The Primary Residence taxation, the Residential Replacement Rollover, Sec. 1034 exception is gone. Previous capital losses still apply, if the property is held as investment property and sold at a loss and that loss can be carried over for up to 7 years. For those over age 55 the primary residence or residential sale exclusion of taxation is gone. Tax deferred exchanges remain a viable way of deferring taxation on investment real estate.
It is required to analyze and pre plan prior to transaction. That analysis must be done by an updated tax deferred exchange professional such as those we have on retainer. Not only do you need a tax attorney, but a real estate attorney, and an expert attorney working with them – that is a specialist in only tax consequences; especially those of tax deferred real estate transactions. There must be proper forms and written documents before the transaction is done. This requires planning and a review of limitations as well as a formal and professional critique of assumptions and decisions.
Most Realtors, Attorneys and CPAs do not have sufficient expertise to guide you in a legitimate and defensible tax deferred exchange. The key here is defensible, as the IRS will usually audit the tax deferred transaction and if it’s done correctly so that it is easily defensible you will sail right through the audit for little or no money. Your personal tax profile and that of your other business and family identities must be factored in the decisions. It may be necessary to legally refigure, adjust, and compartmentalize your purchase or sale – and document that appropriately, BEFORE you begin to put any part of the transaction in writing. Planning is legally done BEFORE and if it is done after the transaction you can be liable for fraud. The IRS does not take kindly to fraud especially regarding real estate.
For instance you must know your straight line depreciation factor; for investment property that is currently 39 years. For instance: Any depreciation taken during the ownership of the property will be picked up in a recapture tax upon the sale of the property.
Federal and State taxations must be combined properly, according to numerous factors that must be researched by your team of advisors. Since the total taxation on the gain is approximately 35% of the gain plus the recapture tax – your fees to professionals can be well worth it to you if they better your tax situation. The tax deferred technique can defer till later or eliminate your tax payment and consequence. Of course the only real and usual way to eliminate the tax is to die. There are ways to defer the tax however until that death. Tax deferred strategies are sometimes called alternative strategies or alternative tax deferment strategies.
Note: if you are speaking with anyone and they speak of TAX FREE EXCHANGE or TAX FREE SALE of your property, they are not well informed and thus you should be wary of any other advice they give you. There is, effectively, no such thing as a tax free sale or tax free exchange of real estate.
Exchanging is an effective tax planning tool. Large potential tax liability can therefore be deferred. And, there are savvy investors who have deferred taxation on millions of dollars of properties for decades and thus given themselves many millions of dollars of additional investment money with which to leverage their wealth.
Like kind exchange can now be defined as: any kind of real estate in exchange for any other kind of real estate.
We hear of qualifying property or properties – yes there can be more than two properties involved, in some cases there can be several and you don’t have to ever see or even know about the other properties involved. You will need good advice however, professional advice. This exchange of any kind of real estate for any other kind of real estate was not always true. This tax deferment alternative is not for everyone. Some owners should not defer.
We must realize, as well, that there is ALWAYS a risk of audit. The larger the dollars involved and the more suspect (according to the IRS) that the participants in the transaction are, the more likely an IRS audit of the procedure is. If there are several million dollars in tax deferment involved, and especially if one or more of the participants are considered audit targets by the IRS for any reason, you may become involved in an expensive tax audit. The cost of the audit, even if you are successful in defending your decisions, can be far greater than the tax deferments. And if the deferment is disallowed there WILL be penalties, fines, interest and even more substantial legal and accounting fees – plus an amended return in some cases which may trigger more consequences and even more audits. I hope I’ve made myself quite plain here – get good advice from legal and accounting specialists on these exchanges.
There is a time line, for several of the acts and consequences in exchanges according to the IRS. In addition to timing there are other qualifying or disqualifying situations and these situations include the use of the properties, before, during and after the transaction by those involved or their families, friends, associates, etc… In addition to the normal criteria for the exchanges, if Realtors, investors, attorneys, or those who buy and sell real estate frequently are involved in exchanges; the IRS makes special, more restrictive rules that will result in more scrutiny by the IRS. In fact the IRS can make up reasons why they think a person needs more scrutiny; that can include political affiliations, relationships to politicians, your social position, your affiliation with judges, and conspicuously wealthy or well known people and even your religious affiliations and charitable giving recipients. In fact, there can be a tax deferred exchange that will work for one side of the exchange and not for the other person or entity involved.
