General Real Estate related and Hard Money industry news, etc.

1031 Tax Free Exchange will Save You Money

Since property values are going up some of you might be considering selling and taking profits on your properties. If the property you are considering selling is NOT your personal residence and qualifies as an investment property then the option is available to sell by taking advantage of IRS tax code section 1031. This is the tax code that allows investors to defer paying capital gains taxes when selling investment properties. This procedure is referred to as a “1031 tax free exchange”.

Under current tax laws the capital gains tax rate for selling investment property is taxed at a rate of 15%. The tax rate for capital gains is lower than most marginal tax rates, so it would be beneficial to take advantage of selling using a 1031 tax free exchange to get immediate tax savings.

There is a catch as there so often is with tax laws exceptions. The catch is that you can’t get your profits in cash, but you are allowed to roll over your profits into another investment property that you MUST purchase within 180 days.

If you don’t “need the money now” then rolling your profits into a replacement property will add to your net worth by saving taxes now and should allow for greater appreciation of the property purchased.shutterstock_187606628

One other reason to do a 1031 tax free exchange is that the IRS calculates a 3% depreciation amount for every year an investment property is owned. This amount is “re-captured” at the time of sale by being added back into the property’s cost basis and taxed at the taxpayer’s marginal tax rate. Taking advantage of selling using a 1031 tax free exchange will also allow for the taxation of IRS depreciation to be rolled into the replacement property.

Under IRS tax code 1031 a tax fee exchange is treated as an exchange and not as a sale. This is an important distinction since selling is always treated as a “taxable event”.

It is this unique distinction that allows for any profits also known as capital gains to be transferred into the replacement property. It is VERY important that each requirement of tax code 1031 be followed very carefully as the devil is in the details, since if all requirements are not followed the exchange can be rejected and the “sale” will then be subject to capital gains taxes in the year of sale.

A few things need to be explained or defined prior to going any further:

Capital Gains: Taxable profits from an investment property

Like Kind Property: Property qualifying to be included in a 1031 tax free exchange must be considered like kind. In the world of real estate all real estate is considered like kind.

Replacement Property: This is the property that is purchased.

Accommodator: Company or third party that accepts and controls the net money from the sale of the property sold while the 1031 tax free exchange is in process.

Boot: Any sum of money received by the seller of a property in a 1031 tax free exchange. The amount of money received is taxable at the taxpayer’s marginal tax rate.

Recaptured depreciation: This is the taxable event that is triggered upon the sale of investment property when depreciation is added back to the cost basis of the property. The IRS 3% annual depreciation calculation is added back at the time of sale and taxed at the tax payer’s marginal tax rate.

“3” Property Rule: This is the rule that states that no more than 3 potential replacement properties can be identified to the IRS in any 1031 tax free exchange.

The general requirements of an IRS 1031 tax free exchange are:

  • The property must be an investment property
  • The replacement property much be like kind
  • The replacement property much be of equal or greater value
  • The seller is prevented from receiving the net cash proceeds
  • The funds much be handled by a third party, known as an accommodator
  • The replacement property much be identified within 45 days
  • The purchase of the replacement property must close within 180 days

shutterstock_118606231There are applications in the law that allow for “partial tax free exchanges”. Under this situation the percentage of cash received under the law is referred to as ‘Boot”. In partial tax free exchanges the proportional percentage of cash received from sale of the property will be subject to the recapture of property depreciation and becomes a taxable event in the year the property is sold.

There are companies known as accommodators that can be retained to perform the duties of handling the funds, filing required forms and completing paperwork required to finalize an IRS 1031 tax free exchange. There are companies that only act as accommodators. There are also escrow companies that provide accommodation services in addition to standard escrow services.

It is very important that any accommodator you chose to handle your transaction needs to have adequate insurance and fidelity bonds to guard against misappropriation of your money while in their custody. There are many reputable companies that can professionally handle an IRS 1031 tax free exchange.

There are reasons other than tax deferment to consider when selling by way of an IRS 1031 tax free exchange. Some things to also consider are:

  • Relinquishment of management duties: The options exists to exchange into a managed real estate investment where monthly management duties are handed by a management company or by a general partner or some other management arrangement.
  • Exchange into a triple net property: Where management duties, costs and expenses relating to property ownership are transferred to the tenant occupying the property.
  • Exchanging multiple properties: It is permissible to exchange numerous properties into one replacement property thus reducing multiple management duties required when owning more than one property.

