SPECULATORS HELPED FUEL FLORIDA'S HOUSING BOOM

That's the title of an article in the Wall Street Journal written about the slump in sales in Naples, Florida.   My best friend (besides my wife) bought a unit in Naples about 5 years ago.   His builder held a lottery to see who would get the unit.  You had little choice of which unit you were going to get--the market was very hot.   The median price for units more than doubled in less than 5 years and they weren't cheap before they doubled. 

The WSJ said,  "The frenzied run-up promoted economists at banking concern National City Corp. and the economic consulting firm Global Insight Inc. to label Naples ‘the most overvalued’ housing market in the U.S. in the second quarter of 2005, a dubious honor it retains.  Today, prices are dropping, the number of unsold homes on the market has swelled to more than twice the national average and investors are scrambling to unload their properties...It's increasingly evident that investors and speculators here and elsewhere played a greater role than previously thought in pumping up the real estate bubble--especially near the end of the run." 

It is interesting to note that the National Association of Realtors (NAR) estimates that 28% of all buyers in 2006 were investors.  In Naples, Florida, it was estimated that more than 50% of the purchasers were investors.  My friends saw another property they would like to purchase in the Naples area.  They have had their existing unit listed with a Realtor for the past 8 months with only 1 person who even came close to making an offer, and that was subject to the sale of his unit in Naples, which of course like most others did not sell.  Numerous Realtors predict it's going to be at least another 12 months before the Naples market has any type of rebound.  I hope my friends can hold on.

ONE OF OUR EXCHANGE CORRDINATORS HAS A FATHER THAT.........

Most of you bloggers know that an Exchange Coordinator is the person in our office who handles all of the paperwork on the Section 1031 exchange.  They are highly trained and experienced individuals.  In fact, in our office, the EC must have been a real estate paralegal for at least 5 years before we even interview them for an EC position. 

Now that I've given you the experience factor, one of our EC's asked me to solve a problem for which she had no resolution.  She tried to solve it, but couldn't come up with a satisfactory answer. It involved her father.  Her father built a spec home and wondered whether he would be able to do a 1031 exchange.   

She told her father, correctly by the way, that she didn't think he would qualify because most developers or builders who build or renovate and then sell, would be considered to be a dealer, because they held the property primarily for the purpose of reselling it.   That of course would not qualify for a Section 1031 exchange, because you must hold the property for investment purposes or for use in the trade or business.  It can't be inventory or primarily held for sale.   

If this were to go to through the court system, the main test would be:  What was your intent?  If you can prove that you are an investor and not a dealer then, of course, you can pursue the 1031 avenue or, at least, pay capital gains taxes.  If you are a dealer and this is a business, then no matter how long you held the property, it would be taxed as ordinary income. Ordinary income, of course, is taxed at a higher rate.

IS THE DIFFERENCE BETWEEN 1031 AND 1033 REALLY ONLY 2?

Numerically 1033 minus 1031 does equal the number 2.  But we are referring to the different sections of the Internal Revenue Code and this is whey it is an interesting question.  Last week we had a client ask this question and additionally, it was also asked in the question and answer period of my speech given last month at Harvard.  So let's review both sections of the Internal Revenue Code--Sections 1031 and 1033. 

My bloggers know that Section 1031 allows an investor to sell (exchange) his investment property or property used in a trade or business for another investment property or property used in a trade or business.  The taxpayer must identify the replacement property he would like to exchange for his existing property within 45 days of the sale of the relinquished property. The taxpayer must close on the purchase of the replacement property within 180 days of the closing of the original sale.   

One of the keys to a Section 1031 exchange is that the taxpayer can purchase any type of real estate for any other type of real estate.  For example, the taxpayer could exchange a piece of raw land for an office building.  They are both defined as real estate. As along as they are investments or used in a trade or business, they can qualify under Section 1031. 

Under Section 1033, a tax deferral is allowed when the taxpayers property is taken by a governmental agency by condemnation or the imminence of a taking.   Generally, the taxpayer is only allowed to replace real property held for investment or productive use in a trade or business, and the replacement must be "similar or related in use."  In effect, under Section 1033, the property replaced must be the same type of real estate that was condemned. 

