New Tax News for 2016 Regarding FIRPTA

FIRPTA increases from 10% to 15%.

Currently if a foreign person sells United States real estate the buyer is required to withhold 10% of the gross sales price and remit this to the IRS. However pursuant to the Protecting Americans from Tax Hikes Act of 2015 closings as of February 16, 2016 the FIRPTA will increase in most instances from 10 to 15%.

Congress created FIRPTA based on reports that foreign investors were purchasing U.S. real estate and then selling it at a profit without paying any U.S. taxes. Consequently, FIRPTA created a requirement forcing buyers to withhold 10 percent of the purchase price and remit it to the Internal Revenue Service at the time of closing, subject to a few exceptions.

The settlement agent is the party that withholds and remits the funds to the IRS, but the buyer is legally responsible.

A few exceptions are noted in the below. First is that at a sales price of $300,000 or less and buyer acquires as a principal residence there is no withholding.  Second is a sales price of $300,000 to $1,000,000 and the buyer acquires as a principal residence the withholding is 10%.

Other exceptions are:

No withholding is required under the following additional circumstances:

•    Seller provides Non-Foreign Affidavit

•    Seller  provides a Withholding Certificate from the IRS which excuses the withholding

•    The amount realized by the seller is zero

•    The property is acquired by the United States or a political subdivision thereof

1031 Exchange Rules

Rule # 1 Both the relinquished property and replacement property must be held for investment purposes or used in a business and be ‘like kind’.

Rule # 2 The IRS requires the investor to identify the replacement property or properties within the 45 day ‘identification period’. The identification period begins the day of closing of the relinquished property. The replacement properties much be properly identified by the Exchanger.

They may identify up to three replacement properties regardless of market value (Three Property Rule). Or they may identify unlimited number of properties provided that the total value not exceed 200% of the relinquished property (200% Rule. The minimum requirement is 95% of the value of the relinquished property

Rule #3 You must close on the replacement property the earliest of within 180 days of the closing of the relinquished property or the due date of the tax return or file an extension. And this is 180 calendar days … no time off for weekends or holidays.

Rule #4 On a delayed exchange, you must work with an IRS approved Qualified Intermediary.

For more detail

Four Basic Rules of a 1031 Exchange

IRS Section 1031 Exchange Basics

Since we’re getting into tax season, I’m getting more calls over the last few days regarding the basics of a 1031 delayed or reverse exchange so I thought it best to review some of the most important aspects of  a 1031.

This allows investors to use all of the sale proceeds to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate holdings. And notice that I wrote “all of the sales proceeds”. If that rule is not followed, then you would have to pay ‘boot’ on the proceeds taken out of the 1031. This isn’t tax fraud, but does seem to invite an audit.

I get a number of question regarding what type of property qualifies for a §1031 tax deferred exchange. The Internal Revenue Code Section 1031 states that “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.” “Like-kind” property can include, but is not limited to, any of the following, provided it is held for investment:

  • Single Family Home Used as a Rental
  • Duplex
  • Apartment
  • Commercial Property
  • Undeveloped Land

For example, raw land can be exchanged for a single family rental, or apartments or a commercial building. Properties can be exchanged anywhere within the United States.

Another question I get from sellers new to this process is “does the 1031 exchange need to simultaneous”? No, contrary to what some property owners envision, a §1031 tax deferred exchange is rarely a simultaneous two-party swap. In fact, I’ve never done one.  Most exchanges are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of the replacement property. They must identify the potential replacement property (or properties) within 45 calendar days from closing on the relinquished property.

When can you use section 1031 exchange? It is applicable whenever a property owner intends to sell any property that is not their primary residence, and falls under the definition of “like-kind” and plans to BUY another ‘like-kind’ ‘replacement’ property within 180 calendar days following the closing of the relinquished property.

Paramount to any exchange is a competent and experienced Qualified Intermediary. A few intermediaries filed for bankruptcy during the last crash and left the exchanger contractually obligated to complete the purchase plus they owed the capital gains taxes and without the funds held by the bankrupted intermediary. I sure there are bigger disasters that one can encounter, but that’s up there.

1031 Exchanges – October 18 to December 31 2012

This is review and reminder to a post earlier in the year.

A 1031 exchanger must complete the acquisition of a replacement property in a 1031 exchange before midnight on the earlier of the 180th day after the date the relinquished property was transferred, or the due date (including extensions) for the income tax return for the taxable year in which the transfer of the relinquished property occurs. (U.S. Treasury Regulations section 1.1031(k)-1(b)(2)).

