Taxes After 1031 Exchange?
To all 1031 and Tax gurus out there,
Some background info:
I am new to REI and currently still have a full time job in IT consulting. I dont have a LLC or S/C Corp. I recent bought a SFH for rehab (short-term gain) and getting ready to sell. This is my first and only rehab this year. I've been reading many articles within this forum and understand the dealer status but I think I am ok since I am only doing one this year.
My questions:
My plan is to do a 1031 exchange (a 1 for 2 exchange). The 2 that I am exchanging for I plan to Lease Option them.
1) What taxes do I have to pay during the Lease Option?
2) What taxes do I have to pay if the tenant decide to pay the property?
3) What are the tax implications AFTER the 1031 exchange?
4) Is there a better way out there to defer taxes?
Thanks and I greatly appreciate any advice on this!
Sincerely,
Roland
Quote:I've been reading many articles within this forum and understand the dealer status but I think I am ok since I am only doing one this year.Roland,
Would you please elaborate on this statement? How do you see yourself in relation to "dealer" status?
There are some pitfalls in your strategy, but I would like your input first before I give you my feedback.
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I inadvertently deleted Roland's response to my question. His answer was that from discussions he has had with others (to include accountants) he is not a dealer, because he is only doing one flip this year. [ Edited by DaveT on Date 10/15/2003 ]
Roland,
OK, I see that you don't quite have a handle on all the issues yet. The dealer status question has been discussed extensively in this forum. This post encapsulates all the discussion quite clearly: http://www.thecreativeinvestor.com/ViewTopic13355-23-4.html
The first step in your strategy is to flip a property, then use the proceeds in a 1031 exchange to acquire two new properties.
I hope from the thread at the link I just gave you, you see that your flip property is a dealer disposition and, therefore, not eligible to participate in a 1031 exchange.
The next step in your strategy is to L/O your "replacement" properties. I hope that you now see that this creates a pattern of dealer activity as well. Eventually, the IRS will look at the substance and circumstances of each of your transactions and may characterize each one as a dealer disposition.
The bottom line -- your first flip transaction is a dealer disposition and the property is not eligible to participate in a 1031 exchange as you propose. As a dealer disposition, you would report your flip activity on Schedule C and Schedule SE.
Lets look at the Tax Code again:
Section 453.
(l) Dealer dispositions
For purposes of subsection (b)(2)(A) -
(1) In general
The term ''dealer disposition'' means any of the following dispositions: ,
,
(B) Real property
Any disposition of real property which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer's trade or business. Go back to those accountants you talked to and ask them to clarify their advice. Specifically, ask how the use of the term "ANY disposition" in the definition above means anything other than your first flip is a dealer disposition. [ Edited by DaveT on Date 10/15/2003 ]
I would approach it this way: Tell your CPA you have bought a property on the side as an investment, improved it, are selling it and are looking at a couple of other properties to purchase and do the same with. Your full-time day job is as an IT consultant. You would rather claim investor status than dealer status. The key question is whether that would create any "Circular 230" issues for him. http://www.irs.gov/pub/irs-pdf/pcir230.pdf . If not, claim investor status.
In that case, it's the IRS's prerogative, should it decide to do so, to declare you a dealer. Your positiion doesn't need to be airtight, or even a 50-50 shot of winning. Some commetators suggest that if you have about a one in three chance of winning, it's OK.
Something below that figure would expose you to the negligence penalty, and if it were any worse than that, you might be into tax fraud.
The relevant parts of Circular 230:
'10.34 Standards for advising with respect to tax return positions and for preparing or
signing returns.
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(a) Realistic possibility standard. A practitioner may not sign a tax return as a
preparer if the practitioner determines that the tax return contains a position that does
not have a realistic possibility of being sustained on its merits (the realistic possibility
standard) unless the position is not frivolous and is adequately disclosed to the Internal
Revenue Service. A practitioner may not advise a client to take a position on a tax
return, or prepare the portion of a tax return on which a position is taken, unless--
(1) The practitioner determines that the position satisfies the realistic possibility
standard; or
(2) The position is not frivolous and the practitioner advises the client of any
opportunity to avoid the accuracy-related penalty in section 6662 of the Internal
Revenue Code by adequately disclosing the position and of the requirements for
adequate disclosure.
(b) Advising clients on potential penalties. A practitioner advising a client to take
a position on a tax return, or preparing or signing a tax return as a preparer, must
inform the client of the penalties reasonably likely to apply to the client with respect to
the position advised, prepared, or reported. The practitioner also must inform the client
of any opportunity to avoid any such penalty by disclosure, if relevant, and of the
requirements for adequate disclosure. This paragraph (b) applies even if the
practitioner is not subject to a penalty with respect to the position.
(c) Relying on information furnished by clients. A practitioner advising a client to
take a position on a tax return, or preparing or signing a tax return as a preparer,
generally may rely in good faith without verification upon information furnished by the
client. The practitioner may not, however, ignore the implications of information
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furnished to, or actually known by, the practitioner, and must make reasonable inquiries
if the information as furnished appears to be incorrect, inconsistent with an important
fact or another factual assumption, or incomplete.
(d) Definitions. For purposes of this section--
(1) Realistic possibility. A position is considered to have a realistic possibility of
being sustained on its merits if a reasonable and well informed analysis of the law and
the facts by a person knowledgeable in the tax law would lead such a person to
conclude that the position has approximately a one in three, or greater, likelihood of
being sustained on its merits. The authorities described in 26 CFR 1.6662-4(d)(3)(iii), or
any successor provision, of the substantial understatement penalty regulations may be
taken into account for purposes of this analysis. The possibility that a tax return will not
be audited, that an issue will not be raised on audit, or that an issue will be settled may
not be taken into account.
(2) Frivolous. A position is frivolous if it is patently improper.
It appears the commentators' suggestion of a 33.33% possibility of success has actually been incorporated into the text of the most recent version of Circular 230.
Thanks for both of your advices. This is a really great forum for RE investors. I am really learning a lot by reading all the posts here.
Now if I decide to be on the conservative side and stay out of the dealer status. What is the best way to structure this so I will pay the minimal amount of tax? Should I lease option it? Rent it out? I I really dont want to do this since it is difficult to lease this house out since the piti is around $2k and the area is more for 2nd time home buyer and no renters in the neighborhood. Or should I incorporate and take all the expenses as deductions and put the rest in mutual fund? What are other creative ways to minimize or defer taxes as a rehabber?
Thanks in advance!
- Roland