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Avoiding A Big Tax Bill On Real Estate Gains

Selling your home for a huge profit is nearly every homeowner’s dream come true. Who wouldn’t want to make a pretty penny off his or her home? But in order to really profit on your home’s sale, you may want to defer taking your profit in lump sum. Read on to find out why, and to learn about another option: an installment sale.

Big Payout = Big Tax Bill
Let’s take a look at a common homeowner situation:

Example – When a Gain on a Property Increases Tax Liability
Hal Bookman looked at the buyer\’s offer for his rental home and couldn\’t believe the number that was printed there. His property had doubled in value in only five years, and he hadn\’t considered it cheap even when he bought it. However, when Hal gleefully told his tax advisor about the sale, his advisor was less excited; taking the income in one lump sum would not be in Hal\’s best interest from a tax perspective.
If Hal declares the entire proceeds of the sale in the same year he sells the property, he will be ineligible for virtually all of the tax credits to which he would normally be entitled. His itemized deductions would also be reduced as a result of the additional income from the sale. Hal asks his tax advisor if there is anything he can do to reduce his taxable income for the year. The advisor knows just the tool to use: an installment sale agreement.

The Purpose of Installment Sales
According to Publication 537, the IRS allows taxpayers to defer gains on major sales of property or other investments with an installment sale agreement. This arrangement permits sellers to declare a prorated portion of their capital gains over several years, as long as the proper paperwork is completed during the year of the sale.How the Installment Sale Method Works
Declaring gains under an installment sale is theoretically simple. The taxation of installment sales mirrors that of annuities, where a prorated portion of each payment is considered a return of principal. The only stipulations are that the property being sold cannot be a publicly traded security of any kind, and the taxpayer cannot be a dealer of the sold property in any sense.

Let’s take a look at an example of this method, and see how Hal could structure his installment sale if he wanted to defer his income taxes to a future year.

Example – Deferring Taxes With an Installment Sale
Hal receives $400,000 for his rental home. He bought the property for $188,000 and paid $12,000 in selling expenses, which are added to the home\’s basis, making it $200,000. Therefore, Hal has $200,000 ($400,000 – $200,000) of reportable gain to declare. Hal\’s advisor recommends he break down his sale proceeds into eight annual installments of $50,000 each, instead of declaring $400,000 in one year. As long as the installments are constructively received each year, this method will allow Hal to remain eligible for tax credits and deductions that the lump-sum payment would prevent him from receiving.

Reporting Installment Sale Income
Installment sale income can be broken down into three separate categories: gain, principal and interest. Each of these categories is treated differently on Form 1040.Capital Gain
In the above example, Hal must declare the gain each year as being either long or short term depending upon whether the gain was long or short term in the year of the sale. Long-term gains are taxed at a lower rate, while short-term gains are taxed as ordinary income. Because Hal held the house for five years, the gain in this case will be long-term. If the gain had been short-term, Hal still would be taxed on the installment income at a lower rate than he would if he had to declare the lump sum gain. This is because short-term gains are taxed as ordinary income at the taxpayer’s top marginal tax rate. The gain from an installment sale is reported on IRS Form 6252 and then carried to the Schedule D on Form 1040.

Taxpayers with installment sale income must also charge interest to the buyer at a rate that is the lower of the applicable federal rate (or 9% compounded semiannually). The buyer will pay interest on the unpaid installments until the balance has been remanded. Therefore, if Hal charges the 9% rate on his sale to the buyer, he will also receive and report approximately an additional $4,500 of interest income for each $50,000 installment that has yet to be paid. The interest is reported separately as ordinary interest income on Schedule B. (Note: If the interest is not reported separately, then the IRS will consider part of the sale proceeds to be interest.)

Part of each installment sale is considered by the IRS to be a tax-free return of principal. This amount can be determined by calculating the exclusion ratio. Divide the amount of actual gain by the sale price, which in this case is $200,000/$400,000, providing an exclusion ratio of 50%. Simply multiply this ratio by the amount of the installment: This is the amount that is to be excluded from tax because it is designated as principal. Therefore, $25,000 ($50,000 x 50%) of principal is returned each year.

Mortgages and Contract Price
If the buyer of the property assumes a mortgage or some other promissory note with the purchase, the cost basis of the property must be reduced by the amount of the mortgage/note. For example, if the rental property that Hal sold for $400,000 has a mortgage of $100,000, then the contract price is reduced to $300,000 ($400,000-$100,000). This means that Hal will only have $100,000 of total gain to report in installments.

If the amount of the mortgage exceeds the total adjusted basis of the property, then the difference must be reported as a payment in the first year, and the contract price is increased by that amount. For example, if Hal’s property has a mortgage of $250,000, the basis of the house will be $200,000 ($188,000 + $12,000). In this case, Hal will have to report an excess payment of $50,000 during the first year in addition to the installment payment. The contract price will also then be $250,000, leaving $150,000 for a taxable gain.

There are many rules and regulations pertaining to installment sales that must be followed carefully. However, those who understand the rules can retain their eligibility for many deductions and credits that must otherwise be forfeited. For more information on subtopics like changes in selling price, the different forms that payments received can take, and when it might be better to forgo an installment agreement and take a lump-sum payment instead visit the IRS website or consult your tax advisor.

If you’re selling a prime piece of real estate, you can probably get top dollar in today’s market. But it may be worthwhile to structure the deal so you receive payments over several years.

Strategy: Sell the property on the “installment sale” basis. As long as you receive payments from the buyer in two or more tax years, you don’t owe current tax on all of your gain in the year of sale.

Not only does this defer the tax, it may also reduce your overall tax bill on the gain.

Recent tax-law changes further encourage real estate sellers to use the installment-sale method.

Here’s the whole story: Under the installment sale rules, only a portion of the gain is taxable in the year in which you receive a payment. Also, the taxable portion on the sale qualifies for favorable capital gain treatment.

The current maximum federal income tax rate on long-term capital gains is 20% for taxpayers in the highest ordinary income tax bracket. How­­ever, most taxpayers will owe no more than 15% to the feds on long-term capital gains. For sales of depreciable real estate, a maximum federal rate of 25% applies to the portion of gain attributable to your depreciation deductions. In addition, a 3.8% Medicare surtax now applies to the lesser of “net investment income,”(NII) which includes most sales of rental real estate properties, or the amount by which your modified adjusted gross income (MAGI) exceeds a threshold of $250,000 for joint filers (or a MAGI of $200,000 for single filers). These figures are not indexed for inflation.

Thus, you could pay an effective tax rate of 23.8% (20% + 3.8%) or 28.8% (25% + 3.8%) on the sale of highly appreciated long-term capital gain property in 2015.

What is the taxable portion of the payment? It’s based on the “gross profit ratio.” Gross profit ratio is determined by dividing the gross profit from the real estate sale by the contract price.

Example: You acquired a parcel of commercially zoned land several years ago. It has an adjusted tax basis of $600,000. In 2015, you agree to sell the property for $1.5 million in five annual installments of $300,000 each with the first installment received in 2015. Because your gross profit is $900,000 ($1.5 million – $600,000), the taxable percentage of each installment payment is 60% ($900,000 divided by $1.5 million).

When you report the sale on your 2015 tax return, you’re only taxed on $180,000 of gain (60% of $300,000), reducing your exposure to the 20% capital gains rate and the 3.8% net investment income tax.

For simplicity, let’s say you save the 5% capital gains differential on $100,000 of income each year. That’s a tax savings of $25,000 (5% of $500,000)—well worth the wait.

