Foreclosure Shop   Educational Resources
 

Print Defer Your Taxes via Like-Kind Exchanges
Combine with gain tax exemption on home sales!

By Andrew Goloboy, CPA

Andrew Goloboy, CPA
I would like to take this opportunity to describe a very important tax planning arrangement approved by the IRS for property owners. You may have heard it called a tax-deferred Section 1031like-kind exchange or "tax-free exchange." The tax savings from participating in a like-kind exchange can be substantial. Additionally, you can convert a primary residence to income-producing property, and exchange down the road while preserving your gain exemption on the sale of your home!

Like-kind Exchanges in General

A like-kind exchange provides a wonderful alternative to selling property. The sale of property causes you to recognize a gain, on which you must pay taxes. A like-kind exchange, on the other hand, allows you to avoid gain recognition through the exchange of qualifying, like-kind properties. The gain on the exchange of like-kind property is effectively deferred until you sell or otherwise dispose of the property you receive.

The IRS allows this tax-deferred transaction because it recognizes that since your economic position remains the same (i.e., you have merely exchanged one property for another), you should not have to incur taxes on your gains. You will, however, have to recognize gain on any money or unlike property that you receive in the exchange.

This Article is an excerpt from the 16 Page Print Edition!

Are YOU getting the print edition of ForeclosuresMass Monthly?

Get a FREE copy* of this month's newsletter (worth $49.97!) when you pickup your Real Estate Investors ONLY Free Gift (worth over $267.97!)

First Name:

Email Address:

* Next 37 17 investors only!

Only qualifying property may receive like-kind treatment. To qualify, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Rental houses, buildings, land, trucks, and machinery are examples of property that may qualify.

Like-kind exchanges provide a valuable tax planning opportunity if:

  • You wish to avoid recognizing taxable gain on the sale of property that you will replace with like-kind property
  • You wish to diversify your real estate portfolio by acquiring different types of properties with the exchange proceeds without tax consequence
  • You wish to participate in a very useful estate planning technique (continued like-kind exchanges allow you to avoid recognition of gain permanently)
  • You would generate an alternative minimum tax liability upon recognition of a large capital gain in a situation where the gain would not otherwise be taxed. (The like-kind exchange shelters other income from the alternative minimum tax.)

Convert Residence to Rental Property for Tax-Free Exchange

Do you want to convert home equity into income-producing assets and avoid the income tax hit that would result from an outright sale?

To avoid paying taxes when selling your home, you can instead convert it into a rental property. Then, exchange it for another piece of income-producing real estate down the road in a tax-deferred Section 1031 like-kind exchange. This transaction avoids any immediate tax hit, and it converts your home equity into an income-producing asset.

With careful timing, you can even arrange to receive up to $250,000 (if single) or $500,000 (if married) of tax-free gain as part of the like-kind exchange. You can do this by taking advantage of tax-free gain exclusion on the sale of a primary residence. The eligibility requirements for the $500,000 joint-filer gain exclusion are:

  • The property that's being sold or exchanged must have been owned for at least two years during the five-year period ending on the sale date. This requirement is called "the ownership test".
  • The property must have been used as a principal residence for at least two years during the same five-year period. This requirement is called "the use test".
  • You or your spouse must not have claimed home sale gain exclusion within two years of the sale date.

Some people worry that the like-kind exchange will be treated as a partial sale that would somehow be ineligible for the gain exclusion. The IRS explicitly permits claiming the full exclusion amount on a gain from a partial sale, under the appropriate circumstances. You must get the timing right, because if you rent out your former residence for too long, you will obviously fail the use test and thereby lose the $500,000 gain exclusion.

How to Convert a Former Personal Residence into a Rental Property

You must convert your residential property to investment property before a like-kind exchange can occur. Why? Because the tax rules only cover swaps of business or investment property for other business or investment property. So, you can't make a tax-deferred like kind exchange of a personal asset for business or investment property. Those properties would not be considered like kind.

The courts have provided a bit of guidance when a personal residence can be considered converted into a rental for the purposes of: (1) claiming a deductible capital loss for a property that has declined in value or (2) claiming deductions for operating expenses and depreciation after the homeowner has moved out. Any actions that are attempts to reduce the owner's out-of-pocket costs of holding the property for sale after it has been abandoned as a personal residence are not permissible. The rental activities must be legitimate and for-profit. The law says a former personal residence can't be converted into a rental property simply by renting it out for less than market value while it's also being marketed for sale. Renting a former personal residence on and off while trying to sell it doesn't do the trick either.

To be safe, you need to arrange for rental activity that has a profit motive in and of itself. Therefore, holding the former personal residence for sale during rental periods is fatal. So is failing to rent the property as regularly and continuously as market conditions allow, or renting to friends, relatives, business associates, or anyone else for less than market value.

It appears safe to say the IRS would agree that a former personal residence qualifies as a rental property for Section 1031 like-kind exchange purposes after two years of legitimate for-profit rental activity. Remember: if you are counting on getting the $250,000 or $500,000 home sale gain exclusion, the former residence cannot be rented out for more than three years after you vacate the premises. So, you should exchange the property in the third year after conversion, which may not provide the best timing for realizing the highest value for the property. Buyer (or exchanger) beware!

Conclusion

As with any complex tax strategy, there are a lot of layers to cut through. Recent IRS guidance in early 2005 clarifies the interrelationship between the home sale gain exclusion and the like-kind exchange rules. As always, future tax court cases or further IRS guidance could steer the tax-free exchange ship on a different course. As it stands today, however, personal residence conversion for future tax-free exchange allows you to defer capital gains taxes via a like-kind exchange without forgoing the home sale gain exclusion tax benefit.

