Why NOW is the Time to Do a 1031 Exchange

Many property owners see the values of their properties lower today than in the past few years and are reluctant to sell those properties at declined values. Some investors, however, see today as the time to attack the market.

Consider the past for a moment. A few years ago, an investor may have sold an investment property that he owned free and clear for $275,000. He could have taken that money, done a 1031 exchange real estate, and leveraged the proceeds into two properties worth $200,000 each. He would have needed additional funds in the amount of $125,000 to achieve this goal, which he would have contributed out of his own funds or, more than likely, borrowed. Once acquired, the investor may have rented those properties for $1,300/month each. The monthly cash flow after debt service may not have been strong, but the investor may have hoped for future appreciation.

What if the same investor had held on to his property instead? Today, that property would surely not be worth $275,000. If he were to sell that property today for $175,000, he could still purchase two properties at reduced values, most likely for cash. In addition, if the investor traded the properties in a 1031 exchange, almost all of the original proceeds could be used for the purchase of the new properties without offset for taxes. Although the amount of rent collected would likely be less than a few years ago, there is no debt service to pay. This is a substantial benefit to the investor, as he has pure positive cash flow.

Many investors are taking advantage of the market and setting up their financial futures. Have you spoken with your advisor and First American Exchange to set up yours? Also, if you’re looking for other opportunities to invest and take a more aggressive approach to invest for your future, you may wish to look at the stock market for companies that have the potential for future growth, such as looking to buy RKT shares for instance.

Thank you to Jim Ogan of First American Exchange for this article.

Jim Ogan
Business Development Manager
(503) 740-3453
Email Me

1031 Basics: What Not to Do in a 1031 Exchange

Although tax deferred exchanges under Section 1031 have become quite common, most people outside of the exchange industry are not familiar with the legal requirements surrounding a successful tax deferred exchange. A 1031 exchange can benefit you if you are a real estate investor, but it is important to know the rules surrounding it. Certain strict timelines apply in every 1031 exchange, including: (i) a 45 day “identification period” and (ii) a 180 day exchange period. Each of the foregoing time periods commences on the sale or transfer of relinquished property. Starting then, the taxpayer must deliver a written identification letter to a qualified intermediary or other party to the transaction that describes the property sought to be acquired as replacement property in the exchange. The taxpayer must actually receive the replacement property identified in the exchange no later than the earlier of the 180th calendar day following the transfer of the relinquished property or the due date for the exchanger’s tax return, including extensions. There is a lot more nuance to the rules, but if you want to learn more, click on What Not to Do In a 1031 Exchange.

Don Leadroot, Esq.
NW Representative
Direct: 503-819-2663
don@apiexchange.com
2020 SW Fourth Ave., Suite 190
Portland, OR 97201

The Exchange Equation: Balancing the Exchange

Whenever property is sold, it is important to make the distinction between realized gain and recognized gain. Realized gain is defined as the net sale price minus the adjusted tax basis. Recognized gain is the taxable portion of the realized gain. The objective of many 1031 exchanges is disposing of a property with significant realized gain and acquiring a like-kind replacement property so there is no recognized gain. In order to defer all capital gain taxes, an Exchanger must “balance the exchange” by acquiring replacement property that is the same or greater value as the relinquished property, reinvest all net equity and replace any debt on the relinquished property with debt on the replacement property (although a reduction in debt can be offset with additional cash.)

THE EXCHANGE EQUATION

The Exchanger can quickly calculate whether there will be recognized gain based on the following principals:

  • Taxable boot is defined as non like-kind property the Exchanger may receive as part of an exchange. Cash boot is the receipt of cash and mortgage boot (also referred to as debt relief) is a reduction in the Exchanger’s mortgage liabilities on a replacement property. Generally, capital gain income is recognized (and therefore taxable) to the extent there is boot.
  • For a fully deferred exchange, an Exchanger must reinvest all net equity and acquire property with the same or greater debt. Compare the relinquished property with the replacement property in terms of: Value, Net Equity (after deducting costs of sale) & Debt.

Example 1

The Exchanger is acquiring property of greater value, reinvesting the entire net equity and increasing the mortgage on the replacement property. Analysis: There is no boot and no recognized gain.

Example 2

The Exchanger keeps $50,000 of the exchange proceeds, reinvesting only $150,000 as a down payment on the replacement property. Analysis: There is $50,000 of cash boot which results in recognized (taxable) gain.

Example 3

The Exchanger acquires property of a lower value and while reinvesting all equity in the replacement property, acquires less debt in the process. Analysis: The Exchanger has reduced the debt by $100,000 (mortgage boot) which results in a recognized (taxable) gain.

