1031 Exchange Offers Tax-Deferment of Capital Gains

If you are considering selling your investment property, remember that the IRS will tax your capital gains at 15% and then California will take an additional 9.3% for a grand total of 24.3% in taxes on your hard-earned equity. If you would like to defer that painful tax bill, you may want to consider doing a 1031 Exchange. What is a 1031 Exchange you may ask? A 1031 Exchange allows investors to ‘exchange’ ‘like-kind’ properties rather than sell them through the use of a Qualified Intermediary who holds the sale proceeds from the first property until a replacement property(ies) can be purchased within a very specific, non-extendable time period. Let us walk through the salient points of this description one-by-one so that we can get a better understanding of the 1031 Exchange requirements.

A transaction is considered an exchange rather than a simple sale when the seller expects to acquire a replacement ‘like kind’ property. That means that if you are selling an investment property, you must state that you plan to acquire replacement investment property(ies) within a specific time frame. A special note, acquiring investment property outside of the United States in exchange for investment property within the United States is not considered ‘like-kind.’

When you acquire the replacement property(ies), you must roll all the net proceeds from the first property into the replacement property(ies) or you will be taxed on the unused proceeds. Additionally, the value, equity, and debt on the replacement property(ies) must be equal to or greater than the value, equity, and debt on the relinquished property.

You may choose one or more replacement properties to replace your relinquished property though you do need to satisfy one of the following requirements:

1. Three-Property Rule - Up to three potential replacement properties may be identified regardless of their value.
2. The 200% Rule – Any number of properties may be identified as replacement properties as long as their value does not exceed twice the value (200%) of the relinquished property.
3. The 95% Rule – The taxpayer may identify any number of properties for exchange but you must acquire 95% of the aggregate Fair Market Value (FMV) of all identified properties by the end of the exchange period. Put another way, in order for the exchange to be valid, 95% (or all) of the identified properties must be purchased.

The timeline (wiki link) for a 1031 Exchange is very specific and does not afford anyone room for error. Firstly, you must identify the property for exchange in writing, signed by you , and delivered to an independent party, i.e. a Qualified Intermediary, prior to the closing of said property. After closing, the countdown begins. First, you enter the Identification Period in which you have 45 days to identify the replacement property(ies). Secondly, you must acquire the replacement property(ies) within 180 days of closing commonly referred to as the Replacement Period. One must note that the Identification Period and Replacement Period overlap and both begin with the closing of the relinquished property. These two time periods must be strictly adhered to and are not extendable even if the 45th or 180th day falls on a weekend or holiday.

To facilitate the exchange transaction (wiki link), a Qualified Intermediary (QI) must be used. Your relationship with the QI generally begins when you identify the property for exchange. Of course, there are several rules by which you must abide when choosing a QI. The QI may not be related to you or have had a financial relationship during the two years preceding the property exchange. In other words, your current attorney, CPA or real estate agent may not act as your QI.

The Qualified Intermediary preforms three functions during the exchange. They acquire the relinquished property and transfer ownership to the buyer. The QI then holds the sale proceeds , thereby preventing you from having actually realized any funds from the sale of the relinquished property. The QI then acquires the replacement property(ies) and transfers it to you within the time limits to complete the exchange.

Interestingly enough, there are some situations where you can combine the 1031 Exchange with the Internal Revenue Code Section 121, which allows a married couple to exclude up to $500,000 of gain on the sale of their personal residence. In order to use both the 1031 Exchange and Section 121 in tandem, you must comply with all the rules in both sections, with Section 121 regulations applied to gain before applying the 1031 Exchange regulations. Revenue Procedure 2005-14 explains how the two statutes may be combined for one property.

As with any tax legislation, there are numerous rules and regulations that you must follow – more than I can possibly cover well in this article. I strongly recommend that you consult a tax attorney or CPA before deciding to embark upon a 1031 Exchange or a Section121/1031 Exchange combination. For more information on 1031 Exchange, please visit www.1031.org.

Existing Home Sales Across U.S. Plummet: Silicon Valley Take

Local station CBS5.com reports that existing home sales dropped sharply in 2006 across the country. 