Even though an exchanger may be entitled to a tax extension, they must actually file IRS Form 4868 with the IRS to obtain the tax extension. Consequently, some exchangers closing late in 2012 may need to file for an extension to have the benefit of the entire 180-day exchange period. As a general rule, exchangers should not file a 2012 Federal Income Tax return until the 1031 exchange is complete.

More specifically, if the 180th day following the closing of the first relinquished property falls after the due date for filing the 2012 tax return (generally April 15, 2013 for individuals), an exchanger must file IRS Form 4868 with the IRS to actually extend the filing date. If a 1031 exchanger does not file for such an extension, they will not be able to acquire any replacement property in an exchange after the tax return due date.

FASB / IASB New Accounting Rules on Lease Expenses

Randyl Drummer from CoStar News reported that after months of negotiations the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) agreed on accounting rules regarding how companies should account for lease expenses on their balance sheets by agreeing on two methods instead of one unified approach.

The two boards have agreed that companies should be required to capitalize leases on their balance sheets as assets and liabilities as the primary part of the revision of lease accounting rules.   However, they have not been able to reach a consensus on the method that the leasee should use to record leases expenses under various types of leases including ground and property leases and equipment leases.

In spite of the apparent compromise detail of the classifications may cause further conflicts between property owners and leasees.  “The positive is that the board understands that there are many types of leases and motivations for leasing, and it’s not just a form of financing,” said Mindy Berman, managing director of capital markets for Jones Lang LaSalle Berman. “That’s the big breakthrough we’ve been working on for more than a year.”

CoStar News – Article – Rule Makers Reach Compromise On Lease Accounting Approach

1031 Exchange Tax Court Case

1031 ExchangesThere’s a relatively new U. S. Tax Court case Reesink v. Commissioner, (April 23, 2012) T.C. Memo 2012-118, that could be of interest regarding a 1031 exchange.

The Reesinks, husband and wife, purchased a residential residence for investment purposes to use as a residential rental. The Reesinks after much effort over a period of eight months were unable to find to find a tenant and obtain the rent they wanted so they moved in and sold their then current home.

Tax Court found that the Reesinks “intended” to hold the rental property as an investment at the time they engaged in the 1031 exchange and purchased the residential rental as the ‘upleg’ or replacement property as its known to the IRS.

1031 Exchange, U.S. Tax Court, Intent to Hold for Investment, Reesink v Comm

Capital Gains Versus a 1031 Exchange

1031 ExchangesThis is part four in my series on 1031 exchanges.  Keep in mind that I’m using the current capital gains rate of 15%.  Depending what happens on November 6th, these number may change … radically.

See attached for calculations

One of the primary advantages of a 1031 exchange is not just the tax savings, but the purchasing power it can create.  Using some leverage, the Exchanger can purchase two to three times more investment real estate for the replacement property.

Investors are shocked to find out that capital gains can be far high than the federal rate when you add state taxes.  In California for example, capital gains are taxed at the earned income rate. Plus, depreciation taken over the ownership period is taxed at 25%, resulting in a sizable percentage of the profits to paying taxes. Under the 4th calculation, the net equity times three (assuming a 33% down payment) is the value of property you could purchase after paying all capital gain taxes.

Using a 1031 exchange allows the exchanger to defer all capital gains taxes allowing to use the entire proceeds of the relinquished property to acquire considerable more real estate as the replacement property(s)

Calculating Capital Gain for 1031 exchange

Why Do a 1031 Exchange?

1031 ExchangesUnfortunately, we may have a much better reason in a few months to do a 1031 exchange when and if the Bush tax cuts expire.  However, there will likely be folks who decide to cash out and sell before the new rates take effect.  Frankly, that make a bunch of sense if the new rates are going to be at or near the earned income rate.

However, for the purposes of this post, which is the third in my miniseries on 1031 exchanges, let’s look at the five primary reasons for doing a 1031 exchange.

Preservation of equity

A properly structured and executed  1031 exchange provides the investor with the opportunity to defer 100% of federal and state capital gains taxes.  This, for all practical purposes, provides the investor an interest free no term loan on taxes due until the property is sold.  Capital gains taxes can be delayed indefinitely by exchanging from one property to the next thereby greatly increasing the value of their investments over time.

