San DiegoAuthor: Staff

In a recent unpublished California appellate decision, the plaintiff appealed after a bench trial was conducted on his complaint for breach of contract and breach of fiduciary duty. The case arose when one of the defendants, who’d worked as a real estate developer in Illinois for 21 years before moving to San Diego, needed seed money for a potential development. He contacted his childhood friend to see whether he’d be interested in creating a partnership to invest money to follow the opportunity.

The childhood friend agreed and formed Gimbel Corporation with another friend. Meanwhile, the defendant formed Kriozere Corporation, in which he was the sole shareholder. The two corporations formed a general partnership. Gimbel invested $250,000 in a development in downtown San Diego, and both partners enjoyed profits from this first project.

In 1993, the initial partnership agreement was changed to reallocate profits between the partners. Gimbel invested in some properties with Kriozere under the second agreement. In 2006, the partners restructured their partnership so that Gimbel was a limited partner, while Kriozere was a general partner. The childhood friend’s other friend replaced the childhood friend as director of Gimbel.

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highriseAuthor: Staff

In a recent California appellate decision titled Ito v. Ito, the appellate court considered how to value two brothers’ respective interests in real estate they’d bought and sold. One of the brothers, a programmer, had gone into business with the other, a real estate investor, and then they fell out. The programmer sued the investor to wind things up. Ultimately, the real-estate investor appealed.

The main issues in the lawsuit were how to value each brother’s interest in real estate they’d bought and sold and how to treat their interests in a corporation they’d formed to make arrangements. The programmer testified that when they formed the corporation, he was making more than $300,000 a year as an independent contractor. His brother had no money, and the programmer agreed to do his business through a corporation and give his brother a 50% share of the business to take advantage of the brother’s tax losses. The brother got a salary under an employment contract with the corporation, but according to the programmer, he didn’t do anything for the corporation. In 2002, the brother forfeited his share of the business.

At trial, the court labeled the corporation an illegal scheme by the programmer to avoid paying income taxes and decided the brother had no interest from the beginning. The brothers had jointly bought about 39 properties and continued to own six of them through partnerships and limited liability companies at the time of trial. The investor argued that their interests should be determined by their capital accounts in the property, with the amount of the accounts fluctuating based on their contributions. He argued that the programmer’s capital accounts for the properties were zero because whatever he’d put in, he got back in the form of payments he’d received from the investor.

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1031-apartment-building

Author: Matthew Riley

Matthew Riley is an attorney with Bona Law, primarily focused on antitrust, commercial litigation, real-estate, and federal administrative law.

Does property that started off as non-qualifying (i.e. primary residence), but over time has changed its character to fit a qualifying purpose fit within the requirements of Section 1031?

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Does property used concurrently for both non-qualifying and qualifying purposes, for example a primary residence, a part of which functions as an office space, qualify as Section 1031 property?

Over time the purposes a property serves can change or multiply.  When this occurs, the applicable tax rules may change as well.  For example, a primary residence may later become rental property and convert to a business or investment purpose.  Or, perhaps the property owner devotes part of their residence for use in a business.

The frequency of questions raised in relation to primary residences and whether or not such properties qualify for a Section 1031 Exchange has spurred the IRS to compose many well-developed tax rules pertaining to these circumstances.

These tax rules, though involving the disposition of Section 1031 property, primarily center upon two other issues:

The first concerns Section 121’s applicability to a Section 1031 Exchange; and the second instructs how to allocate and treat gains recognized in that Exchange.

We will take up the second part, categorizing and calculating taxable gains, later. Here we focus on the initial requirements that must be met before a primary residence can be included in a Section 1031 Like-Kind Exchange.

Section 121 applies when a taxpayer’s primary residence is sold [exchanged] and treats taxable gains from that exchange differently than Section 1031.   That is, Section 121 excludes taxable gains from a sale, up to $250,000 for a single taxpayer ($500,000 for those filing taxes jointly), from taxation.  This tax-free treatment of gains under Section 121 for primary residences differs from the tax-deferral treatment for business/investment properties under Section 1031.  Under certain circumstances, a taxpayer may be able to enjoy the tax advantages of both rules for the same property.

