IRS to step up enforcement of Starker exchanges

Survey finds property owners abusing tax rules

By Benny L. Kass
Inman News

If you are considering a 1031 exchange (also known as a "Starker exchange"), you better make sure that you do it right. The Internal Revenue Service plans to increase its audits and its enforcement of these exchanges by the summer of 2008.

Usually, when a taxpayer sells a business or investment property, the taxpayer must pay a tax on any profit that is made. If the property was owned for more than one year, it will normally be considered a long-term capital gain and the tax will be based on your income. Currently, the highest tax rate is 15 percent.

However, if the taxpayer engages in an exchange, and strictly follows the complex rules, this gain can be postponed. For example, if you purchased your investment property for $100,000 and sold it for $200,000, you would in most cases have to pay the IRS $15,000 in addition to any state or local tax. However, if this property was sold in connection with a Starker exchange and you obtained another investment property worth $300,000, you would not have to pay any capital gains tax. Instead, the basis of the old property would be transferred to the new one; you would have to pay the tax only when you ultimately sold the replacement property and did not engage in yet another 1031 exchange.

But you must understand that a 1031 is not a "tax-free" process; it only defers the time when you have to pay the capital gains tax.

In a report issued last month, the Treasury Inspector General for Tax Administration (TIGTA) advised the IRS that "there appears to be little IRS oversight of the capital gains (or losses) deferred through like-kind exchanges."

When a taxpayer engages in a 1031 exchange, he or she must file Form 8824 with the IRS for the year in which the exchange took place. The Inspector General reported that more than 338,500 forms were filed in 2004 (the year of the TIGTA's study). This amounted to deferred gains or losses of more than $73.6 billion. According to the report, "while this represents a doubling of the number of like-kind exchanges reported in 1998, the total dollars amounts deferred more than tripled."

Like-kind 1031 exchanges serve a valuable function. According to the TIGTA report:

Taxpayers who take advantage of like-kind exchanges increase their purchasing power, as well as their financing and leverage capabilities, because payment of federal tax on the gains is deferred ... with additional equity to reinvest, taxpayers can execute exchange after exchange to create a pyramiding effect. The tax liability may be forgiven upon the death of the investor because the heirs may qualify for a stepped-up basis on the inherited property.

But because of the lack of enforcement by the IRS, taxpayers have been taking advantage of these favorable tax rules. For example, the Government Accountability Office (GAO) conducted a similar survey and found that taxpayers often made misrepresentations of the assets that were being exchanged. In order to have a successful 1031 exchange, real property must be exchanged for like-kind property. While this is a very broad category -- you can exchange a single-family investment property for raw land, an office building for a shopping center, or a condominium unit for a cooperative apartment -- the exchange will not be accepted if you want to exchange your principal residence for some other kind of property. Nor can you exchange a business for real property: it is not "like-kind."

However, the Inspector General discovered that the IRS generally will not impose any penalties if a taxpayer does not file Form 8824.

The report also highlighted other abuses, such as related party exchanges, incorrect basis figures, and partial, step and bartering exchanges. These are highly complex technical issues that will not be discussed or explained in this column.

Based on its findings, the Inspector General made three specific recommendations, all of which have been accepted by the IRS.

1. The IRS should study tax-reporting and compliance issues involved with like-kind exchanges The IRS agreed to conduct research studies and complete its work by Aug. 15, 2008. Based on the outcome of this research, it appears likely that exchanges that take place this year will be given greater scrutiny.

2. The IRS should provide better information and guidance to taxpayers on how to conduct a proper 1031 exchange. The IRS has agreed that by Jan. 15, 2008, it will provide more information on a number of its publications and forms so as to assist taxpayers in understanding how the exchange process works. Specifically, Publication 17 (entitled Your Federal Income Tax) will be updated to specifically remind taxpayers that they must file Form 8824 with their income tax return if they have been involved in a 1031 exchange during the previous year.

3. The IRS must provide clear guidance to taxpayers regarding the rules and regulations governing like-kind exchanges with respect to second and vacation homes that were not used exclusively by owners.

This is an area that is extremely complex. According to the Inspector General, "the absence of clarification on this issue leaves unrebutted the sales pitch of like-kind exchange promoters who may encourage taxpayers to improperly claim deferral of capital gains tax by selling nonqualified second and vacation homes through 'tax-free' exchanges."

Here, too, the IRS agreed. By March 15, 2008, the IRS will provide additional information to consumers and to tax practitioners about the filing requirements for Form 8824. More importantly, the IRS will increase its "consumer warnings" so as to caution taxpayers to be "wary of individuals promoting improper use of like-kind exchanges."

The IRS will not discourage the use of the Starker exchange. This process is specifically authorized in Section 1031 of the Internal Revenue Code. But investors must be on their guard against deceptive and fraudulent promotional schemes. Keep in mind that a Starker exchange is not a "tax-free" exchange; it is a "tax-deferral." If done properly, it will allow the taxpayer to use the moneys that otherwise would go to Uncle Sam for additional investments.

If you plan to get involved in a 1031 exchange, you should make sure your own lawyer and accountant review the process at every step.

