While you are doing so, we would recommend you consider at least the following five legal issues for each of your business entities:

1. Registered Agent.  Make sure your entities’ registered agents’ information is current and correct.  Moreover, make sure your registered agent doesn’t get you in trouble because they are not fulfilling the requirements of the registered agent statute.
2. Converting to LLC.  If your entity is a Corporation (whether taxed as an S-Corporation or not), the owners are missing out on a level of asset protection they would otherwise have if the entity was an LLC.  With the proper legal planning and implementation, an existing corporation can be converted into an LLC that is treated by the IRS as if it is still the same corporation (same tax ID number) and there is no need to transfer any assets.
3. Single Owner LLC.  If your entity is already an LLC but is owned entirely by one person, understand that in your case the regular LLC asset protection does not apply.  However, without careful legal structuring, the mere addition of a second member can bring a host of potential problems.  Who you choose as your new “partner” can also make a difference, and care must be taken not to disrupt the entity’s desired tax treatment.  Balancing the legal and tax issues is key when adding a second member to achieve asset protection without unnecessary exposure.
4. Partnership Agreement.  If you do have partners but don’t have a co-ownership agreement (shareholder/operating agreement), don’t wait until you have a problem.  These problems usually come up when one of the owners dies, gets sick, become lazy, gets divorced, is sued, loses interest, etc., etc.  If you have executed co-ownership agreements for each of your entities, look at them again – carefully, and if they do not reflect what you think the deal should be (or if you don’t understand them), then get them updated.
5. Ownership Title.  Review how ownership in your business is actually documented.  Is the corporate book in order? Are those documents consistent with what is being reported on the tax return?  Have changes in ownership been documented?  Have any of the “owners” put their interest in someone else’s name, without creating legal protections for the intended “owner” (and the other actual owners) should the owner of record voluntarily or involuntarily fail to honor the agreement?  Should the ownership interest be titled in the name of the owners’ trusts or a holding company?

If it turns out you have not covered one or more of the above or you have any questions whatsoever, just give us a call to see how we can help you maximize your legal advantage while avoiding hassles and costly disputes down the road.

Swiss bank Wegelin is charged with helping U.S. Taxpayers hide over $1 billion from the IRS.  Any deal Wegelin makes to avoid prosecution will likely include giving up the names of more U.S. citizens and green card holders that will in turn lead to more investigations.  Once the IRS has the name of a U.S. citizen or green card holder in connection with an offshore account, that taxpayer no longer qualifies to participate in the limited amnesty known as the Offshore Voluntary Disclosure Program…

Click here to read more about the recently reopened IRS amnesty for unreported offshore activities.

See:  Swiss Bank Wegelin Charged in U.S. With Aiding Tax Evasion – Bloomberg

Introduction

• The cost of doing business, investing or spending significant time in the U.S. is being subject to some level of taxation and other legal obligations
• The tax law is extremely complex and everyone’s situation is different
• Advance legal planning can avoid legal exposure and reduce the amount of tax that must be paid
• The following is a brief outline of some of the issues foreigners can expect to discuss as they prepare their own plan

Agenda

• Foreigners Who Are Not Tax Residents
• Consequences of Tax residency
• Planning For (and Against) Tax Residency
• Planning Methodology
• Some Critical Non-Tax Legal Issues
• Common Pitfalls

Foreigners Who Are Not Tax Residents

• Only taxed on income defined in the tax law coming from a “U.S. Source”; not on income that is considered “Foreign Source”
• However, some U.S. Source income is still exempt from tax (e.g. capital gains on the sale of U.S. stock, certain loans to U.S. person, etc.)
• U.S. Source income is usually taxed at a flat 30% rate without taking any deductions, unless reduced by a treaty
• The person paying the foreigner is normally required to withhold the tax
• Sometimes deductions are allowed when the U.S. Source income relates to certain business activities

