{"id":820,"date":"2015-03-12T10:09:04","date_gmt":"2015-03-12T17:09:04","guid":{"rendered":"https:\/\/shellyrobersonrealtor.com\/?p=820"},"modified":"2015-03-25T21:51:10","modified_gmt":"2015-03-26T04:51:10","slug":"irc-1031-121-powerful-combo","status":"publish","type":"post","link":"https:\/\/shellyrobersonrealtor.com\/irc-1031-121-powerful-combo\/","title":{"rendered":"Attention Downsizing Baby Boomers \u2013 Sell Your House, Protect All Your Equity, and Pay NO Capital Gains Taxes with this Simple Strategy Using Tools Congress Gave Us"},"content":{"rendered":"
Many of my parent\u2019s friends who have fortunately accumulated significant equity in their homes over the last several decades are faced with a dilemma of downsizing into a smaller home because they can no longer conveniently or adequately take care of their properties.\u00a0 Importantly, many of them desire a simpler-smaller property, usually all single-level, accessible and easy to maintain.\u00a0 The problem exists because if they sell their home with substantial equity they face significant capital gains exposure even with the IRC Section 121 exclusion in place.<\/p>\n
<\/p>\n
For example, a married couple may exclude from capital gains tax $500,000 (Sec. 121) if they have resided in their primary residence two (2) out of the last five (5) years.\u00a0 So, if a couple has accumulated $2,000,000 in equity in their home (after improvements and original purchase price) they would still have a $1,500,000 capital gain.\u00a0 In California, with all of the taxes included, the capital gains rate is approximately 33% (highest in U.S.).\u00a0 Thus, this couple would have to pay approximately $495,000 in capital gains taxes in the next tax year after their sale.\u00a0 So how do we get around this challenge?<\/p>\n
With the Congressional enactment of the American Jobs Creation Act of 2004 and the Housing and Economic Recovery Act of 2008, and Department of the Treasury Revenue Procedure 2008-16 the government has made it easier for homeowners to keep more of their equity \u2013 and even not pay any capital gains taxes, ever \u2013 if they don\u2019t want to.<\/p>\n
This code section says that if a property is your primary residence and you (or you and your spouse) have lived in it for two (2) out of the last five (5) years you can sell the property and exclude from taxes $250,000 if you are single, or $500,000 if you are married and file a joint tax return.\u00a0 This code does not apply to second homes, vacation homes, rental homes, or investment properties.\u00a0 Another wrinkle is that you can only exclude capital gains and not recaptured depreciation (but that is another article).<\/p>\n
A 1031 exchange allows a person to sell a property (\u201crelinquished property\u201d) that was held as a rental or investment property and then exchange the proceeds from that sale into a new \u201clike-kind\u201d property (\u201creplacement property\u201d) also to be held as a rental or investment property.\u00a0 The benefit of using a 1031 exchange is that no matter what capital gains you may have accumulated in the \u201crelinquished\u201d property they are all transferred into the \u201creplacement\u201d property and no taxes are due or payable at that time. The taxes are deferred into the replacement property.\u00a0 The 1031 exchange does not apply to a primary residence, but you can convert your primary residence into a rental property and take advantage of all its benefits.<\/p>\n
Over the 239 years or so that this country has existed there has never been one set of laws that allowed more American families to accumulate more wealth than Section 1031.\u00a0 Mind-boggling multi-generational wealth has been created by clever investors who never pay capital gains taxes on their real estate portfolios even though they keep selling and buying more and more and bigger and bigger buildings.<\/p>\n
With careful and meticulous tax planning people can combine both IRC 121 and 1031 to legally avoid and\/or defer all capital gains taxes on the sales of real property \u2013 while improving the assets by buying bigger and better buildings each time one is sold.<\/p>\n
There are three (3) distinct transactions which these two code sections will allow sellers\/investors to take full advantage of the code.<\/p>\n
