I’m about to sell an investment property and I’d like to use the proceeds to buy another property and defer capital gains tax with a 1031 exchange. I plan to build a house on the new property over the course of a year and use the property for commercial agriculture at the same time. After a year I may move into the house built on the property. From the website for the Professional Trade Association for Qualified Intermediaries (http://www.1031.org/about1031/faq.htm):
"Q - Can the replacement property eventually be converted to the taxpayer’s primary residence or a vacation home?
Yes, but the holding requirements of Section 1031 must be met prior to changing the primary use of the property. The IRS has no specific regulations on holding periods. However, many experts feel that to be on the safe side, the taxpayer should hold the replacement property for a proper use for a period of at least one year."
However, I just spoke to a CPA who says this plan won’t work if I move into the house built on the property after a year because it won’t pass the “smell test”. Furthermore, he says I won’t be able to defer all of the taxes unless I spend all of the sale price of the old property on the new property regardless of my basis in the old property. I don’t understand how that can be.
I told him I thought I should talk to a 1031 Qualified Intermediary and he told me they aren’t qualified to give tax advice and I would be stuck with an unexpected tax bill after going through the 1031 process with them.
In order to qualify for a 1031 Exchange, the Relinquished and the Replacement Properties must both have been acquired and “held for” investment or for use in a trade or business. The amount of time that the property must be “held for” use in a trade or business is not specified in either the Code or the Regulations.
The position of the IRS has been that if a taxpayer’s property was acquired immediately before an exchange, or if the Replacement Property is disposed of immediately after an exchange, it was not held for the required purpose and the “held for” requirement was not met.
There is no safe harbor holding period for complying with the “held for” requirement. The IRS interprets compliance based on their view of the taxpayer’s intent. Intent is demonstrated by facts and circumstances
The IRS has ruled that two years was adequate in a private letter ruling (Ltr Rul 8429039) but this was not made mandatory. In any event, the burden is on the taxpayer to support compliance with the “held for productive use in investment or a trade or business” requirement.
So you might be ok if you held it as a rental for TWO years.
HOWEVER, if your plan is to convert the rental so you can avoid cap gains completely by using the residence exclusion, be aware:
A 2004 change to the law now states that an Investor who performs an IRC §1031 tax deferred exchange into a Replacement Property that is later converted to the Investor’s principal residence is not allowed to exclude gain under the principal residence exclusion rules of IRC §121 unless the sale occurs at least five years after the closing date of the Replacement Property purchase. The actual provision reads as follows:
Sec. 840. Recognition of gain from the sale of a principal residence acquired in a like-kind exchange within 5 years of sale. (10) PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE – If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property.
So rent for two, then residence for at least 3 more.
Thank you mcwagner. Your post was extremely helpful.
I’m confused why my CPA told me that I must use all of the proceeds from the sale of the old property to buy the new property in order to defer all capital gains tax, regardless of the cost basis of the old property. Can you explain why that is?
basis carries over to the new property, so is not a factor in taxability of the transaction (in most cases).
the market value of the property you get must equal or exceed the market value of the property you give. market value. no basis involved.
If there is no gain in market value then there is nothing to tax, no cash that can be taken out and there is no need for the 1031 exchange, right?
so, ANYTHING you take out of the deal is gain. it must be. there is nothing else it can be.
If you take cash out of the deal, it will be taxable. that cash represents gains you are taking out today, as opposed to leaving in the deal as deferred gains.
there are lots of other ways you may inadvertently trigger taxes, especially when dealing with rental properties that may have cash transactions at closing (prorated rent, utility deposits, etc). this is where a good intermediary is necessary.
OK, it sounds like I’m going to have to pay up ($75k). I don’t want to be required not to move into the property for 2 years in case that doesn’t fit my circumstances when the house in finished in 9 months or so.
Even if you do your 1031 exchange as a construction exchange, the exchange window is still six months. Nine months to complete construction, even for a property that you will use for a qualified investment purpose, may in itself cause the exchange to fail.