The use of trusts in asset protection is quite popular but the distinctions between a revocable and irrevocable trust are important to understand. In an irrevocable trust, possession of the asset is transferred to an independent trustee; the original possessor is no longer tied to them. Thus, for 1031 exchange purposes the irrevocable trust has a separate tax identification number. Therefore, in compliance with the same taxpayer rule, a revocable trust can be used interchangeably with personal ownership but an irrevocable trust cannot.

For a table depicting the differences, click here.

For those who own interest in oil & gas wells, mines, timber, mineral deposits or reserves, and other natural deposits the IRS provides a deductable “depletion allowance”. An easy parallel can be drawn to depreciation, the end result being a deduction due to the erosion and “cost recovery” of the asset during the course of investment. In the case of depletion there are two methods of accounting: cost and percentage basis.

Cost basis depletion involves an allowance based on the original investment. If one were to invest $5M in an oil well, the investor would be entitled to regain that capital investment. This process would take place as the oil is extracted and sold. IRS code “permits the taxpayer to divide the cost of the investment by the estimated total of recoverable units in the natural deposit. This cost per unit is subsequently multiplied by the number of units sold annually, which results in the depletion deduction permitted for that year.” This can be used for a maximum of $2M in deductions each year. The caveat with this method is that it can only be used to recoup the original cost basis.

Percentage depletion is much different in that it allows for a fixed deduction rate in extraction and selling operations every year in perpetuity. For oil and gas investments, this rate is “15% of the gross income based on your average daily production of crude oil or natural gas”. This method is allowed to carry on for as long as the investment is in use, regardless of whether the deductions outweigh the original investment cost.

Some taxpayers combine the best of worlds, utilizing cost basis at the outset before switching to the percentage method. This ensures the capital investment is recouped via cost basis while also allowing for extra deductions through the percentage basis.

It is important to consult qualified tax personnel before making these decisions as individual circumstances often can change the picture. However, as with anything, if the tools are used correctly great rewards can be reaped.

As an additional strategy please refer back to oil and gas investment website and the features and benefits of using mineral interests as replacement property when residential rental real estate is fully depreciated.

In the hit show I Love Lucy, Ricky Ricardo was known for saying “Lucy, you’ve got some ‘splaining to do!” in his memorable Cuban accent. With 1031 exchanges the ‘splaining is done by substantiating your tax positions with other financial and Tax documents. The best case of substantiating comes with residential rental property, a subject we want to address before Memorial Day in honor of summer.

The Tax Court recently ruled the sale of a vacation home and the purchase of another via 1031 exchange ineligible because the homes were not held for investment (Moore, TC Memo 2007-134). It is common knowledge that for a property to qualify for a 1031 exchange it must be held for investment. The problem in this case was that the taxpayer believed “investment” constituted buying a house and waiting for it to appreciate for eventual sale. The house was not rented out (nor was any attempt made to do so) and used for personal purposes only.

The facts of the case don’t make it any prettier. The taxpayer purchased this second/vacation home three hours away from his residence. The property was utilized for recreational purposes a few times a month until Labor Day, and then closed until the following spring. During the off months, the taxpayer would occasionally visit the property in the role of caretaker.

After moving his primary residence further away, the property fell into disuse and became run down. The decision was made to purchase a closer vacation home and treat the transaction like a 1031 exchange. Obviously the property was used only when wanted and convenience played a large factor. Typically, not how investments, especially ones you hope will appreciate, are treated. However, the kicker was that on his tax return he listed the properties deductions for “home mortgage interest” instead of “investment interest” and did not deduct depreciation, maintenance or other expenses.

Therefore taxpayers are left with “breadcrumbs” to follow regarding property that has both personal and rental use present. Taxpayers should (a) hold the property out for rent and have the listings; (b) declare the income as rental income; (c) take on offsetting depreciation deduction; (d) take a deduction for investment interest expense, (e) try to keep purely personal below 14 days a year.