Income Taxation of Tax Residents

• Taxed on worldwide income, both U.S. Source and Foreign Source
• A Tax Resident’s taxable Foreign Source income can include, for example:
• dividends and interest generated by non-U.S. investments
• gains from the sale of foreign real estate or businesses
• commissions or fees earned for the performance of personal services outside the U.S.
• gains from the exchange of foreign currency, etc.
• A “Foreign Tax Credit” can usually be taken for the amount of income tax on the same income that was actually paid to another country

Tax Residents Must Also Report Information Regarding:

• Foreign bank and financial accounts in which they have a direct or indirect financial interest or signature authority;
• Foreign financial assets;
• Direct and indirect ownership in and economic activity of, certain foreign companies and partnerships;
• Transfers to and from certain foreign trusts;
• Receipt of gifts and inheritances from foreigners; and
• Virtually anything else that a U.S. citizen must report.

Planning Objectives For Foreigners Who May Become Tax Residents (Manage Foreign Source Income)

Depending on the foreigner and their circumstances, various tactics can be employed to:

• Exclude Foreign Source income from U.S. taxation
• Accelerate recognition of Foreign Source income to occur prior to establishment of Tax Residency
• Delay recognition of Foreign Source deductions or losses until after establishing Tax Residency
• Most importantly, avoid or at least delay as much as possible the establishment of Tax Residency (i.e. the taxability of Foreign Source income)

The Inbound Journey

• Passive Investment/Vacation
• Opening business/ relocating family
• Securing long-term visa/ permanent status
• Preparing for long-term U.S. residency
• Discontinuing social and economic ties to home country
• The decisions you make regarding when and how you take these steps will have tax and legal consequences

At what point along the inbound journey do you become a Tax Resident ?

• It could happen before or after obtaining permanent residence.
• It could happen at different times for purposes of income tax than for purposes of estate and gift taxes.
• This presentation focuses on income taxes.

Who is a Tax Resident?

• U.S. Citizens and Permanent residents (i.e. “green card” holders), even if they have another nationality or have never been to U.S., unless qualified to elect non residency pursuant to a tax treaty
• Persons with a “substantial presence” in the U.S., unless qualified to elect non residency pursuant to the “closer connection” exception or pursuant to a tax treaty
• Note: Tax Residency does NOT depend on immigration status, although that is relevant

What is Substantial Presence?

• The Substantial Presence Test is one measure of Tax Residency for Income Tax purposes (not used for Estate & Gift tax purposes)
• Basic formula counts all days present in the U.S. in the current year, one-third of the days present during the prior year and one-sixth of the days present the year before that
• Some days are excluded from the calculation, for example
• Days present in the U.S. holding some visas
• Days present in the U.S. while unable to leave due to a medical condition
• Other exceptions
• A foreigner has a substantial presence in the U.S. if the three year formula yields 183 days or more without counting the days subject to any of the exceptions.

Closer Connection Exception to Substantial Presence

• Allows a foreigner to avoid being treated as a Tax Resident, even if they meet the substantial presence test
• Must be present less than 183 days in any one year, after subtracting days present subject to any exception
• Must file a statement with the IRS to claim this exception
• The foreigner’s personal circumstances must meet the legal criteria to prove a “closer connection” to another country

Treaty Exception to Substantial Presence or Permanent Residence

• Allows a foreigner to avoid being treated as a Tax Resident
• Can be present in the U.S. any number of days
• Foreigner must have a “tax home” in a country that has a treaty with the U.S.
• Only western hemisphere treaty countries are Canada, Mexico, & Venezuela
• The foreigner’s personal circumstances must meet the legal criteria set forth in the treaty
• Must file a U.S. tax return and report all worldwide income, but not required to pay tax on Foreign Source income

