Avoiding Capital Gains on Investment Property
Thinking of selling investment property and buying a retirement home or a second home on Cape Cod or in Florida? With a little planning, you could be retiring to a home in a destination of your choice without paying capital gains taxes of approximately 30%. You could have 30% more buying power if you were to perform a 1031 tax-deferred exchange.
The increase in property values throughout Massachusetts has given investors large equities in their properties thus subjecting them to higher capital gains taxes on the sale of such properties. Consequently, many investors are using 1031 tax-deferred exchanges in order to defer paying capital gains taxes by purchasing retirement homes or second homes.
Internal Revenue Code (IRC) Section 1031 allows a property owner, who holds property for “the productive use in a trade or business or for investment”, to defer paying any capital gains taxes if such property owner, in accordance with the provisions and requirements of Section 1031, sells such property, identifies like kind property within 45 days and acquires other like kind property within 180 days.
Although these time constraints and an active real estate market can make it difficult for a taxpayer to find and close on a replacement property, the IRS issued Revenue Procedure 2000-37 which allows a taxpayer to perform a “reverse exchange.” Reverse exchanges allow a taxpayer to acquire the new property (the “replacement property”) before selling the old property (the “relinquished property”). This creates greater flexibility for investors who do not want to pass on a great investment opportunity before they have sold their relinquished property.
Like kind property includes all real estate; that is, all real estate may be considered “like kind” to any other type of real estate. The important issue is how the property is being used. If both the relinquished property and the replacement property are used for investment or business purposes, then a three family rental property in South Boston may be exchanged for a home on Cape Cod, in Florida or both. However, the Cape Cod or Florida home would need to be held for use in a business or for investment (i.e. rented) for a period of time to qualify for tax deferral treatment and personal use of the property should be limited to IRC Section 280A – no more than the greater of 14 days or ten percent of the number of days that the property is rented.
After establishing the new Cape Cod or Florida home as an investment property, it can later be converted into a vacation home or a retirement home. There is no bright line rule which provides a specific time that an investor must rent the property before converting the property to a personal residence, but most tax planners suggest a minimum of one year. The longer one holds the replacement property for investment purposes, the less likely the IRS will challenge the transaction in the event of an audit.
An added benefit is that once the Cape Cod or Florida property has been converted to a principal residence, IRC Section 121 allows a taxpayer to exclude up to $250,000.00 of gain ($500,000.00 if married filing jointly) from the sale or exchange of a principal residence, provided the principal residence must have been owned for five years and used as such for an aggregate of two or more years during the five year period ending on the date of the sale.
Consequently, if an investor sells a three family investment property and uses a 1031 exchange to buy a home on Cape Cod, rents the Cape Cod home for a period of time, the investor could defer paying any capital gains taxes on the exchange. Furthermore, if the investor then converted the Cape Cod property into a principal residence and later sold the Cape Cod residence, the investor would be able to avoid paying capital gain taxes (except for any depreciation adjustments for periods after May 6, 1997) under IRC Section 121 exclusion.
There are many technical tax and legal rules that must be followed in order to achieve tax deferral treatment under Section 1031. One important rule is that the seller of investment or business property must not have actual or constructive receipt of the sale proceeds. To avoid such a problem, most 1031 tax deferred exchanges involve a “Qualified Intermediary”. The Qualified Intermediary holds the sale proceeds until a replacement property is purchased and provides the proper documentation to preserve the integrity of the exchange.
In summary, with proper tax planning, 1031 tax-deferred exchanges provide investors with great opportunities to diversify, consolidate, or rearrange their real estate holdings and defer paying capital gains taxes.