Defer Capital Gains With Sec. 1031 Exchanges

If you’re a savvy investor, you probably know that you must generally report any mutual fund distributions as income, whether you reinvest them or exchange shares in one fund for shares in another. In other words, you must report and pay any capital gains tax owed.

But if real estate’s your game, did you know that it’s possible to defer capital gains by taking advantage of a tax break that allows you to swap investment property on a tax-deferred basis?

What Is a Section 1031 Like-kind Exchange?

Named after Section 1031 of the Internal Revenue Code (IRC), a like-kind exchange generally applies to real estate. It is designed for people who want to exchange properties of equal value. If you own land in Oregon and trade it for a shopping center in Rhode Island, as long as the values of the two properties are equal, nobody pays capital gains tax even if both properties may have appreciated since they were originally purchased.

Section 1031 transactions don’t have to involve identical types of investment properties. You can swap an apartment building for a shopping center or a piece of undeveloped, raw land for an office or building. You can even swap a second home that you rent out for a parking lot.

There’s no limit on how many times you can use a Section 1031 exchange. It’s possible to roll over the gain from your investment swaps for many years and avoid paying capital gains tax until a property is finally sold. Keep in mind, however, that gain is deferred, but not forgiven, in a like-kind exchange and you must calculate and keep track of your basis in the new property you acquired in the exchange.

Section 1031 is not for personal use and is limited to exchanges of real property. For example, you can’t use it for stocks, bonds, and other securities or personal property (with limited exceptions such as artwork). Furthermore, in 2021, the IRS issued a legal memo concluding that swaps of certain cryptocurrencies cannot qualify as a like-kind exchange under Section 1031.

Properties of Unequal Value

Let’s say you have a small piece of property and want to trade up to a bigger one by exchanging it with another party. You can make the transaction without paying capital gains tax on the difference between the smaller property’s current market value and your lower original cost.

That’s good for you, but the other property owner doesn’t make out so well. Presumably, you will have to pay cash or assume a mortgage on the bigger property to make up the difference in value. This is referred to as “boot” in the tax trade, and your partner must pay capital gains tax on that part of the transaction.

To avoid that, you could work through an intermediary, often known as an escrow agent. Instead of a two-way deal involving a one-for-one swap, your transaction becomes a three-way deal.

Your replacement property may come from a third party through the escrow agent. The escrow agent may arrange evenly valued swaps by juggling numerous properties in various combinations.

Under the right circumstances, you don’t even need to do an equal exchange. You can sell a property at a profit, buy a more expensive one, and defer the tax indefinitely.

You sell a property and have the cash put into an escrow account. Then the escrow agent buys another property that you want. They get the title to the deed and transfer the property to you.

Mortgage and Other Debt

When considering a Section 1031 exchange, it’s important to consider mortgage loans and other debt on the property you plan to swap. For example, if you hold a $200,000 mortgage on your existing property but your “new” property only holds a mortgage of $150,000. Even if you’re not receiving cash from the trade, your mortgage liability has decreased by $50,000. In the eyes of the IRS, this is classified as “boot,” and you will still be liable for capital gains tax because it is still treated as “gain.”

Advance Planning Required

A Section 1031 transaction takes planning. You must identify your replacement property within 45 days of selling your estate. Then you must close on that within 180 days. There is no grace period. If your closing gets delayed by a storm or other unforeseen circumstances, and you cannot close in time, you’re back to a taxable sale.

Find an escrow agent specializing in these types of transactions and contact your accountant to set up the IRS form ahead of time. Some people sell their property, take cash, and put it in their bank account. They figure all they have to do is find a new property within 45 days and close within 180 days. But that’s not the case. As soon as “sellers” have cash in their hands, or the paperwork isn’t done right, they’ve lost their opportunity to use this tax code provision.

Personal Residences and Vacation Homes

Section 1031 doesn’t apply to personal residences, but the IRS lets you sell your principal residence tax-free as long as the gain is under $250,000 for individuals and under $500,000 if you’re married.

Section 1031 exchanges may be used for swapping vacation homes but present a trickier situation. Here’s an example of how this might work: Let’s say you stop going to your condo at the ski resort and instead rent it out to a bona fide tenant for 12 months. In doing so, you’ve effectively converted the condo to an investment property, which you can then swap for another property under the Section 1031 exchange.