Planning Methodology Regarding Establishment of Tax Residency

• First, determine if Tax Residency has already been established under the general formula
• Review the personal circumstances to determine whether any days present in the U.S. can be excluded from the computation under one of the various exceptions
• If necessary, review whether the facts and circumstances support an election under the Closer Connection exception or a tax treaty, if available
• If Tax Residency has been irrevocably established, what tax returns and reports are required and have they been filed?
• If there is non-compliance determine how to comply with minimal taxes, civil penalties, and criminal exposure

Planning Objectives Prior to Establishment of Tax Residency

Going Forward: Understanding the composition of your worldwide asset portfolio, as well as your personal goals, limitations and plans with respect to yourself, your family, your business and your assets in the short and medium term, we can help you:

• Determine how many days you may be present during the remainder of the year and in subsequent years without becoming a tax resident
• Identify and help you implement various tactics to restructure your worldwide assets in order to minimize the U.S. tax impact upon becoming a U.S. Tax Resident
• Develop a legal plan to defer the establishment of Tax Residency perpetually, if possible, or at least long enough to execute your plan prior to being treated as a U.S. citizen for tax purposes

• A completely different set of rules determines when a foreigner becomes a Tax Resident for purposes of the Estate & Gift Tax (“Transfer Taxes”).
• The consequences are that transfers of their worldwide assets become taxable both during life and upon death.
• Pre immigration Transfer Tax planning can reduce or eliminate a multinational family’s current and future transfer taxation for generations.

Critical, Related, Non-Tax, Legal Issues

A good tax lawyer will understand that tax planning does not occur in a vacuum and be capable of multidimensional legal analyses, including:

• Planning for the possibility of death and incapacity while residing in the U.S.
• Minimizing personal liability for U.S. business or investment activity
• Protecting U.S. assets from unforeseen personal legal judgments
• Structuring U.S. business entities and legal agreements with third parties to provide maximum legal advantage
• Working effectively with your U.S. accountant and investment advisor

Just a Few Common Pitfalls

We are often called in to repair damage caused by clients:

• Following legal advice from non-attorneys (e.g. “notaries”, accountants, realtors, etc.)
• Following legal advice from attorneys not licensed in Florida
• Following tax advice from a CPA or tax attorney who is not experienced in the international aspects of U.S. tax law.

Waiting to see a U.S. tax attorney until after:

• Tax Residency has already been irrevocably established
• Taxable transfers have been made to other Tax Residents
• Contracts to purchase businesses/real estate have already been signed
• Unexpected death or illness occurs while living temporarily in the U.S.

Other common pitfalls:

• Not ensuring the immigration attorney is coordinating with the tax/business attorney
• Self-planning based upon incorrect or only partial application of the formula to determine substantial presence
• Incurring substantial penalties for failure to file the proper tax returns on time
• Closing on the purchase of U.S. real estate in individual name, as opposed to a carefully designed and implemented structure utilizing the proper entity or entities
• Dealing with a “professional” who races to legal conclusions without carefully evaluating your personal circumstances
• Working with someone who seems to speak your language but doesn’t really understand you; or someone who you don’t understand
• Not updating your estate planning after moving to the U.S., even temporarily.
• Signing poorly drafted or unfair business contracts with the assistance of non-attorneys or foreign attorneys

Working With Us

Click here to see our wealth preservation methodology.

Proper planning for the inevitability of death and the possibility of incapacity involves simultaneous analyses of multiple, complex legal and tax issues. We can design a plan that details how your assets are to be managed and to whom and under what conditions they are distributed after you and/or your spouse passes away, while eliminating or reducing any estate taxes to the legal minimum. A complete plan also addresses decisions regarding your health, your property and the care of those who depend on you, during any period of your temporary or permanent incapacity. This chart compares three major approaches to effectuate the transfer of property when someone dies. Please seek legal counsel as warranted and always consult your accountant and financial advisor.

The IRS decision to reopen this special disclosure initiative follows continuing interest from taxpayers with foreign accounts. Over 33,000 tax payers came forward during the 2009 and 2011 special voluntary disclosure programs.

