Banks should be on alert for Russian oligarchs attempting to circumvent U.S. sanctions by investing in commercial real estate, a U.S. Treasury Department watchdog said.
Wealthy Russians with ties to the Kremlin are likely attempting to evade the economic sanctions placed on them in the U.S. by moving money into the commercial-real-estate sector, where complex financing methods and opaque ownership structures can help bad actors hide funds, the Treasury’s Financial Crimes Enforcement Network, better known as FinCEN, said Wednesday.
FinCEN, which serves dual roles as the U.S.’s financial intelligence unit and anti-money-laundering regulator, is the recipient of the suspicious activity reports that financial institutions are required to file if they suspect a transaction may be illicit in nature. Law-enforcement officials can consult the reports when conducting investigations into financial crimes.
The Biden administration has targeted wealthy Russians as part of its response to President
invasion of Ukraine last year, placing those with close ties to the Russian government on blacklists that are intended to prevent them from accessing the U.S. financial system.
The alert issued by FinCEN on Wednesday is the Treasury’s latest effort to prevent sanctioned Russians from finding ways to evade such financial restrictions. In an 11-page report, FinCEN listed a number of potential red flags and typologies it said banks should be on the lookout for.
“Thanks to international pressure and the economic restrictions that more than 30 countries have imposed on Russia for its brutal war against Ukraine, sanctioned Russian elites are increasingly left with fewer options for moving and hiding their ill-gotten wealth,” FinCEN Acting Director
Sanctioned individuals may try to use pooled investment vehicles or offshore funds to avoid due-diligence processes, FinCEN said in its alert. Banks aren’t typically required to verify the identities of individuals who own less than 25% of a fund. Sanctioned individuals could keep lowering their stakes to avoid detection, while still maintaining control of the fund, FinCEN said.
Oligarchs also may use shell companies and multiple layers of legal entities or trusts, or transfer their assets to a family member or business associate to conceal their ownership, the Treasury bureau added.
Sanctioned individuals aren’t just investing in high-end or luxury properties, according to the alert. In some cases, they may seek out more inconspicuous investments that provide stable returns without drawing unwanted attention. Such sanction evasion strategies are just as likely to occur in small to midsize U.S. cities as they are in the largest metropolitan areas, FinCEN said.
FinCEN’s latest alert builds on a similar warning issued last year, in which the watchdog advised banks to pay close attention to transactions involving high-value assets such as artwork, luxury yachts and jewelry.
Federal prosecutors have warned that lawyers, consultants and other service providers who work for sanctioned individuals could run afoul of the law.
An indictment unsealed earlier this week charged a former high-level FBI agent and a former Russian diplomat with sanctions violations in connection with work they did for
a raw-materials magnate who was placed on a sanctions blacklist in 2018.
Write to Dylan Tokar at email@example.com
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LOS ANGELES — Southern California beachfront property that was taken from a Black couple through eminent domain a century ago and returned to their heirs last year will be sold back to Los Angeles County for nearly $20 million, officials said Tuesday.
The heirs’ decision to sell what was once known as Bruce’s Beach was announced by Janice Hahn, chair of the county Board of Supervisors, and state Sen. Steven Bradford, who led local and state governmental efforts to undo the long-ago injustice.
“This fight has always been about what is best for the Bruce family, and they feel what is best for them is selling this property back to the County for nearly $20 million and finally rebuilding the generational wealth they were denied for nearly a century,” Hahn said in a statement.
Bradford, who authored the state legislation that enabled the land’s return, said he supported the heirs’ decision to sell it to the county because current zoning regulations would prevent them from developing it in an economically beneficial manner.
The land in the city of Manhattan Beach was purchased in 1912 by Willa and Charles Bruce, who built a small resort for African Americans on the south shore of Santa Monica Bay.
The Bruces suffered racist harassment from white neighbors, and in the 1920s the Manhattan Beach City Council condemned the property and took it through eminent domain. The city did nothing with the property, and it was transferred to the state of California and then to Los Angeles County.
The county built its lifeguard training headquarters on the land, which includes a small parking lot.
Hahn learned about the property’s history and launched the complex process of returning the property, including determining that two great-grandsons of the Bruces are their legal heirs.
Terms of the transfer agreement completed last June called for the property to be leased back to the county for 24 months, with an annual rent of $413,000 plus all operation and maintenance costs, and a possible sale back to the county for nearly $20 million, the estimated value.
