1031, Deductions On L/O's, CFD's
Newbie question here.
I'm trying to figure out the tax implications of some of the selling techniques being utilized. If I understand 1031 basics, I can't just flip houses and qualify, but how do the other selling techniques come into play?
Can I 1031 if I sell on 2 year L/O? What about CFD? There are several tax factors I'm trying to understand in order to choose the appropriate selling method. For instance, I understand that if I buy sub2, then I get the mortgage interest deduction, but I am still unclear as to how my method of selling affects that deduction as well.
Overall, I guess I am trying to figure out what the various combinations of tax benefits are depending on the manner in which the property is sold, and how to evaluate the benefits of tax savings, both long and short-term when devising a selling strategy.
Thank you.
If you are flipping property, regardless of the exit strategy used -- whether lease option, contract for deed, or straight sale, your income is ordinary income. No capital gains tax treatment applies regardless of your holding period.
Mortgage interest you pay is included in your holding costs and reduces your total taxable profit. Your profit is also used to calculate your self-employment income taxes on Schedule SE.
Review a copy of Schedule C (1040) from the IRS website and instructions for that form to get a clearer idea of how your profits are reported and taxed.
OK, thanks Dave. I'm learning a ton from your posts, but am rapidly reaching maximum capacity... some of it is spilling out my ears.
The reason I had the question was I was thinking that a L/O is actually a lease for the first 2 yrs, and the "sale" part doesn't occur until execution, until then it's just an option, and the person occupying the property is paying rent... So I guess the IRS doesn't see it that way?
I must say there's a ton of info here. For my first few deals, I'm not going to attempt to reinvent the wheel, just do what the masters say, but I would like to learn as quickly as possible the tax implications and strategies... I've been crippled in business by taxes before, and that's WITH a supposed expert accountant.
I see the legal, contractual, and liability reasons for the various structures used when acquiring property, but I think the tax part is going to take me a little longer to digest... It seems this has partly to do with structure, and partly to do with exit strategy (holding vs. flipping, etc.)
Can anyone put in newbie terms (or point out a resource) what tax implications I should be aware of in the following examples depending on exit strategy:
I acquire a property sub2 in a separate trust with llc, blah, blah... like everyone says to do. I then turn around and.
A Sell it outright
B Sell it but hold a secondary note
C L/O on 2 yr term
D Sell it on CFD (I forget if this is dif. than wrap)
E Rent it out for x years before doing one of the above.
Is it the length of time I do E first that determines eligability for 1031? Is there an L/O structure that makes me eligable?
You get the idea. I know it's a big open-ended question, and I'm not looking for a CPA education (yet)... just some of the basics guidelines to help me uncover hidden values or expenses in these methods.
The actual requirement that must be met in order for a transaction to qualify for 1031 exchange treatment is that the taxpayer/exchangor must have the INTENT to HOLD the property for rental or investment or use in a business. The Treasury Regulations are very clear that INTENT is very important, but they do not define how to demonstrate INTENT. This is where the amount of time for holding a property comes in. The easiest way to demonstrate your INTENT to hold a property for rental or investment is to do just that - HOLD it. The longer period of time that you HOLD it the better your case of proving that you intended to hold it. Most tax advisors recommend at least one (1) year.
It is also clear that if you qualify as a dealer you do not qualify for 1031 exchange treatment. And, similarly, if your INTENT is to buy, fix up and then flip a property you clearly do not have the INTENT to HOLD the property and will not qualify for 1031 exchange treatment.
Having said all of that, only the taxpayer/exchangor can determine how aggressive or conservative they want to be. The shorter the time for holding a property the more aggressive you are positioning yourself, and the longer the time for holding a property the more conservative you are being.
Understood. And I can see how intent could be argued either way with L/O's which may have a low close-rate.
I guess what I'm looking for is how courts have ruled in related cases... and do those rulings have to do with the woding of L/O's, or just the fact that they were used as the instrument of transfer.
As with most things, I'm trying to figure out where the real-world line is... after all, I've heard the "1 year" estimation a number of times, and if your L/O's are well-structured and never close anywhere near that.... well someone must have already fought the battle on this...
I have not seen any court decisions that specifically relate to this issue. The issue of demonstrating INTENT is very difficult in these types of structures. This does not give you much in the way of guidance - and there is really no sure thing - but I would look at the big picture. If you routinely structure L/Os on all of your properties immediately after purchasing them then your position is weakened and difficult to demonstrate that you INTEND to hold the properties (although it may still be allowed if you hold it full term). Alternatively, if you routinely hold all of your properties and only use the L/O every now and then due to the specific issues within certain transactions then you are in a much stronger position. You can not make a statement either way that it does or does not qualify, only that certain positions and techniques may strengthen or weaken your position/arguements to be used in the event of an audit.
Well, I certainly appreciate all the guidance... it seems, though, that the concept of "dealer status" is shrouded in shades of grey.
I'm a very "big picture" person. Once I understand WHY I'm doing what I do, and what the rules of the game are, I can make the appropriate play in any situation. Without that eagle's view, however, REI would be too risky for me.
I guess the big picture here boils down to the pros and cons of being a "dealer" Before reading on here, I assumed I would be buying and holding. I also assumed I would take my time and cherry-pick higher equity deals, and use a property management company.
I have always liked the concept of a L/O for obvious reasons. The more reading I do on here, the more I am starting to see that the longer view is not always better... sometimes the medium-range plan can pay off handsomely with far fewer troubles. Ultimately, I want what most of us do: To create as much passive income as possible as quickly as possible... AND TO BE ABLE TO KEEP IT!
That being said, I'm not one to cut off my nose to spite my face, nor one to win the lottery and complain about the taxes, so does anyone have a rough guide for figuring out (for someone starting without $) the relative values and costs associated with protecting an investor status vs. biting the bullet and hitting the ground running as a "dealer"
I realize this is probably very subjective, but even if you have only a strong preference in one direction or another, I would love to get different viewpoints to have a balanced perspective. Which side of the fence are you on and why... and now that you've learned a few things about taxes in the trenches, would you do it differently if given the chance? If your best friend were starting out, how would you advise them to make the most with the least effort, and least tax exposure?
Thanks as always, and I appreciate the wealth of knowledge each of you have shared.
Cardinal Rule of Real Estate Investing:
Never make taxes the sole basis of your investment decisions.
Your attitude concerning taxes should be, "I can't wait for the day when my income tax bill reaches $1,000,000 !!" When that happens, your total income is likely to be somewhere near $5MM. To pass up an investment because you will have to pay taxes is short-sighted.
Remember, noone ever went broke taking a profit, even after taxes.
If you eliminate the tax angle, your question really boils down to whether you should start investing for quick cash profits or take a slow road to wealth as a landlord. This question has been discussed often in the Beginners Forum, and is really outside the scope of this forum.