New Section 121 Rules Begin to Bite

By:  George E. Foss III

As the days and weeks pass, the effectiveness (from IRS’ perspective) of the new provisions slipped into Section 121 grow and grow.

It used to be true that you could move into one of your rental properties, live there for two more years as your primary residence, and then sell the place and exclude $250,000 of the capital gain ($500,000 married.)

The first “chink” came in October, 2004, when Congress enacted Sen. Grassley’s amendment.  This states that to be able to claim the exclusions above, you have to own a property for five (5) years and live in it as your primary residence for the last two (2), unless you purchased the place with your own money.  No longer could a taxpayer take a residential rental as an exchange property and sell it any sooner.

Since the Amendment did not significantly lengthen the time a taxpayer would need to fully qualify for full Section 121 treatment (it extended the necessary time from four (4) to five (5) years, the industry just shrugged.

However, the next “chink” came at the end of July, 2008, when Congress passed the “Housing Bill,” and its infamous Charles Rangle Earmark.  From January 1, 2009 on, owners of rental properties (and vacation homes) would carry around an ever increasing fraction of “Non-Qualified Use” periods; the size of the fraction is the capital gain you pay tax on, no matter what.

Both the denominator and the numerator of this fraction change every month.

The denominator of the fraction is the number of months you have owned the property, for any purpose.

The numerator of the fraction is the number of months since January 1, 2009 that the property was NOT your principal residence.

Imagine, for example, a couple who rent in the city and own a getaway place in the country that they hope to eventually retire to.  Cong. Rangle himself probably falls into this category, but I digress.

The new rule really hurts these people, because after many years of non-primary residential use, the numerator and the denominator of the fraction are virtually identical, meaning that any gains they eventually realize on the sale of their property, even if they live there for two (2) years, will be almost all tax; no exclusions for them, or greatly diminished ones if any.

I have attached a chart (Click here) to this post which shows the results for various holding periods and various periods of non-primary residential use. Look at Row 10, Column 12: This is the percentage of tax (83%, no matter what) to be paid by someone owning a property for 12 years, and moving into it after Year 10.

It’s too bad that there were no hearings on this proposal, because it would have become pretty clear that the effects of the change were aimed an a completely unsuspecting group of city-dwelling, second home owners.

Connecticut River Bank, NA, sponsors class….

By:  George E. Foss III

On Tuesday, September 29, 2009, more than 20 attorneys, accountants and Enrolled Agents gathered at the Mountain View Grand Hotel in Whitefield, New Hampshire for a four (4) hour Continuing Professional Education course  on The Power of Section 1031.

Presenting were John D. Hamrick and George E. Foss III.

Sponsoring the course was Connecticut River Bank, NA, headquartered in Charlestown, New Hampshire and with branches between Keene, NH in the South, to Lancaster, NH in the North, all along the Connecticut River.

Gary Gray, President, has observed that the bank’s founders, 150 years ago, viewed the Connecticut River as an economic corridor, first for barges, then for railroads, and now for automobile and truck traffic, via Interstate 91.  This philosophy continues today.

Edmund & Wheeler developed the class and got it approved by the Accountancy Boards and Bar Associations of New Hampshire and Vermont.  The course was also submitted to the Internal Revenue Service for approval for credit for its Enrolled Agents, which was quickly granted.

Topics include Exchange Basics; Accounting Practice; Case Studies; and Alternative Exchange Strategies.  Emphasis is placed on the strategic planning aspects of Section 1031 and how the attendee can better assist his/her clients in their asset dispositions going forward.

There are three more classes scheduled as of this date; please click on:

www.Section1031.com/crb

to find a location convenient to you and to register.

NH Governor approached; DRA tactics under review

By:  George E. Foss III

On September 17, 2009, the New Hampshire Association of Realtors arranged for me to meet Governor John Lynch.

The purpose of the meeting was to describe to him what the Department of Revenue had been doing to hapless NH taxpayers since last November, namely opening previously completed Section 1031 Exchanges as far back as 2005, and assessing the Business Profits Tax if the entity names did not exactly match.  This usually happens when the Exchangor forms a Single-Member Limited Liability Company (SMLLC)  to receive and hold the Replacement Property in a Section 1031 Exchange.

