Tag Archives: tax law

Are Our Economic Problems Just in Our Minds? John McCain’s Chief Economic Advisor Thinks So

Are the nation’s economic problems — the financial crisis, the mortgage meltdown, the tidal wave of foreclosures, soaring gas prices, increasing job losses, and a tumbling dollar — only in our minds?

It appears that Phil Gramm, John McCain’s chief economic advisor and co-chair of his presidential campaign, thinks so.

He also thinks that those of us who are seriously troubled by the state of the economy are “whiners.”

In an interview in yesterday’s Washington Times, Gramm said that “this is a mental recession. We may have a recession; we haven’t had one yet.”

Gramm says that Americans have “become a nation of whiners.” 

Americans, according to Gramm, are constantly “complaining about a loss of competitiveness, America in decline.”

“You just hear this constant whining,” he said.  “Misery sells newspapers,” Gramm said.  “Thank God the economy is not as bad as you read in the newspaper every day.”

What also sells newspapers are bone-head comments from key advisors to presidential campaigns.

We said last month that Gramm was on thin ice in the McCain campaign because of his ties to the mortgage meltdown and financial crisis

As a U.S. Senator from Texas, Gramm spearheaded sweeping changes in federal banking law, including the Gramm-Leach-Bliley Act in 1999, which repealed previous rules separating banking, insurance and brokerage activities, and which some analysts blame for creating the legal framework for the current mortgage meltdown and credit crisis.  For that effort, Gramm has been called “the father of the mortgage meltdown and financial crisis.”

In addition, Gramm is currently vice chairman of UBS, the giant Swiss bank that has been a major player in the U.S. subprime mortgage crisis.  While advising the McCain campaign, Gramm was paid by UBS to lobby Congress to roll back strong state rules that sought to stem the rise of predatory tactics used by lenders and brokers to place homeowners in high-cost mortgages.

Gramm’s leadership role in UBS — whose stock has fallen 70 percent from last year — also raises questions about his economic, and not just his political, judgment. 

As a recent article in Slate.com observes, “UBS’s investment banking unit made disastrous forays into subprime lending. Last December, having already announced a third-quarter loss, UBS raised about $13 billion to replenish its balance sheets, mostly from the Government of Singapore Investment Corp.  In the fourth quarter of 2007 and the first quarter of 2008, it racked up Mont Blanc-sized losses on subprime debt of nearly $32 billion. In May, it sold about $15 billion worth of mortgage-related assets to the investment firm BlackRock — but only after it agreed to finance most of the purchase price. In June, UBS raised another $15.5 billion in a rights offering. The credit losses — some $38 billion so far, according to UBS — caused the bank to replace its chairman and install new leadership at its investment bank.”

In addition, Massachusetts has charged UBS with defrauding customers who had purchased auction-rate securities. UBS is accused of “selling retail brokerage customers products that turned out to be profitable for the bank’s investment banking unit but caused the customers to suffer significant losses.”

UBS is also the subject of an ongoing federal investigation, in which Bradley Birkenfeld, an American UBS private banker who was busted on tax evasion charges, has plead guilty and is cooperating. 

UBS has also recently paid millions of dollars to settle a lawsuit with the victims of a 1031 exchange scam.  UBS was one of several defendants who were alleged to have participated with Donald Kay McGahn and and others in a scheme to steal the money that had been entrusted to them to facilitate tax deferred 1031 exchanges.

And most recently, the Financial Times, which called UBS “Europe’s biggest casualty of the US subprime crisis,” reported that UBS’s write-downs could total another $7.5 billion.  UBS’s stock fell 7 percent in trading on Monday.

With that resume, we think it would be best for everyone, not least John McCain, if Phil Gramm was no longer introduced to voters as “John McCain’s chief economic advisor.”

UPDATE:

As of July 18, Gramm has resigned as co-chair of McCain;s presidential campaign.

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What Property Qualifies for a 1031 Exchange? (Part Three)

This is Part Three of our series on what property qualifies for a 1031 exchange.  You can also see Part One and Part Two.

