Free 1031 Exchange Hotline: 877-471-1031

  Notes from Leonard, Your 1031 Guy

In our last newsletter we discussed "taxes on short sales and foreclosures." Since then, we have received some very good news from the State of California regarding this issue.  A new state law allows some taxpayers to immediately exclude from their income the amount of mortgage debt on their home loan that has been forgiven by their lender. 

The new law, SB 401 (Wolk), allows most taxpayers to exclude canceled mortgage debt income of up to $500,000 on their principal residence. It applies to debt forgiveness in 2009 through 2012 resulting from a foreclosure, “short sale,” or loan modification of a taxpayer’s qualified personal residence.  For more info. visit the Franchise Tax Board web site.

  Common Questions From 1031 Exchange Investors  

Over the course of the last 24 months, the inquiries coming in to our office have taken on a slightly different nature.  Five years ago, 1031 Exchange clients seemed to have different types of questions than they do today.  Below are some of the common questions we have been fielding over the last 24 months:
 
Q: If I buy a foreclosure, fix it up and sell it, will it qualify for a 1031 Exchange?
A: Generally speaking, no.  Most tax advisors will advise that a property needs to be held for a minimum of 24 months before it qualifies for a 1031 Exchange.  A quick flip is usually taxable at ordinary income rates.   Ordinary income taxes range from 10-35% at the federal level and are as high as 9.55% at the state level. 

Q: The buyer of my 4-plex wants me to carry a note for $100K.  Will this jeopardize my 1031 Exchange?
A: A 1031 Exchange can still be accomplished with seller financing, however, the process is more complex.  In most cases, the value of the note will have to be replaced with cash by the investor.  This can be accomplished by the investor coming out of pocket with his/her own cash or by simply selling the note to a third party. 

Q: I want to make an offer on a replacement property, but my 1031 Exchange downleg (relinquished) property has not sold yet.  What are my options?
A: There are several options for an investor in this situation.  The offer on the replacement property can be made contingent upon the sale of the downleg property.  The offer can be made with an unusually long escrow period to ‘buy time’ in hopes the downleg property will sell first.  Finally, the investor can also enter into a “Reverse Exchange”.  In a Reverse Exchange, Asset Exchange Company will actually take title to the replacement property as an “Exchange Accommodating Titleholder”.  Once the downleg property sells, Asset Exchange will transfer title of the new property to the investor.  A Reverse Exchange is complex so an investor contemplating a Reverse Exchange should contact us (877-471-1031) prior to making an offer on the replacement property.

Q: I have no gain in my property, but my CPA said I still owe a tax?
A: Although there may be no gain in a property, a tax may still be owed on the total amount of depreciation taken over the life of the property.  The depreciation recapture tax rate is currently set at 25%.   Conducting a 1031 Exchange will allow an investor to defer the payment of this tax. 

Q: You do such good work, can I refer you to all my friends and colleagues?
A: Please do.

If you would like to refer your friends and colleagues to us, our phone number is 877-471-1031.  We are also more than happy to answer any questions. 

Most investors know that in order for a property to qualify for a 1031 Exchange it needs to be held for productive use in trade or business or for investment.  The problem many investors have is that the IRS does not clearly state what this means.  Most tax advisors will recommend that in order for a property to qualify for a 1031 Exchange it should be owned and rented (or placed in use for business purposes) for at least 24 months.. 

The key however is that the IRS will also look at “intent” as a factor in determining if a property qualifies for 1031 Exchange.  If it is clear that a property was not intended for business or investment purposes, the IRS can and will disqualify the exchange.

A good example is the case of the Goolsby’s (Goolsby v. Commissioner April 1, 2010).  The Goolsby’s sold a rental and purchased replacement property in Pebble Beach Georgia via 1031 Exchange.  After two months, the Goolsby’s moved in to the property.  Upon audit, the IRS disqualified the exchange and also held the Goolsby’s liable for accuracy-related penalty.  

The court surmised that the taxpayers were contemplating use of the Pebble Beach property as a personal residence before the exchange.   Some of the factors that influenced the courts decision included:

• Efforts to rent the property were minimal (one advertisement in a local paper for two months).
• The Goolsby’s began preparations to finish the basement of the Pebble Beach property, having a builder obtain permits for construction, within two weeks of purchase.
• The purchase of the Pebble Beach property was contingent upon sale of their personal residence in California.

The lesson to be learned: make sure your 1031 Exchange property qualifies for the 1031 Exchange.  Own and rent the property for at least 24 months.  As the Goolsby's know, an IRS audit can be daunting and expensive.  Make sure you work with Asset Exchange Company, so you can avoid their mistakes. 

Feel free to contact 877-471-1031 if you have any questions.