Capital Gains Rates Revisited

SOME VERY USEFUL INFORMATION

In this edition of the Real Estate Revolution, we will share some useful information that is to short to warrant a single newsletter.

CAPITAL GAINS RATES REVISITED

Exactly what Capital Gains rate applies to the sale of your property depends on several things, including when you bought the property, when you sold it, your overall income level and sometimes what tax-code changes are made in the meantime.

Currently, capital gains may be taxed at 5 percent, 15 percent and 25 percent or a combination of rates (These lower rates are scheduled to end on Dec. 31, 2010). These tax levels are known as long-term capital gains and apply to property that you hold for not less than 366 days (more than one year). The long-term capital gain tax is, generally, much lower than what you pay on your regular income.

In fact, it is a taxpayer's income level that generally determines which capital gains rate is owed. If your profit pushes you into a higher bracket, you could possibly be taxed at a combination of rates. And you could face yet another rate depending upon the type of property you sell.

Remember, each of the rates state here are the "long-term" capital gains rates. In most cases, that means you have to hold a property for more than a year before you sell it (366 days). If you cash it in sooner, you'll be taxed at the "short-term" rate, which is the same as your ordinary income tax level, which could be as high as 35 percent.

5-PERCENT RATE: This capital gains rate applies to taxpayers in the 10-percent income tax brackets. They will pay a maximum 5-percent long-term gains rate on property they held for more than 366 days.

15-PERCENT RATE: This most widely paid capital gains tax rate applies to long-term investments by individuals in the 25-percent or higher tax brackets. When you hear "lower capital gains rate," it generally means this level, because there are few investors with incomes low enough to qualify solely for the 5-percent rate.

25-PERCENT RATE (RECAPTURE OF DEPRECIATION): This rate applies to part of the gain from selling real estate that you have previously depreciated. Basically, this keeps you from getting a double tax break. The Internal Revenue Service will first recapture some of the tax breaks you've been getting via depreciation. You'll have to use Schedule D to figure your gain (and tax rate) for this property, known as Section 1250 property. More details on this type of holding and its taxation are available in chapter three of IRS Publication 544, Sales and other Dispositions of Property.

CAPITAL GAINS AND YOUR VACATION HOME

One mistake people make is thinking that because their vacation home is a residence, the capital-gains tax exclusion applies says lawyer William Abrams, a partner with Abrams Garfinkel Margolis Bergson LLP, a law firm in New York. "They say, 'It's a house. I am not going to have to pay capital gains tax on it when I sell it," says Mr. Abrams. That's not the case, he says. In actuality, the capital-gains tax exclusion ($250,00 non-taxable capital gain per spouse), generally applies only to principal residences, says Mr. Abrams, whose practice includes tax law. Vacation or second homes don't normally qualify.

UNDERSTANDING A HOMES ADJUSTED BASIS

What is known as a home's "adjusted basis" figures prominently into how a gain or loss is calculated after a residential property is sold. A home's "adjusted basis" is how much a homeowner originally paid for a house, including closing and settlement costs and debt (this doesn't include mortgages other than the original mortgage though), plus any qualifying home improvements made. These qualifying home improvements include ONLY items that increase the value of the property like a pool, another room, new roof etc.

For Uncle Sam, the gain or loss on your home sale is calculated by subtracting the adjusted basis from your selling price (less any related expenses (like qualifying home improvements) BUT not ANY of the debt other than the original mortgage). Therefore, the larger your adjusted basis, the less your gain may be (in the IRS's eyes), which may reduce your tax load.

IRS INSTALLMENT SALES

An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. If you dispose of property in an installment sale, you report part of your gain when you receive each installment payment. NOTE: You cannot use the installment method to report a loss.

General Rules: If a sale qualifies as an installment sale, the gain must be reported under the installment method unless you elect out of using the installment method OR you are not a qualified "accrual" method taxpayer. Most people/entities use the "cash" method of accounting and not the "accrual" method of accounting.

References/Related Topics

Form 6252, Installment Sale Income (PDF)

Publication 537 Installment Sales

Please visit www.priorityservicellc.com for lots more info regarding capital gains

The Depreciation Recapture Tax Trap Part 2

In this edition of the Real Estate Revolution, we will provide our readers with an understanding of depreciation.

Wow! The recently passed tax law just lowered the capital gain tax rate to 15%... great, uh? Well yes, but not so fast! We all know how important it is to understand how the tax law affects our real estate investments. Understanding and forecasting the tax ramifications of rental property ownership is a critical step in the screening and decision making process. Misunderstanding and misapplying the tax law during your analysis can result in ghastly surprises.

As a real estate investor, you can depreciate our rental property and enjoy the positive cash flow resulting from write-off of tax depreciation. Tax depreciation helps shelter rental income that is subject to "ordinary income" rates which is generally higher than capital gain rates. The depreciation taken reduces our property's tax basis, which effectively increases our tax gain when we later sell. If the property is later sold at a gain, this gain may have resulted from the depreciation previously taken. To the extent the gain is attributable to depreciation taken, this gain is generally referred to as "recapture", or Internal Revenue Code (IRC) Section 1250 gain.

The Taxpayer Relief Act of 1997 imposed a 25% capital gains tax rate for unreceptive IRC Section 1250 gains. When coupled with the changes made by the 2003 Tax Act, all depreciation taken can give rise to a higher rate of tax than the newly reduced 15% long-term gain rate. The effect of which is that you will most likely pay more tax upon the sale of a rental property than the 15%.

