James's Blog

The Death of the Estate Tax?

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Fri, 04 Dec 2009 15:03:15 -0600

The Estate Tax (or Death Tax), which levies a 45% top tax rate on couples estates valued over $7 million and individuals over $3.5 million, is slated to expire on Dec. 31^st. However, it is also scheduled, like a beheaded hydra, to reappear with more ferocity in 2011, with top rates of 55% for estates valued over $1 million. This makes 2010 a weird twilight zone because it will effectively be without an estate tax. Assuming people don't view this as a can't miss opportunity to dispose of their parents, there could still be affects on investors and their estates.

Many expect some sort of resolution in the near future as the uncertainty which would be caused through the tax's expiration would cause much confusion. People would like to know what to plan for, rather than going into the future somewhat blind. However, the debate on just what the resolution will be is currently becoming more contentious. Many on the right favor either imposing an estate tax with rates lower than those currently or abolishing it all together. Those on the left tend to favor higher rates or keeping the status quo. One possibility currently making the rounds is that congress will pass a law keeping the tax at current levels around March and apply it retroactively to the previous months. As it stands right now, the House has just passed a law which would extend the current rates but this has not yet been ratified by the Senate.

If the tax should expire, the estate tax would be replaced by a capital gains tax on all but the first $1.3 million in inherited assets. Heirs who sell those assets would pay between 15 to 28 percent in taxes on any appreciation in value those assets observed from the date they were acquired. Whether or not this situation is more preferable to that of the estate tax most likely depends on the wide range of situations investors may find themselves in. In anycase, it seems the fates of many depend on the political machine in Washington and its eventual decision.

Note: A little known fact is that one of the largest supporters of the estate tax is none other than the life insurance lobby. Why? Because they make a lot of money through selling life insurance policies which provide liquidity for those dealing with estate taxes

Easy Money Can Lead to Uneasy 1031 Exchanges

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Mon, 23 Nov 2009 10:17:33 -0600

Do you know what a 1031 exchange is? Many investors think they have a handle on it. Unfortunately, often they know enough to appreciate the sentiment but not enough to navigate its many nuances. As investors learn the hard way, one false step can lead to millions of dollars forfeited in failed 1031 exchanges.

For starters, a 1031 exchange is a transaction whereby investors are allowed to sell one property and obtain another without paying capital gains tax. But if you went on that definition alone, you would most likely find yourself in violation of the IRS code, because like all things involved the IRS, there are layers. A key element, often missed, is that to be eligible the property must be held "for productive use" (i.e. not for purposes of reselling). This is catching more people lately because in our current economic climate there is a desire to buy now when prices are low and then quickly flip the property.

A 1031 exchange is not for the "intent to resell"; the IRS has been very clear about this and will invalidate your exchange if it sees that as the true purpose. Furthermore, even if you complete the exchange and then dispose of your new property immediately after, the IRS will retroactively declare your 1031 exchange defunct because the new property was not held for qualified purposes. In short the mantra is intent. There are some common rules of thumb, such as if you hold the property for a year and a day or two tax years you are perceived to be "less aggressive" amongst most groups of tax advisors. But no where does the IRS or congress say this, it is just a general understanding that has evolved. The only way to be "100% buttoned-up" is to contact a CPA or tax attorney before proceeding with any aspect of the exchange and evaluate your unique facts and circumstances. In the end it is important to remember you have to be an investor, not a dealer, to reap the rewards of a 1031 like-kind exchange.

The 1031 Exchange in Relation to Vehicles

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Fri, 20 Nov 2009 10:17:19 -0600

It is widely known that 1031 exchanges apply to different property types, such as office to multifamily or even raw land to oil wells. However there is usually some uncertainty about using a 1031 exchange in the case of vehicles, such as airplanes or boats. The rule of thumb in these circumstances is that 1031 exchanges are acceptable but only within the same asset class. You can trade an airplane for another airplane but not for a boat.

The reasons for exchanging vehicles are slightly less intuitive than those for exchanging real estate assets. The usual purpose behind the 1031 exchange is to defer the tax you incur on appreciation in value in the underlying real estate. Vehicles represent another story, as they rarely appreciate in value. Instead, 1031 exchanges are primarily used with regard to vehicles in order to avoid "depreciation recapture".

In order to illustrate this point with more clarity, here is an example:

Three smaller trainer Cessna aircrafts from the 1980s were exchanged for a new Cessna. When you buy a plane for 500k, you depreciate it over 5 years to offset its business income. When you get to year 6 your adjusted basis is zero so if you sell you trigger "depreciation recapture" a tax on your 5 years of depreciation. If you buy a plane of equal or greater to 500k, you will defer these gains. Most people "trade up" to get new basis by the amount of the trade up. So in my example you can buy a 650k plane and have 150k "fresh basis".

So here we can see how the 1031 exchange can be of great value to those who own fully depreciated vehicles. This is an important point to remember, as it is often is forgotten, costing many to waste valuable resources on unnecessary taxes.

LandAmerica Settlement Leaves Guidance on How to Handle Proceeds

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Fri, 13 Nov 2009 15:16:22 -0600

Imagine waking up one morning and getting a call from your bank informing you that for every dollar you had, you now have quarters. In other words, there is only 25% of your cash left. This horrible scenario is now dawning over many former LandAmerica 1031 exchange customers and they may have little choice but to accept.