This third initiative is very similar to the 2011 Offshore Voluntary Disclosure Initiative (OVDI) with a few key differences.  The overall penalty structure for 2012 is the same except the 25% penalty is now 27.5%, meaning that people who did not come in through the 2011 voluntary disclosure program will not be rewarded for waiting. However, the 2012 initiative does add new features.  The penalty framework essentially requires individuals to pay a penalty of 27.5 percent of the amount in the foreign bank accounts in the year with the highest aggregate account balance covering the 2003 to 2010 time period. Some taxpayers will be eligible for 5 or 12.5 percent penalties. Participants also must pay back-taxes and interest for up to eight years as well as paying accuracy-related and/or delinquency penalties.

The 2012 initiative offers clear benefits to encourage taxpayers to come in now rather than risk IRS detection. Taxpayers hiding assets offshore who do not come forward will face far higher penalty scenarios as well as the possibility of criminal prosecution. It is important to note the IRS has not announced any deadline to participate. As such, the IRS may modify the terms or close the amnesty at any time.

Some Foreigners and Many Recent or “Temporary” Immigrants Must Also Report Offshore Income, Companies, Trusts and Bank Accounts

Anyone considered a resident for tax purposes [1] is also potentially subject to the above penalties for non-compliance.  This can come as a surprise, because many recent immigrants, including those who intend to reside in the US only “temporarily” for various reasons, still haven’t realized they became tax residents in 2010 or earlier.  Among many other 2010 tax obligations due in 2011 such as reporting and paying tax on the 2010 sales of their foreign businesses and other assets, these persons must also report their foreign financial accounts, foreign corporations, foreign trusts, etc., or suffer the same consequences as a U.S. citizen, plus have to explain all this if they seek a visa renewal or permanent residency down the road.  Fortunately, carefully designed and executed pre-immigration tax planning can avoid the need to report foreign financial accounts, as well reduce income and estate taxation relating to foreign income and assets [2].

Common But Invalid Excuses for Not Reporting Foreign Bank Accounts

Whether as a citizen, permanent resident or “tax resident”, the person(s) who have a direct or indirect “financial interest” or “signature authority” in connection with the account are responsible for reporting it.  The definitions of these terms have been in considerable flux recently as the IRS attempts to cover the infinite variety of ways one can be associated with a foreign account.  Before deciding one is not required to report the account, a careful legal analysis should be conducted.  Here are some common excuses I have seen for not filing an FBAR:

• I never accessed or benefited from the funds.
• The funds were a gift / inheritance.
• It’s not in my name; it’s in a trust.
• It’s not my money, because:
• I am just the trustee of the trust that owns the bank account.
• I am only an officer/director of the corporation that owns the bank account
• I am only a director of the foundation that owns the bank account.
• I only have a power of attorney given to me by the individual who owns the account
• I am just the legal guardian of the person who owns the account.
• I am just holding it for a family member.
• The money is in a non-interesting bearing account.
• The money was earned before I became a tax resident
• The money was earned outside the U.S.
• My non-international tax attorney advisor told me I didn’t have to report it.
• I only use the money in the account when I am outside the U.S.
• The account is held by my disregarded U.S. Limited Liability Company, and I am definitely not a US tax resident

Generally speaking, none of the above by itself is an exception to the FBAR reporting obligation.  One of the most dangerous excuses I have heard for not filing an FBAR is that they already closed the account and either transferred the funds to a bank in the U.S. or to another individual outside the country.  While this may eliminate the requirement to file FBARs in future years, not reporting the account for the year in which the transfer occurred might actually be used in a criminal prosecution as evidence that the taxpayer consciously chose not to report the account and then attempted to conceal its existence.  Furthermore, whenever the foreign account is generating income or there is a foreign corporation or trust involved, the IRS requires additional forms that are probably also delinquent if the bank account wasn’t even reported in the first place, resulting in further penalties and criminal exposure.

