1. WHAT THIS COURSE IS ABOUT
It’s not what you earn.
It’s what you keep.

2. WHAT THIS COURSE WILL COVER
How to calculate basis, depreciation and taxable gain.
Primary residence capital gains tax exclusion – IRC §121
IRC §1031 Tax Deferred Exchange
IRC §1033 Condemnation Exchange
Replacement Property Strategies
Structured Installment Sales – IRC §453

3. BASIS, DEPRECIATION, CAPITAL IMPROVEMENTS AND CALCULATING CAPITAL GAIN TAX

4. COST BASIS, DEPRECIATION, CAPITAL IMPROVEMENTS AND DEPRECAITION
In order to figure out a capital gain you must first determine the adjusted basis in a property.
Many people talk about “basis” but “adjusted basis” is the figure that is important to figure out a gain.
Cost Basis is generally what an investor pays for a property, plus closing costs. If the property is acquired in an exchange or non-arms length transaction the basis may be different.
Closing costs do not include prorated items (e.g., taxes, insurance, rent); finance charges paid by the buyer; or expenses that physically affect the property (e.g., repairs)
Adjusted Basis is the cost basis of the property, plus capital improvements, minus depreciation.
Capital Improvement - If the improvement materially adds to the property’s value (not just a repair) and prolongs the property’s useful life.

5. WHAT IS DEPRECIATION?
Depreciation is the periodic expending of an asset over the property’s theoretical economic life. IRC §1250
This tax deduction is intended to recognize the decrease in value caused by, among other things, wear and tear, and outdated interior improvements.
Depreciation benefits investors while they own a property and is a liability when a property is sold.
An investor’s cost basis is reduced by the amount of depreciation they have taken.
Land is generally not depreciable and an investor must allocate the purchase price between the land and improvements. (Properties rarely have a true zero basis.)

6. WHAT IS DEPRECIATION RECAPTURE?
Depreciation not only causes a reduction in basis, but is taxed at the Federal level at 25%, instead of 15% capital gain tax rate.
Most states do not have a separate rate specific to depreciation recapture. Instead, depreciation is taxed at a capital gain tax rate.
For Federal tax purposes the adjusted basis must be divided into gain from appreciation and depreciation.
Property that has not appreciated can still have a gain due to depreciation recapture.

7. DEPRECIATION METHODS
You must use the depreciation method in place at the time the real property was acquired.
Feb. 12, 1913 – Dec. 31, Economic Life
Jan. 1, 1981 – March 14, Years – ACRS
March 15, 1985 – May 8, Years – ACRS
May 9, 1985 – Dec. 31, Years – ACRS
Jan. 1, 1987 – May 12, /31.5 Years* – MACRS
May 13, 1993 – Present /39 Years* – MACRS
*Under MACRS first life is for residential real estate and the second life is for commercial real estate. Building must contain 80% residential rental to be considered residential property. You must chose one life for one building.
MACRS mid-month depreciation convention - When real property is placed into service the depreciation amount is computed from the mid-point of the month, regardless of when it is actually placed into service.

8. SAMPLE DEPRECIATION SCHEDULE
Period
Year
Book Value Period Start
Depreciation Expense
Accumulated Depreciation
Book Value Period End 1
2000
$1,000,000
$24,573
$975,427 2
2001
$25,641
$50,214
$949,786 3
2002
$75,855
$924,145 4
2003
$101,496
$898,504 5
2004
$127,137
$872,863
6-35
$872,863-$129,274
$152,778-$896,368
$847,222-$103,632 36
2035
$103,632
$922,009
$77,991 37
2036
$947,650
$52,350 38
2037
$973,291
$26,709 39
2038
$998,932
$1,068 40
2039 $0

9. FIGURING OUT A CAPITAL GAIN
1st Calculation: Net Adjusted Basis
Original Purchase Price (Cost Basis) Add: Capital Improvements Less: Depreciation
$400, , ,000
Equals: Net Adjusted Basis
$375,000
2nd Calculation: Capital Gain
Today’s Sales Price Less: Net Adjusted Basis Less: Cost of Sales
$750, , ,000
Equals: Capital Gain
$350,000
3rd Calculation: Tax Due
Recaptured Depreciation Straight-line ($75,000 x 25%) Federal Capital Gain ($275,000 x 15%) State Tax ($350,000 x 7%)
$18,700 $41,250 $24,500
Total Tax Due
$84,450

10. BENEFIT OF DEPRECIATION
The following examples show the benefit of depreciation deductions:

11. WHAT IS A COST SEGREGATION STUDY (CSS
A Cost Segregation Study (CSS) allows investors who own business or investment property to increase the profitability of their investment by accelerating their depreciation deductions.