In deciding whether a particular property has been held for productive use in a trade or business or for investment, the IRS looks at how you have characterized that property on your tax returns. If you have historically taken depreciation on or reported rental income on a property, there should not be any problem with that property qualifying for a Section 1031 exchange.

In addition, it is important to note that the IRS has ruled that the Section 1031 requirement that property be “held for productive use in a trade or business or for investment” excludes primary residences, vacation homes (when they are not held for investment), and second homes. When a personal residence is exchanged for other property, the Section 121 exclusion rule applies (providing that up to $250,000 of capital gain, or up to $500,000 for a married couple, is not taxable), not Section 1031.

The burden of establishing that a property is held for productive use in a trade or business or for investment (and not for a non-qualifying use such as inventory for resale) is on the exchanger, not the government.

The “for investment” requirement is somewhat trickier than the requirement that the property be “held for productive use in a trade or business,” since all property could conceivably be considered an investment.

Each property must be evaluated on a case-by-case basis. What the IRS looks at is the intent of the property owner and whether, on balance, the property is held for investment purposes or personal enjoyment.

If you want to do a Section 1031 exchange of property that you now use as your primary residence or as a second or vacation home, you must first turn it into qualifying property that is productively used in a trade or business or for investment. In other words, even property you have used as a primary residence, a second home, or primarily for personal enjoyment as a vacation home, may still qualify for an exchange under Section 1031 – if you re-characterize that property by using it for business purposes for a sufficient period of time.

The date the IRS uses to determine whether property has been held for a qualifying business use is the date of the transaction; any previous use is theoretically irrelevant. There is also no clear rule regarding how long a “holding period” is required in order to re characterize property and qualify for a Section 1031 exchange. Tax advisors recommend a period of one to two years (opinion is split on which time period is sufficient, but in no case less than 12 months) in the new use, and that you are able to report rental income and deduct depreciation and other business expenses regarding the property on your tax returns for that period of time.

It should also be noted that one can also exchange many types of non-real estate property that is held for investment or used in a business. For example, an airline can sell its airplanes as part of a like-kind exchange and avoid recapture of depreciation.

But the “like-kind” requirement is interpreted much more narrowly by the IRS for non-real property than for real property. While any real property held for trade or business use or for investment and located in the United States can be exchanged for any other real property held for trade or business use or for investment use and located in the United States, non-real estate properties exchanged under Section 1031 must be essentially the same type of asset.

Airplanes can be exchanged for airplanes, trucks for trucks, pizza ovens for pizza ovens, oil digging equipment for oil digging equipment; but airplanes cannot be exchanged for trucks, and oil digging equipment cannot be exchanged for pizza ovens. In addition, franchise rights and certain types of licenses can also be exchanged under Section 1031.

The replacement property, like the relinquished property, must meet certain requirements to be eligible for a Section 1031 exchange.

First, the replacement property, like the relinquished property, must be property, not securities or services, and it must be intended for “productive use in a trade or business or for investment.” 

Section 1031 applies only to “the exchange of property…for property.” For this reason, you cannot exchange property for securities or services. As with the relinquished property, this is a matter of the how the exchanger intends to use the property. The use of either property by the other party in the exchange is irrelevant.

Second, the replacement property must be of a “like-kind” to the relinquished property. What does “like-kind” property mean? In a typically obtuse ruling, the IRS has stated that:

“As used in IRC 1031(a), the words like-kind has reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale.”

Got it? Okay, now let’s unpack the “like-kind” requirement in language that makes sense.

As used in Section 1031, “like-kind” property does not mean property that is exactly alike – or even alike at all in any normal sense. Instead, the IRS interprets the “like-kind” requirement very broadly – so broadly that if two or more properties are located in the United States and are held for productive use in a trade or business or for investment, they are considered “like-kind” property under Section 1031.

In other words, all real property located in the United States is considered “like-kind” to all other real property located in the United States.

Conversely, foreign property such as property located in Canada or Mexico) or in overseas U.S. possessions, such as Guam or Puerto Rico, is not considered “like-kind” to any property located in the United States.