Simply speaking a zero transaction is the acquisition of a property using a highly leveraged loan (loan to value usually 88% plus) with all rental income dedicated towards debt service, thus producing “zero income” for the property owner. One of the vehicle’s applications is to defer tax liabilities incurred in a commercial foreclosure.

The Problem

Though it is not widely known, the foreclosure of a commercial property is often a taxable event. How the IRS computes the tax depends on whether the property was financed with a recourse or non-recourse loan. In the case of a recourse loan, tax liability is calculated by taking the difference between a property’s fair market value and its adjusted basis. The tax liability of a non-recourse loan (which the remainder of this piece will be dealing with) is calculated by taking the difference between a property’s outstanding mortgage balance and the property’s adjusted tax basis.

The key element which catches investors off guard is that “outstanding mortgage balance” includes any loan taken out during a refinancing of the property.

For example:

Let’s say you bought a property for $5M (your cost basis) which subsequently has been depreciated to an adjusted tax basis of $3M. Let’s also say you refinanced this property during an upsurge in the market and pulled out $8M of equity. If this transaction was foreclosed upon (without any action to defer tax liabilities), you would face a taxable gain of $5M, i.e. the $8M in outstanding mortgage amount minus the $3M in adjusted tax basis.

Thus, investors who think returning the keys to the bank absolves them of all monetary concern involved in a commercial foreclosure are gravely mistaken. The IRS views any money pulled from a property via loan refinancing to be taxable gain, even though the property is foreclosed upon.

The Solution

With proper scheduling and use of the 1031 exchange, the situation above can be avoided through the purchase of a “zero income” property. The reason a zero income property can be so beneficial is due to its highly leveraged nature and its ability to defer a taxable gain through a 1031 transaction. A portion of the money an investor would have otherwise paid to the IRS can be used instead to acquire the zero income property through the 1031 exchange.

For this transaction to work a few things usually need to be in place:

• Due to the rules of the 1031 exchange, the replacement “zero income” property has to be of equal or more value than the original property. In this case the value the client needs to trade equal or up to is the value of the outstanding mortgage being forgiven.

• Furthermore all 1031 exchange procedures must be followed including preparing exchange agreements, identifying replacement property and closing within 180 days.

• The investor must carefully select the zero income replacement property. The primary characteristics will be a triple net lease (NNN) and an investment grade tenant (usually rated by independent agencies such as S&P or Moody’s). These properties are considered extremely stable real estate investments and are normally the only ones capable of being financed with the highly leveraged loan needed in a zero transaction.

• A “deed in lieu of foreclosure” must be obtained to allow for the appropriate transfer of the original property to the bank. Creditors generally prefer a deed in lieu of foreclosure because it terminates the debtor’s equity of redemption and is quicker, less expensive and less unwieldy than a traditional foreclosure. In order for the transaction to flow smoothly, it will have to be properly organized and scheduled on an individual basis.

It should be noted that a zero transaction is not possible without outside assistance of at least a Qualified Intermediary and qualified professional tax and accounting advice. If done properly, this strategy can be an invaluable tool for investors caught in a foreclosure situation.

Here is how our previous example would be impacted by a zero transaction:

Assuming a tax rate of 25% (Federal capital gains rates, Federal recapture rates and states taxes), the $5M in gain would cost $1.25M in taxes. If instead, a zero transaction was pursued, the investor would need to replace the balance of the debt, $8M. By exchanging into a zero income property for approximately 10% of the $8M debt amount replaced ($800,000), there would be a $450,000 savings ($1.25M-$800,000) and the investor would own NNN property with a very high credit tenant.

When you think of tax planning you think of someone who looks forward to helping you navigate your facts, circumstances and decisions, minimizing the tax liabilities of your investments and business operations. Unfortunately, many CPAs that advise clients look backward, reacting to the year’s events and shaking their heads that you have large tax implications as a result of the business decisions that you have made. This blog addresses those sinister CPAs and their even more sinister sisters- the CPA that confidently advises you – to make bad decisions!

Here are three common examples of how CPAs directly or indirectly impeded successful client tax deferral.