If you bought an investment\/rental property and later wanted to convert it to a primary residence you will have to move into the property for a minimum of 2 years to qualify for IRC 121.\u00a0 There are some other restrictions but the main benefits of 121 + 1031 are still available to you.<\/p>\n
This case is similar to 1 above.\u00a0 The difference is that the original purchase of the investment property was done with a 1031 exchange.\u00a0 The minimum time you will have to own this property is five years to qualify for IRC 121 exclusion and then you can 1031 exchange it again.\u00a0 You do not have to live it in for five years, but only two out of the last five years. There are some other restrictions but the main benefits of 121 + 1031 are still available to you in this fact pattern.<\/p>\n
This is the golden strategy that applies to many people.\u00a0 The Internal Revenue Service drafted Revenue Procedure 2005-14 which allows you to move out of your primary residence and convert it into a rental property.\u00a0 Although there is no rule or statute it is common practice that a person should rent the converted property for a minimum of one year (I always say a year and a day with full intention of making it a rental).\u00a0 The year and a day rule of thumb cures the primary residence into a \u201crental\/investment\u201d property.\u00a0 Now you can sell the rental\/investment property and take advantage of IRC 121 ($500,000 exclusion) and 1031 exchange the property into another, more profitable or desirable building \u2013 thus deferring any leftover capital gains exposure.<\/p>\n
When I talk to people about this strategy the first question they always ask is \u201c[W]here am I going to live?\u00a0 The answer is \u201c[A]nywhere you want to.\u201d\u00a0 A person can take the proceeds of the rental income from their newly converted rental property and go and rent somewhere else for the 12 or so months why the property is \u201ccuring.\u201d\u00a0 In fact, most of the time the rental\/investment property will kick-out substantial rental income such that the owner can find suitable rentals and still have left over monies each month (more than likely their mortgage obligations on their primary residence is exhausted).<\/p>\n
I tell my clients to look for something to rent on a golf course, a simple single-level condominium, or a beautiful unit in a high-rise building. There are so many different options all of which can be afforded by the budget from the rental income.<\/p>\n
I have always counseled my clients to look for a commercial building or a mixed use building to exchange into.\u00a0 Well positioned commercial buildings will typically have tenants on triple-net leases where the tenant is paying more than 100% of the actual expenses of the building including property taxes, insurance, improvements, etc.<\/p>\n
If you purchase a building with greater value than the proceeds from the relinquished property just make sure the amount of rental income will be enough to cover your expenses.\u00a0 A discussion about capitalization rates for commercial buildings was covered in a previous article I wrote right here http:\/\/bit.ly\/VmlTeB.<\/strong><\/a><\/p>\n A mixed use building with retail and residential components are attractive because the owner may decide to live in one of the residential units. \u00a0You can also hire a professional property manager<\/a> to manage your property for you to relieve you of any associated duties – and their fees are tax deductible.<\/p>\n The ultimate answer is it really doesn\u2019t matter.\u00a0 There are so many opportunities that exist the possibilities are endless.<\/p>\n Step 1. Accumulated Equity Above $1,500,000<\/strong><\/p>\n Step 2. Move out and convert primary residence to rental for a year and a day<\/strong><\/p>\n Step 3. Find rental for you to live in with proceeds from renting your previous primary residence<\/strong><\/p>\n Step 4. After 12 months or so sell the rental\/investment \u201crelinquished\u201d property to take advantage of Sec. 121<\/strong><\/p>\n Step 5. 1031 exchange the proceeds of the relinquished rental sale into a new building<\/strong><\/p>\n Step 6. Identify \u201creplacement\u201d property within 45 days of the sale and close escrow within 180 days of sale of \u201crelinquished\u201d property<\/strong><\/p>\n Step 7. Continue to rent at your discretion \u2013 or find a new rental \u2013 or move into the \u201creplacement\u201d property<\/strong><\/p>\nStep By Step Procedure Looks Like This<\/h2>\n