But urban real estate in Los Angeles can be exchanged for a ranch in Utah, a ranch in Utah can be exchanged for a factory in Delaware, a factory in Delaware can be exchanged for a gas station in Las Vegas, and a gas station in Las Vegas can be exchanged for a conservation easement in Seattle. The quality or type of the real property does not matter so long as each real property is located in the United States. Under Section 1031, an apartment building in Chicago can be exchanged for an office building in Los Angeles, an office building in New York can be exchanged for a car wash in Nashville, a car wash in Seattle can be exchanged for a tenancy-in-common ownership in a resort in San Diego, and a tenancy-in-common ownership in a mall in Arizona can be exchanged fortimberland in Oregon, a farm in Wisconsin, a factory in Pennsylvania, or a gas station in Louisiana.

The fact that one property is improved and the other property is unimproved, or that one property is in a run-down part of a city while the other property is located in an upscale neighborhood is irrelevant.  Moreover, even partially completed property can, if properly identified, qualify as “like-kind” property with completed property. The “like-kind” requirement refers to the nature or character of property, not to its grade or quality. As long as a property is located in the United States and is “held for productive use in a trade or business or for investment,” it is “like-kind” to every other property located in the United States that is “held for productive use in a trade or business or for investment.”

See also “What Property Qualifies for a 1031 Exchange?” Part One and Part Two.

To contact Melissa J. Fox for 1031 exchange or other real estate or legal services, send an email to strategicfox@gmail.com

1031 Exchanges Between Related Parties — and Other 1031 Exchange Issues

Special rules govern 1031 exchanges between related parties, and running afoul of them can turn your tax-free exchange into a taxable sale. 

Here is an example:

Brad and Ellis are brothers. Brad lives in Dallas, Texas, where they grew up, and Ellis lives in a suburb of Boston, where he settled after law school. As a result of an inheritance from their grandparents, Brad and Ellis own several houses in Dallas as joint tenants.

They have rented these houses to tenants and divided the expenses and the profits equally between themselves. The largest of these houses is a five bedroom ranch style home sitting on 3.5 acres.

Brad now wants to move into this house, and wants Ellis to sell him his one-half ownership so that Brad can own the house on his own. The house’s fair market value at the time of their inheritance was $600,000. Its current fair market value is $950,000.

Ellis points out to his brother that if he sells his share of the house to Brad, he will be required to pay capital gains taxes of approximately $45,000. Instead, Ellis proposes that they do a Section 1031 exchange, in which he and Brad would swap their portions of ownership of several of the properties that they own together.

Specifically, Ellis proposes that Brad exchange his joint ownership portion of two of their smaller properties with a combined current fair market value of $890,000 for the ranch house property worth $950,000 that Brad wants. Once Ellis has sole ownership of these properties, Ellis plans to remodel and sell them within the next two years.

Does Ellis’ proposal make sense?

What about the $60,000 difference in value between the property that Ellis wants to exchange in return for the ranch house?

Are there any special problems for the brothers to consider, and is there anything that they could do to avoid these problems?

The first point to recall here is that special rules apply to Section 1031 exchanges with anyone who is a “related party” to the taxpayer.

Related parties include family members, such as spouses and lineal descendants (parents and children, brothers, sisters, grandparents and grandchildren), as well as corporations, partnerships, trusts, and estates in which a related person owns more than 50 percent either directly or indirectly.

You can engage in a Section 1031 exchange with these related parties, but only if neither the relinquished property nor the replacement property is sold or otherwise disposed of within two years of the transfer.

The IRS monitors exchanges between related parties by requiring that both parties file a special tax form, Exchange Form 8824, in the year of the exchange and for the next two years.

In this example, Brad and Ellis can exchange properties, but the exchange will be treated as a taxable sale if either the relinquished property or the replacement property is sold or otherwise disposed of within two years of the transfer.

