Talking Expat Taxes #10

Pleasure. I really appreciate the opportunity.

Yeah, so we're not that big of a place, we're kind of a boutiquey place. In regard to 1031 exchanges, we, uh, operate a company called Mission Exchange. We're located in Lafayette, California, which is a, uh, a Bay Area suburban community. Uh, I've been in Lafayette practicing tax work for. About 36 years.

And, uh, we, we stumbled onto the exchange practice, uh, in 89. Somebody walked in the door and they had an exchange and we kind of studied it and looked at it. And then born after that was an exchange company. Um, and we've been doing it ever since, uh, in various forms and, and morphed and so forth and so on.

So what does an exchange company do? Uh, the tax regulations under 1031 provide. That, uh, when someone wants to do what's called a nons simultaneous exchange, which is what most exchanges are, they are in a safe harbor if they engage the services of a qualified intermediary. Uh, and that's what mission is.

Mission Exchange is a qualified intermediary. So fundamentally in exchange works something like this. Uh, you own an investment property, and this could be a commercial building. Uh, multifamily, residential, single family, residential raw land. Uh, and then the 20 regulations actually expanded that. But basically any real estate, which is not considered, uh, personal use, real estate, like vacation homes, uh, or certain other dealer type property is qualified to be involved in a, uh, 1031 exchange as, uh, business or investment real property. So you, you have a, you have a property you own, you want to sell it. Uh, you call Alex and you say, okay, well if I sell this property for a million bucks, uh, am I gonna pay any taxes? And he looks it up and he said, oh, you bought the property in 1990 for $5 or something, and you're fully depreciated and your gain's about 900,000 and federal and state taxes being what they are.

You live in maybe a, a high tax state or something, but maybe you're gonna pay 300 grand and you don't want to pay 300 grand, particularly since you want to. Uh, continue to invest in real estate. You just want to get out of what you're in. So that's, that's kind of the genesis of this whole concept. mechanically what happens is that we have a, uh, a taxpayer who's selling, they call up their real estate agent, just like any other real estate transaction.

They say, we wanna sell, how much are we gonna get, et cetera, et cetera. Uh, they list the property for sale. Uh, the broker procures a contract from a buyer. They open an escrow. And at that point, um, the escrow will typically from a pure real estate, uh, transaction point of view, it's typically anywhere from 15 to 90 days between the time that contract is ratified and the closing date.

So during that escrow period, uh, the taxpayer wants to do an exchange, and I'm loosely calling an exchange for the moment, but that's what it is. They, they would call us, for example, and we have many competitors and there's major title companies to our competitors and so forth. But, um, they would call us up and they'd say, okay, we're, we're selling, uh, a black acre and we want to, uh, do an exchange.

We don't wanna pay the tax, but we want to use the, the proceeds and we wanna go back into, uh, another property which has either been located or perhaps has not yet been located. So that, that's kind of the, the fundamental mechanics of how it starts.

So you go through, let's say you go through the, the closing timeframe and you, you sell for a million bucks, uh, net of all the selling expenses, just to keep it easy.

And you say there's no loan, there's no loan, gets paid off. So at May 15th, on the hypothetical closing date, we would have, uh, ordinarily the seller would get the money. And at that time. The seller would be, uh, that would be a taxable event. It would be, uh, gain recognition, uh, liabilities would be due and reported on that year's tax return. So, by contrast, if, uh, if the services of a qualified intermediary are implicated, uh, we, and we go through a bunch of, um, sort of formula, paperwork and exchange agreement and so forth. The upside of that is that the money from the. Closing the settlement attorney, the closing agent, whoever the case may be, they transfer that money to our company holding a trust account, a segregated trust account on behalf of the taxpayer.

