VACATION--SECOND HOMES---NEW INTERPRETATION

Good news!  After years of strict interpretations, the IRS just issued Rev. Proc. 2008-16, which gives a new and broader definition of "dwelling units" and how they can qualify as  “like kind” real property.

In order for property to qualify for a Section 1031 tax-deferred Exchange, the property sold must have been held for productive use in a trade or business or held for investment purposes.  The property purchased as the replacement property must also be “like kind” and thus must also be held for productive use in a trade or business or for investment purposes. 

So where does that leave a vacation/second home?  Can it qualify for a Section 1031 Exchange?  There have been many interpretations answering this question.  More than 18 months ago, we discussed this very topic -- the vacation/second home issue -- in our August 30, 2006 blog.  The interpretation had been rather narrow and strict.

First, the technical information.  If a taxpayer owns a vacation/second home for at least 24 months immediately before the Section 1031 Exchange and rents the dwelling unit to another person(s) at a fair market rental for 14 days or more a year and uses it for personal use less than 14 days a year or 10 percent of the number of days during the 12-month period the dwelling unit is rented at a fair market rent, the property will qualify under Section 1031 for a tax-deferred Exchange. 

Whew--that was a long technical statement.  Please note the same rule applies for the property the taxpayer purchases as a replacement property if that is going to be a "dwelling unit.  I have a three letter word for this new Rev. Proc.---WOW !!! 

Now, let me give you a nontechnical interpretation.  A taxpayer who owns a vacation or second home for at least 24 months, uses it for 14 or less days a year, or less than 10% of the time it was rented in any of those years, can qualify that dwelling unit for a tax-deferred Exchange. 

The taxpayer doesn’t have to rent it out for an extended length of time, it could be rented for just 14 days a year and could qualify under this new Rev Proc.  What if the taxpayer was purchasing a replacement property  that was a "dwelling unit"?  The same rules apply, the taxpayer could then find a replacement property which would also have to be owned for 24 months, rented out for 14 days or more a year, etc.  But, again, there is no obligation to rent it out long term. 

This is a monumental change in the interpretation and is sure to benefit many vacation-second home owners.  It becomes effective March 10, 2008.   As I said, WOW!!!   FYI--You bloggers now have information on Vacation homes or second homes that probably the majority of people in my own industry, as well as CPA's, are not even aware of yet.   I do try to keep my bloggers as up to date as possible.

HOW LONG MUST A TAXPAYER HOLD THEIR PROPERTY IN ORDER FOR IT TO QUALIFY FOR A 1031 EXCHANGE?

Our office gets asked that question daily. 

First and foremost, the property involved in a 1031 Exchange must be held for “investment or productive use in a trade or a business.”

When looking at “investment intent” the courts will often look to the period of time over which the property is held by the taxpayer. That said, there is no specific holding period requirement for either the relinquished or replacement property. 

Generally, it has been IRS's position that taxpayers who hold their relinquished property for two years or more, satisfy the requisite intent for a 1031 Exchange (or two tax reporting periods, since in an audit the IRS may look backwards and forwards two tax returns). A holding period of over a year has generally been accepted by the courts, but may be subject to review by the IRS.

A much shorter holding period has been accepted by some courts, where a change in circumstances indicates that the taxpayer had intended to hold the property for a longer period (there are only 3 reported cases supporting this shorter time period that I have been able to find). The IRS will look at ‘investment intent’ and will call a taxpayer quickly flipping property a ‘dealer’ vs. an ‘investor’. 

IMPORTANT NOTE--You NEVER want to be described as a "dealer" because you will be taxed at ordinary income tax rates, which normally are a lot higher than long term capital gains rates.   

Finally, "dealers" generally don't qualify for Section 1031 tax deferred exchanges.  So unless you are involved in a card game, you don't want to be described as a "dealer".

CAN I EXCHANGE ONE PROPERTY IN ONE STATE FOR A PROPERTY IN ANOTHER STATE?

Mary Brown (fictitious name) sold an investment property located in the State of  Nevada.  She wanted to do a Section 1031 tax deferred exchange and so she identified 3 properties, all of them in the State of Florida, which obviously is in a different State.   Section 1031 is part of  the Internal Revenue Code, a Federal Law.  I am happy to inform you that the taxpayer can purchase any investment replacement property, which is like kind, in any State in the United States.  So Mary, could purchase those properties as replacement properties, even if they are in Florida.

IS NOW THE BEST TIME TO REFINANCE YOUR HOME?

The Real Estate Center recently reported that there may not be a better time than the present to refinance your home.  Their economist, Dr. Mark Dotzour said:  “Inflation is clearly rampant all over the world, including in the United States,” he said. “When inflation is a problem, mortgage rates go up. Rates probably should be much higher right now, but they aren't.” 