Generally, Revenue Ruling 59-229 disqualifies primary residences from a Section 1031 Like-Kind Exchange.  Revenue Procedure 2005-14, however, allows the Exchanger to use such property in an exchange when the property’s use as a primary residence is either concurrent or consecutive to its use for a qualifying business/investment purpose under Section 1031.

To qualify for tax-free and tax-deferral treatments under Section 121 and Section 1031, respectively, two conditions must be met.  First, the property must be held as the Exchanger’s primary residence for at least 2 years during a 5 year period ending on the date of the sale or exchange.  And, secondly, at the time of the sale or exchange, the Exchanger must have held the property long enough to establish and demonstrate an intention to use the relinquished property for a qualifying business or investment purpose.

For many, the second condition raises the question, How long does it take to establish a demonstrable intention to use a property for a qualifying business or investment purpose?  Unlike the first condition, which outlines a specific time requirement, the IRS does not provide the same bright-line holding period for the second condition.  Rather, whether the Exchanger has held the property long enough to establish the proper intention is determined on a case-by-case basis.  Case-law, legislative history, and heuristics provide guidance to determine whether the required holding period to establish business or investment intention has passed. You should consider the following:

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windowsAuthor: Staff

Sometimes investors in California are interested in having the flexibility of a partnership structure but are worried about personal liability. In a limited partnership, there are one or more general partners and one or more limited partners. There always needs to be at least one general partner, and the general partner or general partners will have unlimited liability for the partnership’s debts and liabilities. Under California Corporations Code § 15611, the limited partners contribute capital but don’t get to manage or have other responsibilities and aren’t held liable for partnership obligations that go over their capital contributions. Often, however, an Limited Liability Corporation (LLC) is considered a more favorable vehicle for real estate than a limited partnership in California. For example, all of the owners of an LLC can manage it.

To form a limited partnership in California, investors file a certificate of limited partnership. Limited partners do not need to disclose their names or legal information. There is no legal requirement that a partnership agreement be in writing, but it is important to have one. The agreement will set forth why the partnership is being created, how business is going to be conducted, the rights and liabilities of each partner, and other contingencies. Negotiating and creating a written agreement about how a limited real estate partnership will be conducted can eliminate litigation down the road.

In most cases, a limited partnership is a good way for passive investors in real estate to become involved. A limited partner gets to invest in real estate and share in profits when the project is successful, but they aren’t held responsible for liability when it exceeds their initial capital contribution. The general partners are liable beyond this amount and are considered jointly and severally liable to third parties when a lawsuit arises from their actions on behalf of or in the course of the partnership.

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mallAuthor: Staff

Real estate syndication involves multiple investors pooling funds and putting them into real estate projects, either to acquire a property completely or as an equity contribution to fund the cost of a project. But there is a great deal of variety in which types of projects are considered real estate syndication, and certain private placements may be heavily regulated.

Sometimes disputes involving real estate syndicate projects are arbitrated before the Financial Industry Regulatory Authority (FINRA), which regulates all securities firms by regulating brokers and brokerage firms and monitoring stock market trade.

In an unpublished 2015 case in a California state appellate court called Stark v. Beaton, a defendant appealed after the court denied his petition to vacate an arbitration award associated with a real estate syndication project. The case arose when the parties submitted the defendants’ claims to expedited arbitration under the FINRA rules.

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Red Rock CanyonAuthor: Staff

Real estate syndication allows you to put your private savings into real estate investments when other financing isn’t available for them. The syndicator’s responsibilities and obligations to an investment group and the investors’ responsibilities to each other are determined by how the syndication is organized.

