Some Types of Taxes When Selling Real Estate, and a 1031 Exchange May Save Money

There are certain differences between owner-occupied property and investor property (non-owner occupied) when it comes to selling--and buying, but here we are concerned more with selling.

Some owners who have rented out their residences and moved on to another location are surprised to find out when it comes time to sell that they may have lost their capital gains exclusion ($250,000, or $500,000 for married owners). On top of that, they may be paying the State of California 3-1/3% withholding tax upfront at the close of escrow.  Additionally, if you took depreciation on an income property you now own as an investor, you will have additional reckoning at tax time.  Please see IRS Publication 523 for specific information.

Depreciation is a method for matching the costs of acquiring property over the properties’ estimated
economic life.  The IRS requires that most properties be depreciated via the ‘straight-line’ depreciation method.  Using the straight-line method, residential income properties are depreciated over 27.5 years.  Commercial properties are depreciated over 39 years.

Depreciation Calculations
Land is not depreciable.  In order to properly calculate depreciation, the value of land must be excluded. For example, a $1MM duplex with land worth $300,000 has $700,000 worth of depreciable real estate.  Using the straight-line depreciation method, the annual depreciation amount is approximately $25,500 ($700,000/27.5)  NOTE: The IRS will typically not challenge the assessment of the land value if it is reasonable. A tax advisor, attorney or real estate agent should be able to provide guidance for what is reasonable based on the location and type of land.

Depreciation Benefits
Depreciation is an ‘intangible expense’ that will reduce the reportable taxable income from the property, and means less tax to the IRS.
Here’s how it works:
The yearly rental income from the example duplex is $36,000. At the end of the year, this will have to
be reported to the IRS. However, the IRS does not tax the entire $36,000. The taxable income from the property is calculated as follows:

• Rental Income
• (Expenses)
• (Depreciation)
• Taxable Rental Income

If the expenses of operating and managing the duplex are $5,000 for the year, the taxable rental
income is calculated as follows:

• Rental Income $36,000
• (Expenses) ($5,000)
• (Depreciation) ($25,500)
• Taxable Rental Income $5,500

NOTE: Please always seek the guidance of a tax advisor. Capital gains may or may not apply depending on how long you lived in the property, and depreciation items may be calculated on different schedules. To completely avoid last minute upsets and lose your deal, it's important to obtain your information before you sell--I once represented a buyer on a very nice fourplex where the seller finally obtained tax guidance after we opened escrow, only to be shocked by how much recapture tax had to be paid to the IRS since the property had been owned long enough to be fully depreciated.  The seller cancelled escrow, much to the buyer's disappointment.

Depreciation Tax
Upon the sale of an investment property, the IRS requires the payment of a depreciation re
tax, which means you have to "pay back" the money you were entitled to take previously. The tax rate is currently set at 25%. In the example above, if the duplex was owned for 10 years, the entire depreciation taken on the property would amount to $255,000 ($25,500 x 10).  The IRS requires a recapture tax on that entire amount. Hence, the sale of the duplex will result in a $63,750 depreciation recapture tax (255,000 x 25%). This is in addition to state and federal capital gains taxes. The depreciation recapture tax as well as any associated capital gains taxes can be deferred in full via a 1031 Exchange.

Conclusion
Of all the benefits of owning real estate, depreciation may be one of the most important. The tax advantage depreciation offers is powerful. The IRS will always assume that depreciation is taken and
will hold an investor liable for the deprecation recapture tax – even if the investor failed to take advantage of the depreciation. Bottom line: make sure you are taking advantage of this powerful tool.
Thanks to Asset Exchange Company for this sample.