Finally, watch out for a little-known tax trap. If the sales price of your property (other than farm property or personal property) exceeds $150,000, interest must be paid to the government on the deferred tax to the extent that your outstanding installment receivables exceed $5 million.

Thursday, 2 Jun 2016 | 9:26 AM ET

It looks so easy on TV. Buy a bargain-basement house, pull up some nasty carpet, re-tile the bathroom, paint away the wall stains and sell it for a hefty profit.

It’s not, however, all those popular shows that are driving the flipping market today. It’s pure and simple prices — and profit. There is a severe lack of good quality, turn-key homes for sale, and that has created a seller’s market across the nation, even for those reselling homes.

After cooling off in 2014, home flipping is on the rise again — its share of all home sales is up 20 percent in the first three months of this year from the previous quarter and up 3 percent from the same period a year ago, according to a new report from RealtyTrac, which defines a flip as a property bought and resold within a 12-month period.

While flipping today is nothing like it was during the housing boom a decade ago, when investors used risky mortgages, it is reaching new peaks in 7 percent of the nation’s metro markets, including Baltimore, Buffalo, New Orleans, San Diego and even pricey Seattle.

Dana Rice, real estate agent and home flipper, at her latest project in Bethesda, Maryland, a very small colonial, within walking distance to shops and Metro.

Diana Olick | CNBC
Dana Rice, real estate agent and home flipper, at her latest project in Bethesda, Maryland, a very small colonial, within walking distance to shops and Metro.

“While responsible home flipping is helpful for a housing market, excessive and irresponsible flipping activity can contribute to a home price pressure cooker that overheats a housing market, and we are starting to see evidence of that pressure cooker environment in a handful of markets,” said Daren Blomquist, senior vice president at RealtyTrac.

That’s because flippers today largely use cash — 71 percent did in the first quarter of this year. Compare that to just 27 percent who used cash at the height of the housing boom. That helps keep most flippers conservative, but it also exacerbates the problems for entry-level homebuyers, who are facing one of the tightest housing markets in history. They simply can’t compete against all-cash buyers.

Usually flippers look for distressed properties either in the foreclosure process or already bank-owned. These are not always listed on public sale sites. There are fewer of those today, so flippers are moving to the mainstream market, creating that new pressure.

“A telltale sign is when flippers are acquiring properties at or close to full market value. Those markets are so competitive that even the off-market properties flippers are looking to buy are not selling at much of a discount — and there may be very few distressed properties available,” said Blomquist.

Examples of these markets include San Antonio, where Blomquist says flippers are actually purchasing at a 7.8 percent premium above estimated full market value, as well as Austin, Texas; Salt Lake City; Naples, Florida; Dallas and San Jose, California.

Despite the premium to buy, flippers are still seeing growing gains in profit. Home flippers realized an average gross profit of more than $58,000 in the first quarter of this year, the highest since the third quarter of 2005, according to RealtyTrac.

Real estate agent Dana Rice and her husband flip houses in the tony D.C. suburb of Bethesda, Maryland. Prices there are well above the national median, and there are few distressed properties. Instead, they target old, small fixer-uppers. Even those command a hefty purchase price up front, but they can also offer big rewards.

“I didn’t want a teardown. There is so much character in this part of Bethesda,” said Rice. “I don’t think that everybody wants a brand new build. There is a hole in the market because not everyone wants to do a renovation. If you put a little bit of effort in, these numbers can be huge.”

Rice purchased her latest project, a very small colonial, within walking distance to shops and Metro, for $680,000. She expects to put half a million dollars into the renovation, adding both square footage and high-end finishings; she is confident that in this competitive market she will see an 18-25 percent return on investment.

“It’s like birthing a baby. … If you’re overpriced, you’re dead in the water.” -Dana Rice, real estate agent and home flipper

“It’s like birthing a baby,” she said, noting that she will wait to list it until she feels the market is just right. “If you’re overpriced, you’re dead in the water.”

The lack of inventory is certainly a double-edged sword for flippers. Their initial investment price can be high, and flippers are often competing against local builders, who may want to tear the house down and put something up that is twice the size. On the other hand, not everyone wants or can afford a huge, new, expensive home, and that gives flippers the edge.

“The key here is that there is particularly a dearth of listed inventory in good condition,” said Blomquist. “That is the inventory flippers are competing against when they sell.”

Reference Book – A Real Estate Guide

* Please note, format and page numbers differ from the printed version. The printed version will be available for purchase after January 5, 2011. To purchase a copy, submit a Publications Request (RE 350) . The chapters of the Reference Book below are in PDF format. You will need Adobe Reader to view them.