By way of example, let's assume you purchase a rental property today for $100,000. The total tax depreciation you plan to take over your estimated ownership period is $25,000. You also project the property will be worth $140,000 when it is time to exit your investment. Your projected tax gain will be $65,000 ($140,000 less $75,000 ($100,000 cost less $25,000 depreciation)). Since your gain is greater than your accumulated tax depreciation, the recapture rule will apply. As a result, your tax on sale is not $9,750 ($65,000 x 15%), but rather $12,250, 25.6% more in taxes than what you planned!

The amount subject to the higher (25% or ordinary) rates is limited to the gain on the Sec. 1250 property. If the gain is allocable primarily to the land, the rate of tax on the overall gain from sale may be brought back toward the lower 15% long-term rate. The consequences could range from no benefit for buildings, which have increased in value above their original acquisition basis, to significant benefit where a building is close to the point of being demolished, the principal value component being the land.

In summary, make sure you take into consideration the potential depreciation recapture tax bite when performing your cash flow and rate-of-return analysis.

EDITOR'S NOTE: Adding insult to injury, ALL transaction wherein the investor have depreciated their property, the taxman will expect to receive Self Employment taxes of 15.3% on the first $97,500 of income received by the investor. Depreciation is truly a tax trap for the unwary.

Real Estate Investors Beware!

The depreciation recapture tax trap part1

In this edition, Priority Services Group will help our readers understand depreciation.

You cannot exclude from taxation any gains, which are attributed to the depreciation you claimed after May 6, 1997. I'll explain what that means in a minute.

You have owned the rental property for 11 years (which means you bought the property in 1995), and you rented out the property starting in 1997 (after living there for two years), it is likely that all or most of your depreciation will be recaptured.

Here's what recapture means. It means you have to pay tax on the gains that are attributed to depreciation. And these gains are taxed at your ordinary income tax rates, not at the much lower long-term capital gains tax rates. This is explained in IRS Publication 523, Selling Your Home, in the section entitled Business Use or Rental of Home (link to IRS Web site).

Let's provide an example with numbers to illustrate how depreciation recapture works in real life. I'm going to be making these numbers up. Your actual tax situation will be different. Let's say you bought the home for $120,000. And you started renting out the house on July 1, 1997. (This is conveniently located after the May 6, 1997, cutoff date. I'm trying not to have a math headache today.) You would have claimed $2,000 in depreciation in 1997, $4,363 in 1998, and $4,363 every full year after that that your property was rented out. So let's say the property was last rented in December 2005. This would give you eight full years of depreciation, and one partial year of depreciation, for a total of $36,904. This total depreciation is what accountants call "accumulated depreciation."

Accumulated depreciation reduces your cost basis in the property. So your initial cost of $120,000 gets reduced by this accumulated depreciation of $36,904, leaving you with an "adjusted cost basis" of $83,096. There may be other adjustments to your cost basis as well, such as capital improvements (roof, foundation, etc.).

Now, let's say the house will be worth $250,000 when it is sold, and you plan to sell the house after meeting the two-out-of-five year rule. The selling price minus the adjusted cost basis will equal the gain or loss. In this case, $250,000 minus $83,096 equals a gain of $166,904. Here's where the fun begins. Of this gain, the first $83,096 is taxed at ordinary income tax rates as depreciation recapture. (These are called "ordinary gains.") The remainder is considered capital gains. The capital gain portion in our example is $166,904 total gain minus $83,096 ordinary gain equals $83,808 capital gain. Only capital gain portion can be excluded under Section 121, up to the limits I mentioned above. As long as you live there a total of 24 months out of the 60 months preceding the sale of the house, these capital gains can be excluded.

Now, I hear a tiny voice somewhere saying, "Ah, well what if I didn't claim any depreciation? Then I won't have to recapture the depreciation." This wily tax strategy is already anticipated in the tax law. You must recapture depreciation you actually claimed or could have claimed for renting out the house.

The bottom line, in this example, is that your total gain is partially excluded and partially taxed. You will report the sale on IRS Form 4797 (Sale of Business Property).

Because of the complexity of your tax situation, now would be a good time to make friends with a tax professional. You will need to gather documents to accurately calculate your adjusted cost basis. Very likely, your tax professional will provide additional tips of what documents to gather.

Additional resources

Selling Your Home: Capital Gains Taxes

Selling Your Home, IRS Publication 523

How To Depreciate Property, IRS Publication 946

Residential Rental Property, IRS Publication 527

When Must You Recapture the Deduction, from Publication 946

A collapsing real estate market, how can you survive?

The Escrow Recovery Program can help during a collapsing real estate market

In today’s collapsing real estate market property sellers need all the help they can get in order to retain as much of their hard earned equity (profit) as they can. Unfortunately, this declining market is expected to worsen over the next 12 months while the market attempts to stabilize.

However, it is interesting to note that real estate IS selling in almost every market, but those properties that are selling are those that are “priced right” for the market they are in. In a “down market” such as the one we are in, having your property priced to sell (priced right) will make the difference between selling and not selling.

OK, now that we have stated the obvious, lets discuss what can be done to overcome these problems and effectuate a profitable sale. Some people have resorted to the use of what is called a 1031 exchange. This is a suitable alternative should you not need to receive any funds from the sale of your property and you don’t have a problem with the process requiring you to purchase another “like-kind” property through a disinterested third party who you MUST use to handle your transaction within a very narrow time frame. However, this tax deferral program will catch up to every participant when they stop trading one property for another and want some cash from the sale of their property. At that time, ALL the taxes that would have been paid on each sale (transfer) are combined into one giant tax bill that in many cases becomes far more onerous than if you had paid the taxes on each sale (transfer).