Close to 350 former LandAmerica customers had until November 10 to vote on a plan which would have split the proceeds of a bankruptcy ruling according to the type of 1031 exchange agreement they had in place (A U.S. trustee has filed an objection to the ruling which has delayed proceedings). Customers who set up non-segregated plans would have received only $0.25 for every dollar held, those with segregated accounts would have received $0.70, and those who specified their funds be held in an escrow account would have received $0.97.

The reason this tragedy came about was that those customers in LandAmerica without segregated accounts essentially had their money commingled with other customers' exchange assets. This cash was then used for investment purposes, in this case, auction rate securities which eventually were frozen. As unimaginable as it may seem, this sort of account process is commonplace among many large corporations who facilitate 1031 exchanges. Once your money is handed to them, unless you have asked the question or direct the QI yourself, your cash is dumped into the communal pool of assets. More importantly, you have the worry that the exchange group does not have any knowledge of where the money is held. Your money may be wired to "Treasury Services" such as what happened at LandAmerica.

What has emerged from this case is that you can obtain the same protection for you assets by having the appropriate contract language in place and making sure your proceeds are in separately identified accounts (which ES Group uses 100% of the time). Had this been done, LandAmerica customers would have been able to obtain higher recoveries. Of course, hindsight is always 20/20 and this provides little consolation to those who have seen their wealth disappear. Cases like LandAmerica demonstrate who you do business with and how you do it, is of paramount importance.

At Exchange Solutions Group, we have always ensured our customers' investments were safe through allowing customers to identify their own bank in which their money will be held. Though it may seem obvious, this option is not available at most other 1031 exchange corporations. By allowing customers to choose their own bank we allow them to introduce a third party (a banker) who is separate from the exchange and can ensure their investments are alone in a separately identified account. The essence of the 1031 exchange is to defer capital gains taxes and continue your investment; this becomes a failed strategy if it's derailed by poor corporate decision making, or alternatively not knowing what pitfalls to lookout for!

The Tax Haven that is Delaware

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Thu, 05 Nov 2009 09:28:53 -0600

In a recent survey of the laws, practices and size of inflows in 60 jurisdictions, Delaware was found to be the "most secretive financial destination". Coming after Delaware were: Luxembourg, Switzerland, the Cayman Islands and the United Kingdom. These findings may strike some as odd due to the well known reputation of the other front runners but upon closer look, what better secret destination could there be than a state few people bother to notice?

In 2007 the U.S., led by Delaware, received $2.6 trillion in deposits from non-resident individuals and corporations. Delaware draws such attention due to its investor friendly laws which give businesses opportunities they cannot find elsewhere. For instance, Delaware does not tax profits realized outside the state or require that companies be physically present. Furthermore, there is no state sales tax or corporate tax, one person may be the only stock holder and hold all executive offices of the corporation and officer names do not need to be listed on the articles on incorporation. Delaware also boasts a uniquely specialized corporate court system known as the Delaware Court of Chancery which uses judges who have expertise in corporate law instead of juries. All told, there are about 700,000 entities active and registered in Delaware, among which nearly half are publicly traded. UBS and Credit Suisse alone have about 200 entities in the state.

Besides 1^st year law students, many LLC's or small businesses don't concern themselves with have their "corporate veils" pierced. However, much of Delaware's traffic is driven by their respect for the LLC entity as an independent driving force from the people behind the company. When analyzing potential liability, business owners are always looking to mitigate risk.

A Credit to 1031’s: New Homeowners Get a Tax Credit Extension and Investors Get to Sell

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Mon, 02 Nov 2009 09:52:42 -0600

The Senate is considering a proposition that will both extend a popular tax credit for first-time home buyers past the previous Nov. 30 deadline and expand it to include certain current homeowners. This development has implications which directly affect the market for 1031 like-kind exchanges, as it will propel home purchases, allowing many investors to exchange their rental properties in a 1031 exchange.

So far, ES Group has already facilitated three of these exchanges this week. The reasons for exchange have been somewhat varied. In two cases the owner simply exchanged their previous residential rental property for another, often times with a more desirable location, such as a rental property closer to a daughters college or in a potential ideal retirement community. In the other case, the owner was simply tired of running an active investment and decided to enter into a tenant-in-common syndicated commercial real estate investment (TIC). Either way, the tax credit is having an affect on those interested in utilizing the 1031 exchange.

With the tax credits extension, it seems only logical that there will continue to be an upswing of 1031's in this area. Especially since residential values have been faring better recently, recovering from their precipitous decline. The economy, though posting a positive GDP in the latest quarter, remains in an economic quagmire with unemployment still high and showing little signs of lessening in the near future. Thus, selling now to people incentivized by tax credits could be less risky than waiting for opportunities during a "jobless recovery". These government incentives will not continue forever and investors need to constantly keep an eye on where they would like to end up.

If Capital Gains Rates Go Up, 1031 Exchanges and Net Leases Could Too

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Thu, 22 Oct 2009 12:47:34 -0500

If untouched, capital gains rates will automatically revert to 20% on December 31, 2010. Currently the rate stands at 15% and if the Obama Administration makes good on earlier indications, the rate could be raised even higher to 28%.

