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§1031(a) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. In other words, there are four general exchange requirements for non-recognition of gains under § 1031. 1. There must be an actual exchange and not a sale. The exchange must be of "property" of a type that qualifies under § 1031. Under § 1031(a)(2), the properties involved in a like-kind exchange may not be stock in trade or other property held for sale, stocks, bonds or notes, other securities or evidences of indebtedness or interest, interests in a partnership, certificates of trust, or beneficial interests or chooses in action. 2. The properties exchanged must be of like kind. Essentially, all real property located in the United States is like-kind property and can usually qualify under the like-kind exchange rules. Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved (i.e. office buildings can be exchanged for undeveloped vacant land, shopping centers can be exchanged for farm land, etc.). However, real property in the United States and real property outside the United States are not like-kind properties. In addition, § 1031(b) provides that if an exchange would otherwise be eligible for tax-free treatment under § 1031(a) but for the receipt of cash or non-qualifying property (boot), then any gain realized on the exchange is recognized to the extent of the boot received. Taxable boot includes relief from liabilities (i.e. debt on the property). If a loss is realized on a like-kind exchange in which boot is received, the loss is not recognized. 3. The property transferred and the property received must be held for productive use in a trade or business or for investment. The property to be exchanged (relinquished) must be used in the seller's trade or business and/or for investment at the time of the sale. The replacement property (the one to be purchased) must be of "like kind" meaning to be used in the Buyer's (was the Seller) trade or business or held for investment. Any property being held in this fashion can be depreciated and the investor will be obligated to pay or be permitted to defer depreciation recapture and capital gains taxes upon its disposition or exchange. 4. The taxpayer must meet the specified timing requirements. Under § 1031(a)(3), the transferor of the relinquished property is allowed up to 45 days to identify the replacement property and 180 days to close on the acquisition of the replacement property. The taxpayer may identify any 3 properties or multiple properties with a fair market value not in excess of 200% of the FMV of the relinquished property. If these four requirements are not met, gain or loss on the exchange must be recognized by the taxpayer. On the other hand, if the taxpayer prefers to have a gain recognized—for example, to obtain a stepped-up basis, to offset a loss, or to recognize a loss already realized—the transaction must be intentionally structured to fall outside of the requirements of § 1031 because the like-kind rules are mandatory, not elective. |
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Related Party and Multiparty IRS §1031 Exchanges 1. Related Parties. Under § 1031(f), non-recognition treatment on an exchange of property with a related person will be lost if the taxpayer or the related person disposes of either property within 2 years. The 2-year period will be suspended under § 1031(g) during any period in which any of the exchanged properties is subject to a put, a call, a short sale, or a transaction with similar effect. Related parties include the following relationships: (1) Members of a family, as defined in subsection (c)(4); (2) An individual and a corporation more than 50% in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; (3) 2 corporations which are members of the same controlled group (as defined in subsection (f)); (4) A partner engaged in a transaction with the partnership other than in his capacity as a member of such partnership (5) A grantor and a fiduciary of any trust; (6) A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts; (7) A fiduciary of a trust and a beneficiary of such trust; (8) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts; (9) A fiduciary of a trust and a corporation more than 50% in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust; (10) A person and an organization to which § 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual; (11) A corporation and a partnership if the same persons own: (A) more than 50% in value of the outstanding stock of the corporation, and (B) more than 50% of the capital interest or the profit interest in the partnership; (12) An S corporation and another S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation; (13) An S corporation and a C corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; or (14) Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate. 2. Multiparty and deferred exchanges. In a multiparty exchange, the taxpayer holds relinquished property that is sold to a buyer. The buyer in turn acquires the replacement property desired by the taxpayer. The seller of the replacement property conveys it to the taxpayer at the direction of the buyer. |
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Differences Between S-Corporations and April 29, 2008
By Joshua Fine
S-Corporations and Limited Liability Companies (“LLCs”) generally serve the same purpose: namely, they both provide a Legal Liability Shield for the owners and allow the owners to be taxed as a partnership is taxed, however, there are numerous important distinctions between these two forms of business entities. This article highlights the primary differences between the S-Corporation and the LLC.
Differences in Formation
All corporations are created with the filing of its Articles of Incorporation. After formation, the corporation must draft, adopt, and adhere to its corporate By-Laws. An LLC is created with the filing of its Articles of Organization, and then must draft, adopt, and adhere to its Operating Agreement.