In fact, depending on the amount of your gain, it may be best to just pay the capital gains tax and not become a landlord on the new replacement property. Your financial advisors will be able to assess and assist you in making this important decision.

(Note: The entire report can be located on the Web at www.tigta.gov; click on 2007 audit reports. It is report 2007-301-72).

Even thirtysomethings need living trusts

Untimely death means major assets must be probated

By Robert J. Bruss
Inman News

DEAR BOB: My 31-year-old niece died recently without a will. She purchased a condominium about three months ago. Can her mom now sell the condo, or does she have to do something else first? --Georgia Z.

DEAR GEORGIA: Unfortunately, because your niece died intestate without a will or a revocable living trust, her condo and other major assets will have to be "probated." That means the local probate court will determine who inherits her assets.

If her mother is her closest living relative, the state law of intestate succession will probably give the assets to the mother after all debts are paid.

Before the mother can sell the condo, she first must receive the title transferred to her name by the probate court. Depending on the state where the condo is located and the local court backlog, this can take six to 12 months, sometimes longer. The mother should consult a local probate attorney.

This sad and potentially costly situation could have been avoided if your niece held title to her condo and other major assets in her revocable living trust. If that had been done, probate costs and delays would be avoided. The named successor trustee (presumably her mother) could then have transferred title according to the terms of the living trust. More details are in my special report, "24 Key Questions Answered: Living Trust Secrets Reveal How to Avoid Probate Costs and Delays," available for $5 from Robert Bruss, 251 Park Road, Burlingame, Calif., 94010, or by credit card at 1-800-736-1736 or instant Internet delivery at www.BobBruss.com.

BIG POTENTIAL PROBLEMS WITH HOME SELLER'S REMORSE

DEAR BOB: I recently put my house up for sale. I received a purchase offer from a buyer and we agreed on closing the sale. But due to job-related issues, I am no longer willing to move and do not want to close the sale. Can I get out of this agreed purchase offer without selling my home? --Tim S.

DEAR TIM: Home seller's remorse can be a very expensive disease for a home seller. Presuming there are no loopholes in the sales contract for you to cancel the sale, if your buyer really wants to own your house he can sue you in a specific performance lawsuit.

He will probably record a "lis pendens" against your title to effectively prevent you from selling to another buyer or refinancing the mortgage.

If there was a listing agent or a buyer's agent, even if you can get the buyer to cancel the sale, you may still owe a sales commission because a ready, willing and able buyer was found by the agent.

Be sure to consult the agent(s) to learn if you will have to pay a sales commission even if no sale takes place. For more details, please consult a local real estate attorney.

TAX-DEFERRED EXCHANGE DOESN'T APPLY TO PERSONAL HOME

DEAR BOB: Can a Starker tax-deferred exchange be used on a primary residence? I find myself moving often within the same town. My next move will be within less than 24 months. I am always moving up in value and equity. --Eric G.

DEAR ERIC: Sorry, an Internal Revenue Code 1031 tax-deferred exchange applies only to real estate held for investment or use in a trade or business, such as a rental house. Your personal residences won't qualify.

However, if you own and occupy your principal residence at least 24 of the last 60 months before selling, then Internal Revenue Code 121 applies and you can claim up to $250,000 tax-free capital gains (up to $500,000 for a married couple where both spouses meet the occupancy test).

You could be entitled to a partial IRC 121 exemption if the sale is due to health reasons, job location change qualifying for the moving expense tax deduction, or unforeseen circumstances. For full details, please consult your tax adviser.

HOW A JOINT TENANT PARTIALLY BROKE UP A JOINT TENANCY

DEAR BOB: My husband and I together with a third party owned a house under joint tenancy with right of survivorship. The third party married and quitclaimed his one-third share into a revocable living trust. The third party died a year ago. The quitclaim deed was recorded, but I do not believe the deed was changed. Has the joint tenancy been broken if a new deed was not recorded? --Donna L.

DEAR DONNA: Unless the house is located in one of the few states that require issuing a new deed each time title is transferred, the recorded quitclaim deed from the joint tenant to his living trust transferred his one-third share. The other two-thirds remain undisturbed as joint tenants. Nothing further is required.

The one-third share that was held in the deceased's living trust may now be distributed according to the terms of the deceased's living trust.

Transfer of a joint tenant's interest in a property does not require the consent of the other joint tenants. For full details, please consult a local real estate attorney.

NO STEPPED-UP BASIS IF WIDOW DIDN'T INHERIT ANYTHING

DEAR BOB: Does a widow get a new stepped-up basis on a home where the title was only in her name? Her husband died in 2005 but was not on the title because of his poor credit. --David F.

DEAR DAVID: Sorry, but the widow didn't inherit anything. To obtain a new stepped-up basis for the asset's market value on the date of the decedent's death, there must be an inherited asset. Therefore, the widow doesn't get a new stepped-up basis. She should consult her tax adviser for full details.

