Better to fully understand the tax consequences before sale then to realize to late that it could have been avoided. The use of the property can be changed and capital gains tax deferred if you plan two years in advance. There is no tax penalty to declare the property as investment/rental property. Keep good records, document the income and expenses and declare it on your tax return.

Rather than sell the property, exchange it for other investment/rental property in a new location that meets your anticipated needs.  Rent the new property for the following two years. The property can be converted back to personal use if you desire, all without the payment of capital gains tax.

Well, that’s only half the story. There is a new tax of 3.9% dubbed the “Medicare payroll tax” on capital gains and other investments starting January 1, 2011. Combined, the capital gains tax rate will be 23.9% beginning next year.

If ever there was a time to do some planning, it’s now. Exchanges will defer all of this but some situations will dictate a sell and pay the tax.  If this is your decision, get going before the pain gets worse. Oh, and don’t forget to add the recapture of deprecation at 25% and state capital gains tax. This could make the sale subject to as much as 36-40%.

Purchasing a multi-family home is a great way to acquire a starter home and have the added benefit of receiving rental income to help out with the mortgage payment, taxes and maintenance. If the goal is to live in the property just long enough to build some equity and ownership experience, then you will face a tax decision at the time of sale.

Technically, a portion of the property has served as your primary residence and a portion as your investment property. For example, if the property is a three family and all of the units are of the same approximate size, then two-thirds of the property has been used for investment purposes and the expenses associated have been tax deductible during your ownership. At sale, only the one-third portion reserved for your personal residence will qualify for Section 121 tax exclusion and the remaining two-thirds is subject to state and federal tax. There are two levels of taxation to be aware of; recapture of previously taken depreciation and capital gains tax. On the Federal level, the first is taxed at 25%, the second at 15%. Depending on your state, the total tax can expose the sale to at 28-35% burden.

Three options should be considered; sell and pay the tax, hold the property and rent all of the units (no tax due until sale) or exchange the investment portion and defer the tax to some date far into the future. Exploring all of the options before sale will produce a better net value regardless of the course taken.

Utilizing Section 1031, an investor’s sale of forestland abounds with reinvestment opportunities if the transaction is facilitated by a Qualified Intermediary (QI). This third-party facilitator cannot be your broker, attorney, accountant or relative.  Engaging a QI before sale will document the exchange intent, create a defensible audit trail, and preserve the right to defer the tax.

In an exchange, the goal is to go even or up in value from the sale of the old or Relinquished Property to the new or Replacement Property. To the extent that the value is not matched, the difference, not the entire transaction, will be subject to capital gains tax. It is possible conduct a partial exchange and take cash or unlike-kind property at the closing without collapsing the tax deferment on the matched portion. Investors have the opportunity to reinvest the value in a variety of new properties. This allows for a diversification of type and location of property.

The existing or old property and the new property must be “like-kind” in an exchange. There is no need for this term to cause confusion for investors not accustomed to handling their forestland sales as an exchange. Investors often assume a literal interpretation of the term and miss the point of the definition encompassed in the code. It simply means that if you sell real estate you must replace it with real estate to satisfy the like-kind test. It can be any kind of real estate and it can be located anywhere in the United States. For example, this can be made up of forestland for rangeland or land and buildings, single family or multi-family rental property, commercial property, or business property used by the investor.

Strict guidelines for timing and identification of the new property must be followed to achieve full compliance with the regulations. Exchanges must be conducted in the same tax year or within 180 days, whichever comes first. If you start an exchange in December, then to take advantage of all 180 days, it is necessary to file for an extension of the tax filing due on April 15^th or the exchange will be cut short by the due date of the tax return. Within 45 days of the sale of the Relinquished Property, a list of possible Replacement Property choices must be delivered to the QI. This is the most restrictive aspect of 1031 so knowing what you want before you sell will produce the best results.

Three rules guide the identification of the new property. The most commonly used rule is the Three-Property Rule. It allows the investor to list three properties of any value and acquire any one, two or three of the properties identified. The 200% Rule provides more flexibility for the investor to list any number of properties as long as the value of the listed properties does not exceed twice the value of the old or Relinquished Property. The third rule is called the 95% Rule and removes the restriction for the number or value of the properties listed as long as 95% of the identified properties are acquired. This rule is rarely used because of the risk involved in tainting the exchange if one property fails to be acquired.

It is important to know that the legal ownership or title of the Relinquished Property must be the same for the Replacement Property. The IRS is always tracking the tax identification number of taxpayer or entity and any change in the ownership will result in a red flag and unnecessary tax liability.