There is another little known and much misunderstood alternative that most CPAs and other professionals have overlooked for years. That is an Internal Revenue Code Section 351 transfer. Like a 1031 exchange, it is a tax deferral process but one that can and will eliminate much of the cumbersome aspects inherent in 1031 exchanges.

In the 351 process you need not purchase a “like-kind” property, don’t need third parties to officiate the transaction, can defer (and possible eliminate) all taxability related to the sale of the property and the 351 exchange WILL allow program participants to receive cash from the sale without penalty.

How a 351 exchange works:The 351 exchange is a process whereby a property owner creates a specially crafted C-Corporation and exchanges the “basis” they currently have in their property for the stock of the corporation. When exchanged, the stock becomes “valued” at the “basis” that the property was valued at. Then, when the corporation sells the property, the Internal Revenue Code considers the income as the “ordinary income” of the corporation and not as a capital gain to the corporation. Thus, eliminating federal capital gains taxes all Additionally, by incorporating the corporation in a tax-free jurisdiction such as Nevada, you WILL eliminate state taxes as well together.

OK, so what’s the big deal about ordinary income? Ordinary income is the income generated in the ordinary course of the business of a company. For example, a new car dealership purchases cars to sell. These cars are considered inventory in the Internal Revenue Code. When a car is sold, the income derived in commingled with the income derived from servicing the cars and the parts the dealership sells for the cars. This income is never considered capital gains. This is a very important concept to understand. People think that real estate is always a capital asset. That is not true. Should your corporation be in the real estate business you are selling “inventory” and not a capital assets. Hence, capital gains are eliminated.

Now, if this income is ordinary to the business then it stands to reason that that same business can “write-off” its ordinary business expenses that relate to the acquisition of that income as well as the costs associated with making those sales.

In the real estate business what could those deductible expenses be? Travel to view properties that you might want as inventory or as rental property. Vehicles, office space (could be in your home) computers, telephones, health insurance, life insurance, retirement plans, the purchase of more “inventory”, consulting fees, club dues, entertainment and a host of additional items.

Better still, all these expenses are paid with pre-tax dollars not after tax dollars, as they are when you sell property or conduct the business of real estate through any other process.

Here is a truism the reader should understand:

Individuals receive income, pay taxes and then buy things with the “after tax” money. Conversely, “C”-Corporations receive income, buy things with “pre-tax” dollars and then pay taxes on any money left over.

So, the bottom line is this. In a “down market” the property seller must become very competitive in their pricing if they want to sell their property. If you as the seller continue to try to sell using those outmoded methods (selling a property titled in your name or undertaking a 1031 exchange) you will face the maximum in taxability and thereby needlessly loose far to much of your hard earned equity (profits). Should you undertake our 351-exchange program you will receive 15% to 45% more net income at the closing of the escrow from the sale of you property. This extra cash can afford you the ability to reduce your sale price making your property more appealing while at the same time not affecting your net income at the close of the escrow.

To find out more visit our website at www.priorityservicellc.com and request our free reports

The Esentials of Corporate Estate Planning

A CORPORATION NEVER DIES; IT JUST GETS A NEW PRESIDENT

Moving your estate into your corporation is very advantageous with Nevada C-Corporations. We will take a look at how you pass your estate to your families without probate and attorney's costs through C-corporations. Many approaches to family estate planning are legitimate, and often effective ways of preserving family estates, but consider the rapidly changing tax and legal trends when looking to preserve a lifetime of hard-earned assets.

Planning for the next generation is important. Currently the value of your estate that can be transferred to heirs tax-free is $2,000,000 and the exemption will gradually increase during the next couple of years to no taxes at all (in 2010). Keep in mind that at any time Congress can change this rule. If a Democratic administration takes place it has been said they would like to change this to as little as they can get away with. After this unified credit that we receive, the taxes on the remaining average 45%. Some individuals think there is no way their estate would be subject to the estate tax because it’s only for the extremely wealthy. Think again; just add up the value of all your assets, real estate, cash, jewelry, bank accounts, brokerage accounts AND the value of your life insurance. The life insurance is tax-free but the value is added into your estate value for determining estate taxes. Start making plans, because there are creative, preventative measures to keep the government out of your pocket.

THE ESTATE PLAN THAT NEVER DIES: Many creative estate-planning strategies have been developed for use by Nevada C-Corporations. Nevada C-Corporations are generally more flexible and creative when passing estates to heirs than living trusts are, while providing similar benefits such as avoiding probate, and potentially eliminating all estate taxes. There is an old saying that is as true today as it was 100 years ago.

“A CORPORATION NEVER DIES; IT JUST GETS A NEW PRESIDENT.”

HERE IS HOW THIS PROCESS WORKS: Long Term Corporate Planning is not just estate planning. Estate planning by itself is done in contemplation of death, and such planning has tax implications and interpretations by the IRS that simply don’t apply here. Long Term Corporate Planning is not done in contemplation of death, but when you do pass on and your living estate happens to be very successfully handled due to your foresight in long term corporate planning, then you have successfully accomplished a dynamic feat.