With capital gains rates set to increase, it only makes sense that more people will want to defer their impending tax burdens by transferring their wealth through 1031 exchanges. Furthermore, it could be possible that the Net Lease market segment will benefit greatly from this.

Net Lease Investments, which are characterized by their long term stability and hands off managerial approach (functioning like a bond), could afford people an opportunity to avoid their large capital gains hit while retaining a revenue producing asset which requires no personal management.

Instead of selling ones $1 million asset and bearing a $200,000 to $280,000 loss through capital gains taxes, you could exchange that asset for a net lease building, defer taxes, and get a monthly income stream.

Timothy Harris: A Man to Remember

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Mon, 19 Oct 2009 12:43:53 -0500

Timothy Harris, an estate planning attorney and founder of Timcor Exchange, passed away two weeks ago after his battle with cancer ended. He was known throughout his profession as a trailblazer and as one insider commented; "a pioneer for all independent exchange companies".

Timothy Harris will be remembered by the many he inspired and missed by all he knew.

1031 Reverse Exchange Insights

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Thu, 15 Oct 2009 16:22:22 -0500

I recently ran into a very interesting blog by Net Lease Insider on the benefits of the 1031 Reverse Exchange. They interviewed Stan Freeman, President of Exchange Strategies Corporation and he provided some useful insights:

1. You can extend the time limits of your 1031 reverse exchange above 180 days because you are dealing with multiple properties, each with their own schedule.

2. You can actually make enough money from the exchange to offset the fees for completing it. If the properties you own are both producing cash flows, you are still privy to the revenues from them while waiting for the exchange's completion.

There is more detailed information within the Net Lease Insiders post; those who are interested in 1031 exchanges will find the piece very interesting.

Watergate: Symbol of Two National Crises

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Wed, 07 Oct 2009 11:51:55 -0500

When someone mentions Watergate, I instinctively think of the Nixon scandal and how that event highlighted and even symbolized the problems our country faced. Government was not to be trusted and our leaders were, contrary to their protests, crooks. Even though the event itself was relatively minor and as the subsequent 1972 election results proved, completely unnecessary, it was a microcosm of all that ailed the nation.

Today I read another story about Watergate, this one about how the hotel part of that complex is about to be sold for around $40 million after its previous owner, "an affiliate of Monument Realty, a Washington D.C. developer, and an affiliate of Lehman Brothers Holdings inc." defaulted on their $43 million dollar loan. They had planned to redevelop the property "into a boutique hotel with some condominium units". This story seems to feature all the major players of our current crisis: defaulting loans, foreclosure auctions, and of course Lehman Brothers.

The tale seems all too common and unfortunate, a group over leverages itself on a loan for a building, attempts to redevelop it, then defaults as the credit crises hits. Except here it takes place in our nation's capitol, with regard to an iconic building, which at one point in time was the symbol of high end property. It is an amazing microcosm, reflecting the fall from grace that has befallen our real estate industry. One has to wonder at how a singular building can find itself mirroring the woes of a country so perfectly on two separate occasions.

When Will Buyers and Sellers Get Together?

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Wed, 30 Sep 2009 14:20:42 -0500

Recently, I have been searching for an automobile to replace my current 1990 Volvo Station Wagon. When I speak to people about this search I often hear about how "this is a great time to buy a car", the economy is terrible and buyer power is at an all time high. Operating under this assumption, I made multiple visits to various auto dealers, assuming each time a great deal awaited me. But to my surprise and utter frustration, the fabled deals did not exist. Instead I encountered four letters which I thought would be of no value in this climate: MSRP.

In an economy where GDP is shrinking and unemployment is going up, how could MSRP possibly matter? As far as I understood, "MSRP world" went away about 2 years ago and we are now living in something called "discount world". But this fact did not resonate with dealers; they were intent on getting close to their MSRP value.

When I mentioned this to a co-worker, he exclaimed that the same thing was currently hampering commercial real estate. Buyers and sellers were living on different planets, each with their own set of prices. For proof you can check out this report from CA Real Estate Journal. The divide between the two is eerily reminiscent of those middle school dance scenes we see in movies, where the boy and girls stand on opposite sides of the room, each waiting for the other side to come to them. Likewise, you can imagine buyers and sellers standing on opposite sides of a room, nervously eyeing each other, looking for some sign or signal that the other side may be willing to close the gap and concede to their price point.

Of course in the movies eventually some bold individual breaks the ice, causing a chain reaction whereby both sides meet nicely in the middle. So when will that happen for commercial real estate? When will we find common ground? Well of course if we knew that, there would be no issue, our situation would be resolved. As it is, we must linger in uncertainty, standing on opposite sides of the price spectrum, waiting for that mutual resolution. Until then, I'll just keep low-balling dealers.

Commercial Real Estate Loans, A Refinancing Time Bomb?

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Wed, 23 Sep 2009 14:17:49 -0500

Like it or not, we could be locked in between two forces heading towards each other at breakneck speed, our fates depending on which one reaches us first. In one corner we have the economy, a once seemingly unassailable force of nature, now hobbled by recession and slowly trying to recover. In the other corner there looms billions of dollars worth of commercial real estate loans, quietly waiting as the seconds tick off towards their maturity date. We stand in the middle, our fates tied to the outcome of this race.