Reference Book

  • Introduction
    Cover, Preface, Location of Department of Real Estate Offices, Past Real Estate Commissioners, A Word of Caution
  • Chapter 1 – The California Department of Real Estate
    Government Regulation of Brokerage Transactions, Original Real Estate Broker License, Corporate Real Estate License, Original Salesperson License, License Renewals – Brokers and Salespersons, Other License Information, Continuing Education, Miscellaneous Information, Prepaid Residential Listing Service License, Enforcement of Real Estate Law, Discrimination, Notice of Discriminatory Restrictions, Subdivisions, Department Publications, Recovery Account
  • Chapter 2 – The Real Estate License Examinations
    Scope of Examination, Preparing for an Exam, Exam Construction, Examination Weighting, Exam Outline, Exam Rules – Exam Subversion, Materials, Question Construction, Multiple Choice Exam, Q and A Analysis, Sample Multiple Choice Items
  • Chapter 3 – Trade and Professional Associations
    Real Estate Associations and Boards, Related Associations, Ethics
  • Chapter 4 – Property
    Historical Derivations, The Modern View, Personal Property, Fixtures, Legal Difference Between Real and Personal Property, Land Descriptions, Other Description Methods
  • Chapter 5 – Title to Real Property
    California Adopts a Recording System, Ownership of Real Property, Separate Ownership, Concurrent Ownership, Tenancy in Partnership, Encumbrances, Mechanic’s Liens, Design Professional’s Lien, Attachments and Judgments, Easements, Restrictions, Encroachments, Homestead Exemption, Assuring Marketability of Title
  • Chapter 6 – Transfer of Interests in Real Property
    Contracts in General, Essential Elements of a Contract, Statute of Frauds, Interpretation, Performance and Discharge of Contracts, Real Estate Contracts, Acquisition and Transfer of Real Estate
  • Chapter 7 – Principal Instruments of Transfer
    A Backward Look, the Pattern Today, Deeds in General, Types of Deeds
  • Chapter 8 – Escrow
    Definition, Essential Elements, Escrow Holder, Instructions, Complete Escrow, General Escrow Principles, General Escrow Procedures, Proration, Termination, Cancellation of Escrow – Cancellation of Purchase Contract, Who May Act As Escrow Agent, Audit, Prohibited Conduct, Relationship of Real Estate Broker and the Escrow Holder, Designating the Escrow Holder, Developer Controlled Escrows – Prohibition
  • Chapter 9 – Landlord and Tenant
    Types of Leasehold Estates, Dual Legal Nature of Lease, Verbal and Written Agreements, Lease Ingredients, Contract and Conveyance Issues, Rights and Obligations of Parties to a Lease, Condemnation of Leased Property, Notice Upon Tenant Default, Non-Waivable Tenant Rights, Remedies of Landlord, Disclosures by Owner or Rental Agent to Tenant
  • Chapter 10 – Agency
    Introduction, Creation of Agency Relationships, Authority of Agent, Duties Owed to Principals, Duties Owed to Third Parties, Rights of Agent, Termination of Agency, Special Brokerage Relationships, Licensee Acting for Own Account, Unlawful Employment and Compensation, Broker-Salesperson Relationship, Conclusion
  • Chapter 11 – Impact of the Penal Code and Other Statutes
    Penal Code, Unlawful Practice of Law, Business and Professions Code, Civil Code, Corporations Code
  • Chapter 12 – Real Estate Finance
    Background, The Economy, The Mortgage Market, Overview of the Loan Process, Details of the Loan Process, Federal and State Disclosure and Notice of Rights, Promissory Notes, Trust Deeds and Mortgages, Junior Trust Deeds and Mortgages, Other Types of Mortgage and Trust Deed Loans, Alternative Financing, Effects of Security, Due on Sale, Lender’s Remedy in Case of Default, Basic Interest Rate Mathematics, The Tools of Analysis
  • Chapter 13 – Non-Mortgage Alternatives To Real Estate Financing
    Syndicate Equity Financing, Commercial Loan, Bonds or Stocks, Long-Term Lease, Exchange, Sale-Leaseback, Sales Contract (Land Contract), Security Agreements (Personal Property)
  • Chapter 14 – Real Estate Syndicates and Investment Trusts
    Real Estate Syndication, Real Estate Investment Trusts
  • Chapter 15 – Appraisal and Valuation
    Theoretical Concepts of Value and Definitions, Principles of Valuation, Basic Valuation Definitions, Forces Influencing Value, Economic Trends Affecting Real Estate Value, Site Analysis and Valuation, Architectural Styles and Functional Utility, The Appraisal Process and Methods, Methods of Appraising Properties, The Sales Comparison Approach, Cost Approach, Depreciation, Income (Capitalization) Approach, Income Approach Process, Income Approach Applied, Residual Techniques, Yield Capitalization Analysis, Gross Rent Multiplier, Summary, Appraisal of Manufactured Homes (Mobilehomes), Evaluating the Single Family Residence and Small Multi-Family Dwellings, Typical Outline for Writing the Single Family Residence Narrative Appraisal Report, Conclusion, Additional Practice Problems, The Office of Real Estate Appraisers (OREA)
  • Chapter 16 – Taxation and Assessments
    Property Taxes, Taxation of Mobilehomes, Special Assessments, Certain Assessment Statutes, Federal Taxes, Documentary Transfer Tax, State Taxes, Miscellaneous Taxes, Acquisition of Real Property, Income Taxation
  • Chapter 17 – Subdivisions and Other Public Controls
    Basic Subdivision Laws, Subdivision Definitions, Functions in Land Subdivision, Compliance and Governmental Consultation, Types of Subdivisions, Compliance With Subdivided Lands Law, Handling of Purchasers’ Deposit Money, Covenants, Conditions and Restrictions, Additional Provisions, Grounds For Denial of Public Report, Subdivision Map Act, Preliminary Planning Considerations, Basic Steps in Final Map Preparation and Approval, Types of Maps, Tentative Map Preparation, Tentative Map Filing, Final Map, Parcel Map, Other Public Controls, Health and Sanitation, Eminent Domain, Water Conservation and Flood Control, Interstate Land Sales Full Disclosure Act
  • Chapter 18 – Planning, Zoning, and Redevelopment
    The Need For Planning, General Plans, Redevelopment
  • Chapter 19 – Brokerage
    Brokerage as a Part of the Real Estate Business, Other Specialists, Operations, Office Size – Management, Office Size, Career Building, The Broker and the New Salesperson, Specialization, A Broker’s Related Pursuits, Professionalism, Mobilehome Sales
  • Chapter 20 – Contract Provisions and Disclosures in a Residential Real Estate Transaction
    A Basic Transaction, A Basic Listing, Purchase Contract/Receipt of Deposit, Disclosures
  • Chapter 21 – Trust Funds
    General Information, Trust Fund Bank Accounts, Accounting Records, Other Accounting Systems and Records, Recording Process, Reconciliation of Accounting Records, Documentation Requirements, Additional Documentation Requirements, Audits and Examinations, Sample Transactions, Questions and Answers Regarding Trust Fund Requirements and Record Keeping, Summary, Exhibits
  • Chapter 22 – Property Management
    Professional Organization, Property Managers and Professional Designations, Functions of a Property Manager, Specific Duties of the Property Manager, Earnings, Accounting Records For Property Management
  • Chapter 23 – Developers of Land and Buildings
    Subdividing, Developer-Builder, Home Construction
  • Chapter 24 – Business Opportunities
    Definition, Agency, Small Businesses and the Small Business Administration, Form of Business Organization, Form of Sale, Why an Escrow?, Buyer’s Evaluation, Motives of Buyers and Sellers, Counseling the Buyer, Satisfying Government Agencies, Listings, Preparing the Listing, Establishing Value, Valuation Methods, Lease, Goodwill, Fictitious Business Name, Franchising, Bulk Sales and the Uniform Commercial Code, California Sales and Use Tax Provisions, Alcoholic Beverage Control Act
  • Chapter 25 – Mineral, Oil and Gas Brokerage
    History, Mineral, Oil and Gas Brokerage, 1994 – No Separate License Requirements
  • Chapter 26 – Tables, Formulas, and Measurements
  • Chapter 27 – Glossary

This article is an overview of exchanging. Before you actually put one into motion, you should get a qualified attorney and/or CPA to complete the deal. The regulations sound complicated, but once you cut through the mumbo-jumbo, the basic requirements are pretty simple, but they must be followed to the letter. 

There are three components to a tax-deferred IRC Section 1031 Exchange: 

1.      Qualifying property

2.      Values

3.      Timing 

Qualifying Property


The actual definition in the Title 26 Section 1031 of the federal code says “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” 

The properties exchanged must be of the same general nature, characterized by being held for investment or use in a trade or business. That opens the door to a whole slew of possibilities, including trading for airplanes, artwork, etc., but for now let’s keep it simple. Property such as inventories, stocks, bonds, and notes are not considered “like-kind,” and are in fact specifically excluded. However they receive similar treatment under other sections of the code. When it comes to real estate, all property is “like kind” to other real estate. The exception is your residence. That is treated elsewhere in the code, and is not included in qualifying properties for Sect. 1031 purposes.


The general rule for a fully deferred exchange is that the exchanger must trade equal or up in:



Fair Market Value

That means you must trade for a property or properties that are equal or greater in value, your equity position must be equal or greater than in the relinquished property, and you must owe at least as much or more on the new property(s) as you did on the old. You can trade one property for multiple properties, or multiple properties for one property, as long as the aggregate values and debt are equal or greater. 


There are two basic forms of tax-deferred exchanges. They are a simultaneous exchange, and a delayed exchange. There are multitudes of variations on these two types of exchanges, but they will all fall into one of the two categories. 

The Simultaneous Exchange

The most basic type of exchange is the simultaneous exchange, also called an “In Lieu Exchange.” In a simultaneous exchange, the Seller wants to sell Property X, for which she has agreed to accept Property Y “in lieu” of cash payment. If the Buyer already owns Property Y, then the two parties simultaneously transfer their respective properties, being careful to adhere to the value rules above. In the case of the Buyer not owning Property Y, then the Buyer must purchase Property Y and transfer it to the Seller simultaneously with the transfer of Property X to the Buyer. In order for the Seller to preserve the tax-deferred status of the transaction, she must not receive any cash or debt relief.

