Yes, Virginia, There is a Way to Defer the Gain!

Most investors think about the immediate tax perks of completing a 1031 exchange but may not consider the long-term benefits of the tax deferral. An exchange provides the opportunity to apply pre-tax dollars towards replacement property and keep that money working for you. This money can help you acquire a more expensive replacement property that has a higher annual return on investment and enjoy greater long-term appreciation. Exchanges also provide the opportunity to diversify real estate holdings, consolidate properties and acquire property that is less management intensive.    

A 1031 exchange is a tax-deferral strategy, but there are ways to defer the tax indefinitely. If an investor’s strategy is to always exchange and never cash out, the gain may eventually be eliminated. When that investor passes away, his heirs inherit the property with a stepped up basis (which means at the fair market value at the time of death).  A stepped up basis eliminates the tax liability on the deferred gain. Keep in mind, depending on the size of the estate, there may be estate taxes due and investors would be wise to work with a financial advisor to do some good estate planning and minimize the tax consequences for their heirs. Currently, the first $5,000,000 of an estate is exempt of estate tax but we don’t know what will happen with estate taxes effective January 1, 2013. 

There are other ways to defer tax liability on some of the gain. For example, under Section 121 of the Internal Revenue Code, if someone owns a property and uses it as his or her primary residence for 24 of the last 60 months, he or she is entitled to a $250,000 exclusion on the sale of the property provided he or she did not take that exclusion within the past 24 months. Married taxpayers filing jointly are entitled to a $500,000 exclusion.  An exclusion is a wonderful thing as there is no requirement to pay taxes on it or reinvest. This is important to know because there is a way to take advantage of Section 121 when selling property acquired in a 1031 exchange.

exchange vs. typical sale

See the Exchange vs. Typical Sale example. Assume “John and Mary” purchased a property in a resort area for $250,000 twenty years ago and are now selling it for $1,000,000. To determine their tax liability, first we have to recapture the depreciation taken during the many years the property was held as a rental at 25% (regardless of tax bracket). If John and Mary took $150,000 in depreciation and recaptured at 25% they would owe $37,500 in taxes. Next, John and Mary must determine how much they must pay in capital gains. Their appreciation is $750,000 (the difference between the $1,000,000 sale price and the original purchase price of $250,000). The maximum capital gain tax rates for individuals who have held an asset for at least 12 months is 15%.  Note that the current capital gain tax rates are scheduled to sunset at the end of the year and we do know what will happen with them on January 1, 2013.  The capital gain tax liability would be $112,500 ($750,000 x 15%).  The total tax due would be $150,000 ($37,500 + $112,500), but with a 1031 exchange, John and Mary have the opportunity to use the $150,000 towards replacement property.  Used as part of a down payment of 25%, John and Mary can afford to acquire something that is $600,000 more. Let’s assume John and Mary use the money to acquire two new properties and intend to use both as rentals.  After renting the properties for a number of years, John and Mary decide they are ready to retire and would like to move into one of their properties. John and Mary can sell their current primary residence (assuming they have owned it and lived in it for at least 24 months) and qualify for a $500,000 exclusion. Next, John and Mary can move into one of the two properties (with a lot of money in the bank!) and after living there for two years, and if certain other criteria are met, can sell it and exclude up to $500,000 of gain again. 

While it may seem like a loophole, the federal government is well aware of it. In 2005, included in The Jobs Act (HR4520), was a provision that required those that acquired a property under Section 1031 to own it for five years and use it as their primary residence for at least 24 months before qualifying for the exclusion. The Housing Assistance Act of 2008 provides a modification to the Section 121 exclusion affecting those who exchange into a property and later convert it to a primary residence.  Effective January 1, 2009, the exclusion will not apply to the portion of gain from the sale of the residence that is allocable to periods of “non-qualified use,” with certain exceptions. Non-qualified use refers to periods of use as a rental or second home. 

Even with this recent modification, there may still be substantial benefit to converting a property acquired in an exchange to a primary residence after maintaining it as a rental for a period of time. In John and Mary’s situation, they satisfied the 5 year ownership requirement.  Note that under Section 121, if John and Mary did eventually sell their “new” primary residence, the amount of gain they can count towards their $500,000 exclusion would be prorated based on the number of years the property was used for qualifying use.  Since you cannot exclude depreciation when taking your primary residence exclusion, you would also have to pay tax on the depreciation recapture but only back to May 1997 when the current regulations went into effect.  That would mean all of the depreciation taken prior to May 1997 is essentially erased. 

Don’t overlook the power of 1031 exchanges…they can help you acquire not only short-term investment objectives but also many long-term ones.