Strategies by using 1031 Exchanges
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Use these tax saving strategies! Using, the 1031 tax-deferred exchange is widely known and utilized by investors to defer capital gains tax when selling and buying investment property (Not familiar with 1031 Exchanges? Click here to learn about the basics of 1031 Exchanges.) To qualify under IRC Section 1031 the basic requirements to maximize your tax-deferral are:
- Acquire “like-kind” property to be held for investment or productive use in a trade or business;
- Identify replacement property within 45 days of closing the relinquished property;
- Reinvest all your cash and acquire replacement property(ies) of the same value or more 180 days from the first closing; and
- Use a qualified intermediary to meet the safe harbor.
There are, however, additional tax savings strategies that are not as widely known. These savings can be beneficial when it comes to selling your primary residence or vacation/second home. Properly executing the strategies described below can help save you tax dollars.
Tax Saving Strategy Number 1
Tax Savings: Converting a Personal Residence to an Investment Property
When a personal residence is sold, IRC section 121 allows for capital gain tax exclusion of up to $250,000 if a taxpayer is single. If a taxpayer is married, the exclusion is $500,000. If the residence has been owned and used by the taxpayer for two of the preceding five years before the sale, it is eligible. Although this amount is generous, what if you have more gain than the exclusion allows? See Rev. Proc. 2005-14 for guidance for a way to combine Section 121 and Section 1031 to defer taxes on all of the gain.
An Example
For example, Rick and Sue are a married couple who purchased their home for $100,000 20 years ago. It is now valued at $1 million, and the taxable gain is $900,000. Upon the sale, the couple would receive their $500,000 exclusion but taxes would be owed on $400,000 of gain. With the proper tax advice and planning, they could move out of the property and convert it to a rental. They could then exclude the $500,000 tax free at closing under Section 121. Next, they would perform a 1031 exchange by purchasing an investment property for $500,000. They would then exclude the remaining $400,000 of gain!
Now, they have excluded or deferred all their taxable gain and they own an investment property that could bring them income.
Tax Saving Strategy Number 2
Converting An Investment Property to a Primary Residence
Utilize a 1031 exchange to convert an investment property you own into your primary residence. Let’s say that Rick and Sue in the example above exchanged into a rental house. They rented the property for two years (per their tax advisor) and then moved into it. It was then converted into their primary residence.
Rick and Sue acquired the property in a 1031 exchange. Next, they converted it to their primary residence. Now, they must own the property at least five years before being eligible for the 121 exclusion*. Additionally, if they acquired the property in the exchange after January 1, 2009, federal law limits the amount of gain here. If the house was used as a rental, the exclusion applies if it was used as a primary residence.** They may not receive the entire $250,000/$500,000 exclusion. Even so, they will still reap the benefits of tax savings.
When considering this strategy, consult with your tax advisor regarding your specific circumstances to determine the tax-free benefits.
Tax Saving Strategy Number 3
Qualifying a Vacation Home for 1031 Treatment
Many properties are owned as vacation homes. Do they qualify for a 1031 exchange? In 2008 a revenue procedure was issued that provides a safe harbor for vacation homes***.
The following are the requirements under the safe harbor:
- Both the relinquished and replacement properties must have been owned by the taxpayer for at least 24 months immediately before and after the exchange.
- In each of the two 12-month periods immediately before and after the exchange, the properties must be rented at a fair market value for 14 days or more.
- The taxpayer’s personal use cannot exceed the greater of 14 days or 10% of the days during each 12-month period that the property was rented at a fair market value.
- Personal use includes; the taxpayer’s family members, any other person with an interest in the property or their families. Anyone using the property under an arrangement which enables the taxpayer to use some other property (even if no rent is charged); or if the property is rented for less than fair market value rent.
With a bit of planning, you can take advantage of the 1031 exchange and defer taxes on your gain when you sell your vacation home.
Wrapping It Up
Understanding the tax saving strategies available through the 1031 exchange can help you save tax dollars! For additional information about the tax-deferred exchange and these concepts contact us or call at 717-293-9760.
Footnotes
* 26 USC 121(d)(10)
** 26 USC 121(b)(4)
*** Rev. Proc. 2008-16
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