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©Dearborn Real Estate Education, 2007 1 Understanding 1031 Tax-Free Exchanges, 2 E
©Dearborn Real Estate Education, 20072 Course Objectives By the end of this course, you will: ► Discuss the basic rules of an exchange ► Go through an example of an exchange ► Have forms to execute a 1031 tax-free exchange
©Dearborn Real Estate Education, 20073 Course Foundations ► This course is not designed to substitute for the use of a Certified Public Accountant (CPA) or Tax Lawyer ► Your role is as presenter of concepts to be verified by your client’s tax professional ► Do not hold yourself out as being a 1031-expert, tax consultant, or estate planner
©Dearborn Real Estate Education, 20074 Course Benefit ► The ability to properly explain and competently execute a 1031 Tax-Free Exchange can set an agent apart from his or her competition. This expertise can help your clients avoid significant tax liability.
©Dearborn Real Estate Education, 20075 Key Vocabulary ► Property your client wants to sell is called the old property or the relinquished property ► Property your clients wants to purchase (exchange for) is called the new property, or the replacement property ► When executing a 1031 exchange, sale refers to the marketing of the relinquished property; purchase refers to the acquisition of the replacement property
©Dearborn Real Estate Education, 2007 6 Chapter One General Discussion of Taxes
©Dearborn Real Estate Education, 20077 Income Taxes ► Taxes on ordinary/earned income ► Taxes on unearned income Interest Dividends Rental Capital gains/losses
©Dearborn Real Estate Education, 20078 Capital Gains Taxes ► Capital gains result form the sale of assets ► If you acquire an asset and then sell the asset, you may have either a capital gain or a capital loss
©Dearborn Real Estate Education, 20079 Long-Term Capital Gains ► A gain on the sale of an investment held “more than one year” is treated as long- term capital gain ► As of 2003, maximum tax rate for long- term capital gains is 15% (5% for people in the two lowest tax brackets).
©Dearborn Real Estate Education, 200710 Depreciation ► The Modified Accelerated cost Recovery System (MACRS) extends depreciation over 27.5 years for residential real estate and 39 years for commercial real estate. ► Taxpayer may only use straight-line depreciation. ► Land is not depreciable. ► Calculating Depreciation
©Dearborn Real Estate Education, 200711 Computing Capital Gains Three Step Process ► Step One: Determining the Cost Basis of Property ► Step Two: Determining the Adjusted Sales Price ► Step Three: Computing Capital Gain
©Dearborn Real Estate Education, 200712 Computing Capital Gain ► Step One: Determining the Cost Basis of property Original Cost Basis (Purchase Price) Original Cost Basis (Purchase Price) +Cost to Purchase +Capital Improvements -Depreciation Taken (if any) =Adjusted Cost Basis
©Dearborn Real Estate Education, 200713 Computing Capital Gain ► Step Two: Determining the Adjusted Sales Price Sales Price Sales Price -Cost to Sell =Adjusted Sales Price
©Dearborn Real Estate Education, 200714 Computing Capital Gain ► Step Three: Computing Capital Gain Adjusted Sales Price Adjusted Sales Price -Adjusted Cost Basis =Capital Gain
©Dearborn Real Estate Education, 200715 ADJUSTED COST BASIS OWNER- OCCUPANT INVESTOR Purchase Price $230,000$230,000 Depreciation-0-$105,000 Adjusted Cost Basis $230,000$125,000
©Dearborn Real Estate Education, 2007 16 Chapter Two Installment Sales
©Dearborn Real Estate Education, 200717 Installment Sale Defined Installment sale takes place when the seller (through a real estate listing agent) offers to sell the property by taking back owner financing. Can be structured in many ways
©Dearborn Real Estate Education, 200718 Installment Sale Advantages To the buyer Low closing costs Fast closing To the seller Fast closing Creation of annuity Future property taxes paid by buyer Buyer purchases homeowner insurance policy showing seller as first mortgagee Buyer responsible for maintenance Seller collects negotiated interest rate Spreads capital gains tax over the term of payments
©Dearborn Real Estate Education, 200719 Installment Sale Disadvantages Buyer may default Prepayment may be costly to seller Bankruptcy
©Dearborn Real Estate Education, 2007 20 Chapter Three The 1031 Tax-Free Exchange
©Dearborn Real Estate Education, 200721 Tax-Free Exchange Defined ► Method of selling a capital asset, like real estate, according to certain prescribed rules and procedures in such a manner that all or most of the capital gains taxes will be deferred to the future. ► Taxpayer is not selling capital asset, but reorganizing his/her investment.
