Converting a Primary Residence

Now the market is improving and tax exchanges are back in full swing. This issue of blended property or converting rental property or investment property into a primary residence is a big issue for discussion. Folks this is huge.

Notably, there is an additional “anti-abuse” rule applies to rental property converted to a primary residence that was previously subject to a 1031 exchange. For instance, let’s imagine a situation where an individual completes a 1031 exchange of a small apartment building into a single family home, rents the single family home for a period of time, then moves into the single family home as a primary residence, and ultimately sells it (trying to apply the primary residence capital gains exclusion to all gains cumulatively back to the original purchase, including gains that occurred during the time it was an apartment building!).

To limit this activity, the Congress created “The American Jobs Creation Act of 2004 (now IRC Section 121(d)) affecting specifically tax deferred exchanges. That Act stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange.

The strategy to exchange an investment rental for a new investment rental in a location where you or your customer may wish to retire takes some advance planning, but will maximize their tax savings in the end. When one exchanges their current investment rental property into a new investment rental property, they defer the tax they would normally have to pay on the gain. This is reflected in the lower basis assigned to their new replacement property. This, of course, is basic Section 1031 knowledge.

When they sell their current principal residence, they may exclude the gain up to the Section 121 limits. Then, after they convert their replacement property into their new principal residence, they become eligible once again for exclusion of up to $250,000/$500,000 of gain after they have owned the replacement property for five years and used it as a principal residence for two years. The five-year ownership rule on a principal residence only applies to properties that have come to your client from an exchange. Capital gains tax will be due on gains above the Section 121 limits and any depreciation taken after May 6, 1997.

If your customer just acquired a property by doing a like-kind exchange, they must hold the new property as an investment, rental, or business property in order to qualify for the exchange itself. We look at the facts and circumstances surrounding the exchange at the time of the acquisition. No one can tell your client how long the exchange replacement property must be held in investment status before they convert it to personal use, but most of our attorneys in our office recommend not less than one year. IRS issued Revenue Procedure 2008-16 which defines a safe harbor and includes a two-year holding period of limited personal use and a rental period if you want to be safe. We are happy to meet with clients and help you design a transaction that allows you to convert from investment to primary residence use.

Another issue we need to revisit in relation to tax deferred exchanges is that effective January 1, 2009, the IRS Section 121 was changed to require parties whether inside or outside an exchange to allocate gain based upon use. Before the President signed H.R. 3221, the Housing Assistance Tax Act of 2008, on July 30, 2008, a revenue-raising provision first promoted by Representative Charlie Rangel (D, N.Y.) was included by the conference committee as Section 3092 of the bill. This provision was an amendment to Section 121 and has had a major impact on small landlords and taxpayers who were planning to convert their rental or second home to a principal residence and then exclude any gain from their income when they sell the property.

The term “Period of Non-Qualified Use” referenced in the amendment is very important and means any period during which the property is not used as the principal residence of the taxpayer, the taxpayer’s spouse, or a former spouse.  Importantly, the period before January 1, 2009, is excluded. January 1, 2009 is the date upon which this statute became law.

In addition, subsection (4)(C)(ii) of the amendment provides additional exceptions to the  Period of Non-Qualified Use. These exceptions are (1) any portion of the five-year period (as defined in Section 121(a)) which is after the last date that such property is used as the principal residence of the taxpayer or spouse, (2) any period not exceeding 10 years during which the military or foreign service taxpayer, or spouse, is serving on qualified official extended duty as already defined, and (3) any other period of temporary absence (not to exceed a total of two years) due to change of employment, health conditions, or such other unforeseen circumstances as may be specified by the HUD Secretary.

The amendment states “gain shall be allocated to periods of non-qualified use based on the ratio which (i) the aggregate periods of non-qualified use during  the period such property was owned by the taxpayer, bears to (ii) the period such property was owned by the taxpayer.”

How does this affect your planning?


EXAMPLE FOR ILLUSTRATION:  Suppose the married taxpayer exchanged into an investment property and rented it for four years. They moved into it at that time and lived in it for two additional years. The taxpayer then sold the residence and realized $300,000 of gain.

