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VACATION HOMES---MORE PROBLEMS AHEAD

In order for a property to qualify for a Section 1031 tax deferred exchange, the property must be" held for" productive use in a trade or business or held as an investment.  Personal residences do NOT qualify for a Section 1031 exchange.   

A very important point I want to establish at the outset of this particular blog is that "the incidental use of the vacation home" will not necessarily taint the property otherwise held for investment.  This "held for" rule is determined at the time of the exchange and whether a particular property is held for a proper purpose is a question of fact.   

The reason why I am briefly educating you bloggers on this subject, is that I just returned from the FEA (Federation of Exchange Accommodators--the national trade organization for Qualified Intermediators) Convention.  It was pointed out in our Board of Directors meeting (I am on the Board) as well as at one of the general convention sessions, that IRS is getting stricter on its interpretation of whether a second/vacation home qualifies as an investment.  IRS's stricter interpretation is due to the recent, Moore v. Commissioner, T.C. Memo 2007-134 (2007) case. 

In that case the taxpayer owned a vacation home on the lake and used it around 2 to 3 weekends a month during the summer.  They had made numerous improvements to the property and never advertised or attempted to rent the property.  On their tax return, they did not claim deductions for investment interest, maintenance or repair costs.   The Tax Court found that the investment must be primary, not one of the motives for holding the property.   

In short, IRS is going to have you prove that it was an investment.  Did you rent it out?  Did you list it for rent with a Realtor or advertise the property for rent.  How much rent did you receive and did you pay taxes on that rent?  How many days a year did you use it personally?  What type of loan did you get on the property?--That's a real good question--because if you got a loan that was a second home loan(usually at a lower interest rate than an investment property loan) and you are saying this is an investment property, IRS could ask:  who did you lie to?--the Lender who gave you a second home loan not an investment loan or are you lying to IRS and this really is a second home and not an investment.  In either case they got ya. 

Finally, on another issue dealing with vacation homes, the Chicago Sun-Times reported last week that "The House Ways and Means Committee, seeking revenue to help homeowners in foreclosure, unanimously approved higher taxes on the sale of vacation homes."  They are trying to attack the use of Section 121 which allows taxpayers to exclude as much as $500,000 in profit from capital gains taxes.   This is not law yet--I as usual will try to keep you up to date.  We also have current news on Section 1031 on our website at:  Bayview1031.com.

CAN MY BANK HOLD THE EXCHANGE FUNDS?

The answer is :   It's not a real good idea to have your bank as the depository of the relinquished funds.  One of the major rules in Section 1031 Exchanges is the requirement that the taxpayer not control the funds received from the sale of the relinquished property.   

That is why I continuously point out to questioners that your Qualified Intermediary should be someone completely independent.   There are numerous cases pointing out where taxpayers had in the eyes of IRS, control over the proceeds and therefore were denied the use of Section 1031.   Your bank is just one example of someone you could have control over.   The safest way not to be in violation of this rule is to make sure that you DO NOT have the proceeds held by your Attorney, CPA, Realtor, Bank, Relative, Friend or Acquaintance.  That is another reason why QI's(Qualified Intermediary's) are used.   Qualified Intermediaries are independent and  help ensure that the taxpayer has met all of the safe harbor requirements.

INSIDE THE COUNTRYWIDE LENDING SPREE

As most of you bloggers are aware, every once in awhile, I spend a session on a subject that has nothing to do with Section 1031, but rather has to do with the Real Estate Industry. 

I just finished reading a well written article on the sub-prime mortgage debacle, written by Gretchen Morgenson that appeared in the New York Times.  I think it's well worth reading, so here is an excerpt: 

"On its way to becoming the nation's largest mortgage lender, the Countrywide Financial Corporation encouraged its sales force to court customers over the telephone with a seductive pitch that seldom varied. "I want to be sure you are getting the best loan possible," the sales representative would say.  But providing "the best loan possible" to customers wasn't always the bank's main goal, say some former employees.  Instead, potential borrowers were often led to high-cost and sometimes unfavorable loans that resulted in richer commissions for Countrywide's smooth-talking sales force, outsize fees to company affiliates providing services on the loans, and a roaring stock price that made Countrywide executives among the highest paid in  America.  Countrywide's entire operation, from its computer system to its incentive pay structure and financing arrangements, is intended to wring maximum profits out of the mortgage lending boom no matter what it costs borrowers, according to interviews with former employees and brokers who worked in different units of the company and internal documents they provided.  One document, for instance, shows that until last September the computer system in the company's subprime unit excluded borrowers' cash reserves, which had the effect of steering them away from lower-cost loans to those that were more expensive to homeowners and more profitable to Countrywide.  Now, with the entire mortgage business on tenterhooks and industry practices under scrutiny by securities regulators and banking industry overseers, Countrywide's money machine is sputtering...last week, Bank of America invested $2 billion for a 16 percent stake in Countrywide, a move that came amid speculation that Countrywide's survival was in question..."

MUST YOU TELL YOUR BUYER OR SELLER THAT YOU ARE DOING AN EXCHANGE?

