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April 2011
The Exchange Update
A Newsletter For 1031 Tax-Deferred Exchanges
Getting the Most from Your Home Mortgage Interest Deduction
The home mortgage interest deduction is limited to interest on debts that are secured by your principal residence and one second home. The deduction is also limited in amount, depending on the purpose for borrowing the money. You can deduct interest paid on the first $1 million of debt used for acquiring, constructing or substantially improving your residence (this is called “acquisition debt”). In addition, you can deduct up to $100,000 of home equity debt, no matter how you used the money. There are other details to consider. For example, you cannot take advantage of this deduction unless you itemize your deductions, and there are different rules for mortgages in place before October 14, 1987. These details and more are explained in IRS Publication 936.
One of the biggest areas of confusion arises when homes are refinanced to take more money out than the original balance of the loan. According to the IRS, refinanced acquisition debt is treated like the original acquisition debt, but only up to the balance of the debt immediately before the refinancing. The rest of the refinanced debt is eligible for the interest deduction only to the extent it doesn’t exceed the $100,000 limit on home equity debt.
For example, John and Mary Smith acquire a home in 1990 for $500,000 with a $400,000 loan and $100,000 in cash. The $400,000 debt is acquisition debt and all of the interest on that debt can be deducted because the debt doesn’t exceed $1 million. In 2003, the property is worth $700,000 and the mortgage balance is $300,000. The Smiths refinance the debt with a new loan equal to $550,000. What can they deduct? The Smiths should be able to deduct the interest on $400,000 of the debt ($300,000 as refinanced acquisition debt and $100,000 as home equity debt). The interest on the $150,000 of debt in excess of that amount is considered personal interest and will not be deductible.
Deducting interest that is paid on a home mortgage is one of the most popular tax breaks around. Although there has been some discussion lately about whether to continue this tax deduction, it is currently used by millions of Americans who itemize deductions and own a home. It is important to understand the details of the rule, however, so check with your tax advisor to make sure that your deduction is accurate.
If you own investment property (rather than property you live in or use as a second home), there are other rules about deducting interest on debt secured by that property. In addition, before you sell investment property, contact First American Exchange to discuss doing a 1031 exchange to defer paying capital gains taxes, which is another valuable tax benefit available to property owners.
__________________________________________________________________________ What is a related party exchange? A related party exchange is a 1031 exchange where either the buyer of the relinquished property or the seller of the replacement property (or both) is considered “related” to the investor doing the exchange. There are special rules and restrictions on the ability to defer tax in a 1031 exchange that involves related parties. What is a related party? “Related party” has a special meaning in tax law. For Section 1031 purposes, a related party includes certain family members, such as spouses, brothers, sisters, ancestors (parents and grandparents) and lineal descendants (children and grandchildren). Another example of related parties includes a corporation or partnership and a person who owns more than a 50% interest in the corporation or partnership. For a complete list, see Internal Revenue Code Sections 267(b) and 707(b)(1). Can I do an exchange iNVOLVING a related party? The answer to this question depends on several factors. First, are you swapping properties with the related party, transferring your relinquished property to the related party, or acquiring your replacement property from the related party? These three situations are analyzed separately below. Related party exchanges get special scrutiny from the IRS and are reported separately on IRS Form 8824, the form used to report exchanges. wHaT’S THE PROBLEM With a related party EXCHANGE? The IRS is concerned that related party exchanges would encourage abusive basis shifting, because a like-kind exchange results in the substitution of the basis of the relinquished property for that of the replacement property. Related parties could engage in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property, in order to reduce or avoid the recognition of gain on the subsequent sale. Because of this potential for tax avoidance through basis shifting, some 1031 exchanges with a related party may not qualify for tax deferral.[i][1] “Swapping” with a related party Occasionally an investor wants to swap properties with another investor. Both parties are doing an exchange and no third party buyers or sellers are involved. When related parties swap directly with each other, each related party must hold their respective replacement properties for at least two years after the last transfer occurs in the exchange. If either party transfers their property before the expiration of the two year holding period, both parties’ exchanges will be disqualified, and gain must be recognized on each of the original transfers, as of the date of disposition of the property. Related parties are able to structure their transaction to provide for disposal of their respective replacement properties upon the expiration of the two year holding period.[ii][2] “Selling” to a related party More frequently, the investor is using a qualified intermediary and wants to sell the relinquished property to a related party and acquire replacement property from an unrelated party. Technically, the investor is exchanging with the qualified intermediary, not the related party. There have been several Private Letter Rulings in which the IRS has held that the related party two year hold requirement does not apply when the investor is using an intermediary and through that intermediary is selling to a related party and acquiring property from an unrelated party.[iii][3] The basis for these decisions is that, since the related party never owned the replacement property, the taxpayer and the related party did not swap properties in order to shift the basis of those properties. “Buying” from a related party If an investor is using an intermediary and wants to acquire the replacement property from a related party and sell the relinquished property to an unrelated third party, it is far more likely that the exchange would be disqualified, with no deferral of tax. This is because there is a potential for basis shifting when acquiring property from a related party in an exchange. The IRS looks at the related party and the investor as one economic unit, and does not like to see the investor get tax deferral while the related party “cashes out.”[iv][4] One exception to this has been when the taxpayer acquires replacement property in an exchange from a related party who is also doing an exchange. [v][5] Exchanging fractional interests in multiple parcels There is support for the ability of related parties to exchange fractional interests in multiple parcels with the goal of consolidating their interests. In one instance, the taxpayer exchanged with a related trust and her siblings. She exchanged her undivided 25% interest in parcel #1 for a 100% interest in parcel #3.[vi][6] The IRS ruled that this was a valid exchange under §1031. In addition, the trust's subsequent sale of its interest in parcel #1 prior to the end of the two year period was not a disposition that caused recognition of gain to the taxpayer, because the avoidance of federal income tax was not one of the principal purposes of the exchange.[vii][7] What should I do? Before doing a related party exchange, particularly when planning to acquire replacement property from a related party, it is important to discuss the exchange with your tax advisor. First, make sure that you are “related” for purposes of § 1031. Not all relatives are “related parties.” If you plan to swap properties with a related party, you should consider getting a written commitment from the related party that he will hold the property he has acquired for at least two years. The two year period starts as of the date of the last transfer in the exchange, which can occur as late as 180 days after the first relinquished property closes. References; Internal Revenue Code Section 1031(f), Revenue Ruling 2002-83,FSA 200137003, PLRs 200440002, 200616005, PLR 200712012, 200728008, 200706001, 201027036, 200730002, 9926045 and 200709036).
An Overview of Related Party Exchanges
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