Thus, if either Brad or Ellis sells or otherwise disposes of the property involved in the exchange within two years of the transfer, the IRS will retroactively disqualify the original transaction as a Section 1031 exchange and order that capital gains taxes be paid.

Moreover, if either brother sells or disposes of the property before the two year holding period is over, the other brother will be required to pay capital gains taxes on the transaction even though he was not the party who sold or disposed of the exchanged property.

Here, if Ellis carries out his plans to remodel and sell the property he receives in the exchange within the next two years, the IRS will retroactively declare the exchange to be a taxable sale and both Ellis and Brad will be required to pay capital gains taxes.

Accordingly, Brad should consider doing the exchange only if Ellis agrees, in the written documents controlling the exchange, to a provision specifying that if either party triggers the taxation of gain within the two year holding period, the innocent party will be reimbursed for the adverse tax consequences.

In addition, a transaction to qualify as a Section 1031 exchange, both the relinquished and the replacement properties must be held for use in a trade or business, or for investment. In this example, Brad wants to move into one of the exchanged properties and use it as a personal residence.

If he does so, the property is not held for use in a trade or business, or for investment, and the transaction will not qualify as a Section 1031 exchange. Brad can move into the five bedroom ranch style home only after a prudent holding period of at least two years, during which he uses the property in a trade or business or for investment.

Brad should also be concerned about the $60,000 difference in fair market value between the property he will be giving up and the property he will receive in the exchange.

In order to use Section 1031 to avoid paying any capital gains taxes, the basic rule is to exchange up, never down.

Here, if the exchange were to go forward as Ellis proposes (that is, Brad would receive property with a fair market value of $890,000 in exchange for property with a fair market value of $950,000), then Brad will have a capital gain of $60,000 on which he will required to pay capital gains taxes.

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

 

Obama and McCain Discover that Ties to Countrywide and Banking Industry are Political Kryptonite

Given its central role in the subprime mortgage debacle, it is no surprise that Countrywide Financial has become politically radioactive.

The most recent evidence for the politically deadly consequences of an association with Countrywide or its corporate officers is the sudden and ungraceful exit of businessman James A. Johnson, a long time Washington insider and lobbyist, from Barack Obama’s vice-presidential selection team.

Johnson was chosen by Obama to lead the group, which also includes Caroline Kennedy Schlossberg and Eric Holder, that would help him select a running mate. The appointment seemed obvious, if uninspired, since Johnson is an old Democratic Party insider who played a similar role in selecting the vice presidential choices for both Walter Mondale and John Kerry.

But last week, Johnson came under withering fire for his association and possible sweetheart deals with former Countrywide chairman Angelo Mozilo. Specifically, Johnson was charged with having profited from special sweetheart deals on three home loans, with usually preferential mortgage terms, approved by Mozilo as the head of the Countrywide only for his close friends.

Bloomberg.com reports that “Angelo Mozilo, the chief executive officer of Countrywide, the biggest U.S. home lender, may have given Johnson and other friends good deals on mortgages, the Wall Street Journal reported on June 7, citing unidentified people familiar with the matter. The newspaper didn’t provide any specifics on whether favors were granted. Since then, Johnson’s position on the search committee has drawn criticism from Republicans who noted that Obama, the presumptive Democratic nominee, repeatedly denounced Countrywide for its role in the subprime-mortgage crisis.”

It was soon discovered that Johnson had other political liabilities, including criticism for his role as chairman and chief executive officer of the Federal National Mortgage Association (Fannie Mae) from 1991 to 1999, and also faced questions about his role on corporate compensation committees that awarded large payouts to corporate executives.

As New York Times columnist Gail Collins pointed out, “Johnson is the former head of Fannie Mae, which under his direction, according to regulators, engaged in accounting practices that were, at best, sloppy. At the same time, he sat on the boards of five different corporations, where he appeared to serve as cheerleader for the theory that corporate executives deserve to be paid obscene amounts of money. How does someone go up to Barack Obama, who once sponsored a bill to curb excessive executive compensation, and say — ‘You know the vice-presidential search committee? For chairman, how about Jim Johnson? Remember, the guy who tried to give the head of United Health Group $1.4 billion in stock options?'”