The IRS is on the Warpath

The obligation to report offshore income, transactions and bank accounts is actually nothing new; there just hasn’t been much enforcement and as such too many tax advisors not familiar with international issues tend to underestimate the consequences. The IRS specifically warned us that they are allocating more resources towards enforcing foreign income and bank account reporting and they have indeed followed through by hiring more agents and even opening offices abroad.  Using a carrot and stick approach, the IRS already offered a partial amnesty in 2009 so taxpayers with unreported income and accounts from prior years could avoid criminal prosecution and enjoy reduced civil penalties by coming forward voluntarily.  Thousands of individuals took advantage of this carrot, but many more did not.  The IRS is already cross checking the databases of information they obtained from the last amnesty, as well as information obtained using tax treaties [3], through submissions from whistleblowers, informants and other sources.  We are already seeing them use the stick, and the IRS Commissioner has made it clear that this is just the beginning.

Criminal and Civil Penalties that Could Apply if a Taxpayer is Detected Prior to Making a Disclosure
Besides criminal exposure, here are some of the civil penalties that could apply if a taxpayer gets caught prior to submitting a valid voluntary disclosure:

• A penalty for failing to file the Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts, commonly known as an “FBAR”). United States citizens, residents and certain foreigners must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign accounts exceeded $10,000 at any time during the year. Generally, the civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign account per violation. See 31 U.S.C. § 5321(a)(5). Non-willful violations that the IRS determines were not due to reasonable cause are subject to a $10,000 penalty per violation.
• A penalty for failing to file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Taxpayers must also report various transactions involving foreign trusts, including creation of a foreign trust by a United States person, transfers of property from a United States person to a foreign trust and receipt of distributions from foreign trusts under IRC § 6048.This return also reports the receipt of gifts from foreign entities under section 6039F.The penalty for failing to file each one of these information returns, or for filing an incomplete return, is 35 percent of the gross reportable amount, except for returns reporting gifts, where the penalty is five percent of the gift per month, up to a maximum penalty of 25 percent of the gift.
• A penalty for failing to file Form 3520-A, Information Return of Foreign Trust with a U.S. Owner. Taxpayers must also report ownership interests in foreign trusts, by United States persons with various interests in and powers over those trusts under IRC § 6048(b).The penalty for failing to file each one of these information returns or for filing an incomplete return, is five percent of the gross value of trust assets determined to be owned by the United States person.
• A penalty for failing to file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under IRC §§ 6035, 6038 and 6046.The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
• A penalty for failing to file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. Taxpayers may be required to report transactions between a 25 percent foreign-owned domestic corporation or a foreign corporation engaged in a trade or business in the United States and a related party as required by IRC §§ 6038A and 6038C. The penalty for failing to file each one of these information returns, or to keep certain records regarding reportable transactions, is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.
• A penalty for failing to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under IRC § 6038B. The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.
• A penalty for failing to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. United States persons with certain interests in foreign partnerships use this form to report interests in and transactions of the foreign partnerships, transfers of property to the foreign partnerships, and acquisitions, dispositions and changes in foreign partnership interests under IRC §§ 6038, 6038B, and 6046A. Penalties include $10,000 for failure to file each return, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return, and ten percent of the value of any transferred property that is not reported, subject to a $100,000 limit.
• Fraud penalties imposed under IRC §§ 6651(f) or 6663. Where an underpayment of tax, or a failure to file a tax return, is due to fraud, the taxpayer is liable for penalties that, although calculated differently, essentially amount to 75 percent of the unpaid tax.
• A penalty for failing to file a tax return imposed under IRC § 6651(a)(1). Generally, taxpayers are required to file income tax returns. If a taxpayer fails to do so, a penalty of 5 percent of the balance due, plus an additional 5 percent for each month or fraction thereof during which the failure continues may be imposed. The penalty shall not exceed 25 percent.
• A penalty for failing to pay the amount of tax shown on the return under IRC § 6651(a)(2). If a taxpayer fails to pay the amount of tax shown on the return, he or she may be liable for a penalty of .5 percent of the amount of tax shown on the return, plus an additional .5 percent for each additional month or fraction thereof that the amount remains unpaid, not exceeding 25 percent.
• An accuracy-related penalty on underpayments imposed under IRC § 6662. Depending upon which component of the accuracy-related penalty is applicable, a taxpayer may be liable for a 20 percent or 40 percent penalty.