For example:  an apartment house for an apartment house--but the time limit is longer in this case, because under Section 1033, it could be two years or more.  That additional time line could be a major advantage.  Also, there is no need for a Qualified Intermediary when doing a Secton 1033 transaction.   There are some other provisions that make these transactions different, but they are too cumbersome to discuss in a blog.  But yes, there are major differences between these two sections of the IRS CODE.  So you may have an advantage in the amount of time you have to close on your replacement property under Section 1033, if your property is condemned.  As one of my Exchange Coordinators pointed out, there are not many situations where a governmental agency condemns ones property.

YOU CAN START OUT SMALL AND STILL BECOME PRESIDENT OF THE UNITED STATES

Last month, President Gerald R. Ford died.  He will be remembered fondly by most Americans, as a President who was not elected into office, but who had the best interests of Americans in heart and did an admirable job in very trying times.  The American Bar Association's e-Journal Report said in an article written by James Podgers about President Ford, that his career choice was one "... any young lawyer fresh out of school might have to make.

“Solid grades at a prestigious law school had garnered lucrative offers from some large firms on the East Coast. The attractions of living and working in New York City or Philadelphia were tempting, and there would be a chance to continue a serious romantic relationship. Seemingly a no-lose situation.

But the decision was not all that easy. The hometown—a small Midwestern city, pleasant, hardworking, but a bit stolid—beckoned, as well.

That was the dilemma facing Gerald R. Ford, approaching his 28th birthday as a member of the 1941 graduating class of Yale Law School.

Turning his back on what surely would have been a successful legal career in a large firm (not to mention that romance), Ford opted for home. In May 1941, he and Philip Buchen, a friend from undergraduate days at the University of Michigan, opened their law office in Grand Rapids, a bustling city of some 150,000 people near the eastern shore of Lake Michigan, where Ford had grown up.

While Ford harbored some vague notions about using law practice as a springboard into local politics, that first major career decision set a course that even he hardly envisioned.

Seven years after opening the firm, Ford won his first election to the U.S. House of Representatives from the district that included Grand Rapids.

Twenty-four years later, he became the Republican leader in the House. And just more than 30 years later, in 1974, he became the nation's 38th president when the Watergate scandal finally toppled Richard M. Nixon.

Although the United States in which Ford began his career more than 50 years ago may seem like a distant world to lawyers starting out today, his experience still resonates with the message that small-firm practice can hold unlimited possibilities." 

My comments as a young lawyer when he took office still resonate today:  "He did the right thing at the right time."

NON-TAX REASONS TO DO A 1031 EXCHANGE--PART 2

Here are some more Non-Tax Reasons a Taxpayer will want to do a Section 1031 Tax Deferred Exchange:

8. The Taxpayer decided to relocate to another state and would like to have all of their investments within a reasonable distance from where they live.   This becomes especially important to the Taxpayer who must manage and oversee their investments personally.

9. Consolidation is an important concern to many of our clients.   They own a number of investment properties and managed them for a number of years.  They have decided that it would be better to own fewer, but more expensive investments.   This could decrease the Management responsibilities, as a larger/more expensive property is more conducive for hiring a management company to take care of the investment.

10. Multiplication and Leverage--no I'm not talking about 3 x 3 = 9.  Many Taxpayers are hoping that through their investments, their net worth will appreciate.  For example:  A Taxpayer who owns a piece of property valued at $500 that will appreciate 10% in a year, will have an investment worth $550 at the end of the year (appreciation of $50 that year).  A Taxpayer who exchanges that $500 (I am presuming there is no debt on the property to make this example easy to understand) for a $2,000 investment (that would be 25% down--$500--with the remaining $1,500 in borrowed money) would have at a 10% appreciation factor, a $200 appreciation that year.  We know which is more--$200 is more than $50.  So through multiplication and Leverage--the Taxpayer's net worth can appreciate at a much quicker pace.

11. Reduced Management Responsibilities--I know I have intimated this reason above, but it is a very important reason that many Taxpayers transact a 1031 exchange.  They exchange the property they presently own and replace it with one with less management headaches, or replace it with a property that they don't have to manage at all, such as a Tenant-in-Common type of property--that is professionally managed by others.

12. Exchange out of a property they own a partial interest in--and exchange into a property they will own just by themselves.  That way they no longer have to get an approval to do anything to or with the property from their "co-owner."