After years of sidelining its economy as rigid anti-COVID policies trumped all else, China seems — at least on paper — set for a robust 2023.
Investors and analysts see a promising landscape for several reasons.
Last year’s weak growth should provide a low baseline for comparatively rapid expansion. Removing the crushing first year of the pandemic, China’s economy in 2022 likely grew at its slowest rate in nearly 50 years.
Second, policy makers in recent weeks have hammered home that the economy is now priority No. 1. At last month’s top annual economic summit, President Xi Jinping and other leaders promised that a steady and ongoing economic recovery would kick off this year — with ample government support.
On Thursday, China’s finance ministry said it would accelerate spending to boost growth, particularly in tech and other nationally strategic sectors.
Other measures, such as tax cuts for businesses and issuance of special bonds to fund targeted projects, alongside increased fiscal transfers to local governments, are to be rolled out as well, the ministry said.
Most important in reviving China’s beleaguered economy, however, is last month’s sudden dismantling of “zero-COVID” measures that have crippled business activity for more than a year.
It is “certain” that China’s economy will recover this year, said Lu Ting, chief China economist at Nomura. ”The question is how much.”
Yet for Beijing-based economist Michael Pettis, a senior fellow at the Carnegie Endowment, what matters most is which parts of the economy grow, and which the government chooses to stimulate.
For him, any rebound is only significant through healthy domestic demand — namely, consumption and business investment — and how sustainable that demand becomes.
“Analysts must stop interpreting Chinese economic data in the same way they interpret data from other countries. In China, where so much growth is driven by soft-budget spending, GDP does not mean what it means abroad, where most spending is limited by hard-budget constraints,” he said.
Whether China moves to permanently shift the structure of domestic demand will determine if this year’s economy regains its health — “and more importantly, how costly China’s longer-term adjustment is likely to be,” Pettis said.
Policy makers may finally be moving in that direction.
At last month’s summit, Chinese leaders stressed that expanding domestic demand was vital, and for the first time prioritized consumption higher than investment and infrastructure.
Part of stimulating domestic spending will be allaying rattled consumers, who have been saving rather than buying amidst the uncertainty of last year’s COVID restrictions and the losses of jobs and businesses.
Stimulating consumer confidence and domestic demand will lead Beijing’s economic policies this year, China International Capital Corp.
said in a recent note. The investment-management firm said various short- and long-term policies will be rolled out to stabilize the sector.
China faces a few caveats for its recovery hopes, however. The explosion in COVID cases since it opened up is ongoing, and the death toll and pressure on the health-care system are clouded by the Communist Party’s characteristic lack of transparency in releasing data and other potentially sensitive information.
Moreover, economists are predicting a potentially sharp global slowdown this year, with the chance of recessions in the U.S. and Europe, which would dampen trading with and investment into China.
And with COVID restrictions largely out of the way, the long-struggling property market has returned as the economic elephant in the room.
While the sector is suffering a record contraction, with every subsector from housing to commercial property in distress, new credit data offers a glimmer of hope, said Shehzad Qazi, managing director of consultancy China Beige Book.
“Borrowing and bond sales are picking up, which suggests the much talked about policy turn may finally be approaching,” he said in an emailed statement.
“But forget a return to days of old: It will take considerable policy support in 2023 just to pull property out of the gutter.”
After China’s most economically and politically turbulent year in more than three decades, investors are keen to see how 2023 will unfold for the world’s second largest economy.
The country is experiencing an explosion of COVID infections, after authorities earlier this month suddenly dropped most of the notoriously draconian restrictions that have shackled business activity and daily life through much of the pandemic.
But so far, experts’ predictions of widespread deaths and a nationwide overwhelming of hospitals have yet to materialize. More than 90% of Chinese are fully vaccinated, compared with 68% of Americans, according to the countries’ respective health authorities.
Officials have said publicly that they now deem the virus weak enough to weather a surge of infections as rapidly as possible — with the hope of then reviving the country’s economic doldrums.
The following are the stories to watch over the coming year as we gauge just how successful — or unsuccessful — this approach becomes.
Loosening of internal COVID restrictions surprised citizens with its suddenness. Meanwhile, China is moving more slowly — but steadily — toward reopening to foreign travelers and businesspeople. Next month, it will abolish a centralized quarantine for arrivals, and require only three days of isolation at home or in a hotel, Chinese media reported Wednesday.