Download a one page PDF of this information: The Exchange Equation

Special thanks to Asset Preservation Inc., a 1031 Exchange Company

Don Leadroot, Esq.
NW Representative
Direct: 503-819-2663
don@apiexchange.com
2020 SW Fourth Ave., Suite 190
Portland, OR 97201

An Overview of Personal Property Exchanges

Investors thinking of exchanging their business often have a variety of assets other than real property associated with that business, including equipment, computers, and other types of personal property. In any exchange transaction involving a business, the investor must examine what exactly is being sold in order to determine: (1) if the particular asset can be exchanged, and (2) what sorts of replacement assets will satisfy the like-kind requirement for a successful exchange. When it comes to investments, either for buying, selling, or exchange, an investor can contact an investment management company or an advisor like Lincoln Frost to obtain information regarding the process, legal advice, and profit analysis. Moreover, understanding your assets can be as important, and for that, we have outlined a few things you should keep in mind during personal property exchange.

EXCHANGEABLE ASSETS

The first step for an investor thinking of exchanging his business is to itemize the various assets and determine which of those assets are exchangeable. Real property and many types of personal property can be exchanged under Internal Revenue Code §1031; however, assets such as goodwill, stocks, inventory, and covenants not to compete are not exchangeable.

LIKE-KIND REQUIREMENT

Real property and personal property are not like kind and therefore cannot be exchanged for one another. However, personal property held for the productive use in a trade or business or for investment purposes can be exchanged for other “like kind” or “like class” personal property also held for the productive use in a trade or business or for investment. A sum of money invested in something by a person rather than a company or organization, or the total value of these investments: Real estate and precious metals are usually the preferred personal investments. Personal investment is defined in the financial sector as an investment made by an individual who can manage his financial instruments himself, such as stocks, bonds, property, and others. These personal investments might also aim to improve the liquidity and efficiency of the individual’s equity and capital.

The Federal Regulations provide a safe harbor for tangible depreciable personal property in the same asset class. This means that assets falling within the same asset class are deemed to be like-kind.

The asset classes are described in Revenue Procedure 87-56. If the assets do not fall within the same asset class, they may still be considered like-kind if they fall within the same product class. Product classifications can be found under Sections 31, 32 and 33 of the North American Industry Classification System (NAICS), set forth in the Executive Office of the President, Office of Management and Budget, North American Industry Classification System, United States, 2002, as periodically updated (also called the NAICS Manual). An electronic version of the NAICS Manual can be found at: http://www.census.gov/epcd/www/naics.html.

Even if personal property assets are not considered like-kind under the regulations’ safe harbor, the assets may still be considered like-kind for purposes of the exchange if the assets are similar enough to each other. The IRS provides little guidance as to what types of assets are considered like-kind, and the minimal case law on this topic is very specific. For example, an SUV has been held to be like-kind to a passenger car, and fishing permits for a particular species and a particular location have been held to be like-kind to fishing permits for another species and location.

Personal property that is not like-kind under the rules described above cannot be exchanged. For example, an investor may own a truck worth $50,000 and a computer system worth $35,000. The truck can be exchanged for another truck, and the computer system for another computer system. However, an investor cannot combine the proceeds of the sale of these two items to purchase an airplane worth $85,000 because a truck, computer and airplane are not like kind.

Investors may also own intellectual property assets such as trademarks or trade secrets as part of their business. Intellectual property is considered intangible personal property and certain types of these assets, such as patents, trademarks, and software, may be exchangeable depending on (1) the nature or character of the rights involved and (2) the nature or character of the underlying property to which it relates. In other words, in order for an exchange to work, the character of the rights must be the same (i.e., a patent for a patent) and the underlying property to which the rights relate must be like-class or like-kind (i.e., a mail sorting machine for a mail sorting machine). If it turns out that these trademarks are not theirs and they do not own them, then legal action may be taken through firms like https://www.dhillonlaw.com or others, depending on the case.

IDENTIFICATION

For multi-asset exchange transactions, identification of replacement property can be tricky. Fortunately, any replacement property purchased within the 45-day identification period is deemed properly identified. If an investor cannot close on his replacement property within the 45-day identification period, formal identification will be necessary. For personal property assets, each replacement asset needs to be described with as much detail as possible. For example, IRS Regulation 1.1031(k)-1(c)(3) states that, generally, a truck is unambiguously described by stating the model, make and year. Descriptive information such as a vehicle identification number or a serial number can also add to a precise description.

Personal property that is considered incidental to other larger personal property or real property does not need to be separately identified. In order to be considered “incidental”:

(1) the property must be typically transferred together with the larger property in commercial transactions (for example the transfer of a hotel building and furnishings and equipment used in connection with the hotel); and

(2) the aggregate fair market value of all of the incidental property cannot exceed 15% of the aggregate fair market value of the larger item of property (for example, if the real property portion of the hotel is worth $1 million, then the personal property value does not exceed $150,000). It is important to note that this exception relates to the identification rules only, and even if the personal property is worth less than 15% of the real property, the personal property must still be exchanged only for other like kind personal property.

