This Capital Tax Code change caught me by surprise as I just learned about it.  I had not heard anything about it and perhaps other real estate professionals are in the same situation.  In the past I have had numerous clients that have used this section of the IRS code and several that are currently taking advantage of the code (including myself) but will now be affected as this goes into effect January 1, 2009.  Unfortunately there is nothing preventative that can be done.  A synopsis of the Internal Revenue Code follows:

A Modification of Internal Revenue Code §121

The federal government recently heightened the restrictions for those who seek to exclude capital gains on the sale of real property held as a primary residence under IRC §121.  This legislation will go into effect on January 1, 2009.

IRC §121, also known as the 121 exclusion, permits homeowners upon the sale of real estate they have owned and lived in as their primary residence to exclude up to $250,000 of the capital gains ($500,000 for a married couple filing jointly) that would have otherwise been recognized.  To qualify for this exclusion the real estate sold must be, or have been, the primary residence and lived in by the taxpayer for any two of the last five years.  Certain exceptions apply for the two year "lived in" requirement.  Taxpayers can take advantage of the 121 exclusion once every two years.

The careful utilization of the 121 exclusion has permitted taxpayers to implement strategies to take full advantage of its benefits.  Such examples include:

• A taxpayer acquires investment property, not purchased as part of a 1031 exchange, and then converts the investment property into their primary residence.  The taxpayer, after living in the property for at least two years, may sell the property and take the full 121 exclusion.

• A taxpayer acquires investment property as part of a 1031 exchange and then converts the investment property into their primary residence.  In order to take advantage of the 121 exclusion the taxpayer must live in the property for at least two years and additionally must have owned the property for at least five years. 

The latest change to IRC §121 restricts a taxpayer from taking the full 121 exclusion for periods of "non-qualified" use prior to it being held as their primary residence.  Non-qualified use is any use of the property other than as a primary residence (i.e. second home, vacation home, rental).  A "qualified" use is then, by default, any period in which the property is held as a primary residence. 

Upon the sale of the property, the capital gains attributable to the Non-qualified time period prior to its conversion to a primary residence is no longer excludable.  Any periods of Non-qualified use after conversion to a primary residence is not counted against the taxpayer, as long they would otherwise qualify for the 121 exclusion.

The allocation of capital gains between the Qualified and Non-qualified periods involves a simple fraction that takes the total capital gains associated with the sale and divides that amount between the respective periods.  The Qualified period represents the amount of the capital gains that can be excluded and is determined by the number of years the property was held as the primary residence over the total years of ownership.  The Non-qualified period represents the amount of capital gains that can no longer be excluded and is calculated using the same fraction, the number of years held in Non-qualified use over the total years of ownership.  Keep in mind, any Non-qualified periods after the conversion of the property to a primary residence is not counted against the taxpayer.

For example, a taxpayer acquired real property in January of 2009 and owned the property for eight years.  The property was held for investment for the first six years.  It was then converted to the primary residence for the last two years of ownership.  Of the total capital gains associated with the sale only one-quarter (2/8) can now be excluded under the 121 exclusion.  The remaining three-quarters (6/8) can no longer be excluded as they are allocated to the Non-qualified period.

These changes will undoubtedly impact those that have acquired investment property and intend to change the character of the property to their primary residence in order to take full advantage of the 121 exclusion. "

I had a borrower come to our office on Monday afternoon and drove 30 miles without an appointment.  They were emotionally devastated  looking for a loan and were referred to me from a past client.   The reason they were here is that they had applied to a bank who will not be directly named but sort of like Bank of Something NA.  They had applied on June 6th, providing tax returns, assets, etc and received a formal commitment letter stating they were"Approved" for a 30 year conventional fixed rate loan @ 6.5% for $190,000 with a 95% LTV.  

