In this clip from the latest Equity Advantage 1031 Exchange class, David Moore explores 1031 Exchange Questions surrounding gain, including phantom gain and how to determine gain. Learn it all right from the 1031 exchange expert himself!
What Is Gain?
Watch, Listen or Read:
What is gain? I’ll say this. The great thing about my job is, gain is only important from the perspective that it justifies the transaction. I don’t have to figure this out. However, with that said, every day I go through this with people because I want to know whether the exchange makes sense or not. I want to know what that person has, what the property is, what they paid for it, what they’ve put into it from the time they’ve owned it, so on and so forth. So gain is simply the adjusted sales price minus the basis on the property. What’s your basis on the property? Purchase price, plus capital improvements, minus depreciation… in a nutshell.
And once again you want to talk to your tax people, get their perspective on things and understand exactly what your obligation is, but this is how quickly it changes. Remember I talked about gifting? If I gifted a property to a kid of mine, what would their basis be? It would be what mine was. If I bought the property and they inherited it, they get the stepped up basis. Like I said, basis is purchase price, plus capital improvements, minus appreciation. My point is, depending on how you receive that property, that initial number varies dramatically.
What if you did an exchange into it? And you had a basis carry forward.
A 1031 is a tax deferred exchange, it’s not a tax-free exchange. I hear people say tax-free all the time. It’s not. It is tax deferral. Basis gets carried forward, and gain goes forward. Anybody remember 1034, the old residential rollover? So in ’97, we had that change for 1034 to 121. A 1034 was a rollover. So, you sold your home, and you had two years to buy a new home of equal or greater value. If you’re 55 or older, you have a one-time exclusion of $125 in gain. The reason I bring that up is, we had a basis carry forward once again.
Depending on how you got that property, that initial acquisition price is going to vary. If you pull it out of your pocket, that’s what you paid for it and that’s the initial number. But if you exchange into it, you got a basis carry forward. 1034, basis carry forward. Gifting. The person that granted the gift, their basis. Inheritance, stepped up basis. So, that number can vary dramatically. Plus, improvements. So, I talk to people every day and I say okay, during the time you owned the property, did you do any capital improvements? “Oh yeah, I did this, did that, did all these different things.”
So, did you write off anything? “Oh, I wrote it all off.” What’d they do?
David Moore: They expensed it, they didn’t capitalize it. Expensing, if you write it off, does nothing for your basis. Capitalizing does. Depreciation. Did you take depreciations? It’s been a rental house for the last 10 years for you, did you take depreciation? “No, no I didn’t do it.” What’s the government’s position?
Attendee: You gotta take it.
David Moore: You should have; therefore you did. So maybe you didn’t even get the benefit of it, but they are going to treat you as though you did. So that’s even worse than the other, but the bottom line is that you’ve got depreciation and it’s going to be on that. If you just bought a property, say an investment house for example and never rented it, you’re not gonna take depreciation on it. It is just sitting there. But if you start renting it then you’ve got to take depreciation.
I have a question. Let’s suppose you started with one thing, and then 30 years later, things get swapped to say, property number six or seven. And suppose you have your basis carries forward, who besides you is keeping track of that?
David Moore’s Answer:
Remember your tax people… Every time you do an exchange, the year in which you do the exchange with your tax return and you’re filing an 8824, which has a basis carry forward calculation. But as far as going back-
Yeah, how do they go back? So what’s to prevent you from making a mistake in the basis calculation?
David Moore’s Answer:
Well, that’s the thing, if you made the mistake long enough ago then you’re fine. I think that they can only go back so far. But, once again that’s why you want tax people … I want tax people anyway because I don’t want to have to deal with that stuff. Just think about that change, that drop and swap I talked about changing ownership. What happens with that if somebody questions it? I want to make sure that’s done.
Let’s say you take your home and convert into an investment. Or, we take an investment and convert it into your home. There’s no tax consequence on the conversion, but there potentially is downstream if we’re not careful with what’s going on. How can you argue against flat tax? It’s just straight, and simple. But, what are most politicians? Lawyers, right? And, what percentage of legal practices is estate planning or tax planning, and back of the tax world too?
So you think about that stuff. You think about deductions, you think about write offs, or any number of things that could go wrong and it’s complicated. It gets very complicated very quickly. So that’s why you’re always looking at maintaining records the best you can. For example, I once had a gal I’ll never forget. She got a property, so I’m going through the stuff with her. And I asked, so well, what’s your basis forward? She said, “I don’t know”. What do you mean you don’t know? “Well, my husband gave me your name”. Well, can you talk to him? “No he’s incarcerated”. Well, where did he get it? “Well, he got it from a buddy who’s incarcerated.”…
So obviously what was my advice? Okay go talk to some tax people, so you’re not going to be incarcerated, let’s do that. The deal is you have to fix it, do the best you can, and make sure you have a reason to support it. If you’re making changes to stuff, make sure that you have a reason to do the stuff. There’s a bold down there that says phantom gain, and I think this is something that’s really important. Something that people do not understand.
If the debt exceeds the basis, the delta between the debt and that basis IS gain.
Unfortunately, the last decade has been pretty tough on a lot of people. You got a lot of foreclosures, and a lot of things happened. But you’ve got a home foreclosed, and you’ve got some tax relief on that foreclosure. On income properties, you don’t. With income properties, sort of the ultimate slap is, you could lose a property to foreclosure, and pay for that privilege. What I mean by that is, in a foreclosure, the government treats the debt on the property as the sales price. So if the debt exceeds the basis, the delta between the debt and that basis IS gain. And believe it or not, I think we’ve got two more properties that we’re expecting to go through. These are big properties, like this once we are in being foreclosed before years end. And what happens is, we end up getting involved in transactions just pre-foreclosure so that when the property’s foreclosed, our client has been removed of any actual debt relief. And that’s what we’re talking about, triggering the gain in that situation.
And their choice is this, they lose the property and pay tax for that privilege or, we set up an exchange. It’s really sort of funny because we don’t get any money, we just have an exchange agreement in place, and assignment of membership interest that transfers the asset once foreclosed. We have just isolated our client from debt relief, and the date of the assignment starts at $45,180. So for our clients it’s a pretty easy choice. If they’ve got money to go forward, their choice is, hey, I’m gonna pull money out of pocket, pay the tax and get nothing or I can pull roughly the same amount out, and go get a property. So they’d obviously rather do that.