Under prior law, the taxpayer would be eligible for the full exclusion and would pay no tax. Under the new law, the exclusion will have to be prorated as follows: four-sixths (4 out of 6 years) of the gain, or $200,000, would be taxable and thus would be ineligible for the exclusion. Two-sixths (2 out of 6 years) of the gain, or only $100,000, would be eligible for the exclusion.

Importantly, non-qualified use prior to January 1, 2009, is not taken into account in the allocation for the non-qualified use period, but is taken account for the ownership period.


EXAMPLE FOR ILLUSTRATION:  Suppose the taxpayer had exchanged into the property in 2007, and rented it for three years until 2010, and then converted the property into a primary residence. If the taxpayer sold the residence in 2013, after three years of primary residential use, only one year of rental, 2009, would be considered in the allocation for the non-qualified use. Thus, only one-sixth (1 out of 6 years) of the gain would be ineligible for the exclusion. Why? The period before 2009 is not counted as the law was not in effect until 2009.


SPECIAL RULES FOR PRIMARY RESIDENCE CONVERTED TO RENTAL PROPERTY

In general, the allocation rules only apply to time periods prior to the conversion into a principal residence and not to all time periods after the conversion out of personal residence use. Thus, if your customer converts a primary residence to a rental and never moves back in, but otherwise meets the two-out-of-five year test under Section 121, the taxpayer is eligible for the full exclusion when the rental is sold. This rule only applies to non-qualified use periods within the five-year look-back period of Section 121(a) after the last date the property is used as a principal residence. The rule allows the taxpayer to ignore any of the non-qualifying use that occurs after the last date the property was used as a primary residence although the 2 out of the last 5 rules must be satisfied.

EXAMPLE FOR ILLUSTRATIVE PURPOSES: Your client owns a primary residence. Your client bought it and lived in it since 2008. Your client gets a job offer from California in 2014, but the economy is still in recession and decides NOT to sell then, but to hold on until the market improves. She rents it out in 2014 and takes depreciation on the house. It is now 2015 and the client wants to list the property with you for sale. Can she take advantage of Section 121 or will she be a landlord or will she be required to allocate her gain?

Even though there have been one (1) or potentially two (2) years of non-qualifying use as a rental it won’t count against her and all amounts will be excludable except for depreciation recapture. Even though your client does not live in the house as a primary residence, the client has still used the property as a primary residence two of the last five years (as she lived there in 2012 and 2013 before renting in 2014).

Happy Investing!

Today's blog courtesy of Ed McFerran, McFerran and Burns

Investment Taxes

What Are the Taxes Due on the Sale of Investment Property?

Capital Gains Tax:  Is 15% for most taxpayers, for those with annual income less than $400K per individual or $450K per married couple who file jointly.    

Section 1411 Medicare Surtax or Affordable Care Act (ObamaCare) Surtax:  3.8% only applies to those who have an annual income of over $200K per individual or $250K per married couple filing jointly.

Combined Tax Rate:  That means that those with an annual income over $400K or couples who file jointly making over $450K, would be taxed 23.8% in taxes on the profits from their investments!

Depreciation Recapture:  No matter what your annual income, the portion of your total gains that were depreciated is taxed at 25%. That is called Depreciation Recapture and is often the biggest surprise for most investors.

Tax-Free Exchange?

I know you often see internet mention of a tax-free exchange, but it is really a tax deferred exchange. You get to use the money that you would have paid to the IRS today, and as long as you don’t sell the property, you don’t have to pay the taxes on it. Not unlike a 401K

What about State Taxes

Every state has different rules. In Washington we have an Excise Tax. That is like a sales tax and cannot be deferred in an exchange. If Washington were to enact a capital gains tax that would likely also be exchangeable.

Happy Investing!

Today's blog courtesy of Kevin Hummel, McFerran Law

Defer Capital Gains Tax

There are two ways to defer capital gains tax on real estate profits. One way was discussed in my previous blog post - that is, to use seller financing to defer income from the proceeds of a sale on an income property.

The other way to defer capital gains tax on real estate is to make use of a 1031 tax exchange. What is a 1031 tax exchange?

According to Wikipedia, under Section 1031 of the United States Internal Revenue Code ... the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.