The Delayed Exchange

The other type of exchange is the delayed exchange, also known as the Starker exchange. The Starker exchange gets its name from the court case that established the legality of a delayed exchange, using what is known as a Qualified Intermediary (QI). Fees charged by a QI are fairly reasonable, $500 or less for the first leg of a deal, and less thereafter. In this type of transaction, the Seller closes the sale of her property, and escrows the proceeds of the sale with the QI. In no event can the Seller ever take possession of the proceeds, or the tax deferral status of the transaction will be disallowed. After closing the sale of her property, the Seller then has 45 days to identify in writing to the QI the property or properties to be exchanged for. The identified properties must be purchased within 180 days of the sale of the relinquished property.

Properties must be clearly and accurately identified in writing and MUST be delivered to the QI by midnight of the 45th day. Deletions or substitutions of properties made during the 45 days must also be in writing. There are NO circumstances that will allow for an extension of the identification period.


There are three rules governing the identification of multiple properties: 

1. The Three Property Rule: The Three Property Rule indicates that you may identify up to three replacement properties regardless of their fair market value. It is not necessary to purchase all of the identified properties. Even if you intend to buy only one replacement property, it is advisable to identify one or two alternate properties in case the first property purchase falls through. For those who are planning to identify and purchase no more than three replacement properties, the following 200% and the 95% Rules will not apply. 

2. The 200% Rule: The regulations permit the identification of more than three replacement properties but only under the following circumstances. The total fair market value of ALL of the identified properties must not exceed twice (200%) of the contract price of the property sold. Exceeding the 200% limit will void the exchange. However, there is one exception to this rule, which is: 

3. The 95% Rule: If more than three properties have been identified, and their total fair market value exceeds 200% of the value of what was sold, the exchange may still be valid if 95 % of the total cost of all properties on the list are purchased. This means if there are properties costing $100,000 on your list, then you must purchase at least $95,000 of them.

None of the above-described rules are applicable if all of the acquisition properties are closed within 45 days of the close of your old property. It’s easy to see that by planning to acquire multiple properties, avoiding the 200% Rule in particular could be advantageous. Wrapping up the exchange in 45 days may seem difficult, but adequate planning before the exchange begins can lead to a successful close within 45 days. If exchanging out of multiple properties, the first property that closes will begin the 45-day identification period. 

Other Variations

There are many variations on these basic structures, including scenarios where there can be a partial tax-deferred gain. For those types of situations you need to sit down with a qualified attorney or CPA that has knowledge about Section 1031 of the Internal Revenue Code. There is specific language that should be included in either sale or purchase contracts to put all parties on notice that one of the parties intends to treat the transaction under Section 1031. Again, this is a straightforward declaration of the intent of the party that wishes to exchange, and does not require any magic document, but the rules have to be followed. 

Online Resources

There is a lot of help information online for facilitating exchanges. Some of the sites I have seen and used are: 

And the actual code can be found at:

(search for Title 26 Section 1031)

There is also a firm that several people whose advice I trust and value have recommended to me as a very good company to use as a Qualifying Intermediary.

I have not used them personally, but understand that their services are professional, reasonably priced, and most importantly, accurate. That company is Asset Preservation, Inc., and can be contacted at

Avoiding the Tax Bite

You will find that there is a whole world of new terminology used in structuring exchanges. Don’t be intimidated by the terms, just ask what they mean when someone throws one at you. I have found that in many cases people will come up with catchy phrases and terms just to further mystify the process. It isn’t necessary, and those professionals that are worth their salt will bend over backward to make the deals understandable. 

Once you have a basic understanding of how a 1031 exchange works, you can start thinking about your own situation, where you want to go, and how 1031 may help you get there without paying the tax bite that accompanies the sale of low basis real estate.

I hope that this has been specific enough without being overwhelming. It is a difficult subject to write simply about and still maintain accuracy. Most importantly though, DO NOT rely on my opinion alone. Get a qualified attorney and/or CPA to review your situation before committing to any action.

– Ray Alcorn

By Leonard S. Spoto

The concept of tax free exchanges as set forth in Section 1031 of the Internal Revenue Code has been part of the tax code for over 80 years and has been used by countless investors as a means to defer capital gains taxes on the sale of investment real estate.

Yet, today, many investors still fail to take advantage of what has been called the single greatest tool available to help create wealth. Unfortunately, many real estate investors are either unaware of its benefits or are confused with the guidelines that the IRS sets forth for conducting a 1031 Exchange.

What is Section 1031?

Section 1031 of the Internal Revenue Code establishes the rules for an investor to defer the payment of capital gains taxes on the sale of an investment property. Property Qualifications – The Internal Revenue Code states that the properties involved in an exchange must be held for productive use in trade or business or for investment, and they must be “like-kind”.

The “like-kind” requirement is often a source of confusion for investors.

All real estate is like-kind, with the exception of real estate outside the United States.

For example, provided the properties are within the U.S., an investor selling a rental home can exchange into a four-plex. Similarly, an investor selling a warehouse can exchange into a fractional interest in an office building.

Timeline – The Internal Revenue Code provides 180 days for an investor to complete an exchange.

The 180 day timeline begins at the close of the property being sold. Replacement property must be acquired on or before day 180. No Exceptions!

If the investor cannot close on the replacement property on or before day 180, the exchange will fail.

In addition, the investor must identify potential replacement property by midnight of the 45th day.

Many investors have difficulty finding suitable replacement property within the strict timeframe so advance planning is strongly recommended.

Identification Rules – By day 45 of the exchange, the IRS requires that the investor identify potential replacement properties that may be acquired.

The IRS provides two rules for identifying potential replacement properties:

The 3 Property Rule – Investors using the 3 Property Rule are allowed to identify three properties of any price. The identification must be done in writing and include an unambiguous description of the property.

Investors can change properties up until day 45, but there can be NO substitutions after day 45.

If the investor cannot close on any of the identified properties, the exchange will fail.

For this reason, it is very important to identify wisely.

The 200% Rule – Investors wishing to purchase multiple replacement properties may choose to use the 200% rule for identifying.

This rule allows the investor to identify as many replacement properties as they desire, provided the combined aggregate fair market value of all properties identified does not exceed 200% of the fair market value of the relinquished property.

For example: Investor A sells a rental home for $500,000.

Investor A can identify ten $100,000 rentals, five $200,000 rentals or any combination of properties, provided the aggregate fair market value does not exceed $1,000,000.

100% Tax Deferral – If it is the intent of the investor to defer 100% of their capital gains taxes, the investor simply needs to

a) reinvest all the cash that was generated from the sale of the relinquished property and

b) purchase property equal or greater in value to the property sold.

This can be accomplished in a variety of ways.

For example, an investor selling a $500,000 rental, with $200,000 in equity, can purchase two $300,000 properties with a $100,000 down payment on each. Investors wishing to exchange into a less valuable property (i.e. sell for $500,000, purchase for $400,000) can still utilize Section 1031 but they need to be aware that such a transaction will result in only a partial deferment of the tax liability.

Some, but not all, of the taxes will be owed.

To insure maximum benefit, it is suggested that the investor seek guidance from their tax professional prior to completing their exchange.

Why Exchange?

Tax Deferral – The primary motivating factor for any 1031 Exchange is the deferral of the capital gains taxes.

An investor doing a 1031 Exchange can deferral payment of the following taxes:

15% Federal Capital Gains Tax

9.3% California Tax Rate (each state tax varies)

25% Federal tax rate for the recapture of depreciation

Buy More Real Estate – Utilizing Section 1031 of the Internal Revenue Code essentially provides for an interest free loan from the government. Instead of paying a tax liability now, savvy investors keep their money working for them. The sale of a duplex may result in a $100,000 tax liability.

Without Section 1031, that money goes straight to the government.

With a 1031 Exchange, the investor defers payment of $100,000 in taxes and has more money to leverage into additional real estate.

