2015 Tax Season- What You Need to Know About 1031Exchange

1031_2015 Tax Reform

The 2015 tax season brings an end to the 1031 or like-kind exchange of property.  It means the end of dramatic tax benefits of a like-kind exchange of property.  Taxpayers using this technique in 2007 (the last year for which figures were available) deferred the tax on a total of $82.6 billion in gain, due mainly to swaps involving real estate and vehicles.

Let’s start with this basic premise:  If a client owns investment property like real estate that has appreciated substantially in value, they might owe a large capital gain when they finally sell the property.  In addition to paying the maximum 20% tax rate on long-term gains if they’re in the top ordinary income tax bracket (15% for most others), they may also be liable for the 3.8% surtax on net investment income.  Yet there is no current tax liability if they exchange the property for “like-kind” property in time.  The tax is deferred until they sell the replacement property, if ever.

Surprisingly, the IRS was quite lenient when it came to treating investment property as being like-kind under this tax law provision.  For example, you could have swapped an apartment building for a warehouse, or vice versa, and still qualify.  But both the property being relinquished and the property you were acquiring had to be investment or business property.  In other words, a personal residence couldn’t be part of a like-kind exchange on either end.

Typically, real estate swaps were difficult to consummate without involving multiple parties.  Both the IRS and the courts had approved such arrangements where the timing requirements were met.  In fact, a real estate investor could use a qualified intermediary to “park” the property until a qualified like-exchange could be finalized.

Consider the tax impact for a top-bracket investor who bought an apartment building for $500,000 years ago that is now worth $1.5 million.  If the investor sells the property for $1.5 million, the $1 million gain will effectively be taxed at a 23.8% rate (20% + 3.8%), resulting in a tax bill of $238,000, not even counting any state taxes.  However, if a timely swap of like-kind properties was arranged, the federal income tax bill is zero!

Previously, we alluded to meeting certain timing requirements.  To qualify for tax deferral on a like-kind exchange, you must:

  • Identify or actually receive the replacement property within 45 days of transferring legal ownership of the relinquished property
  • Receive title to the replacement property within the earlier of 180 days or your tax return due date (plus any extensions)

Note that the 180-day period begins to run on the date legal ownership of the relinquished property is transferred.  When the period straddles two tax years, the deadline might be shortened by the upcoming tax return due date.  For instance, if a client identifies replacement property on December 1, 2014, the exchange must be completed by April 15, 2015, absent any tax return extension.  To learn more, contact a member of the Gratia Group team at (239) 333-2221.

Owning Land can Lead to Worthwhile Tax Deductions

Tax Deductions

FL land has long been viewed by many as an attractive investment.  After all, it’s the stuff they’re not making any more of.  You usually earn no income from  land, but you do have expenses for such items as property tax, interest and other carrying costs.  Can you deduct these costs?  It depends.

First of all, for tax purposes there are two types of people who own vacant land: investors and real estate dealers.  Real estate dealers are in the business of buying and selling land.  A dealer buys property and resells it, usually at a price higher than the purchase price, and normally after only a short holding period.  A good example is a subdivider who buys large tracts of vacant land, divides them into smaller lots, and then resells the lots separately.  Numerous and continuous sales over an extended time period are the hallmark of a real estate dealer.

Real estate dealers are entitled to much the same deductions as any other business owner.  They can deduct all the expenses of owning the vacant land they buy and sell, including interest, taxes and other carrying costs.  If a sole proprietor, these are deducted on IRS Schedule C.

On the downside, all the profits real estate dealers earn from their business are taxed at ordinary income rates instead of capital gains rates.  Moreover, they must pay Social Security and Medicare taxes on their net self-employment income, as well as income tax.  Also, real estate dealers are not allowed to take depreciation deductions.  So if land has structures on it, their cost cannot be deducted.

A person who purchases real estate as an investment is not in the business of buying and selling vacant land on a continuous and extended basis.  Rather, he or she purchases land and usually holds on to it for some time in the hope that it will appreciate in value.

Since an investor is not engaged in a business, he or she is not entitled to business deductions and does not file Schedule C.  However, many investment expenses are deductible as personal itemized deductions on Schedule A.  These expenses are an ordinary tax deduction that results in tax benefits at your regular income tax rate, which can be as high as 39.6 percent (43.4 percent if you’re subject to the Medicare net investment income tax).

Any interest an investor pays on money borrowed when buying investment land is investment interest that can be deducted only as an itemized personal deduction.  Moreover, the annual deduction for investment interest is limited to the investor’s net investment income for the year.  Any excess is carried over to future years.  You determine the amount of your net investment income by subtracting your investment expenses (other than interest expenses) from your investment income.

