Exchanges & IRA's

The information contained herein is for informational purposes only and does not constitute tax, legal or accounting advice. You are advised to seek appropriate professional advice regarding your facts and circumstances.

Remember too if you are planning an exchange you obvious goal is to exchange into something that will also appreciate. If you sell that property in the future you will then be subject to capital gains (perhaps at an even higher rate should the laws change).

TAX DEFERRAL UNDER § 1031

Real Estate that has been or will be held for income production (rental), investment or used in a trade or business will qualify for 1031 tax deferral. Generally, any type of real estate may be traded for another type of real estate. That means, Hotels, Rental Homes, Multi-Family Dwellings, Commercial Office Buildings, Farmland, Raw Acreage, Leases for more than 30 years may all be exchanged for another type of Real Estate. To view IRS Forn 8824-Like-Kind Exchanges (w/Instructions), click on this link...http://www.irs.gov/pub/irs-pdf/f8824.pdf

The most commonly used tax-deferral strategy is the Forward Delayed Exchange. In a typical Delayed Exchange, the taxpayer sells a business or investment property and acquires replacement property of equal or greater value within 180 days. The use of a Qualified Intermediary (QI) is required to facilitate a valid tax-deferred exchange.

Before you begin the exchange process, be sure to consult with your tax or financial advisor to insure that a 1031 exchange is right for you. Then, contact a Qualified Intermediary (see below) to help you complete the exchange process in three easy steps:

Step One: Sale of the Relinquished Property. Before the sale of the first property the Exchanger must add certain facilitating language into the Exchanger’s Contract for Sale (specific language is recommended for insertion into the "special provisions" paragraph of Texas contracts) and complete the additional documentation prepared by the Qualified Intermediary. On closing, the closing proceeds are delivered directly to the Qualified Intermediary.

Step Two: Identification of the Replacement Property. The Exchanger must identify the property to be purchased (generally called the “Replacement Property”) within 45 days following the sale of the Relinquished Property. The taxpayer may generally identify up to three properties as a potential Replacement Property, or more subject to certain restrictions.

Step Three: Purchase of the Replacement Property. The Exchanger must obtain the Replacement Property within 180 days following the sale of the Relinquished Property, which must be identified property, subject to the rules listed above. On closing, the closing proceeds are paid directly by the Qualified Intermediary, and the Exchanger receives the Deed to the Replacement Property.

The general idea behind a qualified exchange is that the proceeds (and therefore the profit) from the sale are never held (realized) by the seller.

§ 1031 Exchanges and Vacation Homes

IRS Code Section 1031(a) specifically provides that “no gain or loss shall be recognized on the exchange of property held for productive use in trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment”.

Courts that have analyzed whether property held by a taxpayer for investment have generally concluded that the requirement is met if the property is held primarily for investment.

In other words, limited use of the property for the taxpayer’s personal enjoyment will not destroy the investment character of the property if there is objective evidence that the taxpayer’s primary motive is to hold the property for investment.

In February of 2008 the IRS issued revenue Procedure 2008-16, which creates a “safe harbor” under which real property held for investment and used for the taxpayer’s personal enjoyment will be treated by the IRS as held primarily for investment. The safe harbor requirements are met with regard to a property relinquished in an exchange if:

The taxpayer has owned the relinquished property for no less than two years; and
In each 12-month period during the two-year look-back period, the taxpayer has rented the property at a fair-market rent for 14 days or more, and the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10% o the days the property is actually rented at a fair-market rent.

While there are other technical niceties relating to how days rented and days used are counted (please consult a qualified professional), the foregoing ownership and use requirements comprise the main features of the safe harbor test. Similarly, vacation home replacement property acquired in an exchange will qualify for the safe harbor if it is retained for two years and the previously mentioned use test is met during each of those two years.

There are other types of exchanges, such as reverse exchanges, improvement exchanges, and personal property exchanges. For more information on these types of exchanges and other important information, click on the links below and browse the websites of the following QI's: http://www.expert1031.com, http://www.summit1031.com , www.1031cpas.com or www.texas1031.com

USING IRA SAVINGS (AND OTHER "QUALIFIED" FUNDS) TO INVEST IN REAL ESTATE

Most investors believe they cannot use IRA money to buy real estate. Developed or undeveloped. They are wrong.

You can invest IRA money in a wide range of investments, including stocks, bonds, mutual funds, money market funds, saving certificates, U.S. Treasury securities, promissory notes secured by mortgages or deeds of trust, limited partnerships and … real estate. That includes houses, condos, office buildings -- even if located in another country.

You cannot; however, use IRA money to buy your own residence, or any other property in which you live. It has to be investment property. But when you retire, you can direct your IRA to turn it over to you as a distribution, at the current market value.

Given the real estate boom of the 1980s, and its current resurgence, it's curious that so little is understood about “the real estate IRA." IRA accounts invested in stocks, bonds and other financial paper are very lucrative for banks, mutual funds, insurance companies and brokerage houses. These institutions will gladly act as your trustee (the middlemen in all IRAs) and sell you their wares. But they won't act as your trustee if you want to buy real estate with IRA money. Why? They have too much to lose because they're not (nor can they be) in the real estate business.

So you're pretty much on your own investing in a real estate IRA. You have to find your own property, trustee and perhaps a management company, to collect rents and maintain the property. First, contact an independent trustee (see below) to open a self-directed IRA or convert your existing plan structure. This trustee must follow your "self-directed" instructions to the letter. Second, sign broker-to-broker papers that will transfer designated portions of your existing IRA to your self-directed IRA. Finally, find and buy the property using a real estate attorney to create the usual documents. Remember, you must clearly explain your IRA ownership and goals to them. Then, the trustee will take title at your direction.

The rules governing real estate IRAs are strict:

The house or property must remain in the trust until distribution at retirement.
It must be treated like any other investment.
You cannot manage the property. But your trustee can hire a third party -- a real estate broker, or local manager -- to collect rents and maintain or improve the property.
All rental profits must be returned to the trustee.

The biggest drawback of the real estate IRA is that it may lack the funds to make a substantial purchase. At present, it is controversial as to whether your IRA can take a mortgage, or if this would violate several IRS provisions and render all of your IRA assets taxable. Most expert advise: Don't use IRA money as a down payment and take a mortgage for the balance due.

Until the IRS clarifies borrowing rules, a special technique allows you to participate in real estate ownership through your IRA, even if there is not enough in capital to pay for the entire parcel. That technique consists of buying fractional shares of property through the use of a general or limited partnership.

For more information on these types of transactions and other important information concerning IRA, Roth IRA, SEPA and 401(k) accounts, contact your financial advisor or call me for recommended suggestions.

For a primer on this increasingly popular investment option, read the e-book from the grandaddy of self-directed IRA firms, Pensco Trust.