Uh, and if you follow that and you follow certain other guidelines that are not easy to, or not hard to uh, do, then you avoid the recognition at that sale date and now you leave open the possibility. To buy a replacement property.

no, it's two, two separate steps. So I know in a lot of the Eastern and Southern states in the United States, uh, there's a settlement attorney, and I suspect that in the. In the foreign jurisdictions, it's gonna be a, a law office. Uh, typically, uh, in the Western States, California, for example, uh, we will, uh, we don't use lawyers for closings.

We use title companies, and the title company will be the escrow holder, uh, the settlement agent, if you will, for the transaction. So whether there's an exchange or a sale. There's gonna be a settlement agent, uh, either an attorney or a title company or something along those lines. And proceeds will be made available at the closing.

You know, buyers bring in a million bucks and then the money is paid over to the seller and it's up to the seller at that closing through the paperwork that we provide to say, no, I don't want the money. 'cause I know that would be taxable.

But instead, what I'd, I'd rather have the money sent to Mission exchange.

So that we

Right. And it's very critical. Uh, and, and it's kind of a, a sort of a standing joke around here. We, about three or four times a year, we will get a phone call to say, yeah, we closed last week through, uh, attorney settlement agent, and he still has the money. And now we want to start our exchange. Well, in general, that's too late.

of the paperwork, our company has to be implicated in the closing. And so it's a legal fiction by which our company is actually the seller for tax purposes, and our company's name will appear on the closing papers. And those papers will designate instruction signed by the taxpayer to transfer the funds from the settlement agent to our company.

That is correct

Yeah.

That is correct. And so, uh, you know, we like to have a little notice, although we are, uh, famous for emergencies as well. So we'll get a. You know, 24 hour turnaround time is, uh, not appreciated, but, uh, oftentimes happens.

Well, well, it, it's not necessarily off the table. I mean, I can get really, uh, you know, nerdy here at this point. There's, there are some rulings. So you can imagine that there is a, uh, there's a continuum. I mean, when, on the one end of the spectrum, if you have a commercial office building or a multifamily.

Uh, project and you're renting it and, and your whole aspiration is non-personal. Well, that clearly qualifies

if you exclusively use a property as your principal residence or as a secondary residence with no rental, um, application. Well, that's not qualified very clearly. Then we have what you just said, which is we do a little bit of both, so.

And, and we only have, I mean, I could regale you with eight hours of analysis, but, uh, basically at that point we need some tax person. Usually it's a tax repairer, uh, or perhaps a, uh, an outside consultant to evaluate the upshot of the use of the property. And it might be that the property doesn't qualify.

And then in looking at some rules regarding, um, uh. How, what does qualify, notwithstanding personal use. Now, we might wanna hold off on the sale and rehabilitate the characterization of the, of the property by reducing or eliminating our personal use for say, a year or two, and then selling it at that time so you don't implicate any, any sort of, uh, situations that screw up the um, 1031 exchange.

Yeah. And those discussions should really happen in what I call the, just thinking about it phase. Because if you're in escrow, you're, you're on the train to go closing and you can't really do a lot to rehabilitate the character of, uh, the property.

Uh, correct, correct. And then, and then going one step further, if you don't qualify now, uh, change your conduct and then go forward a little bit and then maybe will qualify.

not true. That's always been that way.

Yeah, correct. It was, uh, yeah, correct. It was personal property before the Trump, uh, tax act in 17.

so just to, just to deviate a little techie here. There's a thing called revenue procedure 2008 dash 16. 2008 dash 16 Doesn't take that long to read it. If you comply with the, the conduct and the timeframes and the testing periods that are shown in that rev proc, then the IRS will guarantee that you will qualify for 1031 exchange.

that's a good, uh, point of reference. If you don't qualify it for it, uh, not qualifying for the safe harbor doesn't knock you out, but it puts you back into a more general facts and circumstances test. Um, so you know, that's the starting point for practitioners or or taxpayers to read that

Correct.

Okay, so let's use an illustration here. May 15th is a closing date.

the, the statute says that a taxpayer wishing to buy a replacement property has 45 days, which would be June 29th, uh, to make a written identification of, uh, usually up to three potential replacement properties. So if I'm selling for a

from closing, yeah.

