Don’t Burn up Your Loss Carry-Overs on Real Estate

Sometimes taxpayers opt not to conduct a 1031 exchange because they have prior loss carry-overs that can be applied to reduce their tax liability. 

What is a Loss Carry-over?

If in the past a taxpayer has sold a capital asset for less than their adjusted basis, this results in a capital loss. If the taxpayer is unable to take advantage of the loss with a corresponding tax deduction for the entire amount for the current tax year…then that loss (lingering or pending tax deduction) can be carried over into future tax years.

Keep your Powder Dry

Loss carry-overs are valuable tax attributes because they can be used in the future to offset future income (this is especially so if tax rates increase). Generally, I tell people to save their loss carry-overs for gains that cannot be deferred, and indefinitely defer the real estate gains through a 1031 exchange, especially if they own other assets such as stocks.

Always Exhaust the 1031 Option First

If the taxpayer is inclined to buy more real estate anyway, it may be prudent to set up a 1031 to keep their options open for 45 days to see what they want to do, and if they want to identify any replacement properties.

You Gotta Know When to Hold'em

Sophisticated taxpayers and their tax advisors know that it is better to not burn up their loss carry-overs without considering an alternative that allows them to defer their gains and also keep these valuable tax attributes (to use against other future gains).

Defer, Defer, Defer…Die

Because of the step-up in basis, the ability to refinance replacement properties (to pull out equity tax-free) and the long duration that 1031 properties can be held (until after the death of the taxpayer), it is prudent to consider all of the alternatives before playing the loss carry-forward card on real estate.

• Start Your 1031 Exchange: If you have questions about real estate loss carry-overs, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Exchanges Between Family Members

Generally, related party 1031 transactions should be avoided, especially as to the purchases of replacement property. We'll explain why in this article.

Would a Taxpayer be Able to 1031 into a Piece of Land Owned by His or Her Daughter?

Internal Revenue Code (“IRC”) Section 1031 (f) has special rules for exchanges between related persons that may require the related parties to hold their respective properties for two years after an exchange. However 1031 (f) also contains a killer clause that the related party exchange cannot be part of a transaction structured to “avoid” the imposition of tax. It’s hard to discern a compelling differentiation between the intention to legally and indefinitely defer one’s taxes and an impermissible intention to avoid the imposition of tax. The IRS has picked up on this and has successfully fought some heart-breaking cases. The result is that there are a string of unfriendly tax court cases and rulings that have really muddied the waters for related party purchases.  In one case a son purchased his replacement property from his mother…and the IRS disallowed the 1031 exchange.

“Related Person”

The term “related person” means any person bearing a relationship to the taxpayer described in section IRC Sections 267 (b) or 707 (b)(1) and can broadly include family members and people you are in business relationships with (such as a partnership, corporation or trust). To make matters more complicated, because of the IRS’s rules of attribution, a person may be considered to be a related person even if you wouldn’t normally consider them a related to you.

The problem for farmers who want to buy adjoining land, and families with closely located properties that they know and understand, is that these desirable replacement properties may be owned by related parties, such as an uncle, mother or brother.

• Start Your Exchange: If you have questions about 1031 exchanges between family members, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Identification Best Practices

Note: This is a continuation of our previous article: A Primer on 1031 Identification Rules.

1031 Best Practices for Sending-in an ID

The most common and safe practice is to use a qualified intermediary and to fax or otherwise send in your 1031 replacement property identification form early; then ask your qualified intermediary to send you back written confirmation that they have received it. On IRS form 8824, which is a worksheet that you attach to your federal tax return to give the IRS information about your exchange, question 5 requires you to provide the “date” the like-kind property you received was identified by written notice to another party (month, day, year).  

If you are ever audited by the IRS, is important to have a good records on When, How and to Whom you sent your identification to so that you can substantiate the information in your federal tax return and on IRS Form 8824.  For an extra level of thoroughness, in addition to faxing or e-mailing a signed PDF of the 1031 replacement property identification form, you may also send the identification to the qualified intermediary through the US Postal Service by First Class Certified Mail Return Receipt Requested. 

That way you can keep the Return Receipt as proof that you sent it, and further, your qualified intermediary can retain the postmarked envelope as proof of when it was sent. Make sure that you take your letter to the US Postal Service and have it postmarked (legibly) before the 45th day.  If you simply drop your letter into a mailbox, it may not be picked-up, processed and postmarked by the US Postal Service with the same date that you actually dropped it into the mailbox.

Is Signing a Purchase Agreement for Replacement Property Sufficient to Constitute an Identification for 1031 Purposes?