Here are the thirteen points made to Governor Lynch, plus our recommendations at the end:

POINTS MADE TO GOVERNOR LYNCH – 9/17/09

1.                  SECTION 1031 EXCHANGES ARE VERY OLD, FIRST PASSED INTO LAW ON MARCH 8, 1921.   (Note:  Here we presented the Governor with a diagram of a Delayed Exchange – Case #1)

http://www.section1031.com/Case%20Studies/CS1.htm

2.                  EVERY STATE (BUT ONE: PA) RESPECTS THIS TAX CODE SECTION.

3.                  NEW HAMPSHIRE USED TO RESPECT IT TOO, BUT AS OF ABOUT APRIL, 2008, HAS BEEN DISALLOWING CERTAIN OTHERWISE VALID EXCHANGES.   THERE ARE A NUMBER OF CASES BEFORE THE DRA AT THE PRESENT, TO OUR KNOWLEDGE.

4.                  THE AFFECTED TAXPAYERS FALL INTO TWO GROUPS:

5.                  THERE IS A VOLUNTARY GROUP OF TAXPAYERS WHO TOOK THEIR REPLACEMENT PROPERTY IN A SINGLE-MEMBER LIMITED LIABILITY COMPANY FOR LIABILITY PROTECTION PURPOSES; AND

6.                  THERE IS AN INVOLUNTARY GROUP OF TAXPAYERS WHO TOOK THEIR REPLACEMENT PROPERTY IN A SINGLE-MEMBER LIMITED LIABILITY COMPANY BECAUSE THEY WERE REQUIRED TO BY THE BANK FINANCING THE TRANSACTION.

Note:  With the permission of the taxpayers to use their actual names, one of each of the above cases with the actual DRA Letter of Assessment was presented to the Governor.  He seemed quite interested and asked a number of specific questions.

7.                  BANKS TYPICALLY REQUIRE TAXPAYERS, ESPECIALLY GROUPS OF TAXPAYERS WHO WISH TO PURCHASE A PROPERTY AS TENANTS-IN-COMMON (TIC), TO TAKE THEIR INDIVIDUAL INTERESTS IN A (DELAWARE) SINGLE-MEMBER LIMITED LIABILITY COMPANY.  THESE COMPANIES HAVE IN FACT TWO MEMBERS, THE TAXPAYER AND A NORMALLY SILENT MEMBER APPOINTED BY THE BANK KNOWN AS THE “SWING MEMBER”  WHOSE ONLY PURPOSE IS TO VETO A BANKRUPTCY FILING ON THE PART OF THE ENTITY.

8.                  IN THIS WAY, BANKS CAN ASSURE THEMSELVES THAT THEIR BORROWERS ARE “BANKRUPTCY REMOTE.”

9.                  BUT THE DRA HAS STARTED (IN APRIL, 2008) TO DISALLOW COMPLETED EXCHANGES IF THE NAMES ON EACH SIDE OF THE TRANSACTION DO NOT EXACTLY MATCH.

10.              THE POLICY WAS UNANNOUNCED TO ANY PROFESSIONALS OR TO THE INDUSTRY; IN DECEMBER, 2008, THE DRA BEGAN APPLYING THE POLICY RETROACTIVELY, AS FAR BACK AS 2005.

11.       SINCE IT IS IMPOSSIBLE FOR A TAXPAYER WISHING TO START A SECTION 1031 EXCHANGE TO PREDICT MANY MONTHS IN ADVANCE THE EXACT NAME THAT A BANK OR A TIC COMPANY WILL ASSIGN THEM, THE EFFECT OF THE DRA’S POLICY IS TO PREVENT NEW HAMPSHIRE TAXPAYERS FROM PURCHASING A TIC PRODUCT OR FROM FINANCING WITH A BANK THAT REQUIRES THAT ITS BORROWERS TO FORM A NEW, CLEAN ENTITY, EITHER TO ASSURE THAT IT IS BANKRUPTCY REMOTE OR TO PREVENT ANY PAST LIABILITIES FROM TAINTING THE TRANSACTION, OR BOTH.  LARGE COMMERCIAL TRANSACTIONS WILL BE ESPECIALLY HARD-HIT.