Example: George purchases a vacant lot on which he pays annual property taxes of $1,000 and interest of $2,000.  His only other investment is a savings account, which earns $2,000 in annual interest.  His net investment income is $1,000 ($2,000 interest income – $1,000 property tax expense = $1,000).  Thus he may deduct only $1,000 of his interest expense.  The excess $1,000 is carried over to future years.

An investor can also deduct property taxes paid on vacant land as a personal itemized deduction on Schedule A.  This deduction is not limited to the amount of net investment income.

Any other carrying costs such as legal and accounting fees, insurance, and travel expense are also deductible on Schedule A.  However, they are deductible only as miscellaneous itemized deductions.  This means that they can be deducted only if, and to the extent, they exceed 2 percent of the taxpayer’s adjusted gross income.

If you don’t itemize your deductions on your tax return, you won’t be able to deduct any of the expenses you incur from owning vacant land.  In this event, you should elect to add these expenses to your land’s cost basis.  This will reduce any taxable profit you earn when you sell the property.

Example: Jean purchases a vacant lot for $10,000 in 2009.  During 2009-2013 she elects to add $5,000 in carrying costs to the lot’s cost basis.  In 2013, her adjusted basis in the lot is $15,000.  She sells the lot for $20,000.  Her taxable gain is only $5,000 ($20,000 sales price – $15,000 adjusted basis = $5,000).

You must make an annual election to add these costs to your land’s basis — “capitalize” them in tax jargon.  You can elect to capitalize all your costs, or capitalize some and not others — for example, you could capitalize interest but not taxes.

To make this election you should add a statement like the following to your tax return:

“For tax year _____, taxpayer hereby elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize, rather than deduct, property taxes, mortgage interest, insurance expenses, and other miscellaneous carrying costs on the 111 First St. vacant lot.”

You need to make this election each year you want to add these costs to your land’s basis.  If you wish, you can make the election some years you own the property, and not make it in others.

To learn more about buying land and lots for sale contact a member of the Gratia Group land sales team at (866) 501-6273.

Buying Land for Home Building vs. Investments

People generally buy land for two reasons; to build a home for their family or for investment purposes.  This week’s Gratia Group Land Investor Blog highlights the differences between these two main types of land buyers.

Buyers of land for the purpose of building a home actually require a bit more work than buying for investment purposes.  Many investors will never even set foot on their purchased land, while buyers looking for a home lot will be buying a piece of land that many will reside on for the rest of their lives. 

Check with local authorities (city, county and state) to determine zoning ordinances and whether you can build the type of home you want before committing to buying available land for sale.  Ask about future zoning, whether there are plans to put in shopping centers or airports, or to change nearby land uses that could also devalue your land and cause future headaches.

Buyers that are looking for purchase land or lots for sale for investment purchases will want to look for parcels that are being sold low prices in communities and areas that are currently seeing an increase in their local real estate markets.  Look for properties that will increase ROI when you choose to sell in the future.  Consider buying parcel packages that include 3-5 lots in hot areas. 

To learn more about purchasing land for home building or investment purposes contact a member of the Gratia Group land sales team at (239) 333-2221. 

Direct Ownership of Real Property for Foreign Investors

Foreign investors see Florida as a stable and secure place to invest in real estate and land and lots for sale.  Foreigners easily can purchase real property in the United States unlike some countries that make it difficult for foreigners to own real estate.  The weakening of the U.S. dollar and lower real property prices due to foreclosures make these investments even more attractive for foreign investors

Direct ownership of U.S. real property by a non-resident alien is probably the least complex structure and has some advantages.   A principle advantage is the long term income tax treatment currently at 15 percent.   Another advantage is possibly avoiding some unintended tax issues such as triple taxation that can occur when a U.S. parent company owns a foreign wholly owned subsidiary that disposes of U.S. real property held by the foreign corporation.   Another advantage is that the transaction is more transparent and less subject to IRS scrutiny.

Foreign investors looking to purchase real property that will become a future residence should consider direct ownership.   Section 121 personal residence gain exclusion rules apply to foreign investors, but additional rules must be met.   A foreign investor currently must live in the residence 50 percent of the time over the course of the two 12 month periods.   A foreign investor is also limited to investment real estate purchases of $300,000 or less.   The Housing Assistance Tax Act of 2008 has modified some of the rules for section 121 gain recognition by making it necessary in some cases to allocate some of the gains to periods of nonqualified use thereby reducing the deduction that might be received.

There are a number of disadvantages to direct ownership as well.  A direct owner will be required to file a U.S. income tax return because the real property creates the assumption of a business or trade.  Also a direct owner can be exposed to estate tax issues which can often times involve higher tax rates.  A direct owner will pay income tax at the time real property is disposed of, which may not necessarily be true under other structures.

