Q:

Subject: Exchange Question

 

We are considering doing a 1031 exchange on a single family rental, which has been held for 32 years, and is owned free and clear. 

 

The idea would be to exchange this rental home for TWO single family homes, and use them as rentals (like/kind).  Then, after 3 years, move into one of the rentals and live in it for two years,  meeting the five year holding requirement & 2 year residency requirement …. Then we would sell new Rental Property #1 as a personal residence, and then move into the Rental Property #2 as a permanent residence, and live in it indefinitely.

 

Each of the newly exchanged properties would be rentals – the first one for 3 years (then move in for 2 years), for a total of 5 … and the next exchange property would be a rental for 5 years until we could meet the time requirements.

 

This is hard for me to explain, but I hope you can get a grasp of what I’m trying to do.  Trade one rental for two, and live in the two rentals (over a period of five years before moving into rental #2) so as not to pay capital gain taxes.    Would these time lines work? 

A:

That plan could work, assuming our rulers in DC don’t mess with the tax laws over the next five years to change any of the timing details, which you have correct for the laws as they stand now.

I have one very big word of caution for you.  Keep your intention to reside in one of the new rentals to yourself. Blabbing around to a lot of people that you had that plan from the beginning could jeopardize your 1031 exchange because an aggressive IRS agent could classify the house as personal at the time of the exchange.  I have seen and heard of cases where people shot themselves in the foot by bragging about plans such as yours.  All it takes is one jealous person to turn you in and you’re cooked.  The decision to move into the rental has to appear to be made long after you take ownership of it.

Other than that, it sounds as if you are looking at things creatively, which is what makes the tax game so much fun.

Good luck.

Kerry Kerstetter

Q:

Subject: Sale of home question

Hi Tax Guru,

Found your website while browsing for an answer to my question about a sale of a home I own with my parents. Here’s the situation:

Here are the circumstances:

My brother and I own a property with my parents. We are all on title as joint tenants (1/4 undivided interest to each of us and 50% undivided interest to my parents). The house was bought in 2000, my parents supplied the down and my brother and I have payed for the mortgage and taxes since. We’ve split the deductions every year between the two of us. My parents have used this as their primary residence since 2000 while my brother and I do not. We have considered it our 2nd home as we each own our own primary residence. We are now interested in selling the home and are wondering what is the best way to reduce the tax implications for everyone. I estimate the capital gains on the home to be approximately 300K.

Since my parents use it as their primary residence, would they be able to “claim” all the capital gains (300K) or do the gains have to be divided equally among the 4 owners? If it has to be divided, is there any way to get off the title so that my parents can take advantage 500K exemption without triggering gift tax consequences for my brother and I? Any suggestions on how we can either structure the title or the sale such that taxes are minimized for all parties? My parents income is low while my brother and I are in much higher brackets if we had to pay taxes.

Appreciate any insight you might have on mitigating the tax burden.

Thanks very much!

A:

This is an issue that you all really need to work on with the assistance of an experienced professional tax advisor because there are a number of ways in which it can be handled and several factors that need to be considered, such as the following.

It is obvious that your parents can qualify for the Section 121 tax free exclusion of the gain on their one half of the home’s net gain. The gain on the half that you and your bother own is a much more complicated issue.

Let me address the gifting option. You and your brother could gift your shares of the home to your parents. However, this would require you both to file gift tax returns to report it and either pay gift tax or use up part of your million dollar lifetime exclusion. Your parents would assume your cost basis in the 50% of the home they are given and would essentially be accepting full responsibility for your and your brother’s gain.

The half of the home that your parents are given will not qualify for the Section 121 tax free exclusion because the law requires the seller to both own and occupy it is their primary residence. While your parents have obviously met the occupied test, they would fail the ownership test and would thus be required to report the gain on their “new” 50% share as taxable long term capital gain (LTCG). Because they had been using all of the home for personal purposes, its sale cannot be structured as a Section 1031 like kind exchange, which is only available for business and investment property.

If you and your brother keep your share of the house, the gain is potentially taxable, depending on how you and he are classifying its ownership, which should be consistent with how you have been reporting the deductions for interest and property taxes on your 1040s.

If you have been treating the home as investment property, you can structure your disposal of your share of the home as a Section 1031 like kind exchange, which will require you to use the services of a neutral third party facilitator to reinvest the proceeds into new (to you) business or investment property within 180 days. These rules are all explained at tfec.com.

If you have been reflecting that you have been personally using the home, it will not qualify for Section 1031 and you will have a taxable LTCG.

You and your brother don’t necessarily have to report this in exactly the same way. The strategy for each of you and your brother could be different depending on your unique situations. For example, one of you may qualify for a Section 1031 exchange, while the other may not.

The actual tax hit on any taxable gain could be spread out over several years under the installment method if part or all of the sales price is carried back. Your personal professional tax advisor can show you how that would work with your numbers and sales terms.

I hope this gives you some idea of the various details that you all need to be evaluating with your personal professional tax advisors.

Good luck.

Kerry Kerstetter