

Based on your credit and the equity in your house, your lender is prepared to give you a mortgage loan of $500,000. Because your “acquisition indebtedness” is $250,000, you will be able to deduct interest only up to $350,000 — that is, the acquisition indebtedness plus the maximum $100,000 home equity.

The Internal Revenue Service has ruled that one does not have to take out a separate home-equity loan to qualify for this aspect of the tax deduction. The remaining interest is treated as personal interest, and is not deductible.

3. Seller-paid points: Here’s an area often overlooked by buyers. Points paid to a mortgage lender will reduce interest rates. Each point is 1 percent of the loan, so that on a $300,000 mortgage, a borrower will have to pay $3,000. And typically, for every point that you pay a lender, the interest rate will be reduced by one-eighth of a percent.

When negotiating a real estate sales contract, buyers will often ask the seller to make certain financial concessions so that a deal can be reached. Such concessions include (1) the seller paying some or all of the buyer’s closing costs, (2) the seller giving a cash credit at settlement, or (3) the seller paying some or all of the buyer’s points.

The IRS has ruled that points paid by a seller can be deducted by the purchaser. Let us look at your example. You will pay $450,000 for your new house and obtain a loan of $360,000. The lender can give you a fixed 30-year conventional loan for 6.5 percent, with no points, or 6.25 percent with 2 points, for $7,200. If you can convince your seller to pay this sum — and have your sales contract reflect that the seller is paying this money as points — you should be able to fully deduct the entire payment from your income tax that you file for this year.

There is one drawback to deducting seller-paid points: The amount of the points paid by the seller will be used to reduce the purchaser’s tax basis — the number that will eventually be used to calculate whether a sale results in taxable capital gains. In our example, if you pay $450,000 for the property, and deduct the $7,200 of seller-paid points, your tax basis in the property becomes $442,800 ($450,000 minus $7,200).

Under current tax law, this may not be a problem for home buyers. As will be discussed later in this series of articles, taxpayers who live in their house for at least two years can fully exclude from taxable income up to $250,000 of gain ($500,000 for married couples filing a joint return) on the sale of their principal residence.

Thus, the lower tax basis may not be significant — unless the taxpayer makes a profit that exceeds these amounts.

On Jan. 16, 2008, the IRS announced that it has revised Publication 17, Your Federal Income Tax. According to the IRS, they have “added new features to assist taxpayers to more easily navigate this widely used publication. The online version of Publication 17 now contains electronic links for greater ease of use.”

Two other useful IRS documents are Publication 936, entitled “Home Mortgage Interest Deductions,” and Publication 910, “IRS Guide to Free Tax Services.” It is to be noted that the IRS has cautioned consumers that if a Web site purporting to be from the IRS does not contain the “.gov” suffix, it is not a legitimate IRS Web site.

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Successful real estate brokers apply a personal touch to their businesses. They remember birthdays, and ask their clients meaningful questions about their personal and financial goals. They also keep track of where their clients are in their individual life stages. If their clients are nearing retirement age, shouldn’t they want to simplify their financial affairs? Which of their clients have excess funds to invest, and which of their clients should be considering building a commercial real estate portfolio? Have any of their clients relocated recently, and do they still have out-of-State properties that have become a management headache?
A good real estate broker or agent gets a feel for each of his or her clients, and if the professional has kept up to date on real estate strategies, can provide valuable advice and guidance.

Questions to Ask Your Client.

Realtors and real estate brokers are in a unique position to help their clients identify and achieve their investing goals, as well as growing the realtor’s business by providing innovative solutions to client needs. When presented with a client that wants you to list for sale his investment property (personal residences do not qualify under Internal Revenue Code Section 1031), the first question the realtor or broker should be asking is “Why do you want to sell this property now?” Some possible reasons for the sale include:
  (1) fear of declines in property values—especially when the client has substantial built-in appreciation in the property;
  (2) relocating or retirements;
  (3) a desire to increase cash flow or generate a steady monthly income;
  (4) difficulty in managing the property; and
  (5) consolidation of several properties or diversification into additional properties or markets in order to provide protection in the event of a regional decline.
Each of these answers could indicate that the client should explore a 1031 tax-deferred exchange.