If the economy recovers before the proverbial time bomb of CRE loans detonates, we should be fine. In the next five years, nearly half of all commercial real estate loans mature, Deutsche bank predicts that around 65% of these will not qualify for refinancing. This could represent either a large opportunity or threat, depending on our state of affairs. If the economy has recovered, unemployment is down, credit is flowing and consumers are spending, the glut of properties available to the market should be eagerly grabbed by buyers.

However, if there has been little or no recovery, there is a good chance those properties will lay vacant, property values will drop and banks will be flooded with assets taking a loss. Already there is dire news, July saw a 5.1% drop in the commercial property price indices, marking a 39% fall from its October 2007 high. Furthermore, according to Real Capital Analytics, the number of commercial property sales which are classified as "troubled" (properties in default or close to it) almost doubled to 23% in July from March. Total commercial real estate sales through July of this year have been about 1/3^rd of those last year. There has been positive news as well, as Fitch Ratings reports the credit outlook for retailers has improved over the course of 2009.

We know the economy will improve but as with all things, timing is everything. 2012 marks the year most of these loans come due, by then the economy is projected to have mostly recovered. If that is the case, then disaster will probably be averted and 2012 could mark a period of substantial growth and recovery. If not, 2012 could be remembered as an ugly cliff from which we had a nasty fall.

Maryland Nonresident Form 505 – Trap for the Unwary

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Wed, 02 Sep 2009 15:23:37 -0500

We often hear talk of the "hidden pleasures" of life, the little things, like enjoying the Sunday paper or catching the fleeting glimpses of a sunset. And as everything seems to have an inverse in this world, there are also "hidden antagonisms" of life, little nondescript and unapparent tortures which spring upon us at our most misfortunate position. Often they come in unassuming yet ominous forms, as is the case of one particularly devilish horror: Form 505 or The Maryland Nonresident Income Tax Return.

Its full name should give some clue as to the nature and power of the Demon, this is no lesser creature; it comes fully charged with the powers and relentless malevolence of a tax collector. However, its most insidious characteristic is one which we are at fault for: the ignorance of its existence. And this is one situation where ignorance has a steep price.

The scheme behind it is simple enough: anyone who has an investment in Maryland, such as a rental property or a sole proprietorship, should be taxed at Maryland's exorbitant rates, regardless of whether they live there. The taxpayer is usually not warned that they must file anything and years can pass before they ever find out that they needed to file a MD form 505. If you work with a certified public accountant (CPA) he/she should pick up on this and advise the tax payer of their liability if there is one. Since this is common, Maryland can work with the taxpayer to file past returns and keep them in compliance.

For Example, consider this fact set:

Say you owned a rental property in Maryland from 2003 to the present while you held residence in Virginia. Today you have a net of $380k on the property which at 7% makes the Capital Gains tax $26.6k. Also, let's say you earned $35.2k in income from the rental property which you paid taxes on in Virginia and you never filed a Form 505.

Today if you tried to dispose of the property you would be responsible for the cap gains tax of $26.6k, all the back taxes never paid on the $35.2k in income (regardless of the fact you already paid them to Virginia) and subsequent penalties for not filing Form 505. Clearly, an investor's paradise.

Again, talking to your CPA is important to find out how to work with the state that you never filed the nonresident return. Most of the time, if you filed the non resident return and paid the taxes accordingly, you can offset resident tax liability as a credit from the nonresident tax liability you have to pay. So going back to this example, if the tax payer would have to pay the nonresident tax to Maryland, he/she could have taken an offsetting credit up to the amount he/she paid taxes to Maryland on his/her Virginia resident return. This helps avoid double taxation. Since each state has different tax rates, the credit may not be dollar for dollar of the taxes paid to the non resident state.

The Solution?

If you are going to invest in rental property or a business that is not in your state, consider speaking to your CPA or lawyer if there will be a nonresident state tax or other requirement for that state.

1031 Mailbag: Can You Do a Reverse Like-Kind Exchange for a Replacement Property Worth Less than the Original?

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Mon, 24 Aug 2009 14:58:59 -0500

We received this inquiry from a successful Realtor® in a resort Community in Maryland- Can You Do a Reverse Like-Kind Exchange for a Replacement Property Worth Less than the Original?

Q: Let's say you have a place on the market for $1,350,000 and want to buy a place that is less. Can you still perform a 1031 exchange? Furthermore, let's say you want to take cash out of the place for sale to buy the other prior to the sale of the one your selling, basically a reverse exchange of a property substantially less. Is this possible as well?

A: There are three questions in here:

1) Whether your client is the ideal prospect for a Reverse Exchange? That is an issue we address outside the scope of this blog but in full detail on our site. Some clients are ideal for reverse exchanges some are not.

2) Whether you can do a partial exchange and buy a replacement property for less value than your relinquished property. Absolutely yes you can do that. However, you would want to analyze your cost basis to make sure you do not trade so far below your value that you're not getting any benefit from the 1031. For instance if you paid $500,000 and sold for $1,300,000 you would get no value by buying $400,000 worth of replacement property. 1031 exchanges defer the liability on gain above the basis not on a "pro rata basis". So in this case you wouldn't just be deferring taxes on the $400,000 amount. This area is black and white; it all depends on your basis.