13. Estate Planning is a major reason Taxpayers want to do an exchange.  Although this blog is titled Non-Tax Reasons--I just had to sneak this one in because, if done correctly, most Taxpayers will pay NO tax when doing a Section 1031 exchange and at the Taxpayers’ demise, their heirs will receive these assets at a stepped up basis-and it's very likely that there will be no estate taxes.   Isn't this a wonderful world--That's why I love being the Qualified Intermediary--I can make my client, the Taxpayer, happy as well as their heirs.

FOR A MORE THOROUGH BREAKDOWN OF THESE AND OTHER BENEFITS GO TO OUR WEBSITE:  www.bayview1031.com

NON-TAX REASONS TO DO A 1031 EXCHANGE--PART 1

My bloggers are aware that doing a Section 1031 tax deferred exchange allows  Taxpayers the privilege of not having to pay their federal capital gains taxes, depreciation recapture taxes and state income taxes (if any) on the property they held for investment or on the property that they used in their trade or business.  Whew--that was a long sentence. 

So deferral of payment of taxes is a major reason astute Taxpayers use Section 1031 of the Internal Revenue Code.  But there are numerous Non-Tax reasons to do a 1031 exchange.  I will cover some of these reasons in this blog and will continue with more reasons in the next blog.  Let's begin.  Non-Tax reasons to do a Section 1031 Exchange:

1. Taxpayers may want to sell a property that they have fully depreciated and exchange into a more expensive property that can be depreciated.

2. Taxpayers may want to exchange a property that is not producing income into a piece of property that does produce an income stream.  The typical example would be the exchanging of a piece of raw acreage into a replacement property, such as an office building that produces a positive cash flow.   A lot of retirees do this type of exchange, because they are looking for that income stream in their retirement years.

3. Taxpayers' "Property of Their Dreams," becomes available and so they exchange an investment property they are not particularly fond of for the "Property of Their Dreams."

4. Taxpayers exchange a property that is not producing a satisfactory cash flow for another that will produce a higher cash flow.

5. Taxpayers want to diversify their investments.  They might own one large property.  They could sell the property (relinquish it) and purchase (replace) with numerous investment properties.   They may want to diversify because they would like to have properties in various different states so that if one state has an economic problem, the rest of their assets are not affected.  Or they might want to own different types of property.  For example they could exchange a large office building and replace it with a small strip shopping center, an office condominium, and other property--all being different types of real estate.  Remember--the property sold (relinquished) must be "like kind" to the property purchased (replaced).   In the case of Real Estate, all real estate is "like kind" to any other type of real estate.

6. The Taxpayers may want to exchange a property that is not appreciating at the rate they would like for another property that has a better possibility for increased appreciation.

7. The Taxpayers may decide to do a 1031 exchange because the present property they own may be harder to sell in the future and the replacement property may be easier to dispose of in the future.

REMEMBER:  IT IS IMPORTANT TO HIRE AN INDEPENDENT QUALIFIED INTERMEDIARY WHO IS KNOWLEDGEABLE IN THE ENTIRE 1031 EXCHANGE PROCESS.  We will continue with more Non-Tax Reasons for a 1031 exchange in our next blog.

CAN'T PUT 20% DOWN?

A lot of prospective homeowners don't have enough funds to purchase their dream home.  I started practicing law over 35 years ago---so far back that there was no such thing as cell phones.  In the early 1970's, a prospective homeowner who didn't have enough funds for a payment, would generally ask the seller to give them additional financing. 

As the years passed, lenders increased the amount they would lend on a 1st mortgage (loan). In some cases they would lend up to 97% of the purchase price. But if they did loan more than 80% of the purchase price, they were required, since these were generally government guaranteed loans, to have an insurance policy to cover any possible losses for nonpayment. 

About five or 6 years ago, a second loan, also called a "piggyback loan" was introduced into the market place by lenders.  Its intent was to help cash strapped consumers get as much financing as possible without having to pay for an insurance policy guaranteeing loan payments. A "piggyback" loan is in effect a second loan on the property which is typically given by a lender and is usually given in the form of an equity loan or line of credit type of loan. 

All interest on primary residential loans are tax deductible.  Now comes the news that new federal legislation will give most consumers the right to deduct mortgage insurance premiums on their income tax returns.  According to the Wall Street Journal, the "...new guidelines issued recently by bank regulators could make it tougher for some borrowers to get piggyback loans, particularly if these are paired with exotic types of mortgages that may increase risk."  Representatives at many lenders are "rethinking their strategies."   For example, J.P.Morgan Chase & Co., is "...currently looking at how to help its loan officers understand the new rules and decide whether mortgage insurance or a piggyback is a better bet for borrowers."  There are a lot of other variables to consider, but it looks like mortgage insurance is back in the residential market game, especially since the borrower may be able to deduct the insurance premium on their income tax return.

