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1031 EXCHANGE

By Jeff Riddell

If there are taxes to be saved, a 1031 exchange should be considered as the exit strategy for any real estate that qualifies.  Under the current rules the process is simple: Hire a qualified intermediary (QI) company and sign an exchange agreement, sell your relinquished property, escrow the proceeds with the QI company and reinvest in qualified replacement property within 180 days. Except for personal use properties, any real estate qualifies if it’s held for investment or productive use in a trade or business—including rental real estate of every kind. Tax deferred exchanges under Section 1031 of the Internal Revenue Code are referred to variously as 1031 exchange, tax deferred exchange, tax free exchange, Starker exchange and like-kind exchange, but they all mean the same thing.

Personal use properties are things you live in all or part of the time: your main, second home, vacation home, etc. Second and vacation homes were considered a 1031 exchange gray area by some commentators, but the issue was probably put to rest by a 2007 Tax Court case. The case held that second homes and vacation homes are not qualified for 1031 exchange even if you claim investment intent, i.e., “I would have rented when I went on vacation if I didn’t want to own an investment that I could make a profit on when I sold it.” However, the case involved a vacation home with absolutely no rental history, so ask your tax advisor about claiming 1031 exchange for the sale of a vacation home with at least some rental history.

Although your main home—sometimes called your primary residence—is not a candidate for 1031 exchange, you usually won’t care because there is better tax avoidance available for your main home. It’s called Section 121; it replaced the old Section 1034 “rollover” rule that allowed a once in a lifetime $125,000 exemption after you turned 55. Under Section 121, as long as you satisfy the “two out of the last five years” occupancy test, you can forget about paying any capital gains tax on the first $250,000 of gain on your main home sale if you are a single person, or the first $500,000 of gain for a married couple filing a joint return—and you could do this every two years for the rest of your life. In contrast to 1031 exchange which provides only tax deferral, the Section 121 exemption for your main home actually forgives the capital gains tax that would otherwise be due up to the $250,000/$500,000 capital gain limits. If your main home capital gain is more than $250,000/$500,000, you will pay the capital gains tax on the overage; and where your home was previously a rental, depreciation recapture tax is never forgiven. Depreciation recapture tax, if applicable, is due when you ultimately sell your home even though you claim the Section 121 exemption.

If the gain on your main home sale exceeds the $250,000/$500,000 Section 121 limit, it might be possible to convert your main home to a rental property and then sell it in a 1031 exchange. Here’s an example: I was referred an exchange in which the relinquished property was selling for $10 million; the seller had purchased the property several years earlier and had lived in it with his wife as his main home. If he sold it as his main home, he would pay capital gains tax on $4.5 million.  Instead, he and his wife moved into one of their other houses and rented the $10 million property to a well healed tenant for a year. On their tax return, they reported the house as rental property; then sold the house in a 1031 exchange. They replaced their “rental house” with $10 million worth of income producing replacement property—they saved $675,000 in taxes. This couple is now earning income on their tax savings as well as the balance of the proceeds they received on sale of the house.

Jefferson F. Riddell is a Florida Board Certified Real Estate attorney with thirty-five years of experience assisting people with a variety of residential and commercial real estate matters. U.S. 1031 Exchange Services, Inc is a 1031 exchange qualified intermediary (QI) and a member of the Federation of Exchange Accommodators (FEA). As President of U.S. 1031 Exchange services Jeff has been facilitating 1031 exchanges for more than twenty years. Jeff has been awarded the Certified Exchange Specialist (CES) certification. Jeff may be reached at 941-366-1300 or via email at jeff@us1031.com. www.us1031.com.

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