3) The second inquiry, whether you can pull equity out of the relinquished property, is more of a red flag issue for the IRS. First, any refinance of the relinquished property should be as close as possible to one year before sale. The IRS frowns on the refinancing of relinquished properties and generally prefers the refinance of replacement property. The rationale is there is less risk of a predetermined cash out of the replacement property and more likelihood that this transaction is an "independent" transaction. If not the IRS views it as a cash out. It would be preferable for you to get an unsecured line or a line on another property to buy the replacement.

Navigating Closing Costs and the 1031 Tax Deferred Exchange

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Wed, 19 Aug 2009 16:05:03 -0500

When entering into a 1031 exchange one often does not consider the ancillary costs that come with closing the transaction. Often the assumption is made that these costs will be subsidized by the 1031 exchange proceeds. However, while some of these costs certainly can be bankrolled by the tax deferred exchange, some cannot. Knowing how to avoid these expenses being deemed boot can keep your transaction out of hot water.

Covered Costs:

It is generally acknowledged that "payment of brokerage commissions from exchange proceeds does not create taxable boot." Thus, payment of these "non-recurring" costs of sale or purchase from the exchange proceeds should not be considered taxable boot. Brokerage commissions are one example of non-recurring costs; however certain other costs are excluded.

They are as follows:

Real Estate Commissions
Recording Fees
Direct Legal Fees
Title Insurance Premiums
Qualified Intermediary Fees
Agreed Property Inspections
Escrow or Closing Agent Fees
Documentary Transfer Fees

Note: Expenses have to be customary in the jurisdiction (e.g. 6% listing agreement).

Un-Covered Costs:

Certain costs are generally not covered and considered taxable boot if they are involved with anything else besides acquisition of the replacement property. The issue most people run into involves getting a new loan on the replacement property. Because the costs for acquiring the new loan are not related to the acquisition of the replacement property (according to the IRS), they are considered taxable boot.

These Include:

Loan Fees
Points
Prorated Mortgage Insurance

Another issue to consider is that prorated property taxes, insurance payments and rents are considered deductible ongoing expenses. As such, they are not included in the 1031 exchange; however, their payment does not impact the use of the Qualified Intermediary safe harbor.

Maryland 1031 Non-Resident Pitfall

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Wed, 05 Aug 2009 09:45:42 -0500

Like-Kind Exchanges are fairly identical state-by-state. However, locally, in Maryland we have a big pitfall to watch out for when conducting a 1031 Exchange. When your seller is a Non-Resident of Maryland (does not personally call Maryland their domicile) and they plan to conduct a like-kind exchange upon the sale of a Maryland property, the client must file an exemption form with the Maryland State Comptroller at least 21 days in advance of the relinquished property settlement.

While this may seem trivial, I have seen this one item derail both portfolio sales of one billion dollars and Baltimore row house sales for $50,000.

To obtain an exemption certificate, nonresident exchangors must submit by mail to the Comptroller of Maryland, twenty-one days in advance of settlement, Maryland Form MW506AE, Application for Certificate of Full or Partial Exemption. The Comptroller's Office will then issue the taxpayer their certificate.

If a nonresident taxpayer has income from a Maryland property (even if there is a net loss), they need to file a Maryland Form 505, Maryland Nonresidential Income Tax Return, annually. If the Form 505 has not been filed for previous years, the Comptroller's office may reject the application for exemption as there is no Maryland record that the property was held for business or rental purposes to qualify for the IRC Section 1031 exemption.

No tax will be collected if the seller certifies the property was their principal residence in accordance with the federal rules in IRC Section 121.

If an individual or a corporation has paid withholding tax at settlement in excess of the amount owed, they may file an Application for Tentative Refund of Withholding on Sales of Real Property by Nonresidents (Maryland Form MW506NRS). The request for refund may be filed with the Comptroller after 60 days have elapsed from the date the tax was paid to the Clerk of the Court or Department of Assessments and Taxation.

Here is a link to the form: http://forms.marylandtaxes.com/current_forms/MW506AE.pdf. Call with any questions.

As always, for your clients seeking a Qualified Intermediary, don't hesitate to reach out and schedule a free in-person consultation in the DC area.

Sincerely,

James Brennan Esq.,LL.M.
Exchange Solutions Group, LLC
Principal/Corporate Counsel
11150 Sunset Hills Road, Suite 300
Reston, VA 20190
Direct 703.801.4178
Fax 703.663.9889
www.1031esgroup.com

Conservation Easement: The Greener Side of 1031

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Wed, 15 Jul 2009 09:25:43 -0500

Everybody wants to go green these days and as it turns out, there is a way for those owning real estate to do so as well (without installing solar panels or wind turbines). The solution is found within something known as a "Conservation Easement", a government provision enacted to provide incentive for private owners who donate their land for conservation purposes. By applying the 1031 exchange to this process, a property owner can both preserve the environment and make a new real estate investment.

A conservation easement is essentially a deeded fee interest that Land Trust Commissions or other government entities buy in order to preserve the natural state of the land. It comes in handy in two distinct situations: 1. You own property and want to sell it but do not want it to be developed for environmental reasons, 2. You own property and want to sell it but cannot find a buyer. In both situations a conservation easement can be beneficial, as the government will use the land in an environmentally friendly way and provide consideration through its purchase of the easement.

