How Real Estate Investors Can Pay Zero Taxes! - Part 2 8.
What is the Basis?
For the purposes of a 1031 exchange, basis is the term you give to the
price which was originally paid for the relinquished property, less any
depreciation, plus any the costs of any improvements made to the property.
Example: You brought a property ten years ago for $30,000 that you’ve
been depreciating at $1,000 a year for the last ten years. You would subtract
the $10,000 depreciation from your $30,000 purchase price to arrive at your
current basis in the property: $20,000.
The basis of the replacement property becomes the same as the basis
of the relinquished property, plus any amount paid in excess of the adjusted
sale price of the relinquished property.
The adjusted sales price is the price the property sold for, less the
selling cost and less any other cost to make the property ready to sell.
Example: You sell a property for $100,000 with a basis of $20,000 and you
buy a replacement property for$150,000. You paid $50,000 more for the
new property, so the basis on your new property is now $70,000 ($20,000
plus $50,000). Also any expenses that you pay to acquire the replacement
property are added to the new basis. These costs would include the real
estate commission and other normal closing costs.
Basis is used as the base point for the calculation of capital gain on a
transaction. Capital gain is described as the difference between the basis and
the adjusted sales price of a property.
Don’t confuse capital gain with equity. There is no comparison
between the two. Equity is the amount of money you have in your pocket
after you have sold the property and paid off all the mortgages.
Example: The property you bought ten years ago for $30,000 now has a
basis of $20,000. If you sold that property for $115,000 and paid $15,000 in
sales and other costs to prepare the property for market, you have equity of
$100,000. However your capital gain on this property is the difference
between your basis of $20,000 and your adjusted sales price of $100,000.
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That is a taxable capital gain of $80,000! If you do not do a 1031 Exchange
you would have to pay a capital gains tax of $16,500. ($10,000 depreciation
X 25% = $2,500 plus $70,000 X 20% = $14,000. These calculations are
based on tax rates in effect at the time this was written.)
If you have borrowed money on this property you will need to repay
this loan at the time of closing. This will result in the relief of debt, which is
the same as if you received cash according to IRS rules.
Example: You have borrowed $90,000 on the property. Your equity on the
adjusted sale price is now $10,000, but you have an obligation for capital
gains tax of $16,500. It is in this area that you must be extremely careful not
to trap yourself with a regular sale. You are almost restricted to an exchange
in a case like this unless you have the additional funds to pay the taxes.
In larger transactions with larger dollars and leveraging the situation
only gets worse. A 1031 exchange is the alert real estate investor’s magic
bullet aimed at capital gains taxes.
Basis and Mortgages
The primary rule to consider when the relinquished property has a
mortgage is this: the IRS considers the relief of debt the same as the receipt
of cash. This rule applies whether the other party assumes the mortgage, or
whether it is paid off.
The basis calculation remains the same regardless of equity. The
easiest rule to follow when considering replacement property is this: You
must purchase replacement property with a total value equal to, or greater
than, the adjusted sale price of the relinquished property. And you need to
use all of the proceeds being held by the qualified intermediary. You can
add either cash or borrowings to the exchange proceeds to accomplish this.
Example: You sell a property for $100,000, which you have mortgaged for
$40,000. The exchange proceeds are $60,000 and you have debt relief of
$40,000.
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You buy a replacement $160,000 property by paying the $60,000 of
proceeds, $25,000 from savings and the balance from proceeds of a new
loan for $75,000. This results in a complete tax deferred exchange.
Boot
Cash, notes and unlike property in an exchange is called boot.
Receiving boot as part of an exchange does not defeat the non-taxable
provisions of Section 1031. However if you receive boot you probably will
have taxable gain on the value of the boot. If the other party assumes any of
your liability as part of the exchange it will be treated as if you received
cash.
Sample Exchange
Sale Price $150,000.00
Less selling costs -$12,000.00
Adjusted Sale Price $138,000.00
Less Original Price (Basis) -$50,000.00
Plus Depreciation Taken +$35,000.00
Taxable Gain $123,000.00
Tax on Gain (25% of $35,000) $8,750.00
(20% of $88,000) $17,600.00
Capital Gains Tax Due $26,350.00
Instead of paying the $26,350.00 in Capital Gains tax you could
exchange and use that money to purchase a replacement property.
If you left this money in your real estate investment and exchanged
four times you would have gained over $100,000 in purchasing power.
Exchanging allows you to maintain leverage and compound your real estate
profits.
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A Few Details
You don’t have to reinvest the all of the proceeds from your
relinquished property in a replacement property, but you will be taxed on the
amount that you do not reinvest. Unused proceeds are “boot” and are taxed
on their face value at the capital gains tax rate.
You can receive boot at anytime after you have acquired each of the
properties identified in your 45-day identification. If for some reason you do
not actually purchase those properties, then the unused proceeds cannot be
released until the earlier of the due date of your tax return including
extensions, or 180 days after the closing of the sale of the relinquished
property.
You can sell your relinquished property by accepting a note and trust
deed to finance the sale. However, if your name appears as the beneficiary
of the note it will be taxable and may not be used to buy a replacement
property.
The note should be made out to the intermediary, and then you will
have four choices on how to use it to buy replacement property:
1.) You can use the note to acquire replacement property by trading it to the
property owner for part of the purchase price of the new property.