Another important question to ask your client who is intending to sell his or her property is: “What do you intend to do with the proceeds of the sale?” If the client intends to purchase new investment property, he or she will definitely benefit from a 1031 tax-deferred exchange—there would be virtually no reason to pay the unneeded taxes that would occur from a sale rather than an exchange. Often, the client will say that he or she is “gun-shy” about the real estate market, or feels that the market is “soft”. Faced with this outlook, you may want to point out that the commercial (rather than residential) real estate market has not seen the rampant price inflation that is evident in the residential market; moreover, office, industrial and shopping center vacancies are at an historic low, so there is still plenty of room left for growth in the commercial market, irrespective of whether the residential market is suffering from oversupply. Finally, you may want to educate your selling client about the flexibility inherent in Code Section 1031 tax-deferred. In a 1031 tax-deferred exchange, an investor can exchange any type of realty for any other type of real estate, including properties that are currently subject to stable long-term leases providing a positive monthly cash flow. Such properties actually act more like a bond that pays interest each month, than a traditional more speculative real estate asset.

Benefits of a 1031 Exchange.

The real estate professional should spend a little time becoming familiar with some of the potential benefits of a 1031 exchange. The major benefits include:

Financial Leverage. When the tax liability in a transaction is deferred, the taxpayer receives an increase in available capital, because the federal and State taxes are deferred. All of this capital can be applied to acquiring additional replacement property. Most lenders require a downpayment of approximately 20% on replacement property; thus by using this increased borrowing power, the taxpayer can purchase up to five times the capital they received. This is a major advantage of a Section 1031 exchange when compared with the alternative of a taxable sale. The taxpayer gains financial leverage through an exponential increase in cash flow and appreciation – which provides more buying power.

Minimizing Tax. Minimizing taxes are the most common benefit of a 1031 Exchange. Tax minimization allows the investor to sell one property and purchase a property of equal or greater value while deferring capital gains tax. With depreciable property, gain on a sale is taxed at a flat federal rate of 25% of all depreciation claimed, and a 1031 exchange also avoids this “recapture” of depreciation at this higher rate. In addition, a 1031 exchange defers State income taxes as well as federal taxes and depreciation recapture taxes.

Number of Properties. The investor can sell several properties, and purchase a smaller number, thus reducing management headaches. Alternatively, the investor could diversify his holdings by selling a few properties, and diversifying into many properties. Your clients may also wish to spread his risk over several different States or geographic regions by utilizing §1031, thus avoiding holding properties in areas that have substantially appreciated and where prices have reached their peak.

Diversification. The investor can diversify his or her investments by purchasing properties in several States. An investor could exchange his existing property with a different class of real estate such as long-term leases, shopping centers, raw land, farmland, office buildings, industrial properties, or even percentage interests in large complexes. With respect to real property, Code Section 1031 is very liberally construed in determining what is “like kind” between different classes of real estate.

Cash Flow & Retirement Income. An investor may swap non-revenue producing property, such as raw land or underutilized property, for high-revenue shopping centers, leases of 30 years or longer, or office complexes that already are full of paying tenants. Alternatively, the investor can exchange high-revenue properties for those with greater growth potential such as resort-area acreage or lots in rapidly developing communities. How about avoiding taxes on real estate gains, and re-investing the proceeds in a safe investment that pays the investor monthly income for the rest of his or her life? Shopping centers, strip malls, and office buildings that are already under a long term lease can provide a nearly certain monthly income for the rest of the investor’s life, with rates of return much higher than any government bond. At the taxpayer’s death, all potential capital gains taxes are “wiped away” and his or her heirs will own the property at a “stepped-up” basis, without incurring any built-in taxes that he or she would have been forced to pay if they sold the property without re-investing in a replacement property.

