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VOL. 39 | NO. 15 | Friday, April 10, 2015

Bypass the taxman via property exchange

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Most of us are ankle, knee, elbow, perhaps even chin deep in the process of filing tax returns. A recent publication noted that even those due refunds wait until the last minute to submit their bills to Uncle Sam.

Many are lamenting increases in capital gains and ordinary income. Imagine how George Harrison felt when the Beatles were subjected to England’s super tax in 1965 and were forced to pay 95% of their earnings to the Queen.

“Let me tell you how it will be

“Here’s one for you, nineteen for me

“Cos, I’m the taxman, yeah, I’m the taxman

“If you drive a car, I’ll tax the street

“If you try to sit, I’ll tax your seat

“If you get too cold, I’ll tax the heat

“If you take a walk, I’ll tax your feet

“Don’t ask me what I want it for

“If you don’t want to pay some more...” (Taxman, George Harrison)

All of this sounds rather bleak with no way to avoid taxes. But there is a way to sock away cash and defer – avoid for the time being – paying taxes. The answer is Internal Revenue Code Section 1031, often referred to as a 1031 Property Exchange or a tax free like-kind property exchange.

Wagon Wheel Title, a highly regarded title company in town, recently hosted a series of conferences designed to educate those who might be candidates for the tax-deferred events.

Brandon Miller, an attorney with Wagon Wheel Title, noted there has been a gigantic increase in the demand for the 1031 exchanges as the real estate market has appreciated in the area.

Many property owners are becoming aware that their real estate holdings are worth more than they could have imagined, and with developers combing the countryside in search of dirt to convert, there are letters flying into letterboxes with staggering offers to purchase.

While these proposals seem appealing to the owners on the surface, after some due diligence, the realization that the taxman will cometh and that the gain may be either 20 percent or even as high as 39.8 percent less than anticipated price sours some deals. In some cases it could be worse, as many properties have been depreciated over time. Upon the sale, the deprecation is recaptured at a rate of 25 percent.

But it does not have to be that way. Angie Lawless, another attorney at Wagon Wheel, provided the following example: A sale of $1 million of fully depreciated property could result in taxes that include capital gains of 20 percent, perhaps a depreciation recapture of 24 percent and the Medicare surcharge of 3.8 percent.

However, if the seller bought another property for the same amount or more money, the entire tax burden could be deferred.

With interest rates as low as they are, the sellers could take some or even all of the cash out with no tax liability, then finance the new property and have a positive cash flow with no visit from the taxman.

Lawless noted that there are some inaccurate myths surrounding 1031 exchanges.

Many clients approach her, she said, who have heard they need to find a person that will swap property with them. For example, one person must find another person who will swap a parcel dead even with them. That is not the case.

The seller has 45 days in which to identify a property to purchase, Lawless added.

The buyer then has a total of 180 days following the sale of the property to close on another property in order to defer the tax liability, Miller added.

It is important that the funds go to a “qualified intermediary” at the closing in order to be eligible for the exchange. Once the sale is closed and the funds are collected, it is too late to qualify.

Another myth is that these transactions are difficult, expensive and only for large property owners. Fees are only slightly more than any other real estate transaction, Miller explained, if properly handled from sale of the original property can be easily transacted. What is important is that the exchangers (sellers turned buyers) hire an intermediary.

If the transactions are not closed simultaneously, the seller may identify up to three properties of any value as exchange possibilities as long as their market value does not exceed 200 percent of the relinquished property.

There are several procedures that must be followed for property identification, the most important of which is it must be in writing and signed by the exchanger. It also must be delivered, mailed, faxed or otherwise sent within the 45 days of the close.

For those who bought vacation homes during their heyday, up through 2008, there is “safe harbor” for the vacation homes and a way of rolling 1031s with various investment properties and even primary residences into a situation in which a person can own a “dream, retirement home” without having been taxed on all of the gains on the others.

So take some solace. There is a way of earing profits that are not taxed.

And lastly, a line in Harrison’s ‘Taxman” usually attributed to John Lennon:

“Now my advice for those who die

“Declare pennies on your eyes.”

Richard Courtney is a real estate broker with Christianson, Patterson, Courtney and Associates and can be reached at richard@richardcourtney.com.

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