Real Estate Tax Strategies- IRC 1031, 121 & DST

Transcription

1 Real Estate Tax Strategies- IRC 1031, 121 & DST Matthew K. Scheriff, CPA, CES IRC 121 AND PRIMARY RESIDENCES

2 IRC 121 AND PRIMARY RESIDENCES IRC 121 provides for an exclusion from capital gains tax upon the sale of a primary residence. An IRC 121 exclusion is available if the taxpayer has lived in the property as their primary residence two out of the preceding five years. The exclusion is $250,000 if the taxpayer is single and $500,000 if the taxpayers are married. You can only have one primary residences. Spouses having separate primary residences can only each claim $250,000. IRC 121 AND PRIMARY RESIDENCES A reduced exclusion may apply for taxpayers who sell their principal residence but (1) fail to qualify for the 2 out of 5 year rule; or (2) previously sold another primary residence within the 2 year period ending on the sale date of the current home in a transaction in which the exclusion applies. Taxpayers may qualify for a reduced exclusion for some of the following reasons: Must sell home due to change of place of employment (50 miles); Health related issues of taxpayer or family pursuant to IRC 152(a); Sale is caused by unforeseen circumstances that taxpayer could not have anticipated before purchasing the residence.

3 IRC 121 AND PRIMARY RESIDENCES Previous to Rev. Proc (1/27/2005, corrected 2/3/2005) and revised by Internal Revenue Bulletin (2/14/2005) taxpayers had to choose between an IRC 1031 tax deferred exchange or an IRC 121 primary residence capital gains tax exclusion. Where a taxpayer may have rented out a property and also used it for more than two years as a primary residence, or where there is a split business/personal use of the property, it is possible to utilize both 1031 and 121 While 121 does not forgive depreciation recapture, you may use 1031 for that amount, if any. IRC 1031 AND PRIMARY RESIDENCES Effective October 22, 2004 IRC 121 was modified to provide for a five year waiting period for property acquired using an IRC 1031 tax deferred exchange. If property acquired through an IRC 1031 is later converted to a primary residence the taxpayer must own it for five years before they may obtain the benefits of IRC 121. Earliest date you can claim an IRC 121 exclusion is five years.

4 IRC 121 PRIMARY RESIDENCE RULE CHANGES Housing Assistance Tax Act of 2008 (H.R. 3221) will affect any taxpayer selling their primary residence as defined in IRC 121 if they do not continuously use their property as their primary residence for the five years preceding the date of sale. Previously, so long as you used the property as a primary residence for 2 out of the previous 5 years you would be entitled to 100% of the capital gains tax exclusion of 121. H.R modifies 121 to provide that the exclusion will not apply to periods of non-qualified use prior to being used as a primary residence. However, non-qualified use after the property was a primary residence will not count against the homeowner. IRC 121 PRIMARY RESIDENCE RULE CHANGES IRC 121 Primary Residence Exemption Year Scenario 1 Scenario 2 Scenario Rent Live in Live in Rent Live in Live in Live in Live in Live in Live in Rent Live in Live in Rent Rent Live in Exemption Amount $300,000 $500,000 $416,667

5 IRC 1031 INVESTMENT & BUSINESS PROPERTY IRC 1031 TAX DEFERRED EXCHANGES No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment. Deferral of tax, NOT a tax free transaction.

6 IRC 1031 STEPS 1 SELL the Relinquished Property in coordination with a Qualified Intermediary 2 INDENTIFY the Replacement Property within 45 days of the sale of the Relinquished Property 3 ACQUIRE the Replacement Property within 180 days from the sale of the Relinquished (caveat- the tax filing date) LIKE KIND REAL PROPERTY INTENT Intent: actions over a period of time. LIKE KIND Held for productive use in a trade or business. or Held for investment purposes.

7 LIKE KIND REAL PROPERTY LIKE KIND PROPERTY REVENUE PROCEDURE Vacation Homes A dwelling unit qualifies for IRC 1031 treatment under the safe harbor if it is owned for 24 months and during such period: 1) The property is rented at fair rental for 14 days or more each year; and 2) The taxpayer s personal use does not exceed the greater of 14 days or 10% of the days rented. If a taxpayer reports a transaction as an exchange expecting to meet the standards, but ultimately does not, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange. It is just a safe harbor. An exchange may still fall outside the parameters and meet the statutory requirements, but you should expect heightened scrutiny in such a case.