There  is no requirement in the IRS Code or Regulations that the contract for sale of either the relinquished or replacement properties specify that the properties are going to be exchanged.  In fact, the taxpayer in many cases has not even decided when they sign their contract of sale that they are in fact going to do an exchange. 

My office, Bayview Financial Exchange Services (BFES) encounters numerous taxpayers that decide just before the closing, sometimes they decide right at the closing table, that they want to do a Section 1031 exchange.  In our case (BFES), we have the ability to prepare documents on a standard deferred exchange and have them delivered within minutes--that's of course a part of our great service.   Hopefully the taxpayer (exchanger) and the party on the other side will agree to sign our necessary paperwork--that of course makes the transaction a lot simpler. 

It always suggested that you have a cooperation clause inserted in your contract, when you are selling and when you are purchasing.  For a well written cooperation clause, go to www.cooperationclause.com.

A LOT OF INFORMATION IS IN OUR PAST BLOGS

I want to quote from a note that was sent to me from one of your fellow bloggers.  He went back to a number of our past blogs and said:  "I obtained more information from your old blogs than I had been able to gleam from all of the other sites I have visited."  My comment is thank you for the compliment and would add that you too should look up our old blogs.  We have them listed by the month on our blog site.  You might also want to go to Bayview Financial Exchange Services (BFES) website (www.bayview1031.com) and look up information at the resource center.  We answer a lot of your questions on that site also.  If there is still something you need to know, just give our office a call, at 866.903.1031 (toll free) and speak to any of our Exchange Coordinators.  FYI, for truly technical questions that cannot be answered by our Exchange Coordinators, please ask for one of our 6 CES's (Certified Exchange Specialists), who certainly will be able to get you the answer you need.

HOW TO AVOID CRIMINAL PROSECUTION FOR NON PAYMENT OF TAXES

I recently read an article by Jose Marrero written in Rachlin and Cohen's monthly newsletter.  The article pointed out that you may have had good intentions when filing your tax return or thought you were up to date and low and behold you owe so much in taxes that IRS claims there are criminal violations.  So the question is what should you do?  Marrero says:  "The IRS has a program that allows individuals to voluntarily disclose situations that may be considered attempts to evade taxes, enabling them to avoid criminal prosecution.  This programs has been successfully utilized to avoid prosecution and reduce taxes, penalties and interest in various situations such as:

• Employment Taxes...where the courts have made it clear that any person, regardless of corporate title, may be held liable for unpaid employment taxes if (1) the person knew or should have known that the employment taxes were unpaid; and (2) they had some connection with the corporation to affect a decision on the payment of the taxes.
• Income Taxes...During divorce proceedings, one or both spouses may be aware of unreported income or false deductions related to previously filed federal income tax returns...Violations and penalties can arise regarding any form of income, employment, excise, gift or estate tax, with the most common being:  tax evasion, failure to collect or pay over tax, signing a return known to be fraudulent or containing false material statements, aiding in the preparation of a false return, etc."

"...While a voluntary disclosure will not automatically guarantee immunity from prosecution, it may be the only opportunity you have to avoid a prosecution recommendation.  To qualify for consideration, any communication to the IRS must be truthful, timely and complete.  And, you must demonstrate a willingness to cooperate to determine the correct tax liability.  You also need to make good faith arrangements with the IRS to pay in full all taxes, interest and penalties determined to be applicable.  An early review and analysis of any financial and related tax issues in these situations could save you from an expensive criminal investigation, potential prosecution and additional taxes, penalties and interest.  The amount of tax due is not the determining factor, but rather the timeliness and truthfulness of the information disclosed."

SIMULTANEOUS EXCHANGES--ARE THEY VALID TODAY?

A simultaneous exchange occurs when the taxpayer sells its property to its buyer and then simultaneously purchases its replacement property on the same day.  And the answer to the question is--of course they are valid under Section 1031.   

The real issue is how many taxpayers really transact simultaneous exchanges?  The answer is very few people transact simultaneous transactions. 

The reason is that most taxpayers like the option of having 45 days from the closing of the sale of their relinquished property to select (identify) properties they possibly will purchase.  Additionally under Section 1031, the taxpayer has 180 days to close on the purchase of the replacement property from the date they closed on the sale of their relinquished property.   This is a wonderful option, putting a lot less pressure on the taxpayer and giving them a lot more time to select what they want to purchase and to figure out how they will pay for that purchase should they need additional funds.   

I might add, this option of the additional time is one of the major reasons Section 1031 tax deferred exchanges have become so popular.  For you history buffs, the regulations giving the time line options came out in 1991, resulting in Section 1031 becoming a very popular tax tool

DO THE RIGHT THING WHEN YOU GIVE TO A CHARITY !!

    I realize this blog is supposed to be about Section 1031.  Most of our articles are written on that subject--but I also like to include some other consumer oriented issues in the blog.  For example:  Chris Weir, a residential mortgage broker, has a newsletter that I receive about once a month.  The following is a well written excerpt from his most recent newsletter.  The subject: making donations to charities.