Management Relief. Your client may be too busy or not inclined to deal with management issues, collections, finding new tenants, repairs, maintenance or other headaches that come from owning rental properties. The investor may be approaching retirement age, and thus does not want to be stressed over management issues. Using Code Section 1031, the investor can exchange his high-maintenance property to low or no-maintenance property such as shopping centers that are fully leased with a management team in place, or triple-net leases where the investor owns some or all of a long-term lease, and the owners of the underlying property have to deal with all management issues.

State Taxes and Relocations. Suppose your client’s property is in a high-state income tax state such as New York, Connecticut or California? By swapping for a property in a tax-free State such as Florida, Texas, or Nevada, not only can annual income taxes on rental profits be eliminated, the investor can also completely eliminate State income taxes on the ultimate taxable sale of the property. In many cases, investors desire to move and cannot successfully manage their properties from afar. 1031 Exchanges permit the location of the investment property to change along with the residence of the investor.

Why 1031 Exchanges Benefit Realtors and Brokers.

If your client is conducting a taxable sale of his or her property, as the listing agent you will receive a commission—none of us work for free. On the other hand, with a 1031 exchange, as listing and purchasing agent, you will receive two commissions– one on the sale for the relinquished property and one on the purchase of the replacement property. If you extend yourself a bit, and explain what you are accomplishing in the 1031 exchange to parties on the other side of the transaction (the buyer of your client’s property for example), you may find that by passing along the details and benefits of the 1031 exchange, the other party often wants to do an exchange with their property as well. By positioning yourself as an expert resource on such issues, brokers and realtors can gain valuable future contacts including potential new clients.

When is it Too Late to Conduct an Exchange?

Surprisingly, it is possible to turn a straightforward sale of property into an exchange at the closing table. Often our firm gets a phone call while a seller is at the closing table, and we draft the documents in less than 15 minutes to change a sale into an exchange. The rules of Code Section 1031 provide that the taxpayer has 45 days from the date of sale to identify which replacement property he or she is going to purchase, and the taxpayer has an entire 180 days to actually complete their purchase of the replacement property. In order to properly engage in this type of delayed exchange, the client must engage a “Qualified Intermediary “, which is an independent party that holds the proceeds of the sale and to purchase the replacement property and transfer it to the taxpayer within the 180 days. A good rule of thumb is to already be fully engaged in the process of shopping for one’s replacement property while the sale of the relinquished property is in process. It is never too early to begin scouting for replacement property, as the 45 day rule is absolute—there are no extensions.

To summarize, your position as the client’s broker, agent, advisor and counselor places you in the unique position of being able to add value to the transaction, and to help grow your client’s portfolio by asking questions, listening to your clients’ needs, and providing an innovative solution to your clients’ real estate questions. Your practice will continue to grow as you gain and demonstrate your expertise on variety of real estate investment strategies, with 1031 exchanges being one of the most powerful investing tools still available as a tax and investment strategy.

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With the recent gains in the real estate market, the approaching retirement age and increased mobility of the “baby boomer” generation, and the record wealth transfer now in full flower, professionals are seeing a growth in pent-up demand for Code Section1031 Tax Deferred Exchanges. Taxpayers are frequently asking their professional advisors whether they can qualify their vacation homes, or primary and secondary residences for a Code Section 1031 exchange.

Exchange Mechanics. There are two properties that are considered in the typical exchange: the property being sold (the “relinquished property”), and the property being purchased (the “replacement property”).

Vacation Homes. Vacation homes, primary and secondary residences (hereinafter referred to collectively as “Personal Use Realty”) generally have not qualified for Section 1031 tax deferral, if either the relinquished property or the replacement property is Personal Use Realty, since they are not considered to be “held” for investment or business purposes. If either: (1) the relinquished property was previously used as Personal Use Realty; or (2) the replacement property is intended to ultimately be used as Personal Use Realty; in order to conduct a valid §1031 exchange it is often necessary to have such property rented to unrelated parties for a period of time both before and after the exchange.