However, there’s a catch if you want to use your new property as a vacation home. You’ll need to comply with a 2008 IRS safe harbor rule in each of the 12-month periods following the 1031 exchange; you must consecutively rent the dwelling to someone for 14 days (or more). In addition, you cannot use the dwelling for more than the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented out for at fair rental price.

You must report a Section 1031 exchange to the IRS on Form 8824, Like-Kind Exchanges, and file it with your tax return for the year in which the exchange occurred. If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.

Questions?

Like-kind exchanges may seem straightforward but can be complicated. If you’re considering a Section 1031 exchange or have questions, please contact the office for assistance.

Tax Implications When Employed in the Family Business

When a family member employs someone, the tax implications depend on the relationship and the type of business. Taxpayers and employers need to understand their tax situation. Here is what to know:

Married People in Business Together

• Generally, a qualified joint venture whose only members are a married couple filing a joint return isn’t treated as a partnership for federal tax purposes.
• Someone who works for their spouse is considered an employee if the first spouse makes the business’s management decisions and the second spouse is under the direction of the first spouse.
• The wages for someone who works for their spouse are subject to income tax withholding and Social Security and Medicare taxes, but not to FUTA tax.

Children Employed by Their Parents

If the business is a parent’s sole proprietorship or a partnership in which both partners are parents of the child:

• Wages paid to a child of any age are subject to income tax withholding.
• Wages paid to a child age 18+ are subject to social security and Medicare taxes.
• Wages paid to a child age 21+ are subject to Federal Unemployment Tax Act

If the business is a corporation, estate, or a partnership in which one or no partners are parents of the child:

• Payments for services of a child are subject to income tax withholding, social security taxes, Medicare taxes, and FUTA taxes, regardless of age.

Parents Employed by Their Child

If the business is a child’s sole proprietorship:

• Payments for services of a parent are subject to income tax withholding, social security taxes, and Medicare taxes.
• Payments for services of a parent are not subject to FUTA tax regardless of the type of services provided.

If the business is a corporation, a partnership, or an estate:

• The payments for the services of a parent are subject to income tax withholding, social security taxes, Medicare taxes, and FUTA taxes.

If the parent is performing services for the child but not for the child’s trade or business:

• Payments for services of a parent are not subject to social security and Medicare taxes unless the services are for domestic services and several other criteria apply.
• Payments for services of a parent are not subject to FUTA tax regardless of the type of services provided.

Questions?

Many people work for a family member, whether a child is helping at their parent’s shop or spouses running a business together. If you are one of them, your tax situation may be more complicated than you think. Please call the office for assistance if you need help understanding how your work situation affects your taxes.

What is the Capital Gains Tax?

The time when you have to pay the capital gains tax is when you sell the investment. For instance, if you already have stocks in a tax-deferred account, any appreciation in value will not result in a tax bill. However, when you sell your shares, you must include the proceeds in your taxable income. Since this is a capital gain, you must pay tax on it at that rate.

The federal government levies a tax on all profits made from the sale of assets. When you’ve held an investment for less than a year, any profit or loss is considered short-term capital. Gains or losses on the sale of an asset held for more than a year are called long-term capital gains or losses.

The tax rate on capital gains is higher for the former than the latter. This variation is on purpose to prevent day trading. Frequent stock and asset trading can raise exposure to market risk and volatility. In addition, the transaction fees paid by private investors are higher.

Methods of Calculating Capital Gains Tax

The long-term investment tax rate is lower than the short-term investment rate, but both are standard.

1. Your ordinary income tax rate applies to all of your short-term capital gains. Assuming you can hang onto your investments for longer than a year, you’ll likely save money on taxes.
2. Long-term capital gains are taxed at a rate that varies with the investor’s marginal tax rate. The capital gains tax is often low or nonexistent for those with an adjusted gross income of less than $80,801 (married filing jointly) or $40,401 (married filing separately, single).

Capital Gains Tax Substitutes

Losses sustained by investors in financial instruments like stocks, bonds, and mutual funds can be deducted from taxable income. The same holds true for intangible assets that were purchased for business purposes rather than for the individual’s use. For example, one could invest in real estate, precious metals, or rare collectibles. Gains and losses in capital over time might cancel each other out.

