Filing Your Tax Return After Selling Property In A 1031 Like Kind Exchange

Filing Your Tax Return After Selling Property in a 1031 Like Kind Exchange: A Hidden Landmine in a Safe Harbor

Section 1031 which permits deferral of gains for the sale and subsequent acquisition of a “like kind” property is a powerful tax device for savvy investors. But the rules governing exchanges are a “safe harbor,” meaning that the failure to comply exactly with these technical rules will violate the exchange and force the taxpayer to recognize and pay tax on the gain she was attempting to defer.

One of the biggest reasons for unintentionally violating these rules, relates to the date by which the taxpayer must actually complete the purchase of the replacement property. A quick example will help.

Example: Bob owns a rental property with 10 units. He sells the rental property on November 1, 2013, and properly executes 1031 paperwork and instructs his settlement agent to transmit the proceeds to a Qualified Intermediary. Bob buys another like-kind property and closes on it on February 1, 2014.

Under the IRS rules, there are two deadlines to be aware of. First, within 45 days of the sale (which happened on November 1, 2013) he must identify the property which will be acquired (see my prior article for the rules on identifying replacement properties). Second, Bob must close on the replacement property within the time allocated by the IRS. And here is where it gets complicated.

Generally, the rule for closing on the replacement property is that it must close no later than 180 days from the date of the sale of the relinquished property. In the example above, the relinquished property closed on November 1, 2013, which is April 30, 2014. But be careful, the IRS regulations have a minefield here. The exchange is not violated if the replacement property (the property Bob is buying as a replacement for the property he sold) “is received after the earlier of the date that is 180 days after the date on which the taxpayer transfers the relinquished property, or the due date (determined with regard to extensions) for the transferor’s federal income tax return for the year in which the transfer of the relinquished property occurs.”

Huh? The regulation accelerates the date by which the exchange must be completed to the earlier of the following two dates:  (a) 180 days after sale (e.g. April 30, 2014), and (b) the date that Bob files his 2013 tax return! Suppose Bob is quite efficient, and is ready to file on January 1, 2014 and in fact does file on that date. Bob will have inadvertently blown the 1031 exchange because the date of his acquisition of the replacement property (February 1, 2014) happened after the date on which he filed his 2013 return (January 1, 2014). Sometimes, efficiency just does not pay!

The easy work-around: Bob’s CPA must avoid filing the 2013 tax return until the replacement property is acquired. In this example, Bob had until April 30, 2014 to close on the property he is buying. So if he goes right up to the wire, and does not close until that date, his CPA should file for an extension for the 2013 taxes prior to the normal April 15, 2014 filing deadline in order to avoid tainting the exchange.

Paying Capital Gains On The Sale Of Commercial Real Estate? Why?

Paying Capital Gains On The Sale Of Commercial Real Estate? Why?

The sale of commercial and other real estate held for business, trade or investment triggers significant tax consequences that the careful taxpayer must understand in order to make prudent decisions. A properly structured 1031 Exchange permits the seller to defer gains on the sale by purchasing another, qualifying property. The rules for 1031 Exchanges are strict, and it’s important to consult an attorney before selling to ensure that you qualify for the IRS “safe harbor” surrounding the 1031 Exchange. But done correctly, the tax savings can be significant.

Most individuals are aware of the capital gains tax due on the sale of investment real estate. Currently 15% at the federal level, this tax is also applied at the state and local level to the gain realized on the sale of real estate held for business, trade or investment. But there is another, and higher, tax that is also implicated on sale. The Internal Revenue Code permits owners of non-residential real estate to depreciate the property on a 39 year straight-line. At sale, this depreciation must be recaptured, if the property is sold at a profit greater than the depreciation realized, and the applicable rate is capped at the individual’s current tax rate, or 25%, whichever is lower. Effectively, most taxpayers will use the 25% figure. This can add a significant burden to the tax bill of a seller who has been properly depreciating property over the period of ownership.

It’s important to remember these tax considerations when structuring a sale. The safe harbor provided by a 1031 Exchange permits the taxpayer to defer taxes on gains and depreciation recapture indefinitely. And upon death, the taxpayer’s heirs may qualify for a “new basis at death” on the property. The election will depend on the size of the estate, but for most estates the heirs will elect to proceed under the 2011 IRS rules which permit a $5 million estate exemption in exchange for permitting heirs to take property at the current market value at the time of death. So an inheritance of a commercial property that was the result of a series of 1031 exchanges would not require the payment of the deferred tax gain. Rather, the heir would take the property at the fair market value at time of death, and pay only gains from that point to sale, and the whole process of gains deferral can start over for that new taxpayer!

Preparing For April 15 – The IRS Limits The Interest Deduction On Non-Married Couples

Preparing For April 15 – The IRS Limits The Interest Deduction On Non-Married Couples

As the tax filing deadline for the 2011 tax year nears, the IRS has recently ruled on a subject that will be of interest to many taxpayers who co-own property with a person who is not their spouse.

First, let’s review the basic rules on home mortgage interest deduction. Taxpayers who itemize deductions on Schedule A can include interest paid on mortgages with certain limits. Only interest paid on a loan secured by a principal residence, and a second home, is deductible. Additionally, taxpayers can only deduct interest on loans for which they are legally liable. So contributing to the payments on a loan for someone else will not qualify.

Assuming these criteria are met, the amount of interest a taxpayer can claim is limited. Taxpayers cannot deduct the interest on more than $1,000,000 of debt for their first and second residence together. Married couples filing jointly are limited to $1,000,000 for the couple, and if they file separately the limit is reduced to $500,000 each. In addition, a taxpayer can also deduct the interest on the first $100,000 of home equity loan debt. So an unmarried taxpayer with a mortgage and home equity line of credit could deduct the interest on $1,100,000 in total.

But what if an unmarried couple jointly owns a home together that has more than $1.1 million of qualifying mortgage debt? Can each taxpayer deduct the full extent of their individual limit? Prior consensus had always been yes. But recently, the IRS ruled that the limit should be applied applied by residence, not by taxpayer. Thus, one or two homes which are the principal and second homes cannot provide more than a total of $1.1 million interest credit no matter how many taxpayers own the homes. Once the $1.1 million of interest deduction is used from the first and second home, no further interest deduction can be claimed.

An example will help. Suppose Bob and Sue own two homes jointly and are not married. The principal residence has a first mortgage debt of $1,500,000, and the second home has a first mortgage debt of $1,000,000. There is no home equity loan in place on either. According to this ruling, Bob and Sue cannot together claim interest on more than $1,000,000 of total mortgage debt, despite the fact that they file separately and are not married, because the mortgage debt is related to the same first and second homes. If instead, Bob owned property one with debt of $1,500,000, and Sue owned property two with debit of $1,000,000, then each taxpayer could claim the full $1,000,000 limit providing they were otherwise eligible.

Tax planning can help in this situation. Non-married couples who own a first and second home should consider structuring transactions to have one home owned entirely by the first taxpayer and a second home owned entirely by the second if this is possible. Under that scenario each taxpayer should be able to deduct the full extent of the interest on $1,000,000, rather than splitting it as they would when owning both homes jointly. Non-married co-ownership is common in our market and likely on the increase, so be careful to consult tax advisers before purchasing to ensure that the structure permits maximum deduction.