How Can I Make Sure my Property Qualifies? Section 1031 contains no fixed amount of time needed to qualify a transaction for tax-deferred status. Instead, Section 1031 requires that the taxpayer have the intent to hold the property for either an investment purpose or a business purpose, at the time of the exchange to avoid a taxable exchange. The case law on Section 1031 follows a line of precedence where courts will attempt to determine the taxpayer’s intent…

The court applies a “facts and circumstances” test to objectively measure whether the taxpayer had a bona fide intention to hold each property as investment or business property at the time of the exchange. The taxpayer’s actions, written and oral communications, and tax filings, constitute evidence for examination if the Internal Revenue Service challenges the tax-deferred status of the exchange. The following chart illustrates some of the factors that the Internal Revenue Service will likely examine:

 

EVIDENCE AGAINST INVESTMENT OR BUSINESS INTENT
EVIDENCE FOR INVESTMENT OR BUSINESS INTENT
The taxpayer puts up a “for sale” sign, lists the property for sale, or signs a listing agreement soon after its purchase. The taxpayer sells the property on his own, receives an unsolicited offer, or lists the property for sale after holding as an investment for a substantial length of time.
The taxpayer applies for “owner occupied” financing on the property. The taxpayer obtains financing listing himself as a non-occupant investor.
The taxpayer inadvertently checks a box in the Purchase and Sale Contract that he intends to live in the property. The taxpayer is careful to read the entire Purchase and Sale Contract to avoid any reference to his occupying the property.
The taxpayer moves into the replacement property soon after its purchase. The taxpayer waits for at least two (2) tax filing periods before moving into the property.
The property is not rented during the term that the property has been held, or the leases have been in effect for a brief period. The property has been rented by its tenants for a significant time.
The taxpayer claims the “mortgage interest” deduction for the property on his tax return. The taxpayer treats the property on his books and income tax returns as investment or business use property
The taxpayer “swaps” rental time in the replacement property for rental time in another party’s property. The taxpayer does not exchange rental time or act in a manner similar to a “time-share” arrangement.

Changes in Purpose. The purpose for holding the property must be for investment or business use in order to qualify for Section 1031 treatment; nevertheless, the purpose may change during the holding period. In Internal Revenue Service Revenue Ruling 57-244, property that the taxpayer originally owned as his primary residence and was later converted into rental property, qualified as investment property. The determination of the taxpayer’s intent is made at the time of the exchange, not at the time of the property’s acquisition.

How Much Personal Use is Permitted? Mere incidental personal use of property that is otherwise considered investment property may not disqualify the property from  1031 Exchange treatment, according to Internal Revenue Service Private Letter Ruling 8103117 (remember that these rulings are only binding with respect to the taxpayer who requested the ruling, though they are some evidence of the IRS’s position) . “Incidental personal use” is not defined by the Code, Regulations, or by other guidance issued by the IRS. If the property is not rented out by the taxpayer, then use of the vacation home for anything other than “incidental personal use” will disqualify the property from receiving tax-deferred exchange treatment.

For exchange purposes, subsection (d) of Section 280A contains the primary test likely to be applied. Personal use of the property does not exceed the greater of:

1. fourteen (14) days; or
2. ten percent (10%) of the number of days that the property is rented at fair market value to others.

Is there a Minimum Holding Period? Some commentators have believed that the taxpayer should hold each exchange property for at least two (2) years. In Rev. Rul. 84-121, the Internal Revenue Service asserted its position that relinquished property acquired and exchanged soon after its acquisition will not qualify for a Section 1031 exchange, because the taxpayer is deemed to have acquired the property with the intent to dispose of it, rather than to hold it for investment or business purposes. Some of the courts, especially those in the Western States have construed Section 1031 much more liberally. In Bolker v. Commissioner, 760 F.2d 1039 (9TH Cir. 1985), the court permitted a holding period of only three (3) months to qualify for a 1031 exchange. The court opined that the taxpayer satisfied the holding and intention requirements by owning the property without the intent to liquidate the investment or to use it for personal pursuits. However, this case is the exception rather than the majority rule.

(Talk to Your tax professional for more advise!)

