Some Trojan Horses Real Estate Investors Should Know About

Posted @ 10:58 pm - Filed under 1031 Exchanges, Dallas, Lunch With Mom, RE investment strategies, Retirement Income, Tax Shelter, Texas

Some thoughts for you which came my way after lunch with Mom. Nothin’ like crazy thick pork chops and veggies after an incredible salad to get the gray cells doin’ their synapse thing. She even sent me home with an extra chop, which I left in Josh’s car when he dropped me off. He was raised right, so I’ll get it back tomorrow. Faith is a wonderful thing, isn’t it?

Think buying income properties, allowing them to grow in value over time, then exchanging them — tax deferred via 1031 — for the next 30-40 years is the ticket to your dream retirement? Think again 1031 Cult Breath. Here’s the wicked little surprise that’ll be awaiting you on the first April 15th upon retirement.

Think of a gigantic teeter-totter you’ve lovingly constructed during those 3-4 decades of investing and tax deferred exchanging. One end is heavy laden with tons of retirement income. Pat yerself on the back — great job. The other end of the teeter-totter is loaded with the $4.93 a year of depreciation you have left, due to a huge lack of Planning when it came to tax shelter for all that retirement income.

Oops.

A relatively recent change in tax law involves the taxing of ‘used depreciation’, called ‘Recapture’ at a different, read, higher rate than capital gains. You can pay 24% on the accumulated depreciation you claimed on your tax returns during the ownership of any particular property. You shrug, saying OK, whatever.

Here’s whatever — this tax is on a ‘paper’ event. This isn’t like capital gains taxes for which the taxpayer usually has cash from which to pay said capital gains tax. Nooooo — This tax will come from whatever money you happen to have on hand. So if yer a do-it-yourselfer, be aware of this potentially nastiest of surprises.

Finally, in the last couple decades I’ve been the bearer of bad news on this specific fact of real estate investment life about a dozen times or so. A couple of those times I was told BEFORE it was too late. Here’s the scenario. You bought a property eons ago, and now find yourself with a couple boatloads of equity. You decided to pull out a largish portion of that equity in the form of a new loan. You take the lion’s share of your new found, absolutely tax free (not deferred) cash to buy more property, pay off your Beemer, and write two tuition checks for a couple youngsters carrying your DNA.

A month later you decide it’s time to trade that property, as you’ve become aware of some superb duplexes in the Dallas/Fort Worth area. You sell the property, quickly turning it into a tax deferred exchange — following the rules at every turn. You close the exchange and are very pleased with the results. Then you fill out that irritating form your CPA sends you at some point every year around Halloween or thereabouts, which asks all kinds of questions in anticipation of that year’s tax return, due next April. Then you get the phone call. Your accountant says you may have an itty bitty problem, and by the way, why didn’t you keep him/her in the loop during the exchange?

See, you paid $200,000 originally, then borrowed $400,000 shortly before you did the 1031. You’re intent was pure — refinance to purchase more investment property, pay off your car loan, and get your kids through another year of college. Problem is, the IRS employs a very cynical group. They may send you a staggering tax bill for capital gains received via that very same loan you put on the exchange property just before you did the exchange dance. Why? Simple — You took the ‘tax free’ cash out via the new loan (here it comes) ‘…in anticipation of executing a tax deferred exchange for the sole purpose of avoiding the capital gains taxes for which you would’ve generated had you taken that same cash out of the exchange proceeds’. Have fun finding that wad of cash.

Oops.

Now to be fair, I’ve seen clients and other investors do exactly this and not pay taxes. Why? Who knows? My theory’s always been that it’s something most investors don’t do, at least on purpose, and it just doesn’t get picked up by those reviewing your return. But still, who knows? Not me. But like Clint Eastwood said, “Ya feelin’ lucky?”

Everybody have a wonderful July 4th weekend, and stay safe. Keep this post in mind when you call me the first of the week. 619 889-7100. Have a good one.

This entry was posted on Thursday, July 2nd, 2009 at 10:58 pm and is filed under 1031 Exchanges, Dallas, Lunch With Mom, RE investment strategies, Retirement Income, Tax Shelter, Texas. 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.