How to pay no taxes on the sale of investment and owner occupied
properties
By David P. Greenberger, Esq.
Taxpayers are earning record gains on both their investment real
estate and personal residence, which means potential record taxes.
But did you know you can avoid all taxes on sale through creatively
combining Internal Revenue Code (IRC) Sections 1031 and 121?
When you both live in and hold a property for investment, such as
living in one of the units in an apartment building you own, or occasionally
using a vacation home you rent out, or living in a residence that
sits of land held for investment, you may qualify for two tax breaks
under IRC Section 121 and also Section 1031.
Many people are familiar with IRC Section 121 which allows an individual
a $250,000.00gain exclusion ($500,000.000 if you are married filing
jointly) on the sale of your principal residence. The property
must have been your residence for at least two (2) years out of
the past five (5) year period. The period begins on the date of the
sale of the property. But what many people do not know is that one
can combine section 121 with section 1031 in a transaction, and utilize
section 1031 on the same transaction for the portion of the property
the taxpayer is not living in. Suppose a couple lives in one unit
in a multi family building and uses section 1031 to exchange the
portion of the property in which they do not reside. In this way,
the unit they reside in is sheltered up to $500,000 in gain, and
the remainder of the building is valued and exchanged as investment
property under section 1031.
How do you divide the value between your residence and your investment
property? This calculation may be based on the square footage, or
you may use any appraisal which has been conducted for the unit one
is living in and calculate the difference from the sales price for
the investment part of the property.
How is the exchange/transaction conducted? The closing agent should
prepare two closing statements, one for the value and adjustments
relative to the personal residence, and one for the remainder of
the property. The exchange accommodator will prepare exchange documents
which describe only that portion of the property that is being exchanged.
When the monies are disbursed at closing, the funds that relate
to the personal residence portion of the property are disbursed
directly to the taxpayer. The remainder of the funds are disbursed
to the exchange accommodator who processes the exchange. The taxpayer
reports the transaction on form 1040 schedule D for the personal
residence sale and the 1031 exchange portion of the transaction
is reported on forms 4797 and 8824. In this manner, a taxpayer who
has resided at the property while renting out the remainder of the
building can successfully avoid taxes on the gain for the entire
parcel and exchange into a new investment using tax free dollars
to purchase it.
This type of mixed use transaction need not only
be performed in a multi family unit property but can be used for
a transaction when the "non residence" portion of the property is any other kind of investment property; commercial or land. In the instance of land, an allocation issue does arise. The land which surrounds the residence can be exchanged under section 1031 and the personal residence will qualify for section 121 treatment. An appraisal should be done and the value of the residence should be sectioned out of the value of the adjoining land.
What about a vacation home qualifying for 1031 treatment? In most
cases, homes that are exclusively used for vacation residences will
not qualify for treatment under section 1031. There is no specific
formula to use and cases of "incidental use" have been permissible. If one were to look to section 280a which doesn't
specifically deal with 1031 matters but talks about the deductibility of losses
on vacation homes the rules are more straightforward. They say 14 days per year
or 10% of the time the property is rented throughout the year may be dedicated
to personal use. There are no straight forward rules for vacation homes and section
1031; however, one can extrapolate that if property were held for personal use
and then rented over a period of time, at least for a few years before doing
an exchange one would be able to exchange it as property which has been used
primarily for rental/investment.
The clear victory comes when the taxpayer who resides in a mixed
use property takes advantage of section 121 and 1031 to remove all
taxes on gains and diversify into other properties. Clearly, living
in a property that appreciates and does not present you with a tax
bill when you leave makes for a very welcomed stay.
David P. Greenberger,
Esq. is General Counsel of the licensed and bonded accommodation
firm 1031 Exchange Advantage, Inc., and provides no-charge 1031
exchange guidance to Creative Real Estate Magazine readers through
www.1031ExchangeAdvantage.com or toll-free at 866-944-1031
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