Planning for a retirement or second home using a 1031 Tax Deferred Exchange - by Brendan Greene

Brendan Greene, Greater Boston Exchange Company, LLC

Thinking of selling a multi-family or other investment property and buying a retirement home or a second home on Cape Cod or in Florida? With a little planning, you could be retiring to a home in a destination of your choice by deferring and/or excluding most of your capital gains taxes. You could have more buying power if you were to perform a 1031 tax-deferred exchange.

Internal Revenue Code (IRC) Section 1031 allows a property owner, who holds property for “the productive use in a trade or business or for investment”, to defer paying any capital gains taxes if such property owner, in accordance with the provisions and requirements of Section 1031, sells such property, identifies like kind property within forty-five days of the sale, and acquires other like kind property within one hundred eighty days of the sale.

Like kind property includes all real estate; that is, all real estate may be considered “like kind” to any other type of real estate. The important issue is how the property is being used. If both the relinquished property and the replacement property are used for investment or business purposes, then a three family rental property may be exchanged for a single or multi-family home on Cape Cod, in Florida or both. However, the Cape Cod or Florida home would need to be held for use in a business or for investment (i.e. rented) for a period of at least two weeks a year for two years in order to qualify for tax deferral treatment, and personal use of the property should be limited to no more than the greater of fourteen days or ten percent of the number of days that the property is rented.

After establishing the new Cape Cod or Florida home as an investment property, it can later be converted into a vacation home or a retirement home. There is no bright line rule which provides a specific time that an investor must hold and treat the replacement property as investment property before converting the property to a personal residence or vacation home. However, the IRS issued a safe harbor ruling in Revenue Procedure 2008-16 which states that a replacement property will be recognized as investment property as long as (1) the taxpayer owns the property for at least twenty-four months and rents the property for at least fourteen days for a fair market rental value in each twelve month period, and (2) the taxpayer’s personal use is limited to the greater of fourteen days or ten percent of the amount of time the property is rented during a twelve month period.

An added benefit is that once the Cape Cod or Florida property has been converted to a principal residence, IRC Section 121 allows a taxpayer to exclude up to $250,000.00 of gain ($500,000.00 if married and filing jointly) from the sale or exchange of a principal residence, provided the principal residence must have been owned and used as such for an aggregate of two or more years during a five year period ending on the date of the sale, subject to some limitations.

The limitations are as follows: (1) taxpayer must hold the property for at least five years and (2) the exclusion does not apply to the portion of the gain where the property was not used as a principal residence. For example, if a property is acquired in a 1031 exchange, and the property is rented out for two years, then the taxpayer lives in the property for 3 years prior to selling, then 3/5ths of the gain is eligible for the exclusion.

There are many technical tax and legal rules that must be followed in order to achieve tax deferral treatment under Section 1031. One important rule is that the seller of investment or business property must not have actual or constructive receipt of the sale proceeds. To avoid such a problem, most 1031 tax-deferred exchanges involve a “Qualified Intermediary”. The Qualified Intermediary holds the sale proceeds until a replacement property is purchased and provides the proper documentation to preserve the integrity of the exchange.

In summary, with proper tax planning, 1031 tax-deferred exchanges provide investors with great opportunities to diversify, consolidate, or rearrange their real estate holdings and defer paying capital gains taxes.

Brendan Greene, Esq., is a parter in the law firm McCue, Lee & Greene, LLP and a principal in Greater Boston Exchange Company, LLC, Boston, Mass.