Leverage

Many investors 1031 exchange from a property that is free and clear into a more valuable property using some leverage.  A larger property provides more cash flow plus a greater depreciation write-off, which increases the return on investment.   This of course depends on market interest rates being lower than market caps rates.   If market caps are 6% and the market interest rate is 7% then this isn’t going to much help.

Conversely, if an investor owns a property free and clear in a 4 ½ cap market and sells, does a 1031 exchange, and invests in one or more (200% rule applies) properties at a 6% cap with 50% leverage, there can be a huge increase in after tax cash flow.

Diversification

1031 exchanges allow an investor to diversify to other geographic regions or to other products types.  If an investor owns in a cyclical market such as LA with huge swings up and down, it would be possible to diversify some of those holding into markets such as the plain states or certain cities in the Midwest where average appreciation is lower, but a far more linear market plus the cap rate is a couple of points higher.

Another possibility is exchanging from high maintenance PITA multifamily residential into absolute net retail where there are properties with no landlord responsibilities. .

Management Relief

This one ties in the above  a bit.  Maybe you as an investor have accumulated a large portfolio of multifamily residential properties over the years and you’re not quite as young as you were 15 or 20 years ago so you might be looking for a way to reduce the multifamily residential headaches by doing a 1031 exchange on some of your properties into absolute net or triple net retail or even net leased distribution or warehouse.

Estate planning

I’ve had several calls just like this recently.   Sometimes a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property, which they can either hold or sell.

Five Reasons to do a 1031 Exchange

 

1031 Exchange Basics

1031 ExchangesThis allows investors to use all of the sale proceeds to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate holdings.  And notice that I wrote “all of the sales proceeds”.  If that rule is not followed, then you would have tp pay ‘boot’ on the proceeds taken out of the 1031.  This isn’t tax fraud, but does seem to invite an audit.

I get a number of question regarding what type of property qualifies for a §1031 tax deferred exchange. The Internal Revenue Code Section 1031 states that “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.” “Like-kind” property can include, but is not limited to, any of the following, provided it is held for investment:

  • Single Family Home Used as a Rental
  • Duplex
  • Apartment
  • Commercial Property
  • Undeveloped Land

For example, raw land can be exchanged for a single family rental, or apartments or a commercial building. Properties can be exchanged anywhere within the United States.

Another question I get from sellers new to this process is “does the 1031 exchange need to simultaneous”?  No, contrary to what some property owners envision, a §1031 tax deferred exchange is rarely a two-party swap. In fact, I’ve never done Most exchanges are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of the replacement property. They must identify the potential replacement property (or properties) within 45 calendar days from closing on the relinquished property.

When can you use section 1031 exchange?  It is applicable whenever a property owner intends to sell any property that is not their primary residence, and falls under the definition of “like-kind” and plans to BUY another ‘like-kind’ ‘replacement’ property within 180 calendar days following the closing of the relinquished property.

Paramount to any exchange is a competent and experienced Qualified Intermediary.  A couple of intermediaries went BK during the crash.  I can’t think of too many bigger disasters than that  Asset Preservation is the entity which structures, guides and documents the exchange transaction from beginning to end.

Introduction to 1031 Exchanges

1031 ExchangesI’m going to create a series of posts on 1031 exchanges over the next couple of month from the basics, starting with this post to the more complex.

First of course is the disclaimer:  always seek professional help through your tax attorney and/or CPA before and during an exchange.  I am a commercial real estate professional and not an attorney or CPA.  That said, with the number of 1031 exchanges I’ve done, I’m pretty familiar with the rules, strategies, and tactics, so let’s get started.

IRC Section 1031 has been around since 1921 and is one of the last significant tax advantages for the real estate investor.  It could become even more important if the capital gains rate rises after the election and that rise could be to the earned income rate.

The IRS allows up a maximum of 180 calendar days for completion of 1031 exchanges, and not a day more, between the sale of the ‘relinquished property’ and the purchase and closing of the ‘replacement property’.  Within the 180 days the investor must properly identify suitable replacement properties and close on one or more of these properties one or before the 180 days.

I will say that if the capital gains rates go up substantially there will be investors who will decide to liquidate, get out and pay the 15% rate prior to the rate increase.   In fact, I expect to see quite a bit of this.   For the purposes of this post, let’s assume that you’ve chosen to do the 1031 exchange and review the four primary rules.

Rule # 1  Both the relinquished property and replacement property must be held for investment purposes or used in a business and be ‘like kind’.

Rule # 2  The IRS requires the investor to identify the replacement property or properties within the 45 ‘identification period’.  The identification period begins the day of closing of the relinquished property.   The replacement properties much be properly identified by the Exchanger.

