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(Listen Here 4:49 min)
When you are doing a 1031 Exchange, you generally want to hit three benchmarks called the napkin test. These are generalities that typically bear out to be good indicators of whether or not all of the gains will be deferred in a 1031 Exchange. Here are the benchmarks.
Step One – Equal or Greater Value
One, you typically want to buy a replacement property of equal or greater value than the relinquished property that you gave up. So, we want to go up in value, and get a bigger, better property.
 Step Two – Equal or Greater Equity
Secondly, we want to take all of our net equity, all of our proceeds from the disposition, the sale of our relinquished property. Imagine a big stack of poker chips in front of your relinquished property. I want to slide all of those poker chips over into the replacement property. So, I am moving all of my equity from A to B. So, the second rule of thumb is I want to move all of my equity into the replacement property rather than taking any cash or chips off the table, which would be treated as taxable boot.
Step Three – Off-set Your Debt Relief
The last benchmark, the third thing that I am trying to juggle, is that to the extent that I am paying off mortgages and debt on the relinquished property, I need to offset that debt relief with either new debt taken out in conjunction with the replacement property. So, I could take out a new purchase money mortgage, or I could assume the seller’s existing mortgage that would satisfy my debt relief if I acquired a replacement property with at least an equivalent amount of debt. Or, alternatively, I can offset my debt relief by putting more of my own cash into the replacement property. Cash in will also offset debt relief.
Coming Up Short on “Sufficient Valueâ€
 Well, here is where things get a little bit crazy. What if a person wants to acquire a replacement property that is not of sufficient value, but they are willing to gross up that price, fabricate, inflate the value of the price and report the transaction as if they acquired a replacement property of greater value. Let’s say that the real value of the property is $100,000, but the taxpayer grosses up the sale price to $150,000, so that they acquiring a replacement property of sufficient value. Suppose that they are buying from a friend who is willing to go along with it. Perhaps the friend is even willing to split the difference and to send back some of that inflated proceeds to the purchaser. They will give it back under the table. This is not acceptable. Filing a false or fraudulent tax return is a criminal offense. Knowing and willful attempts to evade or defeat income tax due is a crime.
There is a big difference between legally deferring your taxes in a proper 1031 Exchange and stretching the truth to fabricating the value of your replacement property.
Do Not Do the Crime
Section 7201 says that any person who willfully attempts to evade or defeat any tax imposed by this title, or the payment thereof, shall in addition to other penalties provided by law, be guilty of a felony. And, upon conviction thereof, shall be imprisoned not more than five years. Or they may be fined not more than $250,000 for individuals or both together with the costs of prosecution.
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(Listen Here 6:01 min)
Today’s podcast is highlighting some of the changes that came from the American Recovery and Reinvestment Act of 2009 – otherwise known as the Tax Stimulus Package. In particular, we are going to be talking about Section 25A, which is the Hope Scholarship Credit. Remember, a tax credit is like a negative tax. It offsets dollar for dollar your liability to the government, and it is better than a deduction.
Old Section 25A on Steroids
Here are some of the enhancements for tax years 2009 and 2010. This has been entitled by the government, The American Opportunity Tax Credit. But, it is really just an enhancement of Section 25A, which is for the Hope Scholarship Credit. Under the old Hope Credit, you were able to take a credit for one hundred per cent of the first $1,200 expended for tuition and related expenses. Then you were able to take a credit for fifty per cent of the next $1,200. So, the maximum credit under the old rule was $1,800.
The New Rule is Better
You get to take one hundred per cent of the first $2,000 and then twenty five per cent of the next $4,000 that is expended for tuition and related expenses. (That’s a total $2,500 tax exclusion) By the way, that now includes “course materialsâ€. So, it is a broader definition for what we can spend our money on. Under the old Hope Credit, you were only allowed to take this exclusion for the first two years of Post Secondary Education. The new version allows us to take it for up to four years. So it is a broadening to include four years of Post Secondary Education. Thus, if you are on the four year plan, you should be able to cover all four years of college.
More People Qualify
Another enhancement is that they have expanded the range of people who qualify to take this credit. Under the old rule, there was a phase out. If you made two much money, the credit was no longer available to you. Those phase outs started around $50,000 for single filers and $100,000 for joint filers. Under the new rule, those phase outs have been raised. So, a person making $80,000 (Adjusted Gross Income or AGI) for single filers and $160,000 (AGI) for joint filers is where the phase outs now start to kick in. Under the new rule, if your income for a single filer equals $90,000 (AGI) or $180,000 (AGI) for a joint filer, then you are phased out from taking these credits.
If Child Claims Exclusion – They Must Provide 50% Support
One thing that continues, though, is that if a child is going to take this credit for themselves, they have to provide for more than fifty per cent of their own support. So, unfortunately, if Mom and Dad are providing for more than fifty per cent of a child’s support, that child won’t be able to take this tax credit.
This Credit keeps Getting Better
One interesting facet of this new legislation is that this credit applies against the alternative minimum tax (AMT).
And Partially Refundable
What if you have very little income, and you have very little tax liability because of the low income, and you get this credit? Can you take the credit? Normally, a credit offsets your tax liability dollar for dollar. But, what if the amount of your credit exceeds the amount of your tax liability or your debt to the government? This is a unique tax credit in that it is refundable or partially refundable. Forty per cent of this credit can be paid to you as a refund if the amount of your credit exceeds the amount of your income tax liability. So, as an example, let’s say that if I have zero tax liability for 2009, but I fully qualify for one-hundred percent of this credit. That means that forty percent of the $2,500 credit will be paid to me as a refund. Remember, forty percent times $2,500 equals $1,000 of cash in my pocket because up to forty per cent of this tax credit is refundable.
This is a Good Deal for Taxpayers
In summary, the old Section 25A Hope Credit was a good deal for taxpayers. The new version under the American Recovery Act and Reinvestment of 2009 is even better. It has expanded definitions of what we can spend money on, and it has expanded the range of taxpayers who can qualify because of a lengthened phase out period, and we can use it for more than two years. We can use it for four years of Post Secondary Education expenses. This is a wonderful tax incentive. It is designed to stimulate the economy and encourage education.
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