When real property is disposed of it is treated as though the individual was in a trade or business under code section 897.  Section 897 rules do not affect residency status, so foreign real property holders need to review residency separately from their real property holdings.  Though real property is treated as a trade or business at disposal any rental income may be treated differently. To learn more contact a 9 Core Realty Representative here.

Tips for Buying Land through a Self-Directed IRA

Here are five things to keep in mind when considering investing in land or real estate through a self-directed IRA.

#1:  It Takes Time: It’s advised devising a timeline based on the account-opening process, transferring or rollover of assets and finding the actual investment.  It normally takes two to three weeks to open an account at a typical brokerage firm, and you’ll need to find a custodian who will hold real estate inside an IRA.  The down payment must come from IRA funds, so rollovers may be required.

When a real estate investment is contracted, the IRA account holder reviews and signs the purchase agreement and then the custodian must approve it and release of funds to the title company.  All of this takes time, so it’s imperative to learn as much as you can before jumping into a decision.

#2:  You Cannot Take Advantage of IRA Investments until you Retire:  You can’t use the fund to pay off your mortgage or live in or use the property you buy as an investment in the self-directed IRA.

You buy it because it is anticipated to appreciate in value, plain and simple. You also lose the depreciation tax deduction that you would otherwise receive on an investment property.

#3:  Your Spouse, Immediate Families or Companies you Have a 50% Interest in Cannot be Involved: While it is possible for the property to be held as tenants in common, an IRA is an individual account—and you must avoid any conflicts of interest.

Self-dealing or enabling a transaction that is beneficial to you on the other end is strictly prohibited.  You also cannot use the IRA as collateral for a loan; it should be treated like other retirement accounts.

#4:  It’s a Lot of Work:  While there are many highlights and potential benefits, many investors don’t fully appreciate or understand the reporting and administrative requirements involved in using a self-directed IRA to buy real estate.  For example, the investor should not be doing the work on the property, especially because he can’t get reimbursed.

All expenses, maintenance, taxes and insurance are paid from the IRA.  If there are association dues or golf memberships, those all must be withdrawn from the IRA.  Finding tenants and contractors may take time, and every penny in and out must be approved by the custodian.   In many instances land investment over an existing home is a better choice when purchasing with a self-directed IRA as no maintenance or dealing with tenants is required.

#5:  All Income from the Property is Tax Deferred:  That includes rental income and capital gains. If you plan to be in a lower tax bracket at retirement, this is quite beneficial.  You can also make tax deductible contributions to the IRA.

To learn more about investing in land or real estate through a self-directed IRA visit http://www.gratiagroup.com or call a member of our land sales team at (239) 333-2221.

Vacant Land Rolls in Tax Savings for Investors

With all of the discussion lately of the benefits of home ownership, it becomes easy to forget that these benefits apply, in one form or another, to just about any type of real estate ownership.  This can include the ownership of raw land.  Whether held for investment or residential purposes, a parcel of land comes with a number of tax deductions built-in.

1) Mortgage Interest

As long as your land is held as a primary residence, secondary residence or investment property, the mortgage interest that you pay on it is tax deductible. As of May 2013, if it is a residence, you will itemize the deduction on your Schedule A, as long as the total value of your first and second homes is $1,000,000 or less if you are married or $500,000 are single.  If you hold the land as an investment, you can report its interest as an expense on your Schedule E.

2) Property Tax

Property tax is treated similarly to mortgage interest.  For land held as a personal residence, you can deduct it on your Schedule A.  Your ability to deduct property tax, as well as other state and local taxes, can be limited, though, if you are subject to the Alternative Minimum Tax.  Because the property taxes on land held as an investment are expendable on Schedule E, though, they are not subject to AMT limitations.

3) Miscellaneous Expenses

If you hold your land as an investment for which you file Schedule E, you can expense just about anything you spend in the process of owning it.  Traveling to inspect the land would be an allowed expense, as would the cost of clearing or cleaning it, as well as maintaining any roads through it.  You cannot take these expenses as deductions on your Schedule A for land held as a primary or secondary personal residence, though.

4)  Depreciation and Land

Although investment property is depreciable, land held for investment purposes is not.  The reason for this is that while buildings gradually decay, land is generally permanent.  Barring some sort of large natural process like earthquake, flooding or large-scale erosion, most land was in existence hundreds of years ago and will be in existence hundreds of years from now.  However, certain improvements that you make to your land, like roads or certain types of land preparation can be depreciated on Schedule E over the improvement’s individual useful life.

To learn more about all the tax benefits of owning land contact a 9 Core Realty representative at (239) 333-2221.  Be sure to check back on this blog for more upcoming articles in our land taxation series!  The next blog in this series will cover tax breaks for the development of raw land!