Differences in Terminology
An S-Corporation, like a C-corporation, is owned by Shareholders, is governed by a Board of Directors, and is run on a day-to-day basis by corporate Officers, such as a President/CEO, CFO, Vice-President, and Secretary. An LLC is owned by Members, not Shareholders; there is no Board of Directors; and the day-to-day operations are run by the Managing Member(s) or an outside management team, individual manager, or company hired by the Members. Notwithstanding, an LLC is free to designate Managers with traditional titles such as President/CEO, CFO, Vice-President, etc. Finally, a Shareholder of an S-Corporation owns Shares or Stock in the S-Corporation, while a member of an LLC owns a Membership Interest in the LLC.
Differences in Formalities
All Corporations are required to hold an Annual Meeting of the Shareholders as well as the Board of Directors (this is true even if there is only one Shareholder and/or Board Member), and memorialize the content of said meetings in the form of Corporate Minutes. LLCs are not required to follow this formality, however, in order to preserve the distinction between the LLC and the individuals who own the LLC, it is advisable for the LLC to hold an Annual Meeting of the Members, keep Minutes, and document major company decisions.
Differences in Voting and Evidence of Ownership
As stated previously, an S-Corporation issues Shares/Stock while an LLC issues Membership Interests. An S-Corporation may only have one class of Shares/Stock. An LLC has no restrictions on the amount of classes of Membership Interests. Often, an LLC has two (2) classes of Membership Interests: Non-Managing Membership Interest and Managing Membership Interest.
Differences in Profit Distribution
LLCs offer more maneuverability with respect to distributions of profits. With an S-Corporation, profits must be allocated in exact proportion to the Shares owned by the respective Shareholders (i.e. if Shareholder A owns 42% of the Shares in 2008, then Shareholder A must receive 42% of the 2008 profits). However, an LLC may deviate from proportionate allocations of profits, to a degree, and distribute profits to its Members without regard to its Members’ precise Membership Interests (i.e. Member Z has a 25% Membership Interest in 2008 but landed a very big customer for the LLC, therefore, the LLC allocated 35% of 2008 profits to Member Z).
Differences with Taxable Losses
In determining the maximum allowable business losses for any given year’s tax returns, S-Corporation Shareholders are allowed to include the Basis of their Shares/Stock and also personal loans to the Corporation. Members in an LLC may include the Basis in their Membership Interest, personal loans to the LLC, and their pro rata share of monies borrowed by the LLC.
Differences in Effective Ownership of Capital Contributions
Generally, with an S-Corporation all capital contributions—meaning cash, assets (real or personal property), or services, but not loans—given to the S-Corporation in exchange for Shares are owned by the Shareholders in proportion to the percentage of Shares the Shareholder owns. Assume Shareholder A received 50% of the corporation’s issued Shares in exchange for services he rendered to the corporation, and Shareholder B received 50% of the corporation’s issued Shares in exchange for a cash contribution of $100,000. Upon dissolution, Shareholder A would receive 50% of all cash remaining in the corporate accounts after all liabilities have been paid, even though he did not contribute any cash. In an LLC this is not necessarily the case. Because each Member has a separate Capital Account, it is possible for the Member(s) who have contributed cash to insolate that cash from other Members upon the event of dissolution. In the same scenario illustrated above, Member B could receive all of the LLC’s cash and Member A would receive nothing. In addition, Member B could potentially face adverse tax consequences.
Differences in Existence
An S-Corporation, like a C-Corporation, has a perpetual existence, meaning it exists beyond the death or withdrawal of its Shareholders. AN LLC may be subject to certain state requirements. Further, an event such as death or withdrawal of a Member may trigger dissolution, depending on the terms of the Operating Agreement, as may a certain agreed-upon occurrence (i.e. the LLC may terminate upon the sale of its principal asset).
Differences in Ownership Restrictions An S-Corporation cannot be owned by a C-Corporation, another S-Corporation, an LLC, or a Partnership. LLCs, on the other hand, may be owned by any of the aforementioned business entities. Further, an S-Corporation may only have one hundred (100) Shareholders (or 35 if the S-Corporation opts for Close Corporation status), while an LLC may have an unlimited number of Members. Still further, an S-Corporation’s Shareholders must be U.S. residents. An LLC’s Members may be non-U.S. residents. Professionals such as lawyers, architects, and accountants cannot conduct their professions through a California LLC, rather they must opt to form a limited liability partnership (LLP) or a professional corporation.
Differences with Transferring Ownership
As a practical matter, it is difficult to transfer one’s ownership in an S-Corporation or an LLC, at least with respect to transfers that do not involve selling to a current Shareholder or Member, respectively. Generally speaking, there is an illiquid market for S-Corporation Shares and LLC Membership Interests. Notwithstanding these practical impediments, there are mechanisms for selling one’s ownership interest in each of these two business entities. An S-Corporation’s Shares are freely transferable and may be sold, but that transfer is subject to IRS regulations and restrictions. An LLC’s Membership Interests may be transferred pursuant to the rules set forth in its Operating Agreement, which often require approval of a majority or all of the remaining Membership Interests.
