CALIFORNIA REAL ESTATE UPDATE #6

LICENSING UPDATE

Get Your License Now

The real estate market in California is torrid at this time. When the public sees licensees making lots of money, many of them suddenly want to get a license. Last week we received a special notice from DRE that test dates would be delayed due to "the extremely high volume of test applications". If you know anyone who want to get on the crowded bandwagon, have them call us.

As you know, to apply for a test date you must pass a college- level Principles of Real Estate Course. We are the people to call for this requirement. Some of the reasons why you should use us include:

• You can test on the Internet
• Our passing grade is only 60%

TEST YOUR KNOWLEDGE ON SAVING TAXES WHEN YOU SELL A HOME

One topic of interest to real estate investors, future investors, agents, brokers, etc., is Real Estate Exchange. Following is an exam to test your knowledge and increase your knowledge about avoiding capital gains on disposal of real estate.

1. Real estate professionals use which of following terms when referring to exchange of properties?
   
   1. Starker Exchanges
      
   2. Tax-Free Exchanges
      
   3. Tax-Deferred Exchanges
      
   4. All of above

2. Which term does IRS use on their reporting form of an exchange?
   1. Tax-Deferred Exchange form
      
   2. Reverse Exchange form
   3. Like-Kind Exchange form
   4. Are You ready for an Audit form

3. Which of following exchanges defer tax?
   1. Direct Exchange
      
   2. Simultaneous Three-Way Exchange
      
   3. Deferred Exchanges
      
   4. All of above

4. If I properly exchange a six unit apartment house for a more expensive twelve unit apartment house, six unit apartment is called
   
   1. Downleg Property
      
   2. Upleg Property
      
   3. Boot
      
   4. None of above

5. To receive non-recognition of gain a tax payer must exchange
   
   1. Like-Kind Property
      
   2. Same Class of Property
      
   3. Improved for Improved, etc.
      
   4. None of above

6. Like-Kind property is property held for
   
   1. Productive use in a trade
      
   2. Productive use in a business
      
   3. Investment
      
   4. All of above

7. An apartment house is considered
   
   1. Productive use in a trade
      
   2. Productive use in a business
      
   3. Investment
      
   4. None of above

8. A reason for doing an exchange instead of a sale and purchase could be
   
   1. Avoid income tax
      
   2. Increase an owner's depreciable basis
      
   3. Acquire a more suitable property
      
   4. Any of above.

9. I have a six unit apartment house. Which of following properties would be considered like-kind?
   
   1. Commercial or industrial building
      
   2. Raw land or ranch
      
   3. Four rental houses
      
   4. Farm or ranch land
      
   5. Land subject to a 99 year condominium lease
      
   6. Apartment house in foreign country
      
   7. Timberland
      
   8. A property to be my personal residence
      
   9. Someone's personal residence that I will rent
      
   10. Business machinery
       
   11. Limited partnership interests

10. If I want an exchange on my six unit apartment and I have a motivated buyer who wants property now, what can I do?
    
    1. Use an intermediary or accommodater
       
    2. buyer will have to wait
       
    3. Sell and pay tax
       
    4. None of above

11. In a delayed exchange, money must
    
    1. Stay with the escrow company until the new property is purchased
       
    2. Be given to an intermediary to hold
       
    3. Be kept in a separate account of the taxpayer
       
    4. None of above

12. If a taxpayer correctly handles a closed escrow on a downleg property, the upleg property must be designated
    
    1. Within 45 business days
       
    2. Within 45 days
       
    3. Within 180 days
       
    4. None of above

13. In designating a property, the taxpayer must
    
    1. Give an unambiguous description
       
    2. Identify in a written document signed and delivered
       
    3. Realize the limitations of how many can be identified
       
    4. All of above

14. A taxpayer must complete an exchange transaction
    
    1. Not more than 180 days after first transfer or by due date of his or her tax return including extensions whichever is first
       
    2. Not more than 180 days after the first transaction
       
    3. Before end of taxpayer's tax year
       
    4. None of above

15. Acccommodators / Intermediators / Facilitators could be disqualified to act for a taxpayer if
    
    1. Within the past two years, person was an agent of the taxpayer
       
    2. They are a spouse, family member, etc., of the taxpayer
       
    3. Taxpayer owns more than 10% of the corporation
       
    4. All of above

16. If a taxpayer receives anything of value such as cash, notes, personal property, etc., at the end of an exchange, this property could be taxable and is called
    
