I had two small condo which I plan to sell and use the profit in a 1031 exchange into a house for my family. Now if I live there for 2 years and then decide to sell the house, would I still have to pay taxes on the profit? I know that any profit you use to finance another property in a 1031 exchange still must be paid when you sell that 2nd property. But what if I use that 2nd property as my primary residence for 2 years? Wouldn’t the laws allow me to keep up to 250k of profit without tax?
Under the 1031 rules, the replacment property in your exchange can not be your primary residence.
Your replacement property should be “intended” to be investment property. The 1031 Exchange allows you to defer taxes to build wealth through investment like-kind properties. But there are exit strategies that I know have worked where the replacement property, which was “intended” as an investment became the primary residence of the investor. Once this is done, the property would fit the 2 out of 5 rule.
If you haven’t noticed, INTENT is the keyword here. If the IRS can prove that you intended to move into your replacement property then your 1031 could be nullified and you would be held fully taxable at cap gains rate. If not then you’re safe. Any Qualified Intermediary will tell you to speak with your CPA and let them know what you’re trying to do and what your tax advantages would be.
REIMan does not give you the whole story.
The replacement property in a 1031 exchange must be USED for a qualified investment purpose to validate the exchange. The current guidance is one year of investment use before converting your investment property to your primary residence. Less than one year of investment use before conversion suggests to the IRS that your intent was tax avoidance and not a valid investment purpose for the exchange.
At least one year of use as an investment rental would validate the exchange, and allow you to convert the rental to your primary residence. However, to qualify for the capital gains exclusion, you must cccupy the property at least two years as your primary residence AND own the property a total of five years prior to the sale.
The basis in the property will be your adjusted cost basis in the relinquished properties in your 1031 exchange further adjusted for the depreciation allowed while the replacement property was a rental. Even though the capital gains exclusion will shelter the first $250K of profit from appreciation (per taxpayer), the profit from depreciation will still be recaptured at 25%.
If you sell before five years of ownership, then your profits will be fully taxable as capital gains and unrecaptured depreciation will still be taxed.
This five year ownership rule for your primary residence is a special exception to the two year ownership rule that only applies when your primary residence is originally acquired in a 1031 exchange.
Great answers guys… you have to be accomodators! ;D
Usually the people I go to for the tricky topics…
Thank you for the kind words.
No, I am not an accomodator, just an investor with a few exchanges under my belt. If fact, I find that many professional 1031 exchange companies don’t always get the details correct. For example, on your own website, you state that one requirement for a successful exchange is to “replace debt and equity from your sale”. For a delayed exchange, there is no requirement to replace debt. I can use all my own cash to supplement the exchange proceeds resulting in a free and clear replacement property, and still have a valid exchange .
Rather than searching for a professional exchange company, I just use the trust department at my local bank as my qualified intermediary. Since I use direct deeding, I don’t need the intermediary to do anything more than serve as escrow agent holding my exchange proceeds.
I agree with you when it comes to exchange details… there are many misconceptions… and confusing ins and outs…
I always thought that equity & debt replacement was a requirement. In fact, on the Federation of Exchange Accomadators faq, about a 1/3rd of the way down… they address debt replacement.
Are you able to get around this because of the direct deeding? Or is the FEA being to general about this being a requirement.
I don’t know; this is what I’m getting on the subject of “debt reduction boot”
Debt reduction boot which occurs when a taxpayer’s debt on replacement property is less than the debt which was on the exchange property. As is the case with cash boot, debt reduction boot can occur when a taxpayer is "Trading down" in the exchange.
Hope it’s not the case man…
You are applying the FEA comments too broadly.
Mortgage boot, or debt relief, only comes into play in a direct exchange. I trade my property for your property and each of us assumes the other’s debt – is a direct exchange for which no intermediary is required. We only have a potential tax consequence due to mortgage boot in this one exchange instance.
I would venture to say that direct exchanges are extremely rare for the investors participating in these forums. Instead, for the residential dwelling properties where an exchange is needed to defer capital gains, the delayed exchange (Starker Exchange) is the most flexible. A delayed exchange (often called a forward exchange) allows us to “sell” our relinquished property to one party and to “purchase” our replacement property from yet a third party at a later date. There is no direct exchange of property for property, but rather a sale and purchase take place under an exchange umbrella.
When I sell my relinquished property, I must transfer clear title. This means than any underlying mortgage is paid off from the sale proceeds, then whatever is left over is deposited with a qualified intermediary. Since the mortgage on the relinquished property is paid in full at settlement, there is no debt relief to be gained.
Hence, for a delayed exchange, only two general rules must be met for a valid exchange.
The value of the like-kind replacement property must equal or exceed the value of the relinquished investment or business use property, and,All of the exchange funds must be applied to the acquisition of the replacement property.