12. DEPRECIATION RECAP
Depreciation is the periodic expending of an asset over the property’s theoretical economic life.
This tax deduction is intended to recognize the decrease in value caused by, among other things, wear and tear, and outdated interior improvements.
Cost Segregation Studies are all about getting the most benefit out of depreciation rules.

13. WHAT IS A COST SEGREGATION STUDY?
CSS firms are generally made up of several different types of professionals, including engineers, appraisers, architects, accountants, and attorneys.
A CSS involves reviewing a building and identifying items, such as supplemental air conditioning units, floor and wall coverings, electrical distribution systems that may be depreciated over a period of 5, 7 or 15 years.
Identifying items with a shorter depreciable period can yield substantial tax benefits to an owner of property.

14. WHAT ARE THE BENEFITS OF A COST SEGREGATION STUDY?
Most real estate investors default to depreciating their property over 27.5 years for residential and 39 years for commercial.
Included in their purchase or improvements are items which would more properly be classified as personal property with a shorter depreciable life.
Instead of waiting 27.5 or 39 years for the full benefit of the depreciation benefits, a CSS allows clients to receive those benefits over a 5, 7 or 15 year period.
Bottom line: “Its your money. Do you want to wait 39 years to get it, or do you only want to wait 5 years?”

15. Land Improvements 15 years Furniture and Fixtures 7 years
COST SEGREGATION
A cost segregation study allows taxpayers to pull out different components of total building cost which will enable them to utilize much shorter depreciable lives as follows:
Land Improvements 15 years
Furniture and Fixtures 7 years
Machinery & Equipment 5 years

16. BENEFIT OF DEPRECIATION
The following examples show the benefit of depreciation deductions:

17. IRC§121 AND PRIMARY RESIDENCES

18. IRC §121 AND PRIMARY RESIDENCES
IRC §121 provides for an exclusion from capital gains tax upon the sale of a primary residence.
An IRC §121 exclusion is available if the taxpayer has lived in the property as their primary residence two out of the preceding five years.
The exclusion is $250,000 if the taxpayer is single and $500,000 if the taxpayers are married.
You can only have one primary residences.
Spouses having separate primary residences can only each claim $250,000.

19. IRC §121 AND PRIMARY RESIDENCES
A reduced exclusion may apply for taxpayers who sell their principal residence but (1) fail to qualify for the 2 out of 5 year rule; or (2) previously sold another primary residence within the 2 year period ending on the sale date of the current home in a transaction in which the exclusion applies.
Taxpayers may qualify for a reduced exclusion for some of the following reasons:
Must sell home due to change of place of employment (50 miles);
Health related issues of taxpayer or family pursuant to IRC §152(a);
Sale is caused by “unforeseen circumstances” that taxpayer could not have anticipated before purchasing the residence.

20. IRC §121 AND PRIMARY RESIDENCES
Previous to Rev. Proc (1/27/2005, corrected 2/3/2005) and revised by Internal Revenue Bulletin (2/14/2005) taxpayers had to choose between an IRC §1031 tax deferred exchange or an IRC §121 primary residence capital gains tax exclusion.
Where a taxpayer may have rented out a property and also used it for more than two years as a primary residence, or where there is a split business/personal use of the property, it is possible to utilize both §1031 and §121
You may (must) apply §121 first and then do a §1031 exchange on the remaining portion.
While §121 does not forgive depreciation recapture, you may use §1031 for that amount, if any.

21. IRC §1031 AND PRIMARY RESIDENCES
Effective October 22, 2004 IRC §121 was modified to provide for a five year waiting period for property acquired using an IRC §1031 tax deferred exchange.
If property acquired through an IRC §1031 is later converted to a primary residence the taxpayer must own it for five years before they may obtain the benefits of IRC §121.
Earliest date you can claim an IRC §121 exclusion is five years.

22. IRC §121 PRIMARY RESIDENCE RULE CHANGES
Housing Assistance Tax Act of 2008 (H.R. 3221) will affect any taxpayer selling their primary residence as defined in IRC §121 if they do not continuously use their property as their primary residence for the five years preceding the date of sale.
Previously, so long as you used the property as a primary residence for 2 out of the previous 5 years you would be entitled to 100% of the capital gains tax exclusion of §121.
H.R modifies §121 to provide that the exclusion will not apply to periods of “non-qualified use” prior to being used as a primary residence.
However, non-qualified use after the property was a primary residence will not count against the homeowner.