A net capital gain occurs when long-term profits are greater than long-term losses. But if your net long-term capital gain is less than your net short-term capital loss, you can deduct the loss and keep the gain at zero.

Any other income, like a salary, can be reduced by the amount of your net capital gain losses. But that’s capped at $3,000 every year, or $1,500 if you’re filing as single. What are the repercussions if your net capital loss for the year exceeds the maximum allowable deduction? You can roll over any losses that you don’t use into the following year’s taxes.

What This Means for the Economy

According to a 2019 report from the Tax Policy Center, the richest 1% of taxpayers account for 75% of capital gains taxes.

Those who rely on investment income to make ends meet may end up paying taxes totaling 23.8%, and that’s before factoring in the 3.8% Net Investment Income Tax (NIIT) that applies to some high-income earners.

Hedge fund managers and other Wall Street professionals, who make their living solely from their investments, are not exempt from this tax.

That is to say, their marginal tax rate is less than the rate paid by those in the next tax bracket (those with taxable income between $86,375 and $164,925).

There are two potential results of this tax loophole:

1. It promotes corporate expansion by fostering investors’ interest in the stock market, real estate, and other asset classes.
2. It contributes to the widening gap between the rich and the poor. People who are able to support themselves only through investment earnings are already considered to be among the world’s wealthiest. They have been fortunate enough to have a surplus of income over the course of their lives, and have used that surplus to make investments that have provided a satisfactory rate of return. That is to say, they were able to save money for other necessities besides food, shelter, and medical care.

More people are now subject to the 20% tax on long-term capital gains as a result of the Tax Cuts and Jobs Act (TCJA). When the Internal Revenue Service (IRS) makes its annual inflationary adjustment to the income tax brackets, they will be placed in that group. There will be some increase in these brackets, although it will be less dramatic than in the past. The CPI was changed to a chained CPI under the Act.

More people will eventually be pushed into higher tax brackets as a result of this.

 

Questions?

If you have any inquiries about the capital gains, don’t hesitate to get in touch with us. Contact us at admin@fas-accountingsolutions.com or call us at 713-855-8035.

Personal Property Tax: What It Is and Some Examples

Personal property tax is called “ad valorem” tax and is based on the value of the property. It must be paid every year.

The tax on personal property is different from the tax on “real” property, which is the tax on homes, buildings, and land. The main difference is that personal property includes things that can be moved, like cars, boats, tools, or furniture. Real property, on the other hand, only includes structures or things that can’t be moved. The IRS says that personal property tax is one of the four types of non-business taxes that can be deducted (IRS).

Personal property that is taxed and property that isn’t taxed may be defined a little differently in each state or city. In California, for example, taxable personal property must be something that can be touched, like portable equipment, tools, office supplies, and furniture, and so on. In some places, animals and other livestock may be considered personal property.

How It Works

Some states and cities also tax personal property that is not attached to the land, like cars, furniture, and boats. This is in addition to taxes on real property, which is the building and land. Personal property taxes are a way for state and local governments to get money.

Do I Need to Pay Personal Property Taxes?

Yes, you do if you live in a state or locality that taxes personal property. The good news is that even though each state and local government has its own rules and tax rates, everyone can deduct personal property taxes from their federal income tax if they itemize.

For you to be able to deduct personal property taxes, the only requirements are that the taxes you paid were based on the property’s value and that the tax was paid once a year.

What is the difference between real property tax and personal property tax?

Real property is anything you own that is attached to the land or can’t be moved. For tax purposes, this is usually real estate. Personal property is everything you own that you can move and take with you.

Is it considered a direct tax?

It is a direct tax because you pay it directly to the government when you file your income taxes each year. At some point in the process of buying property, there may be indirect taxes. However, these are taxes that can be paid by someone else, like the seller.

 

If you need help in preparing your individual income tax return, don’t hesitate to get in touch with us! Visit our website at https://fas-accountingsolutions.com/ or email us at admin@fas-accountingsolutions.com.