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In order to complete a 1031 exchange and close on the replacement property in a subsequent tax year to the year in which the relinquished property is sold, it is absolutely necessary that the taxpayer file a Form 4868 Application for Extension to File Tax Return. Otherwise, the intended exchange will not qualify for tax deferral, but will instead be treated as a taxable sale made on the installment method.

In the event that the taxpayer fails to close within the 180 deadline, in effect the taxpayer has underreported his income in the year of disposition, and thus would owe interest and penalties. One benefit of the §1031 Regulations is that they provide that if the taxpayer intended in good faith to complete an exchange, the taxpayer is treated as receiving the consideration for the sale of the relinquished property under the installment method (i.e. on the date that the taxpayer received a refund of his money held by the Qualified Intermediary). There are no automatic interest or penalties imposed if the taxpayer intended the property to be exchanged.

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The Economics of a Condo Conversion. Why convert your apartment units into condominiums? Several economic reasons are making it more lucrative to convert units into condominiums, including: (1) the escalating sales prices of the past few years; (2) developers paying substantial premiums to acquire and transform both large and small rental properties into condos; (3) apartment owners finding their apartment units are worth much more if divided and sold as condos, rather than marketed as a single apartment complex; (4) rents falling behind the increasing sales prices for the apartment units in many parts of the U.S.; and (5) the existence of many more potential unit buyers than buyers of entire buildings. Some of the leading regional markets for conversions are those in resort areas and in growing retirement areas, as the baby-boom population continues to age and increase their leisure options.

How is it Done?
The mechanics are relatively simple: First, the investor or developer purchases the property, or the existing landlord of the apartments makes the decision to convert and sell the units on their own behalf. Then the building owner/developer obtains the necessary approvals to sell individual condo units from the municipality in which the project is located. Usually, certain improvements will be required so that each individual unit can be operated as a separate unit, rather than as one part of a larger operation. With permits and improvements in hand, the owner/developer can begin to sell the units.

How is it Taxed? The condo developer or building owner normally wants to receive capital gains treatment on each individual unit. Capital gains are presently taxed at a 15% federal tax rate, plus the taxpayer’s state tax rate, which vary from zero to 11%. However, in the case of real estate that has been depreciated, some or all of the depreciation is taxed as “depreciation recapture”, which is generally at a 25% federal tax rate. Finally, for sales of property that do not qualify for long-term capital gains, the maximum federal tax rate is 35%. In high tax states, the combined effective tax rate can approach 46% on the taxpayer’s gain on his or her real estate.

How can I Avoid or Defer Paying the Tax? Tax deferred exchanges under Internal Revenue Code Section 1031 permit the condominium seller to delay paying any tax on the sale of his property until he or she ultimately sells his “replacement property”, rather than at the time the converted units are sold. Replacement property can consist of raw land, other apartment buildings, commercial buildings, and even properties that are under a long term lease that requires the tenant to pay all of the repairs, maintenance, taxes, interest or other expenses commonly charged to owners of the property. You must carefully plan and structure your transaction in order to qualify to rollover your federal and state income taxes on your gain from the sale of a converted condominium. First the property must have been held for a “reasonable time”. What exactly constitutes a “reasonable time” is a question of fact, but generally it should be held at least more than a year and one day. Second, the condominium seller must not be considered a “dealer” in apartment units. If he is considered a dealer, then his gains are taxed similar to sales of inventory (generally at the highest tax rate) and his sales are not eligible for tax deferral. To put it in plain terms, at the time of acquisition, the owner must “intend” to hold the property as an investor, not a dealer.

Establishing Intent. The test as to whether an exchange will be classified as made by a dealer or alternatively as an investor, revolves around the taxpayer’s intent at the time of the exchange. Sometimes a taxpayer changes his intent during the period that he or she holds the property prior to the exchange. Determining the taxpayer’s intent is a question of fact, and therefore all of the facts and circumstances involved in the transaction are considered in determining the taxpayer’s intent.