WHY IS THIS A DYNAMIC FEAT? Because with your Long Term Corporate Planning little is left for a lawyer to do. Legal expenses or taxes don’t consume your estate. That’s why some lawyers aren’t going to tell you how to take advantage of Long Term Corporate Planning. It is bad for their business. The tax collectors aren’t going to tell you either because they won’t be able to rip apart the results of your life’s work with taxes.

WHAT’S THE MAGIC? Well, corporations are immortal (unless terminated by statute or by its corporate articles). Corporations do not cease to exist because one of their key people dies. Here is where Nevada really shines; it allows its C-corporations to issue “bearer shares.”

BEARER SHARES. Nevada allows corporations to issue stock to the “bearer,” which is very much like writing a check to “cash.” The person who controls the bearer certificates, or has the

shares in their possession, technically has the power to redeem those shares as the beneficial owner. As a negotiable instrument, it may be difficult to determine how many times the stock has changed hands since it was first issued.

Bearer shares are generally considered to be an attractive solution for individuals who desire to own or control assets or business activities, while maintaining a high degree of financial privacy. It is true that privacy can be accomplished through bearer share ownership, however there are many issues, which are broadly misunderstood regarding the use of bearer shares.

Most states base their corporate law extensively on the Revised Model Business Corporation Act as developed by the Committee on Corporate Laws of the American Bar Association. It should not surprise you then that there are amazing similarities in the Corporation Codes of the various states. However, because the Model Act has been refined and modified over time, and because of the stubborn independence of the various states not to conform entirely to the Model Act, each state has developed its own eccentricities that set it apart from the others.

In Nevada’s case, one area in which it separates its Corporation Code from the Model Act is in the information required on the stock certificate of a C-Corporation. Under the Model Act, for instance, a stock certificate is required to contain: 1) the name of the issuing corporation and the state under which it is organized; 2) the name of the person to whom the stock is issued; and 3) the number and class of shares and the designation of the series, if any, the certificate represents.

The Nevada Revised Statutes (NRS) reads differently, and by omission of the language of the Model Act, creates an opportunity to issue shares of a Nevada Corporation to “The Bearer.” NRS 78.235(1) reads in part as follows: “every stockholder is entitled to have a certificate, signed by officers or agents designated by the corporation for the purpose, certifying the number of shares owned by him in the corporation.”

In other words Nevada law, specifically, only requires two things: 1) the name of the corporation, and; 2) the number of shares represented by the certificate (according to an attorney with the Nevada Attorney General’s office assigned to the Nevada Secretary of State’s office). Nevada is the only state with this language. Since the name of the shareholder is not specifically required on the certificate, there has been broad use and acceptance of bearer shares in the State of Nevada for many years.

Even so, officials with Nevada agencies such as the Attorney General’s office, the Securities Division and Corporation Division of the Secretary of State’s office, are reluctant to take an official position one way or the other on bearer shares. There are no Attorney General opinions on this issue, and surprisingly, there is absolutely no case law on the subject. The most positive affirmation I have received on the viability of bearer shares came from Mr. John Cunningham, an attorney with the Securities Division, who confirmed that bearer shares could be used as long as the corporation was not required to qualify for a public offering.

WHY BEARER SHARES ARE USED: There are two clear reasons why a corporation would issue bearer shares. First, as a tool to achieve total privacy in corporate ownership due to the fact that true ownership is extremely difficult to determine. Secondly, as a vehicle to provide for convenient transfer of ownership interests. Let’s discuss these individually.

PRIVACY: There are only two tangible sources of information on ownership of a Nevada Corporation: the stock certificate, and the stock ledger. The stock ledger has its own legal requirements under Nevada law. The ledger must contain, in alphabetical order, the names of the stockholders, their residence address, and the number of shares owned by each.

This list must be revised annually, and would be a significant document for a legal adversary to obtain. However, Nevada law provides a statutory barrier to getting and using information on the stock ledger that includes it's own penalties. As discussed above, NRS 78.257 provides that any stockholder who owns at least 15% of the issued shares of a corporation has a right to inspect all books and records upon five days notice, but must bear the costs of such an inspection. But subsection 3 of that statute states that, “Any stockholder or other person exercising (these rights) who uses or attempts to use information, documents, records or other data obtained from the corporation, for any purpose not related to the stockholder’s interest in the corporation as a stockholder, is guilty of a gross misdemeanor.” (Emphasis added).

In other words, the penalty for using corporate information for any other purpose than to have a stockholder defend or demonstrate his or her interest in the corporation is up to one year in the county jail and up to a $2,000 fine. Clearly, a non-shareholder in a Nevada Corporation has no legal right or authority whatsoever to view the stock ledger. However, the burden of proof; in the cases of Roney v. Buckland, 4, Nev 619 (1868), falls on the corporation to prove improper motivation for such a request.

TRANSFER OF OWNERSHIP: Most of the confusion surrounding bearer shares has to deal with the issue of transfer of ownership. A bearer instrument is negotiated differently than an instrument made payable to order. If an instrument is made payable to the order of John Doe, it is negotiated by delivery with any necessary endorsement (signature and proof of identity). If an instrument is made payable to bearer, it is negotiated by delivery. It is commonly believed that bearer shares allow you to transfer ownership of a Nevada C-Corporation in complete privacy, without any adverse impact. Three important facts must be established on this topic:

1. A stock certificate is not stock itself. The stockholder may own the stock with or without the stock certificate. The Nevada Attorney General has published a formal opinion on this subject (AGO38). The certificate is merely a piece of paper that indicates ownership. Because Nevada does not require corporations to issue certificates at all, it would be foolish to assume that possession of the certificate equals ownership of the shares.