Thinking of Taking Money Out of Your California 1031 Exchange? Do It The Right Way

A basic feature/requirements of 1031 exchanges is that the taxpayer doing the exchange cannot have access to their funds--that's why there's an accommodator, or "qualified intermediary" (QI).  In real estate, 1031 exchanges are allowed where the property owner has not lived in the property as a principal residence, but has owned it usually as some form of income or investment property. There are certain exceptions to this, but they will not be covered here.  Just know that the rules surrounding IRS 1031 exchanges are specific and detailed, and must be complied with to the letter.  A principal 1031 exchange benefit is in deferring capital gains taxes on the sale of property by shifting funds into a new purchase, also a non-owner occupied property.  For a property owner who bought in a low market, and is selling in a much higher market, the tax savings can be significant. Simply, in this type of transaction, the taxpayer is not allowed access to funds which are handled through the QI, unless there is an agreement that the taxpayer is taking money out of the first sale, known as "boot", which will not be used in the acquisition of the next property.

As previously covered in other posts, the State of California wants all of the money it's entitled to, so recently a tax audit of an exchange failed because the State said the taxpayer didn't follow the 1031 exchange agreement.  So that means the taxpayer is now probably paying a lot of taxes which otherwise would not have been the case.  The State didn't like the taxpayer giving the escrow officer, not the QI, instructions to exclude $150,000 from the purchase of the next property and send it over to the taxpayer.  The Franchise Tax Board said the taxpayer thus really had access to the funds, which he/she was not supposed to have, and so the exchange was violated.

Moral of this story:  If you're doing a 1031 exchange transaction and you want to take out money from it, make sure it's included in the actual written agreement with the QI, because the QI is who is responsible for handling all funds in the exchange, not the escrow officer. Make sure you are using an experienced and known professional accommodator, are following the advice of an experienced tax professional, and are working with an experienced REALTOR as well.  It could make a huge difference to your bottom line.  Read more at Asset Preservation.

Do You Own Income/Investment Property? Read This about Proposed 1031 Changes

I just received this in my e-mail this morning:

• "There are currently three different proposals that the federal government is weighing, which would significantly alter Section 1031:
•  Former Sen. Max Baucus (D-Montana), who became U.S. ambassador to China earlier this year, released a draft proposal when he was chairman of the Senate Finance Committee that would potentially eliminate 1031 exchanges. His proposal, which is still before the Senate Finance Committee for discussion, contains other provisions unfavorable to real estate investments, including lengthening depreciation schedules for commercial and residential properties from 39 and 27.5 years, respectively, to 43 years for both and characterizing gains from real estate sales as ordinary income, instead of capital gain.
•  U.S. Rep Dave Camp (R-Michigan), chairman of the House Ways and Means Committee, has released a proposed tax bill eliminating all Section 1031 exchanges beginning Jan. 1, 2015.
• President Obama, in his 2015 budget proposal, wants to limit the amount of capital gains deferred in a 1031 exchange to $1 million (indexed for inflation) per taxpayer per taxable year, beginning Jan. 1, 2015." 

As so often happens, legislators propose laws that probably won't accomplish what they intend, in this case, raise tax money.  Property owners benefit greatly from the 1031 tax exchange laws, and should changes occur which prevent or greatly affect the benefits which have been in existence since 1921, many owners just won't make a change.   Sizeable tax consequences can be faced by some investors, so they could very well hold onto their properties rather than sell.

Real estate transactions generate business for many professionals, ancillary businesses and services. The ripple effect from a change in investment and/or commercial sales will impact not only the brokers, but many other job holders, i.e., environmental companies, appraisers, title and escrow personnel, contractors who restore/rehabilitate such properties.

Currently, the company that sent me this email has just exanded their office space on the East Coast because they are currently doing much more business.   But curtailing 1031 exchange activity may curtail many jobs and other economic activity.

"What can you do to help preserve Section 1031 exchanges? Contact your representatives in Congress to express support for Section 1031 in its current form, and the economic activity and job-stimulating aspects of this powerful tax code section."

Selling a California Property and 1031 Exchanging Out-of-State

Suppose that today, January 27, 2014, you closed escrow ("sold") your California property due to be part of an exchange in the state where you currently live (not California).  Did you know that the State of California now wants its money, if any is to be made? 