8 Tax Court Memorandum Goolsby v. Commissioner (April 1, 2010) The Tax Court denied the exchange when the taxpayer moved into the replacement property two months after acquiring it. Minimal efforts to rent (merely placed an ad for a couple of months with no further effort to gain rental exposure). Taxpayer began preparations to finish the basement within two weeks of purchase. The court also found the taxpayer liable for accuracy related penalty due to a substantial understatement of tax, as they failed to provide any evidence they acted with reasonable cause and in good faith. LIKE KIND PERSONAL PROPERTY LIKE KIND NOT LIKE KIND

9 1031 RULES DELAYED EXCHANGE TIME LIMITS 45 DAY IDENTIFICATION RULE Exchanger has 45 days from the date of the sale of the first property to identify potential replacement property. 180 DAY EXCHANGE PERIOD Exchanger has 180 days from the date of the sale of the first property, or the date upon which Exchanger has to file its Federal tax return for the year in which the relinquished property was sold, to complete the acquisition of all replacement properties.

10 DELAYED EXCHANGE TIME LIMITS There are no individual extensions. 45 and 180 days are calendar days, not business days. Time limits begin to run on the earlier of the date the taxpayer transfers the benefits or burdens of ownership of the first relinquished property to a buyer, or recording a deed evidencing a transfer, whichever occurs first. IDENTIFICATION RULES THREE PROPERTY RULE Exchanger may identify up to three properties regardless of value. 200% RULE Exchanger can identify an unlimited number of properties, provided that the total value of the properties identified does not exceed 200% of the value of all relinquished properties. 95% EXCEPTION If Exchanger identifies more than three properties which are worth more than 200% of the value of all relinquished properties then Exchanger must acquire 95% of the value of all properties identified.

11 RULES TO OBTAIN A COMPLETE DEFERAL Napkin Test To be a fully tax deferred exchange, the replacement property must be: Equal or greater in value AND Equal or greater in equity EXCHANGE VESTING ISSUES SAME TAXPAYER REQUIREMENT With very limited exception, the person or entity who relinquishes property must be the same person or entity to buy the replacement property. A good rule of thumb is that you must have the same tax identification number on both sides of the transaction.

12 EXCHANGE VESTING ISSUES STRUCTURING DISOLUTIONS FOR EXCHANGES INVOLVING ENTITIES If you dissolve an entity and make each former member a tenant in common they will be holding property for resale purposes unless done with property planning a year or more in advance of the contemplated sale (a/k/a drop and swap). If more than 50% of members/shareholders/partners wish to the exchange the most expedient solution is to make a distribution at the closing and let the surviving members do the exchange in the name of the entity. Major issue when less than 50% of the ownership interest wants to do an exchange. An existing entity will be deemed a new entity by the IRS if more than 50% of the ownership changes. Partnership Tax Returns Form 1065 (Revised) Form is an information return used to report the income, deductions, gains, losses, etc., from the operation of a partnership. The proposed form 1065 issued on July 24, 2008 (which would apply to returns filed after 12/2008), includes the following questions in Schedule B: 13. Check this box, if during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (including a disregarded entity). 14. At any time during the taxpayer year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in the partnership property?

13 ALTERNATIVE STRUCTURES PARKING ARRANGEMENTS Reverse Exchange Exchanger is acquiring Replacement Property before disposing of Relinquished Property. Improvement Exchange Exchanger wishes to use Exchange Funds to increase the value of the Replacement Property. Reverse/Improvement Exchange Exchanger wishes to acquire and improve Replacement Property before selling Relinquished Property.