Although Republicans are pleased with Johnson’s departure — or at least with the embarrassment to Barack Obama caused by the Johnson episode — John McCain has his own toxic subprime-association worries.

Former Senator Phil Gramm (R-Texas), now serving as John McCain’s chief economic advisor, has been called “the father of the mortgage meltdown and financial crisis.”

Gramm spearheaded sweeping changes in federal banking law, including the Gramm-Leach-Bliley Act in 1999, which repealed previous rules separating banking, insurance and brokerage activities, and which some analysts blame for creating the legal framework for the current mortgage meltdown and credit crisis.

In addition, New York Times columnist Paul Krugman observed that “According to federal lobbying disclosure records, Gramm lobbied Congress, the Federal Reserve and Treasury Department about banking and mortgage issues in 2005 and 2006. During those years, the mortgage industry pressed Congress to roll back strong state rules that sought to stem the rise of predatory tactics used by lenders and brokers to place homeowners in high-cost mortgages.”

Gramm is also under fire for his connection with Swiss investment banking giant UBS, which is the subject of a federal investigation into whether it helped wealthy clients to use offshore accounts to hide as much as $20 billion in assets from the Internal Revenue Service and dodging at least $300 million in federal taxes. Gramm is vice-chair of UBS Securities, UBS’s investment arm.

The New York Times reports that “The case could turn into an embarrassment for Marcel Rohner, the chief executive of UBS and the former head of its private bank, as well as for Phil Gramm, the former Republican senator from Texas who is now the vice chairman of UBS Securities, the Swiss bank’s investment banking arm.”

So far, McCain has rejected calls to remove Gramm from his inner circle. But our guess is that, fairly soon, Gramm will join Jim Johnson in the growing Class of 2008 Ex-Presidential Candidate Advisors Club.

UPDATE:

For more on Phil Gramm, John McCain, and UBS, click here.

When Can — or Should — You Revoke an Identification in a 1031 Exchange?

Sometimes it is necessary to revoke an identification in a 1031 exchange.

For example, Dwight is doing a Section 1031 exchange involving a 300 unit apartment complex he owns in San Antonio, Texas, and has identified three replacement properties under the Three Property Rule. He then learns that one of the properties he has identified is no longer available.

What should he do?

Dwight should revoke his identification of the unavailable property and identify a new replacement property in its place.

An identification of replacement property can be revoked at any time before the end of the identification period

If Dwight did nothing, he would be left with only two replacement properties, and if those properties did not close he would be unable to complete a Section 1031 exchange.

If, however, Dwight timely revokes the identification of the property that is no longer available — or appropriate — for whatever reason — then he can add a new property to his identification list.

For maximum security when using the Three Property rule, the goal is to end the identification period having named three qualified and suitable replacement properties, any of which can be used as a replacement property in the exchange.

This strategy also applies to other 1031 exchange identification rules (the 200 Percent Rule and the 95 Percent Rule).

Remember, too, that the revocation of identification must, like the earlier initial identification, be made in a written document signed by you that unambiguously describes the property whose identification you have chosen to revoke.

And as with the earlier identification, a revocation of identification must be hand delivered, mailed, telecopied, or otherwise sent to either the person obligated to transfer the replacement property to the exchanger, or any other person involved in the exchange other than the taxpayer or a disqualified person.

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

Can You Use a 1031 Exchange for Non-Real Estate Assets?

Section 1031 exchanges are not limited to real estate.

To qualify for the tax benefits of an exchange under Section 1031, the property you want to exchange (or relinquish) needs to be “held for productive use in a trade or business or for investment.”

The property does not have to be real estate.

But when you’re exchanging non-real estate assets, the requirement that the relinquished property and the replacement property be “like kind” is much more narrowly construed.

