Real Estate Blog for Palo Alto, Mountain View, California, and Surrounding Communities

• Jul. 11, 2008 - Using Exchanges as a Retirement Planning Tool

In my last post I offered a short history and explanation of 1039 exchanges with the recent update that the IRS has finally issues a regulation that you must rent income property out at fair market rent for 2 years after obtaining it through an exchange before moving into it to establish it as your own personal residence. So, the question is, how can I use this information to help me to plan my retirement?

First, current market conditions have created an absolute bonanza for savvy real estate investors in many areas of the country. If you plan to retire to any of the communities that have been hit by the mortgage meltdown there will be a large number of properties for sale at ridiculously low prices. This is the best buyer’s market we have seen since the great depression. Ultimately we will get out of this crisis and properties will resume their inevitable climb back up. But you can exchange now into a home that you might ultimately want to retire into, for a very low purchase price. The trick is that you must rent it out at fair market rent for at minimum of 2 years. After that, if you decide to retire to that community, you can move into the house and convert it to your own personal residence without having to pay the taxes that were deferred when you purchased it as an investment property.

Here is a second scenario. Perhaps you would like to move to the area that you have exchanged into but you don’t want to live in the property that you purchased. After renting it out for at least 2 years you can move into it for 2 years to establish it as your personal residence. They when you sell it in order to buy your dream retirement home, you can retain $250,000 of your profit if you are single or $500,000 if you are married, tax free and buy the home you really want.

I have clients who have done this several times in succession. First they sold their personal residence and moved into an investment property they owned, keeping $500,000 from the sale of their personal residence tax free. Two years later they sold the investment property that they had moved into and kept another $500,000 in profits, tax free. They then moved into another investment property that they owned, lived there 2 years to establish that one as their personal residence, and sold that one, keeping yet another $500,000 tax free. They repeated this one last time and eventually sold that property, keeping $500,000 of the profit tax fee. They started this process 10 years prior to their actual planned retirement. It required a total of 4 moves but they ended up with $2 million tax free with which to purchase the retirement home that they really wanted, with lots left over to live on as well.

In case you think you may not make $250,000 or $500,000 profit in just a few years, remember that your basis will be the basis of the property you exchanged from (because you carry the basis with you in an exchange.) So, if you owned a property for a long time before exchanging into the current property, you may have more profit than you imagined. It gets even more complicated because the depreciated value is subject to recapture rules. Also, if you acquired a property in an exchange you have to own it at least 5 years AND live in it for 2 of those last 5 years in order to qualify for the $250,000/$500,000 exemption, so be sure to see a tax consultant before you do anything to make sure you know all the rules and everything works in your favor.

If you purchase or exchange into a property as a rental, you do have to rent out the property at fair market value. In most of these communities the rental market has actually improved so it should be a safe investment, but you have to do your homework. Also, not that the taxes are deferred when you do an exchange, but they are not forgiven. The deferred taxes will be due when you eventually do sell the property or when you die.

I do have to warn you that the exchange rules are more complicated than I have indicated here and in my previous post, and also that I am not a tax professional. You always should consult with a tax professional if you are considering and exchange to make sure you know all of the details and that it will work in your particular situation.

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• Jul. 6, 2008 - delayed tax defered 1031 exchanges as a retirement tool

One of the first transactions I undertook after I obtained my real estate license in the early 1980’s was a delayed tax-deferred 1031 (Starker) exchange. When I asked my broker for guidance, he advised me “not to get involved” and to stick to simple transactions. But I love a challenge, so I consulted with a reputable attorney and a reputable CPA and together we completed the transaction.

Although delayed tax-deferred exchanges are taken for granted now, they weren’t then. Prior to 1970, tax-deferred exchanges of investment property were always simultaneous exchanges directly between the buyer and the seller. But in 1970 the Starker family entered into a trust agreement with Crown Zellerback, Inc. in which the Starker family agreed to sell timberland they owned to Crown Zellerback, Inc. Funds from the sale were set aside in a trust account, with the agreement that Crown Zellerback, Inc. would use these funds to purchase replacement property for the Starker family at a later date. The IRS disallowed the exchange on the basis that it was not simultaneous, but eventually the courts agreed with the Starker family and the “Starker exchange,” also known as a 1031 delayed tax-deferred exchange, was born.

It wasn’t until 1984 that Congress adopted the 45 calendar day identification deadline and the 180 day closing deadline that we are now familiar with. And the IRS did not write the proposed rules and regulations for these exchanges until 1990. These rules were adopted in 1991. Before that, investors who participated in a tax deferred exchange risked having the IRS disallow the exchange because the guidelines had not yet been established.

There was one item left over, however, and that was the holding term for the replacement property involved in the exchange. There is no rule that says an owner can’t decide at some time later to move into the replacement property and convert it to his or her own personal residence. But there were never any written guidelines as to when that could happen.

Well, that has finally changed. As of March of this year (yes, 2008, nearly a quarter of a century after Starker exchanges were firmly established!) the IRS has finally issued those guidelines. The answer is….. 2 years. Now an investor who exchanges into a property that he or she might eventually want to move into knows that they can safely do so after 2 years! The impact of this is to eliminate uncertainty and, perhaps, encourage more investors to take advantage of this great benefit. More to follow!!

