In last week’s article, we explored the anatomy of a 1031 exchange and the government’s reasoning for creating such a powerful tax-saving tool. This week, we’ll look at a hypothetical example such that we may more clearly understand how a 1031 exchange works. We’ll close by addressing some common concerns. Let’s get to it!

Ted’s First Investment Property

Ted understands the advantages or real estate investing and does everything he can to acquire his first investment: a nice little income property located at 101 Main Street. After careful analysis, he purchases it for $400,000 and pays $8,000 in acquisition costs. Over the next year, he operates the property as a rental—this is crucial because simply acquiring property for the sole purpose of resale does not qualify for a 1031 exchange. During this time, Ted replaces the roof and makes some other capital improvements totaling $15,000. He also takes a depreciation tax deduction of $5,333.

At the end of the year, Ted decides to sell his property for $475,000. So, what is his capital gain? First, we must calculate the adjusted basis. Add the original cost ($400,000), acquisition costs ($8,000), and capital improvements ($15,000) and subtract depreciation ($5,333) to come up with the adjusted basis of $417,667. To calculate his capital gains, subtract the selling costs ($28,500) and adjusted basis from the selling price to come up with $28,833 [=$475,000 (sales price)-$417,667 (adjusted basis)-$28,500(selling costs)].

How Ted Avoids Paying Taxes

Ted doesn’t want to pay taxes on his gain of $28,833, and he doesn’t have to if he properly performs a 1031 exchange. He starts the process by identifying a replacement property at 505 Clark Street that he can purchase for $500,000 (he can choose up to three replacement properties; that way if one doesn’t pan out, he has two back-ups available). Before he sells his original property—101 Main Street— he sets up the exchange with a qualified intermediary. The intermediary holds the net proceeds from the sale of 101 Main Street until Ted closes the sale on his replacement property, 505 Clark Street. Keep in mind, however, that the exchange must be completed within 180 days after the sale of the original property. Therefore, it’s a good idea to plan the exchange well in advance and to utilize the expertise of someone experienced in performing such exchanges.

Ted completes the exchange and purchases 505 Clark Street for $500,000. What is the new basis? Assuming that the acquisition costs were $8,750 and knowing that the deferred gain is $28,833, the new adjusted basis is $462,417 [=$500,00 (purchase price) - $8,750 (acquisition costs) - $28,833 (deferred gain)].

What’s the Big Deal?

While the above is simply a hypothetical example, realize that people have deferred much larger gains in real life. It San Diego, it is not uncommon to find a property owner who purchased an building ten years ago for $500,000 only to sell it today for $3,000,000. You can imagine how steep the taxes on those capital gains might be were it not for the 1031 exchange.

Some of you may be shaking your heads thinking, “won’t Ted have to pay taxes on his gains eventually? He’s just delaying the inevitable. Why not just pay the taxes now?” To address the first question, Ted may never have to pay taxes. There are ways he could transfer the property to loved ones tax-free. To understand the answer to the second question is to understand the “Time Value of Money (TVM)” theory. The theory suggests that money today is worth more than money tomorrow because it can be invested and, thus, earn a return. The money Ted would have paid out in taxes will instead be reinvested. Understanding this, it becomes easy to see how blowing off Uncle Sam for as long as possible bears sweet financial fruits.

Understand the 1031 exchange and use it to increase your net worth.

Happy investing!

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Don’t Pay Taxes on Your Capital Gains (Part 2): 1031 Exchanges

Most real estate investors understand the general concept of a 1031 exchange or, at the very least, have heard of it. Few, however, understand exactly what takes place within one of these exchanges and how powerful a tool it truly is. So let’s explore a subject that is close to everyone’s heart: not paying taxes on hard-earned money!

What’s in it for Uncle Sam?

So, why does the IRS Section 1031 like-kind tax-deferred exchange exist in the first place? After all, doesn’t the government relish every taxable opportunity? While the government is certainly not adverse to taxation, they also use the tax code as a tool, encouraging or discouraging certain acts they deem beneficial or detrimental to the economy. As it turns out, the private sector is pretty darn good at providing housing to society (a lot better than the government). As such, Uncle Sam provides various benefits to real property owners (mortgage interest deductions, real estate investment expense deductions, ability to depreciate, etc.).

