THE ESCROW PROGRAM
IS A SUPERIOR VEHICLE FOR REAL ESTATE INVESTING
WHEN COMPARED TO THE OUT DATED 1031 EXCHANGE
In this edition of the Real Estate Revolution, we will discuss why the Escrow Program has rendered real estate 1031 exchanges obsolete.
1031 Exchange History: In the summer of 1990, the I.R.S. laid out in detail the procedure for turning a sale and purchase type transaction into an exchange that came to be know as a 1031 Exchange. These new rules allowed owners of certain types of like kind Real and Personal property to sell their property and buy other like kind property without immediately paying the Capital Gains Tax.
The IRS Classification Of Real Estate For 1031 Exchanges: The classification of properties to be exchanged determines if the property qualifies for Section 1031 treatment. The last two types of property shown below qualify for Section 1031-tax deferral, but the first one doesn't.
- ˜ Property held primarily for sale. ("Flipping" Property)
- ˜ Property held for productive use in a trade or business. (Business Property)
- ˜ Property held for investment. (Rental Property) The Role Of The Qualified Intermediary:
The role of the Qualified Intermediary is essential to completing a successful exchange. The Qualified Intermediary is the glue that puts the buyer and seller of property together into the form of a 1031 Exchange.
In order to take advantage of the qualified intermediary "safe harbor" there must be a written agreement between the taxpayer and intermediary expressly limiting the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the intermediary.
A qualified intermediary is formally defined as a person who is not the taxpayer and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.
THE DISADVANTAGES OF A SECTION 1031 EXCHANGE
Future Tax Basis: The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain, which was deferred on the sale of the relinquished property in the exchange. Thus, the replacement property includes a deferred gain that will be taxed in the future if the taxpayer cashes out of his investment.
Property, Which Does Not Qualify For A 1031 Exchange, Include: Please note that all of the types of property listed below are what creates the IRS designation of a "dealer" with the single exception of the personal residence.
- A personal residence
- Land under development for resale ("Flipping" Property - IRS Dealer Status)
- Construction or fix/flips for resale ("Flipping" Property - IRS Dealer Status)
- Property purchased for resale ("Flipping" Property - IRS Dealer Status)
- Inventory property ("Flipping" Property - IRS Dealer Status)
Replacement Property Title Must Be Taken In The Same Names As The Relinquished Property Was Titled: If a husband and wife own property in joint tenancy or as tenants in common, the replacement property must be deeded to both spouses, either as joint tenants or as tenants in common.
THE RULES OF "BOOT" IN A SECTION 1031 EXCHANGE
A Taxpayer Must NOT Receive "Boot" from an exchange in order for a Section 1031 exchange to be completely tax-free. Any "boot" received is taxable.
The Term "Boot" is not used in the Internal Revenue Code but is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange. "Boot" is the money or the fair market value of "other property" received by the taxpayer in an exchange. Money includes all cash equivalents plus liabilities of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject to. "Other property" is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes. "Other property" also includes such things as a promissory note received from a buyer (Commonly used in Seller Financing situations).
THERE YOU HAVE IT: The exchange process can get complicated and has many tax traps should you violate ANY of the rules governing the 1031 Exchange process that is so popular with real estate investors today. Now let's compare what we have just learned about the 1031 Exchange process to the Escrow Program.
THE ESCROW PROGRAM
The Escrow Program is NOT a deferral of the capital gains taxes you owe on the sale of each property you sell/exchange until a future date when the taxman WILL surely exact his due. It is the ELIMINATION of the capital gains taxes you would otherwise owe on the sale of each property you sell. There is a major difference between defer and eliminate. To Defer means to wait or postpone an action, such as a payment, until a later date while to Eliminate means Remove or to get rid of. Which one makes more sense to you?
Additionally, 1031 exchanges don't take into consideration the other taxes that you would be obliged to pay such as self-employment taxes or state taxes when you sell a property. These too, are totally ELIMINATED by the Escrow Program.
The authority for the Escrow Program can be found in Section 351 and several other places in the Internal Revenue Code. Additionally, because we employ a corporation (that is in the real estate business) as the entity selling the property, all of the income received in the escrow can be classified as "ordinary business income" under the IRS Code rules.
Thus the money you receive from the sale can be spent on ANYTHING that could be classified as ordinary and/or necessary for the operation of your real estate business. This includes things like employee benefit plans (for you), vehicles, health insurance, retirement plans, travel and even to buy more real estate.
Further, under 1031 rules, should you take money from the sale/exchange of a property to pay for these "ordinary business expenses" you would be required to pay taxes on the gross amount you took to pay for these items (in AFTER TAX dollars). This is not the case with the Escrow Program. In CGR Plan, you use BEFORE TAX dollars to pay for these items and pay taxes ONLY on the money left over at the end of the year.
With the Escrow Program you will find no restrictions such as "like-kind" or types of property that won't qualify. Additionally, the Escrow Program will ELIMINATE all IRS dealer status issues as well.
Lastly, 1031 exchanges will NOT provide any asset protection from predatory attorneys. However, the Escrow Program WILL.
SO, IT ALL COMES DOWN TO THIS FINAL NOTE: Use a 1031 exchange and defer your taxes until they move you into the highest tax bracket so you can pay the maximum in taxes OR use the Escrow Program and ELIMINATE the capital gains, self-employment and state income taxes right from the get go.
WITH ALL THINGS BEING CONSIDERED, I THINK YOU WILL AGREE THAT THE ESCROW PROGRAM IS SUPERIOR TO 1031 EXCHANGES.
