HARVARD HERE WE COME!!! --ALSO-- CAN A TRUST DO AN EXCHANGE?

I will be giving a lecture at Harvard University next week, of course, on my favorite subject, Section 1031 tax deferred exchanges.  While up in Boston, I will also be meeting with one of our clients, who has a concern about whether he and his sister can do an exchange, as the title to the property in question is held in a trust, and they are the beneficiaries of the trust. 

First and foremost, there is no problem with a trust exchanging the real estate it owns for another piece of real estate.   But what if, as is in this case, one of the two beneficiaries (owners of the trust) wishes for the trust to sell the property and disburse his share of the proceeds to himself (which will result in a tax being due).  Meanwhile, the other beneficiary wishes her interest to be exchanged under Section 1031, so that her interest will have no taxes due, because they will be deferred?   

The answer to this convoluted question is that these taxpayers may split up their interests, if the trust is taxed directly to the beneficiaries.  My advice to them, as always, is to check with their CPA, in order to see how their trust and the taxes thereon are handled.  You might want to mention to your CPA the term "disregarded entity."  That will help them to understand how I arrived at the answer above.

TARGETS ON CAMPUS

A couple of months ago I gave a seminar at the Business School of Cornell University.  Prior to the seminar, I walked around the beautiful campus and passed by a bank which was offering a "special" for opening up an account.  The same types of “specials” were in the bookstore for magazines, credit cards, etc.  It reminded me of my college days, when you could get a neat T-shirt if you opened up an account with that "special" bank. 

So the question is:  Why would these magazine companies, credit card companies, or banks for that matter, give these specials to college kids when they generally don't offer these "specials" to the general public?   The answer to that question appeared in an article in the September 6, 2006, issue of the Wall Street Journal, which said, "...For many banks, students represent one of the fastest growing business segments.  Moreover, their research shows that a young adult who opens an account often remains a loyal customer for many years to come." 

So what are the banks offering these days--a souped up version of the same old T-shirts?  Nope!!!  Sovereign Bank is giving free airline tickets.   Bank of America pays up to $50 to the student when the account is opened.  Chase is offering--wait till you here this one--12 dozen bottles of Coca Cola and the best of all--Tah Dah-- KeyBank is enticing the students with a free ipod shuffle music player. 

But it's not only banks that are targeting the college student.  The WSJ points out that insurance companies, for example, State Farm, who gives seminars on insurance and is sponsoring rock concerts on campus and credit card companies have increased their marketing positions on college campuses by more than 30% from last year. 

The answer to why are these companies targeting the college students was answered by Ed Stolbof, senior vice president of marketing for Morgan Stanley's Discover Financial Services. He said, "Young adults tend to be very loyal to their first card...It's really important to get to card members as soon as we can in their credit cycle."  If you are a college student or are the parent of a college student, the WSJ suggests to keep in mind the following:  "Be alert to what is required in order for a bank to waive monthly fees on checking accounts; for convenience, consider the size of a bank's ATM network and if it reimburses fees for using out-of-network cash machines; select a credit card that offers low rates if you expect to carry a balance, and low credit limits to limit spending.”

EXCHANGING AN EASEMENT FOR REAL PROPERTY

At one of the seminars I just gave, a CPA asked whether a taxpayer could exchange an easement for a piece of real estate. 

I don't want to get too technical in this blog, so let me first explain that an easement is an interest in real estate that gives the holder the right to use, but not possess, the real estate.  A right of way, a right to cross over the land of another, is a good example of an easement.  Another example could be an easement given to your local telephone or electric company permitting the utility company to place poles or underground wires at designated sites and run wires between those sites. 

Since the owner of the real estate has given up a right of ownership or limited their right of ownership by giving an easement, they have partially devalued their property.  The purchaser of the easement now has a "partial" ownership right in the real estate.  If the State provides that an easement is real estate, then for Section 1031 purposes, the sale of an easement can be exchanged for the ownership of other types of real estate.  Just as importantly, the Internal Revenue Service, in Rev. Rul. 72-549, has already ruled that an exchange of an easement is "like kind" with other real estate.

DEVELOPERS WOO FAMILIES

According to the Wall Street Journal, "time was when a patch of outdoor space with a swing set and a sandbox was enough to draw young parents with children.  But now, new developments are playing to "Type A" parents by playing up the kid stuff.  In a strategy developers and builders started during the booming housing market--and one they say will help them stand out in a slowing one--they're spending millions of dollars on elaborate water parks and fake fossil digs and promoting couture romper rooms by name-brand designers."