 

Habits are something we cannot change overnight. We pamper ourselves daily despite knowing our limits. While most of us recognize good financial habits, there are still many businesses failing.  It is because it takes a lot of effort, time, and resolve to overcome bad financial habits.

Here are bad financial habits that need to be avoided or changed:

 

1. Using Credit as Emergency Fund

The total America’s revolving debt, the sum of the credit card balances accumulated to $1.7115 trillion in August 2019 according to the Federal Reserve. (See the source below) This had become a habit to treat credit cards as free money.  It is not money or a debit card that you can use freely to pay expenses, it accumulates interest.

The machine breaks, a vehicle needs repairs, product damage or flood – a rainy-day fund is a lifesaver in these times. But if you don’t have it, you might need to borrow money. This will save your present problem but will create more trouble if it is not paid sooner as it increases the debt because of the interest.

It is not bad to have a credit as long as there is a limit but having a rainy-day fund is more reassuring.

Source: https://www.federalreserve.gov/releases/g19/current/

 

2. Constantly Changing the Financial Plan

 

It is important to pay attention to news regarding your investments and the business’ industry. But constantly changing financial plan due to a day-to-day report in the industry is as bad as not having a plan. What if it is just a small setback? It can make you miss out on an opportunity. A financial plan is a long-range plan. You need to have a rational reason to change it and not just by impulse.

 

3. Disregarding Cash Flow

Cash is the lifeblood of the business. There should be a proper flow of money. It is not enough that you have money in your bank, there should be “control” by understanding the inflows and outflows because if you run out of money how can the business continue? How can you pay your operating expenses, credit cards and debts?

Changing bad financial habits is not an overnight process. Make a plan and be patient for the result. Financial peace of mind is fulfilling and being financially healthy is a step closer to business success.

If you need assistance with your bookkeeping and tax preparation or guidance for your financial planning, contact us today admin@fas-accountingsolutions.com or 832-437-0385.

The flat 21% federal income tax rate for C corporations under the Tax Cuts and Jobs Act (TCJA) has been great news for these entities and their owners. But some fundamental tax truths for C corporations largely remain the same:

C corporations are subject to double taxation.

Double taxation occurs when corporate income is taxed once at the corporate level and again at the shareholder level as dividends are paid out. The cost of double taxation, however, is now generally less because of the 21% corporate rate.

And double taxation isn’t a problem when a C corporation needs to retain all its earnings to finance growth and capital investments. Because all the earnings stay “inside” the corporation, no dividends are paid to shareholders, and, therefore, there’s no double taxation.

Double taxation also isn’t an issue when a C corporation’s taxable income levels are low. This can often be achieved by paying reasonable salaries and bonuses to shareholder-employees and providing them with tax-favored fringe benefits (deductible by the corporation and tax-free to the recipient shareholder-employees).

C corporation status isn’t generally advisable for ventures with appreciating assets or certain depreciable assets.

If assets such as real estate are eventually sold for substantial gains, it may be impossible to extract the profits from the corporation without being subject to double taxation. In contrast, if appreciating assets are held by a pass-through entity (such as an S corporation, partnership or limited liability company treated as a partnership for tax purposes), gains on such sales will be taxed only once, at the owner level.

But assets held by a C corporation don’t necessarily have to appreciate in value for double taxation to occur. Depreciation lowers the tax basis of the property, so a taxable gain results whenever the sale price exceeds the depreciated basis. In effect, appreciation can be caused by depreciation when depreciable assets hold their value.

To avoid this double-taxation issue, you might consider using a pass-through entity to lease to your C corporation appreciating assets or depreciable assets that will hold their value.

C corporation status isn’t generally advisable for ventures that will incur ongoing tax losses.

When a venture is set up as a C corporation, losses aren’t passed through to the owners (the shareholders) like they would be in a pass-through entity. Instead, they create corporate net operating losses (NOLs) that can be carried over to future tax years and then used to offset any corporate taxable income.

This was already a potential downside of C corporations, because it can take many years for a start-up to be profitable. Now, under the TCJA, NOLs that arise in tax years beginning after 2017 can’t offset more than 80% of taxable income in the NOL carryover year. So it may take even longer to fully absorb tax losses.

Do you have questions about C corporation tax issues post-TCJA? Contact us.