So we say May 15th to June 29th is. And I only use that to remember that 'cause I have that in my class. I teach so,

so on or before June 29th, the taxpayer is sending us a letter or some sort of transmission timestamped on that down date saying, okay, I'm identifying property one, property two, property three.

And it must be very specific. Um, and it's not done in a vacuum. I mean, part of our service is to coach the client as to what might be possible, what might, might not be possible.

so in, in, as a practical matter, usually around day 40, uh, before you're reaching that deadline, we say that clients send us, uh, an email or a scan of, of what you propose to identify, and we will evaluate that to see that it, it meets your needs, uh, because once the 45 days is over.

There's no replacements, there's no going back. That's it. And people whine all the time that, well, you know, they all, I identified three properties and they sold to other people, and now I'm outta luck and I should be able to substitute or, or something. And, and the, and the statute has no, uh, no tolerance, no, uh, no provision for that.

Just three. There, there is another rule that allows you to do multiple, uh, called the 200% rule, but, um. But we start with just three to keep it simple. And there's a whole reason why that is. And,

again, I'm coaching, so usually what happens on the exchange things is they call me directly. I mean, part of that background thing you were talking about earlier, so I'm a CPA and I'm a tax attorney and I do tax returns and I do, you know, other kinds of work.

Uh, so. I'm not just the, the clerk taking the phone call and that kind of thing. I'm, I'm, I'm actually in the weeds as far as, you know, what all these things mean and how to do it and how to navigate it, and so forth and so on.

when somebody calls me with an inquiry for a, a potential case, I will definitely spend, uh, some time with him on the phone as, as gratis and basically say, Hey, I'm gonna, um, I'm gonna ask you all about your transaction.

And we're gonna figure out what you wanna do and why you wanna do it, and all that kind of stuff. Um, so that will give them some insight and will give me some insight to help them decide whether they're gonna do three properties or, or some other number that might be permissible under the rules.

Yeah, that's correct. So for tax purposes, uh, if you don't identify anything by the due date, which in June 29th of my illustration, your income recognition date is June 30th, is it is the next day. And that's said to be the day of failure.

Yeah, well that's what I was gonna say, but it can be an advantage too. So for those people that are closing after July 4th, um, if they go into an exchange, and even if they ultimately don't buy something, the failure rule also applies on day 180, which we haven't talked about. If you go to the end of your exchange period and you don't buy anything the next day, day 180 1 is the recognition date.

there's a concept of pushing it over into the following year under the same principles used for installment sales.

And so you can pick, pick this year or next year depending on how you feel.

Well, yeah, essentially, I mean, let, let's back up for a minute. As a practical matter, we encourage people to close before the 45th day

and think about the seller. The seller gets wind that you're in an exchange and you have to close 'cause you have no more. Uh, selection.

gonna, and you want, and you wanna get the repairs paid for.

They got you over a barrel.

encourage people, uh, to line up their properties. And you could even be in contract to buy something on day five. You don't have to wait. You can do it, you can do the same day, you can do it simultaneously. And there's even a concept of doing it in reverse order.

Well, well being under contract. So if you close the sale on May 15th and you've closed the purchase on, uh, May 16th,

then that's considered a forward style exchange. Sell first, buy second. There is a concept of closing the replacement property prior to that May 15th date. That's a reverse exchange.

and that eliminates the 45 day problem.

That's an option. It, it's a little more expensive from our fee point of view, and it's also a little more. Um, unwieldy, shall we say, but depending on who it is and so forth, it, it is a possibility. And, and a lot of people choose that, uh, option.

It's a form. You sign your mail to us. That's all it

Alright. You, I, I say at least get in contract 'cause you know you've got something you can fall back on,

Well, the, the, the, the, uh, second part of the statute on the, on the Nons simultaneous exchange is the 180 day, um, exchange period. So in that, in that same example, when you close on May 15th, you're closing, uh, the purchase of the replacement property, not later than November 11th. Which is 180 days, people say six months all the time.

