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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?

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 $250,000 exclusion per taxpayer.  They are advised not to sell because “Uncle Sam” will end up with a healthy percentage of their net proceeds upon sale.

Now what?  There is another solution by effectively use the tax code to defer the capital gains tax.

Joining 1031 exchange with the 121 exclusion, in this regard, is an effective strategy to benefit from available tax tools. 1031 exchange, under IRS Code, is a strategy that allows investors to "defer" their paying capital gain tax on investment properties when they are sold and the funds reinvested in a new income producing asset.   

The 121 exclusion, on the other hand, can help a taxpayer exclude $250,000/$500,00 of the gain from the exchange or sale of property that is used as a principal residence. Combining the exclusion and deferral strategies allow investors or property owners to maximize tax planning and deploy highly benefit strategies when seeking a new lifestyle home and buying income property. 

Understanding the interplay of the two tax codes: 

Primary Residence-121 Exclusion

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 for married couples filing jointly.  For many places in the Nation, this exclusion is sufficient to shelter all of the capital gain from the sale of a home.  However, in the parts of the nation where properties have benefited from substantial appreciate, this good fortune can be a limitation for those to which to sell and move into a new home as the capital gains reduces their overall net worth.

Investment Property- 1031 Exchange

Section 1031 of IRS (the Internal Revenue Code), 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 in most cases.

It is worth mentioning that you, as a property owner or investor, can only use 1031 exchange if you have held your property for investment or rental or business use. The tax code is not applicable to the property you have held for your personal use. For example, you cannot use your primary residence, vacation property, or second home for this purpose. However, certain exceptions may apply to this condition.

Joining 1031 Exchange and the 121 Exclusion

With proactive and careful tax planning, you can combine the advantages of the 1031 exchange and the 121 exclusion. The result is that you can take the exemption amounts of $250,000/$500,000 and defer the balance of the net equity by investing in another income producing property.  A couple of examples of putting this into action would be to sell the residence, invest the $250,000/$500,000 in a new personal residence, perhaps a condo in town or a home on a golf course.  The balance of the funds can be rolled forward to the purchase of an income property such as an apartment building or NNN investment.  This is just one example.  There are multiple ways to prepare to tax advantage of the combination of 121/1031, but after analysis many homeowners realize they are not trapped.

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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
DRE# CalBRE#: 00952732

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