RECEIVED THE FOLLOWING E-MAIL FROM A PROSPECTIVE CLIENT: PLEASE EXPLAIN A TAX FREE EXCHANGE.

Well, this prospective client got me on this one.  I can't explain a tax free exchange because by law, there is no such animal.  I had to explain to her that Section 1031 of the Internal Revenue Code relates to Tax Deferred Exchanges, NOT Tax Free Exchanges.  I further explained that our infamous Capital Gains Tax does not disappear when doing a 1031 exchange. Instead, it is deferred until the Replacement property is finally sold, rather than exchanged into something else.  Of course, with proper tax planning, the tax may never be paid. 

For more information on this subject, go to our website: www.bayview1031.com and order one of our 1031 handbooks.

MIXED USE SECTION 1031 EXCHANGES

Invariably, when I give a seminar on 1031 exchanges, a question on mixed use exchanges is queried. 

What is a mixed use?  Pretend my last name is McDonald.  Further pretend that I am a farmer. AND on my farm--E- I, E- I - O, --ENOUGH of the nursery rhyme--but if I had a farm and I lived in the farm house, but farmed the surrounding land, I would have a mixed use property.  The farm house would be my personal residence and the surrounding farm land would be property that I used in my trade or business (in this case, farming) or was being held as an investment. 

I could sell the property and use both sections 121 and 1031 of the Internal Revenue Code (IRC).  How does that work you ask?  Under section 121 of the Internal Revenue Code(IRC), a taxpayer can sell their personal residence, and if they lived in the personal residence 2 of the last 5 years, up to $250,000 of profit per person or up to $500,000 per married couple, can be received TAX FREE.  That of course is presuming that the personal residence (in this case the farm house) went up that much in increased equity.  The remaining portion of the sales price could be allocated to the farm land, which would qualify for a Section 1031 exchange. 

Let me give you an example.  Mr. and Mrs. taxpayer purchase a farm for $300,000 in 2001.  It has a farmhouse on it and 50 acres of farm land.  The farmhouse is valued at $200,000 and the land at $100,000 (that of course equals $300,000).  In 2007 they agree to sell the farmhouse and 50 acres for $1,100,000.  If they can justify the value of the farmhouse at $700,000, they could receive the profit on the farmhouse TAX FREE(sales price of farmhouse $700,000 less original purchase price of $200,000 equals a TAX FREE PROFIT of $500,000 under IRC Section 121). 

The farm land which was originally purchased for $100,000 is now worth $400,000, so there was a profit of $300,000 on the land.  The taxpayer could do a  IRC Section 1031 exchange on the $400,000 of land and purchase another real estate investment for $400,000 or more.  If taxpayers did that, they would defer any and all taxes that would be due on the sale of the farm land (that of course is covered under IRC Section 1031). 

It's a convoluted example--but WOW--what a way to save money, pay no tax on the personal residence profit and defer paying tax on all of the other profit. I'll say it again, acting as the Qualified Intermediary on a Section 1031 exchange is a wonderful job--the client is always happy because you have helped him/her save payment of taxes and, in some cases, they will never pay any tax.

BLOWING THE WHISTLE TO IRS MAY BE MORE REWARDING

The Wall Street Journal reported that President Bush will be signing into legislation a law that "...authorizes the Internal Revenue Service to pay higher rewards to many informants in cases involving large amounts of money.  The reward could be as much as 30% of what the IRS collects...a Senate Finance Committee aide says the new provision applies to a tipster with information involving business or, in the case of an individual, someone whose gross income exceeds $200,000 for any year in question." 

The bad news is that IRS in the past has rejected most reward claims, because they produced little or no helpful information.  What I thought was interesting is that a number of IRS officials emphasized that "...many tips flow in from people seeking revenge against an ex-spouse, an ex-business partner or a former employer."   

It is estimated that IRS has paid out in the past 30 years more than $89 million in rewards. Maybe this new legislation will create more reward payments, but as large as $89 million seems, it only reflects around 8% of the reward claims made.