In the first post about 1031 Exchanges and rental properties, we discussed the secondary residence.
But what about savings on capital gains on your primary residence? This post talks about combining the 1031 Exchange with an IRS section 121 primary residence exemption of $500K/$250K for married/single filers. That’s the most interesting use case, in my opinion, and one that many of us are interested in.
So how can equity be removed from a primary residence paying the least amount of taxes? First and foremost, your primary residence must become a rental for 2 years. This isn’t an area to play fast and loose with the IRS. To take advantage of the 1031 Exchange in this scenario, you cannot live in the property for 2 years, you must have real renters, and you must declare the income from those renters on your taxes.
After 2 years of rental history, you can sell the property and roll the proceeds into another property, multiple properties or land. You will still have an IRS code 121 $500K capital gains exclusion for married couples and $250K for singles on the sale of this property since it was your primary residence for 2 of the last 5 years. You can take that $500K to do whatever you wish, without paying capital gains taxes, as long as the leftover proceeds are used to purchase more investment property.
Let’s go through an example. First, we’ll start with a basic primary residence sale, not a 1031 Exchange. Say you and your spouse bought a primary residence for $800K and over time it’s now worth $3M, lucky you, you probably live in the Bay Area! For simplicity, let’s assume that no improvements were made. If you were to sell it outright, here’s how it would look: After subtracting your purchase price, closing costs, and your primary residence capital gains exclusion, you still end up with a significant taxable gain:
Sales Price of Home without 1031 Ex $3,000,000
Original Purchase Price 800,000
Closing Costs (5% est) 150,000
Cap Gains Exclusion of Primary Residence 500,000
Taxable Gain 1,550,000
(assuming 33% combined CA state and federal tax rates)
Tax Due $511,500
Now, let’s look at this example if we use a 1031 Exchange. If the property is legitimately rented out for two years before the sale, you can still take the Section 121 500K primary residence exemption, but now you must roll the remaining $2,500,000 into another (or multiple) rental properties to defer the capital gains tax.
If you want to do a 1031 Exchange of a home that was a primary residence, you cannot subtract the original cost of the house or any improvements.
Sales Price of Home with 1031 Ex $3,000,000
Original Purchase Price Not Applicable in 1031
Cap Gains Exclusion of Primary Residence 500,000
Gain for further investment property 2,500,000
Taxable Gain $0
So now you have 2.5 M to invest in “like kind” properties and you decide to buy two properties, one for 1M and another for 1.5 M, and rent them both out. After two years, you can move into one of these properties and use it as your primary residence. You can decide to stay in the home as long as you like or sell again after two more years, once again taking advantage of IRS section 121 to claim a primary residence deduction of 250K/500k. There is a little more complexity here, but for this example I’ve tried to keep it simple. Since you’re holding for a shorter amount of time, most likely your appreciation will be much lower, possibly less than the $250K/$500K primary residence exemption so you may be able to sell without much tax burden, if any.
Remember, if you keep the properties until you pass away, they go to your heirs at the stepped-up basis of the current market value at the time of death, and the previous capital gains deferments are no longer due.
If you want to talk in more detail about exchanges or would like the recommendation of a reputable 1031 Exchange firm, please give me a call. I love talking about this stuff!
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Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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