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Changes in the Tax Code Should Change the Way You Think About Real Estate Investments

Changes in the Tax Code Should Change the Way You Think About Real Estate Investments

There are few things in this world more confusing than IRS codes, IRS definitions, and IRS procedures. Fewer still are the changes to these codes that turn out to be beneficial to the taxpayer. An obscure and underutilized section of the tax code that has only been of practical use for the last 2 or 3 years happens to be one of these elusive favorable changes. It pertains to ?like/kind? tax deferred real estate exchanges for investment property.

Many pro athletes have become involved in real estate via investment strategy or by purchasing office space for off-season ventures. As most real estate players already know, it [real estate] is easy to get into but rather difficult to get out of. To add insult to injury there will be a capital gains tax owed during the year of sale.

Now IRS ?1031 gives those of us that own investment property the opportunity to defer our capital gains tax temporarily if not indefinitely. Your attorney or CPA may already know what section 1031 is in theory, but just like on the field of play, the challenging part is how well the theory is executed. To add to the difficulty, using your CPA or attorney during the transaction may jeopardize favorable 1031 tax treatment. More on that topic later.

Section 1031 remains underutilized due to its complexity and inherent time constraints. Going into detail would make the most stoic financial professional numb with information overload. The short version is that when an investment property is sold the seller only has 45 days (from the closing) to identify the next property and 180 days to close on that property. If that seems extremely stringent, your intuition is correct. The 45-day ID period puts a very real kink in the proverbial 1031 armor. Imagine if there is no target property, or worse the target property deal collapses (real estate deals are susceptible to failure because there are many parties involved).

There is a silver lining; many groundbreaking changes came out of IRS Revenue Procedure 2002-22. As improbable as it may seem, positive change came out of an IRS ruling. There was a long-standing guideline that prevented individuals from owning a fractional piece of property without the arrangement being titled as a business partnership (this title eliminates the favorable tax treatment of investment property). REV PROC 2002-22 reversed this rule and went as far as to list fifteen guidelines to meet in order for multi-owner properties to be considered for favorable 1031-exchange treatment. Since 2002-22 has been released and understood, sponsor companies can now, for the first time, confidently put Tenant In Common (TIC) arrangements together for up to 35 investors on one single piece of property. The benefit to current owners who plan to sell is they can exchange right into a TIC structure, which is normally Class A office or retail space. Or, the seller can use the TIC as a back-up strategy just in case the identified property falls through during the 45 day ID period. This gives real estate investors much more latitude when it comes to exchanging property.

In the old days, prior to REV PROC 2002-22, there was no practical way to get out of the "like/kind exchange" strategy. Owners invariably ended up exchanging into the exact same type of property that they just sold (i.e. an apartment building to another apartment building). What if the owner no longer wishes to carry out landlord activities or simply wants to diversify? Now an apartment owner (or any type of investment property owner) can exchange directly into Class A office and/or retail space using the TIC strategy.

Earlier, I mentioned a potential pitfall if an investor used their customary CPA or Attorney for the transaction. One way to jeopardize the tax treatment of the proceeds is to use an attorney, CPA, or financial advisor that you have compensated in the last two years. There are many ways in which to make errors in the process so interview a few advisors that specialize in 1031 transactions. As you can tell by reading this abbreviated article, 1031s are not run of the mill transactions. They take dedication, time and resources to successfully execute. 1031 exchanges are powerful tools; but they are just that, tools. These tools should only be used as part of a prudent and comprehensive financial plan.

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