2. The Nevada Revised Statute (78.240) specifically states that shares of stock are personal property. So, all rules, regulations, and applicable taxes that would otherwise apply to transfers of personal property will also apply to transfers of bearer shares.

Bearer share certificates, like personal property, may be stolen, borrowed, obtained under false pretenses, lost, copied, sold, inherited, bought, willed, etc. My car is personal property also. On occasion, I have lent my car to a friend. Simply because he was in possession of my car during that time did not mean he was the owner.

3. Nevada case law requires a transfer of stock to be registered upon the corporation’s books before the transfer is valid against the corporation. This is done to protect corporate officers in determining ownership of and the right to vote corporate shares. (61 Nev. 431, 132 P.2d 605. (1942)). So can bearer shares be used to transfer ownership of a Nevada Corporation? Absolutely. But the new owner must register his/her/its ownership with the corporation before the corporation can grant ownership with those protections in place, the only other tangible source of ownership information is found on the stock certificate itself. A bearer certificate could only be considered circumstantial.

BEARER SHARES AND THEIR USE IN TRANSFERRING CORPORATE ASSETS TO HEIRS: Here is how to use bearer shares to eliminate any problems regarding passing the corporation on to your heirs when you die:

1. When you issue the shares of stock in your corporation, issue them by putting the word “bearer” in the blank for the name of the person receiving the stock and use the address of the corporation for the address of the bearer.

2. Next, split up the stock the way you want it distributed to your spouse, children, relatives and/or friends after your death.

3. Next, place the shares into individual SEALED envelopes and write on the outside of the envelopes: DO NOT OPEN EVEN UPON MY DEATH. INSTEAD, GIVE THIS SEALED ENVELOPE TO XXXXXXX.

4. Once provided to your “heirs”, upon your death, each will open their individual envelopes and because they now represent the shareholders of the corporation, they need only hold a shareholder meeting and create a resolution electing a new president (and/or officers and directors) and create a new resolution changing the signatories on the corporate bank account.

It’s that simple. Almost without a hick-up, the corporation has moved on to the next generation. This is only possible with a Nevada corporation because for all other states, shareholders are a matter of public record and bearer shares are not available. Thus when a shareholder dies, the stock of that shareholder MUST be shown as part of the estate and probated if not otherwise held in a living trust.

Your heirs now have the stock and they own the corporation, but you while living, have complete control of the corporation, its assets, its money, real estate — everything. You can sell these assets and pay yourself the money, or add to the assets, pay for any and all expenses, travel, medical and so forth. You can do anything you want for as long as you live.

THE BOTTOM LINE RELATING TO CORPORATE ESTATE PLANNING: When you pass on to the “happy campground in the sky”, your heirs already own all you want them to have. If you’ve ever thought of striking back from beyond “the grave”, here’s your chance. Since your heirs already own your estate when you pass on, there’s no transfer, no probate, no taxes -- no problems.

With this plan you know what is going to happen to your loved ones when you pass on. Everything you have worked for, acquired and have is going to the ones you wish it to go to. There won’t be a long drawn-out probate case in court. You can have peace of mind. What can take years of legal delay, astronomical expenses, waste and agony for the ones you love is accomplished by them at their stockholders meeting through the election of directors and officers (probably prearranged). The transition is smooth. Everything continues without interruption. You have the peace, joy, satisfaction and confidence of knowing that your loved ones have exactly what you intend for them to have.

Take advantage of this corporate immortality. Put what you have into a “C” corporation and the corporation will live long past you to successfully distribute your assets to the people you wish to have them. This will eliminate the normal pitfalls of estate planning, probate, and taxes and eliminate the need for a “living Trust or other probate eliminating vehicle.

PLEASE CONTACT PRIORITY SERVICES GROUP, LLC FOR A FREE CONSULTATION AND/OR TO LEARN MORE ABOUT OUR SERVICES AND PRODUCTS.

Capital Gains Tax reality, Personal VS. Corporation, can you afford not to Incorporate?

HERE IS A LOOK AT THE TAXES YOU WOULD BE OBLIGED TO PAY IF YOU WERE SELLING PROPERTY IN YOUR PERSONAL NAME

By selling real estate titled in your name or the name of a “pass-through” entity (LLC or “S”-Corp) you could pay as much as 60% of the income you receive from the sale in taxes. Those taxes include but are not limited to capital gains taxes, self-employment taxes, Alternative Minimum Tax as well as state and federal income taxes. Adding insult to injury, when you sell real estate titled in your own name or the name of a “pass-through” entity, many of your “real estate business expenses” will not be deductible when you file your 1040 tax return.

INCOME TAXES REPORTED ON YOUR 1040 TAX FORM

The tax effect of selling property as an individual or the name of a “pass-through” entity is that profits made from the sale of real estate are added to the income you report on your 1040 tax return. On the other hand, any losses from the operation of the property are deducted from your 1040 tax return (assuming the losses are not limited by IRS and state passive loss rules). Should you be a high-income earner to begin with, adding the income from the sale of a property to your 1040 tax return could be financially devastating. Likewise for your state tax burden as well.

