By 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.

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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.