Forestland is a solid, practical, easy to understand investment vehicle. The use of a Section 1031 exchange at sale will preserve equity and provide long-term wealth building.

Each of the children had begun building their own portfolios and was anxious to stake a claim for dad’s assets. When I brought up the potential exposure to capital gains tax, both state and federal, and recapture of previously taken depreciation, the zest to make changes cooled. I insisted that the legal title to each property be examined to be sure of the correct owner. We soon discovered that there were inconsistencies between the ownership and the tax reporting that had to be corrected. Getting the ownership issues resolved required a direct exchange of two properties.  Once this was accomplished, we went to work on equalizing the values. Since there wasn’t any desire to sell any of the properties in the next two years, this could be facilitated as an exchange between related parties.  Both individuals had to agree to hold their new positions to avoid inadvertently triggering tax.

I asked them to consider receiving properties from dad until after his passing to take advantage of a step-up in basis to the then current market value. We examined the basis of each asset and then ranked them for tax exposure. This analysis provided a succinct plan for the near-term and long-term plans of the family. Exchanges are a powerful tool when all of the options have been weighed; let Newbridge Exchange assist with your plan today.

The Foreign Investment in Real Property Tax Act (FIRPTA) of 1980 was enacted to strongly encourage compliance with US tax law. Until FIRPTA was enacted, it was possible for foreigners to buy US property, make a profit upon sale and repatriate their profits back to their native country and pay no US tax.  Collection is enforced by a system of withholding at sale of 10% of the gross sales price, regardless of gain or loss. Any tax withheld is then credited against any tax shown due on a subsequent tax return, payable at US tax rates.

There are few exceptions to the rule, here are the highlights: 1) if the real property was purchased as a primary residence for less than $300,000, it is exempt, 2) if the sale results in no proceeds, as in a gift transfer, it is exempt, 3) if the sale of investment property is facilitated as a Section 1031 and the US property is replaced with US property, then the tax is deferred until such time as a “cash out” sale triggers the tax.

The duty to file the 10% tax upon sale rests with the buyer of the property. The buyer must report and pay over the withheld tax to the IRS by the 20^th day following the date of transfer along with IRS From #8288 and Form #8288-A. Failure to report will result in liability for the tax, interest and penalties. Know the facts and be prepared in every sale.

There are action steps to consider in breaking up the doldrums of a winter market. First and foremost, stop watching the market! It can be likened to watching the proverbial kettle boil. Your real estate is far more attractive if it can spin off cash flow.

What have you done lately to improve the operating results of your portfolio? Action Step One: Analyze the expenses and tie a discount reward system for tenants that help manage the overhead in a way that benefits you. This shouldn’t sound crazy to you or your tenants. Energy costs can be controlled; outside services like trash removal can be mitigated with a recycling program (managed by the tenants). If a reward system reduces the cash outlay of the tenant, investor and tenant win.

Action Step Two: Review your rent rolls and the tenants that you rely on month in and month out. If you have a vacancy, ask your tenants to recommend a replacement. Yes, a reward is also in order; your success depends on it. Consider rewriting the current lease agreement to keep the tenants that you do have. If you understand their pressures you’ll be better prepared to respond to changes.

Action Step Three: Understand the advantages of Section 1031 exchanges. When activity returns to the market, know where you are going with your investment dollars before the sale. The time to defer capital gains tax is before the transaction is finalized. Once the cash is in hand, the tax is triggered.

Don’t just bide your time, develop a strategy to improve the portfolio and your New Year’s outlook.

Here’s how this works; the goal in an exchange is to go even or up in value from the old property to the new property and to replace the debt paid off with new debt. In this scenario, the investor wants to replace the current property with new property but wants to take $20,000 of the net proceeds at closing to pay other obligations.

A good exchange has been achieved, however the $20,000 of cash received at closing is now exposed to capital gains tax unless the investor has an offsetting capital loss in the same tax year.

If your situation includes an impending sale of real or personal property, don’t go to the closing table until you have investigated the potential for the transaction to be structured as a Section 1031. All real estate used for business or investment purposes will qualify for 1031 treatment while only certain items of personal property can be sheltered by the rules.

In the event that the sale has already taken place and funds are in hand, then the tax has already been triggered. It is possible to unwind the sale and put everyone back in their positions before the transaction took place. Essentially, you have to start over and this time begin with an Exchange Agreement drawn by a Qualified Intermediary, setting forth the sale as an exchange. This could save thousands of dollars in capital gains tax. Once year end passes, it is too late to unwind any sale that occurred in the current year.

An individualized plan will be necessary and there are few precious days to act. Better to ask the questions now than suffer the consequences later!