"Most everyone has received requests from various organizations and charities asking you to donate to their causes. And it sure sounds like a good idea to help disadvantaged children, the local police officers, or help find a cure for cancer. But a call for a donation from the ASPCJ - American Society for the Protection of Cat Juggling - might warrant some further investigation. So how can you tell if the charity that you are considering supporting is legit?

First stop... the web:
    Check to see that their website is full of information about their programs, history and goals. Look into the various programs they support, as much of the time you are unable to specify exactly where your contribution will be used. Be extra cautious of organizations with websites that are skimpy or out of date.

Next stop... the IRS:
    The IRS maintains a list of all organizations that are classified as charities for purposes of tax deductions. You can search for information on the IRS website by hitting this link: IRS Charitable List.

Avoid a nasty surprise by understanding the type of organization you are contributing to. For example, the Sierra Club is not considered a charity, but rather a lobbying group, and as such, donations to the Sierra Club are not tax deductible. However, donations to the Sierra Club Foundation are tax deductible, as it is the charitable organization arm of the Sierra Club.

Important note - if you plan to make a donation other than money (clothing, household goods, car, etc), you will need to keep careful records of exactly what you donated and its value, as the IRS is cracking down on over-inflated valuations of donated goods. This is especially important if the value exceeds $5000, in which case an actual appraisal is required.

Final Stop... the report card:
    The Better Business Bureau operates a website (www.give.org) that tracks many charitable organizations and grades them on twenty standards. These standards range from the makeup and compensation of the board to the percentages of their donations that are used for programs vs. administrative and fund raising costs. A charity that you can feel confident in will hit all twenty of the goals, or if they miss one or two benchmarks, will have provided reasonable explanations for this shortcoming.

Some charities - now using the term loosely - hit very few of the goals, or choose not to respond to the BBB's request for information. Reconsider a donation to an organization whose fundraising and administrative expenses will consume the majority of your contributions. In a random sampling, there were several organizations whose actual pass-through to their programs was under ten percent of the total money contributed. It's important that your donations make their way to help those who need it.

STATE LAW REQUIREMENTS ON A SECTION 1013 EXCHANGE

We talk a lot about the Federal Section of the exchange process, Section 1031.  But do the individual states honor that Federal law and what about the State taxes?   For the most part, most states that have their own income tax, allow the taxpayer to defer all gain (including their own state income tax) just as the Federal law does under Section 1031.  But let me quote from my friend Mary Foster book:  "However, some states have enacted additional requirements that may surprise unwary taxpayers in an attempt to tax dispositions of property exchanged into out-of-state replacement property."  Some states require additional forms to be filled out by the taxpayer.  So it is very important that you hire good financial and legal advisors. 

AIRLINE TRAVEL A MESS ACCORDING TO WHARTON BUSINESS SCHOOL

Every year I give a lot of SECTION 1031 speeches and seminars to large real estate and tax trade organizations--some of these presentations include continuing education credit.  I fly to most of these presentations and as a result, obtain a lot of frequent flyer miles.  I love to get those miles and use them for my vacation travel.  Notwithstanding that fact, we have observed that the quality of airline service and amenities are down.  I agree with results of a Wharton Business School recent study on these issues.  Here are excerpts from that report:

"While airline service is no longer the white-glove experience it once was, it has now gone beyond bad food and snappish flight attendants. Today, when passengers board an airplane, they might well question whether there is a reasonable chance they will make it to their destination in the next few days.
"Previously, airlines worried about dissatisfied customers. Now I don't think they worry about it because the customer service at all airlines is so horrible," says Netessine, a professor of operations and information management.
Airline consumer advocates contend delays are now a routine part of air travel. For the first five months of this year, the major airlines' on-time arrival rate was 73.5%, the lowest for that period in the past seven years, according to the U.S. Department of Transportation's Bureau of Travel Statistics. Complaints about airline service were up 49% from May 2006. As if that weren't troubling enough, airline consumer advocates have testified before Congress that DOT figures do not even measure the true extent of the problems.

The reasons behind the sharp decline in airline service are many. Chief among them is a reduction in airline capacity following years in which the industry hemorrhaged money and major carriers wound up in bankruptcy court because their costs were out of line with revenue. Now, with the supply of airline seats decreasing and demand rising, there are not enough seats to go around, particularly when weather or other problems disrupt schedules.

Flights this summer are booked at historic high levels of nearly 90%. Before the industry was deregulated in 1978, flights typically ran 55% full. "If something happened back then, the airline could easily put you on the next flight because that flight was only half-full, too." He points out that an airline seat is not like canned soup or any other tangible product that can be shelved and sold later if demand is slow. As a result, airlines have honed operations to squeeze the most cash out of every seat they fly, including overbooking to make sure each seat has at least one customer.

According to Netessine, the current level of overbooking comes down to a simple economic trade-off. On one hand, the airline risks flying with an empty seat; that seat comes with a greater cost as fuel prices rise. The other side of the tradeoff is the cost of bumping a passenger. Current law requires airlines to pay passengers $200 if they are bumped but rebooked on another flight within two hours. If the delay extends beyond that period, the passenger gets $400. Department of Transportation officials are now considering several proposals to increase the bumping penalty."