Newsletter

Anniversary of the Passage of An Act Providing Consumer Protection to Clients

Legal 1031 Exchange Services, Inc. is please to celebrate the one year anniversary of the passage of “An Act Providing Consumer Protection to Clients of Exchange Facilitators for Tax Deferred Exchanges”. Todd R. Pajonas, President of Legal 1031 Exchange Services, Inc. spearheaded the two year effort to make this law a reality.

The 1031 Protection Act, which passed in two parts, became law when Connecticut Governor Daniel Malloy signed Public Act 135 on June 19, 2013, as well as Public Act 253 on July 11, 2013, which provided for a small modification to the original bill.

An IRC §1031 tax deferred exchange allows owners of real or personal property to defer the recognition of a capital gains tax they would have recognized when they sold their property. Exchanging allows investors to reinvest money into new business or investment properties which would otherwise have been paid to the government as capital gains tax. In one form or another the ability to defer a capital gains tax through an exchange has been part of the tax code for almost 100 years.

The 1031 Protection Act provides for protection of exchange funds deposited by investors with Qualified Intermediaries operating in the State of Connecticut by establishing investment standards, bonding requirements, and notification requirements to keep clients informed.

Connecticut State Representative John Shaban, who introduced and sponsored the bills during the 2012 and 2013 legislative sessions, clearly explained the bill’s intent by stating, “It is easier to stem a crises than respond to one. This bill offers reasonable and predictable consumer protection at no cost to the taxpayer.”

On March 15, 2012 Todd Pajonas, Suzanne Goldstein Baker, president of the Federation of Exchange Accommodators (FEA), and Anthony Lombardi, president of CATIC Exchange Solutions, testified in Hartford, CT on the need for the protections afforded by H.B. 5415 before the Committee on Banks. In 2013, during the following legislative year, Todd Pajonas once again testified before the Committee on Banks, and extoled the benefits of the 1031 Protection Act. House Bill 6339 and Senate Bill 911 were ultimately passed by the Connecticut Legislature and signed into law by the Governor.

Todd Pajonas, commenting on the one year anniversary, stated, “I want to once again thank Representative John Shaban who took the time to understand how this legislation will protect investors. This Act provided investors in Connecticut, the peace of mind and protections they deserve.”

Matthew K. Scheriff, Executive Vice President of Legal 1031 Exchange Services, Inc., further commented, “1031 exchange transactions help to fuel our economy by allowing investors to grow their investments. It is important for federal and state governments to provide legislative support and security so investors can have the confidence they need.”

Legal 1031 Exchange Services, Inc., with offices in Connecticut, New York, Massachusetts and Florida, provides qualified intermediary services for 1031 exchanges, as well as other real estate tax related services.

 

Link to Public Act No. 13-253

Link to Public Act No. 13-135

 

 

BEST OF BOTH WORLDS – IRC §121 and IRC §1031

A property owner selling a property that is held both as a primary residence and an investment property may qualify for tax benefits under both IRC §121 and IRC §1031. The issuance of Revenue Procedure 2005-14 provides taxpayers with clear guidance on the structuring and removed the uncertainty as to the qualifications of such transactions.

IRC §121 provides for an exclusion of the capital gain tax upon the sale of a principal residence in which the taxpayer lives in the property two out of the last five years (generally speaking). The maximum exclusion under §121 is $250,000 for those filing as single and $500,000 for those filing a joint return.

IRC §1031 allows property held for business or investment purposes to be exchanged for like-kind property while deferring most, if not all, of the capital gains related taxes upon the sale of the property.

In a dual-use property, whereby the property qualifies under IRC §121 and IRC §1031, the portion of the property where the owner lives as their primary residence may qualify for the primary residence exclusion under IRC §121. The portion of the property held for business or investment use may qualify for a tax deferral under IRC §1031.

A common example is when a taxpayer owns a four-family property. They live in one unit and rent out the other three units. In such situation, the taxpayer may qualify for the primary residence exemption on 25% of the property while also qualifying for the 1031 exchange on the 75% of the property representing the rental units. By utilizing both sections of the tax code, the taxpayer can maximize their wealth. In situations where the taxpayer has gains far exceeding the primary residence exemption, the combination of the tax strategies is a very effective means of preserving a taxpayer’s wealth.

