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Archive for the ‘DST’ Category

Another Real Estate Tax Loophole closed - Important to know

Tuesday, September 16th, 2008

This Capital Tax Code change caught me by surprise as I just learned about it. I had not heard anything about it and perhaps other real estate professionals are in the same situation. In the past I have had numerous clients that have used this section of the IRS code and several that are currently taking advantage of the code (including myself) but will now be affected as this goes into effect January 1, 2009. Unfortunately there is nothing preventative that can be done. A synopsis of the Internal Revenue Code follows:

A Modification of Internal Revenue Code §121

The federal government recently heightened the restrictions for those who seek to exclude capital gains on the sale of real property held as a primary residence under IRC §121. This legislation will go into effect on January 1, 2009.

IRC §121, also known as the 121 exclusion, permits homeowners upon the sale of real estate they have owned and lived in as their primary residence to exclude up to $250,000 of the capital gains ($500,000 for a married couple filing jointly) that would have otherwise been recognized. To qualify for this exclusion the real estate sold must be, or have been, the primary residence and lived in by the taxpayer for any two of the last five years. Certain exceptions apply for the two year “lived in” requirement. Taxpayers can take advantage of the 121 exclusion once every two years.

The careful utilization of the 121 exclusion has permitted taxpayers to implement strategies to take full advantage of its benefits. Such examples include:

* A taxpayer acquires investment property, not purchased as part of a 1031 exchange, and then converts the investment property into their primary residence. The taxpayer, after living in the property for at least two years, may sell the property and take the full 121 exclusion.
* A taxpayer acquires investment property as part of a 1031 exchange and then converts the investment property into their primary residence. In order to take advantage of the 121 exclusion the taxpayer must live in the property for at least two years and additionally must have owned the property for at least five years.

The latest change to IRC §121 restricts a taxpayer from taking the full 121 exclusion for periods of “non-qualified” use prior to it being held as their primary residence. Non-qualified use is any use of the property other than as a primary residence (i.e. second home, vacation home, rental). A “qualified” use is then, by default, any period in which the property is held as a primary residence.

Upon the sale of the property, the capital gains attributable to the Non-qualified time period prior to its conversion to a primary residence is no longer excludable. Any periods of Non-qualified use after conversion to a primary residence is not counted against the taxpayer, as long they would otherwise qualify for the 121 exclusion.

The allocation of capital gains between the Qualified and Non-qualified periods involves a simple fraction that takes the total capital gains associated with the sale and divides that amount between the respective periods. The Qualified period represents the amount of the capital gains that can be excluded and is determined by the number of years the property was held as the primary residence over the total years of ownership. The Non-qualified period represents the amount of capital gains that can no longer be excluded and is calculated using the same fraction, the number of years held in Non-qualified use over the total years of ownership. Keep in mind, any Non-qualified periods after the conversion of the property to a primary residence is not counted against the taxpayer.

For example, a taxpayer acquired real property in January of 2009 and owned the property for eight years. The property was held for investment for the first six years. It was then converted to the primary residence for the last two years of ownership. Of the total capital gains associated with the sale only one-quarter (2/8) can now be excluded under the 121 exclusion. The remaining three-quarters (6/8) can no longer be excluded as they are allocated to the Non-qualified period.

These changes will undoubtedly impact those that have acquired investment property and intend to change the character of the property to their primary residence in order to take full advantage of the 121 exclusion. ”

Keith Webb
CEO

Posted in Blogroll, Investment, California, DST, Deferred Sales Trust | Comments Off

The Deferred Sale Trust™ vs. The 1031 Tax Deferred Exchange

Monday, July 14th, 2008

Let’s first get to the Elephant sitting in the room regarding the DST™ and the controversy regarding whether the DST™ is simply a Private Annuity Trust with a different name.

Under the U.S. tax law, U.S. Citizens and residents must declare their income by filing tax returns and must pay tax on their income, and the taxpayer has a legal right to avoid or minimize taxes. Commonly established tax deferral methods include 1031 exchanges and installment sales (IRS 453). Various types of trusts are used by millions of taxpayers to protect and transfer assets to their heirs outside of probate and to minimize having to sell estate assets to pay estate taxes.

The Private Annuity Trust

The creation and implementation of Private Annuity Trusts (PAT) were banned by the IRS in October of 2006. The basic idea of the PAT was to utilize capital gains deferral by transferring a highly appreciated asset to a Trust in exchange for payments for life. After the Taxpayer’s death, the annuity in the PAT would go to the heirs of the Taxpayer as designated in the annuity beneficiary designation. The cited legal authority for the PAT were based on Treasury Regulations, which can be (and were) change(d) at a moments notice. The PAT could sell inventory. Depreciation recapture is not immediately taxable upon exchange and the Trustee of the PAT could be family members who allegedly were not controlled (but were in reality controlled) by the Taxpayer.