In cases where the government can prove the failure to report was intentional, criminal exposure can include:

• Possible criminal charges related to tax returns include tax evasion (26 U.S.C. § 7201), filing a false return (26 U.S.C. § 7206(1)) and failure to file an income tax return (26 U.S.C. § 7203). Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties under 31 U.S.C. § 5322.
• A person convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000.

—

[1] The laws determining whether someone is a U.S. resident for tax purposes are very complex and have many exceptions and mechanisms that can be used to delay or avoid tax residency while still spending ample time in the U.S.  The general rule is that a foreigner who is present in the U.S. for 183 days or more during the calendar year is a tax resident that year.  In counting the 183 days, however, the rules require adding 1/3 of the days present in the US during the prior year and 1/6 of the days present in the US the year before that.  For example, a foreigner who spent a total of 60 days traveling in the US during 2008 on business trips and vacations, 120 days in 2010 doing the same plus looking for a suitable second home in Weston, and 143 days in 2011 temporarily relocating their family and visiting with them, will be a tax resident in 2011 (143 + 90/3 + 60/6 = 183) without proper planning and regardless of their holding most types of visas.

[2] Foreigners with US investments or businesses or who spend over 30 days per year in the US should engage an international tax attorney to undertake “pre-immigration” planning to minimize their US income and estate tax obligations.  This planning generally consists of, among other things, finding ways to defer that certain date one legally becomes a resident for tax purposes and therefore subject to taxation on not just their US income and assets, but also any income or assets they have anywhere else in the world.  This deferral can be accomplished by something as simple as arranging their personal affairs in a certain manner, to making special tax elections with the IRS if qualified, and if available invoking international tax treaties such as the one between the US and Venezuela.  Planning also entails arranging one’s worldwide wealth in order to accelerate the recognition of foreign income or gain from the disposition of business or other assets outside the US prior to becoming a tax resident, so they are taxed only on those items outside the US if at all.  Conversely, planning can be done to defer taking foreign deductions and losses until after becoming a US tax resident.  For estate and gift tax purposes, planning mainly consists of transferring foreign assets in ways that they will no longer be taxed if the person dies subject to US estate tax on their worldwide assets.  Note, the laws that determine when someone becomes a tax resident for estate and gift tax purposes are quite different from the laws used for income tax purposes and usually result in earlier tax residency.

[3] The U.S. has greatly expanded its network of information exchange agreements with tax authorities worldwide, including popular “offshore” jurisdictions such as the Cayman Islands and British Virgin Islands.

[4] As an attorney and CPA giving tax advice for almost 20 years and who also had the honor of working for the U.S. Tax Court in Washington, D.C., I have come to know some excellent accountants who are effective advocates against the IRS. While the services of a good tax accountant are normally required to assist in the preparation of a voluntary disclosure package, however, it’s important to note that there is no federal accountant-client privilege with respect to criminal matters. In fact, the CPA can be compelled to testify against their client and all their records and e-mails can be subpoenaed as evidence. As such, it’s important that any taxpayer with this or any other type of possible criminal exposure speak with a tax attorney first, and then have the attorney hire the CPA to assist with any voluntary disclosure under a special arrangement where the accountant is also covered by the attorney-client privilege.

A 1031 Exchange is an investment strategy that should be considered by anyone who owns appreciated investment or commercial real estate. These exchanges are sometimes called “tax–free exchanges,” because the exchange transaction itself is not taxed. If the transaction is properly documented and coordinated, a delay of up to six months between the sale of the relinquished property and the purchase of the replacement property is permitted.