• May. 18, 2008 - San Jose Street Trees... Whose Trees Are They?

Now here is a good one for you. First let me start by fessing up that I am a tree fanatic. I simply love trees! Not only do they provide shelter for birds and other native fauna, keep us cool, and help minimize global warming by removing carbon dioxide from the air, but they also contribute significantly to the value of a property and they are things of great strength and beauty in their own right. But the city of San Jose has gone too far in my opinion.

The City of San Jose loves trees too, and it has mandating street trees for a number of years in order to enhance the beauty of the city. Some time ago the city decided that, due to budget cuts, maintenance of the street trees, meaning regular pruning and shaping, would be the responsibility of property owners upon whose property the tree resides. The owner is also responsible for repairing the city sidewalks in front of the house if the tree roots damage the walkway. This is a big responsibility. Tree maintenance and street repairs can be pricey and it may be beyond the means of some struggling homeowners who have been told that they must own a street tree to maintain it properly. Still everybody benefits from the trees, including the homeowners, so there may be some just basis for imposing this responsibility on home owners.

Now the city has gone one further and declared that if a street tree falls into a city street, the homeowner is responsible for clearing the tree off the street. If the homeowner does not do it, the city will, but they will bill the owner and if the owner cannot pay for it, they will impose a lien against the homeowner.

This does not seem right to me. It would be different if the homeowner opted to plant the tree. Clearly, then, they would be responsible for its maintenance, upkeep, and, when required, its removal. But this is tantamount to a hidden tax on unsuspecting homeowners. Personally I spend thousands of dollars per year maintaining my trees, but that does not include the two street trees the city planted on my property. Fortunately I do not live in San Jose. If I had to maintain those two additional, fully grown trees, it would at least double my costs each year. I could afford it, but some of my neighbors might not be able to and might prefer to cut the trees down instead. That would damage the integrity of my neighborhood and we would all be losers. Now they would have to worry about their trees or some of their limbs falling every time a wind storm blew into town. Doesn't this consititute the "taking" of one's property? Maybe the city should try to think of some other way to encourage tree planting without imposing it on some people who may not be able to afford it!

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• May. 10, 2008 - What NOT to Do!!

Recently I was listing agent for a home that was purchased by an independent broker representing herself. On the surface it looked like an easy transaction…. All cash, 10 day close, no contingencies. But I knew there would be trouble when I dropped by to water the lawn and discovered the buyer/broker with her sports SUV up on the lawn talking to a man with a chain saw in his hand. He had already, at her direction, removed all of the bushes from the back yard and was proceeding to cut down a tree!!

Needless to say I was astounded. I told the woman that she had to stop immediately and remove the debris right away, and that she absolutely, under no circumstances, was she to do anything else at the premises until after escrow closed. I explained to her (shocking that I should have to do this) that she did not yet own the house, she did not have permission from me or the owner to do any yard work or other improvements on the property, that she was trespassing, vandalizing the property, and breaking the law, and that she should cease and desist immediately. When I got back to my office I put all of the above in writing and emailed and faxed it to her, just to make sure she got the message.

Well, clearly she didn’t. I was away for 4 days but the day I got back she called to arrange a walk through the next day (

I had told her if she wanted a walk through I would escort her, as I had removed the keys.) When I arrived I discovered that, while I was away, the lady had proceeded to rototill the back yard (used to be grass), remove much of the back patio and part of the side patio, dig a trench across the front yard, and remove the hose bib that I had attached a hose to. At that point I probably should have called the police and filed a police report, but we were 2 just days from close of escrow, so instead I told her I would ask the neighbors to keep an eye on the property and instruct them to call the police if they saw her there. Then I proceeded to do just that while she stood and watched me. She knew I was serious!!

Fortunately we closed escrow on time, and in the long run there was no harm done. But there could have been. Any number of things could have happened. Either she or the guy with the chain saw could have been injured by falling off the ladder, tripping on the mess they made, or whatever. The same is true of a neighbor who may have wandered onto the premises to fetch their runaway dog, or even the mailman. Or the escrow might not have closed. In the first example, the owner, my client (who lived in a different state) may have been sued for damages. In the second case, my client would have to spend many thousands of dollars to return the house to its former condition and may have lost time and “missed the market” while doing so, and most certainly would have gone after the buyer/broker for damages to the property and potentially for the difference in the sales price if he had to sell for less.

This is an extreme example, but the underlying message is clear. Even if the property you are buying is vacant, and even if you are very excited and chomping at the bit to start fixing it up to make it your own, it still does not belong to you. IF you really feel the need to make specific changes before escrow closes, at the very least you must get the owner’s permission in writing to do so. Personally I try to discourage any repairs or changes prior to close of escrow. It is better to close early, before the buyer’s move-in date to allow them time to make repairs. You just never know what might happen.

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• Apr. 22, 2008 - Buy Art and Wear It at the Palo Alto Art Center

Here is a fun event for art lovers:

Style 2008

An Art-for-Wear Trunk Show

Saturday, April 26, 2008, 10 AM - 5 PM

Palo Alto Art Center

Admission $10

Proceeds benefit art education programs of the Art Center through support from the Palo Alto Art Center Foundation.

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