Understanding What Code Applies to Your Sale
Although IRC Sections 121, 1033 and 1031 all allow or the deferment of capital gain on property, the code sections operate and impact the taxpayer differently. IRC 1031 may provide more flexibility on the type of replacement property that can be acquired while IRC 1033 offers more flexibility on time constraints and receipt of funds.. so what is your sale considered?
Typically, we’re looking at sales falling under section 121 or 1031. Section 121 replaced section 1034 in the late 1990s, which was a great thing. Instead of the old rule, which was a one-time, lifetime exclusion if you’re 55 or older of $125,000 in gain, the new rule said if you lived in a home for an aggregate of two out of the preceding five years, you get a quarter million individually or a married couple would get a half million dollars.
In the late 1990s that was very attractive value wise, but 20-plus years later, those exclusion numbers don’t do much for a lot of people. I would argue a lot of times that the old 1034 rollover where you sold a home and you had two years to buy a new home of equal or greater value is actually more attractive for people. But it’s gone so we have to look at a sale and understand maybe what it is and what you want it to be. Section 121 applies to any property that’s been used as your primary residence for two out of the preceding five years. It doesn’t mean it’s being used as such at the time of disposition. So you could move out of a home, sell it, and within three years of moving out you can still take that exclusion.
Think of a situation where you’ve got gains on that home well beyond the $250,00 or $500,000: What can you do? Well, move out of it. Establish it as an investment property, go buy a new home, move into it. And now you’re seasoning—the old home is now converted into investment property and after the appropriate period of time you then could use 1031, take the exchange, and you’d still be entitled, as long as you sold it within three years of moving out, to take that exclusion number.
What Do You Want the Property to Be?
You have to ask what you really want the property to be. You want it to be a home, section 121, 1031? Maybe the home’s both. Imagine a home with an issue or an opportunity or a situation that comes up that people don’t think about is, let’s say you work out of your home, a lot of people do today, and your financial people say, “Hey look, let’s treat the home office as a home office.” You start taking depreciation on it and everything and then a couple of years later you go to sell it. Well, what are you selling? You’re selling your home. You thought it was all section 121 but that home office is actually investment property and might need to be treated as a 1031.
A more obvious example might be a duplex that’s half owner occupied and half non-owner occupied. Another example is a farm with a farmhouse and working land, allocations in two different directions. So we can have a sale that could be 121, 1031, or a situation where it could be both. What happens if the government comes in with eminent domain, takes and condemns property? Well, that’s 1033, and we’ve got a different set of rules there. You’ve got to look at that.
What else could happen? Maybe you’ve got a piece of investment property. Define property held for investment. What does that mean? How long does that mean? A court case a few years ago deemed four months long enough. I wouldn’t be comfortable with that, but typically I’m going to say a year based upon a couple of different factors. Ultimately, it’s up to you and your tax people to decide how long is long enough and you want to have this conversation well in advance of April 15.
The important thing is to understand that there are a variety of tools out there. There are a variety of tax codes to use and there are situations where you can combine them and use allocations to your advantage. It all comes down to good, competent tax people. You want tax people that you’re going to be working with year in, year out. They’re going to give you a lot of opportunities.
Lots of people want to flip properties; there’s dealer status. We’ve all heard the ads on the radio, seen them on T.V. Well, some people might argue that a flip is an investment property, but it’s not. Flips are known as dealer properties, property help for resale. You’re going to pay normal income tax on that. One thing to consider if you don’t want to give away all of your profit is instead of buying and flipping the property, do a modified flip. Maybe you buy it, fix it up, and rent it for a period of time. Maybe you pull money out, do a cash-out refi, season the property as an investment for a couple of years, and then do an exchange out of it. The money you got from the cash-out refi really would be representative of what you would net after paying taxes, but you still have the assets. That’s something that works very well for people.
Have questions or concerns? Call Equity Advantage at 503-635-1031 to get started!
