Law Clarifies Strategy




You can stack personal residence exemption on top of a 1031 exchange


 A little-noticed provision of last October’s American Jobs Creation Act clarified that you can combine two unrelated real estate tax shelters.  That can lead to big tax savings.


 But the law set up a strict timeline for doing so.


 Singles already could shelter up to $250,000 in capital gains on principal residences – up to $500,000 for married couples filing jointly.


 And with so-called 1031 like-kind exchanges, you could already shelter net profit on the sale of investment property.  Now you can clearly link the two strategies into a one-two punch.


 The Jobs Act says that once you use a like-kind exchange to swap one investment property for another, you can eventually convert the second property to use as your main home.  You can use the personal residence exemption at a later date on the second property.


 The result can be zero cap-gain tax.  The catch:  You must wait five years from the time of the exchange before you sell.


 “Before, it wasn’t clear you could do this sort of thing, and if so how soon,” said Bernie Kent, tax partner for PricewaterhouseCoopers.  “The clarification is like a new rule.”


 Here’s how it works.  Let’s say you and your wife buy a second home.  To help us keep track, let’s say it is blue.  You pay $250,000.  You rent it out to tenants.  Each year, you depreciate $6,000.



Suppose the real estate market stays hot.  Three years later you sell the blue house for $400,000.  Normally you’d owe tax at 25% of your $18,000 total depreciation.  You’d also owe a 15% federal tax on your long-term gain of $150,000.




Legal Loophole




You can avoid those taxes.  Because the house is investment property, not where you live, you can do a like-kind exchange.  Also known as a 1031 exchange, for the section of the tax code that governs them, this maneuver also typically exempts you from state income tax.


 To qualify, within 45 days from when you close the sale of the blue rental house you must fine replacement property in the U.S.


 It must also be used as investment property.  And you must close on the follow-up deal within 180 days of finalizing the rental-house sale.


 The new house’s value must equal or top the blue houses.  We’ll call this new one the red house.  Your purchase price is say $450,000.  Your basis is $282,000.  That’s the sum of a couple of things:


  • $232,000 for the first home’s $250,000 purchase price, minus $18,000 depreciation.
  • $50,000, the difference between the first home’s sale price and the second home’s purchase price.


 Since it costs more than the blue house, you’d rely on the like-kind exchange rules to avoid taxation.


 What if this red home cost less than the blue house’s $400,000 sales tag?  Suppose you paid only $380,000.  You could not pocket the difference scot-free.  You wouldn’t be taxed on the $150,000 gain plus $18,000 depreciation recapture on the blue house.  But you would be taxed on the $20,000 difference between the blue house’s sale price and the red house’s purchase cost.


 People often find 1031 rules confusing.  Despite its name, a “like-kind” exchange doesn’t mean the old and new properties must be similar.  “Any type of investment real estate qualifies,” said Duke Runnels, president of Fort Properties in Los Angeles.  “You can exchange a ranch home for an office building or apartment complex.  The definition is broad.  But there are limits.  You can’t exchange it for an airplane or a boat, for example.”


 So you must rent out this new home to tenants too.  “There’s no hard-and-fast rule for how long you must do that,” Kent said.  “The rule of thumb is you must rent it at least one to two years.”


 How soon can you sell it, using the personal-residence cap-gain exemption?  Five years after you bought the red house in a like-kind exchange.  First you must live in the red house at least tow of the past five years.


 Reaching Your Goal


 One way to reach your goal would be to keep your tenants for three years.  Then you’d live in the house for two years.  That would bring you to five-year post-exchange requirement.  After that, you could sell this place.  Suppose you do, for $550,000.  Thanks largely to a higher land value; your yearly depreciation on this new home is just $5,000.  Your depreciation would total $15,000, cutting your basis to $267,000.


 That’s well within the $500,000 exemption for married couples, so your gain is tax-free.  If you were single, $33,000 would be taxable because your exemption would be only $250,000.