Law Office of Johan Deprez Tax and Business Attorney: The Sale of Investment Real Estate – A Tax Primer Thanks you all for having me here. And, of course, a special thank you to Thomas Winfield for inviting me and making all the arrangements. I’m Johan Deprez. I’m a tax and business attorney located here in Long Beach. I’ve been a California attorney dealing with tax matters for more than 15 years. Some of that time was with the IRS. I’m also a real estate investor. My goal today is to provide you with some information that may be useful to your real estate investment activities. www.DeprezLaw.com johan@DeprezLaw.com ph.: 562-841-1600 fax: (562) 366-8437

Structure of a Tax Law Practice Tax Planning Figuring out the right things to do in order to minimize taxes before you do them. Tax Compliance This is the filing of appropriate tax returns, submitting related documentation, and the payment of the taxes. Typically (e.g., income tax returns), this is done after the events leading to tax occur. Tax Resolution Dealing with the IRS (or other tax authorities) when they disagree with what you have filed (or failed to file). Before I get into some substantive aspects of residential real estate tax law, let me say a few general things about tax law. You all have heard about the “Tax Code.” Well, here it is. Behind this are the “Regulations” that explain and expand on the Code. The copy of the Regulations that I have are 8 volumes. Then there are other kinds of explanations and rulings that the IRS puts out. Then there is case law (i.e., what the courts say about how taxes work). That is just the Federal stuff. Then there is state tax and local tax. There is property tax. Another general comment. Accountants do bookkeeping (accounting), prepare financial statements, and carry out audits. Tax is an area of law that is not exclusively reserved for attorneys and allows accountants and others (tax preparers) to also participate in. This slide outlines the three types of activities in a tax law practice. My focus in on tax planning. www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Goals of Real Estate Investmen Income / Cash Flow Capital Appreciation Discuss current state of goals How they fit into tax planning www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Business Entity Selection “S” Corporation Limited Liability Company “C” Corporation It starts with selecting the right business entity. I’ve talked about limited liability protection, better organization, and other reasons for setting up a business entity and not operating as a sole proprietor. Selecting the right entity can create tax savings over a sole proprietorship. It also allows for significant tax planning possibilities during the operation and termination of the business. Sole Proprietor / Self-Employed www.DeprezLaw.com Johan@DeprezLaw.com cell: (562) 841-1600 fax: (562) 366-8437

Three Tax Categories of Investment Real Estate Sales Standard Sale The sale is fully taxed in the year the sale occurs. No tax deferral. Installment Sale The sale is taxed in all the years that the payments are received. Partial tax deferral Section 1031 Exchange The “sale” (exchange) is not taxed when it occurs, but taxed when the subsequent property is sold in a taxable transaction. Full tax deferral. www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Standard Sale of Investment RE Typical Characteristics of Sold Property: Held for more than one year. Appreciation of property value since acquisition Improvements made to the property. Rental income earned on the property. Depreciation deduction taken. Outstanding mortgage on the property. Typical Characteristics of Buyer’s Payment: Single full cash payment at close of escrow. Payment may be financed from different types of sources (standard mortgage, “hard” money lender). If any of these characteristics are not true, then the analysis may be significantly different. Be clear that “seller financing” is not one of the alternative financing methods because seller financing does not create a single payment at the close of escrow. www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Proceeds, Equity, and Gain People confuse these terms. There is a full set of possibilities with (1) Equity or net proceeds being positive or negative, and (2) a gain or loss being realized. It is a 2x2 matrix of possibilities. www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Tax on Real Estate Capital Gains www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Tax on Real Estate Capital Gains www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Installment Sales An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. Installment obligation. The buyer's obligation to make future payments to you can be in the form of a deed of trust, note, land contract, mortgage, or other evidence of the buyer's debt to you. Sale at a loss. If your sale results in a loss, you cannot use the installment method. If the loss is on an installment sale of business or investment property, you can deduct it only in the tax year of sale. Key context for this is seller financed situations. Explain why it doesn’t fit with a typical sale when a mortgage is involved Lots of rules associated with what qualifies and what doesn’t. www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Installment Sale Example Tax advantage is deferral. The capital gain is spread over the term of the deal. Discuss in reference to the tax brackets. Total over will be the same if all the terms of the sale are the same if there is no tax bracket advantage. Do example of splitting between end of year and beginning of the next year. www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Installment Sales - Interest Income You must report interest as ordinary income. You may have to treat part of each later payment as interest, even if it is not called interest in your agreement with the buyer. Interest provided in the agreement is called stated interest. If the agreement does not provide for enough stated interest, there may be unstated interest or original issue discount. Discuss interest that is too low and that is too high. There are rules for that. They depend upon the specific facts and circumstances; and monthly updated interest rates from the IRS. Do exercise with people www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Section 1031 Exchange By a proper IRC Section 1031 exchange, the taxes on the gain of the sale of a property would be deferred until you sell the replacement property that you exchanged the first property for. A deferred exchange is an exchange in which you transfer property you use in business or hold for investment and later receive likekind property you will use in business or hold for investment. The transaction must be an exchange (that is, property for property) rather than a transfer of property for money used to buy replacement property. The replacement property will not be treated as likekind property unless the identification and the receipt requirements are met. Discuss business or investment (i.e., not residential) Residential has Discuss likekind at length www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

1031 – Timing Requirements Identification Requirement Must identify the property to be received within 45 days after the date you transfer the property given up in the exchange. This period of time is called the identification period. Must identify the replacement property in a signed written document and deliver it to the qualified intermediary. You can identify more than one replacement property. However, regardless of the number of properties you give up, the maximum number of replacement properties you can identify is: Three properties regardless of their fair market value; or Any number of properties whose total fair market value at the end of the identification period is not more than double the total fair market value, on the date of transfer, of all properties you give up. www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

1031 – Timing Requirements Receipt Requirement The property must be received by the earlier of the following dates. The 180th day after the date on which you transfer the property given up in the exchange. The due date, including extensions, for your tax return for the tax year in which the transfer of the property given up occurs. This period of time is called the exchange period. You must receive substantially the same property that met the identification requirement, discussed earlier. www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437

Law Office of Johan Deprez Tax and Business Attorney: Your Tax & Business Law Solutions Provider! www.deprezlaw.com johan@deprezlaw.com ph.: 562-841-1600 fax: (562) 366-8437