to 1031 law
Tax Bill Narrows A Popular Section 1031 Exchange/Capital Gains
by Kenneth R. Harney
Tax-free exchanging -- one of the most popular real estate strategies
for investment property sellers -- just took a modest hit from
the federal government.
deep inside the $136 billion pre-election tax bill signed into
law by President Bush are new restrictions on certain Section
1031 exchanges involving conversions of investment real estate
into principal residences.
1031 of the Internal Revenue Code allows tax-deferred swaps of
investment and commercial real estate for other "like kind"
properties. The concept dates back decades but recently has become
a major activity for owners of everything from downtown office
buildings to resort rental condominium units.
new tax legislation, the American Job Creation Act of 2004 (H.R.
4250), takes aim at a loophole that has grown popular enough to
nettle the IRS: Owners of investment real estate with substantial
built-up gains have swapped their properties for real estate that
can be readily converted into owner-occupied residential property.
Having completed a tax-deferred Section 1031 exchange of investment
property, the owners then convert the exchange-acquired real estate
into their principal residences. They live in and use the properties
as principal residences for a couple of years, and then sell.
Here's the loophole: Under Section 121 of the Internal Revenue
Code, principal residences qualify for the most generous breaks
anywhere in the tax system -- tax-free exclusions of up to $250,000
(single tax filers) and $500,000 (married joint filers) in sale
profits, provided the taxpayers own and use the real estate as
their principal residence for an aggregate two out of the preceding
1031 allows owners of investment real estate to defer recognition
of their capital gains via qualified exchange, but the gains ultimately
are taxable whenever the property is sold for cash. Section 121,
on the other hand, is more generous: It allows qualified sellers
to pocket all their cash gains tax-free, up to the $250,000/$500,000
limits, as often as once every two years.
some savvy investment property owners, the name of the game has
become: How can I move my deferred Section 1031 exchange gains
into Section 121 territory, where gains (up to the $500,000 limit)
are potentially tax-free.
illustrate, say you've owned a small office or apartment building
for years and face substantial capital gains taxes (appreciation
plus depreciation recapture) if you sell outright. So you opt
for a Section 1031 exchange. But why not sweeten the pot by exchanging
your investment property for real estate that has the potential
to be converted into an owner-occupied principal residence? One
way to do this: Swap your investment real estate for, say, a luxury
rental villa at a golf resort community.
you've acquired the rental villa, you convert it to principal
residence use by living in it for a couple of years. By the way,
under IRS rules, that doesn't even mean you're required to be
a full-time resident of the villa. You just have to live there
a majority of the time during each tax year, and transfer your
drivers license, banking and other indices of principal residence
location as established by the IRS.
you've owned and used the villa for two years -- at least under
the old loophole -- you'd qualify for the tax-free exclusions
under Section121. Voila! Your formerly taxable investment property
gains would be transformed by alchemy into non-taxable gains --
up to half a million dollars -- and you could sell the villa with
limited or no tax exposure, depending on the amount of gain deferred
via the earlier 1031 exchange.
for the new law: It narrows the loophole. It doesn't prohibit
such tax-driven conversions outright, but it does require exchange
property acquirers to own and use the real estate as their principal
residences for five years, instead of the usual two years.
experts say the law could have been much worse. "There's
a silver lining here," says Michael Phillips, a partner in
the San Francisco law firm of Rocca and Phillips and vice president
of Pacific Realty Exchange Inc. "By implication, the bill
confirms that you can do" conversions of exchange-acquired
investment real estate and subsequently use Section 121 to exclude
some or part of the gains.
a practical matter," says Phillips, "it's not all that
November 1, 2004
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