Image of Bubble

2005 was the peak of this recent real estate boom and during that year a whopping 40% of all home sales were to investors or people buying vacation homes, even according to David Lereah, chief economist for the National Association of Realtors.

The dip in 2006 makes perfect sense.  As Lereah says, "A lot of those people have left the market."

Impact on Silicon Valley: Look Around at the Central Valley

The article mentions that analysts have predicted prices will continue to fall in "formerly red-hot markets" like California.  Are you waiting for a large price decrease in Silicon Valley?

The number one factor in real estate pricing is jobs.  Places that have been the hardest hit often lack the number of high-paying jobs needed to support high real estate prices.

For example, the Central Valley markets in California experienced a crushing drop in prices because outside investors, many within driving distance from Silicon Valley, pulled out.

Prices retreated to levels closer to what locals could stretch to afford.  That in combination with housing developers unloading their over-built inventory led to a precipitous drop in home prices.

According to the San Jose Mercury News, though, some jobs are migrating inland in California, which may provide stabilization and future growth prospects.

Now Look at Your Neighbors and Co-Workers

If you live in Silicon Valley, though, you'll need to ask yourself, "Would my co-workers buy that house at that price?" when looking at real estate in the area.

If you ask that question enough times, the answer becomes what the market will bear, setting the general pricing strategy for homes here.

The rule of thumb for real estate, without going into the math, is that prices should never exceed what you can make back in renting it.  

This is rarely the case in Silicon Valley because buyers compete in a market for the scarce land clustered around this high-tech Mecca, with people who make six-figures before stock options.

And since the turn of the century, there has been a general willingness to assume real estate in Silicon Valley will always appreciate --- and pay a premium for the privilege. 

Is This Premium a Bubble?

People call this premium, the artificial difference between the "book price" based on rents and the market price a bubble. 

The questions I pose to you are: 

(1) Despite what your neighbors or co-workers think about a bubble, if they can afford it, would they still consider buying a house in Silicon Valley?

(2) Do you believe a large number of high-paying jobs will stay in Silicon Valley?

(3) Do you believe companies will continue investment in Northern California?

Do-It-Yourself Projects That Will Help You Sell Your House

CNNMoney.com published an article that gives you tips on 5 small home improvement projects that you can do yourself before your house goes on sale.  They rate the projects by skill level required, how much it costs, and how much you'd have to pay a professional to do it.

Image of Wooden Room

They note that because it can be difficult to recoup the full cost of the improvements, you should concentrate on what you can do yourself (i.e. without a contractor) and really home in on the rooms that people focus on.

The Wall Street Journal also lists improvements you should avoid when selling your house.  This article isn't as detailed or thorough as the CNNMoney.com home improvement article but does provide some insight into common pitfalls.

Many times it will be easier and less expensive to offer your prospects a credit towards improvements rather than doing them yourself.  Prospects like having their choice of styles (your buyer's taste is something that's difficult to predict) and you won't have to take on the risk of performing or contracting the work. 

Don't Assume Your Mortgage Broker Is Out To Get You

Sometimes they may not know what they're doing either.  There's a story in the Wall Street Journal about a mortgage loan officer (and landscape designer) whose family invested in a single-family house they wanted to flip.

Image of Bear Trap

Based on the assumption they'd flip the house quickly, they put no money down and took out an 80% mortgage priced well-above market at the time (almost 7%) and a double-digit interest piggy-back loan. 

The article mentions that the market in their area has shifted towards buyers, but that's not the half of it.  My parents retired to that city and it's bleaker than it reads.

Silicon Valley North 

Home to Nike, Intel, and a new Google facility, Beaverton, Oregon (just outside Portland) is a meant to be a suburban copy of Silicon Valley with more rain and better public transportation.

A few years ago, my folks and I looked at houses where there are actually streets named after Silicon Valley cities to make their prospects feel at home.  Now, you can't throw a football around that neighborhood without hitting a "for sale" sign.

If You Fail to Plan, Plan To...

The Catch-22 situation in the Wall Street Journal article was brought about by not considering alternate exit strategies if your primary out falls through.

But the real kicker here is that this was a mortgage loan officer who got herself into the situation of taking out loans that were above market: now they can't rent the place without losing money.  (This is actually abnormal in many parts of the country!)