The report went on to ask a very important question:  "Why are rates so low when inflation is not a fear but a fact? Dotzour says the fear of a global collapse of the banking system is greater than the fear of inflation for the world's bond investors.  “Wall Street has a name for the phenomenon, and it's called the ‘flight to quality.’  When investors get concerned about global conditions, the United States is the haven of safety,” Dotzour said. “As investors moved money into U.S. Treasury bonds, the ten-year treasury rate dropped from 5.3 percent in August to 3.7 percent today.”  Dotzour said investors who are using U.S. treasuries as a safe haven are willing to accept a 3.7 percent interest rate even though the U.S. inflation rate is at 4.1 percent. 

Once the banking system is repaired and the fear of global collapse of the banks is over, Dotzour predicts treasury rates and mortgage rates will move up, maybe substantially.  “If you believe that we are in for a global financial collapse, then don't refinance yet because interest rates will continue to fall,” he said. “If you think the U.S. government and the central banks around the world won't let this happen, then now is the time to get a fixed-rate mortgage at rates we haven't seen in the past 40 years.”

HOW MUCH REPLACEMENT PROPERTY DO I HAVE TO ACQUIRE?

In order to completely defer all applicable capital gains taxes, the taxpayer must use all of the proceeds from the sale of the relinquished property towards the purchase of the replenished(replacement) property. 

This is part of what I have previously referred to as the "Napkin Rule".

But for example purposes:  One of our clients sold a property for the sum of $975,000 which was free and clear of all liens and loans.  They decided to purchase a replacement property for the amount of $850,000.   In that particular case, the taxpayer did not use all of the proceeds and therefore will be taxed on $125,000 ($975,000 - $850,000 = $125,000) they did not use towards the purchase of the replacement property.   The other sums ($850,000) will be tax deferred under Section 1031.  FYI--for you bloggers, the client used the $125,000 to purchase a very expensive Mercedes Benz--I explained to her that she would be taxed on these sums, but she didn't care.  I gave her  a couple of other options, but this is how she wanted to proceed--Se La Vie.

IRS ON THE INTERNET--BE CAREFUL

    For that matter, one should always be careful when dealing with IRS.  I received an interesting newsletter article that should be of interest to all U.S. taxpayers.  The article states:    "...along with the tax man come the inevitable new breed of scam artists. Be on guard - criminals who want your personal information use this hectic and confusing time of year to prey on unsuspecting individuals.   

Watch out for unscrupulous scammers, who are sending emails that appear to be from the IRS. The content of the emails are often written to persuade you to link to a website that will allow you to update your data or receive important information. Remember, these phony emails are quite sophisticated, and the links send you to what usually appear to be legitimate IRS or government websites. In reality, they are not. These sites will prompt you to divulge private information under the guise of the IRS requiring it, to offer a larger refund, or sometimes, ironically, to protect you from identity theft or loss of privacy.

There are some simple steps you can take to avoid falling prey to one of these scams.

Always Be Suspicious of Emails. Remember, the IRS does NOT initiate communication with taxpayers through email, but rather through the regular mail. If you receive an email that says it's from the IRS, you should immediately be suspicious and should forward it in its entirety to the IRS, so that they can take steps to shut down the fraudulent and bogus websites. The IRS requests that you forward all questionable emails to phishing@irs.gov.

Double Check the URL Address. Keep in mind that all IRS websites begin with the following web address: http://www.irs.gov/. So, if you ever click a link in an email or visit a website that you believe is related to the IRS, the first thing you should do is confirm the website begins with the correct URL address. Remember, sometimes it may "look" legitimate, but is actually an imposter site that is "phishing" for information. So always, always double check the actual URL address before you type any information in the site.

Exercise Extreme Caution with Attachments. When it comes to questionable emails, the best practice is to never open any attachments. That's because attachments are an extremely common method that hackers use to infect your computer with programs that may harm your computer or steal your personal information--often without you even knowing!   

In today's technological environment, electronic communication offers us tremendous speed and convenience. But it can also be used for unethical purposes by scammers. Most organizations have worked very hard to put strict privacy policies in place. As a result, government agencies and financial institutions will rarely, if ever, ask you to divulge personal information via email.

If you receive any email asking for personal information of any kind, you should immediately be suspicious. When in doubt, call the customer service lines listed on your statements or documents and discuss the email that you received."    

TAXES RETURNS ARE ALMOST DUE

SO here is a repeat of an April 2006 blog on taxes.  Every once in a while we need a chuckle.

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

WHAT IS THE DIFFERENCE BETWEEN A SALE AND AN EXCHANGE?

As a generalization there are no major transactional differences between a sale and reinvestment into another investment property and an exchange under Section 1031 of the IRS Code.   