Hong Kong last week scrapped all quarantine requirements for international arrivals.
But don’t expect the prepandemic wave of outbound Chinese travelers to resume quickly. More than half of respondents to a survey of 4,000 Chinese consumers by consultancy Oliver Wyman said they would not travel abroad for several months, if not more than a year.
For much of the pandemic, unlike many developed countries, China refrained from large-scale stimulus measures, mostly rolling out supply-side support such as boosting infrastructure projects. This neglect of stimulating domestic consumption was compounded by citizens’ reluctance to spend amid times of uncertainty.
But that appears to be changing. At China’s annual economic summit last week — chaired by Xi Jinping, given a norm-busting third presidential term this autumn — officials declared that “the recovery and expansion of consumption should be given top priority,” according to an official readout. Measures include boosting incomes as well as providing subsidies and incentives in a range of categories such as alternative-energy vehicles, housing renovations and elder services.
“Consumer demand is now quickly moving up Beijing’s policy agenda,” consultancy Trivium wrote Tuesday in response to the announcements.
China’s beleaguered property sector — which last year was on the verge of collapse — has been receiving steadily rising government support. Xi last month said that a raft of new measures would be forthcoming, including requiring lenders to up their loans to developers as well as support for bond issuances by private real-estate firms.
Banks have also slashed average mortgage rates by more than a percentage point in the last several months, and mortgage requirements have eased, while processing times have shortened.
“This pragmatic course correction should lead to a gradual, steady recovery in new-home sales in the second half of 2023,” Matthews Asia investment strategist Andy Rothman said in an emailed statement.
Trivium analysts concurred. “We expect more policies in the new year to restore demand for new housing and to boost construction,” they wrote.
These revitalization moves, if successful, bode well for the beginning of a Chinese recovery next year, analysts said.
Through COVID relaxations and proactive fiscal measures, consumer mobility and rising sentiment will help reinvigorate China’s growth in the second quarter and foster expansion even further in the year’s second half, said Bruce Pang, chief economist for Greater China at Jones Lang LaSalle.
Pang expects China’s economy to grow more than 5% in 2023, a forecast other analysts are revising their own estimates toward. “And don’t forget, China is likely the only major economy with a serious [monetary] policy easing stance, while much of the world is tightening,” he said.
The U.S. Department of Energy is expected on Tuesday morning to announce a breakthrough in ongoing research for nuclear fusion, long heralded for its potential as a source of zero-emissions and essentially, limitless, energy.
The announcement is scheduled for 10 a.m. Eastern time.
Nuclear fusion, if it can be produced at scale, has long been considered the Holy Grail in the push for clean energy and slowing the global warming that is intensifying natural disasters, acidifying oceans and bringing extreme heat and drought. The U.S. and much of the rest of the developed world have been promoting a combination of solar, wind
hydrogren and nuclear energy to replace the coal, oil
and natural gas
that send atmosphere-warming emissions into the air.
Many nations, including the U.S., have said their economies must cut emissions by half as soon as 2030 and hit net-zero emissions by 2050.
On Sunday, the Financial Times reported that federally-funded scientists with the Lawrence Livermore National Laboratory produced more energy than was consumed in a fusion reaction for the first time. Other major news outlets confirmed that reporting, although the lab has said it will wait until Tuesday to discuss the project.
“The recent experiment is a first-of-its-kind feat that could lead to an effective process for producing a zero-carbon alternative to fossil fuels and [traditional] nuclear energy,” said Frank Maisano, senior principal focused on energy with the Policy Resolution Group in Washington.
Nuclear fusion is the process of fusing two or more atoms into one larger one, a process that unleashes potentially usable energy as heat, in much the same way the sun heats the Earth. Nuclear power used today is created by a different process, called fission, which relies on splitting atoms and harnessing that energy, while also producing radioactive waste.
Currently, traditional nuclear plants using fission produce about 10% of the world’s electricity, but their proponents have also pushed their expansion as a key to a diverse portfolio of alternative energy.
Daniel Kammen, a professor of energy and society at the University of California at Berkeley, told the Associated Press that nuclear fusion offers the possibility of “basically unlimited” fuel, but only when the technology can be made commercially viable. The basic elements are easily accessible; in fact, they’re available in seawater.
The Livermore lab isn’t the only effort toward a fusion breakthrough, which scientists have worked on for decades.