Choosing the form of organization requires the syndicator to look at the advantages and disadvantages of each. Many people prefer a limited partnership. When there is a corporate form, you can have central management, but most syndicates do not use this form because of negative tax consequences. General partnerships allow you to avoid double taxation but incur unlimited liability, and in addition, there is no central management. A limited partnership allows you to have centralized management but also keep certain tax advantages.

Some syndicates are organized as limited liability companies. This form allows members to actively participate in managing the syndicate and provides for limited liability with specific exceptions. It can incur taxes like a partnership, while avoiding certain double taxation problems that happen when the form of the syndicate is a corporation. But an LLC cannot hold a real estate license in California.

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houseAuthor: Staff

In a recent California appellate case, a plaintiff sued multiple parties after the nonjudicial foreclosure of his home. The court sustained the defendants’ demurrer without providing leave to amend.

The plaintiff challenged the judgment against the bank that instituted the foreclosure sale and one of the entities that serviced the plaintiff’s secured loan. He argued that it was a mistake for the court to determine he hadn’t stated a cause of action against these two defendants and couldn’t amend his complaint to state a cause of action. The court affirmed the judgement.

The case arose in 2007, when the plaintiff borrowed $528 to refinance the loan on his home. The loan was reflected in a note that both parties signed, and it was secured by a deed of trust on his home. The deed of trust identified him as the borrower and also identified the lender, trustee, and beneficiary. It stated that the borrower understood the beneficiary held legal title to the interests specified in the deed of trust but had the right to foreclose and sell the property and take any action required of the lender, if necessary to comply with law or custom. It also allowed the note to be sold multiple times without giving the plaintiff notice.

The beneficiary entity assigned the note to Mellon Bank, which was a trustee for a securitized investment trust and one of the defendants. The assignment was signed by an assistant secretary and recorded. The trust was organized under New York laws and was governed by a servicing agreement that required a servicer to make certain advances on delinquent loans. One day after the assignment was executed, another entity recorded a notice of default, stating an owed amount of $35,254.26.

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1031-exchange-photo
Author: Matthew Riley

Matthew Riley is an attorney with Bona Law, primarily focused on antitrust, commercial litigation, real-estate, and federal administrative law.

In my first blog post for Titles and Deeds I introduced what I consider the “Golden Rule” of real estate investing—Section 1031 Like-Kind Exchanges. As promised, I’ve returned to help you understand the fundamental rules governing these exchanges, so you can determine whether you may be eligible to enjoy the financial benefits of this rule.

freewayAuthor: Staff

In a recent California appellate case, DNI Food Service, Inc. dba Zaya’s Bistro v. Kim, the owner of a multi-tenant retail building in Los Angeles County was notified that two parcels of its land would be affected by a freeway expansion project. The building wasn’t located on either of the parcels, and there were five tenant vacancies.

Caltrans planned to take some land located between the street and building and create an easement over the sidewalk. Real estate agents working for the builder were communicating with Caltrans. At about the same time, these real estate agents advertised tenant space in the building, marketing the property on the basis of its location and its reduced rents. A food services company and its owner saw the ad and contacted the agents. They were hoping for a two-year lease but signed a five-year lease with a personal guarantee. The food services company spent money and time and opened a restaurant in the spot that they rented.

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Author: Matthew Riley

Matthew Riley is an attorney with Bona Law, primarily focused on antitrust, commercial litigation, real-estate, and federal administrative law. Prior to joining Bona Law, Mr. Riley’s legal practice emphasized transactional work involving real estate and mergers and acquisitions. Matthew’s professional passion is to educate and to clarify complex areas of the law to help clients achieve their goals. Matthew Riley graduated from the University of Kansas School of Law in 2013 and is licensed to practice law in Illinois. He is in the process of obtaining his admission in California.