In addition the tax court looks at intent for use, investment, or purchase and sale — not only the use; past, present and future; of the properties involved but what they think may be or could be the uses and consequences based on all sorts of criteria and even hunches they may have. They also have extensive rules on what like-kind exchanges are. The exchange must also be interdependent. There may not be any receipt or control of cash or other liquid assets from the sale by any of the exchangers. This can be inclusive of debt relief as well. Any of these things will be taxed. In fact, a refinancing of any property involved within two years or less will disallow the tax deferment as well. There are also several time limits and timing criteria involved which must be allowed for and honored.
There are some specific terms; relinquished property and replacement property are the most important terms; after the most important definitive phrase of all: Like Kind Property Exchange. Large potential tax liability can be deferred; that is: NO tax is due upon receipt of the proceeds; from your investment in qualifying real estate, whether buying or selling, can be maximized by deferring the tax liability, the consequences, and using the deferred expenses. That is; you are saving and have the use of the tax money you don’t have to pay now, and you can invest that money in the next property, giving you a multiplied ability to invest and reap further benefits of appreciation and income. Therefore, you will have the additional money, and therefore additional down payment, to invest in an even larger property or pay cash for a more expensive property. This can change your life; your life as an investor, your business life, at least.
The exchange does not have to be simultaneous. You must in general; identify the property within 45 days and settle within 180 days.
There are also delayed exchanges, non simultaneous exchanges, which are sometimes called Starker Exchanges. There can be a buyer assisted, delayed, Starker exchange. This buyer assisted, delayed exchange, is done with the help of the buyer – by letting the buyer possess or even live in the property for a while. This is almost always a bad idea, a very bad idea. There is also such a thing as a reverse-Starker exchange. In a Reverse Starker Exchange the replacement property is acquired before the relinquished property is sold. These are rare, unusual, possible and legal – but not to be considered lightly without adequate counsel involved in your every planning facet.
For the protection of all involved; the contracts, all exchange documents and paperwork should be prepared by specialists in tax deferred transactions. The Realtor should never, ever, prepare the exchange documents!
There are some additional factors and rules. You can name up to three possible properties in that first 45 day period. There is also a rule called the 200% aggregate rule where you can name several
properties up to but not more than 200% of the value of the relinquished property. Property held by a person who deals in property does not qualify. Personal residential use property does not qualify. Partnership interest in property does not qualify. Refinanced property will not likely qualify if it has been refinanced in the last two years. The property must ordinarily be held for investment and generally acquired and held for appreciation and for production of income such as rental income.
Let’s now look at the sale of personal residences. The gain on a personal residence has no tax due on the first $250,000 of gain for one person or $500,000 tax relief for a couple. A principle residence is one that a person resides in for 183 days per year or more and no other. Factors which determine a person’s principle residence are four; each showing the same residential address of that being claimed: A Driver’s License; Magazine, Newspaper, and Internet Subscriptions, Utility Bills such as Cable TV, Telephone, etc. that are mailed to and show the address as residence, credit card bills, checking and savings accounts, voter registration card, personal telephone listing in the white pages.
There are many pages of rules, regulations, code, determinations, tax code, rental and vacancy rules, abandonment according to prescription, determinations of intent, various capricious factors known only to particular IRS agents, time lines, divorce issues, temporary use, rental, vacancy, or abandonment issues, documented or discoverable intentions on the part of participants in the transactions, multiple dispositions in short periods of time, work related occupancy and vacancy requirements, personal business use of property, income streams, family uses, health related and documented residential move or vacancy requirements, court cases and other recorded facts, all manner of special requirements and issues, land installment contract provisions, miscellaneous extenuating and defensible contingencies – which will affect the bona fide legality and defensibility of a tax deferred transaction. There are many points upon which your planning should be based. There are some emergency planning techniques as well.
You can even take some improvement expenses and take a fix up expense for work done to sell the house. You MUST have: Written affirmation of necessary expenses that are needed to sell the property. Be able to prove the work was done within 90 days of the executed contract of sale. There is also, now, a maximum of 20% taxation on the taxable portion of the net gain on the home. Generally tax laws are applied separately to each individual owner or co-owner of the property and each must meet requirements separately and individually.
Take care. Be prepared. Educate yourself and ensure that your advisors are as well. Be legally and financially, well represented and very professionally and personally wary.