23. IRC §121 PRIMARY RESIDENCE RULE CHANGES
IRC 121 Primary Residence Exemption
Year
Scenario 1
Scenario 2
Scenario 3
2011
Rent
Live in
2012
2013
2014
2015
Exemption Amount (Married)
$300,000
$500,000

24. COMBINED IRC 1031 EXCHANGE AND PRIMARY RESIDENCE CAPITAL GAIN TAX EXCLUSION
Units 5
Primary Residence %
20%
FMV
$4,000,000
Basis
$1,000,000
Traditional Sale
1031 Exchange
Primary Residence
Rental Units
Building Allocation
80%
Sale Price- Allocated
$800,000
$3,200,000
Basis - Allocated
$200,000
Realized Gain - Allocated
$3,000,000
$600,000
$2,400,000
Exemption/ Deferral
IRC 121
IRC 1031
Exemption/ Deferral Amount
$500,000
Approximate Tax Due
$625,000
$25,000 $0
Cash
$3,375,000
$775,000
Equity Reinvested
Combined Equity & Cash
$3,975,000

25. IRC§1031 TAX DEFERRED EXCHANGES

26. OVERVIEW AND MYTHS OF AN IRC §1031 TAX DEFERRED EXCHANGES
An exchange is no longer an actual “swap”.
It is sale and purchase with very little difference than a non-1031 transaction.
Exchange documents create the transaction.
The gain from the relinquished property is deferred into the replacement property.

27. IRC §1031 TAX DEFERRED EXCHANGES
No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.
Deferral of tax, NOT a tax free transaction.

28. LIKE KIND – REAL PROPERTY
LIKE KIND PROPERTY

29. LIKE KIND – REAL PROPERTY
INTENT
Intent: actions over a period of time.
LIKE KIND
Held for productive use in a trade or business. or
Held for investment purposes.

30. RULES TO OBTAIN A COMPLETE DEFERAL
Purchase replacement property of equal or greater value to the relinquished property.
Reinvest all of the net proceeds from the relinquished sale into the replacement property purchase.
Obtain equal or greater financing on the replacement property as was paid off on the relinquished property.
Receive nothing except like-kind property.

31. DELAYED EXCHANGE STRUCTURE45
DAYS
180
DAYS

32. IDENTIFICATION RULES THREE PROPERTY RULE
Exchanger may identify up to three properties regardless of value.
200% RULE
Exchanger can identify an unlimited number of properties, provided that the total value of the properties identified does not exceed 200% of the value of all relinquished properties.
95% EXCEPTION
If Exchanger identifies more than three properties which are worth more than 200% of the value of all relinquished properties than Exchanger must acquire 95% of the value of all properties identified.

33. EXCHANGE VESTING ISSUES
With very limited exception, the person or entity who relinquishes property must be the same person or entity to buy the replacement property.
A good rule of thumb is that you must have the same tax identification number on both sides of the transaction.

34. IRC §1033 CONDEMNATION EXCHANGE

35. IRC §1033 CONDEMNATION EXCHANGE
IRC §1033 operates very similar to IRC §1031 in that it defers a capital gain tax upon the involuntary conversion of a property.
An involuntary conversion occurs when an investor’s property is destroyed by casualty or taken in condemnation and the owner uses the insurance or condemnation proceeds to acquire replacement property.
The IRS requires that the involuntary conversion must be by reason of destruction, theft, seizure, requisition, or condemnation.
A threat or imminence of condemnation can justify a voluntary conveyance of property to the condemning authority.

36. IRC §1033 CONDEMNATION EXCHANGE
The cost of the replacement property must be equal or greater than the net proceeds received (including payoff of any mortgages ) from the converted property .
Taxpayer does not have to use the actual funds received from the condemnation award to acquire the replacement property. Unlike a §1031 exchange the taxpayer may obtain a larger mortgage on the replacement property.
Property acquired must be similar or related in service or use; or
If the subject property being condemned was held for productive use in a trade or business the “like kind” requirements of IRC §1031 can be used.

37. IRC §1033 CONDEMNATION EXCHANGE
The replacement property must be acquired within two years after the close of the first tax year in which any part of the gain is realized, unless the property was held for productive use in a trade or business or for investment purposes, in which case the investor has three years to acquire replacement property.
IRS has ruled that under certain circumstances the acquisition of an entity which owns qualifying replacement property will be deemed a valid 1033 replacement property. (Similar use rule must be used – not like kind.)

