In our continuing effort to help investors understand the rules of 1031 exchanges, we present two more common myths. Avoiding these myths and misconceptions will allow investors to maxmimize the return on their investments by reducing the amount of taxes they pay.
Myth No. 9
I only have to reinvest my gain. Or, I only have to reinvest my cash proceeds.
If Alexandra and I have heard this once, we have heard it a million times. The general rule of 1031 exchanges is that the exchanger must buy a replacement property that is equal to or greater in value than the relinquished property. The 1031 rules require the exchanger to reinvest their adjusted sales price, not just their gain or cash equity. The reason is because Section 1031 requires an exchanger to receive like-kind property. Luckily, all United States real estate is like-kind to all other United States real estate, regardless of the type or grade. Non-like kind property (called boot) typically consists of cash or debt relief. To the extent that an exchanger trades down in value (i.e. buys a replacement property of less value than the relinquished property), than the exchanger receives boot, in the form of cash or debt relief equal to the amount of the trade down. Net boot received will always be taxed, to the extent of the taxpayer’s gain. However, often times, paying some tax is better than paying all the tax if no exchange is completed.
So, the easy rule to remember is for the exchanger to buy a replacement property or properties of equal or great value than their relinquished property or properties. The good news, though, is that once these rules are understood, the exchanger realizes that he or she can trade down in value a little without blowing up the whole exchange. Instead, a small amount of gain is recognized, while the balance of the gain is deferred. Thus, the 1031 transaction is still worth doing. To learn more about partially tax-deferred exchanges or taking some cash at the closing, please click here.
Myth No. 10
I can exchange my primary residence tax-free under section 1031.
A primary residence does not qualify under section 1031. In order for a property to qualify under section 1031, the property must be held for the productive use in a trade or business or held for investment. Under these rules, a primary residence is held for personal use, therefore it is not deemed to be held for investment. Thus, a primary residence generally does not qualify under Section 1031.
However, Section 121 provides for gain exclusion on the sale of a principal residence, if certain criteria are met. If these criteria are satisfied, up to $250,000 of gain may be excluded (up to $500,000 for joint returns). The basic rule of section 121 requires that the seller own and occupy the property as a primary residence for at least 2 out of the previous 5 years. However, if the property was acquired as part of a previous 1031 exchange (and the taxpayer converted it from a rental property to their primary residence), than the taxpayer must own the property for 5 years and live there as a primary residence for at least 2 out of the 5 years before they may be eligible for the 121 exclusion. Furthermore, effective January 1, 2009, an amendment to the 121 exclusion will affect the amount of gain exclusion allowed for primary residences with a rental history (AKA “non-qualifying use”). In the event that the gain exceeds this exclusion amount, capital gain must be recognized and cannot be deferred even if a replacement primary residence is purchased. If you are interested in learning more about the tax consequences of the sale of your home, you should consult an experienced tax attorney or CPA to learn more about section 121. It is especially important to consult with your tax advisor if your primary residence has or had an investment or business-use component (i.e. a home office or rental unit). Certain combination or consecutive use properties may allow for the combination of section 121 and section 1031, thereby maximizing the potential tax exclusion and deferral.
So, even for those lucky homeowners who say “…but my home is the best investment I ever made,” I say, “That may be true, but generally, it does not qualify under section 1031.” We continue dispelling as many 1031 myths as we can. Stay tuned for more 1031 myths in the near future; or call us toll free at 877-395-1031 or contact Alexandra L. Hart by e-mail at ahart@allstates1031.com.
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