The Deferred Sale Trust™ or the DST™

The DST™ is based upon Statutory Authority, Internal Revenue Code section 453. The DST ™ is not based upon a Treasury Regulation and it would take an ACT OF CONGRESS to change the legal authority by which the DST™ is founded.

The next consideration is the Trust structure. In order to be a valid Trust, the Trust analysis has to pass a two part inquiry: (1) is there a legal trust in existence and (2) is the Trust a SHAM for income tax purposes?

A trust must have 4 elements to satisfy legality and include: Intent, Trust Property, Lawful Purpose and an Identifiable Beneficiary. Once the 4 elements have been established for the creation of a trust, then the trust must be analyzed to determine if it is a tax sham and an additional 4 factors must be reviewed in detail to ascertain economic substance for Federal Tax purposes. This “Test” is commonly referred to as BUCKMASTER vs. Commissioner, TC MEMO 1997-236 and briefly includes:

1. The taxpayer’s relationship to the Asset before and after the trust formation.
2. An INDEPENDENT Trustee (no ownership or control vested in the taxpayer)
3. No economic interest passed to other beneficiaries of the trust.
4. No restrictions imposed on the taxpayer by the trust or the laws of the trust.

So…..is the DST™ an IRS Accepted Tax Strategy?

I have recently obtained a written legal opinion from a California Law Firm licensed to practice in the U.S. Tax Court that THE DEFERRED SALES TRUST™ ALLOWS FOR THE (1) LEGAL DEFERRAL OF CAPITAL GAINS, (2) PASSES SCRUITNY UNDER THE BUCKMASTER TEST (3) NOT A REPORTABLE TRANSACTION (4) NOT A STEP TRANSACTION AND (5) IS CLEARLY DISINGUISHABLE FROM THE PRIVATE ANNUITY TRUST. In addition a Private Ruling Letter has been requested from the IRS and is pending.

The DST™ is founded upon IRS accepted Strategy to Defer, not the avoidance, of the lawful payment of Capital Gain taxation. While this is a relatively new strategy combining existing statutes of established tax law and trusts, it must be PROPERLY administered by licensed and trained DST™ Estate Planning Professionals, Trust Attorneys and Trustees. This is not a do it yourself project or one to be undertaken with untrained and inexperienced advisors. Done properly the benefits may be extremely rewarding. On the downside, the consequences could be devastating if not done correctly and interpreted by the IRS as a tax sham.

Has the Elephant left the room yet? I hope you are still with me because here is where it gets interesting.

Will the DST™ eliminate the 1031 Tax Deferred exchange?

No way. It is strictly another option for the taxpayer who may for a variety of reasons “Want Out” of ownership of assets that have a large capital gain tax consequence. For Example:

(1) You may want to sell because you are seeking retirement and feel managing your real estate or business is no longer something you want to undertake.
(2) You may want to sell because your investment appreciation is worth more than the monthly cash flow.
(3) You may want steady income and asset protection.
(4) You simply hate to pay the taxes.
(5) You may want to sell but cannot locate an acceptable property to complete a 1031 exchange.
(6) You realize that with the DST™ structure you can invest ALL your sale proceeds including the capital that would have been paid to capital gains taxation and receive an increased income stream.
(7) You realize that properly structured with estate planning you can pass on assets to beneficiaries free of estate taxes.

It is interesting to note that while capital gains tax at the federal level is 15% and while some states do not have capital gains tax, California has a 9.3% capital gain tax for an overall 24.3% tax rate. Now that hurts. So while the real estate market is currently having issues, a taxpayer could actually sell his California property 10% below market value enhancing a sale and still have 14.3% more capital in the trust earning income. Does this make it easier to complete a sale and still provide a benefit to the taxpayer?

Interested in obtaining more in depth information?

There is so much more to the Deferred Sale Trust ™. A brief article called Strategic Management of Tax Liability was the subject of our blog last month. If you see a need for the DST, act now. Go to New 1031 Alternative to view some powerpoint presentations and request an illustration that applies to your own personal needs. As with all estate planning, the DST takes some advance planning to implement.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Posted in Blogroll, Mortgage Pool, Trust Deed Investing, Investment, Opportunities, California, DST, Deferred Sales Trust | No Comments »

Archive for the ‘DST’ Category

Another Real Estate Tax Loophole closed - Important to know

The Deferred Sale Trust™ vs. The 1031 Tax Deferred Exchange

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