Another strategy is whereby a taxpayer converts a previously purchased 1031 replacement property into their primary residence. They will have to hold the replacement property for a period of time to satisfy the investment intent requirement, but after such time, the taxpayer could elect to move into the property as a primary residence. After living in for several years, the taxpayer may be eligible for the primary residence exemption upon the sale of the property. By utilizing such strategy, the taxpayer has effectively converted a deferral of gain to an exemption of gain. The Service has clawed back on such strategy by implementing more stringent requirements to qualify for IRC §121 to include a five year holding requirement and also a pro-rated exemption amount excluding periods of non-qualified use.

Furthermore, in situations where a taxpayer will have a gain far in excess of the primary residence exemption, the taxpayer could elect to move out of the property and rent it out for several years. At the time of sale a few years later, the taxpayer could qualify for both IRC §121 (as they lived in the property two out of the last five years) and IRC §1031 (at the time of sale the property will have been established as an investment property). In this scenario, the taxpayer can benefit from the primary residence exemption, while utilizing the 1031 exchange to defer the tax on the gain in excess of the exemption amount.

We welcome you to contact Legal 1031 Exchange Services, Inc. to discuss any questions relevant to the strategies discussed above or any other 1031 related matters. We look forward to the opportunity to assist you and your clients!

The Resurrection of Reverse 1031 Exchanges

Reverse exchanges appear to be gaining traction in the current real estate market after numerous years of dormancy. The reverse exchange differs from a typical “forward moving” delayed exchange in that the exchanger acquires their replacement property first, and thereafter sells their relinquished property. In order to properly structure a reverse exchange, the qualified intermediary forms an entity known as an Exchange Accommodation Titleholder (“EAT”), which is a limited liability company (“LLC”), to take title to the replacement property. The EAT acts as a “straw man” to hold title until the exchanger sells its relinquished property.

When the seller transfers the replacement property to the EAT’s LLC a transfer tax is due and payable. Once the exchanger sells its relinquished property, the EAT transfers the membership interest in the LLC, which owns the replacement property, to the exchanger. The transfer of this membership interest does not involve a change in beneficial ownership since the EAT was merely acting as a “straw man” to structure the reverse 1031 exchange, and does not generally involve the payment of a second transfer tax.

However, the taxpayer does need to be cognizant of potential costs for duplicate transfer taxes in certain jurisdictions. In a recent transaction, Legal 1031 sought guidance from the New Hampshire Department of Revenue Administration (the “NH DRA”) to confirm that the State would not levy a second transfer tax upon the transfer of the property from the EAT to the taxpayer. Legal 1031 put forth the position on behalf of our client that such transaction should not be subject to an additional tax levy, and ultimately the NH DRA concurred with our position. The NH DRA previously charged a duplicate transfer tax in all reverse exchanges until Legal 1031 vigorously advocated its client’s position that no duplicate transfer tax should be due.

1031 EXCHANGE – FILING AN EXTENSION TO PRESERVE YOUR 180 DAY EXCHANGE PERIOD

IRC Section 1031 requires that taxpayers acquire all replacement property by the earlier of 180 days from the sale of the relinquished property or the Federal tax return due date for the year in which the exchange commenced. Therefore, taxpayers with exchange transactions commencing in the 4th quarter of 2014, may have less than 180 days to complete their exchange, unless they file an extension.

After completing the exchange, taxpayers can then file their Federal return and report their 1031 exchange transaction on IRS Form 8824.

Once a tax return is filed, it typically cannot be amended to include the exchange or for an extension of time to complete the exchange. If you file the return prior to completing the exchange, the sale of the relinquished property should be reported as a taxable transaction.

CALIFORNIA CLAW BACK

An IRC §1031 tax deferred exchange allows owners of real or personal property to defer the recognition of a capital gains tax they would have recognized when they sold their business or investment property. Capital Gains taxes are deferred indefinitely until such time the investor decides to cash out. Generally, the investor is only subject to state taxes in the state where the final property is sold, however, some states take a different position whereby exposing the taxpayer to double taxation.

California regulations employ a “Claw back” provision that requires any gain in property value accrued in California to be subject to California state taxes, regardless of whether or not that property was exchanged for one in another state. At the time of a “cash-out” sale the taxpayer would be subject to the state taxes in which the property is being sold, as well as to California, for the taxes applicable to the gain attributable while in California, thereby creating a partial double taxation scenario. Other states that have imposed a similar claw back rule for nonresidents who have exchanged in-state properties for out-of-state replacement properties are Massachusetts, Montana and Oregon.