They may identify up to three replacement properties regardless of market value (Three Property Rule).  Or they may identify unlimited number of properties  provided that the total value not exceed 200% of the relinquished property (200% Rule.  The minimum requirement is 95% of the value of the relinquished property

Rule #3  You must close on the replacement property the earliest of within 180 days of the closing of the relinquished property or the due date of the tax return or file an extension.  And this is 180 calendar days … no time off for weekends or holidays.  1031 exchanges must be completed on time or pay boot.

Rule #4  On a delayed 1031 exchange, you must work with an IRS approved Qualified Intermediary.

See the attached for more detail.

Intro to Delayed Exchanges

Possible Capital Gains Tax Rate Changes for 2013

Given that election time is but six months away, I’m hearing a bunch of ‘what if’ discussion from clients, friends and other commercial brokers regarding potential tax ramifications with the Bowles – Simpson Plan, the Ryan Plan and the Buffet Rule and the ramifications if you choose not to do a 1031 exchange.

I don’t think any of these stand a chance of passing in their current form by the current congress.  Of course we have November 6th ahead, and the POTUS, new congress and the control of the senate up for grabs.  Who knows what could happen.  Even if Obama is reelected, and I think there’s a 60-40 chance of that.  If the Republicans can hold the house or capture the senate, we probably don’t have a lot to worry about.  If the Democrats win it all, I think we have a bunch to worry about.  I think it’s a certainty that the 15% capital gains rate is a goner.  If it goes to 20% or 28% or even the earned income rate, what do we do?

If it looks like the Dems are going to win it all, we’ll probably see quite a bit of selling to just cash out, pay the current 15% long term rate and be done with it.  That’s a viable option.   Of course if that’s your decision I will be happy to list your property.

There’s much uncertainly ahead regarding exit strategies given what could happen with capital gains tax rates.   What is fairly certain is the option of a 1031 exchange to kick the ball down the road a bit until tax rates are once again favorable to cash out.

With the retail product of choice that’s so hard to find: triple net or absolute net, single tenant, long corporate lease with a credit tenant that’s S&P BBB or better, there’s always the possibility of doing a reverse 1031 exchange.   I’m talking about retailers and fast food such as Walgreens, CVSs, 7-Elevens, Circle Ks, McDonalds, Taco Bell / KFCs, etc.

I’ve attached a link below to one page flyer that examines the three plans put forth that I mentioned in the first paragraph versus doing a 1031 exchange.

As always, if you have any questions, call me, Scott Harris at 310-473-4789 or 614-905-6614 and I’ll do my best to answer your question or find a source who can answer your question.

2013 Capital Gains Possible Tax Rates

Dividend Tax Hike Coming for 2013

As many of us are aware, unless congress takes action, the top tax rate of dividends will increase from the current 15% to 43.4% next year.   That’s a top ordinary income rate of 39.5% plus the 3.8% on investment income as part of Obamacare passed in 2009. 

Another good reason for commercial real estate and the potential of doing a 1031 exchange when it comes time to dispose of an investment property. 

Smart Money.com – Investment strategies – Preparing for taxes on dividends to increase

Columbus / Central Ohio Owners – Property Tax Appeals Due March 31st

This is the last reminder because valuation appeals are accepted from December to March 31.  Your chances of winning are about half so it’s well worth doing, but must be done correctly and very soon.  It’s the 27th so get moving.   Lock your new, hopefully lower, valuation in for three years.

Take a look at the short article at the link.

Columbus Realtors.com – News – Property Tax Appeals

Below is the form for Delaware County

http://www.co.delaware.oh.us/forms/pdf/Auditor/Property%20Value%20Comp.pdf

Franklin County form and instructions

http://www.housecolumbusohio.com/home/services/Tax_Appeal.html

IRS Dirty Dozen Scams for 2012

http://www.irs.gov/newsroom/article/0,,id=254383,00.html

It’s that time of the year again.  This one is scary.  It’s bad enough having your identity stolen let alone have the perp file a fake tax return and claim and receive a refund check.

Identity Theft

Topping this year’s list Dirty Dozen list is identity theft. In response to growing identity theft concerns, the IRS has embarked on a comprehensive strategy that is focused on preventing, detecting and resolving identity theft cases as soon as possible. In addition to the law-enforcement crackdown, the IRS has stepped up its internal reviews to spot false tax returns before tax refunds are issued as well as working to help victims of the identity theft refund schemes.

