Avoid a capital-gains tax hit when you put the proceeds of one home towards another.
Once you start buying and selling property, you enter the world of property taxes and arcane real-estate laws.
Not to mention the Internal Revenue Service.
Deep in this jungle of regulatory mumbo jumbo you can find a group of professionals who make their living based on four digits: 1031.
The number refers to IRS code 1031, which allows someone to take the proceeds from the sale of an investment property and reinvest it into a similar or better property without incurring a capital-gains tax.
The IRS considers the tax deferred since the transaction is more of an exchange than a sale. In order to complete a 1031 exchange, you generally have to have a “qualified intermediary” lined up, of which there are a number of firms that seek to do this, and the intermediary holds the capital gains for you in escrow for up to six months until you close on your next property.
The 1031 exchange has been around since the early 1990s and was intended to ease transactions for real-estate investors who got stuck with ugly capital-gains taxes before reinvesting their proceeds. However, many people have tried to push the rules to expand it to primary and vacation homes .
“The intent of the 1031 is clearly for investment properties,” says Nichola Gardiner, vice president of San Francisco-based Churchill Exchange, which helps investors through the process. “But at the same time, everyone’s situation is different. It’s one of those things you need to talk to your accountant about before jumping into one.”
But that doesn’t stop people from trying.
Here are the nuts and bolts of a 1031 transaction: You own a Fort Lauderdale, Fla., condo that you’ve been renting to a nice old couple for the past 10 years and, despite the down market, you sell it and walk away with a $400,000 profit. You can bank the cash and get killed by the taxes, or you can pay around $1,000 for the services of an intermediary and use the 1031 exchange to purchase another investment property for $400,000 or more.
Now you decide that your next investment property should be in Aspen, Colo., so you find a beautiful two-bedroom condo with mountain views for $850,000. You’ll carry a $450,000 mortgage but you’ll also be earning the hefty rental income that those types of units rake in during peak ski season. According to the rules of 1031, you’re good.
But what if you decide you want to spend some time skiing in Aspen?
“Here’s where it gets tricky,” says Gardiner. “The IRS allows you to use the investment home yourself, but for a very limited time.”
And at an audit, you may have to defend the reason it took the entire month of December to check out your Aspen condo, especially when snow conditions were ideal and you could have easily rented the place out every night.
Another issue is “targeting” a property, which might go something like this: You sell a six-unit apartment building and pocket a $500,000 profit, then use a 1031 exchange to buy a $1.5 million home and rent it out. Your renters leave after six months, so you sell your primary home and move in.
“This is a red flag to the IRS,” Gardiner says. “They want to see that you intended that the property you bought in the exchange was going to be used for an investment.” In general, keep those renters in place for two years before moving in yourself.
There is also the raw-land loophole. You use the proceeds to buy a nice piece of land, thinking you’ll build a duplex on it to earn some cash. But a couple of years down the road, you decide the lot is best suited to build your dream home.
It’s all good according to the rules.
Just make sure your tax advisor is consulted before the foundation is built.
John Morrell, The Horses Mouth
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