On June 25, 2008 they proceeded to enter into a purchase contract on a bank owned property at $155,000 and a loan of $147,250, and a 30 day close of escrow.  So after having provided at the time of application all the required documentation and having a middle FICO score of 792, they were given the good news on July 25th the day of closing that they did not qualify and would need to bring in an additional 10% to qualify for a loan amount of $131,750.   Hard to believe huh!

Not only a "Loan Officer" but an entire supporting staff  apparently did not know what they were doing.  It took me about 30 minutes to review the 1040's, assets and pull my own credit report.  I could immediately  tell it was going to be tight.  I ran a FNMA DU submission and received an Approve/Eligible status but there is absolutely no way in hell these people would qualify for a loan exceeding $150,000.  They have virtually no debt and their overall ratio's are 41/42%.   These people spent money for appraisals, property inspections, made moving plans and then get the bad news literally the day of closing.  It is almost a criminal action in my opinion although one could never press charges.

Yes, I know guidelines are changing but incompetence has nothing to do about changing guidelines.  And yes this may be an isolated incident but do these large institutions not review the basics before wasting borrowers money & time including all the supporting services, Realtors, Title, Escrow etc?  They certainly do not accept any responsibility for their actions!

I submitted everything in less than 24 hours (After all with a couple of phone calls I had preliminary Title, Escrow, & the borrower provided assets, Income...everything but the appraisal) and will have MI approval before I waste any money on an appraisal. The approval will be subject to a satisfactory appraisal.  I am certainly not the only brokerage that can turn things around quickly.    I contacted the listing agent and gave them copies of the DU approval and what my game plan was and received a 20 day extension yesterday afternoon.   I don't know if we will pull this off but I can guarantee after underwriting confirms my findings that I will close it or within 24 more hours kill it.

Moral of the story....Just because it is a national lending institution don't count on anything.  It is never the company but as  Paul Slaybaugh will say from experience, always know the people who you are entrusting your transaction.

Let’s first get to the Elephant sitting in the room regarding the DST™ and the controversy regarding whether the DST™ is simply a Private Annuity Trust with a different name.

Under the U.S. tax law, U.S. Citizens and residents must declare their income by filing tax returns and must pay tax on their income, and the taxpayer has a legal right to avoid or minimize taxes. Commonly established tax deferral methods include 1031 exchanges and installment sales (IRS 453).  Various types of trusts are used by millions of taxpayers to protect and transfer assets to their heirs outside of probate and to minimize having to sell estate assets to pay estate taxes.

 The Private Annuity Trust

The creation and implementation of Private Annuity Trusts (PAT) were banned by the IRS in October of 2006.  The basic idea of the PAT was to utilize capital gains deferral by transferring a highly appreciated asset to a Trust in exchange for payments for life.  After the Taxpayer’s death, the annuity in the PAT would go to the heirs of the Taxpayer as designated in the annuity beneficiary designation.  The cited legal authority for the PAT were based on Treasury Regulations, which can be (and were) change(d) at a moments notice.  The PAT could sell inventory.  Depreciation recapture is not immediately taxable upon exchange and the Trustee of the PAT could be family members who allegedly were not controlled (but were in reality controlled) by the Taxpayer.

The Deferred Sale Trust™ or the DST™

The DST™ is based upon Statutory Authority, Internal Revenue Code section 453.  The DST ™ is not based upon a Treasury Regulation and it would take an ACT OF CONGRESS to change the legal authority by which the DST™ is founded.

The next consideration is the Trust structure.  In order to be a valid Trust, the Trust analysis has to pass a two part inquiry:  (1) is there a legal trust in existence and (2) is the Trust a SHAM for income tax purposes? 

A trust must have 4 elements to satisfy legality and include: Intent, Trust Property, Lawful Purpose and an Identifiable Beneficiary.  Once the 4 elements have been established for the creation of a trust, then the trust must be analyzed to determine if it is a tax sham and an additional 4 factors must be reviewed in detail to ascertain economic substance for Federal Tax purposes.  This “Test” is commonly referred to as BUCKMASTER vs. Commissioner, TC MEMO 1997-236 and briefly includes:

 (1)     The taxpayer’s relationship to the Asset before and after the trust formation.