The Like-Kind Exchange: Apples for Apples?

To go along with this philosophy, the IRS allows real estate investors to defer the capital gains resulting from the sale of their property as long as they identify and purchase “like-kind” property within specified time frames.

So, what is “like-kind” property?

Basically, it is any real property held for a specific use. Hence, vacant land held for investment purposes (the government doesn’t say it has to be a good investment) can be exchanged for a residential income property. In other words, trading investment property for other investment property is allowed. One wouldn’t be allowed to, however, exchange a residential rental property for a brand new single family home in which the investor plans to take residence. You can find the exact IRS verbiage on the IRS Website.

Time is Ticking…

Complicating matters, the IRS imposes rigid timelines for identifying and purchasing these replacement properties—45 days and 180 days respectively. These timelines are long enough to withstand long closing periods, but they are short enough to solicit immediate action. If you are in the process of selling a property and would like to perform a 1031 exchange but you have no replacement candidates, get help immediately!

Please keep in mind that I am not an accountant and, as such, this information is provided for informational purposes. See your tax preparer and CPA for specific information regarding your tax situation. Next week, we will explore an example 1031 exchange (in detail) such that you get a (hopefully) crystal clear understanding of how this powerful tool works. I will also counter the standard (yet misguided) objections to such an exchange.

Until next time… Happy Investing!

Any Questions?

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Don’t Pay Taxes on Your Capital Gains: 1031 Exchanges

Even the most bearish economist is predicting that commercial real estate prices will fall up to 40 percent from peak to trough. However, the data released yesterday from Moody’s Investor Service shows that in April commercial property prices plummeted a record 8.6 percent. According to Moody’s data, commercial property prices fell a total of 29.5 percent from their highs in 2007. This leaves another 10 percent drop in prices if the most bearish economists are correct. In my opinion, much of this drop was due to a speculative credit bubble that caused commercial property buyers to purchase properties that would never produce a positive cash flow, even assuming a strong economy and strong demand for commercial real estate.

I believe that most of the declines in commercial property prices that can be attributed to the credit bubble have mostly taken their toll on prices. But, I surmise that we could experience an even greater decline in commercial property prices due the fact that the economy is fundamentally unsound. If one closely examines the fundamentals of supply and demand for the commercial property sector, the prospects for continued price declines becomes readily apparent, especially in the retail and office building sectors of commercial real estate.

Background to a Crisis

During the speculative credit bubble, developers built many more office buildings and retail stores than could possibly be sustained. Now that unemployment is in the double digits and major economic sectors like the automotive industries are going bankrupt there is less demand for commercial property. There have been many large, well known, retail brands either going bankrupt or severely cutting back growth projections. In a small city, near where I live, there are at least fifteen Starbucks. How many Starbucks stores can one small city support? Circuit city is out of business, Brandsmart may be next. Car dealerships are closing their doors around the country. These are all commercial real estate tenants whose absence can’t easily be filled. The list goes on and on. If so many large retailers are going out of business or curtailing operations then there will be even less demand for all of the vacant commercial retail space.

Commercial Real Estate Breakdown & Predictions

As local, state and federal governments go deeper into debt they will be increasing taxes even further on businesses and property owners. This means higher taxes for the owners of commercial real estate. If the costs to hold a property increase, then its intrinsic value must decrease.

I would challenge the 40 percent figure and would argue that prices could drop even more due to the dismal state of the economy at large. I would go the record to say that the commercial property sector could see real price declines of up to 70 percent from peak to trough. The worst might still be ahead of us.

Source: Reuters
Photo Credit: strangelv

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• ‘Wave of foreclosures’ to hit commercial sector, Insider Q&A; told (lansner.freedomblogging.com)

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Is This the Bottom for Commercial Real Estate Prices?

