You may be eligible for a tax exclusion, but do your homework first
Interesting Q & A from an article in the Bellville News Democrat
Q. In response to a reader who owned three rental properties in addition to his primary residence in Irvine, Calif., you said he could not do a 1031 exchange on his personal property. We've got title companies and aggressive CPAs here in San Jose, Calif., who are suggesting this scenario for highly appreciated properties.
It's pretty commonplace that someone bought a property for $400,000 and now it's appreciated to a $2 million house. Say you've bought a house for $400,000 years ago here in Northern California. You bought in a good community and now the same property is worth $2 million. So you've definitely lived there for five-plus years, although I guess two years should be enough for our example. You move out of the property and rent it for two years, or a year if you're aggressive. You then sell the property as an investment property.
Because you've lived in it for two of the last five years, it should be eligible for a 121 exchange. Since it's also been an income property for two years, after taking your 121 exclusion, you should be eligible to take the balance in a 1031 exchange since it does qualify under a like kind exchange. So you've now pulled $250,000/$500,000 out under a 121 exchange and you're pulling the balance out and deferring gain into another property in a 1031 exchange. I know this is aggressive, but will it hold water?
A. Yes, the strategy that you have outlined will work, but you must be careful to establish investment intent. Because you have lived in the property for two out of the last five years, you will qualify for the 121 exclusion providing tax-free profits on the sale of a personal residence of up to $250,000 for a single person or $500,000 for a married couple.
The 1031 tax-deferred rules are based on the premise that the property that you own is eligible if held for investment or used in a business. It is important to understand that the IRS will consider the intent of how the property is used at the time of the exchange. This allows the owner the opportunity to change the use of the property from a primary residence or vacation property to an investment property.
As part of demonstrating intent, you should rent or attempt to rent the property for fair market value, report rental income on your tax returns, and depreciate the property. The tax code does not address any required amount of time that this must be met to qualify for 1031 tax status. My 1031 exchange intermediary friends feel that logic dictates a two-year holding period or two-year tax cycle as a reasonable amount of time.
Dr. Thomas Musil is the director of the Shenehon Center for Real Estate in the Opus College of Business at the University of St. Thomas in Minneapolis. He has more than 25 years of experience in real estate as a broker, analyst, consultant and expert witness in real estate litigation and arbitration disputes.
Q. In response to a reader who owned three rental properties in addition to his primary residence in Irvine, Calif., you said he could not do a 1031 exchange on his personal property. We've got title companies and aggressive CPAs here in San Jose, Calif., who are suggesting this scenario for highly appreciated properties.
It's pretty commonplace that someone bought a property for $400,000 and now it's appreciated to a $2 million house. Say you've bought a house for $400,000 years ago here in Northern California. You bought in a good community and now the same property is worth $2 million. So you've definitely lived there for five-plus years, although I guess two years should be enough for our example. You move out of the property and rent it for two years, or a year if you're aggressive. You then sell the property as an investment property.
Because you've lived in it for two of the last five years, it should be eligible for a 121 exchange. Since it's also been an income property for two years, after taking your 121 exclusion, you should be eligible to take the balance in a 1031 exchange since it does qualify under a like kind exchange. So you've now pulled $250,000/$500,000 out under a 121 exchange and you're pulling the balance out and deferring gain into another property in a 1031 exchange. I know this is aggressive, but will it hold water?
A. Yes, the strategy that you have outlined will work, but you must be careful to establish investment intent. Because you have lived in the property for two out of the last five years, you will qualify for the 121 exclusion providing tax-free profits on the sale of a personal residence of up to $250,000 for a single person or $500,000 for a married couple.
The 1031 tax-deferred rules are based on the premise that the property that you own is eligible if held for investment or used in a business. It is important to understand that the IRS will consider the intent of how the property is used at the time of the exchange. This allows the owner the opportunity to change the use of the property from a primary residence or vacation property to an investment property.
As part of demonstrating intent, you should rent or attempt to rent the property for fair market value, report rental income on your tax returns, and depreciate the property. The tax code does not address any required amount of time that this must be met to qualify for 1031 tax status. My 1031 exchange intermediary friends feel that logic dictates a two-year holding period or two-year tax cycle as a reasonable amount of time.
Dr. Thomas Musil is the director of the Shenehon Center for Real Estate in the Opus College of Business at the University of St. Thomas in Minneapolis. He has more than 25 years of experience in real estate as a broker, analyst, consultant and expert witness in real estate litigation and arbitration disputes.
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