Differences with Tax Forms
While both forms of business entities enjoy Flow-Through Taxation (meaning, that income or loss passes through to the owners) as opposed to double taxation, they file in different manners. An S-Corporation files IRS Form 1120S and its Shareholders are all given a Schedule K-1 in order to report income loss on their personal tax returns. On the other hand, an LLC with two (2) or more members files a partnership tax return on IRS Form 1065 and the Members are given a schedule K-1. An LLC with only one (1) member files as a sole proprietorship on IRS Form 1040 – Schedule C.
Differences with State Taxes
Annually, both the S-Corporation and the LLC must pay the franchise tax board the greater of Eight Hundred and 00/100 Dollars ($800.00) or One and One Half Percent (1.5%) of the company’s Net Income. However, pursuant to CA Revenue and Taxation Code §17942, LLCs must pay an additional annual state gross-receipts tax (cleverly called an LLC fee not tax) that ranges between Nine Hundred and 00/100 Dollars ($900.00) and Eleven Thousand Seven Hundred Ninety and 00/100 Dollars ($11,790.00), provided that the LLC’s Total Gross Revenue is greater than or equal to Two Hundred Fifty Thousand and 00/100 Dollars ($250,000.00). This LLC fee must be paid on Total Gross Income even if the LLC posts a loss on Net Revenue.
Differences with Self-Employment Taxes An S-Corporation Shareholder must pay self-employment taxes on any salary and/or bonus paid by the S-Corporation to that Shareholder, however, the Shareholder does not have to pay this self-employment tax on his/her allocation of the Corporation’s profits. Generally, any Managing Member of an LLC must pay self-employment taxes on the whole amount of his/her allocation of the LLC’s profits. This figure can amount to Fifteen and Three-Tenths Percent (15.3%) of taxable income. Differences in Asset Appreciation upon Dissolution When an S-Corporation is wound up and dissolved, all assets are distributed to the Shareholders, and the Shareholder is taxed on any gains realized from assets that have appreciated (i.e. real estate). With an LLC, the LLC’s assets are considered, from a tax standpoint, to be personal assets, and no distribution is recognized upon dissolution of the LLC. Therefore, Members are not taxed until the asset is, in fact, sold and the appreciated gain realized. Differences with Conversion to a New Business Form
An S-Corporation can easily convert to a C-Corporation in the event it wishes to issue more than one class of Shares/Stock or wishes to go public. While an LLC can convert into a corporation, the process is a bit more complex. |
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January 3, 2008
By Joshua Fine
A. Introduction For generations, professional real estate investors have agreed that there is a greater fortune to be made in a down real estate market than in an up market. The likely reason is simply that there is more opportunity for big discounts when the market goes south. One of the many opportunities in real estate, regardless of market strength, is foreclosure investment.
B. Causes of Increased Foreclosure Opportunities As one would expect, in an appreciating or rising market, the occurrence of foreclosures is relatively low. However, during a business recession or a declining real estate market, foreclosure opportunities increase. During such times, certain homeowners (1) can no longer make their mortgage payments, and/or (2) are unable to sell their homes prior to foreclosure proceedings. The reason a homeowner would be unable to sell his/her home in a timely manner is either (1) a lack of demand, and/or (2) that the homeowner would lose money by selling the home. To further complicate matters, debt forgiveness as a result of a short sale often has adverse tax consequences for the homeowner in the form of phantom income. The tax ramifications alone cause some homeowners to allow their homes to go into foreclosure. As expected, during recessions, down markets, and natural disasters the delinquency rates increase, which in turn can lead to a doubling or tripling of foreclosures from previous years. In the early 1990s, the U.S. experienced an 800% increase in foreclosure rates (from the rates in the late 1980s). California was especially hit hard. No doubt, the stock market crash of October 1987, the aerospace recession of the late 1980s, and the Northridge Earthquake on January 17, 1994, among other factors, contributed to a depressed real estate market and the high incidence of foreclosures.
C. The Current Market and the Effects of Subprime Lending We are currently experiencing a significant decline in housing sales and housing prices, while seeing an increase in delinquency rates and foreclosures. This current trend, which began in early 2006, followed an unprecedented explosion in the real estate market beginning in 1999, marked by record appreciation rates not only year-to-year, but month-to-month. To accommodate homebuyers, and unfortunately a large amount of speculators, the mortgage industry created risky loan products (such as all interest, zero down, negative amortization, and adjustable-rate mortgage loans) for borrowers who traditionally would not qualify for a home at their desired price point. The situation was worsened by unscrupulous mortgage brokers who falsified loan applications of prospective borrowers in order to obtain risky loans for these borrowers. Several of these brokers are at this very moment in federal prison serving criminal sentences. Suffice it to say, we are currently experiencing the fallout of this so-called subprime mortgage market. This fallout is responsible for the relatively large volume of foreclosure properties on the market today, in addition to the near collapse of Counrty Wide and the actually collapse of Bear Stearns.