As noted before, a taxpayer can technically identify to the seller of the replacement property as long as it is done within the 45 day identification period in a written document and meets the other requirements for a valid designation.  If you want your purchase agreement to constitute an identification of replacement property (which is an uncommon but permissible practice) you may want to clearly state your intention by including text in the purchase agreement such as:

“The Seller acknowledges that the Purchaser herein designates that the subject property shall be the Purchaser’s replacement property to complete the Purchaser’s like-kind exchange of property under Section 1031 of the Internal Revenue Code regarding Purchaser’s disposition [insert address] as relinquished property.”

What if I am Doing a Build-to-Suit?

If you are going to conduct a build-to-suit exchange wherein your qualified intermediary or exchange accommodation title-holder is taking title to the new replacement property while new improvements are constructed, then you should designate in your replacement property identification not only the initial replacement property, but also the new like-kind improvements that will be completed and received by you with the 180 day exchange period.

• Start Your Exchange: If you have questions about 1031 identification best practices, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

A Primer on 1031 Identification Rules

Many taxpayers and their advisors have questions about the rules for identifying replacement property for a 1031 exchange.  For a copy of the Treasury Regulation 1.1031(k)-1(b) and (c) check-out our Library of 1031 resources.

Here is a quick primer on the identification rules of a 1031 tax exchange.

1031 Identification Period

After the closing of your old relinquished property you will have until midnight of the 45th day thereafter to designate (identify) in writing what replacement properties that you want to receive to complete your 1031 exchange.  If you do not send your written designation within that time, your exchange may fail, so it is very important to keep track of this deadline. You can run a calculation of your 45 day identification deadline and your 180 day exchange deadline by going to our 45 / 180 Day Calculator.

Eliminate Stress by Closing within the First 45 Days

Any replacement properties that you close on and receive within the first 45 days are deemed to have been identified by virtue of the fact that you bought it.  So one way to eliminate the stress of having to make an identification is to have the purchase of your new replacement property lined-up to close quickly after the closing of your old relinquished property. However, if for some reason you encounter an unexpected delay with your replacement property (that could extend the closing date beyond the 45th day), it is advisable to fill out and send in an identification just to be on the safe side.

Don’t Fail to Identify

If you do not make a written designation within the 45 day identification period (or do not actually receive your replacement property by closing on it within the 45 days), then your exchange will end, and your qualified intermediary will have to return your 1031 exchange funds back to you. 

• Start Your 1031 Exchange: If you have questions about 1031 identification rules and real estate in Minnesota, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Death & Taxes (Part 2)

Note: This is part 2 of our Death & Taxes blog series. Read part 1 here.

Tax-free Transfers

Section 102 of the internal revenue code says that an heir (beneficiary who inherits property) that receives property as a gift, bequest, devise, or inheritance takes that property tax-free. Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.

Basis of an Heir

The question then becomes, what if your heir sells the property that they received as an inheritance from you? What is the heir’s basis for calculating his or her gain? Will the heir have any tax liability?

At present, Section 1014 of the internal revenue code allows your heirs to take your property through inheritance with a stepped up basis (roughly Fair Market Value (FMV) of the property at the time of your death) so they would not take over your low basis in the property. However, the tax code in this area could change, so you need to talk about this with your CPA or accountant.

Under current Section 1014(a) the general rule applied to property an heir receives from a decedent is that the heir’s basis equals the fair market value of the property at the time the decedent dies. Because of Section 1014, any appreciation of the affected property that occurred (as well as deprecation recapture) during the decedent’s lifetime may never be taxed. The current operation of this code section provides an incentive for taxpayers to defer taxes throughout one’s lifetime until death. One strategy that people refer to with 1031 exchanges is called Defer, Defer, Defer, Die. The idea is that one never recognizes any gains during one’s lifetime, but instead continually defers the recognition of gain (compounding and building wealth tax-free) again and again until they die.

Compounding Returns Tax Deferred Offers One of the Most Powerful Ways to Build Wealth

The importance of compounding and re-investing your gains tax-deferred cannot be stressed enough.  Over time, the more you are able to reinvest without the drag of having to pull-out capital for taxes, means you will have much more capital to put down on bigger and better like-kind investments. Compounding tax-deferred has a tremendous impact on wealth creation, and this is why people like to invest in tax efficient vehicles like 401K plans, Roth IRAs, and whole life insurance products.

If Congress ever acts to change the Step-up Basis under Section 1014, they will probably still allow for a modified form of carry-over basis, so your heirs would likely take over your low basis, and would then need to continue to defer the taxes by utilizing 1031 tax exchanges. The good news (if that ever happens) is that they could also continue the strategy of Deferring, Deferring, Deferring, Dying generation after generation.

• Start Your Exchange: If you have questions about tax-free transfers and 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved