My New Blog

We are now officially in a recession?  What does that mean to you and your financial situation?  Frankly, I don't know.  And neither does anyone else.  Why not?

Because we don't KNOW your financial situation as it exists now.  Do you? 

If not, you may want to start gathering your financial documents together to see just where you are today.

No one can get to where they want to go without knowing where they are.

IRS to step up enforcement of Starker exchanges

Survey finds property owners abusing tax rules

Thursday, January 24, 2008

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).

Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to benny@inman.com.

I must confess that I am going through an existential crisis right now.  I am learning what the money system is all about and how it works.  And I really DO NOT like the answers.

I'm not at all certain that I can continue in the industry, when I believe that it is set up to ultimately and quite deliberately fail--as far as the little person is concerned--to line the coffers of a very few people at the top of the financial food chain.

I do understand that I am probably helping people more by at least informing and educating them on the best mortgage products that are currently available for them, since I realize that they will undoubtedly be pursuing a mortgage regardless of my personal angst.  Running away to proclaim my innocence in the process will  not be helpful.

Please take a look at google video's top 100-viewed videos and find the one entitled "Money as Debt" for a simplified understanding of the situation.

http://video.google.com/videoplay?docid=-9050474362583451279

A man goes to the doctor (a podiatrist) and says, "Doc, you did such a good job on my foot 5 years ago that I thought of you first.  You see, my neighbor just got bypass surgery, and my dad got bypass surgery years ago, and they are both in great health today.  I want you to tell me how much you'll charge me for a bypass--and I'm asking other doctors too, so you better quote me a good price!"

Hopefully, the doctor will say, "Well,  I'm not really qualified to perform that kind of surgery.  And by the way, have you had any tests to determine if you really NEED a bypass?  Let me suggest a few good cardiologists to you."

That's pretty much what it's like when someone calls up any lender out there and says, "My dad told me to get a 30-year fixed loan, and I'm calling around to see who has the lowest rates."

If you want to get financially healthy, you need to go to a financial specialist.  One who will ask you the questions needed to understand your current situation and what you are hoping to accomplish.  The expert also needs to understand those things that you fear will happen if you follow one piece of advice over another.  Don't withhold vital information from your broker.  And ASK them if they know how to do mortgage planning--not just how to fill out an application form.

You have no doubt by now heard all the hoopla surrounding each of the Federal Reserve Board's meeting and decisions to reduce interest rates.  Many of you have expressed surprise that each of the reduction in rates that you've heard about has not resulted in equal reduction in mortgage rates.  Rates are down, but not by as much as the Feds have reduced them.  So what gives?

First, a short primer on just who constitutes the Federal Reserve Board:  Mosst of the following is taken from http://www.federalreserve.gov/pubs/frseries/frseri.htm

On December 23, 1913, the Federal Reserve System, which serves as the nation's central bank, was created by an act of Congress. The System consists of a seven member Board of Governors with headquarters in Washington, D.C., and twelve Reserve Banks located in major cities throughout the United States. [Farmers across the nation were going bankrupt because the Eastern banks were pulling their credit right when the farmers needed it the most.  The theory was to enable other banks across the country responsive to their local needs.]

The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14-year terms of office. Members may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term.  [Think about this--political appointees hold FOURTEEN year terms!  That's one heck of a long time for any president to have his economic policies in place--well beyond any one President's own term in office!]

The primary responsibility of the Board members is the formulation of monetary policy. The seven Board members constitute a majority of the 12-member Federal Open Market Committee (FOMC), the group that makes the key decisions affecting the cost and availability of money and credit in the economy. The other five members of the FOMC are Reserve Bank presidents, one of whom is the [ALWAYS the] president of the Federal Reserve Bank of New York. The other Bank presidents serve one-year terms on a rotating basis. By statute the FOMC determines its own organization, and by tradition it elects the Chairman of the Board of Governors as its Chairman and the President of the New York Bank as its Vice Chairman. [So, the Eastern banks will ALWAYS be represented, with a consequently disproportionate share of power.  Just what was supposedly avoided.]

When account holders panic and think their money is no longer safe in their bank, they may all rush at once to withdraw their money in what is referred to as a "run on the bank."  In the past, that was actually a wise move for each individual to protect his own money, but it had the affect of devestating the entire economy--why?  Because the banks had loaned out so much money that they had very little cash available for withdrawals. 

Now, each bank MUST have a certain amount of cash reserved in its vaults at the end and beginning of every day.  If they don't they must borrow it at least overnight from a bank that has more than enough reserves.  THIS is the rate that the Feds determine--how much banks can charge each other for overnight funds.  But, recently some banks have been refusing to loan their excess reserves for fear of not having sufficient funds themselves--or not getting the money back.

So, when no bank can be certain of its financial health at the end of any given day, they reduce their risk by selling fewer loans at higher rates.

Prior to my incarnation as an equity manager, I had my own real estate appraisal business--and before that, I was an appraiser in the assessor's office.  So lots of folks have been asking me my views on what the local real estate market will do.

One gentleman who asked me this recently became very upset with my answer--as if my merely speaking my opinion would create the conditions where my prognostications would come true.  He believes, like so many others seem to, that low interest rates will equate to more housing purchases, at ever increasing prices.  He thinks that we are "different" from "America" as we islanders so affectionately refer to the "continental US."

Granted, we've had things pretty good here lately, with very low unemployment and commensurately higher initial wages, along with high appreciation in housing values.  And when the national economy was in trouble in the early 90's after a long run-up in housing prices, our home values managed to at least stay level and not actively decrease.  However, I believe that, even though we are an island county, we are NOT isolated from national and global economic realities. 

Now, I'm a mortgage broker and have seen over 200 lenders go out of business in the last year. I've also watched as the Fed Reserve has tried to continue artificially stimulating the econony with lower rates.  BUt low rates aren't going to help those borrowers who are unable to meet their current monthly debts--because their credit got slammed and now they won't qualify for lower rates.  And low rates aren't going to help borrowers come up with a 20% down payment on a home, even if the borrower could afford the mortgage payments.  We're finally going back to borrowers HAVING to have "some skin in the game"--we are going to have to go back to learning how to save money again.  We are going to have to go back to personal responsibility.

Why will this affect home values?  Because we DON'T SAVE OUR MONEY!  We SPEND it!   And if lenders won't lend to borrowers who don't save, sellers are going to have fewer buyers on hand.  Fewer buyers and more sellers--  sounds like supply and demand to me, and I don't have any degree in economics.  Some sellers will be forced to sell at rock bottom prices--those sellers with the most equity will be OK.  They'll come out with SOMETHING, anyway.  But those buyers with little equity may very well lose thousands of dollars if they HAVE to sell.  And that means that those sellers, will NOT be buyers again until they can recoup their losses.  Once again, fewer buyers and more sellers.

How to get off the not-so-merry-go-round?  Simple.  Get yourself out of debt; build up your cash reserves for emergencies and then build up some more to invest.  Seek out good advice on how to invest and then FOLLOW it.  Get your retirement plan funded.  Be reasonable and be responsible.  And remember, SIMPLE does not equal EASY.