©Dearborn Real Estate Education, 200722 History of Tax-Free Exchanges ► 1921-1928First tax-free exchanges executed ► 1954Congress passed Section 1031 of the Internal Revenue Code
©Dearborn Real Estate Education, 200723 Key Wording of Section 1031 “No gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.”
©Dearborn Real Estate Education, 200724 Why would a client want to exchange?
©Dearborn Real Estate Education, 200725 Types of Property and 1031-Tax- Free Exchanges ► Allowed by IRS on: Property held for the productive use in trade or business Investment property ► Not allowed by IRS on: Principal residences, second homes, and time- shares purchased for personal use Inventory property
©Dearborn Real Estate Education, 200726 Types of Exchanges ► The Simultaneous Exchange ► Reverse Starker Exchange
©Dearborn Real Estate Education, 200727 The Simultaneous Exchange ► Also known as straight exchange or simple exchange ► Exchanges are based on equity ► Boot is taxable to the recipient; may be partially offset by deductible closing costs ► All mortgages have to be factored into the equation
©Dearborn Real Estate Education, 200728 Simultaneous Exchange Example Property A Property B Value$100,000$120,000 Mortgage balance $ -50,000 $ -80,000 Equity $ 50,000 $ 40,000 Cash boot $ 10,000
©Dearborn Real Estate Education, 200729 Simultaneous Exchange Example (con’t) OWNER A Relieved of mortgage $50,000 Assumes/Creates mortgage $80,000 ($30,000) This figure will factor into the cost basis of new property B. Boot received $10,000 $10,000 Capital Gain Income Pay taxes in the year of the exchange
©Dearborn Real Estate Education, 200730 Simultaneous Exchange Example (con’t) OWNER B Relieved of mortgage $80,000 Assumes/Creates mortgage $50,000 +$30,000 Paid Boot Cash -$10,000 Net Boot $20,000 Will report $20,000 in Boot Capital Gain Pay tax in year of exchange.
©Dearborn Real Estate Education, 200731 100 Percent Tax-Free Exchange Buy up, Mortgage up, and Spend all the money
©Dearborn Real Estate Education, 200732 Starker vs. The IRS ► Establishment of deferred exchange ► Three-party exchange
©Dearborn Real Estate Education, 200733 Reverse Starker Exchange ► Initially, IRS chose to do nothing ► September 2000, IRS guidelines approve Reverse Starker Exchanges and outline rules for them ► IRS has also established specific requirements to execute an exchange and redefined the meaning of “like kind”
©Dearborn Real Estate Education, 2007 34 Chapter Four The Law and the Rules
©Dearborn Real Estate Education, 200735 Key Wording of Section 1031 “No gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.”
©Dearborn Real Estate Education, 200736 “Held” Law not specific Assumption of one year In case of “related exchange”, two years Always consult with tax professional
©Dearborn Real Estate Education, 200737 “Like Kind” 1990 rewrite of Section 1031 redefined like kind, allowing tax-free exchange of any real estate for any real estate as long as it is “property used in the productive use in trade or business or investment property” New rules do not allow an exchange of a principal residence, second home, a time share, or inventory property
©Dearborn Real Estate Education, 200738 Leases for More than 30 Years Leases for more than 30 years qualify as real estate for 1031 exchange purposes 20-year lease with two 10-year options would quality
©Dearborn Real Estate Education, 200739 If IRS Finds Sale Did Not Qualify for 1031 ► IRS will not allow the deferral of tax liability afforded under Section 1031 ► Taxpayer will have to pay the taxes, interest, and penalty ► Taxpayer may not have the cash to pay, if all proceeds were used to purchase additional property
©Dearborn Real Estate Education, 200740 45-Day Identification Rule ► Replacement property must be closed OR identified within 45 days Taxpayer can gain additional time by “identifying” the subject properties for a total of 180 days Changes in identified property must be accomplished within the 45-day time period After 45 days, taxpayer may not change list of identified properties and must purchase some or all
©Dearborn Real Estate Education, 200741 Three-Property, 200 Percent, and 95 Percent Rules ► Only apply when a taxpayer identifies replacement properties (do not apply if taxpayer is able to purchase all replacement properties within the 45 day clock) ► These rules apply if taxpayer needs additional time to close the purchase of replacement properties and obtains the time by “identifying” ► Taxpayer must meet one of these three alternative rules
©Dearborn Real Estate Education, 200742 Alternative 1: Three-Property Rule ► If no more than three properties are identified, the replacement properties may be of any value, individually or collectively. ► Of importance if taxpayer has already closed on one or two replacement properties but runs out of time ► Properties acquired during the 45-day period count toward the three-property rule.