However, there are major tax differences!!   

I will try to keep this answer as succinct as possible.  In a normal sale, the investor receives their funds, pays their taxes and with the remaining funds goes out and purchases another property.  By doing a sale, the taxpayer of course will have less funds to invest, as they will have had to pay Uncle Sam their capital gains taxes and accelerated depreciation recapture taxes, if any.   If the investor is in a State that has income states, then they will additionally have to pay the State or Municipality their additional taxes also.   

But if the investor decides to do a Section 1031 tax deferred exchange , they will pay NO taxes at the time of sale.   They of course will have more funds to be able to purchase more investment property and most likely will be able to earn more profit over the life span of their investment career than they would have been able to do if they just did a sale. 

For more information on the requirements under Section 1031, go to our website (www.bayview1031.com) and review the information in the "resources" section or review some of the other blog topics we have covered over the past couple of years.

RETIREMENT SAVINGS TECHNIQUES

A friend of mine, Dennis Klienman wrote a wonderful article on retirement savings. I thought I would pass it along to my bloggers.

"Did you know that if you wait until you're 45 years old to start investing for retirement, you'll need to save about $24,000 per year just to reach a reasonably comfortable retirement level? But if you start when you're 25, you can reach that same level by saving just $4,000 per year. So starting as early as possible is important - but even if you didn't, you can use the simple tips below to get on track right away.

Give Your Retirement Plan a Raise
The more you make the more you spend...so the next time you get a raise or a bonus, break the cycle! Set aside that extra money and invest it in your future. You will not even notice it now...but you will in the long run.

Make a Big Impact Without Denting Your Budget
If you're about to pay off a car, student loan, or some other monthly expense, you can make a huge impact on your investment plans by simply adding that extra money to your retirement account. You're already used to living without it, so it won't impact your monthly spending money at all.

Out of Sight, Out of Mind Investing
Don't forget to make your investments automatic. It's much easier--and a lot less painful--to have that money simply deducted from your paycheck and electronically deposited. You'll save the same amount every month...and save yourself the trouble of writing that check!

Eliminate High Rates
Want to earn a 17%, 18% or even 19% return right away? It's easy...put together a plan to pay off your credit cards faster, starting with the highest rates. By paying it off quickly--and keeping it paid off--you'll eliminate the high interest charges that drain budgets and often put people into a downward spiral of debt.

Make the Most of Matching Contributions
If you have access to a 401(k) retirement plan, make sure you are using it--especially if you get matching contributions from your employer. See how much you have to contribute to earn the full matching amount from your employer - and if you can't contribute that much right away, start small and steadily increase your contribution over time until you reach it. You'll double your money with the employer's match...and your contributions are generally taken out of your check pre-tax.

It's NOT All or Nothing
Don't feel like you have to jump in with everything you've got. The most important point is to get started right away...not next month or next year, but right now with whatever amount you can. You can always increase the amount you invest...but you can never get back the compounding interest you'll lose by waiting."

WHAT HAPPENS WHEN TWO INVESTORS WANT TO SELL - BUT ONLY ONE WANTS TO DO AN EXCHANGE?

It depends!!   Now you know I really am an attorney.  Let me quote Mr. Anonymous:  "The devil is in the details". 

The details I am referring to is how the investors hold title to the property.  If the investors hold title to the property, individually in their own names, as tenants in common.  No problem, one investor can sell their undivided interest in the property and pay taxes and the other investor can transfer its interest and do a Section 1031 exchange and defer paying taxes. 

But what happens if the investors hold title in a corporation and they are the only 2 shareholders of that corporation?  Well, in that case the corporation must transfer the property, not the individuals and we now have a problem--Do you see where the details can mess things up.   

Let's go further--what if title to the property was in the name of a partnership, with each investor owning 1/2 of the partnership?  If I had been asked that question 4 months ago I would have said no problem, the partnership could dissolve and put the property in the names of the individuals and then do a transfer.   That technique is called "Drop and Swap".   You drop the property from one entity (in this case the partnership) into the individuals as tenants in common and then transfer the property, with each individual handling their tax situation in the manner they wish.

There are a lot of articles written on "drops and swaps" and  UNFORTUNATELY they seem to be worthless now because IRS stated at the FEA (Federation of Exchange Accommodators) Annual Convention (that's the trade organization for Qualified Intermediaries), that they no longer will honor "Drop and Swaps"--Sooooooo--it looks like that technique will no longer be available when doing a Section 1031 exchange.  I try to keep my clients and bloggers as up to date as possible--and now you have heard it first right here in this blog.   

The law is always changing and so as you can see are interpretations of the law.   Make sure you contact us before you sign your contract to sell your investment property, so that we can help you and your adviser analyze your particular situation.  Yes "the devil is in the details".