An easements value is determined by taking the value of the land without the conservation easement and subtracting that from the value of the land with it. The 1031 comes into play when there has been sufficient appreciation on the property to make the sale of an easement subject to capital gains tax.

For Example:

Mr. Bolan has owned a plot of undeveloped land for 20 years. Over the course of these 20 years the land appreciated in value from $1 million to $10 million. Now Mr. Bolan wants to sell the land but does not want to see it developed, thus he pursues a conservation easement. The land is valued at $4 million with the easement, so $10 million (the lands unrestricted price) - $4 million (the lands price restricted by conservation easement provisions) nets a $6 million easement.

The issue Mr. Bolan runs into is that he will face a substantial capital gains tax, because of the properties appreciation, when he sells the easement. What he can do instead is trade his $6 million easement, in a 1031 exchange, for land of equal value.

Note: This transaction would have to be structured, from the very beginning, as a 1031 to work. To make a 1031 viable, a qualified intermediary would need to take title to both the land and the revenues gained from its sale NOT the actual owner. If the owner were to receive money directly from the sale of the easement a 1031 transaction would be impossible.

Continuing with the example, Mr. Bolan (through his intermediary) receives $6 million from his sale of the easement. The cash is then used to buy an apartment complex, which will provide Mr. Bolan with a steady flow of cash. All of this is done while avoiding the capital gains tax Mr. Bolan would have faced if he just cashed the easement. Through application of the 1031 exchange, he is able to both preserve his previous property and acquire a new one, all the while avoiding capital gains tax.

California Claw-Back Provision: What Happens in California, Will be Taxed

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Mon, 29 Jun 2009 10:53:51 -0500

The 1031 exchange is a great instrument for property owners who wish to defer their capital gains tax. However, not all states treat 1031 exchanges equally. California regulations stipulate that any appreciation in property value accrued in California is subject to their state taxes, regardless of whether or not that property was exchanged for one in another state before its sale. This means that CA property owners cannot escape CA state taxes, even if they exchange their property for one in another state.

Most states conform to federal income tax treatment of like kind (1031) exchanges, where all capital gains taxes are deferred until the properties eventual sale. This is generally interpreted to mean that one is only subject to taxes of the state where the property is sold, discounting the state taxes of any state where the property was exchanged from. Meaning that if I owned a property in NV, exchanged it for one in ID and subsequently sold it, I would only be responsible for federal and ID taxes, not those from NV.

California is a notable exception to this. It employs a "claw-back" provision, entitling the state to tax any gain on property that occurs in California, regardless of where the property is eventually sold.

For example:

Say Mr. Newcombe bought a property in CA for $100. After appreciating to $200, he exchanges it for one in ID. While in ID the property further appreciates to $400. Feeling he has had enough of owning property, he sells it for $400, showing a total capital gain of $300. Mr. Newcombe would not only be liable for $300 of capital gains taxes in ID, but $100 of capital gains taxes in CA as well.

Note: The reciprocal of this situation does not come into effect. If Mr. Newcombe owned property in ID and exchanged for property in CA, he would only be subject to CA state taxes, not those of ID.

From the above example it is clear that owning property in California and exchanging it for property in another state leaves one open to double taxation. There is no way to avoid this situation unless one stays out of CA entirely or performs the final sale there. Being taxed in CA would of course be undesirable because it has some of the highest income tax rates, 9.55% and 10.55% for earnings over $47,055 and $1,000,000 respectively. The claw-back provision really hurts people when they try to exchange out of California's stringent tax system into a friendlier one such as Texas, which has no income tax. In situations such as this, the "claw-back" provision acts like a hand reaching out of the grave to grab and tax people one last time. Needless to say, before making an investment in CA, ensure it will be worth the high amount of taxes you will eventually pay for it.

“Curses are like young chicken, they always come home to roost”

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Wed, 10 Jun 2009 14:48:18 -0500

So you thought what we've seen so far is bad? New research from Deutsche Bank indicates that there is another financial crisis coming, specifically a "refinancing crisis". It deals with the large amount of high risk, debt fueled loans which were taken out to finance commercial real estate investments between 2005 and 2007. Now with the value of these properties gravely diminished, it is projected that many people will have no choice but to default.

Starting in 2005 and peaking in 2007, underwriting standards went on a perilous "walk on the wild side"; bloating loans with so much leveraged debt that today they resemble cumbersome humpty dumpty's teetering atop the crumbling walls of our nation's financial institutions. A key element of debt (recently forgotten) is that at some point it needs to be repaid; in terms of loans this translates to the maturity date, when the principle on the loan is due. For a while people thought that this judgment day could simply be pushed back with the push of a few magic buttons on our financial calculators. But alas, it seems this time people will either have to pay up or get out of town (literally). However, if you fall into this unfortunate category, be comforted, for you certainly do not travel alone.

Of all the loans which are set to mature in 2009 or thereafter, 68.3% ($601.9 billion) do not qualify for refinancing. Coupled with the fact that commercial real estate prices have dropped 40-50% or more, it becomes obvious that most people will have no choice but to default either at maturity or sooner, translating to massive market upheaval.

However, hidden within all this pessimism there is still opportunity. Unlike previous commercial real estate crashes, such as that of the early 1990's, this crash has little to do with oversupply. So though many people may default and loose their properties, the properties themselves will still have definitive value. It is better to think of this crisis as a cleansing of the system, a removal of all the risk and debt which plagued us. Concurrent with the outflow of bad money will undoubtedly be an inflow of good money and a sound ground for the future.