I mean we're talking about FAO Schwartz playrooms and gym wellness programs for children by Equinox Fitness.  So why are the developers using these extreme tactics?  Obviously these services are great attention getters, especially to the parents of the 73.5 million children in the United States who are under the age of 18. 

The WSJ interviewed a Miami real estate developer, whose loft condominiums, being built in the Financial District, will have an all glass facade, including Italian-designed kitchens with a roof top lounge.  As the market has changed and the luxury condo market becomes even more saturated, he, as well as many other developers, is making significant changes.   On his development, the roof top lounge is being shrunken so that he can accommodate a children's pool and playground, with plans to add  "...a separate kids-only activity room and an on-call baby-sitting service to the building."  Is this a great country or what!!!   Doesn't it make you want to be a kid again!!

ASSOCIATED PRESS SAYS SHOPPERS WANT NUTRITION RATINGS

The Associated Press says there are a number of supermarkets that are now rating what food is healthy for you.  One supermarket chain, Hannaford Bros. is using gold-stars to mark the healthiest foods.  For example, if a food is healthy it gets one star; if it's healthier it gets two stars; and if it's the healthiest food it gets three stars.  The rankings are based on guidelines set out by the U.S. Dept. of Agriculture  "...with points earned for meeting recommended levels of nutrients or fiber and taken away for having too much of the bad stuff -- like saturated fats and sugar."  Obviously, this has to do with understanding healthy eating.   

Want some examples?  OK--produce like blueberries and artichokes or cereal like Shredded Wheat get three stars.  However, Cinnamon Shredded Wheat only gets two stars, while one of my favorites--Doritos-- gets no stars.  Please note, the stars do not necessarily support a regimented diet because they don't count calories, but they will naturally weed out many high-calorie foods.  I don't want my wife to read this blog--because she'll find out I know a little more than I profess to know about dieting and healthy eating.  In either case, these types of food rating systems are good for those of us on diets, of which I'm one.

THE NAPKIN RULE

I now have had two of you bloggers request a definition of the Napkin Rule.  The Napkin rule is a rule that was written on a cocktail napkin, a number of years ago by some of my fellow brethren in the 1031 industry.  It describes four "givens" that are used when trying to decide whether a 1031 transaction will be valid. 

So here goes--the description of the famous -- NAPKIN RULE:

Rule #1--The taxpayer must purchase (exchange) a property of equal or greater value to the property sold, in order to completely defer the applicable capital gains tax.  If the taxpayer purchases a property of lesser value, the taxpayer will be taxed on the difference.

Rule #2--The taxpayer must use all of the cash proceeds from the sale of the taxpayer's property toward the purchase of the replacement property in order to completely defer the applicable capital gains taxes.  If the taxpayer does not use all of the proceeds towards the purchase of the replacement property, those proceeds not used will be taxed.

Rule #3--The taxpayer selling the relinquished property must be the same taxpayer who purchases the replacement property.

Rule #4-- In order to have safe harbor protection, the taxpayer must use an independent qualified intermediary.

WHAT DOES ALL OF THIS MEAN? 
The long and short of this rule is that the taxpayer must purchase property of equal or greater value than the property sold. They must use all of the proceeds received at sale towards the purchase of the replacement property. The taxpayer must be the same on the purchase as was on the sale.  So, for example, you can't add your child to the title of the purchase of the replacement property because your child was never on title when you sold your relinquished property. And, finally, make sure you hire a completely independent Qualified Intermediary, not anyone who was or is your agent.

You now have my permission to transact a tax deferred exchange as set out in Section 1031 of the Internal Revenue Code.

COST SEGREGATION--WHAT IS IT AND WHY DO I WANT TO USE IT?

A friend of mine is a cost segregation specialist and he is continually getting asked, “What do you do?”  OK--here is the legal terminology as expressed in a fancy magazine:  "A cost segregation study is an asset-reclassification strategy that accelerates tax-depreciation deductions."   Using this technique will result in the real estate investor being able to lower their current income-tax liability and increase current cash flow. 