1. Over-focusing on Federal Capital Gains Tax Liability.

The major issue we see in this environment is client’s thinking they are potentially cashing out in a 15% capital gains environment. The client’s indicate, “I may as well cash out now rather than later, because capital gains is going up.” While this point is well-taken, clients are not appreciating the three taxes they defer via 1031 exchange: (1) Federal Capital Gains taxes (15%, soon to be 20%); (2) State Level Capital Gains (ranging from 0-9%); (3) Depreciation Recapture Tax (25-50% depending on straight-line or accelerated depreciation). These three taxes always add up to more than 15% unless you are selling non-depreciable property (land) in a no-state tax jurisdiction like Texas. However, if you have property in high state tax jurisdictions like NJ, NY, DC, or MD, you will want to drill down and determine your actual proposed tax liability before opting to cash out. A cocktail conversation with a CPA about capital gains should not suffice.

2. Simplifying the Personal Use Issues.

Beware of CPAs that speak in general rules. Any tax attorney or CPA that is wise usually answers questions with, “it depends”. We had a classic case of oversimplification last year when a client wanted to sell a North Carolina beach house. Under the taxpayer’s property settlement agreement with his ex-wife, he let her use it 5 weeks out of the year. Five CPAs gave oral advice to the client to cash out as the ex-wife’s use of the property constituted imputed personal use to the taxpayer. Thankfully, the business owner, stubborn and determined to get the accurate answer, asked us for our suggestions. We promptly referred the client (one week before settlement) to a regional 1031 exchange tax attorney superstar that issued a tax opinion for $1,500.00 indicating the ex-wife’s use was analogous to a creditor and that the property settlement agreement stipulations were not the equivalent of letting your brother or sister stay at your vacation property. Therefore the 47 out of 52 weeks of being held out for rent plus the ex-wife’s activity did not squelch the deal. Thankfully, the client deferred hundreds of thousands of dollars of gain and tax liability.

3. Not Adequately Understanding 1031 Tax Basis Issues.

This is where the horror stories come into play. While the prior two categories are a function of CPAs not being familiar with the details of tax deferral, this scenario is egregious beyond belief. A local tax preparer with a history in tax preparation at a major chain that employs more seasonal tax preparers than any other company (hint, hint) was indicating to at least twenty clients per year (he was a good marketer) to cash out of the relinquished property because 1031 exchanges used CARRYOVER basis and you will not get any benefit from new cash or new debt. For those of you who know the rules, you should fall out of your chair here. 1031 exchange uses SUBSTITUTED basis giving taxpayers credit for new cash or debt if they trade up in value. If a tax preparer tells you to simply sell and buy instead of exchange, seek a second and third opinion. The tax preparer was relying on the Form 8824 instructions for his understandings and he rationalized his advice by stating that it was “ambiguous” what replacement property basis would be. This tax preparer had no accounting training, just two summers in a strip mall preparing returns. He filed over 200 returns per year.

1031 exchanges include a 180 day exchange period unless you started your exchange in the previous year, say 2009, and April 15th cuts short your 180 period. If this is the case you must file for an extension to get the full 180 days.

NOTE: All 1031 exchanges must be filed on IRS Form 8824. For Form 8824 and applicable instructions, click here. 

It has been recently reported that the US apartment market may have reached bottom and be poised for a rebound. Apartment vacancy rates have stopped rising and rents even showed a modest increase in the first quarter. As life is pumped back into this market, 1031 exchanges could subsequently rise. Apartment investors heavily utilized 1031 exchanges to move from active to passive assets (such as net leases) in the past. Will this trend repeat?

To gain insight, we have solicited the help of James Brennan Esq., LL.M., Managing Director and Corporate Counsel of Exchange Solutions Group, one of the foremost experts of 1031 exchanges.

1. With the possible return to health of the U.S. apartment market, do you expect to see increased 1031 tax exchange action?