 (2)     An INDEPENDENT Trustee (No ownership or control vested in the taxpayer.

 (3)     No economic interest passed to other beneficiaries of the trust.

 (4)    No restrictions imposed on the taxpayer by the trust or the laws of the trust.

So…..is the DST™ an IRS Accepted Tax Strategy?

I have recently received a written legal opinion from a California Law Firm licensed to practice in the U.S. Tax Court that THE DEFERRED SALES TRUST™ ALLOWS FOR THE (1) LEGAL DEFERRAL OF CAPITAL GAINS, (2) PASSES SCRUITNY UNDER THE BUCKMASTER TEST (3) NOT A REPORTABLE TRANSACTION (4) NOT A STEP TRANSACTION AND (5) IS CLEARLY DISINGUISHABLE FROM THE PRIVATE ANNUITY TRUST   In addition a Private Ruling Letter has been requested from the IRS and is pending.

The DST™ is founded upon IRS accepted Strategy to Defer, not the avoidance, of the lawful payment of Capital Gain taxation.  While this is a relatively new strategy combining existing statutes of established tax law and trusts, it must be PROPERLY administered by licensed and trained DST™ Estate Planning Professionals, Trust Attorneys and Trustees.  This is not a do it yourself project or one to be undertaken with untrained and inexperienced advisors.  Done properly the benefits may be extremely rewarding.  On the downside, the consequences could be devastating if not done correctly and interpreted by the IRS as a tax sham.

 Has the Elephant left the room yet?  I hope you are still with me because here is where it gets interesting.

Will the DST™ eliminate the 1031 Tax Deferred exchange? 

No way.  It is strictly another option for the taxpayer who may for a variety of reasons “Want Out” of ownership of assets that have a large capital gain tax consequence. For Example:

 (1) You may want to sell because you are seeking retirement and feel managing your real estate or business is no longer something you want to undertake.

(2) You may want to sell because your investment appreciation is worth more than the monthly cash flow.

(3) You may want steady income and asset protection.

(4) You simply hate to pay the taxes.

(5) You may want to sell but cannot locate an acceptable property to complete a 1031 exchange.

(6) You realize that with the DST™ structure you can invest ALL your sale proceeds including the capital that would have been paid to capital gains taxation and receive an increased income stream.

(7) You realize that properly structured with estate planning you can pass on assets to beneficiaries free of estate taxes.

 It is interesting to note that while capital gains tax at the federal level is 15% and while some states do not have capital gains tax, California has a 9.3% capital gain tax for an overall 24.3% tax rate.  Now that hurts.  So while the real estate market is currently having issues, a taxpayer could actually sell his California property 10% below market value enhancing a sale and still have 14.3% more capital in the trust earning income.  Does this make it easier to complete a sale and still provide a benefit to the taxpayer?

Interested in obtaining more in depth information?

There is so much more to the Deferred Sale Trust ™.  A brief article can be accessed at http://www.trustguardant.com/news/24/strategic-management-of-tax-liability/   If interested your next step in learning how to access the knowledge to assist your clients, (and perhaps yourself) possibly market the DST™ yourself with your own  web site, and where legal, potentially earn solicitor fees is to execute a Non Disclosure Agreement (NDA).

This new tax strategy is going to create many opportuniities for both the public and the real estate industry. Contact me directly for the NDA and I will answer your questions or if appropriate refer you to appropriate legal advice council.