Diversification – In real estate, there are two ways to diversify, by geography and by asset class.

If your portfolio is too heavily loaded in one particular geographic area or one particular property type, it may be time to re-allocate some of your holdings.

The best way to accomplish this is through 1031 Exchange.

Relief of Management Burden

Investors tired of dealing with tenants, leaky roofs and broken toilets may want to consider exchanging out of difficult to manage properties and into investments that require little or no management.

It may also be wise to consolidate numerous difficult to manage properties into one or two easier to manage properties.

Triple net lease properties and Tenant In Common Investments are just two vehicles available today that offer the investor relief of the management burden.


The United States Government has provided a tremendous benefit to many investors in the form of Section 1031 of the Internal Revenue Code.

Although this newsletter provides only a brief overview, it is definitely worthwhile for the real estate investor to have a solid understanding of the possibilities that exist within Section 1031.

As a 1031 Exchange Qualified Intermediary, North American Exchange Company can provide additional insight into some of the more complex elements of exchanging, such as reverse exchanges, construction exchanges, when to refinance and how long to hold a property before exchanging.

Leonard Spoto is the Northern California Business Development Manager for North American Exchange Company, a qualified intermediary in Walnut Creek, California. He can be reached at


I. Due Diligence:

Many people are unaware that it is perfectly legal for Retirement Plans (e.g. Individual Retirement Plans – IRAs) to purchase non-traditional investments, such as real estate, commercial paper, private companies and promissory notes among others.

The only reason that investors remain unaware of this fact is that most IRA Custodians (by policy but not by law) allow only investments that produce commission for them; generally trades in public stocks and funds.

A brokerage firm subsisting on commissions doesn’t sustain itself if they allow real estate or other longer term private investments. As such, they either refuse to tell their clients of the possibilities of non-traditional investments, or they don’t know about it at all.

Most of our clients elect to use a private Limited Liability Company (LLC) wholly owned by the IRA and managed usually by the client (IRA owner). For most of our clients, the investments are straightforward and we always counsel them on the prohibited transactions Code and other relevant regulations.

The IRS Code does not explain what a plan may invest in; it only outlines what a plan may not invest in. Consequently, our attorneys have put a lot of time into thoroughly understanding the Internal Revenue Codes and Regulations affecting your facilitation of client retirement plans into non-traditional investments.

On February 20, 2004 I met with a representative of the Dept. of Labor, Office of Exemption Determinations, in Washington D.C. Our procedures and understanding of relevant Code sections and IRS/Dept. of Labor regulations were verified as accurate by a Pension Law Specialist with 28 years total service in both the Internal Revenue Service (IRS) and the Department of Labor (DOL).

Our procedures have also been verified by a legal opinion from a Certified Public Accountant who also is licensed as an independent attorney holding a Master of Laws in Taxation (LL.M).

We at IRAAA are confident that our basic structure (e.g. an LLC owned 100% by an IRA which is managed by the IRA owner) meets relevant laws and regulations.

In addition, there are often more complicated situations that arise where the law may be unclear. In these situations we have researched law and regulations, researched published opinions and exemptions and submitted written requests for General information that will obtain a written reply from the appropriate government Agency or Agencies.

Finally, where a client’s specific situation is not clearly addressed in the law, we recommend that we obtain a written Letter ruling or Exemption as required by the appropriate Agency. Our clients can be confident that we have undertaken due diligence to verify its processes, procedures and recommendations. In this Memorandum, the relevant Internal Revenue Code sections or other citations are placed as end notes for easier reading and ultimate verification.

II. Congressional Laws, Agencies and their Relationship:

The substantial legal authority supporting our basic products – discussed in greater detail below – is derived from separate independent sources of legal authority. In an effort to be concise, we do not explicitly address certain general areas of tax treatment.

For example, tax-free rollovers, have been in common practice for in excess of a decade. Where the terms of the trustee-to-trustee transfer are satisfied and the Custodian of the new IRA is an IRS approved Custodian, the tax free nature of the transfer will generally be respected. In addition, the capital contribution to a newly formed LLC is also tax free.

The Internal Revenue Service (IRS) is the Agency that carries out the Internal Revenue Code (IRC), Title 26 of the United States Code. The Agency also creates regulations as a means of carrying out or interpreting various Code sections. These are called the “Code of Federal Regulations” or “CFRs.”

Finally, the Agency issues Letter Rulings, Advisory Opinions and other publications that allow taxpayers a more detailed version of the applicability of Regulations and Code Sections. The IRS has carefully outlined in both Code and regulation what a retirement plan may not do. Thus, the IRS has jurisdiction over whether a particular transaction violates the IRC.

However, under Presidential Reorganization Plan No. 4 of 1978, effective December 31, 1978, the authority of the Secretary of the Treasury (IRS) to issue interpretations regarding section 4975 of the Code (prohibited transactions) has been transferred to the Secretary of Labor (DOL) and the Secretary of the Treasury is bound by the interpretations of the Secretary of Labor pursuant to such authority.

The transactions set forth herein warrant detailed discussion. This memorandum will address the following issues related to our products:

(1) Introduction, (2) Prohibited Transactions, (3) Exemptions, (4) Plan Asset Rule,
(5) Unrelated Business Taxable Income, (6) Conclusion.

1. Introduction:

Individual Retirement Accounts or “IRAs,” are entitled to own various assets subject to certain restrictions. This broad investment selection was made clear in Field Service Advisory 200128011 (April 6, 2001) wherein the Internal Revenue Service (IRS) considered the ability of an IRA owner to invest in a Foreign Sales Corporation (FSC). The quote from the text is in bold:

There is no specific Code provision or regulation prohibiting an IRA from owning the stock of a FSC. The type of investment that may be held in an IRA is limited only with respect to insurance contracts, under section 408(a)(3), and with respect to certain collectibles, under section 408(m)(1).

This is consistent with IRS Private Letter Ruling 8241079 dated February 25, 1982, concluding in favor of a retirement plan investing in an unregistered bond. Finally, investment of IRA funds into a business entity is permitted by interpretive bulletins issued in 1975 and the publication of final regulations following these bulletins that was codified on November 13, 1986. While it is conclusive that an IRA can own an LLC interest or a promissory note, this is only the first step of the legal analysis.

The Internal Revenue Code provides a concise statement of law from which to begin our analysis of some additional matters to be considered in order to conclude in favor of the continued tax-deferred environment of the IRA:

[An] individual retirement account is exempt from taxation . . .unless such account has ceased to be an individual retirement account by reason of paragraph (2) or (3). Notwithstanding the preceding sentence, any such account is subject to the taxes imposed by Section 511 (relating to imposition of tax on unrelated business taxable income of charitable, etc., organizations).
(emphasis mine)

By this section, the IRA is lawfully tax exempt with certain exceptions. The references to IRC § 408(e)(2) and (3) are to, respectively, Prohibited Transactions and Improper Borrowing. Section 511 is otherwise known as Unrelated Business Income Tax (“UBIT”). While the other restrictions set forth in this correspondence cause a deemed distribution (and therefore, taxable income) from the IRA, UBIT subjects only certain income to taxation. Because it is probably the most misunderstood and overly dramatized Code section, the Prohibited Transactions code provides an excellent starting point from which to commence the analysis.