With tax rates high and possibly going higher in the near future it only makes sense if you are considering selling to take advantage of IRS 1031 and defer taxes now. In a future Blog we will be discussing tax advantages available when selling a personal residence.

 

 

 

 

 

Proposition 13 – The Homeowner’s Best Friend

shutterstock_232656061Many things in life are movable, such as planes, trains and automobiles, to quote a movie title from years past. Or personal items such as TV’s, golf clubs or a suit case, can all be moved from here to there, down the street or even across state lines. But when it comes to moving real estate a stark reality is immediately apparent: real estate is just not movable and the politicians are keenly aware of this fact.

As such, the political powers have always treated real estate as a target of taxation to fund general government services, special government needs or a politician’s pet project. Since real estate is not movable and can’t be transferred to cities or states where taxes might be lower, owners of real estate have historically been the target of high property taxes. They had simply been subject to whatever tax rate was imposed upon them.

By the mid 1980’s property taxes had increased so dramatically that many older homeowners who had owned their properties for many years could no longer afford to pay the property taxes that were expected by the tax authority. Many were on fixed incomes, pensions or were only receiving social security. Their income had not increased as fast as or in proportion to the increase in property tax rates. There were a lot of people who were property rich but cash poor.

In the early eighties Howard Jarvis literally became a one man driving force in advancing the movement that eventually placed Proposition 13 on the California state ballot in 1987. He had experienced the financial burden of his property taxes going through the roof on real estate he owned. In addition he was involved in a tax organization where he became aware of many others who were experiencing the same situation. So he went out and did the logical thing and started soliciting support from others to rally behind his property tax reduction movement. It developed over time to be one of the biggest tax revolutions in the history of California. He was successful in gathering enough registered voter’s signatures to get what was then becoming known as Proposition 13 on the California statewide ballot.

The voters overwhelming passed Proposition 13 on June 6, 1978 by a 2/3 majority vote and immediately the California Constitution was amended (since Proposition 13 was intended to be a constitutional amendment).

Prior to the passage of Proposition 13, properties in California were subject to the following:

  • No limit on the overall rate of tax
  • No annual tax increase limit
  • No remedy available to homeowners

 

Following the passage of Proposition 13, homeowners and property owners throughout all of California were entitled to:

  • Taxes based on 1% of the assessed property value
  • 2% maximum annual increase in total taxes owed
  • Reassessment only upon the sale of the property at 1% of the assessed market value

 

Property tax rates were immediately rolled back to 1976 levels with many homeowners experiencing a 57% decrease in their annual property taxes.

The only time now that properties can be reassessed is when a buyer purchases a property and the assessed value is then calculated at 1% of the price paid which is determined to be the fair market value of the property. For example, if a buyer pays $100,000.00 for a property the annual property taxes would be $1,000.00 (1% of the assessed value) which is payable in 2 installments of $500.00 each. The first installment would be due on November 1st and (delinquent after December 10th) and the second installment would be due February 1st (delinquent after April 10th).

In addition Proposition 13 provides for ¼ of 1% for bonded indebtedness to be assessed and secured by both General Obligation and Special Obligation bonds as passed by government bodies or by the voters.

Most governmental entitles make it a practice to always increase property taxes by the maximum annual 2% allowable under the law.

Currently there are movements by those that think Proposition 13 was the worst thing that ever happened to California. They believe that the government is being starved for money that would, in turn, provide services and payments to those involved in the governmental process. The reality is that ever since Proposition 13 passed 35 years ago government’s tax revenue has had annual increases that have been far above the rate if inflation. The government is doing better than just about every person and company in California. The claims back in 1987 that government services were going to be put in a desperate situation just never materialized.

The people behind this current movement want to begin chipping away at the protections to homeowners against taxation from their government. All homeowners should take very seriously the current movement by those who always want more government services and are now looking to property owners as a funding source for the money for their pet social programs. Many of the people behind the current movement are not property owners but are from the side of society that believes that if someone owns real estate they are by nature rich and as such should be taxed more because they have it and others need it. Since all levels of government throughout California are broke and spending like crazy there are politicians would like nothing more than to get more money to do more things.

probate-estate-loan-financingHome ownership is a pivotal component that is very important in the economy. Repealing Proposition 13 or placing additional property taxation on real estate not only affects current owners now but will add additional impediments to prospective buyers desiring to own real estate. This one action could have a very negative effect not only in the real estate world but to the economy at large.

