New
Tax Bill Narrows A Popular Section 1031 Exchange/Capital
Gains Loophole
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.
Buried 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.
Section 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.
The 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.
Why? 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 five years.
Section 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.
For 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.
To 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.
Once 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.
Once 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.
Now 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.
Exchange 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.
"As a practical matter," says Phillips, "it's
not all that bad."
Published: November 1, 2004
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