So, effective January 1, 2014, California Assembly Bill 92 now adds a new annual tax reporting requirement for those taxpayers who exchange California property under federal Internal Revenue Code Section 1031 for non-California replacement property.  This means "all individuals, estates, and trusts, and all business entities regardless of their residency status or commercial domicile" must report the amount of the gain (or loss) on the property which is deferred in the 1031 exchange.  If it isn't reported, then the Franchise Tax Board will estimate and decide for you what your amount of income is from the sale of your property, and assess tax, interest, and penalties due it. 

No more taking your property and then avoiding California tax by doing an out-of-state exchange, and then a later sale. Read more here about the new law.

Can I help you decide on the market value of your property? Whether it's one unit (home, condo, townhome), duplex, triplex, 4-units or more, I can help you with an income/expense analysis, plus free information about 1031 exchanges.  Please contact me at 562-896-2609, julia@juliahuntsman.com.

Tips for Wise Property Investment

So you would like to buy investment property in 2014?  So if you are picturing future income, future security, or retirement plans, then these are things you might like to think about in order to make wise choices:

1.  Looking for a opportunity market.  This is where the current demand is low, but likely to get stronger in the future when the value of your investment will go up.  By taking a look at certain types of neighborhoods that were not identified as "desirable" but have now grown into more stable residential zones, you may be making a good risk.  One of the challenges many first-time property investors need to keep in mind is to take themselves out of the picture--this may not be an area you would personally live in, but one that is "home" to others who might become your renters and provide the income you're looking for.

2. Considering different types of property.  You may need to look at a range of properties, and assuming you're considering residential investments, you will need to know the difference, for your purposes, between investing in a duplex vs. a 10-unit apartment building. 

3.  Look for the best yield you can get.  What sort of revenue will you obtain from your rents, and what will your overall return on investment be?  This will vary by the property, the area and type of neighborhood.  One thing some owners forget to consider is that changes in the equity in their property, which changes with the market, may actually be affecting their return on their investment. 

4.  Keeping up with the market.  Political and economic affairs do impact local market values.  Local city/county improvements, or new attractions to the area, may bring (or lose) buyers and sellers, causing an increase in prices.  It pays to keep up with the trends.

5. Be as diverse as possible.  Buying several different types properties may protect you more against market forces beyond your control.  This may mean buying in different cities, regions or even countries. For instance, Riverside County took a very steep drop in values, more so than many areas along the coast.  Those areas, however, have also been recognized as "opportunity" when the prices started to shift upward.

For an analysis of your investment property, at no obligation, just contact me!  Learn about current market rents, current cap rates, and other important facts to consider.

If you would like to try your own property analysis, download the form here:  http://www.juliahuntsman.com/Long-Beach-investment-income-property.html

Julia Huntsman
562-896-2609

Keeping Up With Capital Gains for 2012

It's that time of year when not only are the seasonal holidays of Thanksgiving and Christmas are on people's minds, but so are certain real estate issues, such as capital gains taxes.

The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 extends the Bush era tax cuts until the end of 2012. In 2013, the capital gain rates are set to return to the old 20% and 10%, per Asset Preservation, a 1031 exchange company.

1031 exchanges may not be conducted with an owner occupied principal residences, but they do apply to a taxpayer's investment property which he/she wishes to exchange, rather than sell outright. If your tax bracket is over 25%, you will be paying at the 2003 15% capital gains rate.  Beginning in 2013, this rate will increase to 20%.

So for now, you have another year to accomplish an exchange, but time moves on quickly. Depending on the market value and the time it takes to find the qualified buyer for your current property, find the new property including its selling conditions, the year can melt away. 

To find a comparison for your selling situation, see this exchange vs. sale scenario or see general 1031 exchange information.

Converting Your Property From Rental To Residence

We haven't been thinking of 1031 exchanges so much in the recent past, but even now, properties ARE selling, so if you've got a move underway, here are 2009 1031 exchange laws you should know about if you're considering moving into your income property and later taking the capital gains exemption as a principal residence.