The Baby Boom generation flocked to real estate as an investment class, particularly multifamily. With Baby Boom private investors aging and looking to make life decisions regarding retirement, relocation, and estate planning, and all of those activities are distinguishable from the active process of “adding value” to apartment complexes through sweat equity and property management. Many of those B and C investors are looking to get out of active management. After living through this cycle, they want out more now than ever.

2. What makes apartment owners keen to move from an active to passive asset?

Passive triple net leases are net insurance, net utilities, and net taxes to the tenant. Apartment owners that have built a net worth over $5 million are looking to create annuity-like income for their heirs who often are not in the real estate business. These family patriarchs and matriarchs are not looking to burden their heirs who often are busy professionals in metropolitan areas with decisions regarding leasing up property or fixing the roof. Triple net leases provide credit-rated tenants with predictable cashflow.

3. How popular are net leases for those exchanging out of apartments?

Net leases are not only used by multifamily baby-boomers but also multifamily “financial engineers”. While multifamily financing is often favorable from agencies like Fannie and Freddie many borrowers are in troubled financial shape with distressed assets. These assets often don’t pass muster to be financed or refinanced with agency debt. These investors can 1031 exchange either with low equity or after conducting a deed-in-lieu 1031 into a net lease. Once in the net lease asset, the equity can be unlocked fairly easily through either credit-tenant-lease paydown readvance or through a standard refinance. These strategies allow multifamily borrowers to get an asset banks trust more with a credit rating.

4. What is the psychographic profile of a typical investor who executes this strategy?

Apartment developers are often drivers or family stewards. These decision-makers have built wealth from the ground up often not in a traditional white-collar methodology. These hard-driving decision-makers have provided for their family, and also probably have setup life insurance trusts to allow for estate planning liquidity. Triple net leases go well with this concept of transitioning wealth to the next generation without many opportunities for losing value by the heirs. The family stewards have built wealth and are now simply trying to preserve it.

5. Are there any aspects of this strategy conducive to estate planning techniques?

In an effort to defer capital gains while family stewards are still living the patriarch or matriarch often engages in a like-kind exchange to transition between apartment assets and net lease assets. In a like-kind exchange you can trade into multiple replacement properties. Therefore, if you have three children and you sold your apartment complex for $15 million, you can buy three $5 million dollar net lease assets that produce income that can be divided up amongst the heirs. This avoids management by the one heir that may be more real estate savvy.

Equally as important, the credit-rated aspect of net leases allows trust officers and advisors to sleep at night knowing that they made defendable decisions on behalf of the trust. Therefore, if a real estate trust officer is transitioning from apartment assets, net lease income streams are fiduciary friendly.

Unsuspecting commercial investors are driving to the bank to turn in their keys on projects that did not workout as planned and waking up the following year with an unexpected tax headache. The discharge of the loan can result in a capital gains tax liability. Not only did the clients lose whatever equity they had in the property, but they also face capital gains tax liability for simply how they transferred the property to the bank!

Individuals confuse the property’s tax impacts with the property’s economics. However, these two calculations are different. For tax purposes gain or loss equals the difference between the transfer price to the bank and the adjusted basis. Thus, if you bought a property in 1987 for 700k (your cost basis) and it has been depreciated and now has an adjusted basis of $400K, and it is foreclosed with a 950k loan, this transfer without a 1031 exchange results in a taxable gain of $550K, i.e. $950k transfer price minus the $400K adjusted basis.

Drilling down, the amount of gain for tax purposes depends on whether or not the debt is recourse or nonrecourse. With nonrecourse debt, the taxpayer is charged with gain equal to the difference between the outstanding mortgage amount and the adjusted basis. Thus, the taxable gain equals loan amount minus adjusted basis. To clarify, for nonrecourse debt fair market value of the property is not taken into consideration1 In Commissioner v. Tufts, the Court pointed out that taxpayers receive value when they are relieved of a nonrecourse debt obligation.

For this problem, there is a solution. Exchange Solutions Group designs solutions for property owners facing foreclosure and related imputed gains. By purchasing another property of equal or greater value to the transfer price on the foreclosed property, a like-kind exchange can be used to delay the capital gain. The cash that would have been used to pay the tax liability can alternatively be redeployed into an asset rather than simply used to pay an expense.