12.              A NUMBER OF OTHER STATES (GA, MS, OR, SC, WI) ONCE PREVENTED EXCHANGES OUT-OF-STATE, WHICH IS NOT EXACTLY THE SITUATION HERE.  NEVERTHELESS, SO MUCH INVESTMENT CAPITAL WAS DIVERTED FROM THESE STATES THAT THEY HAVE ALL REPEALED THE RULE.  GEORGIA REPEALED IT RETROACTIVELY!

13.              NEW HAMPSHIRE DOES NOT WANT TO BE SEEN AS DISCOURAGING ANY NEW INVESTMENT, WHETHER IT COMES FROM A BUYER’S PERSONAL RESOURCES OR FROM A SECTION 1031 EXCHANGE.

PROPOSED SOLUTION:

1.  THAT THE DRA DISMISS THE PENDING CASES BEFORE IT THAT PERTAIN TO OTHERWISE VALID SECTION 1031 EXCHANGES.  SOME ASSESSMENTS HAVE ALREADY BEEN COLLECTED WHICH, IN FAIRNESS, SHOULD BE REFUNDED.

2.  THAT GOING FORWARD, IF TAXPAYERS TAKE THE REPLACEMENT PROPERTY IN A DISREGARDED ENTITY AND OTHERWISE QUALIFY FOR SECTION 1031 TREATMENT ON THE FEDERAL LEVEL, THEN THEY WILL ALSO QUALIFY FOR THIS TREATMENT ON THE STATE LEVEL.

3.  THAT THE NEW POLICY OF RECOGNIZING SECTION 1031 EXCHANGES AT THE STATE LEVEL, AND SPECIFICALLY IGNORING NEWLY CREATED SINGLE-MEMBER LLC’S FORMED FOR THE PURPOSE, BE EMBODIED IN AN ADMINISTRATIVE RULE.

Note:  At this point, the Governor was shown the text of some proposed legislation that will be introduced in the NH Legislature if the DRA declines to adopt an Administrative Rule correcting this issue:

If an entity, such as a Revocable Trust or a Single-Member Limited Liability Company or other similar entity, is disregarded by the Internal Revenue Service for the purpose of a Federal Tax Statute Section 1031 Like Kind Exchange, then the New Hampshire Department of Revenue Administration shall likewise disregard such an entity for all State Tax Purposes.  The deferment of taxes on gains and profit allowed through Section 1031 Like Kind Exchanges shall be preserved in New Hampshire so that investment in New Hampshire will not be at a disadvantage to other states.  All current enforcement activity by the Department of Revenue Administration in contradiction to this treatment shall cease immediately.

THE PARTIES PRESENT PLEDGE TO ASSIST THE GOVERNOR’S OFFICE AND THE DRA IN ANY WAY POSSIBLE.  (End of talking points.)

At the conclusion of the meeting, it was suggested that the DRA develop a form for use by taxpayers who complete Section 1031 Exchanges, but in different entity names because of a bank requirement or liability issue.

The taxpayer would submit the form to DRA, which would honor (and not tax) the exchange transaction.  Of course, going froward, if the taxpayer did business in the new entity, then it would owe Business Profits Tax on the economic activity.

Present at the meeting were Governor John Lynch; Paul Sargent, NHAR President; Paul Griffin, NHAR Executive Vice-President; Robert Quinn, NHAR Governmental Affairs Manager; Donald Eaton, JD, CCIM, Commercial Broker; Rick Jacobs, aide to Governor Lynch; and the undersigned.

Governor Lynch understood the issue and asked a number of good questions.  About the only one that we did not have an immediate answer to was the extent of Section 1031 Exchange activity within the state.  All of his other questions were responded to with answers that he appeared satisfied with.

At the conclusion, Governor Lynch stated that he would “speak to Commissioner (of Revenue) Clougherty” and would be in touch.

George E. Foss III

Straight Talk About Section 1031 and Protecting Your Exchange Funds

It’s tough out there right now. To make matters worse, in the past year hundreds of taxpayers who trusted their money, sometimes their life savings, to Qualified Intermediaries to take advantage of Section 1031, lost it all, and still had to pay capital gains taxes!