The Housing Assistance Tax Act of 2008 changed what is known as Section 121 of the Tax Code:
As of January 1, 2009, exclusion must be allocated between the period the principal residence was used as an investment property or second home, and the period of time the residence was used as your principal residence. Any portion of the exclusion amount allocated to the period the property is not used as your principal residence is eliminated.

Suppose you exchange into a rental property which is rented for four (4) years, and then move into this former property and live in it for two (2) years as a principal residence. Then you sell the principal residence and realize $300,000 of gain. Under prior tax law, the you would be eligible for the full $250,000 exclusion and would pay tax on the $50,000 remainder.

Under the new law, the exclusion is prorated as follows (Note: This example does not take into account depreciation taken after May 1997, taxable at 25%):

Two-thirds (4 out of 6 years) of the gain, or $200,000, is ineligible for the $250,000 exclusion.
One-third (2 out of 6 years) of the gain, or $100,000, is eligible for exclusion. [This example was changed to show that the allocation formula takes into account years before the 5 year lookback period in §121(a).]

But, suppose you exchanged into the property in 2007, and rented for 3 years until 2010 prior to the conversion to a principal residence. If you sell the residence in 2013, after three years as a principal residence, only the 2009 rental period would be considered in the allocation for the non-qualified use. Thus, only one-sixth (1 out of 6 years) of the gain would be ineligible for §121 tax exclusion.

So, if you're thinking of property conversion, be sure to check with your accountant or tax preparer about your actual exclusions allowed on your return!

Vacation or Second Homes

Sometimes, actually a lot of times, people think they don’t have the ability or resources to accomplish a certain goal, and then it truly becomes unattainable. A timely quote for this might be, “People don't plan to fail; they fail to plan.” (This was most recently said by a REALTOR in New Jersey, but don’t think he was the first.)

First, you have to ask yourself what you really want—possibly this will lead to workshops on goal-setting, or minor, then major, soul searching, then therapy. We’ll leave that up to you, but we do recognize that for most people making transitions can take time. Fast forward and move onto your second home strategy.

A down market of new and existing home sales spells opportunity, and the IRS allows for certain benefits, if you plan well. Do you plan to make it your future retirement home? Then area will be especially critical. Have you factored in your upkeep and expenses for maintaining a second home vs. an annual summer rental? Are you living in the desert and wishing for ocean breezes—if you’re calling on a coastal listing and it’s 108 degrees where you live now, you might be calling out of desperation (see “Fools Rush In” at the link) rather than a good long-term plan.

Have you talked with your tax accountant or attorney first to be aware of how you can gain or lose with the IRS—how many days you may or may not rent out the second home, how to avoid the Alternative Minimum Tax or minimize it, or how your Subchapter S corporation through your business can benefit you. Have you thought about your 1031 exchange and capital gains factors if you decide to turn this into an investment property, or vice-versa? If you have an vacation investment property you may be able to exchange it or convert it later to personal use:

“A section 1031 exchange lets you sell one investment property and defer the capital gains if you put the proceeds into another. You'll have to rent out that new property, too, to qualify for the tax deferral. But after renting the property out for a year, you can convert it back to personal use. There's still no tax until you sell.” (Jeffrey Schnepper is a New Jersey lawyer and CPA, personal finance columnist and the author of several books on tax strategies.)

You could be considering a family home, a smaller cabin, a condo or townhome or a duplex or a triplex near the beach where you could be gaining income on the other units. The initial planning stages may put you through some work, but it’s better than buying a property and later losing money on it because you bought it in that dream like state while you were on vacation already.

Vacation Homes--What to Do About Taxes

This is the time of year for taking a vacation, or at least thinking about it if you haven't already. Buying a second home has a practical side to it: The IRS says it does not qualify for 1031 tax exchanges because it's a personal use property, not an investment, particularly when any income from it is less than the fair rental market, and if you rent it more than 14 days a year, you must pay taxes on the income. To minimize your capital gains tax consequences when selling, first move into it and convert it to your principal residence. For more on vacation homes, click and read the article.