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Applying 1031 Exchange to your Primary Residence - does it work?

Tuesday, January 12, 2021   /   by Carol Glover

Applying 1031 Exchange to your Primary Residence - does it work?

Written by Carol Glover and Dave Salzman

Many of our clients feel trapped in their homes due to the capital gains tax that would be paid upon sale.
  They are the lucky ones; they invested many years ago in a home and stayed in that home as their families grew up and out.  Now they are thinking about buying a new home that matches their new “empty nester” lifestyle or maybe their family has expanded to include adult children or parents. 

However, they see their tax advisor who gives them the bad news on the amount of taxes to be paid upon sale – even with the IRC Sec 121 Exclusion of $250,000 per resident taxpayer.  They may be advised not to sell because “Uncle Sam” will end up with a healthy percentage of their net proceeds upon sale due to capital gains taxes on equity beyond the 121 exclusion.

Now what?  There is another solution by which one can use the tax code to effectively defer the capital gains tax indefinitely, thereby avoiding a significant reduction in net worth. How?

Joining the IRC Sec. 1031 exchange with the IRC Sec. 121 exclusion, in this regard, is an effective strategy to benefit from available tax tools. 

The IRC Sec. 1031 exchange is a proven technique that allows real property investors to "defer" paying capital gain tax on investment properties when they are sold, and the equity and basis are reinvested in another income producing asset.   

The IRC Sec. 121 exclusion, on the other hand, allows homeowner resident taxpayers to exclude $250,000/$500,000 of the capital gain from taxation upon the sale of property that is used as a principal residence.

Properly done, combining the 121 exclusion and the 1031 deferral strategies allows property owners to reduce or eliminate current capital gains taxes upon the sale of a primary residence.

Understanding the interplay of the two tax codes: 

Primary Residence-121 Exclusion

IRC Sec 121-The Taxpayer Relief Act of 1997 altered the exemption amounts for capital gains on a personal residence.  A homeowner must have lived in the home to be sold for 2 of the last 5 years prior to sale. If this threshold is met, there is a $250,000 exclusion for single individuals and a $500,000 exclusion for married couples filing jointly.  For many places in the USA, this exclusion is sufficient to shelter all the capital gain from the sale of a home.  However, in the parts of the nation where properties have benefited from substantial appreciation, this good fortune can also be a limitation for those who wish to sell as the capital gains tax reduces their overall net worth, sometimes substantially!

Investment Property-1031 Exchange

IRC Sec 1031-Generally referred to as the "1031 exchange”, offers owners of income producing properties a way to defer their tax liabilities. Put simply, they can exchange a property that they have held as an investment or rental asset ("relinquished property") for a "like-kind" property held as an investment or rental property ("replacement property”). It allows them to defer or put off their income tax liabilities and Federal and State capital gains taxes in most cases.

It is worth mentioning that a property owner or investor can only use a 1031 exchange if the property has been held for investment, rental or business use. The 1031 exchange is not applicable to property held for personal use. For example, property used as a primary residence, vacation property, or a second home do not qualify. However, certain exceptions may apply.

Joining 1031 Exchange and the 121 Exclusion

With proactive and careful tax planning, one can combine the advantages of the 1031 exchange and the 121 exclusion. The result is that, on the sale of a personal residence, one can take the IRC Sec. 121 tax exclusion amounts of $250,000/$500,000 and defer the taxes due on the balance of the net equity by performing an IRC Sec 1031 exchange into an income producing property. There are multiple ways to prepare to take advantage of the combination of IRC 121/1031, and the specifics depend upon your unique situation. However, most homeowners with significant taxable equity find that using this technique upon sale of a substantially appreciated residence they accomplish the following:

1. Avoid or defer all taxes due,

2. Have the cash/borrowing power to acquire a next residence, if desired,

3. Have the cash/borrowing power to acquire an investment property,

4. And have the benefit of additional net income from the investment.

It is critically important to plan well in advance as the timing of the various sale and purchase transactions must occur within a well planned and somewhat narrow window of time to ensure these tax section requirements will be met. We can work with your tax, financial, and accounting professionals to set up your circumstances to achieve this outcome for you.

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Carol Glover is a licensed Real Estate Attorney and Broker with Engel & Voelkers.  Dave Salzman is the Broker of record for Engel & Voelkers LA- Southbay and they work with clients to create long term planning goals for their clients’ real estate portfolios.


 

Salzman Real Estate Team ENGEL & VÖLKERS • LA - South Bay
Dave Salzman
1147 Highland Ave
Manhattan Beach, CA 90266
310-871-5314
310-545-2260
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