38. REPLACEMENT PROPERTY STRATEGIES

39. MAXIMIZING A 1031 INDENTIFICATION
Common mistake: Identifying only one property within the 45 day identification period Risk. If unable to close on the primary property after the expiration of the 45 days the exchange will fail.
Solution: Utilizing either the 3 property rule or the 200% rule, identify 3 or more properties to provide a backup property(s) in case the primary property cannot be purchased
Additional strategy: Purchasing multiple properties that in the aggregate will complete the equity and financing requirements. One or more properties can be purchased primarily to absorb the residual equity or financing needed to avoid a tax liability. (i.e. - Zero-Coupon below)

40. REPLACEMENT PROPERTY OPTIONS
TRIPLE NET LEASE PROPERTY
Deeded interest in a property where the tenant is responsible for most or all of the costs (insurance, taxes, maintenance).
Typically a company develops a location, sells it to an investor, and takes back a long term lease.
Examples: CVS, Advance Auto, Home Depot, 7-11.
Credit of the tenant and time left on a lease can have an effect on the investment’s return and subsequent sale price.
Attractive to investors because they have no day to day responsibility for the property.
Most net least properties are priced at $1M+.

41. REPLACEMENT PROPERTY OPTIONS
TENANT IN COMMON (TIC) AND DST PROPERTIES
Undivided fractional co-ownership of real estate between two or more people.
Separate deeds for each undivided interest.
Generally, most tenant-in-common (“TIC”) and DST programs are treated as real estate for exchange purposes and securities for sales purposes. Buyer must be an accredited investor.
Flexible investment amounts as low as $50,000.
Non-recourse assumable financing available.
Professional property management provided.
Certainty of closure once a client has been approved.

42. ZERO COUPON STRATEGY
In order to complete an IRC §1031 the taxpayer must take out an equal amount of debt on the replacement property as was paid off on the relinquished property.
Strategy can also be used for an IRC §1033 condemnation to purchase property of equal or greater value to the net proceeds received.
Net lease property with a credit tenant (such as CVS or Walgreens), and a long term lease, can be purchased with assumable non-recourse financing up to 90% loan to value.
Can be purchased with as little as 10% - 13% equity investment.
Useful for exchangers where their property value has retreated leaving them with highly leveraged property.
Can be used as a strategy to free up exchange equity for other replacement property purchases.

43. ZERO COUPON STRATEGY FOR PROPERTY WITH LOW EQUITY
The following example demonstrates the tax implications for a property that is “under water”:

44. ZERO COUPON STRATEGY TO ABSORB DEBT FOR A 1031 OR 1033 EXCHANGE

45. ZERO COUPON STRATEGY – CASH OUT REFINANCE

46. IRC §453 - INSTALLMENT SALES AND STRUCTURED INSTALLMENT SALES

47. INSTALLMENT NOTE TREATMENT
IRC §453 provides that to the extent a taxpayer does not receive consideration from a sale they are not taxed on the amount outstanding.
An installment sale occurs when the taxpayer receives at least one payment after the close of the taxable year in which the sale or exchange occurs. IRC §453(b)(1)
Installment sales may not be used to defer the recognition of a loss. A loss must be reported in the year of the sale. Rev. Rul
Installment sale treatment may not be used by dealers of real or personal property. IRC §453(b)(2)

48. INSTALLMENT NOTE TREATMENT
In order to figure out what portion of an installment note payment is taxable the taxpayer must determine the gross profit percentage.
GROSS PROFIT PERCENTAGE – the ratio of the gross profit realized to the contract price. IRC §453(c)
If part of the gain recognized is from unrecaptured IRC §1250 depreciation the taxable portion of the gain received is paid first at the higher depreciation recapture rate. (For sales after August 23, 1999) Reg. §
Certain depreciation methods can cause the recapture to be reclassified as ordinary income and not treated as an installment sale. (e.g. – ACRS commercial real property depreciated using accelerated depreciation instead of straight line.)
If a buyer assumes a mortgage liability in excess of the basis of the sale property the difference is considered a payment in the first year. IRC §453(f)(3)

49. DETERMINING GROSS PROFIT PERCENTAGE
1st Calculation: Realized Gain
Sale Price Less: Adjusted Basis Less: Selling Expenses
$800, , ,000
Equals: Gross Profit to be realized
$660,000
2nd Calculation: Contract Price
Selling Price Less: Assumed Mortgage
$800,
Equals: Contract Price
$800,000
3rd Calculation: Gross Profit Percentage
Realized Gain (1st Calculation) Divided By: Contract Price (2nd Calculation)
$660,000 $800,000
Gross Profit Percentage
82.5%