2. Prohibited Transactions

IRC § 4975(c)(1) states that a “prohibited transaction” includes any “direct or indirect”:

· sale or exchange, or leasing, of any property between a plan and a disqualified person;

· lending of money or other extension of credit between a plan and a disqualified person;

· furnishing of goods, services, or facilities between a plan and a disqualified person;

· transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;

· act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or

· receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

Thus, as long as IRA LLC Strategy does not involve a “disqualified person,” no “prohibited transaction” can be triggered. This term generally includes fiduciaries, employers, employees, family members and entities in which equity interests in excess of fifty (50%) percent are owned by the IRA owner (or family members). These are detailed below:

· Fiduciary and Disqualified Persons:

The IRA, through the participation of the Registered Trust Company or Self-Directed IRA Custodian, will usually be the sole member of the LLC. The IRA owner will be appointed as the Manager of the LLC by all members, including the IRA (signed by the Custodian). Then, through a specially designed operating agreement, the manager is given authority to choose investments on behalf of the IRA. Any person who exercises authority or control respecting the management or disposition of the underlying assets, and any person who provides investment advice with respect to such assets for a fee (direct or indirect), is a fiduciary of the investing plan. Thus, after initial formation and capitalization of the LLC, the IRA Owner will be a “disqualified person” with respect to the plan or the assets of the plan. However, the issue then becomes whether the IRA owner is a disqualified person prior to formation or capitalization of the LLC.

Prior to the formation and capitalization, the LLC is not in existence. The LLC has no members or membership interests. The LLC has no equity interests outstanding. Before its legal formation, the LLC does not fit within the definition of a “disqualified person” under the Code. Thus, the initial capital contribution to the LLC by the IRA and otherwise disqualified persons, is not a prohibited transaction. This specific issue was addressed in Swanson v. Commissioner, 106 T.C. 76 (1996). The Tax Court, in holding for the Taxpayer, states the following:

We find that it was unreasonable for [the IRS] to maintain that a prohibited transaction occurred when Worldwide’s stock was acquired by IRA #1. The stock acquired in that transaction was newly issued — prior to that point in time, Worldwide had no shares or shareholders. A corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G). It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide’s stock, thereby causing Worldwide to become a disqualified person under section 4975(e)(2)(G). . . Therefore, [the IRS’] litigation position with respect to this issue was unreasonable as a matter of both law and fact.

The choice of entity (LLC) does not affect this holding. Rather, it is the fact of the newly issued equity interest in the newly formed entity. The IRS is cognizant of the hazards of litigation presented by pursuing this course as a mode of challenge. In holding the IRS’s position “unreasonable,” the Tax Court required the Defendant (the IRS) to pay the taxpayer costs and attorney fees. In conclusion, the direction of funds as an initial capitalization from the new IRA to the LLC does not constitute a disqualified person.

This conclusion was also acknowledged by the IRS in Field Service Advisory (FSA) 200128011 (April 6, 2001). In that FSA, the Service states:

In light of Swanson, we conclude that a prohibited transaction did not occur under section 4975(c)(1)(A) in the original issuance of the stock of FSC A to the IRAs in this case. Similarly, we conclude that payment of dividends by FSC A to the IRAs in this case is not a prohibited transaction under section 4975(c)(1)(D). We further conclude, considering Swanson, that we should not maintain that the ownership of FSC A stock by the IRAs, together with the payment of dividends by FSC A to the IRAs, constitutes a prohibited transaction under section 4975(c)(1)(E).

Even conceding that the LLC Manager and IRA owner is a fiduciary after the formation of the LLC, the basic IRA LLC Strategy does not envision any transaction between the Manager of the LLC and the plan. Therefore, while the disqualified person would be present, the necessary transaction would not. This can change, however, when the manager chooses to take a fee or employ himself in the investment. These must be dealt with on a case by case basis as facts change.

· Employer/Employee

Upon implementation of the IRA LLC Strategy, the IRA involves neither an employer nor employee. The Swanson case, in footnote 14, arrives at the same conclusion.

14/ Furthermore, we find that at the time of the stock issuance, Worldwide was not, within the meaning of sec. 4975(e)(2)(C), an “employer”, any of whose employees were beneficiaries of IRA #1. Although sec. 4975 does not define the term “employer”, we find guidance in sec. 3(5) of the Employee Retirement Income Security Act of 1974 (ERISA), Pub. L. 93-406, 88 Stat. 829, 834. In pertinent part, ERISA sec. 3(5) provides that, for plans such as an IRA, an “’employer’ means any person acting directly as an employer, or indirectly in the interest of an employer, in relation to an employee benefit plan * * *.” Because Worldwide did not maintain, sponsor, or directly contribute to IRA #1, we find that Worldwide was not acting as an “employer” in relation to an employee plan, and was not, therefore, a disqualified person under sec. 4975(e)(2)(C). As there is no evidence that Worldwide was an “employee organization,” any of whose members were participants in IRA #1, we also find that Worldwide was not a disqualified person under sec. 4975(e)(2)(D).

· Family Member

Disqualified Person includes a “member of the family” as that term is defined in IRC 4975(e)(6). The family of an individual, or fiduciary, “shall include his spouse, ancestor, lineal descendant, and any spouse of a lineal descendant.” Id. Note that the definition does not include brothers, sisters, aunts, uncles or other non-lineal descendants. Again, the interaction between the plan and ANY disqualified person must be reviewed on a case by case basis. IRAAA always works with its clients to determine exactly what the client intends as an investment and whether any prohibited transaction might result.

· Equity Interest in an Entity.

Section 4975(e)(2) encompasses equity interests in an entity in excess of fifty (50%) percent. Thus, any entity already owned by the IRA owner or fiduciary in which the IRA/LLC might invest must be scrutinized to ensure that a prohibited transaction in sales, services or loans will not occur between the two entities.

3. Exemptions:

As mentioned in the introduction, since 1978 the Secretary of the Department of Labor has had the authority to issue interpretations regarding prohibited transactions and the IRS is bound by those interpretations. Since receiving this authority, the Department of Labor has issued hundreds of exemptions.

The Employee Retirement Income Security Act of 1974 (ERISA) prohibits certain classes of transactions between employee benefit plans and certain persons defined as “parties in interest”. The law does, however, contain a number of statutory exemptions from the prohibited transaction rules.
In addition, ERISA gives the Department of Labor authority to grant administrative exemptions from the prohibited transaction provisions if the Department first finds that the exemption is:

· administratively feasible;

· in the interest of the plan and of its participants and beneficiaries; and

· protective of the rights of participants and

· beneficiaries of the plan.

Most of the transactions prohibited by ERISA are likewise prohibited under the Internal Revenue Code. The Code also contains exemptive authority similar to that found under ERISA.

The Department of Labor has gained 20 years of experience with the processing of large numbers of applications for exemptions from ERISA’s prohibited transaction provisions. Through that experience with a wide variety of transactions, a number of transactions have emerged which have similar characteristics.

The ERISA law contains several specific exemptions whereby plans may engage in transactions otherwise prohibited by law. In order to use these statutory exemptions, parties must meet the conditions of the applicable exemption.

ERISA generally provides statutory exemptions for, among other things, loans to participants, the provision of services necessary for the operation of a plan for no more than reasonable compensation, loans to employee stock ownership plans, and deposits in certain financial institutions regulated by other State or federal agencies.

Under ERISA, the Department may grant administrative exemptions to an individual or a class of individuals allowing them to engage in a variety of transactions involving employee benefit plans.