2.) You can instruct the intermediary to sell the note on the open market and
add the amount realized to the exchange proceeds. This will give you all
cash to negotiate your replacement purchase. When you sell a note you
must do so at a discounted price, which means you would be giving up a
portion of the profit you earned on the sale of the relinquished property.
3.) A party related to you such as a closely held corporation or relative can
either purchase the note from the intermediary, or provide financing so the
intermediary receives all cash at closing. You must consult your tax advisor
for advice on this transaction.
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4.) You can wait until the end of the exchange and receive the note back
from the intermediary. This will result in the note becoming boot and it will
be taxable. However, you will only have to pay tax on the amount received
each year.
There are two ways that new construction is handled in an exchange:
1.) You contract with a builder to purchase a property, which will be
completed prior to the end of the 180-day exchange period.
You can purchase the land prior to construction as one of your
replacement properties, or you can purchase the land and building from the
builder at the time of closing. This is the least expensive and easiest method
for effecting the exchange.
2.) You can contract to do what is known as a “Build-out Exchange”. This
is where you finance all or part of the construction. Through a special
agreement with the intermediary the builder draws on the exchange proceeds
as certain steps of the construction are completed. This arrangement is much
more complicated, expensive and risky for all concerned.
In either case the purchase and sale agreement should have language
in it the requires the builder to bear responsibility for the exchanger’s taxes
if the exchange fails due to the completion of construction later than the
required 180-day exchange closing period.
The safest why to open escrow on a replacement property is to wait
until after the sale of the relinquished property has closed. The opening of
escrow may constitute “identification”, as the escrow agent is listed by the
IRS as a person involved in the exchange. If escrow is opened prior to the
closing of the relinquished property it can shorten the entire exchange period
to 45 days. Replacement property is identified if it is designated as
replacement property in a written document signed by the taxpayer and sent
to the intermediary prior to the end of the 45-day identification period.
You can combine multiple relinquished properties into one
replacement property. The rule here is that the first relinquished property to
close starts the clock running for all of the other properties.
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All of the relinquished properties to be combined must be closed within 45days
of the first one to close. The same replacement property is then
identified for each relinquished property to be combined.
That is not as complicated as it sounds. In the purchase agreement for
each property that you are selling require that the transaction cannot close
until a specified date.
Reverse Exchange
A reverse exchange, the "flip side" of a deferred exchange, is where the
taxpayer directly or indirectly acquires the replacement property before
disposing of the relinquished property. In a fast paced real estate market,
owners of real property often face the prospect of losing the opportunity to
acquire a desirable replacement property, when the seller of such property is
unwilling or unable to wait while the taxpayer completes the disposition of
the relinquished property.
On October 2, 2000 the Internal Revenue Service ("IRS") issued
Revenue Procedure 2000-37 providing long awaited guidance on structuring
reverse exchanges to avoid IRS challenge. This Revenue Procedure provides
a safe harbor for reverse exchanges if certain requirements are met.
Background
Beginning with the IRS' acceptance of deferred like-kind exchanges,
taxpayers have engaged in a wide variety of transactions, including so-called
"parking" or "warehousing" transactions, to facilitate reverse like-kind
exchanges.
Parking transactions typically are designed to "park" the desired
replacement property with a qualified intermediary until such time as the
taxpayer arranges for the transfer of the relinquished property to the ultimate
buyer in a simultaneous or deferred exchange. Once such a transfer is
arranged, the taxpayer transfers the relinquished property to the qualified
intermediary in exchange for the replacement property,
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and the qualified intermediary then transfers the relinquished property to the
ultimate buyer.
In other situations, a qualified intermediary may acquire the desired
replacement property on behalf of the taxpayer and immediately exchange
such property with the taxpayer for the relinquished property, thereafter
holding the relinquished property until the taxpayer arranges for a transfer of
such property to the ultimate buyer. In parking arrangements, taxpayers
attempt to arrange the transaction so that the qualified intermediary has
enough of the benefits and burdens relating to the property so that the
qualified intermediary will be treated as the owner for federal income tax
purposes.
Rev. Proc. 2000-37 provides that a reverse exchange will not be
challenged if the taxpayer, who will be the ultimate owner of the parked
property, satisfies two requirements:
(i)
the taxpayer enters into a written Qualified Exchange
Accommodation Arrangement ("QEAA"), and
(ii)
the taxpayer engages the services of an exchange
accommodation titleholder ("EAT") which is typically a
qualified intermediary.
1. What are the requirements of a QEAA?
Property will be considered to be held in a QEAA if all of the following
requirements are met:
(a) The property is titled in the name of the EAT or its subsidiary. The Rev.
Proc. requires that "qualified indicia of ownership" of the property is held by
the EAT. This requirement is met by either:
(i)
deeding the property directly to the qualified intermediary or
(ii)
deeding the property to a single-member limited liability company
owned by the EAT. When effectuating a reverse exchange under the
safe harbor, All States forms a single-member LLC to hold the
replacement property so as to protect the taxpayer from any liabilities
arising from any of the other properties held by All States, This document and accompanying materials are designed to provide authoritative information in regard to the subject matter covered in it. It is for illustration purposes only and presented with the understanding that the author and publisher are not engaged in rendering legal, accounting or other professional opinions. If legal advice or other expert assistance is required, the services of a competent professional should be sought. |