CAPITAL GAINS TAXES

There Are Three Holding Periods For Capital Assets Sold: Those held for one year or less are considered short-term and are taxed at your ordinary 1040 income tax rate. You'll simply pay taxes at your "normal" 1040 tax rate on those gains (anywhere from 10% to 35%). This could be a “killer” should your taxable gain plus other 1040-income push you into the highest tax bracket. NOTE: Most sales of “flipping” property will fall into this category.

Those held for more than one year are considered long-term, and will be taxed at the rate of 5% for those individuals below the 25% ordinary income tax rate and 15% for those individuals above the 25% ordinary income tax rate, you will receive a tax break on the sale of those assets while those held for more than five years are considered "super-long-term" and are taxed at an even lower rate than long-term gains.

Computing Your Tax Bracket: One very important point to understand about ordinary income/capital gains is that to determine your normal tax bracket for capital gains purposes, your capital gain income is added to your regular income and you use the total (not just the portion related to your earned income). Then you’re able to use Schedule D to compute your tax.

Don't think that if you have $100 in other income and $1 million in long-term capital gains that you're in the 15% bracket -- and that your $1 million in long-term capital gains will be taxed at the preferred 5% rate. It simply doesn’t work that way. You have to add your $1 million to your $100 and then look at your tax bracket.

THE ALTERNATIVE MINIMUM TAX

Especially vulnerable to the AMT tax are people with income over $75,000. Most vulnerable are taxpayers with several children, interest deductions from second mortgages, capital gains, high state and local taxes and incentive stock options.

Here’s how it works: In effect, you are simply adding back some tax deductions and income exclusions to your regular taxable income to arrive at your alternative minimum taxable income. Here is where the middle class gets soaked. First you have to add back your personal-and dependant-exemption deductions ($3,200 each in 2005, $3,300 each in 2006), then your standard deduction if you don’t itemize $10,300 for joint filers in 2006; $5,150 for singles in 2006). You also lose your state, local and property tax write-offs, as well as your home equity loan interest, if the loan proceeds are not used for home improvements. The AMT also ignores some itemized deductions, such as investments expenses and employee business expenses, and some medical and dental expenses.

Let’s do the math: Under the AMT, adding $1,000 of long term capital gain can increase your taxes buy as much as 22%. 15% is the gain portion and the remaining 7% is the AMT Tax (equaling 22%).

SELF-EMPLOYMENT TAXES

Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. (See IRS Code Section 1402 and/or IRS Publication 533). Publication 533 states that you are self-employed and must pay self employment taxes if:

You Carry On A Trade Or Business: A trade or business is generally an activity carried on for a livelihood or in good faith to make a profit.

You Are A Sole Proprietor: You are a sole proprietor if you own an unincorporated business by yourself or owned by a husband and wife.

Real Estate Rent: Rental income from real estate is NOT included in earnings subject to SE tax UNLESS You provide services for your tenants (you personally manage your properties) or You are a real estate dealer.

REAL ESTATE DEALER STATUS

A real estate dealer is defined as: “An individual who is engaged in the business of selling real estate with a view to the gains and profits that may be derived from such sales.

A negative consequence of the dealer status: If you are considered a real estate dealer, you become ineligible for Section 1031 tax deferred exchanges becaukse the property owned is considered inventory.

CONFUSED YET? MOST PEOPLE ARE BY THIS POINT.
READ ON AND SEE HOW TO LEGALLY ELIMINATE THESE TAXES.

HERE IS AN EXAMPLE OF THE TAXES YOU WOULD PAY SHOULD YOU SELL A PROPERTY TITLED IN YOUR NAME OR IN THE NAME OF AN LLC OR “S”-CORPORATION AT THE TIME OF SALE

The premise for this example: You received a check for $49,000.00 at the closing of the escrow for a “FLIPPED” property you purchased and that you held for less than 12 months when you sold it. The property was titled in your name or in the name of an LLC or “S”-Corporation at the time of sale and you are a married person jointly filing a 1040 tax return with your spouse at tax time (you are in the 15% tax bracket).

NOTE: STATE AND LOCAL TAXES NOT INCLUDED IN THE COMPUTATION.

ESCROW CHECK $49,000

LESS

Self-Employment Taxes (15.3%): (--$7,497)
Capital Gains Taxes (15%): (--$7,350)

Total Federal Tax Obligation from the income received from the sale: (--$14,847)

AFTER TAX PROFIT (FEDERAL TAXES ONLY): $34,153

NOTE If you were required to pay Alternative Minimum Tax, the figures shown above would be even more devastating!

WANT TO MAKE THESE TAXES DISAPPEAR?

Making the taxability disappear: The secret to making the taxability disappear is selling your property in a legal entity controlled by you. One that will afford you exceptional “write-off” capabilities, maximum asset protection and absolute flexibility while at the same time reducing or eliminating the taxes associated with holding and selling real estate.

Internal Revenue Code: Transferring property into your wholly owned “C”-Corp is known as a Section 351 (IRS code section) contribution of property transferred to your controlled entity on a tax-free basis, as no sale to an outside party has occurred.

YOU SAVE BIG $$$ BY SELLING YOUR PROPERTY THROUGH A “C”-CORPORATION!!!

“C”-Corporations are entitled by law to many tax deductions that are not available to individuals, LLCs or “S”-Corps. Additionally, “C”-corporations have a lower federal tax rate at all levels of income up to $250,000 when compared with individuals tax rates for the same level of “TAXABLE” income. (“C”-Corporations pay only 15% tax on the first $50,000 dollars of PROFIT (this is the amount of money left over after all expenses are paid).