Class exemptions are administrative “blanket” exemptions which permit persons to engage in similar transactions with plans in accordance with the conditions of the class exemption without asking for an individual exemption. For example, class exemptions have been granted covering:

* Transfers of individual life insurance contracts between plans and their participants (PTE’s 92-5 and 92-6)
* Sales of customer notes to plans by their sponsoring employers (PTE 85-68)
* Interest-free loans made to plans by their sponsoring employers (PTE 80-26)

Individual exemption requests must be drafted by certain standards and contain specific information to be considered. The attorneys at Legal Strategies, PC can draft exemption requests for those clients who propose an otherwise prohibited transaction, but the transaction meets the criteria for exemption. Where two or more individual exemptions are granted by the Dept. of Labor, a similar fact pattern can achieve an exemption in an expedited fashion. The time line for a formal opinion depends upon the workload of the Department, but they have indicated to IRAAA that it can take as long as six months, or as little as just a few weeks.

4. Plan Asset Rule:

Investment of IRA funds into a business entity is clearly permitted. However, the assets of the LLC are assets of the IRA where the plan owns 100% of the LLC. This is significant because where the LLC assets are considered “plan assets” any transaction between the LLC and a disqualified person is potentially subject to the prohibited transactions Code. This could arise in transactions such as loans between the IRA/LLC and the plan owner, employee or management payments to the plan owner or a lineal descendant, etc. However, the assets of an LLC are not necessary considered “plan assets.” Under the plan asset rule:

…when a plan invests in a non-publicly traded entity, the assets of the plan include BOTH the equity interest and an undivided interest in each of the underlying assets of the entity, unless:

(1) The entity is an operating company, or

(2) Equity participation in the entity by benefit plan investors is not

Under the Code, when a plan owns less than 25% of an entity, equity participation is not “significant” so the assets of the entity are not assets of the plan. The issue then, is whether entity assets are considered “assets of the plan” when 25% to less than 100% of the entity is owned by the plan. This is what we refer to as the “gray area” and can only be definitively answered based upon the facts of each case.

Because the law is not completely clear, IRAAA makes the safe assumption that when a plan owns 25%-99% of an entity the IRA involvement may be considered “significant.” Therefore, we acknowledge that when a plan owns 25% to 99% of an LLC, the assets of the LLC should be considered assets of the IRA for a prohibited transaction analysis, unless the LLC is considered an “operating company.”

Thus, the question becomes, “Is the entity an “operating company,” under 29 CFR 2510.3-101?
Most of our clients who have IRAs owning 25% to 99% of a private company might like to interact with the company such that it might appear to be a prohibited transaction. This includes personal guarantees on loans to the LLC, loans made by a disqualified person to or from the LLC, or other personal benefit from the transaction. This seems possible only if:

· The company fits the definition of “operating company.” and

· The loan guarantee is made to the company loaning to the LLC, not to the plan or plan assets.

In other words, if a personal guarantee of a mortgage on property purchased by an LLC (partially owned by an IRA 25-99%) is required, we would want to be certain that our clients fit within the definition of an “operating company.” Further, we ensure that no other prohibited transactions are taking place in the set up or operation of the entity and its investments. This is what IRAAA provides to its clients in continuing legal support throughout the process. We request that our clients ask questions and provide details of their investment intentions in writing (e.g. E-mail) so that there is no misunderstanding.

5. Unrelated Business Income Tax:

As previously provided above, IRC § 408(e)(1) states:

[An] individual retirement account is exempt from taxation . . .unless such account has ceased to be an individual retirement account by reason of paragraph (2) or (3). Notwithstanding the preceding sentence, any such account is subject to the taxes imposed by Section 511 (relating to imposition of tax on unrelated business taxable income of charitable, etc., organizations). [Italics added].

To the extent that there is unrelated business taxable income (UBIT) earned by the IRA, it will be currently reportable and taxable by the plan participant. For example, the interest earned by a promissory note is expressly excluded from the definition of UBIT.

There shall be excluded [from the definition of unrelated business taxable income] all dividends, interest, payments with respect to securities loans (as defined in section 512(a)(5)), amounts received or accrued as consideration for entering into agreements to make loans, and annuities, and all deductions directly connected with such income.

There are certain factual patterns in which UBIT might apply. We advise our clients on a case by case basis whether the UBIT might apply to the particular investment.

8. Conclusion:

IRAAA is a leader in the area of self-directed pension plans. We can and do help our clients to accelerate their tax free or tax deferred pension plan growth by knowing and understanding the complex laws and regulations affecting pension possibilities. This Memorandum is designed not to teach the reader how to make non-traditional investments, the legal minefield is far too immense to attempt this without years of study. Rather, by this we hope to instill confidence in our clients and associates by explaining the underlying platform of IRAAA products, as supported by DOL and IRS Codes and regulations.

The LL.M. Program in Taxation is designed for those interested in studying complex course work in taxation and tax-related issues. Admission to the LL.M. degree program requires an LL.B. or J.D. degree from a law school approved by the American Bar Association and the Association of American Law Schools. Law degrees from schools in foreign countries do not meet these minimum requirements. To earn the LL.M. degree in taxation, students need to satisfactorily complete 24 credit hours of study in residence. The following courses are required for the LL.M. degree in taxation if they were not previously taken in law school: Estate and Gift Tax Planning, Federal Income Taxation, Partnership Taxation, and Corporate Taxation. No credit is given for any course earning a grade of 75 or below.

Codified in 26 USC § 408(d)(3). (Also known as IRC Section 408).

26 USC § 721.

Governed by IRC Section 408.

IRS FSA 200128011.


See ERISA IB 75-2 and its codification: 29 CFR 2509.75-2.

IRC 408(e)(1).

Defined in IRC 4975(e)(2).

26 USC § 4975(e)(3)(A).

26 USC § 4975(e)(2).

Id. at 25.

29 CFR 2509.75-2

29 CFR 2510.3-101 (h) (3) See Also 29 CFR 2510.3-101(a)(2).

Department of Labor Opinion Letter 90-23. See Also H.R. Rep 93-1280 , 93rd Cong., 2d Session, 308 (1974) and 26 USC § 4975(c)(1)(B).

29 CFR 2509.75-2(a).

29 CFR 2510.3-101(a)(2).

29 CFR 2510.3-101(f).

Id. An “operating company” is defined as an entity that is primarily engaged, directly or through a majority owned subsidiary in the production or sale of a product or service other than the investment of capital (Including venture capital companies and real estate operating companies). A real estate operating company is defined by 29 CFR 2510.3-101(e). An entity is a “real estate operating company” if:
1. On the initial valuation date, at least 50% of its assets are invested in real estate which is managed or developed and with respect to which such entity has the right to substantially participate directly in the management or development activities.
2. During the 12 month period beginning with the initial valuation date, such entity in the ordinary course of its business is engaged directly in real estate management or development activities.

IRC § 512(b)(1).

See also, Treasury Regulation 1.512(b)-1(a)(1).

By Andrea Coombes, MarketWatch
Last Update: 4:02 PM ET Oct 20, 2006

This update clarifies that tax-free charitable distributions from IRAs for those 70 1/2 and older are not necessarily free of state taxes.
SAN FRANCISCO (MarketWatch) — Charitable giving got a lot easier for some taxpayers — and harder for others — thanks to some tax-law changes in the recent Pension Protection Act.

The good news is taxpayers who are 70 1/2 or older can take up to $100,000 out of their IRA tax-free this year and next, as long as they donate it to a qualified charity.

Meanwhile, taxpayers of all ages face slightly stricter rules when it comes to deducting charitable donations: Next year we’ll have to make sure we document any monetary donations, even if less than $250. And, starting this year, those donating clothing or household goods will need to make sure the items are of “good or better” quality.

The real windfall is for those charitable givers who are in their 70s and who’ve got hefty IRA assets. Now they can “take out up to $100,000 per year, give that to charity and not have to include that in income,” said Jere Doyle, senior vice president of wealth management for Mellon Financial’s private wealth management group, in Boston.