CONCLUSION

A 1031 exchange of a business typically involves more than just a simple exchange of real property. Provided that the owner determines which types of real property and personal property are being disposed of and purchased, these assets can be matched up in accordance with the guidelines and regulations published by the IRS, and the owner will have a successful 1031 exchange.

For more information on Personal Property exchanges, go here.

Thank you to Jim Ogan of First American Exchange for this article.

Jim Ogan
Business Development Manager
(503) 740-3453
Email Me


Proposed Rules May Increase Ownership Of Commercial Real Estate

February 2011 – Although accounting rules usually don’t end up as front page news, there are some recent proposals to change the Financial Accounting Standards Board (FASB) accounting rules that should have a significant impact on the commercial real estate industry. The rules may make it more likely that companies will choose to own property rather than rent it, and may also change lease negotiations for those who do rent. Regardless of these rules, commercial real estate is still a big industry, especially for those who are thinking about starting a new business. People can take a look at Commercial Property London if becoming a new entrepreneur is something you have your heart set on. Once you get to the accounting/bookkeeping side of things too, you don’t even have to think about working that out for yourselves, you can easily outsource it to https://www.wizzaccounting.co.uk/ or companies alike. All you have to focus on is finding a property and building up your business!

Currently, a lease can be either a capital lease, which is reflected on the tenant’s balance sheet, or an operating lease, which shows up on financial statements in the form of rent as a monthly expense. Owners of a commercial property may want to look for someone like Thomas Mensendiek to find reliable tenants to lease said property; expertise such as this can be really handy, especially with all these changing rules. The proposed rule would treat almost all leases as capital leases. FASB argues that this rule would encourage transparency and give a more accurate picture of a company’s financial condition.

Although the new rules may improve disclosure and transparency, they have the potential to have a significant effect on the commercial real estate and equipment leasing industries. Many large companies have thousands of operating leases and one reason some of them choose to rent rather than acquire property is the way the property is treated for accounting purposes. The new rules would require a company to include virtually all of its leases on its balance sheet, as if it had purchased the property and was making loan payments rather than paying rent. Bear in mind that these changes are for our local area. Be sure to refer to a commercial solicitor in Leeds if you are based there, or to a local expert to assist you to ensure accuracy.

What are the expected effects of these changes?

  • The accounting benefits of leasing space versus buying property will be eliminated, so some companies are expected to decide to acquire property rather than lease it. This change should increase the volume of sales activity and 1031 exchanges.
  • Financial covenants in loan documents will be affected by this change, so debtors will need to discuss this issue with their lenders in order to ensure that they do not breach the financial covenants in their loan documents.
  • As currently written, the rules do not grandfather in any existing leases, so the administrative burden on tenants could be significant during the transition period.
  • Because the lease term would affect what is put on the balance sheet, and because some option periods would be included when computing what the lease term is, lease negotiations may be affected. More tenants may want shorter term leases and may consider the accounting rules when deciding whether to ask for options to extend their leases.

These rules are not final, but if they are enacted in their current form, they will have a significant impact on some companies who lease property. There is additional information at www.fasb.org.

Thank you Jim Ogan of First American Exchange for this article.

Jim Ogan
Business Development Manager
(503) 740-3453
Email Me

DOES THE HEALTH CARE BILL INCLUDE A NEW 3.8% “SALES TAX” ON REAL ESTATE SALES?

There is a buzz throughout various social media outlets that with the passage of HR 3200, The Health Care and Education Affordability Reconciliation Act of 2010 (the “Health Care Bill”), taxpayers will be paying a 3.8% sales tax when they sell real estate.

This is not exactly true.  If you dig a little deeper, you’ll find that there is a 3.8% tax which has been put into place through the Health Care Bill; this is not a sales tax, but rather a Medicare tax.   This tax will be put into place starting in 2013 and it will only apply under certain circumstances.

First, the tax only applies to “high-earners” as spelled out in the bill.  This includes married couples filing jointly making over $250,000, $125,000 for couples filing separately, and $200,000 for all others.

Next, this tax is only applied to certain income, including gain from the sale of real estate.  For example, if you purchased a property for $200,000 and sell it for $250,000, the tax would be applied to the $50,000 profit, not the sales price of $250,000.

Finally, if the property is your primary residence, Section 121 of the IRS Code may apply.  Under this code section, taxpayers who have owned and lived in a property for 2 of the last 5 years may be able to exclude from tax up to $250,000 of the gain if they are single and $500,000 if they are married. Using the example above, if the $50,000 profit falls within the requirements under Section 121, this $50,000 would be tax free.  If this property was not your primary residence or otherwise did not fall within the guidelines of Section 121, then the 3.8% tax would apply.

This tax is certainly something to keep an eye on for everyone in the real estate industry.  As you prepare for your future real estate transactions, consult with a tax professional to get specifics on whether this tax will apply to you or your client and if so, what the tax liability may be.

Call Jim Ogan for questions related to 1031 tax-deferred exchanges.
503-740-3453