In order for a transaction to qualify for section 1031 treatment, three primary requirements must be satisfied: (1) there must be an exchange; (2) the property must be “trade or business or investment property”, and (3) the property must be of “like-kind.” Some of the Pros and Cons of the 1031 Exchange are:

Pros:

• Capital Gains Taxes and depreciation recapture from the sale are deferred
• The exchanger has more money to reinvest in replacement property
• Because the exchanger’s heirs receive a stepped up basis (Fair Market Value at Date of Death), exchanges can be attractive estate planning tools.

Cons:

• The exchanger may feel compelled to identify and acquire unsuitable replacement property solely to realize the exchange tax savings
• An exchange usually results in additional transaction costs, including attorney/CPA fees and qualified intermediary fees. However, in most instances, the tax savings from the exchange easily offset these costs.

If you do it right, a 1031 Exchange can provide substantial benefits to those looking to buy and sell investment or commercial property. Of course, if you do it wrong, you could be left with a huge tax burden thinking that you’ve avoided that liability all along. At least for now though, the IRS lets you buy and sell investment or commercial property without current tax liability as long as you follow the proper procedural requirements.

At some point during this negotiation, totally beyond any realtor’s control and sometimes even contrary to what the lender’s negotiator has promised, the lender’s attorney will file a foreclosure lawsuit. A few lawyers are good at buying time by presenting a vigorous legal defense or even counter-attacks to foreclosure, and many more lawyers are learning this area of law as they go to make up for a lack of work in their traditional practice areas.

But what happens when a deal cannot be made, or if that deal does not include a written, legally enforceable and full release of further liability to the lender? At least as important if not more than negotiating with a lender and defending a foreclosure is “planning for the worst” by knowing one’s legal rights and considering the following issues while pondering a strategic default that may ultimately become a judgment if a deal is not made along the way:

The Stigma is Gone. There is a certain subset of borrowers who collaborated with crooked mortgage brokers, lied through their teeth on their mortgage application, closed their loans with incompetent or negligent title agents, never intended to make their first payment and have been gaming the system ever since to live “rent free” for as long as possible knowing that they were ultimately judgment proof and would probably never be prosecuted for mortgage fraud. These folks should not be confused with the honest, hard working and increasingly white collar wage earners, professionals and small business owners who just happened to buy property and get overextended during this unprecedented, extreme real estate boom/bust cycle that has turned the American dream on its head. Their predicament is based no less on distorted economic forces beyond their control than it is on their own unfortunate investment decisions, and they are starting to feel like suckers as their lenders get bailed out with their tax dollars while many of their neighbors seem to be “walking away”.

Moral Duty. With the exception of private mortgages from friends or loved ones, deciding whether the risks of defaulting on a mortgage outweigh the rewards is purely a business decision. The original lender was probably a bank that no longer exists and that loan was sold and resold and packaged into complex financial instruments that were again sold and resold by amoral, cutthroat and often insured Wall Street investors who were all speculating that either the home would continue appreciating or that they would be able to flip their loan to another speculator before the whole pyramid collapsed. They don’t take this personally and neither should the borrower.

Don’t Overestimate “Perfect” Credit. As illogical as it may seem to some, for a variety of reasons most lenders simply will not make a new deal with a borrower who is still complying with the old deal, despite government inducements. After missing a few payments, the individual(s) who signed the note can expect a drop in their credit score, but what is that really worth? Not getting the best deal on the next car lease or having to actually save a reasonable down payment before buying their next home is probably not worth more than escaping an amount of debt that represents a significant portion of one’s net worth. In any case, credit can be restored and new lenders should distinguish between borrowers making isolated defaults on one mortgage versus those with a systematic inability to manage their debt.