To execute this strategy all 1031 exchange procedures need to be followed including preparing exchange agreements, identifying replacement propert(ies), and closing within 180 days. Recall, that even if you are unsuccessful and end up with a “failed exchange” in the next year, you can elect installment sale treatment and push the tax liability to the following tax year, if you structured this as part of a 1031 exchange. To conclude, this market will undoubtedly have challenges but it is how we deal with adversity that defines us!Sphere: Related Content

For those who saw their exchange funds evaporate due to a QI declaring bankruptcy, yet still owed taxes on capital gains, Rev. Proc. 2010-14 may provide a much needed solution. Previously, taxpayers who fell victim to a QI default, were obligated to recognize the “gain triggered upon transfer of relinquished property in the tax year in which the transfer occurred.” Rev. Proc. 2010-14 ensures that if an exchange falls apart due to a QI bankruptcy, “gain is deferred until the tax year net liability relief exceeds basis and/or payments attributable to relinquished property are received as a result of the bankruptcy or receivership proceeding.” This applies retroactively to all exchanges past January 1, 2009. In order for taxpayers to utilize Rev. Proc. 2010-14, they must meet four requirements:

1. Transfer (or be deemed to transfer) relinquished property to a QI in accordance with § 1.1031(k)-1(g)(4) (the QI safe harbor);
2. Properly identify replacement property within the 45 day identification period (unless the QI default occurs during that period);
3. Fail to complete the like-kind exchange solely due to a QI that becomes subject to a bankruptcy or receivership proceeding; and
4. Do not have actual or constructive receipt of proceeds from sale of relinquished property (other than liability relief) prior to QI’s bankruptcy or receivership proceeding.

For those who qualify, this development could mean substantial money and time saved. It is unfortunate many were hurt by the recklessness which took hold of the 1031 exchange industry (LandAmerica comes to mind) but steps like Rev. Proc. 2010-14 go a long way in providing some solace now and enhanced protection in the future.

There are times when an investor may want to sell one of his properties and invest its proceeds in another he owns. In the past the IRS forbade 1031 exchanges in such cases, however, today there are means around it. It is known as an “advanced built to suit” transaction and though it has never been explicitly supported by the IRS, it has been upheld by private letter rulings.

The difference between the advanced build to suit transaction and a typical tax deferred exchange (or one with a build to suit component) is the type of property designated as replacement property. In a build to suit tax exchange, the replacement property is owned by a third party, with Exchange Accommodation Titleholder (EAT) obtaining the replacement property’s title, which it holds while the property undergoes its improvements. In the advanced build to suit transaction, the taxpayer is attempting to transfer funds into property already owned by him. However, Rev. Proc. 2004-51 places restrictions on using replacement property owned by the taxpayer within 6 months of the exchange. Thus, the taxpayer is unable to accept either “assignment of the LLC or direct deeding of the Replacement Property after the improvements have been made directly.”

In order to complete this arrangement, the taxpayer must enter into a 1031 like-kind exchange agreement with a QI, after which he enters into QEAA and Construction Management Agreement with the EAT. He would then send cash or agree to a loan with the EAT, allowing the EAT to purchase replacement property and carryout the improvements. The EAT then acquires title to the replacement property and sets it up in a LLC. The EAT also has authority to appoint a Taxpayer General Contractor under the Construction Management Agreement, who acts as Fund Control, making disbursements as construction commences. After 180 days, the QI will direct the EAT to transfer the replacement property directly to the taxpayer, this is accomplished by handing over control of the LLC to the taxpayer.

 If completed correctly, with the right guidance and supervision, this transaction allows investors to greatly improve their own properties and consolidate their holdings. This flexibility can be extremely beneficial during recessions or other economic downtimes, when ancillary properties become less valuable and the need to improve core ones increases. Thus, the advanced built to suit exchange gives investors another tool to use in the marketplace.