December 2005
Like-kind exchanges and residential property
Intentionally or not, Congress and the IRS
have created interesting Section 1031 opportunities
To a knowledgeable
tax advisor, mixing the term “like-kind exchange” with a disposition of a
principal residence is like mixing oil and water: it just doesn’t work.
The Section 1031 like-kind exchange privileges are intended to apply to
swaps of business or investment realty, and technically do not have
application to a taxpayer’s principal or seasonal residence.
Recent
developments, though, in both federal tax legislation and an IRS
pronouncement, create some interesting opportunities. Two situations seem
particularly intriguing:
-
Exchanging a fully depreciated commercial
property into a rental residence that ultimately becomes a principal
residence.
-
Converting a highly appreciated principal
residence into rental property for subsequent exchange into other rental
property.
Conversion of
commercial property to residential. For taxpayers with highly
appreciated commercial or farm property that they would like to convert
into residential property, the following provides a roadmap.
Example: Carol owns a fully depreciated commercial building that
she wants to sell, but the 25% federal capital gain rate represents an
excessive cost. Accordingly, she arranges to dispose of the building in
a Section 1031 exchange, swapping it for a condo that she views as a
desirable retirement residence. However, to make the exchange comply
with the like-kind rules, Carol places the condo in rental status with a
property manager. After several years of rental, Carol moves into the
condo and uses it as her principal residence. Further, if Carol holds
the condo for at least five years from its acquisition in the Section
1031 exchange and has occupied the condo as her principal residence for
at least two of the five preceding years, that residence could be sold
using the tax-free exclusion, i.e., $250,000 of tax-free gain if Carol
is single or $500,000 if filing jointly.
Conversion of
residential property to rental. A recent IRS release provides guidance
on how a taxpayer might use the like-kind exchange rules to change
properties in the other direction, from residential status to rental. This
strategy may become increasingly important if urban residential property
continues to appreciate sharply, outstripping the tax-free residential
exclusion of $250,000 of gain for single taxpayers and $500,000 of gain
for joint filers.
Example: Jack, a single taxpayer, bought a luxury urban condo a
number of years ago for $300,000 and has continuously lived in that
condo as his principal residence. Today, it is worth $1,000,000, and he
wants to sell. The $250,000 principal residence exclusion for a single
filer, however, is inadequate to shelter the $700,000 gain. To defer
taxation, Jack converts his condo to rental status. After several years
of rental, he disposes of the condo using an intermediary and the
like-kind exchange rules, reinvesting in several townhouses that he
believes have better price appreciation potential. Assuming that Jack’s
disposition of the condo occurs within less than 36 months from the
point it was converted to rental status (so that he still qualifies for
the principal residence two-of-prior-five-year test), he can apply both
the $250,000 tax-free residential exclusion and the like-kind exchange
rules. Effectively, Jack has replaced his former residence with other
rental property in a tax-deferred manner. Further, after several years
of rental of the townhouses, Jack might choose to convert one into his
principal residence.
If either of these
examples or similar transactions are relevant to your situation, please
contact your Schmidt Westergard & Company professional.
Based in Mesa, Arizona, and serving closely held businesses in the East Valley,
the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is
an independent full-service tax, audit, accounting and business advisory firm
focusing on the middle market.
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