Now what does this really mean in layman’s terms?  A taxpayer can separate out certain items that are part of the real estate purchase, and instead of taking a depreciation deduction over the standard 27.5 or 39 years, the investor can accelerate certain personal property depreciation deductions over 5, or 7 to 15 years. 

For example:  An investor is about to purchase a small office building.  The Purchase Price is $900,000.  After having a cost segregation study completed, the purchase price could be segregated out as follows:  Real Estate $600,000, Land $90,000, carpeting $110,000, electrical wiring $125,000, lighting fixtures $50,000, and plumbing $25,000. 

Land is not a depreciable item.  The real estate would be depreciated over 39 years, but the other items (carpeting, electrical wiring, lighting fixtures, and plumbing) would be depreciated over a much shorter time period.  This would enable the taxpayer (the new owner to be) to accelerate these depreciation deductions, which, in most cases, lowers the taxpayer's current income tax liability and increases their current tax cash flow.   

Without having a cost segregation study completed, the investor/taxpayer would most likely be stuck at depreciating the assets over 39 years, which most tax advisors would say is a waste of valuable deductions. 

How Can I Make Sure my Property Qualifies?

Section 1031 contains no fixed amount of time needed to qualify a transaction for tax-deferred status.  Instead, Section 1031 requires that the taxpayer have the intent to hold the property for either an investment purpose or a business purpose at the time of the exchange to avoid a taxable exchange. 

The case law on Section 1031 follows a line of precedence where courts will attempt to determine what the taxpayer's original intent was at the time he sold his relinquished property and purchased his replacement property.  The court applies a “facts and circumstances” test to objectively measure whether the taxpayer had a bona fide intention to hold each property as investment or business property at the time of the exchange. The taxpayer’s actions, written and oral communications, and tax filings, constitute evidence for examination if the Internal Revenue Service challenges the tax-deferred status of the exchange. 

For a more thorough discussion on this subject go to our website:  bayview1031.com and look up recent articles written on this subject.

BABY BOOMERS' KIDS PURCHASE TIME SHARES

If you have been reading this blog for awhile, you are aware that I am a Baby Boomer.  I was in Phoenix, AZ, last week giving a seminar on Section 1031 and read, with some interest, an article that appeared in The Arizona Republic. 

It appears that 18.5% of the recent purchasers of Time Shares are children of Baby Boomers.    "Many of those buyers are single professional women, who buy with the intent of traveling" with their friends.  Again as a Boomer myself, I would recommend to my children that they should always check out the management of the development. Always ask for recommendations on which developments allow you to more “easily” exchange your unit for another week in another development. Also, always purchase with the knowledge that Time Shares generally do not appreciate in value.  Finally, you might want to rent a unit in that Time Share development before committing to purchasing a unit. In fact, a lot of Time Share Resorts offer discount accommodations for prospective purchasers.

What Happens if the Exchange Doesn’t Qualify?

In some situations, the question would be:

What happens if I know I can't qualify for a 1031 Exchange, and I'm just trying to get around the tax law? In other words, I’m playing "Russian Roulette with IRS.”

In the normal situation, if I didn't find a replacement property in the required time period-- no problem-- my proceeds will be returned to me, and I will just have to pay the tax that was due.   But many taxpayers know up front that they don't qualify for a Section 1031 Exchange and, therefore, they rely on the “audit-lottery” to save them from the costs of a failed 1031 Exchange, which, in my mind, is a fraudulent transaction.

Playing around with IRS is not very smart, because the costs can be very high indeed.  With the underpayment penalty (up to 25%) and the accuracy penalty (20%), the initial penalty can total 45% of the tax due.  There is also the possibility of a civil fraud penalty that can range up to 75% of the tax due (not to mention the risk of criminal fraud prosecution).  Of course, interest from the date of the transaction through the final determination can substantially increase these financial costs. 

Finally, the normal amount of time available for the IRS to begin an audit begins on the date that the return is filed and ends three (3) years thereafter.  However, in a fraudulent 1031 Exchange, usually the taxpayer has under-reported his income for that year by more than 20%, which means that the Internal Revenue Service has seven (7) years to examine the tax return.  For outright fraud, the IRS can re-open a tax return at any time.  In cases such as these, many taxpayers must sell the property just to pay the taxes, penalties, and interest involved. 

Should you want a more thorough discussion of this subject, go to our education section on our website:  www.bayview1031.com.