What to Do, What to Do?

They can't afford an agent now, so they've listed their property for sale by owner (FSBO).  To better communicate the pros and cons of FSBO, I just finished reading The For Sale by Owner Kit by Robert Irwin --- a quality book --- and will be posting a summary shortly.

The Trap: They Fell In Twice

But Robert explicitly says in his book that most FSBO's are priced too high because the owner sets the price based on what they want to get back, not what the market will bear.

The couple in the story fell into this trap by trying to sell their house at an above market price.  In the meantime, the they're trying to rent their house with a lease-option. 

A lease-option is like "renting to own" and is usually structured where a portion of the rent payments can be applied to purchasing the house at a set price. 

The couple has set the lock-in price at 5% higher than the price they can't sell the house attoday!  And on top of that, they're asking for a deposit for the privilege.  That's both legs in the bear trap.

The Moral: Plan for Contingencies

If this couple would have gotten a set of market price loans, they would have avoided this situation completely. 

The reason why they didn't plan is because they made assumptions about the market direction instead of using solid financial numbers and analysis of their goals.

You may have feelings and even some assumptions based on data about whether the market will go up or down, but when you understand your goals and your exit strategies, you can make good decisions no matter what may be going on around you. 

Also, your mortgage broker or real estate agent may be family or a friend of a friend, but you still need to look out for your best interests.

12-Month Plan to Becoming a Real Estate Investor

Following up on David Crook's Wall Street Journal article on becoming a real estate investor is his outline of a 12-month plan that outlines the foundation you'll need.

Of particular note is how the "beginning [in real estate investment] actually starts well before you're ready to buy a property."  Here's his table on getting started: 

David Crook's Table

Use Other People's Money 

Key to this plan is the concept of leverage, where you use other people's money to accomplish your real estate plans.  They get cash in the form of interest for the privilege and you get the use of their money.

It's Just Like Buying a House... Mostly

You can buy a property of up to four units in the same building under the same rules and financing you'd use to buy a house.

It's important, though, to remove your emotions and personal value judgments from the property you're investing in. 

You may think, for example, that the property is in a neighborhood you wouldn't live in, that there aren't enough bathrooms, or that you'd rather have hardwood than carpeting.

But unlike your search for a home, your search for an investment property isn't about you: it's about your customers and "the math."

Related reading: Getting Started as a Real Estate Investor

Coming Soon: The Math That Makes You Money With Investment Property

Getting Started as a Real Estate Investor

David Crook's article on getting started as a real estate investor for The Wall Street Journal provides some good ideas on getting started conservatively in real estate investment.

Tortoise and Hare

An important nuance I'd like to point out about the article, though, has to do with second homes vs. rentals. 

While you may get more favorable tax treatment when buying a property as a rental as opposed to a second home, your mortgage lender will charge you a premium if you request a loan for an investment property. 

You need to understand what that premium is and understand how that compares to the benefits of favorable tax treatment. 

When you consult with an appropriate professional familiar with your situation, be sure to ask about the different legal structures you can use to hold your property and gain asset protection as well as tax advantages.

Nonetheless, the experience you'll get with some of David Crook's ideas like renting out your in-law unit and taking a "buy-and-hold" approach to property investment will help you overcome much of the fear associated with getting into real estate.

Silicon Valley Vacancy Rates Down, Guess What Rents Are Doing?

According to The Department of Housing and Urban Development's Office of Policy and Development Ressearch (HUD) Q3 2006 U.S. Housing Market Conditions Regional Activity Report, titled as if ink were going out of fashion...

"In the San Francisco Bay Area, the apartment vacancy rate declined nearly 1 percent to 3.7 percent in the third quarter of 2006 from the same quarter a year ago, according to the RealFacts apartment survey."   It continues below the fold with specifics on East Bay and Silicon Valley rents. 

"The average rent for larger, higher amenity rentals rose 7.5 percent in the East and West Bay submarkets and more than 10 percent in the San Jose-Silicon Valley area, the largest increases recorded since the economic boom of the late 1990s," the report goes on to say.  Can't wait until the Q4 report comes out!