NOTE: Individuals receive income, pay taxes and then buy things with the “after tax” money. Conversely, “C”-Corporations receive income, buy things with “pre-tax” dollars and then pay taxes on any money left over.

CORPORATE CAPITAL GAINS

Corporations (in the real estate business) are NOT subject to any capital gains tax liability from the sale of real estate. Instead, corporate gains are included with the rest of the corporate income and therefore become part of the ordinary income of the corporation. Further, the IRS Code makes no distinction between short or long term gains either.

IRS DEALER TAX STATUS AND SELF-EMPLOYMENT TAXES:

Interestingly, “C”-Corporations are NOT subject to dealer status issues or self-employment tax.

HERE IS AN EXAMPLE OF THE TAXES YOU WOULD BE OBLIGED TO PAY SHOULD YOU SELL A PROPERTY TITLED IN THE NAME OF A NEVADA C-CORPORATION AT THE TIME OF SALE

The premise for this example: You received a check for $49,000 at the closing of the escrow for a “FLIPPED” property your held by your C-corporation for less than 12 months when the corporation sold it. The property was titled in the name of your C-corporation at the time of sale.

NOTE: STATE AND LOCAL TAXES NOT INCLUDED IN THE COMPUTATION.

ESCROW CHECK $49,000
LESS
C Corporation would receive 100%: $49,000
Self-Employment Taxes (15.3%): (NOT APPLICABLE) (-$0000)
Capital Gains Taxes (15%): (NOT APPLICABLE) (-$0000)

Total Tax Obligation: Because the business of the C-corp is buying and selling real estate, the total amount of $49,000 would be classified as “ordinary business income” that can be spent by the corporation to pay for expenses such as: vehicles, health and life insurance, retirement plans and even to purchase additional real estate. Additionally, the C-corp would be required to pay taxes ONLY on the NET amount remaining in the account at the end of the tax year (if any). Should that amount NOT exceed $50,000, the corporation would be taxed at 15%. However, it is possible for the C-corp to “ZERO OUT” its net income and pay NO taxes at all.

AFTER TAX PROFIT (AFTER ZEROING OUT FEDERAL TAXES) $49,000

HERE IS A COMPARISON OF THE TAXES YOU WOULD BE OBLIGED TO PAY SHOULD YOU SELL A PROPERTY TITLED IN YOUR PERSONAL NAME OR IN AN LLC OR “S”-CORP OR THE NAME OF YOUR NEVADA “C”- CORPORATION AT THE TIME OF SALE

The premise for this example: You received a check for $49,000 at the closing of the escrow for a “FLIPPED” property held for less than 12 months when it was sold. The property was titled as shown below at the time of sale (NOTE: state and local taxes not included in the computation).

INDIVIDUAL NEVADA LLC, S-CORP C-CORP

ESCROW CHECK $49,000 $49,000
LESS Self-Employment Taxes (15.3%): (--$7,497) (-$0000)
Capital Gains Taxes (15%): (--$7,350) (-$0000)

Total Federal Tax Obligation from the income received from the sale: (--$14,847) ($0000)*

AFTER TAX PROFIT (FEDERAL TAXES ONLY): $34,153 $49,000**

Total Corporate Federal Tax Obligation: Because the business of the C-Corp is buying and selling real estate, the total amount of $49,000 would be classified as “ordinary business income” that could be spent by the corporation to pay for its ordinary business expenses such as: vehicles, insurance, retirement plans and even to purchase additional real estate. Additionally, the C-Corp would be required to pay taxes ONLY on the NET amount remaining in the account at the end of the tax year (if any). Should that amount NOT exceed $50,000, the corporation would be taxed at 15%. However, it is possible for the C-Corp to “ZERO OUT” its net income and pay NO taxes at all.

**Corporate AMT: The Corporate AMT tax is on the chopping block in 2006. However, unitl it is actually repealed it may apply to those corporations earning in excess of $7.5 million in revenues over a 3-year period. In other words, shouldn’t apply to most of us.

Tax profit after zeroing out federal taxes: Zeroing out your corporate tax obligation should not be a problem for real estate investors should they take advantage of the strategies Priority Services Group will teach you.

Investigate our Escrow Program to find out how these strategies can benefit you. Contact Priority Services Group for a free consultation.

The 351 transfer, take control over capital gains

In this edition we will provide our readers with a basic overview of the laws behind the little know 351 transfer.

We continue to hear attorneys and CPAs as well as other allegedly knowledgeable professionals frivolously state that the Revolution can't do what it does. Interestingly, all this so-called expert advice is usually stated without the benefit of even having any understanding of how the process really works let alone how the Internal Revenue Code and court cases taken together do, in fact, provide the unquestionable basis for this unique program.

The Escrow Program is a patent pending proprietary process. We will not delve into every aspect the Priorit Service Group employs in undertaking its program. However, in an effort to aid those interested individuals in understanding the legal, tax and technical aspects of the process, we will provide some of the "authority" for our program. That authority finds its basis in the little known Internal Revenue Code Section 351-transfer process, which is a much-preferred alternative to the cumbersome and limited 1031 exchange.

The 351-transfer process allows homeowners and real estate investors to defer (and possible eliminate) the tax liability on the sale of real estate and/or commercial property (property) by reinvesting the gain. By using the 351 strategy employed by Priority Services Group, the money received from a sale of property does not necessarily need to be reinvested in real estate (a requirement in 1031 exchanges), and unlike 1031 exchanges, the transferring party (owner of the property) will (without a penalty) have an unlimited amount of time to reinvest the proceeds from the sale of the property.