Now, if I wish, I can bring cash, new debt, or both to the settlement table to complete the replacement property acquisition – but, there is no requirement that I have any new debt, nor any requirement that new debt must equal or exceed the amount of old debt.
As long as I have satisfied the two general rules, I still have a valid exchange. Of course, breaking any of the specific rules governing the exchange timeline, use of a qualified intermediary, constructive receipt of funds, use of the property, and required documentation could cause the exchange to fail.
If you now see that there is no debt relief involved in a forward (delayed) exchange, you can also see how I can make the same argument for a reverse exchange and for an improvement (construction) exchange. So, for four different exchange situations, the debt relief issue only comes into play for one of them – the direct exchange (sometimes called a simultaneous exchange).
I did not overlook cash boot, but since cash boot can occur in any of the exchange situations, I did not want to cloud the discussion. My point is specific to mortgage boot (debt relief) only.
Direct deeding avoids assignment of contracts to the intermediary as well as conveyance and reconveyance of deeds between the intermediary and the parties to the exchange.
Hope this clears up the question.
I see what you are saying… and agree, let’s keep the subject to delayed exchanges… 5 yrs of commercial, and I never saw and probably will never see a direct exchange… esoteric for real estate in general, not just this forum…
Specifically, it’s an interesting point, and I understand what you are saying that if you keep the replacement property the same value or greater… it does not matter if you replace the debt from your exchange or if you are using proceeds out of pocket…
I’ll have to do some digging, and understand you.
It’s a very cool point.
I’d be curious to see what an accomodator has to say here, but it would seem that when you close on a property with debt… and do not replace the debt at the time of close on the purchase of a replacement property that this is Debt Reduction Boot.
Essentially, through debt relief, you are decreasing net cash available for investment… which does make sense. The purpose of a 1031 exchange(delayed or simultaneous) is to maintain investment activity/levels, debt relief would decrease investment levels.
From what I’ve read about boot netting rules, cash in your pocket is not like-kind to mortgage debt. By not replacing debt from time of sale to time of purchase, you may have inadvertently had a taxable event.
I looked for a definitive resource, and short of the IRS decisions, I was unable to find any to attach here. But, debt replacement is, at least generally, mentioned on 1,000’s of exchange sites… why would they mention it if it was not a ‘typical’ requirement…
We are definitely on a fringe exchange point… not many investors choose to decrease their leverage or have the resources like yourself to do so.
If you have a resource that says otherwise, I’d be interested… great topic though… this is a very respectable forum…
Here is where you and I diverge.
First, there is no debt relief in a delayed exchange. If you and I swap properties (a direct exchange), you assume my mortgage, and, I assume yours then your assumption has relieved me from liability for my mortgage. If the amount of debt I assume on your property is less than the amount of debt you have assumed on my property, then the exchange has given me a reduction in the amount of debt for which I am liable. In this instance, the net debt reduction is my debt relief and is taxable to me as mortgage boot.
In the delayed exchange, I am not getting any portion of debt on the relinquished property forgiven. Instead, the entire mortgage balance is paid off at settlement, thus there is no debt to gain relief from.
Secondly, even though the mortgage has been paid from the proceeds of the sale, there is no decrease in investment levels. Remember that the value of the replacement property must equal or exceed the value of the relinquished property for a valid exchange.
Example. Let’s say I have a $100K property with a $25K mortgage balance that will be the relinquished property in a 1031 exchange. Ignoring closing costs and exchange fees, let’s say I have $75K in my exchange escrow account after I settle on this property. I have identified a $200K replacement property that I can get for $125K provided I make a sizable, non-refundable earnest money deposit of $50K. I do this, taking $50K out of pocket when the contract is ratified. To complete the exchange, my escrow agent empties the exchange escrow account and deposits $75K with the settlement attorney. After settlement, I now own the replacement property free and clear.
Even though paying off the mortgage on the relinquished property reduced the exchange funds to only $75K, the value of the replacement property was still greater than the relinquished property, AND, all the exchange funds were applied to the replacement property acquisition. My exchange is intact – there is no reduction in investment level.
that was my head exploding
OK, Mark, I will stop. This horse is already dead.
lol… I just think that it’s scarry that we made Data’s head pop…
and I was just getting some coffee in…
This is not to beat a dead horse… :
Dave is correct.
What good is it having a resource center if you can’t go to people for advice? Shot out a few emails and…
They agreed that if you replace debt with cash (investment for investment), therefore, there is not debt reduction boot.
Apologize, this was past my peter point… wanted to set it right.
mcwagner… hope that this doesn’t make your head explode again…
Pbbbbttttthtt (think the noise a balloon makes when you let it go)
exploded and deflated.
Dave is right on the money. You can replace debt with cash. One of the examples contained in Section 1.1031 of the Department of the Treasury Regulations actually covers this.