Those homeowners who have sufficient equity in their homes can usually avoid foreclosure by either (1) selling the property below market price, (2) taking out a home equity line of credit through a traditional lender, or (3) obtaining a hard-money loan (which usually comes with disadvantageous interest rates, initial points, and terms). Unfortunately, those homeowners who financed their home purchases with all-interest, zero-down, negative amortization, and/or adjustable rate mortgage loans are currently finding themselves unable to afford their homes now that their mortgage payments have increased. While unfortunate for these homeowners, these foreclosures provide an opportunity for investors as well as first-time homeowners to purchase a property below market value and/or with a relatively small down-payment.
To put the situation in practical terms: US Home Auctions held an auction in July 2007 at the Los Angeles Convention Center, auctioning a total of approximately 105 homes for Orange, Los Angeles, and Ventura Counties. In that same month, they auctioned approximately 100 homes in San Diego County. In January 2008, US Home Auctions held an auction at the same location, but this time auctioned approximately 1000 homes within five Southern California counties including San Diego, Orange, Los Angeles, and Ventura Counties. This is almost a 500% increase in volume in just six months.
D. The Three (3) Ways to Invest in Foreclosure Properties There are three main ways to acquire foreclosure properties: (1) at Auction, (2) from the bank through a transaction know as Real Estate Owned (also known as an “REO”), or (3) by an Equity Purchase, whereby the investor purchases the property directly from the current owner, who is otherwise know as the Seller-in-Foreclosure. When bidding at Auction, the bidder is attempting to purchase a property that has been foreclosed on by the lender. An REO transaction means the foreclosure process is over, the bank now owns the property, and is offering the property for sale privately. However, when attempting to negotiate with a Seller-in-Foreclosure, the investor is actually involved in a Pre-Foreclosure transaction know as an Equity Purchase (also known as an “EP”). Such an investor is known as an Equity-Purchase Investor or EP Investor.
E. The Equity Purchase Investment If an investor chooses to bid at Auction, the process is relatively clear cut. The main obstacle to a successful purchase is properly valuating the property. If an investor wishes to deal directly with the bank and buy an REO property, the investor can hire a real estate agent, broker, or an attorney and complete the transaction in much the same way as a traditional purchase between a seller and buyer. However, an Equity Purchase Investor in California who desires to purchase an owner-occupied, one-to-four unit residential property is faced with far more obstacles and pitfalls, primarily caused by a complex set of laws governing Equity Purchases. These California laws are commonly known as the Equity Purchase Rules or EP Rules. In order to successfully navigate through the Equity Purchase, an EP Investor must understand and practically apply all the EP Rules. This means strictly adhering to specific contract forms, contract language, and negotiation practices.
To complicate matters for the investor, the law prohibits the investor from being represented by a real estate agent or broker on an EP transaction, but requires that the investor strictly adhere to the law or else expose him/herself to a two-year right of redemption period. However, these rules do not apply to (1) commercial, retail, or industrial properties, (2) residential properties where the owner does not live in the home (non-owner-occupied residential properties), and/or (3) residential properties with five or more units.
Anyone who purchases a foreclosure property, whether at auction, from the bank, or directly from a Seller-in-Foreclosure can make a good or a bad investment. Simply buying a foreclosure or pre-foreclosure property does not guarantee financial success. However, the EP Investor may make a sound investment, only to lose the property and incur financial loss simply because he/she failed to follow the law. The EP Investor must understand that in any EP transaction the formalities are just as important as the substance. In many areas of law there truly are “more than one way to skin a cat,” however, in an EP transaction there is only one correct way.
F. Rehabilitating a Foreclosure Property No matter how an investor accomplishes a foreclosure purchase, the investor must always be aware that the property may require rehabilitation (remodeling or improvements) in order to lease the property or sell it for a profit. An unfortunate, but all too-common, feature of foreclosure transactions is that the Seller-in-Foreclosure neglects to maintain the property—allowing the property to fall into disrepair—or intentionally causes damage to the property in order to spite the bank. Further, even a house that is available below market price may still be unable to command rent sufficient to cover mortgage, insurance, property taxes, and ordinary maintenance. Therefore, all foreclosure investors should, among other things, inspect the prospective property prior to purchase, perform a financial analysis of the investment, and create a budget for rehabilitation if the property requires such work, or hire professionals to accomplish these tasks. |
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