AM I ALLOWED TO KEEP SOME OF THE CASH?

I get asked this question all the time.  I have had clients want to use the proceeds for everything from paying off charge card bills, going on vacations, to buying themselves a Porsche automobile.   

The answer to this question was delineated in one of the four rules of  what we in the Qualified Intermediary industry call the "Napkin Rule".  The part of the rule discussing use of proceeds says:  "Thou shalt use all of the proceeds from the sale of the relinquished property towards the purchase of the replacement property."  OK--so what if you don't use all of the proceeds towards the purchase of the replacement property--will that invalidate your entire Section 1031 Tax Deferred Exchange?  The Answer is NO it won't--but you will be taxed on the portion of the proceeds that you kept and did not use towards the purchase of the replacement property--the rest of the proceeds that were used towards the purchase of the replacement property would not be taxed at this time as a result of Section 1031.  This type of transaction is called a "partial" exchange.

BANKS MOVE QUICKER TO LIMIT FORECLOSURES

The Wall Street Journal Reported in an article written by Ruth Simon that "As the number of borrowers falling behind on their mortgage payments climbs to the highest level in five years, the mortgage industry is trying new strategies to help bail them out. Much of the attention is on homeowners who in recent years took out adjustable-rate mortgages, a popular way to finance a home when interest rates were low. Now with rates having moved up, many of these borrowers have recently seen, or soon will see, their mortgage rate adjust higher for the first time."

So what are the banks doing when a loan goes bad? "…Mortgage companies are reaching out to borrowers earlier. Bank of America Corp. is allowing some borrowers with ARMs to refinance into a different loan at no cost…CitiMortgage…is focusing extra attention on part of California, Florida and New York where home prices have moved up sharply. It is also contacting delinquent borrowers within days after a missed payment, if it doesn’t fit their normal bill-paying habits." There are even some lenders that are allowing the property to be sold for less than what is presently owed and then forgiving the remaining debt. Why would a lender allow this you ask? The reason is that this usually will be less costly than having to proceed with a foreclosure, "…especially in a declining market. For borrowers, it is a way to avoid having a foreclosure on their credit report."

CAN I EXCHANGE FOR A PROPERTY IN ANOTHER STATE?

The answer is YES YOU CAN!! Let me quote from a recent article I wrote, discussing the issue of DIVERSIFICATION.  "The investor can diversify his or her investments by purchasing properties in several States. They could exchange his existing property with a different class of real estate such as long-term leases, shopping centers, raw land, farmland, office buildings, industrial properties, or even percentage interests in large complexes. With respect to real property, Code Section 1031 is very liberally construed in determining what is "like kind" between different classes of real estate."

A REPEAT FROM LAST YEAR--A LITTLE CHUCKLE AS TAX DAY APPROACHES

I love my job as a Qualified Intermediary, because I get to help taxpayers defer the payment of their Federal and State taxes, which results in the taxpayer having more funds to invest in replacement property.  In many cases, the taxpayers may never pay taxes.   Now, as I prepare to pay my Federal Income Taxes, I think of all those taxpayers that may need a laugh.  So here are some humorous quotes on taxes:

“The difference between death and taxes is death doesn’t get worse every time Congress meets.”  Will Rogers

“A taxpayer is someone who works for the federal government but who doesn’t have to take a civil service examination.”  Ronald Regan

“They say that true democracy is a perfect marriage between the people and the state—and in April the government reminds us that they married us for our money.” Anonymous

“I’m proud to be paying taxes in the United States.  The only thing is – I could be just as proud for half the money.”  Arthur Godfrey

“The trick is to stop thinking of it as ‘your’ money” -- Tax Auditor

MANAGEMENT RELIEF IS A MAJOR REASON USED IN 1031 EXCHANGES

I was recently asked by a major real estate magazine to write an article on 1031 exchanges.  So here is an excerpt from the article, discussing why management relief is another reason to do a 1031 exchange.

The investor "...may be too busy or not inclined to deal with management issues, collections, finding new tenants, repairs, maintenance or other headaches that come from owning rental properties.  The investor may be approaching retirement age, and thus does not want to be stressed over management issues.  Using Code Section 1031, the investor can exchange his high-maintenance property to low or no-maintenance property such as shopping centers that are fully leased with a management team in place, or triple-net leases where the investor ownes some or all of a long-term lease, and the owners of the underlying property have to deal with all management issues."

PAY PHONES--NO TALKIE OPTION

When I was practicing law, one of my clients invested heavily into the pay telephone business.   He always looked for sites that were heavily trafficked; generally in low income neighborhoods and tourist spots.   Coin operated laundries, which was his former business, were great sites for pay phones; so were bus depots, train stations, rest-rooms in highly frequented restaurants and bars, and  of course airports.   