Too Much Development or Sales Activity?
Existing apartment owners or non-professional investors whose activities begin to resemble those of traditional dealers in real estate can be at risk of classification as developers if they begin to act like developers. The following activities are some of the many that have been considered by courts to determine whether the seller is classified as a dealer or whether he is entitled to investor status: (1) the original intent of the taxpayer when he purchased the property; (2) the length of time that the property was held; (3) whether the taxpayer has engaged in developer-dealer activities in the past; (4) the use to which the property was placed while it was held by the taxpayer; (5) whether a change of circumstances has occurred with respect to the property or the taxpayer’s economic or personal situation; (6) the extent of improvements on the property, and the time that such improvements were implemented; (7) whether the taxpayer has entered into a joint venture or similar agreement with a developer-dealer; (8) whether the property was leased to a tenant, and the length and terms of such lease; (9) whether the replacement property is disposed of, divided, or the taxpayer otherwise demonstrates that his or her intent in acquiring the replacement property is for purposes other than investment or business use.

The following table illustrates these principles:
 

Evidence for Dealer/Developer Treatment
Evidence for Investor Treatment
The taxpayer classifies the investment on his books and records as inventory, work or construction-in-progress, or fails to claim depreciation on the property. The taxpayer consistently treats the property on his books, records and income tax returns as investment or business use property.
The property is developed, subdivided or sold quickly after its acquisition. The property is held for a lengthy time, used by the taxpayer as investment or business property, or is inherited by the taxpayer.
The taxpayer has not had a change in circumstances that would motivate an ordinary person to dispose of or develop the property. The taxpayer’s circumstances have changed. Unexpected financial pressures, being required to move and thus not being able to manage the property, death of the taxpayer or the property manager, zoning or other changes not instituted by the taxpayer, or the loss of a significant tenant could all be considered relevant to the taxpayer’s motive in conducting the exchange.
The taxpayer has made substantial improvements to the property in expectation of subdividing the property. The property required little improvement in order to subdivide and sell, the improvements were made at a time the selling price is at fair market value or is based its appraised value at the time of purchase.
The taxpayer enters into a joint venture, partnership, or similar agreement with a developer or dealer that provides that the developer share the profits with the taxpayer or that the risk of success or failure is shared by both parties. The taxpayer subdivides and develops the property himself, hires an outside party to construct improvements, or the agreements that the control the development and sale of the property pay the taxpayer a fixed fee for each unit sold, that is not contingent on profits from the venture, or the sales price of the units.
The units are not rented during the term that the property has been held, or the leases have been in effect for a brief time period. The units have been rented by its tenants for a significant time period, or have been offered to the existing tenants under a right of first refusal or similar agreement.
The replacement property is subdivided and sold quickly, or the taxpayer indicates that he or she purchased the replacement property with the intent of selling the property as units. The taxpayer maintains a continuity of interest in the replacement property, holding it for a substantial time period for investment or business purposes, or purchases replacement property that is of a nature not conducive to subdivision or development

Finally, the frequency of sales is important. Too many conversions and sales make an investor look like a developer or dealer. Each of these factors would likely be weighed by a court, if the transaction is challenged by the Internal Revenue Service. No one factor is determinative, but by the same token, “passing” a certain number of these tests will not guarantee the desired tax treatment. Any activities that imply the property was not held with the intent of investment or business use, such as resembling a developer or dealer, make it more likely that the property will not qualify for rollover-deferral treatment under CodeSection 1031. Care should be taken that the taxpayer gives no indication, whether written or oral, that he or she intended to buy the property and later sell off individual units, no matter how far off in the future such sales may occur.

(Consult Your tax professional)

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One of the central tenets of a delayed 1031 exchange through a Qualified Intermediary is that the taxpayer cannot have access to the proceeds from the sale of the relinquished property, except in the form of qualified replacement property transferred via the Qualified Intermediary. This restriction is consistent with the concept that an “exchange” of real estate has occurred, rather than a taxable sale of the relinquished property followed by a purchase of new property by the taxpayer. Nevertheless, there are circumstances where the taxpayer desires access to some of the cash equity in his real property, whether to purchase more investment property, or for any other purpose. Fortunately, with careful planning, it is often possible to tap into the underlying value of the exchange property, by refinancing (in the form of additional borrowing) on either the relinquished property prior to the exchange, or borrowing against the replacement property after the exchange has been completed.

