Q: I purchased a two family rental property for $55,000 about four years ago. I put about $65,000 into remodeling and repairing the building. It has produced excellent rental income and with the improvements to the neighborhood and the real estate market in general, I find that I can now sell this property for about $300,000.

While I know that there are adjustments for commissions paid to Realtors, and recaptures for deductions taken on previous tax returns, my question is this: What is a suitable 1031 exchange? I purchased the property when I was single and am now married. Can I sell this property and invest in a property my husband and I might like to retire to in the future? Are we required to rent out the new property until we retire (approximately 5 - 10 years)?

If we are, in fact, able to purchase our dream retirement home, what happens when it becomes our primary residence? If we retired to the home and lived there for 5 years, would we be exempt from capital gains up to $250,000 as our primary residence?

Julie H.
Maplewood, NJ

A: Ahh, the Section 1031 Exchange (also known as the Starker Exchange). This is a great tool for real estate investors to defer capital gains taxes and keep expanding their equity in real estate at the same time.

One of the good things about real estate investing is that you don’t have to pay on your gain until you finally sell the property AND take the money. However, investors can delay that tax day by exchanging the property for another property that is the same value or higher.

Simply put, you have the opportunity to take the equity that has grown in your investment property and place it into a second replacement property that may have a higher level of appreciation, thus allowing your wealth to grow even faster or greater. It’s kind of like a rollover for real estate investors.

A suitable exchange would be any property or properties that are of the same value as your $300,000 duplex. The like-kind requirement only means that it’s the same type of property, i.e., real estate for real estate, trucks for trucks. You could sell your duplex and buy four condos or one single-family home, if you so desire.

Keep in mind that you cannot take any of the proceeds from the sale or even have access to them in between the transactions and the replacement property or properties must be identified within 45 days. So, get your ducks lined up before moving forward.

In addition, you need to hire a qualified intermediary who will facilitate the exchange. This person will help you move the funds from the first property to the second property and it CANNOT be any of the following people: “your agent at the time of the transaction, employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period before the transfer of property you give up,” according to IRS Publication 544: Sales and Other Dispositions of Assets. The person cannot be related to you, either.

You may, indeed, purchase your dream vacation home for your future primary residence and hold it as an investment property (recommended at least 1 year) before moving into it as your primary residence. My research shows that once you’ve moved into the property and lived there for two years, it then converts over to your primary residence and thus you may reduce your gain again by the basis of the property, expenses of selling the house, and then take your exclusion -- $250,000 for single filers, $500,000 for married, joint filers. So far the IRS has not closed this loophole, but keep your legal eyes open for it in the future.

Resources:

Here’s a very good article on the Starker Exchange from the California Society of Certified Public Accountants: www.calcpa.org/consumers/ask/2000/01.01.html

As usual, the Internal Revenue Service also has plenty of information about Section 1031 Exchanges.

Published: August 8, 2003

Use of this article without permission is a violation of federal copyright laws.