This money was lost because the taxpayer was convinced that their money would be safe and available when the time came to purchase their replacement properties, or to cash out if the Exchange failed. Many factors contributed to these issues including, greed, stupidity, lack of Government regulation and oversight and fast talking pro’s that convinced taxpayers that their money was being held in trust – even though the Agreement they signed clearly gave all control of the funds to the Intermediary.

Since the tax code says that in order to effect a Section 1031 Exchange, the taxpayer cannot have constructive receipt of their funds, a Qualified Intermediary must be used. This being the case, and with the recent instances of flat out theft, many are now thinking twice about utilizing one of the most powerful wealth building gifts the Government has ever given us (Section 1031 went into effect in 1921).

Edmund & Wheeler, Inc. wants you to understand the risks involved in getting involved in a Section 1031 exchange without fully understanding your Qualified Intermediary’s strategy in safeguarding your funds.

The Exchange Security Program (ESP) has been developed by Edmund & Wheeler, Inc. of Littleton, NH, to provide peace of mind for those investors who wish to use Section 1031 of the US tax code to defer capital gains taxes when selling investment real estate or qualified personal property. Below is a synopsis of the program.

• We have been facilitating Exchanges since 1981. We specialize in Section 1031 as a consulting practice and not as a way to aggregate funds.
• We’ve facilitated thousands of Exchanges worth hundreds of millions, nationwide.
• First in the nation to segregate client’s Exchange funds using their own taxpayer ID.
• First in the nation to grant total control of the movement of funds to the client using an online banking authorization system.
• Does not, will not and has NEVER “invested” client funds, and does not have an “investment policy”.
• For 29 years not one dime of any client’s funds have been lost, misused, misplaced or “invested” into anything other than an FDIC insured money bank.

• Provide “best of class” consulting to ensure Section 1031 is the right strategy for the client.
• Properly insure our company with errors and omissions insurance that is sized correctly to protect our client’s funds. Click here to review.
• Maintain a Fidelity Bond issued by Travelers. Click here to review.
• Safeguard all client funds in a segregated bank account using client taxpayer ID numbers.
• Set up bank accounts so that client has full online access to the ledger of the account, 24/7.
• Set up bank accounts so that funds CANNOT be moved without client’s online approval.
• Our clients can rest assured that they have total control of their deposits (without constructive receipt) at all times.

1. Should you Exchange?

We provide unlimited pre-exchange support to make sure that your situation strictly meets all of the requirements of Section 1031. We will work with you and your trusted advisors in establishing that Section 1031 is indeed in your best interests. Our fees are earned by facilitating Section 1031 Exchanges, Section 1031 consulting, professional training and not aggregating funds for any other purpose.

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2. When an Exchange is in your Best Interest

 

When it is determined that an Exchange is the best avenue, we create an Exchange Agreement. This Exchange Agreement will clearly indicate how your funds will be handled and safeguarded. There is no mystery here. Edmund & Wheeler deposits your funds into an FDIC insured money Bank.

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3. How your funds are handled.

 

We deposit and transfer all funds only through wire transfer. We set up client accounts through our primary banking partner:

The segregated account is set up using the client’s taxpayer ID.

The client is granted online access to this account so that it can be monitored 24/7.

When funds are required for deposits, build-t0-suit disbursements, or funding replacement properties, Edmund & Wheeler sets up the funds transfer at the bank with all pertinent information.

The client then must log into the banking system, review the disbursement and then approve the transfer.

Money CANNOT leave the account without the electronic approval of the client.

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4. What if something happens to Edmund & Wheeler, Inc.

 

Good question. Edmund & Wheeler has almost a 30 year track record of successful Exchanges. We have taken every available precaution within the statutes to safe-guard client funds. The fact that these funds are held in a segregated bank account in YOUR name and YOUR taxpayer ID goes a long way in ensuring that your funds will continue to be safe and accessible.

We  have also built in safeguards with our board of directors so that no one member of the Edmund & Wheeler team is a weak link in the availability of your funds when you need them.

For nearly 28 years Edmund & Wheeler has been New England’s most trusted Qualified Intermediary, but that simply isn’t enough anymore. Any Qualified Intermediary that wants you to work with them MUST have the processes in place to ensure that no matter what…your money is available to you when you need it.