    1. Boot
       
    2. Non-qualifying
       
    3. Net proceeds
       
    4. All of above

17. A famous attorney, Marvin Starr, is credited with developing a concept called the Napkin Test. It is a simplified method to check whether an exchange is non-taxable and states a taxpayer should
    
    1. Go up in value and up in liabilities and receive no boot
       
    2. Go up in value and down in liabilities and receive no boot
       
    3. Go down in value and up in liabilities and receive no boot
       
    4. Go down in value and down in liabilities and receive no boot

18. It is good tax planning for some taxpayers to
    
    1. Refinance before an exchange
       
    2. Refinance after an exchange
       
    3. Refinance as part of an exchange
       
    4. A and B above

19. A taxpayer gives money to an accommodater to purchase and hold an upleg property and then sells a downleg property
    
    1. Taxpayer is always taxed
       
    2. This is called a Revenue Starker Exchange
       
    3. New Safe-Harbor regulations were written about this exchange in 2000
       
    4. B and C above

20. If I do a non-taxable exchange and have no tax to pay, what is the main purpose of IRS Form 8824 which must be filed with my tax return
    
    1. Calculate dollar amount of gain
       
    2. List price of new building
       
    3. Determine amount of accommodation fee
       
    4. Determine basis in new property

ANSWERS and EXPLANATIONS

1. D.  All of above names are used to describe non-taxable exchanges under IRS Code. They all refer to same type of transaction.

2. C.  The Form (IRS Form 8824) is called "Like-Kind Exchange". It is form that is filed when an exchange is consummated.

3. D.  A direct exchange is extremely rare. In this transaction two owners would exchange and keep each others properties. Normally, in this method one of owners would have some tax to pay.

   In a simultaneous exchange, owner "A" wanting a Tax-Deferred Exchange would release their property to party "C". At same time, owner "B" would release their property to owner "A". An experienced escrow holder is needed to insure that pro- party "B" would be deeded directly to owner "A" while property "A" would be deeded to owner "B" who would deed it to party C. Some transactions involve more than three properties and could be called, for example, a six Legged Exchange, etc., and all escrows are closed simultaneously. This is chaos unlimited with many agents, owners, sellers, buyers, escrows, attorneys and CPAs involved.

4. A.  In a traditional 1031 Exchange, owner desiring a tax-deferred (like-kind) exchange is called taxpayer or owner "A". Their property is called downleg property. upleg property is higher-valued property that they desire. upleg property owner (owner "B") will normally have some tax to pay. In most cases, they don't want pro- party "A", so that is sold to owner "C" so "B" is disposing of their property.

5. A.  Statement of fact from IRS Code. For an explanation of like-kind, see question 6.

6. D.  This is right out of IRS Code Section.

7. B.  Real estate rentals of all types are considered business properties. Most real estate investors and agents believe that rentals are Investment Property. No so. It is better to have them classified as Business Properties for IRS purposes because losses and interest payments are easier to deduct. In my experiences, only investment property that I have encountered is raw land.

8. D.  And many more.

9. A, B, C, D, E, G, I.  Like-kind has a wide definition. Almost all real estate qualifies except personal residences and vacation homes. Also, C illustrates that more than one property can be exchanged for a single property.

   Answer F is incorrect because 1031 Exchanges can't be made with foreign property of any type. This is different than the Section 121. $250K and $500K Personal Residence Exclusion because a taxpayer can sell a foreign persons residence and get exclusion.

   Answers H and I show that question of whether property is like-kind is based in how I will use property, not its present use.

   Business Machinery is not like-kind with real estate. How- ever, you can do a tax-deferred exchange of Business Machinery for Business Machinery but that is another story.

   Limited partnership interests are not like-kind with an apartment house. However, an apartment house owned by a partnership could be exchanged for other like-kind property.

10. A.  If a buyer doesn't want to wait for owner to find an upleg property, property can be sold and money would go to a third party who would hold money until owner finds right property. There are many rules on these Tax Deferred Exchanges. Some of topics are addressed in some extra questions that are on our Web site, http://www.DuaneGomer.com.

11. B.  To accomplish a delayed exchange, a taxpayer can't receive control of money. Therefore it must go directly from the escrow company processing a sale of any downleg property to an appointed intermediary.