Refinancing with a third-party lender was once considered by the IRS to be equivalent to cashing out of a property, when such refinancing was determined to be “in anticipation of exchange”. The idea was that borrowing against one’s property just before it is to be exchanged, is in effect no different from receiving a partial distribution of the sales proceeds from the relinquished property. In fact, the IRS went so far as to propose an amendment to the Regulations in 1991, which would have expressly made debt incurred on exchange property in anticipation of the exchange equivalent to taxable boot, but the proposed amendment was scratched because it would have added too much uncertainty into the exchange process. As time has passed since the IRS’s 1991 attempt to adopt a blanket rule against refinancing exchange property, the Courts have been much more liberal in construing cases where taxpayers borrow funds either from the replacement property following an exchange, or from the relinquished property prior to an exchange.

The federal cases, and IRS rulings on refinancing immediately before or after a 1031 exchange show a clear trend. In those cases where the taxpayer has bona fide, non-tax reasons to justify the borrowings, the taxpayer generally prevails. In cases where there the borrowings are tax-motivated, and lack substantial economic effect, the amounts borrowed were considered taxable as if they were a distribution of the sales proceeds to the taxpayer. It seems that the following factors will be considered in whether the new loans involved will be respected when used to equalize the exchange liabilities:

1. Independent Economic Significance and Valid Business Purposes.

The primary factor in the decision is whether the financing has independent financial significance, and whether there is a valid business purposes to the financing. Valid business reasons include changes in interest rates, loan covenants, needs to obtain cash for documented expansion plans, or changes in the taxpayer’s financial position that would encourage an exchange. In Garcia v. Commissioner, 80 T.C. 491 (1983) the taxpayer desired to “even up” the equity in two properties by placing loans on the relinquished property prior to the exchange, thus permitting the mortgage netting rules under 1031 to ensure full tax deferral. The Tax Court ruled (and the IRS acquiesced), that gaining such beneficial tax treatment for the exchange, constituted a valid business purpose for the re-financing; hence the borrowing was justifiably not taxable.

2. Timing.

The closer to the exchange date, the more likely the increased debt will not be approved by the IRS. Ideally, the financing should be initiated prior to negotiations for the exchange. In Fredericks v. Comr., 534T.C. Memo 1994-27, the taxpayer’s financing of the relinquished properties immediately before the exchange did not constitute boot, where the taxpayer’s reasons for financing were unrelated to the exchange. The taxpayer’s uncontroverted testimony was that he began attempts to secure long-term financing long prior to the date on which he entered into the agreement to exchange the relinquished property.

3. Identity of Lender.

Loans from related parties, or even from the buyer of the relinquished property are considered by the IRS as inherently suspicious and are more likely to be challenged as lacking substantial economic effect. This was demonstrated in Long v. Commissioner, 77 T.C. 1045 (1981), when the IRS disregarded the re-allocation of liabilities between the partners of a partnership immediately before an attempted 1031 exchange (partners in a partnership are considered related parties).

The cases also make it clear that re-financings that occur after the exchange are much less likely to be challenged than are re-financings that occur immediately prior to a 1031 exchange. If a taxpayer desires to take cash out of an exchange, the safest way to accomplish such borrowings without triggering IRS scrutiny is to document valid business reasons for the loan. Generally, changes in interest rates, a withdrawal deadline imposed by the lender, the desirability to lock-in a rate of interest, or plans to expand ones business constitute valid non-tax motivated reasons to re-finance.

To summarize, while a taxpayer cannot withdraw cash from the proceeds of the sale of his or her relinquished property without triggering taxable gain, it may be possible to take funds out of a 1031 exchange by borrowing against one of the properties in the exchange, if the taxpayer is careful to document a valid business purpose for the loan, and if the taxpayer uses an unrelated third party lender. In general, the longer the taxpayer waits to refinance the replacement property, the lower the risk that the transaction will be deemed taxable.

(Talk to your Tax Professional for more advise!)

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