1031 Exchange is Easy

The success of tax planning strategies for the primary residence is dependent on the classification of the property – both the 1031 Exchange Relinquished Property and the Replacement Property. If the properties do not meet the qualified property of like-kind tests, the IRS will treat the exchange as a taxable sale. The important issue is the property must qualify for 1031 Exchange treatment.  Just saying the property is qualified does not make it so. It’s what you actually use the property for that determines its classification. And you better have substantial records and other proof. If the IRS says the property did not qualify, the burden of proof is on you.

Strategy 1 –

Taxpayers have owned and occupied their home as their personal residence for the last six years. If they sold today, they would realize a gain of $345,000. This gain would qualify for the full exclusion under §121 – it’s less than the $500,000 maximim allowed for a married couple. They decide to sell, take their exclusion and move into one of their rentals acquired many years ago.

Taxpayers pay no tax on the sale of their primary residence.

Converting a rental to their primary residence is not a taxable event. They simply report the property as a rental until vacated by the tenants and treat the property as their primary residence when they move in.

So far, so good. But suppose the taxpayers had acquired the rental property via a §1031 exchange and the basis has gone through many adjustments including the lower than market value substituted into the property (See Chapter Twelve) and a reduction in basis from depreciation allowed or allowable since acquisition. Again, no taxable event because the taxpayers have not sold or exchanged the rental property. They merely reclassified it from Rental Income Property to their Primary Residence.

Now let’s take this strategy to the extreme or, as our astronauts would say, let’s push the envelope and take it to the max. Our taxpayers live in and occupy the property for more than two years. Since they meet the two out of the last five years test for both ownership (remember, they owned the property for a long time even before they occupied it as their primary residence), they qualify for the up to $500,000 exclusion if they now sell the property. But wait, you say, what about all that depreciation they took before they moved in? And what about the fact they acquired it in a §1031 exchange with a low substituted basis? Plus the rental appreciated during the time it was held as a rental—not just the time they lived in it. Does all the gain from those factors qualify for §121 exclusion?

The gain on the sale is the difference between the Adjusted Sales Price and the Adjusted Cost Basis. The Adjusted Cost Basis of our taxpayer’s residence is the total of these adjustments:

• The substituted basis of the property at the time acquired as a rental in the exchange.
• Add any improvements made to the property since acquisition to date of sale.
• Deduct depreciation allowed on the property since acquisition in the exchange.

What about the gain from all the appreciation—both during the time held as a rental and the time occupied as their primary residence? It all qualifies for the §121 exclusion up to $500,000.

Exception: There is an exception to the rule. It’s simple—any depreciation taken on the property after May 6, 1997 may not be excluded under §121. It is treated as long-term capital gain.

There are two possible effects of this exception. Say our taxpayers had taken depreciation after May 6, 1997, in the total amount of $6,500.00. If their total gain on the sale of residence was $300,000, they could exclude $293,500 of the gain and $6,500 would be recaptured as long-term gain. If their total gain on the sale of residence was $700,000—more than the exclusion limit of $500,000—they could exclude the full $500,000 and the balance of $200,000 would be recognized as long-term capital gain.

Observation: Depreciation of rental income property is deducted against ordinary income during the time the property is operated as a rental. The possible recapture of some or all of this ordinary income as long-term capital is a small price to pay for the substantial savings inherent in this tax planning strategy.

Strategy 2 –

Next to getting shot at and missed, one of the greatest thrills is analyzing a taxpayer’s current situation and working out a tax planning strategy permitting them to make necessary sales and purchase of real estate and get great tax benefits at every step of the way. That’s what happened several years ago when we moderated a round-table for relocation specialists at a national real estate company’s annual convention.

The session lasted about three hours and focused on tax problems faced by military due to frequent and numerous relocations. Two of the agents were working with a military location in Texas and our round-table discussion gave birth to a grand tax planning approach to the client’s situation.