 About The Guardant Network

Guardant Investments, Inc., the Guardant Investment Fund LLC and Guard Equity Holdings LLC. are devoted to retirement education in self directed IRA accounts, non-correlated alternative investments for Qualified California Residents only and foremost education of the National real estate community (Residential and Commercial) and the general public about the new Deferred Sales Trust TM

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

It may just seem like the sky is falling with Friday's failure and take over of Indy-Mac along with both Freddie-Mac and Fannie-Mae being on extremely thin ice.  Rumors of other institutions failing as well boded fairly negative news for the real estate and mortgage industry. Nothing seems to be helping the economy or home buyer confidence these days.  As we all know it is the banking industry and the financing of real estate and other business needs that is the core problem.  Even well qualified borrowers are facing extremely difficult underwriting and it  appears it is not going to get better until it gets worse.  No recovery will take place until the banking industry recovers, plain and simple.  The band-aids congress is contemplating on foreclosures do not address the liquidity issues that must be resolved.

Meanwhile, How you communicate with your clients and your spheres of influence will impact your image as an industry leader and not someone just being blown along with the headwinds.   Being positive is always a step in the right direction but being realistic is also paramount.  There is absolutely nothing wrong with real estate that won't be solved when the financial markets establish themselves.  We will probably over react and have much more stringent underwriting guidelines which will put a lid on the speed of the recovery and property appreciation.  Affordability will be the key factor, followed by collateral verification with appraisals being scrutinized with review appraisals if the original appraisal is not supported by AVM's.

So just like every market that has undergone "Irrational Exuberance" we will have a pullback and stabilization and then the market will move forward again.  I doubt we are all going back to tents or mud huts so housing will again become a major component in the U.S. economy.  Helping clients recognize the facts of this market will only help them to make the right decisions.  But be cool, be professional, be factual and you will be not just a survivor but a Trusted Adviser.

This is an interesting lesson in history and what happened to the men  that
signed the Declaration of Independence.

 THE 4TH OF JULY

 Five signers were captured by the British as traitors, and tortured  before
they died.

 Twelve had their homes ransacked and burned. > >>>> > >>>>

 Two lost their sons serving in the Revolutionary Army; another had two
sons captured. > >>>> > >>>>

 Nine of the 56 fought and died from wounds or hardships of the
Revolutionary War. > >>>> > >>>>

 They signed and they pledged their lives, their fortunes, and their  sacred
honor. > >>>> > >>>>

 What kind of men were they? > >>>> > >>>

 Twenty-four were lawyers and jurists. Eleven were merchants, nine were
farmers and large plantation owners; men of means, well educated, but they
signed the Declaration of Independence knowing full well that the penalty
would be death if they were captured.

 Carter Braxton of Virginia, a wealthy planter and trader, saw his ships
swept from the seas by the British Navy. He sold his home and properties to
pay his debts, and died in rags.

 Thomas McKeam was so hounded by the British that he was forced to move his
family almost constantly. He served in the Congress without pay, and his
family was kept in hiding. His possessions were taken from him, and poverty
was his reward.

 Vandals or soldiers looted the properties of Dillery, Hall, Clymer, Walton,
Gwinnett, Heyward, Ruttledge, and Middleton.

 At the battle of Yorktown, Thomas Nelson, Jr., noted that the British
General Cornwallis had taken over the Nelson home for his headquarters. He
quietly urged General George Washington to open fire. The home was
destroyed, and Nelson died bankrupt.

 Francis Lewis had his home and properties destroyed. The enemy jailed his
wife, and she died within a few months.

 John Hart was driven from his wife's bedside as she was dying. Their 13
children fled for their lives. His fields and his gristmill were laid to
waste. For more than a year he lived in forests and caves, returning home to
find his wife dead and his children vanished.

 Many of us take these liberties so much for granted, but we shouldn't. 
The Fourth of July is more than beer, picnics, and baseball games.  It's
about showing gratitude and respect to those gave much more than most of  us
to keep our nation free. So on this 4th of July holiday, take a few  minutes
and silently thank these patriots and others who have given so  much for our
freedom. That's not much to ask for the price they paid.