The Miami Herald reports that "Payphones -- the trusty, clunky, plastic - and - metal standbys favored by Clerk Kent for his Superman transformations - are going the way of the dinosaur....Nationwide, about one million pay phones have been yanked from street corners, bar bathrooms, airport terminals, hotel lobbies and others spots since 1999." In fact, over two-thirds of all payphones have left service in Florida over the past 7 years.  The reason given is the rise in the cell phone industry.  It is estimated that "...about 12 million of Florida's 18 million residents use cell phones, meaning about two of every three people keep a cell phone clipped to a belt, tucked in a purse or glued to an ear."   The payphone industry points out that they serve those persons who don't have access to cell phones or landlines insides homes.  They also point out that you can always get an operator or 911 without a charge on a payphone--"it's like having 40,000 emergency call boxes throughout the state--you don't want to lose that safety blanket."   Well, whether you use them or not, it seems payphones are becoming extinct.   The still to be answered question is:  With payphones disappearing, what facility will Superman use in the future?

RECEIVING CASH AT THE CLOSING?

After speaking at the State of Michigan Board of Realtors Convention, I was asked what happens when a taxpayer receives some of the cash from closing but wants to do a Section 1031 tax deferred exchange.    The answer is simple, the taxpayer will be taxed on the amount of boot (cash is called boot) received at closing.  The rest of the funds, if given to a Qualified Intermediary and then used properly towards the purchase of the replacement property(s), will not be taxed.  I briefly talked about this issue on the Blog titled “The Napkin Rule.”  For more information on this question, go to www.bayview1031.com.

ANOTHER REASON TO DO A 1031 EXCHANGE--ADDITIONAL CASH FLOW & RETIREMENT INCOME

A major benefit for doing a 1031 Exchange is that the taxpayer can increase their cash flow and have additional funds for retirement. For example, an investor may swap non-revenue producing property, such as raw land or underutilized property, for high-revenue shopping centers, leases of 30 years or longer, or office complexes that already are full of paying tenants. Alternatively, the investor can exchange high-revenue properties for those with greater growth potential such as resort-area acreage or lots in rapidly developing communities.

How about avoiding taxes on real estate gains, and re-investing the proceeds in a safe investment that pays the investor monthly income for the rest of his or her life? Shopping centers, strip malls, and office buildings that are already under a long term lease can provide a nearly certain monthly income for the rest of the investor’s life, with rates of return much higher than any government bond. At the taxpayer’s death, all potential capital gains taxes are "wiped away" and his or her heirs will own the property at a "stepped-up" basis, without incurring any built-in taxes that he or she would have been forced to pay if they sold the property without re-investing in a replacement property.

It's a beautiful world when you are knowledgeable on 1031 exchanges. For more information on Section 1031, watch this 7 minute video presentation at www.bayview1031.com.

OFFICE RENTS SURGED IN 2006--BUT

Data just released from Reis, Inc., a New York City based real estate research firm, reflect a 9% rise in office rents nationwide in the year 2006.  That is the biggest increase since the "height of the technology boom in 2000."   The Wall Street Journal quoted Lloyd Lynford, Reis' chief executive as saying, "It is clear that investors cannot expect the same pace of rent growth without a more cooperative level of net absorption."  He further noted that "slowing growth in demand for office space tracks closely with the slowdown in employment growth."  So those in the office marketplace will obviously be tracking monthly employment figures.   

The other major factor that can affect the office market is overbuilding and oversupply.  Chuck Schrieber of KBS Realty Advisors says that at the present time overbuilding is really not a concern, especially in the hottest markets, because the costs of raw land and construction costs still continue to rise, resulting in a limited supply of viable properties available to for new projects.  Certainly Landlords and Tenants will be looking at both of these factors this next year.

SOME 1031 QUESTIONS AND ANSWERS

I keep getting e-mails from you stating you love the question and answer blogs.  So here are some more.  For your information, you can go to our website: www.bayview1031.com and see the other 20 questions I have previously written.  They are in the "Test Your Knowledge" section.

21. It is possible to defer tax on the sale of a working farm under section 1031, while also claiming the §121 exclusion of up to $500,000 of gain on sale of the taxpayer's residence (joint return), if the taxpayer's residence is located on the same property as the farm? True or False?
A. True, provided the other requirements of 121 and 1031 are met.
B. False, the taxpayer must choose between 121 exclusion or 1031 deferral – he or she may not use both code sections together.

22. Which of the following properties must be held for investment or trade or business purposes?
A. the relinquished property.
B. the replacement property.
C. both A and B.
D. neither A nor B.

23. A taxpayer may construct a building on raw land that he or she previously owned, and use the newly constructed building as his replacement property.
A. True.
B. False.

24. Which of the following would likely cause a taxpayer to be treated as a "dealer" in real estate rather than an investor?
A. The taxpayer has made substantial improvements to the relinquished property in expectation of subdividing the property.
B. The property is developed, subdivided or sold quickly after its acquisition.
C. The taxpayer has previously developed and subdivided many properties.
D. All of the above would indicate that the taxpayer would likely be classified as a "dealer" for purposes of 1031.

25. A taxpayer is permitted under 1031 to borrow large sums using his property as collateral:
A. Immediately before the exchange if the collateral is the relinquished property, for any reason whatsoever.
B. Immediately after the exchange if the collateral is the replacement property, for any reason whatsoever.
C. In most circumstances where the taxpayer has a valid business purpose and the loan has independent economic significance.
D. A taxpayer can never borrow against either the replacement property or the relinquished property no matter what the circumstances.

Answers:
21:  A
22:  C
23:  False
24:  D
25:  C