The  mortgage interest deduction, which has long been an untouchable pillar of the tax code for homeowners, is on the chopping block in President Obama’s 2010 budget proposal. The President wants to reform our healthcare system here in America and is proposing the mortgage interest deduction be capped at 28%. This would affect homeowners making $208,850 over the 2009 married filing jointly tax bracket income calculations.  The mortgage interest deduction has been in place since we had an income tax code. All interest used to be deductible but over the years, congress has whittled down interest deductions for non-businesses to only the mortgage interest deduction. That was done with the Tax Reform Act of 1986.  Several groups are up in arms about this proposal as the mortgage deduction is seen as a help for lower income folks to buy a home. Many economists however disagree that the home mortgage interest is all it is cracked up to be. In a recent blog post in the New York Times Economix Blog,  Harvard University Economics Professor Edward Glazer makes some salient points about the flaws of the mortgage deduction. He outlines 5 problems with the “conventional wisdom” of the deduction as a savior of the working class hero:

Problem #1: Subsidizing interest payments encourages people to leverage themselves to the hilt to bet on housing markets. The size of the tax benefit is proportional to your debt. The deduction essentially encourages us to make leveraged bets on the swings of the housing market. That leverage means that housing price swings can easily wipe people out. We are currently experiencing the consequences of subsidizing gambles on housing.

Problem #2: The deduction pushes up prices in places where the supply of new homes is constrained, as it is in many coastal markets. Economics 101 teaches us that if we subsidize demand where supply is inelastic then the only effect is to make prices go up. Housing supply is pretty constrained in places like New York City because of land-use restrictions and lack of land. In these places, the deduction doesn’t make housing more affordable. It just transfers money from buyers to sellers, and that makes little sense.

Problem #3: The deduction is wildly regressive. The tax savings for households earning more than $250,000 is 10 times the tax savings for households earning between $40,000 and $75,000 a year, according to recent research by James Poterba and Todd Sinai.

If there ever was a case for small-government egalitarianism, then this is it. Eliminating the home mortgage deduction and replacing it with an across-the-board tax cut would equalize after-tax incomes without a single new government program.

Problem #4: The deduction encourages people to buy larger, single-family detached homes, and that increases carbon emissions and pushes people out of cities. The deduction encourages people to buy more expensive homes, which are generally bigger homes.

Bigger homes use more energy. The deduction is therefore implicitly urging Americans to run higher electricity bills and spend more on home heating. If global warming is a serious problem, then the government should be encouraging us to live in smaller, not bigger, dwellings.

Problem #5: The home mortgage interest deduction is poorly designed to encourage homeownership, which is, after all, the alleged desideratum. Much of the interest deduction’s benefits go to richer Americans who are likely to own homes in any case.

Poorer people who are on the margin of buying and renting often don’t even itemize. My own research in this area found that when the value of the interest deduction rose, during periods of high inflation, there was no observable increase in the homeownership rate.

If the goal of the deduction is just to increase homeownership, then it would make far more sense just to give a flat tax credit to people who buy homes. If the credit was independent of home value, then this would eliminate the incentive to buy bigger homes. If the credit was independent of borrowing, then this would decrease the incentive to over-borrow.

I would like to hear from the Bigger Pockets community about their feelings on the mortgage deduction.What do you think?  Is it truly something we can’t live without?

(Image Courtesy of: Arizona Mortgage News)

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Mortgage Interest Deduction in Jeopardy

Okay, so despite Josh and my best efforts, we only had 6 people answer our poll through twitter . Therefore, this is by no means a large sampling fit to discern the efficacy of the tax credit, but I liked the headline–Catchy isn’t it? Of those who voted, 4 said it would incent them and 2 said it would not.  Hey, if you are clicking through to the poll–feel free to vote. Maybe I can do a follow up with more data down the road. For now however, I will go into the nuts and bolts of the new $8,000 tax credit. This is not to be confused with the $7500 “tax credit” from last year.

A tax credit of up to $8,000 or 10% of the purchase price (whichever is least) for 1st time home buyers is at the heart of the 2009 American Recovery and Reinvestment Act (ARRA). If you want to know more about the impact of   the ARRA on real estate and financing, I have posted a story on my blog at Arizona Mortgage News. According to lending guidelines, a 1st time homebuyer is someone who has never owned a home, or someone who has not owned or co-owned a house in the last three years proceeding the date that you close on your 2009 purchase.

The tax credit is an attempt by the Federal Government to spur a flurry of home buying in 2009. The question is  will it? According to Lawrence Yun, chief economist for the National Association of REALTORS®,  homebuyers will purchase an additional 300,000 homes in 2009 as a result of the tax credit. “The impact will likely not be felt for at least three or four months, because it generally takes buyers that long to qualify for a mortgage and search for a home,” says Yun.

