Driving Down Pothole Boulevard — The Cost of Not Knowing What You Don’t Know

Posted @ 11:52 am - Filed under 1031 Exchanges, Real Estate Investing, Retirement, Investment Lessons, Communication, BawldGuy Axiom

To tax accountants and CPA’s — I love you guys, and think the public assumes you know much more than is humanly possible. Just as pediatricians don’t have a clue about brain surgery, you guys can’t possibly know all the ins and outs of investment real estate. This is especially true when some of the potholes aren’t found in the Internal Revenue Code, but in a lender’s underwriting manual, or elsewhere. So please, accept my mea culpa, ok? Thanks

No matter how many times I tell clients, every 2-3 years or so I get ‘the call’. It’s the one where the investor — after they’ve closed the front end of a (1031) tax deferred exchange — tells me they own the sold closed exchange property in a partnership, or corporation or something similar. Geez, Louise, Myrtle! And just for the record, all of these exchanges entered escrow before I was invited to the party.

The problem you ask? As I’ve been telling real estate investors for decades now, lenders would have to move up the ‘I care’ ladder five rungs just to be apathetic to the needs of their investor borrowers to follow to the letter the rules found in Section 1031 of the Internal Revenue Code.

Here’s where lender requirements can set your tax deferred exchange on fire — is that your formerly tax deferred cash you smell burning?

For reasons that have sounded less rational to me for years, lenders want their borrower(s) to be human beings — period, no exceptions, stop talking ‘cuz we’re not budging. How is that a problem you might wonder?

If for example you owned your income property inside your family trust, there’s no big deal. The lender will require you to acquire any new property (like newly acquired property(s) in an exchange) in your name only — not the family trust. Again, no big deal. You’ll simply transfer the ownership to yourself, get the loan and close the purchase in your name. After it’s closed you’ll transfer the newly purchased property back into your family trust. Surely a pain, but no big deal, and pretty cheap.

What if you held the property in a general partnership with a few friends? Your group decides to sell with the intent to effect a tax deferred exchange. You’ve exchanged once before so you know the drill. Except this time you’ve changed the facts. Since the partnership owns the property which is now sold and closed, your next step is to find property with which to complete the exchange. This will require a loan. The lender will require you and your partners to sign the loan documents as themselves, not as a partnership. Also, they’ll require the you to take title outside of the partnership.

The minute you go out of title of that partnership you’ve very likely triggered a taxable event — and you won’t be able to ‘unring’ that bell.

Let me say that again.

Once you’ve closed an escrow and are ‘mid-exchange’ to coin a phrase, completing the exchange will require the same entity owning the sold property to acquire the new property. Failing to do this will kill the tax deferral 99 out of a 100 times. Lenders literally couldn’t care less about your intent, or your tax problems. If you complete your exchange by taking title in any other name than the one used to enter into the exchange — your tax deferred party has come to an abrupt and ugly end. You have hit the mother of all potholes. Get your checkbook out, ‘cuz the guy from the government will soon come knockin’ at your door, and he won’t be there to help you.

For most real estate investors this is an answer for which they simply don’t have a question. How many other questions don’t you know to ask?

BawldGuy Axiom: The questions you don’t know to ask will do far more damage to your Purposeful Plan than almost anything else you can think of. There’s simply no defense against abject ignorance.

We all have parts of our lives for which there are questions left unasked due to our ignorance. The quality of your retirement is far too important to risk because you may not have known an answer to a question you didn’t know to ask. The paradox is we don’t know what we don’t know. We do know, however, when we’re not an expert in a particular subject. We demonstrate this every time we need to consult a doctor, right? Why don’t people treat their retirement with the same foresight?

So yesterday I got the call. This means my next call is to the Dirt Lawyer, hoping he’s gonna have enough Magic Fix-It Dust to handle this. This is a deep pothole rarely resulting minor damage, easily and cheaply repaired. Broken axles are not uncommon. Hit this particular pothole hard enough and it could end up with a broken axle. At that point you ain’t goin’ anywhere.

The difference of course is there won’t be a big fat insurance check to pay all the capital gains taxes for you.

Every time this problem has been brought to me, it’s been by very intelligent folks, who’ve followed what they believed to be sound tax advice from their accountant.

New BawldGuy Axiom: CPA’s are no different than you and I. They don’t know what they don’t know either.

The difference? You’re paying them good money to run your vehicle full speed on Pothole Boulevard — and you don’t have any way of knowing it until your axle breaks with that nasty ‘Oh Lord, that can’t be good’ sound. And for the record — unless your CPA is a real estate investment specialist, it’s unfair to blame them. The knowledge I’ve been talking about isn’t found in the Internal Revenue Code.

This entry was posted on Thursday, February 14th, 2008 at 11:52 am and is filed under 1031 Exchanges, Real Estate Investing, Retirement, Investment Lessons, Communication, BawldGuy Axiom. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.