14 REVENUE PROCEDURE Effective September 15, 2000 Provides a safe harbor for reverse exchange transactions that stay within the parameters of the Revenue Procedure. Reverse exchanges may be structured outside the safe harbor. REVERSE EXCHANGE Acquire the Replacement Property first. The Qualified Intermediary sets up an EAT to take legal title. Exchanger identifies the Relinquished Property to be sold within 45 days of acquisition of the Replacement Property. Exchanger sells the Relinquished Property within 180 days. The Reverse Exchange can also be set up under an alternative structure whereby the Relinquished Property is deeded to the EAT and the Exchanger takes direct title to the Replacement Property. The same 180 day timeline applies.

15 IMPROVEMENT EXCHANGE Exchange starts out as a forward moving exchange with exchange funds deposited with Qualified Intermediary. EAT uses funds to acquire Replacement Property. Pursuant to Exchanger s instructions EAT enters into construction agreement and uses exchange funds to build improvements to property. All improvements must be made before 180th day. There can be no prepayment of materials or to contractor. IRC DEFERRED SALES TRUSTS

16 DEFERRED SALES TRUST EXAMPLE: Bought a hotel for $5,800,000 Selling the property for $8,000,000 Mortgage Payoff: $2,400,000 Equity Gain: $2,200,000 Depreciation: $400,000 TYPICAL TAXABLE SALE Real Estate Sale Property Purchase Price: $5,800,000 Sale Price: $8,000,000 Mortgage Payoff: $2,400,000 Net Sale Proceeds: $5,600,000 Taxable Gain: $2,600,000 Sale price less the purchase price plus the depreciation equals the capital gain.

17 TYPICAL TAXABLE SALE Real Estate Sale Property Sale Price: $8,000,000 15% Federal and 7% State taxes: *Each state's tax varies and therefore the calculations herein vary. Depreciation lowers basis which increases Gain. Taxable Gain: $2,600,000. Depreciation: $400,000 Taxes: $584,000 $5,016,000 After Tax Proceeds STRUCTURE OF A DEFERRED SALES TRUST Trustee Step 1 Investors retain a DST Trained and Licensed Tax Attorney to create the Deferred Sales Trust.

18 STRUCTURE OF A DEFERRED SALES TRUST Sell Property Trustee Sale Price: $8,000,000 Step 2 Investors sell their assets to the Trustee of a Dedicated Trust (the DST). STRUCTURE OF A DEFERRED SALES TRUST Sell Property Trustee Sale Price: $8,000,000 Step 3 The Trustee sells the real estate to a new buyer for cash. Net Sale Proceeds: $5,600,000

19 STRUCTURE OF A DEFERRED SALES TRUST Sell Property Trustee Sale Price: $8,000,000 Installment Note Step 4 The trustee pays Investors an 8% interest only annual installment payment of $448,000. Installment payments can be designed depending on their goals and estate planning objectives. TAXABLE SALE VS. DEFERRED SALES TRUST Sale Property Real Estate Sale Price: $8,000,000 Normal Transaction: Sales proceeds after taxes paid: $5,016,000 Earn 8% Annual Interest Income of $351,120 DST Transaction: Taxes deferred, sales proceeds is: $5,600,000 Earn 8% Annual Interest Income of $392,000 DST Income difference is 12% or $40,880 per year

20 DEFERRED SALES TRUST ADVANTAGES Use of Installment Method Allows the sale of assets under a seller carry back arrangement where taxes on the gain are paid over time as payments are received, without the level of risk of not getting paid from the buyer. Security Installment Note Payments are typically secured by the Trustee of the DST and directly against the DST assets. Cash Out Avoid the hazards of a typical seller carry back arrangement with the possibility of a default under an installment sale from a new buyer. Defers capital tax Income tax savings When highly appreciated property is sold the seller defers recognition of gain until receipt of payments. Maintains Family Wealth Maintains wealth within the family. DEFERRED SALES TRUST DISADVANTAGES Mortgage pay-off in excess of adjusted basis is not deferrable. Must adhere to the formalities imposed by Internal Revenue Service and Treasury Regulations. Fees to structure are often higher than strategies such as the 1031 exchange. Reinvestment of the proceeds may involve more or less risk, including fluctuating returns and possible loss of principal, depending on where the proceeds are reinvested.

21 THANK YOU FOR ATTENDING! Ph 877/ Fax 877/