Here are some of the rules for the 2009 ARRA first-time homebuyers’ tax credit:

• Does not have to be repaid, unless the home is sold within three years
• Applies only to first-time homebuyers, defined as those who have not owned a home within the previous three tax years.
• Available only for homes purchased between Jan. 1, 2009, and Dec. 1, 2009.
• Restricted by income; phases out for individuals with an adjusted gross income of $75,000 or above and for married couples with a combined adjusted gross income of$150,000 or above
• Tax credit is for up to 10 percent of the purchase price.
• The credit can be taken on 2008 taxes even when the purchase is made in 2009.

According to the 2009 ARRA, the home you buy must be used as your primary residence. Sorry investors and second home buyers. According to IRS rules, houseboats, house trailers, cooperative apartments and condominiums are acceptable.

If you bought a home in 2008 using the $7,500 tax credit, you will have to repay that credit, or loan as it were, over the next 15 years with no interest. However buyers in 2009 will reap the benefits of the 2009 ARRA first time homebuyer’s tax credit by not having to repay the $8,000. You will have to pass most of the eligibility requirements imposed under the 2008 program and those listed above.

(Image Courtesy of Arizona Mortgage News)

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

67% Say $8,000 Tax Credit is Likely to Incent them to Buy a Home

Cost segregation is a tax saving method that apparently has caught on with the opportunity sales people. I know I get a spam or two a week telling me I can make jillions of dollars by marketing cost segregation to the local business community. Since I receive so many solicitations I’m beginning to believe this tax cutting method has become diluted and now borders on farce.

I say diluted and borders on farce because I’m willing to bet the purveyors of this opportunity have driven the cost through the roof for the business person. I’m also thinking that if I was a businessman holding commercial real estate I’d already be using a CPA who knew about cost segregation. After all, when I studied accounting in college in the 1970’s we had to know about the lives of assets and the different depreciation schedules and write off periods.

It seems nothing has really changed except maybe the liberalization of some of the rules the IRS/Congress create regarding depreciation and its attendant write off periods. I could be wrong but I don’t think so.

The Essence of Cost Segregation

Cost segregation carves out shorter lived assets, which qualify for five, seven and 15 year write off periods. These are normally embedded in a building’s construction or acquisition costs. These would normally be depreciated over 39 years except cost segregation reclassifies these assets and accelerates the depreciation. This brings about tax savings and easier write offs when assets become obsolete.

For the life of me, wouldn’t your CPA or accountant already know this? Yes, if they stay on top of the latest changes to the tax laws. If they don’t, would you really keep paying them?

Back To Opportunity Or Hype

Since this method seems to work best only on properties valued at $1 million or more, it would seem to me the opportunity offering genre are selling a program that is behind the times and not exactly a money maker to the person who buys into the hype. Let me state that that is my opinion but it is based on what I know about the tax laws and the practitioners in the tax preparing arena.

If anyone has more detailed information on this opportunity as to how it really works ( I don’t mean cost segregation, I mean how you sell it), I’d like to hear it. After all, if it is for real, I’d venture the opinion there are business people willing to listen to the presentation.

Just my 2¢ on an opportunity in this wonderful world of real estate.

Photo Credit: tanakawho

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Hype Or Opportunity: Cost Segregation

    
Tax the rich, tax the rich! We can have everything if we just tax the rich. One question: how do we define rich? Would the top ten percent of income earners be considered the rich? The top ten percent already pay 71% of all Federal taxes despite only earning approximately 39% of all pre-tax income. The top one percent could certainly be considered rich, let’s get them to pay! The fact is that they already do, 40% of all Federal tax dollars come from the top one percent of income earners.

There was so much talk on the campaign trail about redistributing wealth. Some were saying that we should model ourselves after many of the European nations in regards to the way they handle the haves and have-nots. I recently came across a column by Jonah Goldberg that talked about that very thing. It seems that we already redistribute more wealth than European countries like France and Sweden do. The article states that the bottom 40% of income earners receive more from the Federal Government than they pay in taxes, isn’t that spreading the wealth?

New Tax Form:

1. What did you earn? 
2. Send it in.

Socialism is a philosophy of failure, the creed of ignorance, and the gospel of envy, its inherent virtue is the equal sharing of misery.
-Winston Churchill

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Taxes: Blood From A Stone