No one wants to pay taxes, and most, if given the option, would pay less.  The United States Tax Code declares certain events taxable (ex. receiving wages, selling property), and establishes rules to assess how much a taxpayer owes on those events.  In some cases the Tax Code empowers taxpayers to choose which tax rules apply, and thereby, how much tax is owed.  Therefore, knowing the tax rules and how they apply to certain taxable events can result in significant and beneficial tax consequences for you and your business.

Like-Kind Exchanges are governed by Section 1031 of the United States Tax Code, as well as Judicial Opinions, Revenue Regulations, Procedures, and Rulings issued by the IRS. Section 1031 should be known as the real estate investor’s “Golden Rule”.  By “Golden Rule” I mean it is a rule investors can apply to accumulate wealth significantly faster than investors who do not follow the rule.

A Like-Kind Exchange is an investment strategy whereby one property is sold and replaced by the acquisition of another of the same kind.  In such an exchange, any taxes that otherwise would be charged to an investor’s capital gains on the relinquished or sold property, are deferred.  The deferment of these taxes allows the investor to enhance their purchasing power in acquiring a replacement property.  To illustrate the ramifications to an investor choosing to apply the Like-Kind Exchange rules, consider the following (fictional) scenario:

Ronald Lump is an investor who got a “steal-of-a deal”, paying $500,000 for an apartment building in an up-and-coming neighborhood in San Diego. After holding onto the property for a couple years and finding his property greatly appreciated from a neighborhood renovation project, Ronald decides to cash out and purchase a bigger-and-better beach front apartment complex in La Jolla. Ronald finds a buyer who purchases his apartment building for $1,000,000.

Below is a table showing the differences in Ronald Lump’s financial position post-sale when applying and not applying the Like-Kind Exchange rules.

Ronald’s Selling Price $1,000,000.00
Ronald’s Original Purchase Price $500,000.00
Total Taxable Gain After Sale $500,000.00
When Like-Kind Rules Are Applied When Like-Kind Rules Are Not Applied
Capital Gains Tax Rate on Taxable Gain N/A 20%
Tax Due After Sale $0 $100,000.00
Total Amount Available to Ronald Post–Sale that can be Reinvested Into the Beach Front Apartment Complex  

 

$1,000,000.00

 

 

$900,000.00

As you can see, applying the Like-Kind Exchange rules enhance an investor’s financial position or purchasing power to acquire a replacement property.  Ronald Lump, by following and meeting the requirements under Section 1031 will have $100,000.00 more than he otherwise would to reinvest in another like-kind property.  Over time, through structuring multiple property exchanges in this way, the value of an investor’s investment portfolio is better preserved and substantially enhanced.

In later blog posts I will provide a basic understanding of what Section 1031 requires and how you can apply it in your next investment.  I will focus solely on real estate exchanges, though Like-Kind Exchanges can be used in exchanges involving other business or investment assets.  The rules and requirements established in Section 1031 are complex, and if not closely followed by an investor, will disqualify an exchange from tax deferment treatment.  Real estate investors structuring a Like-Kind Exchange are strongly encouraged to obtain an attorney’s assistance in preparing and executing such an exchange. By following this “Golden Rule” of real estate investing, you can work to maximize your investing power now and into the future.

Here is a table of contents of our Section 1031 Exchange Articles:

INTRODUCTION – GOLDEN RULE TO REAL ESTATE INVESTMENT

PART 1 – THE RELINQUISHED PROPERTY (SOLD PROPERTY) MUST HAVE BEEN HELD BY THE EXCHANGER FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMEST PURPOSES.

  • PART 1.3 – How do you characterize vacant and unproductive land, which is not used for personal enjoyment nor in furtherance of any trade or business purpose?

PART 2 – THE EXCHANGER MUST INTEND TO HOLD THE REPLACEMENT PROPERTY (ACQUIRED PROPERTY) FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMENT PURPOSES. 

PART 3 – BOTH THE RELINQUISHED AND REPLACEMENT PROPERTY MUST HAVE A NATURE AND CHARACTER THAT IS “LIKE-KIND” WITH THE OTHER.