In Europe earlier this year, a large, doughnut-shaped machine known as a tokamak, developed by scientists working in the English village of Culham, near Oxford, generated a record-breaking 59 megajoules of sustained nuclear fusion energy over five seconds during trials, the scientists revealed. That more than doubled the previous record for generating and sustaining fusion.
While scientists have generated fusion energy before it is sustaining the power that has been difficult to achieve. A magnetic field is required to contain the high temperatures created by the fusion process — some 150 million degrees Celsius, 10 times hotter than the center of the sun.
The Livermore lab uses a different technique than the tokamak, with researchers firing a 192-beam laser at a small capsule filled with deuterium-tritium fuel. The lab reported that an August 2021 test produced 1.35 megajoules of fusion energy — about 70% of the energy fired at the target. The lab said several subsequent experiments showed declining results, but researchers believed they had identified ways to improve the quality of the fuel capsule and the lasers’ symmetry.
In Orange County, California, another contender in the fusion race, TAE Technologies, is on track to develop the first commercial prototype power plant for clean fusion energy by 2030, its CEO Michl Binderbauer told MarketWatch earlier this year. Binderbauer had just attended the first-ever White House Fusion Summit.
At that event, administration officials announced what they called a “bold decadal vision” to accelerate the development of commercial fusion energy.
“There’s a fallacy in thinking that solar and wind can solve everything,” said Binderbauer. “Absolutely, they’re wonderful sources of power where it fits. But there are also limitations. There’s no world that can run on 100% renewables.”
Nuclear industry analysts remind that it will take sustaining and repeating the process, and at scale, for the development to change traditional energy markets anytime soon.
“This doesn’t mean it’s not a big deal, but I still doubt how much this impacts the efforts to bring fusion closer to commercial reality. My sense is fusion is at least a decade or more away from any commercialization,” said Jonathan Hinze, president of UxC, LLC, which tracks the uranium and nuclear markets, in an email to MarketWatch.
The Associated Press contributed.
By James Glynn
SYDNEY–The Australian government’s budget for 2022-2023 reveals a solid bottom-line improvement as surging commodity prices and the strongest job market in half-a-century boost revenues, but the outlook remains grim as spending demands are expected to surge, while inflation stays higher for longer and global recession risks grow.
“The global economy teeters again, on the edge, with a war that isn’t ending, a global energy crisis that is escalating, inflationary pressures persisting, and economies slowing–some of them already in reverse,” Treasurer Jim Chalmers said in a speech to parliament on Tuesday.
Mr. Chalmers said the budget deficit in the current fiscal year will fall to 36.90 billion Australian dollars (US$23.30 billion), less than half of what was forecast in May, but also confirmed that gross government debt will balloon to around A$1.004 trillion, or 40.8% of national output in 2023-2024, before climbing to 43.1% of GDP in 2025-2026.
The short-term improvement in the budget has been helped by gains in a broad basket of commodity prices, including iron ore, which accounts for around one quarter of export earnings. The benchmark price of iron ore has averaged roughly US$125 a metric ton in the year to date, according to S&P Global Commodity Insights.
The budget faces growing spending pressures as costs in areas such as healthcare, defense and aged care spiral over the coming years. The budget’s cash balance will deteriorate in that time, peaking at a deficit of A$51.3 billion, or 2.0% of GDP in 2024-2025.
“While the temporary revenue boosts were are getting from higher employment and higher commodity prices will fade and fall, the profound and permanent spending pressures on the budget are forecast to grow and grow,” Mr. Chalmers said.
The budget is the Labor Party’s first since coming to power in May, with Mr. Chalmers focused on delivering election promises, easing living-cost pressures, while also acknowledging a rapidly deteriorating global economic environment that could drag Australia back into recession, its first since the start of the pandemic.
Still, the resource-rich economy is expected to avoid with recession as growth slows to 1.5% in 2023-2024 from 3.25% in 2022-2023.
“While we intend to avoid the worst of the turbulence from overseas, we cannot escape it completely,” Mr. Chalmers said.
Critically, inflation is expected to remain higher for longer, potentially challenging the Reserve Bank of Australia’s recent decision to slow the pace at which it is raising official interest rates.
The inflation rate is expected to peak at 7.75% in the fourth quarter of this year, but remain above the RBA’s 2% to 3% inflation target until 2024-25.