12. B.  Statement of fact.

13. D.  It is recommended that a prospective exchanger start selecting an upleg property or properties as soon as feasible. If possible, a long escrow period should be demanded in any downleg sale. I believe strongly that you should try t designate and close any upleg purchase in the 45 day period to be sure of IRS compliance.

14. A.  Most investors know the 45 day designation rule but they believe that you have 180 days to close any new purchase. That is not true. You have 180 days or until the due date of your tax return including extensions. For example, you close a downleg sale on December 31^st. Like most people your tax return is due April 15. The period from December 31 to April 15 is 105 days most years and 106 days in a leap year. If you haven't closed your upleg escrow by April 15, you best request an automatic extension. If you don't, you would lose your deferment of gain.

    Why does IRS they have this rule? With this regulation when you file your tax return, you will know whether you can file a Like-Kind Exchange Form 8824 or not. Either you have an exchange or you don't. Some taxpayers have filed their tax return on time only to find out their exchange is not completed so it can't be recognized. That presents some "real problems".

15. D.  Pick an accommadator carefully. There have been many cases of accommodators disappearing with funds of from 1031 exchanges. It is strongly recommended that you use a professional, well-funded, experienced, bonded, corporate entity. Picking a private party could prove to be a problem in case of death, financial problems, bankruptcy, etc. Parties who have had their money stolen are shocked to discover that they now owe tax on their sale because they didn't consummate an exchange.

16. A.  Statement of fact.

17. A.  If you complete an exchange with more real estate and more liabilities and you receive no boot, you can be certain you will have no tax liability, according to Counselor Starr from Oakland who wrote this concept on a napkin during lunch and used this concept in his many lectures and writings.

18. D.  If a taxpayer refinances before or after a exchange, cash could be extracted from their equities and if done properly there would be no tax if an exchange was completed. Doing a refinance as part of an exchange transaction could cause refinance proceeds to be classified as cash boot (not a good thing). There are no set limits in the code on how long before or after an exchange a refinance must be completed so talk to many experts including a tax attorney, a CPA, an accomodater, a lender, an escrow officer, a title officer, an exchange specialist, broker, etc., as soon as possible even before listing any property.

19. B.  Purchasing an upleg property before selling your downleg property is called a Reverse Exchange. Most professionals use term a "Reverse Starker Exchange" recognizing T. J. Starker, an Oregon lumberland owner, who challenged the IRS and received tax deferment on an exchange in 1969. His exchange had no time limits so the IRS established Safe Harbor Rules, for traditional downleg and upleg exchanges. Many professionals started doing Reverse Exchanges because they were not discussed in original Safe Harbor Rules. Consequently, in November 2000, the IRS established Safe Harbor Rules for Reverse Exchanges which are the same time limits and receipt requirements as traditional exchanges, For more information on Reverse Exchanges, go to our Web site and check the Reverse Exchange article.

20. D.  When you do an exchange, you postpone tax on the gain from the sale of your downleg property. There has to be a method of keeping score. The IRS insists that you calculate your gain and subtract it from the value of your new property.

    To illustrate with an over-simplified exchange with no fees, costs, commissions, etc. "A" has a piece of land worth $10,000 and "B" has land worth $40,000. "A's" basis is $3,000 and "B's" basis is $22,000. "A" will give "B" his land plus $30.000 in cash. "A's" nonrecognized gain is $7,000. This would be deducted from the $40,000 fair market value of his new property, so his basis in the new property would be $33,000. (This is the last line on the Form 8824. If you have ever done an exchange in the past, go back to your tax return and check the basis of your acquired property at the close of escrow. If there is no Form 8824, call your tax preparer and find out why. If you did your own return and there is no Form 8824, fire yourself as your tax preparer). Incidentally, "B" would have tax to pay on his gain of $18,000, which is the lesser of gain ($18,000) versus boot received ($30,000).

MOLD AGAIN

State Senate Bill 732, sponsored by Senator Deborah Ortiz from Sacramento, has passed the Senate and now goes to the State Assembly. For a copy of this Bill or more information, call her office at 916-324-4937.

The Bill would require insurers to pay for mold damage resulting from a covered item such as a leaky roof or burst pipe. It also would alert their customers to the presence of mold when it is there.

As of early May, the State Department of Insurance had received 287 notices from insurance companies planning to add mold and water exclusions to their policies. Some are seeking to limit their coverage of mold and water damage; others want to exclude it entirely.

COMPLETE INFORMATION ON REAL ESTATE LICENSING

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