Real Estate: 1031 Exchange Example


1  - Selling residence and moving into rental property...

You own two houses you like equally. One is a rental, the other is your primary residence. You are considering selling one of them, and not sure what to do. If taxation is a consideration, it is important to consider the following...

If you sell the primary residence, and are married filing jointly, you are able to earn $500,000 in capital gain from the house tax free. So, if you bought (or acquired it maybe through inheritance) for $200,000, added improvements of $75,000 over the time you lived in it, and you lived in it for more than 2 of the past 5 years, you can sell it for $775,000, tax free. We ignore costs of sale here, but you will get to deduct them from the selling price to reduce the gain.

If you sell the home for more than $500,000 over cost, the overage will be taxed at lower capital gain rates. 

If you are single, the exclusion is $250,000. So you can sell the property for $525,000 before worrying about paying taxes.

After the sale, you can put than money into whatever investment or savings account you like, move into what was formerly your rental propetry, and increase your retirement nesteg to enhance your lifestyle in whatever way you see fit.

If you sell the rental, get an estimate of the tax damage likely to befall you before doing so,  - and a crying towel.


2 - Exchange the rental property for another you may intend to occupy later... 

You own two houses, a primary residence and a rental property. You want to buy a house for retirement, but not quite ready. The rental is wearing you down, and you want to get rid of it and go on to something else.

Exchange the rental for a house you may someday want to live in, maybe even in which to retire. Exchange that property for the more desirable one, (maybe a beach house) and rent it for a while. If you rent the house for a couple of years, clearly the intent was rental and you exchanged a like-kind property legally. If you move in a week after the closing, the exchange will be void and you will pay the tax on the sale of that rental house, and be possibly asked nasty questions regarding tax fraud. There is a big difference between tax fraud and tax avoidance. Tax avoidance works, fraud usually doesn't.

Remember, you are legally allowed to change the character of a property from personal to rental, and back again whenever you want. For an 1031 Exchange to be valid, intent is the key. You must intend to use the exchanged property in the same way (business use). You did use it as a rental, so you're good.

You rent the beach house for a couple of years and then decide you've had enough of the city and want to sell your residence. you sell the residence and $500,000 of the gain is tax free (joint tax return) because you've lived there a while (at least 2 of past 5 years). So you pocket this money to help with retirement expense and go live at the beach and have a pretty good life-style. If you later sell this exchanged house, there would be some tax related to the time it was rented, we have a tax law beginning in 2009 to thank for that - but if you don't sell it - no tax.

After a few years, you get older and think, what now? What will happen when I die and the kids have to deal with this house. Well the heirs have a choice - they can sell the house and pay not a dime in tax immediately after your death, of they can keep the house and continue its use but now at the new higher stepped-up basis, which is the fair market value at the time of your death.

The original low basis of that first rental for which you exchanged has completely disappeared and is now much higher. If they covert it back into a rental, they will use the FMV at your death as their cost basis, and depreciate it from there. Win, win, win.

If your estate at death is less than about 11 1/2 million dollars (this could easily change in the future - so be vigilant) - tax may never be paid on the sale of those houses – EVER. (State laws may differ, but most follow federal guidelines)

If you decide that that beach house really wasn't for your retirement, you can sell again because it is a rental property and defer the tax again.