The RBA has been raising interest rates since May at the fastest pace since the mid-1990s, but chose to slow the speed at which it is tightening the policy screws this month amid accelerated falls in house prices.
If inflation lingers above the RBA’s target band until 2025, pressure could build on the central bank to keep raising rates for longer or even reaccelerate the pace of hikes.
A silver lining in the budget is in expectations for unemployment.
While the government expects the unemployment rate to rise to 4.5% in 2023-2024 from the current 3.5%, joblessness will still be at historically low levels, a key support for consumers facing spiraling living costs.
As pressure on government spending builds over the coming years, Labor looks set to come under increasing demands to reform the tax system.
“This is just the beginning of our budget repair work, and it’s just the beginning of the conversation we need to have as a country,” Mr. Chalmers said.
The government has retained income-tax cuts slated for mid-2024, despite widening calls for them to be abandoned on the grounds that they are too weighted toward the higher-paid and come with the budget still well short of repair following huge pandemic-related stimulus spending.
Mr. Chalmers was pressured to consider ditching the income-tax cuts given the backdrop of financial instability and political upheavals that followed the UK government’s ill-fated plans to boost growth by massively lowering taxes.
The budget directly targets rising cost of living pressures in the economy, directing funding toward cheaper child care, expanding paid parental leave, cheaper medicines, more affordable housing and efforts to boost wages growth.
Write to James Glynn at firstname.lastname@example.org; @JamesGlynnWSJ
About the author: Susan Wachter is the Sussman professor of Real Estate and professor of Finance at The Wharton School of the University of Pennsylvania and co-director of the Penn Institute for Urban Research. She is currently an advisory committee member of the Bureau of Economic Analysis of the Department of Commerce.
The U.S. housing market has entered an unusual and confusing phase. House prices and rents year over year continue to grow at historically high rates. But construction and sales activity are at the kind of lows that normally characterize a recession. Rents and housing-cost equivalents are more than 40% of the consumer price index and their rises are big contributors to inflation. Despite high prices, developers are walking away from deals, and firms are halting production mid-process. Sales activity is also falling. What is causing these seemingly contradictory outcomes?
Construction-industry profits are at a low, due to high input costs. Supply shortages are driving profits down by causing construction costs to rise faster than prices. New-construction inventory is growing. But the major source of for-sale home inventory is the pool of existing homes, and this inventory is still low.
The reason inventory is low is monetary policy. In an unintended result of the Federal Reserve’s ongoing round of rate increases, monetary policy is causing a locked-in effect that motivates existing homeowners to stay put. When interest rates rise, homeowners frequently decide to retain their attractive mortgage rate and not move to another home. Instead, they may do a home improvement, or simply stay in their current living situation.
Expected inflation contributes to demand, particularly from investors, who often use housing as an inflation hedge. But it also motivates homebuyers who wish to take advantage of still relatively low mortgage rates. While the average mortgage rate of nearly 5.9% may seem high, for those who are motivated to buy, mortgages are a one-way bet that they cannot lose. If rates continue to rise, borrowers can lock in at today’s rates and if they fall, they can refinance. Moreover, although rates have doubled since March, and are now the highest since November 2008, they are still low historically and, adjusted for inflation, lower. Rates and prices are making it harder for the average person to afford a home, but demand is high for those who can qualify. The share of the U.S. population ages 32-36, the largest segment, is at the prime age for home buying.
For home buyers who can afford monthly mortgage payments based on their income, coming up with a down payment is typically the hardest barrier to overcome. But that’s less so at the moment. Since the onset of the pandemic, households have accumulated several trillion dollars in incremental savings. This savings increase has enabled many households to weather the initial increase in inflation, and it has given them a buffer against the effect of rising prices. In addition, the investor share of home purchases, which is not affected by either constraint, is at an all-time high.
Nonetheless, existing home sales fell 20.2% from July 2021 to July 2022. Mortgage applications for purchase are down 23% as of early September. Many would-be buyers are finding it difficult to qualify for the standard mortgage, with affordability, in the National Association of Realtors index, at a 33-year low. For June 2022, the most recent Case Shiller data shows year over year house price rises of 18%, but Black Knight data show the national market is turning, with prices falling nearly 0.8% for the month of July. The median sales price, which reflects the composition of sales, is also decreasing. The median price reached $440,000 in the second quarter of 2022. In July, the median existing-home sales price was $403,800. Although this represents a 10.8% increase from a year earlier it reflects a $10,000 decline from June 2022’s record high of $413,800.