If it's not six months, it's 180 days. So November 11th is the hundred 80th day. So one of those three properties that you've selected in that identification process must close on or before November 11th to satisfy the exchange rules and get the deferral.

Then the, then the failure date would be November 12th in that example. And that would be the gain recognition date for tax purposes?

Correct. Running concurrently.

Correct. I mean, you know people, couple of things I've noticed over the years, people get, or their real estate agents, they get freaked out about exchanges and they don't want to do it or they, they try to talk the client out of it 'cause they don't understand it. So what I say to them is. Number one, it's a sale and a purchase.

And all the ordinary headaches of a real estate deal are incumbent in each of these things. The exchange part of it is just a, an extra layer of bureaucracy, frankly. Uh, but it does have the value of avoiding the taxes on a sale. We're always here to coach. Um, and then if, actually, if the real estate agent realized it, uh, they get a sale.

And then they get a purchase and there's a deadline to get paid the next commission. So they should be happy about this.

That is correct. So the statute says if you, yeah, if you sell in, if you sell in the United States, uh. The only properties in the United States are eligible if you sell outside the United States, then the, uh, only properties outside of the United States are eligible.

I mean the, the most, the most recent one we did, the, the, the money piece of it is, is usually where, um, the most challenges are. So we actually closed, um. deal in London, a sale. And then about two months later, we closed the purchase. So the, the TA and the taxpayer was actually located in California, but he had the properties in England,

when we closed the first deal.

And they've got settlement attorneys in England. So when close the first deal, all of our paperwork is sort of. Like extra. It's, you know, sort of this addend that they don't understand, don't appreciate, don't care about frankly. Uh, but they usually just are, as a courtesy, they're accommodating all this jazz.

And in this case, what we did was the English bank or the English, uh, settlement attorney actually sent, uh, pound sterling to our bank in California, and then we converted to the US dollars. And then when we shipped out the money back to England, we converted again. So there was some currency risk from that perspective.

Um, and of course that's on the client.

I don't require that. Um, and frankly it's sort of a headache, but, uh, I'll do it if it makes sense. So it made sense in this circumstance. Now, the other side of it though is if I'm a us I'm a California corporation basically, and I don't really have any standing or nexus in some of these foreign jurisdictions.

But ordinarily what would happen is I would set up a, some sort of a limited liability company or corporation in the foreign jurisdiction that would hold the money

Yeah. Mission exchange, a California corporation. So they, it would set up, uh, a subsidiary a hundred wholly owned subsidiary, um, that's formed in the foreign jurisdiction.

Okay. And then the settlement attorney would make arrangements to set up the banking, uh, to hold the money. And again, the goal

Yeah. Correct.

Uh,

yeah, I, I mean, I wish I had that much volume.

but

Yeah, a co couple things. One thing, we blow 'em out because if we use them for somebody else, they're kind of like, uh, you know, somebody else using the same go cup or whatever. I

Although our experience with Costa Rica is, I think everything down to your, down to your ATV is incorporated, as I recall. I, I, I did have an, yeah, it's a, it's a, it's a pretty interesting place.

that's from my experience as well.

I agree. I understand.

Correct. I, I would agree.

Right.

I said, I, I've, I've been teaching an eight hour class to all the California CPAs for about 20 years. And, uh, and I, and the interesting thing about this business is there's no, there's always a new adventure. There's always something new that comes up, even though it seems like it should be routine, it's just crazy how.

people, it's just a matter of people and stuff and, and, and things are, uh, unique, so,

well, uh, my phone number is (925) 283-1031.

Yeah. What, what a questions. Yeah, we, Hey, if it was 2020, I'd be an eye doctor.

and then our email is, uh, 1031@goscott.com, G-O-S-C-O-T t.com. 1031@goscott.com.

Yeah.

Okay. Thank you very much.