Attention Accountants & Attorneys in NH & VT – Lunch & Learn – Free CPE/CLE

Connecticut River Bank, NA is pleased to sponsor this exciting series of Lunch & Learn events with Edmund & Wheeler, Inc., New England’s premier Section 1031 specialist.

You will earn 4 hours of continuing professional education (3.25 CLE’s for Attorneys) credits compliments of Connecticut River Bank, NA, review timely information and products from our commercial lenders, have a great lunch and have the opportunity to mingle with some of the region’s brightest minds.

We have scheduled 4 events for you, seating is limited so check your calendar and register today.

Click here for more information and registration information.

Splitting Heirs

The transfer of wealth from one generation to another will hit its peak in just a few years and understanding the tax impact on the heirs is an important consideration.  Traditionally, financial planners have focused most of their efforts on helping clients accumulate wealth, now is the time to plan for the transfer of that accumulation.

It has been reported that more than half of the nation’s personal wealth is held in non-financial assets, such as houses, land, farms and personally owned businesses. Based on past experience, the value of this wealth will grow over the next half century, and at the same time most of it will change hands. The majority of this huge transfer of wealth will go to spouses, children and charitable causes. A significant portion also will go to state and local estate taxes unless a plan is developed to prevent it.

Section 1031 is the perfect strategy to assist clients in moving their active real estate investments into passive investments, without paying capital gains tax.  Tenancy-in-Common (TIC) and Umbrella Partnership Investment Trusts (UP-REIT) properties provide an excellent transfer investment vehicle.  Heirs will gain tax advantage through a stepped-up basis upon the death of the owner and they will not inherit deferred taxes or a management nightmare in the process.   A sale of the property is not necessary; cash flow is easily divisible to the heirs if they elect to hold their newly inherited investments.  Cash flow from passive investments takes little time and attention and there is less arguing between the inheriting parties.

Cashing out of wholly owned real estate requires an agreement of the parties as to broker selection and price.  The sale of passive investments such as TIC’s or REIT shares is simplified; TIC’s are not generally sold until the entire project is sold or refinanced.  A growing majority of REIT shares can be traded openly on the market in a variety of increments thereby negating the need to fully liquidate the investment.  In either case, the sale of investment real estate by the heirs will be at a stepped-up basis so the assets can be passed without the deferred taxes.

Tax Fatality

The sellers of real property are often to preoccupied with the “Sale” to realize that if they were more strategic in their investment decisions, they could reap long term financial benefits.  The concept is simple, don’t touch the cash!  The object in an exchange is to defer the capital gain tax, recapture of previously taken depreciation and any state gain tax.  If you go to the closing without employing a Qualified Intermediary (QI) to handle the sale as an exchange, the tax will be triggered as soon as the cash is touched.  The time to defer the tax is before the buyer shows you the cash.  If you focus on the cash, the fatal attraction, it will cloud the strategy to successfully do a Section 1031 Exchange.  Employing a QI is paramount to setting up the sale as an exchange with all of its tax benefits.

Don’t become another tax fatality, defer the taxes with a Section 1031 Exchange!

3 Tax Hurdles

When potential clients call to find out what the capital gains rate is, they usually think “oh, that’s not so bad”.  What they fail to understand is that there are three tax hurdles to overcome on the sale of a capital asset.

The first hurdle is largely misunderstood and it can be very costly.  Upon the sale of a capital asset, real property or personal property, previously taken depreciation deducted since May 6, 1997 to the date of sale is  recaptured upon sale at the rate of 25%.

Capital gains tax, the second hurdle, is assessed  at the rate of 15%.  It is calculated based on the original cost-plus improvements less cost of sale against the sale price.  This is usually the result of market appreciation and constitutes equity in the property.  While the rate is not insurmountable, it is anticipated to be in excess of 20% in the not too distant future as Congress looks for revenue raisers.

The third hurdle depends on where you live and file your tax return, many states also tax capital gains at the state level and this can range from 3%-9%.