Recently, The State of California Assembly passed legislation adding new sections to the California Revenue and Taxation code that require that 1031 Exchange investors that sell California Property and purchase Non-California Replacement Property to file an annual information return with the California Franchise Tax Board (FTB), reporting this Non-California property. The California State taxes that were previously deferred will be due if and when taxpayers sell their new non-California properties and elect to take their profits rather than continuing to defer taxes through another 1031 Exchange.

This information return must be filed in the year of the exchange and every year thereafter in which the gain is deferred. If taxpayers fail to file the annual return, the FTB may estimate taxes due and assess tax, interest and penalties. The new law shall apply to exchanges of property that occur in taxable years beginning on or after January 1, 2014. Although the new requirement to file an annual information return with the state of California is a burden, investors still will never have to pay the California taxes due under the California Claw-Back Provisions as long as they continue to 1031 Exchange from property to property.

NEW JERSEY BULK SALES ACT

If you plan on conducting business transactions in the State of New Jersey, it is imperative to find out if the sale is subject to the Bulk Sales Law. The current bulk sales law, N.J.S.A. 54:50-38, applies to any sale, transfer or assignment in bulk of any part or all of a person’s “business assets,” other than in the ordinary course of business (e.g. the bulk sales law would not apply to a homebuilder selling homes as they would be considered inventory). If the sale is subject to the bulk sales law, the Purchaser is required to notify the New Jersey Division of Taxation.

To satisfy the notice requirement of the Bulk Sales Act, the Purchaser must submit a completed Form C-9600 and a copy of the executed contract of sale, at least ten (10) business days prior to the proposed closing of the transaction. The C-9600 and contract must be sent by registered, certified or overnight mail by Fed-Ex or UPS. If the purchaser fails to abide by the bulk sales notice requirement the purchaser will be subject to liability for any state tax obligations due by the seller at the time of closing including interest and penalties. Therefore, closings should not commence without a response from the Division of Taxation.

The New Jersey Division of Taxation will notify the purchaser and seller if they will require an escrow to be held at the closing. If an escrow is required, the New Jersey Division of Taxation will notify the buyer to withhold the amount from the purchase price proceeds for possible unpaid tax liabilities of the Seller. Once the amount required is placed into escrow, at or prior to closing, the purchaser may proceed with the closing without liability for deficiencies in the seller’s tax payments beyond the escrow.

1031 Exchanges in Danger of Being Repealed!

A 1031 exchange, which is one of the driving forces of our nascent and fragile economic recovery, is in serious danger of being eliminated. Using pejorative terms such as “loop hole”, “fairness”, and “tax neutrality”, the government is seeking to eliminate one of the greatest economic drivers of the past hundred years. That’s correct – in one form or another the ability to defer capital gains tax when selling business or investment real property has been around for almost one hundred years.

When will such potential changes take effect? With the upcoming election in November, and changes to some of the committee membership, it is unlikely the government addresses tax reform this year.

Before you think this is a screed against a single political party you need to continue reading. The Republicans and Democrats are joining forces to collectively load the gun that will shoot our economy in the foot. The White House, a House Ways and Means bipartisan working group, the Senate Finance Committee, and the Joint Committee on Taxation all have their own recommendations on eliminating or severely restricting IRC §1031 tax deferred exchanges.

But all is not lost! Should the government decide to consign 1031 exchanges to the economic trash can, taxpayers will inevitably took to other tax strategies to structure their transactions to help defer the capital gains tax. One 1031 alternative method in use today, and not part of repeal efforts by the government, is the use of a structured installment sale. A structured installment sale utilizes section 453 of the Internal Revenue Code to allow for the investment of the pre-tax lump sum received from the sale of property. And unlike a 1031 exchange a structured installment sale can be used for a variety of assets including primary residences, business, and personal use property. It is not limited to the sale of business or investment property.

In short, section 453 of the Internal Revenue Code provides taxpayers the ability to defer capital gains tax from the sale property until they actually receive the funds. For example, if an investor sells a property for one million dollar, and agrees to accept a two hundred thousand dollar payment in year one and equal payments over the next nine years, that taxpayer will only have to pay capital gains tax on the principal payment they receive each year.

A structured installment sale works similar to a 1031 exchange in that the funds from a sale are collected by a third party to be used toward the purchase of “replacement assets”. But instead of using the funds to buy real estate a structured installment sale normally involves the purchase of annuities, stocks and/ or bonds.

In conclusion, a structured installment sales currently provides an underutilized method of deferring capital gains tax, but it may become the “only game in town” should the government repeal section 1031 of the Internal Revenue Code.