From Starker to 1031

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Tue, 09 Jun 2009 14:13:30 -0500

Ask members of an older generation about a tax deferred exchange and they will most likely respond with the words "a starker exchange" making no mention of the commonly known term "1031". Indeed, in the old lexicon "1031" is a meaningless unassigned number. "Starker", on the other hand, represents a discernable moment in time, more specifically a court case (T.J. Starker v. U.S., 602 F. 2d 1341 9^th Cir. 1979), when the tax deferred exchange was given relevancy.

Before "Starker" the 1031 exchange was a cumbersome, expensive, and almost impossible venture. Originally created in 1921, the belief was that the exchange of properties must take place simultaneously, making exchanges inordinately difficult. It required that parties directly swap their properties, such as in a deed swap. The problem was it was almost impossible to find two people who wanted to exchange their properties. Sometimes, deals involving 4 or 5 parties would be attempted, but such endeavors would be routinely fraught with complications and fall apart.

Enter T.J. Starker, a former professor at the University of Michigan, he was wise enough to begin buying "second-growth" forest parcels in 1936 and eventually acquired substantial holdings. A "second-growth" forest is land which was originally de-forested and then replanted, thus having to grow a second time. The genius in buying these parcels was at the time they were severely undervalued. It may seem like common knowledge today, but in Starker's day forests were seen to be a somewhat inexhaustible resource. There simply was not a large market for second-growth forests because people believed there were a multitude of old-growth forests to choose from. Of course the reality of the situation soon dawned on people and logging companies became eager to pay high prices for land, which a few years prior, they had not considered worth the cost.

Thus we are brought to the Starker case. In 1967 two timber companies, Crown Zellerbach and Longview Fibre, offered to purchase 1,843 acres of land owned by T.J. Starker, his son Bruce and daughter-in-law Elizabeth. The parties encountered a problem when both companies expressed a need to start logging immediately, before the Starker's had chosen their replacement property. The Starker's would only concede to hand over their property if it was part of a tax deferred exchange, so the parties struck a deal which would lay the groundwork for the 1031 as we know it today. The Starker's transferred their land to the respective companies and in exchange credit accounts were set up at each company to be called upon when the Starker's had settled on a replacement property. Control of cash would never be given to the Starkers, when they settled upon a property it would be purchased by the companies and subsequently transferred. That year the Starker's tax returns were filed with the transactions treated as being tax exempt.

Enter the IRS, who very quickly disallowed the exchanges because the properties were not exchanged simultaneously. They claimed there could not be a time differential between the transfer of properties and demanded the Starkers pay their taxes. The Starkers paid the taxes and subsequently filed suit, resulting in three court cases.

Starker I (1975)

The first case concerned only Bruce and Elizabeth, they simply sued for a refund of the taxes they paid. Surprisingly, the court sided with them and ordered the IRS to issue the refund. However, no mention was made of the mechanics of the property exchange.

Starker II (1977)

The IRS struck back in the second case, as the court (the same one presiding over Starker I) essentially reversed its decision and claimed that no legal exchange had taken place. The exchange of property for a promise to replace it with suitable property was not deemed to be "like kind" and the deal was declared taxable.

Starker III (1979)

The third time was the charm; in 1979 T.J. Starker filed an appeal with the 9^th circuit court contesting the 1977 ruling. The court not only ruled that Starker I barred the government from re-litigating the transfers which were overturned in Starker II but that the requirement for the "simultaneous" exchange in fact did not exist. People were now free to exchange their properties with the delay we currently see as such a common and integral feature today.

So there you have it, the defining moment of the 1031 exchange in a nutshell. Today 1031's are an invaluable tool people use to continue their investments by deferring the capital gains tax. But the incarnation we have today had to be fought for, had to be won in a battle between one man and the IRS (who desperately did not want it to be easier for people to avoid their taxes). Strange then that we now choose to call such an irreplaceable, tax saving tool by the name the IRS gave it, rather than the name of the man who made it work.

1031 Thy Name is Diversity

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Mon, 08 Jun 2009 10:21:17 -0500

It is common to think of a 1031 transaction as one involving land for land or buildings for buildings. However, this is a tragic oversimplification. 1031 transactions deal with "like-kind" property and in most people's minds, "like-kind" means both pieces of property are alike, such as trading land for land. But do not follow this train of thought when dealing with real estate; in the eyes of the IRS "like-kind" refers to all "qualified real estate", opening the doors to a wide array of transactions.

For example:

In one case a person wished to exchange 18 oil wells valued at 1.375 million for an apartment or office building. If they were to simply sell the oil wells and buy their building of choice, they would face a substantial capital gains tax; however, through the use of a 1031 they are now making this exchange tax free. That is because oil wells are considered qualified real estate and are eligible for a 1031 involving all other qualified real estate. Other qualified real estate types include: Coal mines, mineral rights, timber, and vineyards.

This all means that investors have an immense selection of properties to both acquire and exchange using a 1031.

Note: The example above pertains to real estate. A 1031 can also be used for property other than real estate such as medical equipment or airplanes, in which case the property would have to be alike i.e.: airplanes for airplanes, medical equipment for medical equipment.