It would be highly advisable for everyone who reads our blog to get involved in preventing property taxes from going back to the confiscatory level that existed prior to the passage of Proposition 13.

Mortgage vs. A Deed of Trust – What’s in a Name?

Have you ever heard the term “I need a mortgage” or “I just refinanced my mortgage” or another other statement that contains the word mortgage? Was the person making that statement talking about a property in California? Was that person you?

The public has a huge misconception when referring to the legal document used in California known as a mortgage when discussing real estate financing. This is due to the fact that there is no such thing as a mortgage in California. Our country is comprised of 50 states with each state having its own unique laws and customs. States are free to adopt whatever type and form of legal real estate documents.

California is known as a “Trust Deed State” which refers to California legislation requiring that for promissory note to be used as a lien on a property it must be secured with a deed of trust.shutterstock_195175772

The word “mortgage” has simply been adopted by California society as the normal and customary way of referring to a deed of trust, whether knowingly or unknowingly. In fact, there is a mortgage company or bank on just about every corner that advertizes low rates on mortgages. So even the lenders and banks who lend money to purchase or refinance real estate in California are using the wrong word. There are many other such misconceptions often used customarily in society.

The main differences between a mortgage and a deed of trust are listed as follows:

 

Mortgage Deed of Trust
2 party instrument 3 party instrument
Borrower: Mortgagor Borrower: Trustor
Lender, Mortgagee Lender, Beneficiary
Trustee: Has Power of Sale
Reconveyance by Mortgagee Reconveyance by Trustee
Foreclosure by Judicial Action Foreclosure by Trustee Sale

 

As you can see the title of the parties to each respective document is referred to differently, but in each document there is a borrower and there is a lender. It’s just the deed of trust that has the 3rd party that a mortgage doesn’t have. The 3rd party to a deed of trust is the trustee. This is the main difference between the two documents.

The trustee has authority “authorized” by the borrower when they signed the deed of trust. A trustee can be a person, a Title Company or even the beneficiary as it is acceptable for the lender to also be the trustee. The trustee handles reconveying the deed of trust when the loan is paid off or processing a foreclosure sale.

The other main distinction between the two documents is in the way a foreclosure is processed. A mortgage requires that a lawsuit is filed in court and the process is handled in a court of law. The process of foreclosing on a deed of trust is by way of a non judicial process known as a trustee sale. This is processed and conducted by the trustee. A trustee sale is processed outside of court. After simply recording several documents, mailing out notices by certified mail and advertizing in the newspaper for 3 weeks a trustee sale can be held on a street corner or on the courthouse steps. The process is fast and simple.

After a foreclosure sale of a mortgage there is a Right of Redemption period for 1 year allowing the borrower the opportunity under certain circumstances to redeem their property. With a deed of trust that is foreclosed on by way of a trustee sale there is no Right of Redemption. Once the property is sold the borrower has no right to redeem their property.

shutterstock_123019507A deed of trust does allow the lender the option to either foreclose judicially or hold a trustee sale. A judicial sale will take about 1 year to complete and a trustee sale only takes 4 months. A judicial sale does provide for a deficiency judgment which allows the lender the option to foreclose on the property and also get a judgment against the borrower. Lenders almost always though choose the trustee sales route since the timeframe is so much shorter and there is no right of redemption.

The trustee to a deed of trust holds “Naked Title with Power of Sale” for the entire term of the loan. If a borrower has a 30 year mortgage the trustee possesses the power of sale for the entire term of the loan. The power of sale provision only becomes effective if the borrower defaults on their payments. The trustee’s power of sale is only removed when the borrower pays off their loan. The trustee will then issue a deed of reconveyance to the borrower. This action releases the deed of trust against the borrower’s property. It is at this point the trustee’s power ceases to exist.

If the borrower makes the monthly payments and eventually pays off their loan then the differences between the documents will have little to no effect on the borrower. Most borrowers will never even realize the differences.

So, in the future, if someone in California tells you they’re getting a mortgage you can let them know what they really mean is they’re getting a deed of trust.

The Los Angeles Real Estate Market in 2013: Is it Time to Buy or Sell?