Amid this dynamic, Fed Chair Jay Powell indicated last month at Jackson Hole, Wyo., that monetary restraint would continue until it works. The Fed’s position matters because a decline in inflationary expectations and an overall slowing of the economy provide the path to easing housing markets’ supply shortages. When that happens, buyers will face potential price declines, with a whiplash effect in previous high-growth markets. A recession will cause mortgage rates to fall and will ease the lock-in effect, driving some homeowners to sell, since they will no longer fear losing their advantageously priced mortgages. Inventories will then grow in a self-reinforcing rise, as there no longer will be a reason to wait to list due to the lack of inventory. Inventory shortages are likely to reverse quickly and with that, price rises will reverse as well.
Already we see inventory of newly constructed homes rising to new highs, which is why the construction industry is in recession and new home prices are falling. The only good news is the resulting lower owners’ equivalent housing costs and rents will equate to a lower rise in the CPI. The resulting inflation relief will get us back to economic growth.
Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to email@example.com.
If you’re a serious real estate investor, you probably know about tax-deferred Section 1031 exchanges, AKA like-kind exchanges. They allow you to swap appreciated real property for other real property without paying any federal income tax.
While real estate values are still surging in many areas, you may hold appreciated property that you think has topped out and are now looking at what you think are greener pastures. But an outright sale of appreciated property would result in a current income tax hit — maybe a big one. That’s a suboptimal outcome if you intend to use the sales proceeds to buy replacement property.
What to do? Section 1031 exchange to the rescue. Let’s discuss, starting off with a couple of updates. Here goes.
An unfavorable Biden tax proposal is off the table for now
President Biden’s menu of proposed tax increases would have greatly limited the Section 1031 exchange privilege, but it now appears that unfavorable change will not happen anytime soon. That’s a positive non-development. Still, you never know what’s going to happen, so doing 1031 exchanges sooner rather than later is probably prudent.
Favorable IRS regulations
In other favorable news, the IRS recently issued final regulations that define what constitutes real property for Section 1031 exchange eligibility purposes. Basically, if you swap one asset that the regulations classify as real property for any other asset that’s also classified as real property, the swap can qualify for tax-saving Section 1031 exchange treatment.
The regulations define real property to include ownership interests in land; improvements to land, such as permanent structures; unsevered natural products of land, such as crops and mineral deposits; and water and air space “superjacent” to land, such as a marina. Superjacent means overlying. I had to look that up too!
If interconnected assets work together to serve a permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets can qualify as a structural component of real property. For example, a gas line that fuels a building’s heating system counts as real property.
Personal property is considered incidental to real property if: (1) the personal property is typically transferred together with the related real property in commercial transactions, and (2) the aggregate fair market value of the personal property does not exceed 15% of the aggregate fair market value of the property.
Personal property that passes these tests is classified as part and parcel of the associated real property and can therefore be included in a tax-saving Section 1031 exchange. Examples of such personal property include backup power generators, flooring, carpeting, window treatments, and the like. For instance, say you and some partners want to swap raw land for a small hotel worth $20 million. The hotel can have up to $3 million of personal property (15% of $20 million) and still qualify for a Section 1031 exchange.
The regulations also list examples of intangible assets that can count as real property — such as options, leaseholds, easements, and land development rights.
Finally, the regulations stipulate that any property that’s considered real property under applicable state or local law counts as real property for Section 1031 exchange purposes.
Bottom line: the regulations define real property very broadly, which makes it more likely that a property swap that you have in mind will qualify for tax-saving Section 1031 exchange treatment. For instance, you could swap an apartment building for a marina. I don’t say this very often, but thank you IRS.
The impact of ‘boot’
To avoid any current taxable gain on a Section 1031 swap, you must avoid receiving any boot, which means cash and other stuff that’s not classified as real property. When mortgaged properties are involved, boot includes the excess of the mortgage on the relinquished property (the debt you get rid of) over the mortgage on the replacement property (the debt you assume).
If you receive boot, you’re taxed currently on gain equal to the lesser of: (1) the value of the boot or (2) the gain on the transaction based on fair market values. So, if you receive only a small amount of boot, your swap will still be mostly tax-deferred — as opposed to completely tax-deferred. On the other hand, if you receive lots of boot, you could have a big taxable gain.