Identity theft cases are among the most complex ones the IRS handles, but the agency is committed to working with taxpayers who have become victims of identity theft.

The IRS is increasingly seeing identity thieves looking for ways to use a legitimate taxpayer’s identity and personal information to file a tax return and claim a fraudulent refund.
 
An IRS notice informing a taxpayer that more than one return was filed in the taxpayer’s name or that the taxpayer received wages from an unknown employer may be the first tip off the individual receives that he or she has been victimized. 

The IRS has a robust screening process with measures in place to stop fraudulent returns. While the IRS is continuing to address tax-related identity theft aggressively, the agency is also seeing an increase in identity crimes, including more complex schemes. In 2011, the IRS protected more than $1.4 billion of taxpayer funds from getting into the wrong hands due to identity theft.

In January, the IRS announced the results of a massive, national sweep cracking down on suspected identity theft perpetrators as part of a stepped-up effort against refund fraud and identity theft.  Working with the Justice Department’s Tax Division and local U.S. Attorneys’ offices, the nationwide effort targeted 105 people in 23 states.

Anyone who believes his or her personal information has been stolen and used for tax purposes should immediately contact the IRS Identity Protection Specialized Unit.  For more information, visit the special identity theft page at www.IRS.gov/identitytheft.  

Triple Net Leases – Property Tax Reimbursement

I few posts ago I promised that I would go into greater detail regarding aspects of a commercial lease that the prospective buyer needs to examine carefully.  

Without the underlying leases the property is worth replacement costs and comps of similar vacant property.   Given that the cash flow of the leases in place is what you paying for, it’s a good idea to make sure that you’re getting what you think you are.  It’s also an excellent idea that the in place tenants understand what they signed.  Do I have stories of things gone wrong – you betcha!

One of the factors that concern me most on a new build, especially a multi tenant new build, is property taxes.  I’m not nearly as concerned with large national credit tenants in single tenant properties.  Those folks know how it works.  What I’m much more concerned with is a new build, multiple tenant property with local tenants on triple net leases.  Maybe this is the first or second lease they’ve done during the life of their business.  And what if that new build was on unimproved land and taxes reset on a triennial basis or when the property sells?  You already know where I’m going with this?  Actually, all of this is pretty common set of circumstances. 

continued on page 2

IRS – $25,000 Passive Activity Loss Limit on Rental Property

Linked is a US Tax Court case ruling that came down earlier this year that emphasizes the 750 + hour per year active management requirement and documentation required.  Also Discussed in the IRC 469 document is the $25,000 special passive activity loss allowance.

Now that were little more than a month from year end, it’s not a bad idea to think about this one.

http://www.ustaxcourt.gov/InOpHistoric/b2ailey.sum.WPD.pdf

http://www.irs.gov/businesses/small/article/0,,id=146326,00.html

IRS 1031 Exchanges from Fee Simple into Leasehold Interests

Given that fee simple, single tenant, single parcel, national credit, long corporate triple net or absolute net leased retail opportunities are as hot as they are for 1031 exchanges, buyers are looking at alternatives such as purchasing leasehold interests or a fee simple ground lease.  I’ll cover leasehold interests in this post and get into fee simple ground lease in the next one

IRS Section 1031 exchanges typically involve the sale of fee simple real estate property (relinquished property) and the acquisition of like-kind (replacement property). Property bought and held for investment is like-kind with any other property held for investment.

A fee simple real estate held for investment purposes is the most common property type exchanged.  Other types of ownership interests may be used as well such as leasehold interests for 1031 exchange purposes. Always check with your tax professional before the consideration of leasehold interests.  They generally can be used in 1031 exchange transactions, but check the rules as different rules apply to each situation.  While not as common as fee simple exchanges, leasehold interests can be of benefit when used in appropriate circumstances and with the advice of a tax expert.

In many instances, fee simple real estate can be exchanged for leasehold interests. Internal Revenue Service regulations state that a leasehold interest of 30 years or longer is like-kind with fee simple real estate. The IRS has subsequently ruled that option renewal periods are included in determining the leasehold interest length.  I interpret this as – if the initial period of the lease is 20 years and there four five-year options, then the length of the lease is 40 years for 1031 purposes.

Leasehold interests of 30 years or less are not like-kind with fee simple real estate; they may be considered like-kind with other short-term leasehold interests. Again, consult your tax expert before you do it!

Please notice how many times I’ve recommended that you consult with your tax expert BEFORE you do it.