Andrew graduated with an MBA, cum laude, from Babson College in 1997 and with a BA in Economics from Amherst College in 1989. Andrew received his CPA while working as a financial consultant at PricewaterhouseCoopers and Ernst & Young. Goloboy CPA LLC's specialty lies in assisting real estate owners with transaction planning, tax compliance, and financial strategies. Andrew can be reached at: andycpa@mindspring.com.

Sources
* Internal Revenue Service Revenue Procedure 2005-14 , I.R.B. 2005-7, January 27, 2005, corrected February 3, 2005, CCH Internet Tax Research Network.
* PPC Tax Action Memo 1004, "Consider 1031 Exchange Strategy for Greatly Appreciated Personal Residences," February 17, 2004.

 

What did you think of this article? How did this article help you? Let us know, and we just might include your response in the Mail Bag section of the newsletter!
Name: Email:

Did you like this article? You May Also Like:
David Presby Feature Article: Septic Systems - The Good, The Bad and The Smelly
David Presby, CEO of Presby Environmental, Inc.
Title V, the Massachusetts law that stipulates a septic system must pass inspection before the close of sale on a property, is punching big holes in homeowners’ pocketbooks. Septic system expert David Presby explains why Title V is important for the environment and how to troubleshoot your septic system in order to keep it running trouble-free for years.
Gail McCarthy Nothing Succeeds Like Success: Gail McCarthy Powers Her Way to Profits
Gail McCarthy
A real estate investor since 2004, Gail McCarthy recently completed two deals in Alabama for 100+ unit apartment buildings. She talks about her personal journey and how she’s been able to leverage her experience investing in single-family homes into a new career in commercial real estate.
Michael Ouellette Success Strategies: Generating Profit in a Down Market
Michael Ouellette
With property values decreasing across the board and sellers refusing to lower prices, it's more important than ever to know how to determine the true value of a property in order to realize profit. Long-time real estate investor Michael Ouellette explains why you must know the After Repair Value of a property - versus its market value - and why exit strategies such as owner financing can net you greater profits and appreciation long term.
Eileen Schwartz Interview with the Expert: Real Estate Savvy Financial Planners Can Save You Big Bucks!
Eileen Schwartz, Real Estate Investor
Let's say you want to pay off your mortgage and buy the retirement home of your dreams by selling one or two of your investment properties. What most people don't consider, explains financial planner and real estate investor Eileen Schwartz, are the tax implications of these real estate transactions. In this interview, Eileen discusses why working with a financial planner who also understands real estate (including 1031 exchanges!) can literally save you big dollars - now and in the future.
Charles Warnock Success Strategies: Using the Internet to Research Emerging Markets
Charles Warnock
Because travel is expensive and time-consuming, it pays to know how to find information on emerging markets and neighborhoods via the Internet. Charles Warnock, Director of Marketing for eNeighborhoods.com, explains why a town’s Website is your most important first stop, plus how you can find a goldmine of information at local, county and federal government sites such as HUD.
Susan LaPlante-Dube Feature Article: How Effective Networking Helps You Close More Deals
Susan LaPlante-Dube
Motivated buyers. Motivated sellers. Real estate investors. Home improvement specialists. Home inspectors. Electricians. Appraisers. Bankers. Mortgage Brokers. Real estate attorneys. The list of people you need to run a successful...
Robert Tenney Legal Corner: Banks are willing to work with investors to find equitable solution
Bob Tenney, Cunningham Machanic
Bob Tenney, attorney at Cunningham Machanic in Natick, is on the frontline of the foreclosure process. Tenney and his firm review claims by lenders to review properties for foreclosure. If proper conditions are not met, they are also the folks who send out demand letters—the step that begins the foreclosure process for the homeowner. "We send the demand letter and give the homeowner time to reinstate their loans. If that doesn't happen we proceed with the foreclosure," says Tenney...
Eileen Schwartz Interview with the Expert: Eileen Schwartz Plays Real Estate Matchmaker
Eileen Schwartz, Real Estate Investor
Buying and selling properties takes real acumen, and veteran real estate investor Eileen Schwartz has plenty of that - having learned real estate at her mother's knee. Yet according to Eileen, it's building a network that's been the key to success. Read about Eileen's new program for investing locally and in Miami - and learn her tips for building a rock solid network that will deliver the deals you won't find on your own.
Ted Demopoulos Success Strategies: Blogging for Real Estate... A Primer for Starting a Blog
Ted Demopoulos
Blogging has definitely hit the mainstream - and with over 750 real estate blogs at last count - it's time you consider starting a blog if you haven't done so already. In his article, author and blogging expert Ted Demopoulos gives you his three success strategies for starting and maintaining a blog. The key takeaway: become familiar with the blogosphere and get to know other real estate bloggers before you jump in feet first.
Deborah Siegel Interview with the Expert: Finding a Mortgage Broker You Can Trust
Deborah Siegel
With the media full of stories about unscrupulous lenders pushing loans that people can't afford, you may be wondering if trustworthy mortgage brokers still exist. Rest assured- they do. In this month's Interview with the Expert, Debbie Siegel explains the difference between independent mortgage brokers and lending companies -- and the questions you should ask any potential broker or lender before deciding to do business with one.

Copyright © 2003-2009 ForeclosuresMass Disclaimer/Policy Media Inquiries
ForeclosuresMass is a division of ForeclosuresMass, Corp. For more foreclosures, visit: RI CT NH VT ME MA DE CA MD PA NJ