Friends Don't Let Friends Buy Real Estate in C Corporations

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Fri, 05 Jun 2009 13:06:48 -0500

In matters of taxation, "form" consistently trumps "substance". In-fact, there is an entire industry of lawyers and specialists dedicated to the study and application of these forms. Like chemists or biologists they analyze the different ways they interact with stimuli (tax laws) and the forces of nature (the IRS) governing them. Much has been learned from these studies and today with the right person's help, you can avoid many of the arduous taxes which befall the unsuspecting. One of the more clear and poignant lessons learned is also one which many people may find themselves in violation of: Do Not Buy Real Estate as a C-Corporation!

We all learned in business school that c-corporations are taxed twice, once on income received at the corporate entity level and another time on income distributed to shareholders or employees at an individual level. In real estate the same rule applies on its two sources of income, direct income and appreciation. The catch is, if you are a c-corporation, you don't have to own real estate directly, you can hold title to it in a tax friendly LLC or s-corporation. The advantage of each is that income is only taxed once when it is distributed at the individual level, you skip a whole level of taxation! So if you own a c-corporation and are acquiring any real estate, consult a specialist and ensure you are not taken advantage of by the IRS.

Now, let's say someone, "Mr. Bowie" for example, owns real estate in a c-corporation and after realizing his folly wishes to transfer it to an s-corporation or LCC. Is there anything he can do? The answer is: YES. The real estate can still be transferred to a more tax friendly entity; however, certain rules apply:

1. As was said before, real estate earns income both directly and through appreciation. The direct income is realized immediately when it is received, and thus in the above example would have already been taxed at the corporate entity level, thus subject to double taxation (translation: there is nothing Mr. Bowie can do about the direct income received while a c-corporation).

2. However, the appreciation is another matter. Income from appreciation is only realized at the properties sale and since that has not happened yet, can be avoided. The problem is the IRS has made a rule stating you have to wait 10 years after placing the property in an LLC or s-corporation before you can sell it and avoid the double tax. However, the law has oddly been changed recently; shortening the time period to 7 years but only if the transfer is made in 2009 or 2010. If transferred in either 2009 or 2010 Mr. Bowie would only have to wait 7 years before selling.

What is obvious from all this, is that the form in which you do business is of the most paramount importance. Furthermore, there are people who have spent their whole lives studying these topics and are ready to help those in need. Do not hesitate to contact one of these people or do research on your own, a single call could make a huge difference. Remember, with the IRS you get only one chance to make a good first impression.

Starting a Company vs. Selling for a Company

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Fri, 06 Feb 2009 13:49:33 -0600

I recently discussed my new company, www.1031esgroup.com, with Daniel Odio of Drodio and Brian Martucci of Wachovia. Both of these guys are business owners, and were encouraging me that the life of an entrepeneur is challenging, but rewarding. Prior to this venture, I had always had a salary and the security of a regular job. The daily grind wore at me, and I wanted a new challenge.

When I described the differences between selling for a company, and running a company I described how I now need to wear many hats. I have to balance setting up an entity, with running bank accounts, delegating to our director of operations, and mentoring sales staff.

So thus I found myself describing opportunity cost. The opportunity cost of myself contacting prospects and clients, or training people to do it. Teaching a man how to fish- so the company can leverage its efforts.

However, should you just fish yourself? To scale to McDonalds-mega-size you can't do it alone. You need to empower, delegate, and train people you work with to have a team. Afterall, "together everyone achieves more..." right?

In theory this sounds great; however, if you were a hunter wouldn't you pick up a 22 and pick off your prey if you knew you had it all setup? Is this always going to be with me- this uneasy feeling of - I should just do this myself?

What does Like-Kind in a 1031 Mean?

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Tue, 04 Sep 2007 22:01:42 -0500

In a 1031 Like-Kind exchange you can exchange any real property for any other real property within the United States or its possessions if said properties are held for productive use in trade or business or for investment purposes. Examples of 1031 like-kind exchange property include apartments, commercial, condos, duplexes, raw land and rental homes*. As used in IRC 1031(a), the words "like-kind" mean similar in nature or character, notwithstanding differences in grade or quality. One kind of class of property may not, under that section, be exchanged for property of a different kind or class. Examples of qualified 1031 like-kind properties and like-kind exchanges:

apartment building for farm/ranch
office building for hotel
raw land for retail space
unimproved property for commercial property
airplane for airplane

Examples of non like-kind properties include primary residences, stocks and bonds, notes, partnership interests, developed lots held primarily for sale and property to be resold immediately after initial purchase or completion of improvements.
* Qualification for Section 1031 exchanges depends upon the extent of personal use.

Earnest Money Question "Released"...

James Brennan, JD/LLM, 1031 Exchanges (ES Group) — Fri, 31 Aug 2007 08:42:01 -0500

The question whether a Seller in the course of a 1031 exchange can take control of earnest money out of a realtor's escrow account is a very common one. Many intermediaries and attorneys supply their clients with misinformation regarding this point. Sellers CAN take control of earnest money proceeds prior to the closing of the relinquished property. At relinquished property closing ultimately the seller will need to either mail a check for the earnest money directly to the QI or (alternatively) supply the check to the closing attorney/settlement agent and the proceeds can be forwarded along with the balance of the proceeds at settlement.

James