©Dearborn Real Estate Education, 200743 Alternative 2: 200 Percent Rule ► If taxpayer identifies more properties than allowed by the three-property rule, the total value of all purchased replacement properties may not exceed 200 percent of the total sales price of all relinquished properties. ► Properties acquired during the 45-day period count toward the 200 percent rule requirement.
©Dearborn Real Estate Education, 200744 Alternative 3: 95 Percent Rule ► If taxpayer identifies more properties than allowed by the three-property rule, and the 200 percent rule has been exceeded, the taxpayer must purchase, by the end of the exchange period, enough replacement properties to equal at least 95 percent of the fair market value of the identified replacement properties.
©Dearborn Real Estate Education, 200745 180-Day Rule ► Once the taxpayer identifies, additional time is allowed to close the purchases of the replacement property. For closings January 1 – June 30, 180-day rule simple For closings after July 1, the tax-deadline of April 15 requires careful planning
©Dearborn Real Estate Education, 200746 Proceeds of Sale of the Relinquished Property ► Any money resulting from the sale of the relinquished property not invested in the replacement property will go to the taxpayer—boot. ► Boot is taxable in year received.
©Dearborn Real Estate Education, 200747 Safe Harbor/Qualified Intermediary ► Taxpayer may not be in either actual or constructive receipt of the money ► Prior to the closing of the relinquished property, the taxpayer must enter into an “exchange agreement” with a qualified intermediary/safe harbor ► Four safe harbors: Security or guarantee arrangements Qualified escrow accounts and qualified trusts Qualified intermediaries Interest and growth factors
©Dearborn Real Estate Education, 200748 Who Qualifies as a Safe Harbor? ► Any CPA, an attorney, or any trust department of a bank, as long as the professional or bank has not performed any work for the taxpayer for the past two years ► Companies established to act as safe harbors, such as Investors Title Exchange Corporation and Lawyers Title Agency
©Dearborn Real Estate Education, 200749 Functions of a Safe Harbor ► “Dock” the proceeds of sale in a reliable account ► Pay interest on the funds if agreed upon in the “exchange agreement” ► Disburse these funds to close the purchase of the replacement properties at the direction of the taxpayer or the taxpayer’s representative ► Account to the taxpayer for the funds
©Dearborn Real Estate Education, 200750 Additional 1031 Rules ► Interest-bearing account—taxpayer receives 1099 when account is closed ► Cost basis is carried over to the replacement property. ► Depreciation on replacement property is recomputed by tax professional—no start over
©Dearborn Real Estate Education, 200751 Properties Eligible for 1031 Exchanges ► If relinquished property is in the United States, Washington DC, or U.S. territories, the replacement properties must also be in the U.S., DC., or U.S. territories. ► It is permissible to purchase a lot and hire a builder to construct improvements. ► If improvements cannot be completed by the 180 th day, close the purchase and the IRS will count only the cost of the lot and the finished improvements as of the day of the closing for 1031 purposes. ► Foreign exchanges are acceptable when both relinquished and replacement property are not in U.S., DC, or U.S. Territories.
©Dearborn Real Estate Education, 200752 Title Rule ► Whoever has title to the relinquished property must take title to the replacement property
©Dearborn Real Estate Education, 200753 Reducing Future Tax Liability
©Dearborn Real Estate Education, 200754 Replacement Property Issues ► Rules about using funds from the sale of a relinquished property to improve the replacement property that needs work or that is vacant are not clear; taxpayer’s CPA should advise
©Dearborn Real Estate Education, 2007 55 Chapter Five The Paperwork
©Dearborn Real Estate Education, 200756 Forms Required for a 1031 IRS Form 8824: Like Kind Exchange The Exchange Agreement Exhibits to the Exchange Agreement
©Dearborn Real Estate Education, 200757 Forms Required for a 1031 Relinquished Property Assignment Replacement Property Assignment Addendum to Closing Statement
©Dearborn Real Estate Education, 200758 Forms Required for a 1031 Suggested language for real estate contracts
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