Plus, that charitable donation counts toward the required minimum distribution that qualified plans require of those 70 1/2 and older.
The perk exists only this year and next, and the limit each year is $100,000. To take full advantage of the new law, people need to hurry. “There’s only a limited period of time left in this year when you can do this,” Doyle said.

“This is not going to be a gift they can make on Dec. 31. Most [IRA firms] will have cut-off dates after which they will no longer cut a check from an IRA. I would expect most institutions will set a drop-dead date of no later than Dec. 15.”

Another possible restriction: Some IRA account managers may refuse to offer the perk for small donations, less than a few thousand dollars, to avoid the administrative costs of writing many checks.

“One of the concerns is, will the institution say, ‘We’ll only do it if the distribution is over a certain amount of money,'” Doyle said.

Other rules to consider:

Taxpayers should not take a distribution from their IRA and then write a check to the charity. To be tax-free, the distribution must go directly from the IRA to the charity.

The new rule applies only to IRAs, not other qualified plans.

You must already be 70 1/2 years old when you make the contribution.

The donation must be a made to a public charity, and in this case donor-advised funds do not count as a public charity.

If you use this perk to withdraw IRA funds tax-free, you can’t then also deduct that money on your tax return as a charitable donation.

Boon for high-income taxpayers

All taxpayers can benefit from the tax-free IRA distribution (assuming their donation is large enough for their IRA account manager to honor the request), but high-income taxpayers gain the greatest benefit, said Charles Pomo, a certified public accountant and director of the individual tax group at Geller Family Office Services, an investment advisory firm in New York.

That’s because taxpayers with high income often lose 2% of their itemized deductions due to income phase-outs. But under the new law they can tap as much as $100,000 of their required IRA distribution without that money counted in income, he said.

Thus, “their AGI would be reduced by $100,000 that would normally be considered taxable. Indirectly, it’s increasing the value of their deductions,” he said.

“If somebody has an IRA in the millions of dollars, the [required minimum] distribution itself could exceed $100,000. This really works for the charitably inclined person,” he said.
The new law helps those who donate less, such as $1,000 or $5,000, he said. “There’s still a benefit, but the reality is it works really, really well for the high-income taxpayer.”

Plus, taxpayers in states which don’t allow itemized deductions might have even more to gain, Pomo said. That’s because, before the change, an IRA distribution given to charity would get hit by state income tax with no off-setting charitable deduction on the state return. Under the new federal law, it’s possible that donation will be state-tax free as well. But it’s important to note: The tax free treatment of these IRA distributions may not be available for state income tax purposes in all states. Check with your tax expert or state tax department.

Note to self: Improve record-keeping

The Pension Protection Act also made changes related to how taxpayers document their cash and clothing donations.

Before the new law, taxpayers did not need to document monetary donations less than $250. Starting in 2007, taxpayers will need to keep receipts documenting all monetary donations they claim as a charitable deduction on their tax return.

“Now, for any monetary gift, you need a bank receipt or written acknowledgement from the charity, including charity’s name, the date of the gift, the amount of the gift,” Pomo said. A cancelled check or a credit card statement will also suffice, he said.

Taxpayers’ best bet is to avoid cash donations and instead focus on check or credit card payments, he said.

Taxpayers don’t send these receipts to the IRS, but simply keep with their records in case of an audit.

Only the best, or at least ‘good’

The new rule for clothing and other household donations goes into effect for 2006.

“The rules were tightened a bit to counteract what the IRS saw as somewhat heightened value claims,” Pomo said. Now, “clothing and household items must be in what they call good or better condition to qualify for that deduction.

The law does not specify what “good” or “better” means, but taxpayers might consider taking photos of the items or getting a written acknowledgment from the charity that the items are in such condition.

Pomo recommends making a detailed list of the items, such as “three pairs of pants, two shirts.” Then the charity can acknowledge the exact items were received in “good,” or better, condition.

Andrea Coombes is a reporter for MarketWatch in San Francisco.


The file above is a long list of IRS Publications Links (sorted by increasing Pub #)  that you can download from the IRS web site.

Over the last year, a number of interesting questions have come up about tax-free real estate deals.

Is there a risk in doing too many tax free real estate deals in your Keogh or IRA
(also known as the Dealer issue)

What is the difference regarding transactions in a Roth IRA versus a traditional one?

And the ubiquitous Unrelated Business Income Tax question…

The answers to these are not always straightforward:

Based on information we received as recently as 2004 from the same prominent real estate and ERISA attorneys, the dealer issue is now a questionable matter. There are a number of means tests which could be applied to tax deferred plans. These tests are based on case law related to capital gains treatment for dealers and non-dealers. No case law deals with IRAs or Qualified Plans. Intent to act as a dealer, holding real property for sale to the general public and other such issues need to be addressed through competent legal counsel, such as Richard Lipton at Baker & McKenzie in Chicago.

Doing a transaction in a Roth IRA and a traditional IRA is significant in a number of ways:

All funds, including profits in a Roth are tax-free forever. You can withdraw the basis (the amount you paid taxes on) from your Roth at any time. You cannot do this in a traditional IRA setting. You may begin distributions (withdrawals) from either plan type at 59 ½, but you must begin distributions in the year following turning 70 ½ from a traditional IRA. Roth IRAs have no such age requirements. Yes, you can take withdrawals in kind.

Unrelated Business Income Tax:

For Real Estate, if you have a debt financed property you are subject to Unrelated Business Income (UBI) tax in an IRA, but not in a qualified plan, such as a Keogh. You get to take depreciation and other expenses into account in calculating UBI, and are subject to tax if you have over $1,000 profit. If you are out of debt financing for a year prior to sale, you are not subject to UBI. Don’t leverage a property you plan to sell within a year; leverage another one instead.

The real deal remains in Roth IRAs:

We just did a deal where we bought two houses as fixers in a Roth. Using $63,000 in the Roth of basis money (money on which tax had already been paid), we bought two fixers at $31,000 and $32,000. After two weeks, the first is sold at $56,000, and the second at $48,000, for a total profit of $51,000. The total account value was $114,000.

On to the next deal, we used $50,000 for another fixer, which we flipped for $75,000.
The profit of $25,000 boosted our Roth up to $139,000 which had started with less than half that amount in four weeks time. Needing some cash for incidentals is easy in this case. We pulled out $30,000 from the Roth. The $30,000 was not taxed, as it was part of the basis of $63,000. This leaves us with a basis of $33,000, and a total asset value of $109,000.

So we have a lot to make more deals with, and we could still pull another $33,000 out without tax consequences, before age 59 ½ We can do these deals all day long!

In-service withdrawals:

If you have a profit sharing plan, and own your own business look into the in-service withdrawal provision. You can take assets from your Keogh plan and roll them to an IRA even when you are still making profit sharing contributions. You can pay tax on that IRA and convert it to a Roth (if you qualify). Why is this a good deal? If you have real estate in your Keogh, you roll it over at its last appraised value, or at the value you just bought it at (See the Roth item above). You pay tax on that value to convert to a Roth. Some quick math will show you how profitable this can be for you.

These are but a few of the creative ways to do real estate deals.

When it comes to using IRAs and Qualified Plans, your options increase what you may already be doing in your daily life as a real estate professional or as an investor. The IRS code can be a great ally in your present as well as your future. It is just a matter of how you use it. Please just don’t ask anyone to look the other way when you contemplate a prohibited or self-dealing transaction. You can do to many things safely and legally. Remember if it sounds to good to be true, it is to good to be true.