50. DETERMINING GAIN USING GROSS PROFIT PERCENTAGE
ASSUMPTIONS
Sale Price: $800,000, 1st Year Down Payment: $200,000, $60,000 per year for 10 years.
Basis $150,000 - $50,000 depreciation = $100,000 Adjusted Basis
1st Calculation: First Year Down Payment
Down Payment Multiply: Gross Profit Percentage Taxable Gain Multiply: $50,000 x 25% Depreciation Recapture Multiply: $115,000 x 15% Capital Gain Tax
$200,000 x 82.5% $165,000 $12,500 $17,250
Equals: Tax Due on First Year Down Payment
$29,750
2nd Calculation: Subsequent Year Payments
Installment Payment Multiply: Gross Profit Percentage Taxable Gain Multiply: $49,500 x 15% Capital Gain Tax
$60,000 x 82.5% $49,500 $7,425
Equals: Tax Due on Each Installment Payment
$7,425

51. STRUCTURED INSTALLMENT SALES
Structured Installment Sales are considered an alternative to an IRC §1031 tax deferred exchange.
If a seller takes back a note from a buyer to obtain installment note treatment they have to be concerned with the buyer’s ability to pay.
Structured Installment Sale does away with that risk.
Proceeds from sale are invested and seller receives a note secured by the investments.
Seller benefits by receiving income on the deferred taxes as opposed to only receiving income from after tax dollars in a straight sale.

52. STRUCTURED INSTALLMENT SALES
With a structured installment sale the seller assigns the sale contract to a third party company in return for an installment note. IRC §453
The third party company receives the net proceeds from the sale.
The net proceeds are used to purchase an annuity (normally from a life insurance company).
In return the third party company structures an installment note in favor of seller. Payments consist of return of basis (which is not taxed), gross profit (taxed at 25% depreciation recapture and 15% capital gain tax rate ), and ordinary income derived from annuity investment.

53. DEFERRED SALES TRUST
A Deferred Sales Trust™ is a trade name for a type of structured installment sale pursuant to IRC §453.
A DST provides for more flexibility than a structured installment sale.
Instead of purchasing an annuity with the proceeds collected , the funds are placed in a trust account and invested pursuant to risk tolerances dictated by seller during the formation of the trust.
Proceeds can be invested in stocks, bonds, mutual funds, annuities, and many other types of financial products.
Investor can obtain a tax free loan against the income of the note.

54. BENEFITS OF A STRUCTURED INSTALLMENT SALE OR DEFERRED SALES TRUST (DST)
15% Federal and 8% State taxes:
Taxable Gain: $3,600,000. (Capital Gain: $3,200,000 and Depreciation: $400,000)
Tax Due Upon Sale: $868,000
Original Purchase Price: $4,800,000
Sale Price: $8,000,000
Mortgage Payoff: $2,400,000
Gain Due to Appreciation: $3,200,000
Depreciation: $400,000
Taxable Transaction: Sales proceeds after taxes paid: $4,732,000 Earn 8% Annual Interest Income of $378,560
DST Transaction: Taxes deferred, sales proceeds is: $5,600,000
Earn 8% Annual Interest Income of $448,000
DST Income difference is 15.5% or $69,440 per year!

55. STRUCTURED INSTALLMENT SALE AND DEFERRED SALES TRUST ADVANTAGES
Security – Installment Note Payments are typically secured by the Trustee of the DST and directly against the DST assets.
Investment Choices - A taxpayer can choose whether they want to receive income only payments, income plus principal payments, income plus partial principal payments, or defer all income so that it compounds.
Tax Free Borrowing - With certain investments there is the opportunity to obtain a credit line from the income produced by the installment note thereby accessing funds without a tax liability.
Maintains Family Wealth – Unlike Charitable Trusts a Structured Installment Sale or DST maintains wealth within the family.

56. STRUCTURED INSTALLMENT SALE AND DEFERRED SALES TRUST DISADVANTAGES
Mortgage pay-off in excess of adjusted basis is not deferrable. (Same rules for structured installment sale.)
Must adhere to the formalities imposed by Internal Revenue Service and Treasury Regulations.
Fees to structure are often higher than strategies such as the 1031 exchange.
Reinvestment of the proceeds may involve more or less risk, including fluctuating returns and possible loss of principal, depending on where the proceeds are reinvested. However, risk is determined by taxpayer at formation of Structured Installment Sale or DST.

57. LEGAL NOTICE
Legal 1031 Exchange Services, Inc. and Real Estate Tax Strategies, Inc. are not able to provide tax or legal advice, nor can they make any representations or warranties regarding the tax consequences of your transaction. Property owners must consult their tax and/or legal advisors for this information. Circular 230 Disclosure: Pursuant to recently enacted U.S. Treasury Regulations, we are now required to advise you that, unless otherwise expressly indicated, any perceived federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. Legal 1031 Exchange Services, Inc. and Real Estate Tax Strategies, Inc. are separate unrelated companies.