To qualify for Section 1031 of the Internal Revenue Code, the properties exchanged must be held for productive use in a trade or business or for investment. The properties exchanged must be of "like kind", i.e., of the same nature or character, even if they differ in grade or quality.

The challenge with a 1031 exchange is to meet the strict timelines identified by the IRS to qualify for an exchange.

The §1031 exchange begins on the earliest of the following:
the date the deed records, or the date possession is transferred to the buyer, and ends on the earlier of the following:
180 days after it begins, or the date the Exchanger's tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.

The identification period is the first 45 days of the exchange period. The exchange period is a maximum of 180 days. If the Exchanger has multiple relinquished properties, the deadlines begin on the transfer date of the first property.

The following sequence represents the order of steps in a typical 1031 exchange:

Step 1. Retain the services of tax counsel/CPA. Become advised by same.

Step 2. Sell the property, including the Cooperation Clause in the sales agreement. "Buyer is aware that the seller's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with seller to accomplish same, at no additional cost or liability to buyer." Make sure your escrow officer/closing agent contacts the Qualified Intermediary to order the exchange documents.

Step 3. Enter into a 1031 exchange agreement with your Qualified Intermediary, in which the Qualified Intermediary is named as principal in the sale of your relinquished property and the subsequent purchase of your replacement property. The 1031 Exchange Agreement must meet with IRS Requirements, especially pertaining to the proceeds. Along with said agreement, an amendment to escrow is signed which so names the Qualified Intermediary as seller. Normally the deed is still prepared for recording from the taxpayer to the true buyer. This is called direct deeding. It is not necessary to have the replacement property identified at this time.

Step 4. The relinquished escrow closes, and the closing statement reflects that the Qualified Intermediary was the seller, and the proceeds go to your Qualified Intermediary. The funds should be placed in a separate, completely segregated money market account to insure liquidity and safety. The closing date of the relinquished property escrow is Day 0 of the exchange, and that’s when the exchange clock begins to tick. Written identification of the address of the replacement property must be sent within 45 days and the identified replacement property must be acquired by the taxpayer within 180 days.

Step 5. The taxpayer sends written identification of the address or legal description of the replacement property to the Qualified Intermediary, on or before Day 45 of the exchange. It must be signed by everyone who signed the exchange agreement.

Step 6. Taxpayer enters into an agreement to purchase replacement property, again including the Cooperation Clause. "Seller is aware that the buyer's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with buyer to accomplish same, at no additional cost or liability to seller." An amendment is signed naming the Qualified Intermediary as buyer, but again the deeding is from the true seller to the taxpayer.

Step 7. When conditions are satisfied and escrow is prepared to close and certainly prior to the 180th day, per the 1031 Exchange Agreement, the Qualified Intermediary forwards the exchange funds and gross proceeds to escrow, and the closing statement reflects the Qualified Intermediary as the buyer.

Step 8. Taxpayer files form 8824 with the IRS when taxes are filed, and whatever similar document your particular state requires.





If you are interested in learning more about how to do a 1031 exchange for the sale of your income property, please message me privately at HomeLandInvestment@gmail.com.




Happy Investing!

What is a 1031 Exchange?

If one of my commercial properties gets bought out this month, it would generate a significant profit - as well as the corresponding significant tax payments to Uncle Sam. So I have contacted my good friends at McFerran & Burns to discuss one of the two most common methods for deferring capital gains taxes on the sale of property: a 1031 Tax Deferred Exchange.

IN IT’S SIMPLEST TERMS a 1031 Tax DeferredExchange is a method of deferring the capital gains tax paid by an investor as real property is purchased and sold. The tax code permits a taxpayer to exchange property held for a productive use in a trade, business or as an investment for a property of a like-kind without recognizing income, therefore delaying taxes.

One of the best reasons for using this tool is by deferring the tax you are able to reinvest all the cash and equity. This opens the door to many options: property with higher revenues, relocation of investment properties, higher appreciation, increased or decreased actual properties as suits. Essentially it allows the investor to craft their business in manner that suits them best.

Here are some general rules related to a 1031 Exchange:

EXCHANGE must be completed within specific timelines, or capital gains tax is reinstated.