Unfortunately, too many taxpayers dutifully pay the tax each year without understanding that the tax can be deferred, interest free, if the sale is handled as a Section 1031 Exchange.   Every taxpayer regardless of whether that taxpayer is an entity or individual, as long as the property is not personal use property, can utilize exchanges as a tax deferral strategy and never pay the tax!

NH DRA utters its first words on SMLLC’s

By:  George E. Foss III

In yesterday’s post, we referred to a letter that the NH Legislature requested from the DRA.  Well here it is.

The letter is dated June 15, 2009, and sent from DRA to the HB-2 (Budget) Committee of Conference Members.  Copies were sent to the governor, the budget director, and the commissioner of administrative services. In no place is it marked “Confidential.”

On page 2, it reads as follows:

“Like-Kind Exchanges:  New Hampshire’s Business Profits tax is unique in that it is not complemented by a broad-based personal income tax. Because taxability is limited to ‘business profits’ and not wages or salary, it is necessary to apply the statutes in a way that treats all business organizations as similarly situated as possible, in the interest of fairness and equity. New Hampshire, therefore, treats every type of business organization, whether a proprietorship, partnership, limited liability company, or corporation, as a separate taxable entity, regardless of the federal tax status of a given entity. This includes so-called disregarded entities such as single-member limited liability companies (‘SMLLC’). There are instances in which this distinction requires different treatment than that offered under the internal revenue service. DRA is currently working to address this issue through a rulemaking procedure.” (Emphasis added).

The letter is signed by Kevin A. Clougherty, Commissioner.

We offer you the following, and would be interested in your opinions:

1. When the BPT statute was adopted in 1972, and re-codified and re-adopted in 1999, the Internal Revenue Code was adopted by reference.  Why is the DRA now ignoring its own enabling statute?

2. Where is the fairness and equity for the DRA to invent and then impose new, unwritten rules on taxpayers, and to retroactively assess them, with absolutely no notice? What you have just read is the first word uttered by the DRA on this topic, 14 months after beginning its new tactics. Furthermore, where is the fairness and equity to impose BP tax on people who, simply to protect themselves from liability, took their new property in a SMLLC? Or to impose it on unsuspecting people who, through no fault of their own, bought a SEC regulated product (a TIC).

3. So, the DRA wants rules. What will these say, and who will be covered? Can they be retroactive? If so, as far back as 2005?

The DRA has issued Notices of Assessment for $155,000 (in one case), $450,000 (in another) and for over $500,000 (in yet another).   There are at least 20 cases now, perhaps more.  These taxpayers are not going to stand still and just take it. They all have capable counsel, and litigation is looming.

Today, we heard the following, from an attorney: “I understand that the DRA would rather not combine the cases because there would actually be enough at stake for the litigants to make it to the Supreme Court. If the DRA will not combine the cases, why not file a separate action against the DRA in Superior Court with all the taxpayers as plaintiffs?”

We have suggested this before. Any other thoughts?

ZERO, ZILCH, ZIP CAPITAL GAINS FOR SOME TRANSACTIONS

The decision to sell capital assets should not be driven by the tax consequences, however, a small window of opportunity exists to escape capital gains tax for some taxpayers.  A zero percent tax is available until the end of 2010. This provides an opening for the sale of certain assets in the next eighteen months.

This favorable treatment is limited to the sale of long-term assets, that is, assets held for more than one year. The short-term sale of assets, those held for less than one year, are still taxed at ordinary income tax rates. The long-term capital gain rate, currently at 15%, is also expected to increase by the end of 2010 to the pre-2003 level of 20%.

Earnings are limited to take advantage of this tax break. Taxpayers in the 10% and 15% brackets will be eligible to have the capital gains reduced to zero. If your filing status is single, the maximum taxable threshold is $32,550, for head of household the limit is $43,650 and for married couples filing jointly, the limit is $65,100.  These thresholds are based on taxable income, not gross income. With a little planning, a capital sale may escape the tax completely.

Waiting until next year may not turn out as expected.  The current administration may delve back into previous tax cuts and eliminate them a year earlier than scheduled. Pressures on revenue raising items will likely put the capitals gains tax rate and the zero percent rate at risk.  Consult your tax professional for full details before you sell, your state taxing authority may not be so generous!