How many times have you heard a Los Angeles Realtor tell you that it’s “time to sell”? Most Realtor’s spout that term and the other famous term “time to buy” quite frequently – especially in today’s market. The irony with these statements is that there just might be a time to buy or a time to sell. Even a broken clock is right twice a day.

shutterstock_117139972Today, we want to concentrate on the term “time to sell”, which can be motivated by a number of events or factors, such as finding another house that you “just have to have” or a job opportunity that requires moving. Another possible motivator in selling your home might be determining that a high water mark might have been reached in the value of your house and selling now will provide the opportunity to obtain your equity from the sales proceeds.

Determining when it’s time to sell your home in Los Angeles requires knowledge about the real estate market which requires that you know everything you can about selling homes (values of competing and available homes on the market) and buying (number of buyers in the market). It goes back to the supply/demand ratio and the balance or imbalance of homes and buyers in the market. Currently, there are more home buyers in the Los Angeles market than sellers of homes. Prices are up over the last 12 months, but are they topping out or still have a long way up to go?

This situation can best be explained by an event that took place back in the 1920’s, when Joseph Kennedy was having his shoes shined by a man at a shoe shine stand. While the man was shining his shoes Mr. Kennedy was listening to the man tell him about the stocks that he was buying with the money he was earning from shining shoes. Mr. Kennedy listened intensely to what the man was saying. When the man was done shining his shoes and Mr. Kennedy was walking away Mr. Kennedy said to himself “When the man who shines my shoes is also buying the same stocks I’m buying, it’s time to get out”. Later Mr. Kennedy credited this event with his decision to sell most of his stockholdings prior to the stock market crash in 1929 and thus avoided the terrible losses that so many others suffered on that fateful day in October.

The moral of this story (to consider) is that it’s possible that the “time to sell is when everyone else is buying”.

Our Assessment of The Fed’s Monetary Policies for 2013

There is probably no agency or government department at the State or Federal level that has more effect on our daily lives than The Federal Reserve Bank which is responsible for setting Federal monetary policy.

Monetary policy is set by the Federal Reserve Bank in several ways:

  • The Fed increases and decreases interest rates
  • The Fed also increases or decreases the money supply

Currently the Chairman of the Federal Reserve Bank is Ben Bernanke and he oversees the Federal Open Market Committee which is the division of Federal Reserve Bank that sets monetary policy. Currently the Federal Reserve Bank’s monetary policy is focused on lowering interest rates and expanding the money supply.

A short explanation is in order here.

Lower Interest Rates

Lower interest rates are easy to understand as lower rates lead to additional buying power for products that normally require financing, such as cars and houses. Lower rates equate to lower monthly payments. When people have “additional” buying power due to lower rates they are empowered with added purchasing power which leads to a possible imbalance in the supply/demand ratio, which normally leads to an increase in prices, which is currently happening to the price of houses.

With interest rate at historically low levels, more people are able to qualify for real estate mortgages and are able to buy higher priced homoes than if interest rates were at higher levels. Also when interest rates are at such low levels potential buyers develop the attitude that “they don’t want to miss-out” on the low mortgage rates so even if they were not intending to purchase a home for a year or more in the future they often move up their buying plans to get in on the low rates. The effect of this psychological mindset contributes to additional supply/demand imbalance.shutterstock_267426416

Expansion of Money Supply

The second way that the Federal Reserve Bank sets Monetary Policy is through the expansion and/or contraction of the money supply. Currently the policy is to expand the money supply by many of billions of dollars per month. This is often termed “printing money” and is accomplished by contracts the Federal Reserve Bank sets up with the United State Treasury Department through the buying and selling of bonds, where money is really created out of thin air. This monetary policy can lead to inflation as has happened many times in the past. The main reason that consumer prices have not currently increased is due to the continuing effects of the recession and the anemic economic recovery that the economy is experiencing.

In the near future interest rates will begin to rise from their historic lows and the demand for real estate will decrease which will put downward pressure on home prices. If money supply policy continues unabated (The Fed continues to pour billions into the economy), inflation could rear its ugly head which historically leads to higher real estate prices. When the two opposite forces are compared, the drop off in demand due to increased interest rates should more than offset the inflationary pressure on real estate prices.

Our conclusion is that while real estate prices are currently going up there appears to be a ceiling that will be determined on any increase in mortgage interest rates.

Caution is advised in over optimism about the current increase in real estate prices.