Financial Security. If it’s not already obvious to the borrower, a good financial advisor can calculate the opportunity cost of continuing to service the debt on a property that may never be worth more than the debt, versus investing in retirement or college saving plans or just establishing an emergency cash reserve for a rainy day…

Living in Foreclosure. Virtually every homeowner we have seen and many investors have maintained possession of their properties for over one year after foreclosure. It can be stressful for those who are unable to emotionally detach and allow their attorney to manage a process under which nothing may actually happen for months at a time and plenty of notice is afforded if and when the owner eventually has to start packing. The reason for this lag is a combination of lenders not being equipped or willing to assume the responsibilities of ownership and a tremendous backlog in the court system. Those who believe they may be better off postponing a strategic default to the future should beware that this relatively painless and extended state of living in foreclosure will not last forever as lenders ramp up or outsource functions such as collections and property management, and as the courts eventually catch up.

Deficiency Judgment. Near the journey’s end, after enough payments are missed that the lender initiates a foreclosure lawsuit and after that lawsuit has finally run its course and is decided in favor of the lender, only then is the property set for public auction. If no one bids higher than the amount of the mortgage, the court gives the lender legal title to the property. At that point the lender can make arrangements with the current occupant of the property, evict them and/or sell the property to finally recoup some of their investment. If at the time the lender takes title, the property is worth less than the original amount of the loan (plus interest and costs of collection), they have up to five years to request that the court issue a “deficiency judgment” for that difference. The borrower must be put on notice and has the opportunity to dispute the amount the lender alleges the property was worth on the date the lender acquired title. This deficiency judgment (or the right to request one later) may be sold to a collections firm and provides the judgment holder with the power to garnish the borrower’s wages and bank accounts, and lien and/or take personal property, real estate, business interests and other assets while interest continues to accrue. A judgment holder is also entitled to subpoena documents and information from the borrower, guarantors and third parties and even take the borrower’s deposition in order to discover the borrower’s current assets and any prior transfers or conversions of assets they may seek to challenge.

Asset Protection. Protecting one’s property is a constitutional right. Savvy business owners, professionals and high net worth individuals have always taken advance legal measures to protect their assets in the event of unforeseen and uninsurable or underinsured legal obligations due to ridiculously excessive damage awards and opportunistic or nuisance lawsuits. Sophisticated real estate investors also plan ahead to compartmentalize the legal obligations they undertake so if one deal goes sour it doesn’t spoil their other investments. Planning for the possibility of suffering a deficiency judgment is not illegal or immoral, can be done at any time, and will most likely make a tremendous difference in the tone of settlement negotiation that can occur at any time and from time to time along this journey. In fact, when deciding whether or not to pursue a deficiency judgment in the first place some lenders evaluate the borrower’s “collectability” by gauging what assets legally belong to the borrower, what recent transfers/conversions they may have made, and how difficult it would be to take those assets, depending on their legal structure and the legal manner in which any recent transfers/conversions were implemented.

The “B” Word. For some the notions of strategic default, foreclosure defense, and asset protection are too much to wrap their head around. Their blood pressure rises to dangerous levels when they hear a knock at the door worrying that it is a process server signaling the start of a foreclosure or they simply don’t have the energy to fight to keep what they have. For these emotionally overwhelmed borrowers and those who simply have no other assets to lose, bankruptcy may be a quicker and relatively less painful way out, although the impact on one’s credit is more severe and lasts longer, and the stigma remains much higher than foreclosure. The benefits of bankruptcy should still be measured, but for most it is not something they should seriously consider until and unless the lender secures a deficiency judgment and actually starts collecting.

Conclusion. The legal journey that begins with that first missed mortgage payment can lead to very different outcomes, depending on the effectiveness of advance legal planning and ongoing legal management of the situation. Knowing one’s legal rights and acting accordingly is critical to achieving the optimal outcome, regardless of where a borrower finds them self along this journey. The worst outcomes can occur when borrowers act solely on the advice of non-attorneys or attorneys not skilled in asset protection, and/or when they put their heads in the sand until savings are exhausted, their homes are lost and their other assets and businesses become unnecessarily exposed.