Here is an example:

Stan is an avid collector of boxing memorabilia. His collection includes posters for the famous fight between Joe Lewis and Max Schmeling, several pairs of boxing gloves used in the ring by Mohammed Ali, a gold platted championship belt once owned by Jake LaMotta, a mouth piece that belonged to Sugar Ray Robinson, a pair of Archie Moore’s boxing trunks, and a wedding ring worn by Gentleman Jim Corbett, among other treasures.

He is thinking about selling his collection to buy a tenancy-in-common interest in a new hotel that his friend Barbara is opening in Las Vegas, Nevada. 

Stan has heard about the tax benefits of using Section 1031. Can he use Section 1031 to exchange his collection of boxing memorabilia for an ownership interest in Barbara’s Las Vegas hotel.

1031 exchanges are not limited to real estate. One can also exchange other types of tangible non-real estate property held for investment or used in a business. But the “like-kind” requirement is interpreted much more narrowly by the IRS for non-real property than for real property.

While any real property held for trade or business use or for investment and located in the United States can be exchanged for any other real property held for trade or business use or for investment use and located in the United States, non-real estate property exchanged under Section 1031 must be essentially the same type of asset.

Airplanes can be exchanged for airplanes,trucks for trucks, pizza ovens for pizza ovens, oil digging equipment for oil digging equipment, but airplanes cannot be exchanged for trucks and oil digging equipment cannot be exchanged for pizza ovens.

Because Stan wants to exchange his boxing memorabilia for a tenancy-in-common interest in a hotel – an asset of a very different kind – the exchange would not be allowed under Section 1031.

If Stan wants to exchange his boxing memorabilia under Section 1031, he should consult his tax advisor to determine what kind of assets would be considered “like-kind” to his collection.

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

1031 Exchange Q and A: Using a 1031 Exchange to Avoid Recapture of Depreciation — Even If You Have No Capital Gains

Li-Ann owns a shoe factory on Grand Island, New York, that has decreased in fair market value since she inherited it 14 years ago. She was preparing to put the factory on the market when her lawyer suggested that she do a Section 1031 exchange rather than a sale in order to avoid paying capital gains taxes.

Li-Ann told her lawyer that she had no reason to use a Section 1031 exchange, since the property had decreased in fair market value.  She wasn’t going to make a profit on the sale, she said, and therefore wouldn’t be paying any capital gains taxes.  Since she wasn’t making any money on the property, she saw no benefit to a 1031 exchange.

Is Li-Ann correct?

The answer is No.  By focusing exclusively on capital gains, Li-Ann has missed half of the potential benefits of a 1031 exchange.

Li-Ann needs to take recapture of depreciation into account, not just actual profit, when deciding whether she will save money by using a Section 1031 exchange.

In this example, Li-Ann might well be wrong in thinking that because her property has decreased in fair market value, she would not owe any capital gains taxes on a sale.

Because depreciation reduces the adjusted basis in a property, it has the effect of increasing the amount of profit – or, more precisely, the amount of capital gains that the IRS insists that you pay tax on – when you sell the property.

Moreover, the government assumes that you have taken all scheduled depreciation deductions, regardless of whether you have actually taken the depreciation deductions or not, and will insist that this allowable depreciation be recaptured when the property is sold.

The longer you’ve owned a particular property, the more depreciation has been taken, and the lower your adjusted basis.

Thus, the longer you own a particular property, the more depreciation will increase the amount of taxable capital gain, even without any cash profit due to appreciation.

In fact, if you sell a property that you have owned for a long time, you are likely to have a sizable taxable capital gain (and be required to pay sizable capital gains taxes), even though you have no cash profit whatsoever.

On the other hand, if you exchange property that is subject to recapture and no gain is recognized, the recapture potential of the relinquished property is not paid by you but carries over to the replacement property.

This recapture potential can be deferred endlessly if you continue to transfer the property through Section 1031 exchanges.

Li-Ann should therefore consider using a Section 1031 exchange in order to avoid paying capital gains taxes on a potentially substantial “profit” that exists in the account books of the IRS, even though her property has not appreciated in value.

For more information on depreciation and 1031 exchanges, see our previous post Why Do a 1031 Exchange in a Down Real Estate Market?

For everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

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