In a nutshell, in the 351-transfer (exchange) process, a property owner transfers his/her property to a C-Corporation in exchange for the stock of that corporation. When accomplished, the "basis" in the property exchanged for the stock becomes the "value" of the stock received in exchange for the property.

To begin with, we should first address the most fundamental basis regarding the program. That basis is 2 fold. The first is that the government WILL assist people interested in venturing into business for themselves by allowing them to utilize previously owned assets to "fund" their new business venture (the IRC calls this a capital contribution). The second is that the "Code" states categorically that in order for a transfer of real estate to a corporation be tax free, there MUST be a verifiable business reason for the transfer. The majority of our clients transfer property to a corporation in order to provide a source of funding (by selling the property) for that corporation to undertake the business of buying, holding, renting and selling real estate.

IRC Code §351 Transfers-Non-recognition Of Gain Or Loss: "No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control of the corporation. According to Reg. §1.351-1(a)(1), the phrase "immediately after the exchange" does not necessarily require simultaneous exchanges, as long as the transfers are made pursuant to a predetermined agreement. Under §351, shareholder(s) control the corporation if, immediately after the transfer, they own at least: (1) 80% of the combined voting power of all outstanding voting stock, and (2) 80% of the shares of all classes of corporation stock.

To understand more fully what corporation capital contributions are and why the Priority Service Group draws so heavily upon this premise, it is important to delve deeper into what has already been stated and how this might benefit Priority Service Group's clients.

In 1997, the U.S. 9th Circuit Court of Appeals heard the case of Peracchi vs Commissioner. Here is what the court said regarding capital contributions:

The Code tries to make organizing a corporation pain-free from a tax point of view. A capital contribution is, in tax lingo, a "non-recognition" event: A shareholder can generally contribute capital without recognizing gain on the exchange. It's merely a change in the form of ownership, like moving a billfold from one pocket to another [See I.R.C. S 351], so long as the shareholders contributing the property remain in control of the corporation after the exchange, section 351 applies: and,

Corporations may be funded with any kind of asset, such as equipment, real estate, intellectual property, contracts, leaseholds, securities or letters of credit. The tax consequences can get a little complicated because a shareholder's basis in the property contributed often differs from its fair market value. The general rule is that an asset's basis is equal to its "cost" [See I.R.C. S 1012].

The fact that gain is deferred rather than extinguished doesn't diminish the importance of questions relating to basis and the timing of recognition. In tax, as in comedy, timing matters. Most taxpayers would much prefer to pay tax on contributed property years later--when they sell their stock--rather than when they contribute the property (if he ever does, this emphasis is mine).

Now I think it prudent to address the central issue relating to the transfer of real estate that is subject to a mortgage. This single issue relating to transfers subject to liabilities is the most important issue to understand. We will first look to the United States Code Title 26 regarding Section 357 (a), Assumption of Liabilities: Again, we turn to the 1997, the U.S. 9th Circuit Court of Appeals heard the case of Peracchi vs Commissioner to address this issue. Here is what the court said regarding the Assumption of Liabilities:

The property Peracchi contributed to NAC (NAC was Peracchi's corporation- emphasis mine) was encumbered by liabilities. Contribution of leveraged property makes things trickier from a tax perspective. When a shareholder contributes property encumbered by debt, the corporation usually assumes the debt. And the Code normally treats discharging a liability the same as receiving money: The taxpayer improves his economic position by the same amount either way [See I.R.C. S 61(a)(12)}. NAC's assumption of the liabilities attached to Peracchi's property therefore could theoretically be viewed as the receipt of money, which would be taxable boot [See United States v. Hendler, 303 U.S. 564 (1938)].

The Code takes a different tack. Requiring shareholders like Peracchi to recognize gain any time a corporation assumes a liability in connection with a capital contribution would greatly diminish the non-recognition benefit section 351 is meant to confer. Section 357(a) thus takes a lenient view of the assumption of liability: A shareholder engaging in a section 351 transaction does not have to treat the assumption of liability as boot, even if the corporation assumes his obligation to pay [See I.R.C. S 357(a)].

Reading on, the court held that: But what if, as the IRS fears, NAC goes bankrupt, the note will be an asset of the estate enforceable for the benefit of creditors, and Peracchi will eventually be forced to pay in after tax dollars. Peracchi will undoubtedly have worked the deferral mechanism of section 351 to his advantage, but this is not inappropriate where the taxpayer is on the hook in both form and substance for enough cash to offset the excess of liabilities over basis. By increasing his personal exposure to the creditors of NAC, Peracchi has increased his economic investment in the corporation, and a corresponding increase in basis is wholly justified.

In the Escrow Program process, the "note" is the mortgage and the liability to pay that mortgage remains (by contract) solely with the transferring party, even though by the terms of that same contract, the corporation can continue to build its equity and income by paying the expenses associated with the real estate that was transferred.

However, the corporation is not the final place a creditor would look to for payment should the corporation not pay the expenses related to the real estate or should the corporation file for bankruptcy. Instead, a creditor would look solely to the transferring party for payment of the mortgage. Therefore, until the transferred property is sold, the transferring party has a substantial economic investment in the property (amounting to the note (mortgage) discussed above) and therefore would be entitled to a fully tax free exchange.