I am very frustrated this evening.  I submitted a purchase money loan needing a Jumbo Conforming Loan of 80% LTV and debt ratios of 24/36%.  Buyers are W-2 salaried, 20+ years on the same job, have $150K in the bank plus $250,000 in retirement assets, zero debt, 781 Middle FICO scores and have lived in their present residence for 20 years.  Mr. and Mrs. Stability and the type of client or borrower we all strive and hope to find and represent.  I had my lender 'Approved" appraiser who used  3 comparable closings all within 2 months and 1/4 to 3/4 miles away from the subject plus two supportive listings and it was appraised at the sales price.  (My instructions were the usual "Bring it in at a value you can support").   I received the "Conditional Approval" and an AVM was completed and the lender is indicating the value is 100K (20%) below the appraisal and we need to obtain another  appraisal from another "Lender Approved" Appraiser.  These clients did a lot of market research, looked at numerous homes and found what they wanted and made an informed offer.   If the lenders are going to look sideways and make this type of full documented transaction difficult or impossible then we are reallllllllllly going to struggle turning this market around.  I KNOW.....we must need to kill good transactions and provide more lower comparable sales to help the market recover.  That will help.

I presume most of us have heard that Wachovia has suspended their Pick-A-Pay Program.  Sort of like locking the barn door after the horse left the barn, corral, and the County. However, they also announced that they will no longer have early payment penalties and will waive the prepayment penalty on all their existing portfolio.  I guess after you lose 707 Million Dollars in the first quarter and have a 120 Billion Dollar Portfolio of this product you need to do something to make it easier for people to pay you off and reduce your potential liability.  Too bad they did not realize what their contribution was to the overall industry at lot earlier than now.

Oh well, better now than never.

Recently I originated a loan referred to me from a long term past client.  I reviewed their w-2 forms, recent pay check stubs and bank statements.  Then I pulled a three bureau credit report and then ran a FNMA DU approval to provide him and his agent a pre-qualification letter for the purpose of negotiation. So far, so good and normal procedure.

A few days later I was speaking with my client and he made the comment "I am really amazed by the lack of privacy and confidentiality in your business".  Somewhat taken aback I asked what he was talking about?  He proceeded to explain that he had two lenders contact him and said they could give him a better "Deal" without, I might add, even knowing the product, rate, term or costs I had provided.  ( I consider the word "Deal" as repugnant as if we are talking about buying a used car, not a professional financial transaction).

Alas, this was partially my mistake in my clients education of the loan process as this was not the first time this has happened recently.  Four months ago I had a client call me saying that someone contacted him telling him they were working with ME and my title company seeking to get him the best loan and not to do anything until he ran it by them.   I of course contacted my title company representative, T.O. and one of the owners attempting to get to the responsible party in order to strangle them.  I/we could not determine the answer.

Again, three months ago I had the same situation with a 20 year past client who 3 days after opening a loan with me said he had an overnight package at his house with a cover letter saying not to do anything until he contacted them. This time, trying to get to the source of this problem I contacted the owner of the credit bureau I use who explained to me that the Credit Bureau's (probably Experian) were selling this information.  He had personally tried to put a stop to this practice but to no avail ....it is legal.

Can you imagine with all we have to go through regarding privacy and confidentiality that these pond dwelling,scum sucking, low life *&%#@!*& are able to get away with this as standard business practice?. Fortunately these particular clients were all professionals and were not duped by these clowns. I consider this an unethical, disgusting and reprehensible business practice.  I won't mention names but some of the branches of their tree must be broken!

This is apparently not an isolated incident So now I am making it a part of my presentation to explain how some entirely unethical companies who do not have the ability to honestly develop business relationships will attempt to contact you, con, lie and misrepresent facts even though they will appear knowledgeable as they will have your credit report and FICO scores. Unfortunately some of the public will be duped.  I know the honest loan officer,if not both, may be damaged.   Be Careful out there!!!

Anyone else, loan officer or agent aware or run into any similar situations?