The client was a sergeant in the Air Force and was planning to retire in about three years. In the meantime, he was being transferred again to another base in the U. S. Over the years the sergeant and his wife had bought four homes in various locations, all located near Air Force Bases, choosing to own a home instead of renting. When transferred, they converted their homes to rental property and planned to do the same during this latest transfer. They were thrilled with the latest transfer—the location being exactly where they would like to retire. They wanted to sell the rentals because of the scattered locations and the market value appreciation had peaked.

Client would locate a residence at their new location ideal for them to occupy as their primary residence when they retired in three years. They would enter into a §1031 deferred real estate exchange, selling the first three rentals (Relinquished Property) and buy the new rental property as Replacement Property. The cost of the new rental was more than the total selling price of the three rentals being sold. They were, in effect, trading up. Their current residence would be sold at the time of their transfer and qualified for exclusion of gain under §121. At their retirement, they would convert the rental into their personal residence and live happily ever after.

Here is an outline of the plan:

• All three rentals qualified for §1031 treatment.
• The agents believed all three would sell quickly since military housing in the three locations was in short supply.
• The residential property being acquired by the clients qualified for §1031 treatment since it was classified as being acquired and held as rental income property
• The exchange permitted the sergeant and his wife to use the entire equity of the three rentals to pay towards the new rental. No reductions for capital gains tax if they had sold the properties instead of using the benefits of §1031.
• The nonrecognized gains would substitute into the basis of the new rental but who cared? If the clients were, in fact, to eventually occupy the rental as their primary residence, the tax-free gains would rest with the property and after two years qualify for exclusion under §121 if they ever sold the property as their primary residence.

Is this a great plan, or what? All this plus they get to use §121 to exclude the gain on the sale of their current Primary Residence.

The reason this plan is so powerful is this: It permits the client to make every real estate transaction required by their life plan and not suffer from income tax liabilities It permits them to get maximum financial results from their transactions. This is what good tax planning is all about.

By the way, we followed up with the real estate agents and the clients did successfully complete the plan and are now happily retired right where they wanted to be.

Strategy 3 –

This strategy vividly demonstrates how knowledge of the tax part of the primary residence and §1031 exchanges can be blended with good creative thinking to achieve some fantastic results.

Clients owned a duplex in a beach community. They lived in one of the units and rented the other. Their retirement plans called for cashing out their large equity by selling the duplex. They planned to buy a large apartment house and operate it through a property manager, providing them a nice cash flow to supplement their other retirement income. Their retirement plans did not include buying another Primary Residence since they would be traveling for the next several years. Their financial objective was to accomplish all this maximizing their capital and minimizing their income tax costs. Their plan was really quite simple but you would be amazed at how many people would rush out and sell the duplex without any financial or tax planning.

Here’s the plan:

• Enter into an exchange agreement with a Qualified Intermediary and sell the duplex as part of the exchange.
• The portion of the duplex used as a rental qualifies as Relinquished Property, the portion occupied as their Primary Residence does not.
• The sale of the Primary Residence is a taxable event and reported on their tax return as such.
• Gain on the sale of the Primary Residence qualifies for exclusion under §121—up to a half-million dollars for the married couple.
• The proceeds from the sale of the rental portion of the duplex qualify as Relinquished Property under §1031 and since they are trading-up, no gain will be recognized at the time of the sale.
• The clients can use their full before-tax equity in the rental portion as part of their payment towards the apartment complex they are buying.
• The clients can use all or part of the cash proceeds from the sale of the portion of the duplex qualifying for §121 treatment. If their gain was more than $500,000 on this portion, the cash proceeds would be reduced by the capital gains tax on the excess amount.
• Since the clients will be investing a substantial cash payment into the apartment house, they will generate a positive cash flow from the rentals.

The same rules apply to sale of 4-plex etc. Just make the correct allocation between the primary residence (§121) and the rental portion (§1031).