The easiest way to avoid receiving any boot is to swap a less-valuable property for a more-valuable property. That way, you’ll be paying boot rather than receiving it.
Important: Paying boot won’t trigger a taxable gain on your side of the deal. So, if you want to include cash from bailing out of the stock market with real property that you current own for more expensive replacement property, you can do the deal as a tax-deferred Section 1031 swap.
In any case, the untaxed gain in a Section 1031 swap gets rolled over into the replacement property where it remains untaxed until you sell the replacement property in a taxable transaction.
How do deferred Section 1031 exchanges work?
Realty check: it’s usually difficult, if not impossible, for someone who wants to make a Section 1031 swap to locate another party who owns suitable replacement property and who also wants to make a Section 1031 swap. The saving grace is that a deferred exchange can also qualify for tax-deferred Section 1031 exchange treatment.
Under the deferred exchange rules, you need not make a direct and immediate swap of one property for another. Instead, you can in effect sell the relinquished property for cash, park the sales proceeds with a qualified intermediary who effectively functions as your agent, locate a suitable replacement property later, and then arrange for a tax-free Section 1031 exchange by having the intermediary buy the property on your behalf. Here’s how a typical deferred swap works.
* You transfer the relinquished property (the property you want to swap) to a qualified exchange intermediary. The intermediary’s role is to facilitate a Section 1031 exchange for a fee which is usually based on a sliding scale according to the value of the deal.
* Next the intermediary arranges for a cash sale of your relinquished property. The intermediary then holds the resulting cash sales proceeds on your behalf.
* The intermediary then uses the cash to buy suitable replacement property which you’ve identified and approved in advance.
* Finally, the intermediary transfers the replacement property to you to complete the Section 1031 exchange.
Voila! From your perspective, this series of transactions counts as a tax-deferred Section 1031 swap. Why? Because you wind up with the replacement property without ever having actually seen the cash that greased the skids for the underlying transactions.
Important: See the SIDEBAR for the deadlines for making a deferred Section 1031 exchange.
What if you still own the replacement property when you die? Under our current federal income tax rules, any taxable gain would be completely washed away thanks to another favorable provision that steps up the tax basis of a deceased person’s property to its date-of-death fair market value. So, under the current rules, taxable gains can be postponed indefinitely with like-kind swaps and then erased if you die while still owning the property. Wow!
Your heirs can then sell the property and owe zero federal income tax or just a little tax based on post-death appreciation, if any. What a deal. Real estate fortunes have been made in this fashion without having to share with Uncle Sam.
Note: A proposal that was included in the Biden tax plan would have greatly reduced the date-of-death basis step-up break. Thankfully, that unfavorable change is apparently off the table for now. If it comes back, we can hope that it will only affect those who are truly rich. Fingers crossed!
What if I have big stock market losses?
You have a bit of a tax dilemma. If you have a big net capital loss from the stock market’s swoon, you can use it to offset capital gain from an outright sale of appreciated real property. But if you use up your capital loss for that purpose, you can’t use it to offset future stock market gains.
On the other hand, if you unload appreciated real property in a Section 1031 exchange, you can avoid a current taxable gain on the property deal and still have the capital loss in your back pocket to offset future stock market gains. But how soon might you have stock market gains? Good question, and there’s no guaranteed right answer. Make you best guess and act accordingly.
The last word
While arranging Section 1031 exchanges can be complicated, the tax savings can be well worth the trouble. Get your tax advisor involved to avoid pitfalls.
Sidebar: Deadlines for deferred Section 1031 swaps
In order for a deferred real property exchange to qualify for tax-free Section 1031 treatment, you must meet two important deadlines.
1. You must unambiguously identify the replacement property before the end of a 45-day identification period. The period commences when you transfer the relinquished property. You can satisfy the identification requirement by specifying the replacement property in a written and signed document given to the intermediary. In fact, that document can list up to three different properties that you would accept as suitable replacement property.
2. You must receive the replacement property before the end of the exchange period, which can be no more than 180 days. Like the identification period, the exchange period also commences when you transfer the relinquished property. The exchange period ends on the earlier of: (1) 180 days after the transfer or (2) the due date (including any extension) of your federal income tax return for the year that includes the transfer date. When your tax return due date would cut the exchange period to less than 180 days, you can extend your return. That restores the full 180-day period.