A QUALIFIED INTERMEDIARY is required to ensure Exchangor doesn’t have control over sale proceeds during exchange

EXCHANGE AGREEMENTS must be in place between correct parties on strict timelines

CASH FROM EXCHANGE can only be withdrawn at 4 limited times during the exchange

LIKE-KIND PROPERTY means “productive” investment real property rather than stocks and bonds, and not property to be held only for resale.

Thanks to Kevin Hummel at McFerran & Burns for help with this blog post.

Happy Investing!

Tax Deferred Exchange Tips

Build To Suit

What happens when you cannot find a replacement property that is worth the same price of what you sold in a 1031 exchange? One option is to make improvements to the property being purchased. You can literally build the property to suit your needs or the needs of a potential tenant.

Essentially, you can use exchange funds to pay for the improvements made to the property that can be accomplished before the 180^th day of the exchange. It is almost that simple if you are only dealing with a sale that is free and clear. The only factors that can complicate this have to do with debt and lending issues.

The Process?

In simple terms, the Qualified Intermediary (QI) steps into title during the initial purchase, acts as a general contractor to facilitate the payment of improvements, repairs, and even some personal property that is added property. Then, as soon as the work is completed, or we reach the 180^thday, that improved property is conveyed to the exchanger to complete the purchase leg of the exchange.

What Improvements Can Count?

Virtually any capital improvements can count towards the value being added to the property. The QI cannot directly pay the exchanger for labor and the value of improvements is simply their cost. As mentioned earlier, personal property can be included, as long as its value does not exceed 15% of the total value of the finished property. An extreme example was the purchase of a fork lift for use in a warehouse being improved in an exchange, or a lawn mower purchased for a rental.

What If the Improvements Are Not Completed?

The property does not need to be habitable to qualify; it simply needs to be attached. A lumber package sitting in the driveway is only personal property until it is attached to the land. There is no inspection required; you only need proof that the money was spent. Guidelines and case examples use the “snap shot rule”. In other words, if you were to take a photo on the last day of the exchange, whatever is visibly completed can be counted.

Use of an LLC

Very often forming an LLC for the process of an Improvement Exchange is an effective way to package the improvements and tie them to the property. Any agreements made with any contractors during the process would remain in effect, and the final transfer of the improved property are smoothly conveyed by a simply Assignment of LLC Interest. 

 Happy Investing!

Today's blog is courtesy of Kevin Hummel, McFerran & Burns, PS.

Introduction to 1031 Exchange

This article was forwarded to us by Sherrie Sommerseth with Chicago Title, and reprinted here with permission:

As we roll into the summer, it’s refreshing to see continuing economic improvement mirroring the growth of income property sales and 1031 Exchanges. However, the excitement of an increased property sale value can be quickly diminished with unexpected taxes. Many real estate investors are surprised to learn that taxes on their profits are substantially higher this year. When investment real estate is sold in 2013, some taxpayers could pay up to 20% capital gains tax, a 3.8% healthcare tax, depreciation recapture tax and varying state imposed taxes. Added together, these taxes can total anywhere between 30-40%, making 1031 Exchanges an invaluable wealth preservation tool. 

Tax deferral is the hot topic in the real estate community and a 1031 Exchange still allows taxpayers to defer all of these taxes by simply rolling their profits into another property or properties. While the concept of a 1031 Exchange is straightforward, some investors and advisors may not have participated in a transaction for many years and may need to be updated on how to properly execute a 1031 Exchange.

Know your options and make informed decisions for your next 1031 Exchange transaction. Register today for IPX’s two complimentary webinars!

A 1031 Exchange Introduction and Refresher Webinar

This webinar will be held on June 12th and will provide a comprehensive foundation of 1031 Exchange information. Learn the basic rules and regulations and how to apply these to your transaction for maximum benefits.

Click here to register for the June 12th webinar

Advanced 1031 Exchange Issues Webinar

This webinar will be held on June 19th and will discuss the most recent changes in tax deferred exchanges and will cover topics such as reverse exchanges, build-to-suit exchanges, using seller financing in a 1031 transaction, and related party issues.

Click here to register for the June 19th webinar

Happy Investing!