Are Real Estate Auctions Rigged?

We recently came across a study by the University of Melbourne in Australia that questioned whether real estate auctions were “rigged” against potential buyers of the auctioned property.

With the tremendous rise in foreclosures and the auctioning of financially distressed property in this county, we thought we would post the conclusions of the Melbourne report and ask for your comments.

Here is what the professors at the University of Melbourne had to say:

Auctions have always been promoted as a tried and proven method of achieving the highest sale price for a property. It gathers together prospective purchasers in one place at one point in time and sells the property to the highest bidder.

It has been proven in empirical research that auctions generally achieve a higher final transfer price than an open market sale.

Even though both approaches are applied in the same marketplace within the definition of ‘market value’, there have been no valid reasons to explain this difference.

One practice that has been openly acknowledged is the practice of ‘dummy’ bidders, which may partly explain this premium. The use of ‘dummy’ bidders by the vendor and/or auctioneer could have the effect of distorting the true market value, designed to deceive the purchasing public into competing at an inflated price in the auction process.

It appears that the genuine popularity and reputation of the auction process is seriously threatened by the deceitful use of ‘dummy’ bidders. Steps must be taken to eradicate the tactic before the entire residential auction industry is discredited, and the ‘level playing field’ must be returned for the vendor, auctioneer and the bidders alike.

Potential improvements to the auction industry to discourage this practice could include strong fines to both the individual auctioneer and their employer, with endorsement of the fines by the relevant industry body.

Not until after the successful eradication of the ‘dummy’ bid and associated deceitful practices (e.g. ‘two tier’ marketing) will purchasers and vendors be able to confidently trade in a fair and equitable marketplace. Only then will valuers be able to rely on true market value sales with a higher level of confidence.

Does this reflect your experience with real estate auctions? What advice would you give to those who are thinking about buying property today at an auction? Your comments are welcome!

UPDATE:

For our post on the investigation of an auction of foreclosed homes by California-based real estate auctioneer Real Estate Disposition Corp. to determine whether some homes were sold before the foreclosure process was completed, click here.

1031 Exchange Q and A: When Is It Too Late?

Peter and Wendy sold an apartment complex last month for $6,000,000.

Peter complained to his friend James that because his adjusted basis in the property was $3,200,000, he will have to report a capital gain of about $2,800,000 from the sale of the apartment complex on this year’s tax returns, and will have to pay $420,000 to the IRS in capital gain taxes on his profit from the sale.

James tells Peter that he should do a Section 1031 exchange on the property, so that he can legally avoid paying the capital gains tax.

James also tells Peter that he can report the sale as an exchange, even though the sale has already taken place, because he was planning to purchase another investment property this year with his profits, and he had not yet filed his tax returns.

Can Peter use Section 1031 to legally avoid paying capital gains taxes on the sale of the apartment complex?

The answer is No.

Unfortunately, Peter cannot retroactively turn a taxable sale into a tax-free exchange under Section 1031.

The transaction must be structured as a Section 1031 exchange before either end of the transaction (that is, the sale of the relinquished property or the purchase of the replacement property) has taken place.

Remember, if you receive any of the proceeds from the transaction (either by actual or constructive receipt) before the entire exchange is completed, the transaction is a taxable sale.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

House Swapping with Section 1031?

ABC News recently ran a piece about the emerging trend of house swapping, where home owners trade properties as a way of circumventing the tough market in home sales.

The expert interviewed was Wendy Bounds of the Wall St. Journal and Good Morning America. Bounds said that one of the possible benefits of a house swap was the deferral of capital gains taxes, presumably under Section 1031.

She failed to note, however, that 1031 exchanges are limited to property held for “productive use in a trade or business or for investment,” and do not include personal residences.

Home owners who are considering a trade should learn more about 1031 exchanges before counting on deferring their capital gains taxes.

New IRS Ruling on Vacation Homes and 1031 Exchanges

Property owners often ask whether a property that they rent out to others but occsionally use themselves (such as a vacation home) qualifies for a tax defered exchange under § 1031.

In the past, it was not clear whether the IRS would consider such property to be “held for productive use in a trade or business or for investment” and therefore qualified for a 1031 exchange.

The IRS has issued a new Revenue Procedure (Revenue Procedure 2008-16) that explicitly provides that property that is rented to others but also occasionally used by the owners for personal purposes qualifies as property that may be exchanged in a like-kind exchange under § 1031 when certain conditions are met.

Under the new IRS ruling, which goes into effect on March 10, property that is primarily held for the production of rental income, but is also used occasionally for personal purposes, will qualify for § 1031 like-kind exchange treatment when:

(1) the dwelling has been owned by the taxpayer for at least 24 months immediately before the exchange, and

(2) the period of the taxpayer’s personal use of the dwelling does not exceed the greater of 14 days or 10 percent of the number of days that the dwelling is rented at fair market value.

One small cheer for the IRS!

Why Use a 1031 Exchange?

There are many things you can do with your real property – from keeping it to selling it to giving it away to family members or charity.

Each of these choices has predictable financial, legal, and other consequences, and wise real property transactions are made with a full awareness of, and appreciation for, all of these consequences – especially the tax consequences.

The sale of real estate is a taxable event, and all profit from the sale of real estate is taxed as capital gains in the year of the sale. If you sell a property that has appreciated in value, you will be required, in general, to pay capital gains taxes on the difference between what the property cost you and what you get for it now, plus recapture of any depreciation you have previously taken. If your property has substantially appreciated in market value, you will be required to pay a substantial amount of money as capital gains taxes and depreciation recapture to the government.

A Section 1031 exchange allows you to legally avoid paying these taxes.

Section 1031 (a)(1) of the Internal Revenue Code states that “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

What this section means is that Section 1031 exchanges – if done properly – have the special benefit, unlike other forms of real property transactions, of allowing the complete legal avoidance of capital gains taxes and recapture of depreciation.

Technically, a Section 1031 exchange is a tax deferral rather than a tax elimination technique. The new replacement property purchased with the proceeds from the sale of old relinquished property has the same tax basis as the old property, and when the new property is later sold, the deferred capital gain, plus any additional gain realized since the purchase of the new property, is subject to taxation.

But since you can continue to exchange the new properties you obtain through Section 1031 exchanges again and again, you can continue indefinitely to legally defer taxes.

In other words, by taking advantage of the full benefits of the Section 1031 exchange process, you never have to pay taxes on the transfer of real property. Upon death, the basis of property gets “stepped-up” to its fair market value and the accumulated capital gain is never taxed. Even those who inherit the property can sell it at its fair market value at the date of death and not pay tax on that gain.

As Section 1031 exchangers like to say, you can “swap ’till you drop.”

You don’t have to be a financial genius to recognize that avoiding tax liability is always a good investment practice. If you can defer payment of taxes to some indefinite date in the future, you will have more money to invest today.

By putting the money that you save in taxes today to work for you now in sound real estate investments, you will have more equity in the future. By properly using the tax avoidance strategy of Section 1031 exchanges, with the money you save by legally avoiding capital gains taxes and depreciation recapture, you are able to continually step up your real estate portfolio and build substantial wealth from your original investment.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com