WHEN SELLING HOME, ALLOW EXTRA TIME TO PAY OFF IRS TAX LIEN

DEAR BOB: We are in the process of prepping our home for sale. We have an IRS tax lien on which we are making monthly payments. Will the tax lien have to be paid off before we list our home for sale, or can we pay the lien off when we pay off the mortgage at the closing? --Candace P.

DEAR CANDACE: You can list your home for sale with a real estate agent while the IRS lien remains on your title. However, be sure to disclose the situation to the listing agent. Explain you plan to pay off the IRS lien from the sales proceeds when the home sale closes.

The IRS tax lien must be paid off at or before the closing so you can deliver marketable title to your buyer. Be sure to allow extra time so the IRS can receive your final payment and remove the lien from your title.

Consult the firm that you expect to handle the closing of the sale now for details on the extra time needed because the IRS is not known for speedy service.

IS HOME SELLER'S WRITTEN DISCLOSURE LEGALLY BINDING?

DEAR BOB: How legally binding is a home seller's disclosure statement? I have a statement that says all major systems are in working order. This is not the case. --Dave R.

DEAR DAVE: If you can prove the home seller knew of a significant property defect but failed to disclose it to you before you bought the house, the seller may be liable to you for the cost of repairs.

However, your difficulties will be (a) proving the seller knew of the undisclosed defect; (b) obtaining a court judgment (presuming the seller denies knowledge of the defect); and (c) collecting on that judgment from the seller.

If the defect is not expensive to repair, after sending a written demand letter to the seller setting a deadline for the seller to make repairs at his expense, rather than hiring a real estate attorney you might consider taking the seller to the local small claims court.

CAN CONDO BUYER TAKE OVER THE MORTGAGE PAYMENTS?

DEAR BOB: My partner and I own a condo located on a golf course. We bought it two years ago for $275,000 and are presently renting it for $1,400 per month. With property taxes and other fees, we have a $700-per-month negative cash flow. We are both retired and this is becoming a burden. If we sell, after paying a sales commission and because property values have dropped in our area, we would probably wind up with about $234,000, which is approximately our mortgage balance. Are there any companies that would buy our mortgage for what we owe? --Robert T.

DEAR ROBERT: Nobody buys an existing mortgage for its balance because there's no profit.

What I think you are asking is can the condo be sold to someone who will take over your mortgage payments? Your tenant is the obvious logical buyer. Have you asked him?

Be sure to get the mortgage lender's permission for the buyer to take over payments. In today's home-sale market, the lender would be crazy not to approve a mortgage takeover by a creditworthy buyer.

www.LagretRealEstate.com

Can sibling force sale of inherited house?

Sister refuses to give up comfortable living situation


By Robert J. Bruss
Inman News



DEAR BOB: My mother died about two years ago. Her will left everything to my sister and me equally. I was living with my mom when she died of cancer, so my sister has allowed me to live in the house if I pay the property taxes and insurance. There is no mortgage. The house is worth around $400,000. Now my sister thinks we should sell the house, but I don't want to sell, as I am very satisfied with the status quo. Can my sister force me to sell? --Naomi N.

DEAR NAOMI: Yes. As a co-owner, your sister can bring a partition lawsuit to force the sale of the house. In most partition lawsuits, the judge orders the property sold with the sales proceeds divided among the titleholders.

It is extremely difficult to defend a partition lawsuit unless there are extraordinary circumstances. To save litigation costs, you and your sister could enter into an agreement to sell the property and divide the net proceeds, thus saving court attorney fees.

NO INHERITANCE IF DECEASED SPOUSE DIDN'T HOLD TITLE TO HOME

DEAR BOB: My wife died last year. Under the terms of her will, I inherited all her assets, including the house. I just presumed as the sole heir I would receive a new "stepped-up basis" to market value, as you often discuss. However, when I recently consulted my tax adviser about selling the house, she says that because title to the house was held in my name alone, I didn't receive any stepped-up basis and am stuck with our low $47,000 purchase price many years ago. Is this true? --Marv W.

DEAR MARV: From your description, your tax adviser appears to be correct. If the title to the home was held in your name alone, when your wife died last year, you didn't inherit anything so you didn't receive a new partial or full stepped-up basis to market value. Your tax adviser appears to be correct.

NO TAX-DEFERRED EXCHANGE OF U.S. TO FOREIGN REAL ESTATE

DEAR BOB: Due to a semi-permanent overseas job transfer and big promotion, we decided to sell our apartment building here in the United States at a substantial profit. Our plan was to buy a similar rental building near London. But our tax adviser said we can't make a tax-deferred exchange of a U.S. rental property for a foreign rental property. If Uncle Sam taxes our overseas earnings, why can't we make such a tax-deferred exchange? --Richard R.

DEAR RICHARD: I don't make the tax laws. If I did, everything would be fair and just.

Although I am told it is possible to make an Internal Revenue Code 1031 tax-deferred exchange of a foreign rental or business property for another qualifying foreign property, under current tax law it is not possible to make an IRC 1031 tax-deferred exchange of a U.S. rental property for a qualifying foreign rental property, or vice versa. Your tax adviser appears to be correct.

www.LagretRealEstate.com