Seeking a Silent Partner? I Know a Guy...

Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation.

You might be surprised to learn that Uncle Sam can become your silent partner in real estate investing. Why would you want to partner with the government? Because using your own tax dollars creates the opportunity for exponential portfolio growth.

And why is the government willing to forgo tax dollars to provide capital for your ongoing real estate investing? In short, both home ownership and real estate investing support the U.S. economy.

The capital Uncle Sam invests with you is your own tax dollars. This capital is available either tax-free or tax-deferred when you sell your home or productive investment real estate. It’s all laid out in Internal Revenue Code (IRC) Sections 121 and 1031.

To demonstrate, this article provides a summary of the provisions and a couple of scenarios.

The Partnership Agreement

To understand this opportunity, you need to familiarize yourself with how the “partnership” will work.

These are the provisions in the tax code:

Section 121 offers a primary residence tax exemption to all U.S. homeowners. You simply have to own and live in your home for two years. Then, when you sell it, you can take up to $250,000 in profit tax-free. And it’s $500,000 if you’re married. You can read up on this and financing opportunities unique to this asset in my last article.
Internal Revenue Code (IRC) 1031 lets you defer capital gains taxes when you transition from one investment property to another. Following IRS guidelines, you can roll all of your sales proceeds into your next investment tax-free.

They can work independently or together:

Section 121 and IRC 1031 can be combined if you have more than $250,000/$500,000 in profit in your primary residence. Section 121 allows you to take the tax-free portion of your profit as cash to invest without restriction. IRC 1031 lets you put all the remaining profit into a real estate investment.
IRC 1031 and Section 121 together can convert a real estate investment into your primary residence. Once you have demonstrated that your investment has been held for productive use in business or trade, its use can be changed. You must own the property for at least five years and live in it for at least two years. Then, you are allowed to receive a prorated share of the profit tax-free upon sale.

So, follow Uncle Sam’s rules and regulations and you get to keep the specified gain on your house tax-free and the rest tax-deferred. And there is your capital to reinvest, courtesy of the federal government.

Partnership in Action

Here are a couple of ways I have personally taken advantage of the combination of these provisions.

Rehab to Rental to Primary Residence

Completed 1031 exchanges out of investment properties in former home city
Among other things, purchased distressed property held for renovation and rental near new home
Renovated and placed on rental market (clearly acted on my original intent)
Eventually moved into investment property and made it my primary residence
When this property sold, a prorated portion of proceeds was sheltered from tax under section 121
Purchased a sailboat!

Vacation Rental to Primary Residence

Completed 1031 exchange out of lease-purchase property as scheduled
Lived in the frigid Northeast at the time, so rolled all of the proceeds into a Florida vacation rental
Continuously held for rental (clearly acted on my original intent) but took full advantage of two weeks of personal use allowed annually (this was a deliberately selfish investment)
Reports and reviews from vacationers having fun in our house eventually made us question why we moved north not south (seriously, what were we thinking?)
Sold above-referenced property and converted vacation rental to primary residence by moving into it
After two years of occupancy, the tax began to disappear
But we had been paying dockage for our sailboat and found a home it would fit behind
So, moved into a new primary residence and converted it back into a vacation rental
Qualified for partial 121 exemption and partial 1031 tax deferral when sold within three years of moving to a new primary residence

Partnership With Flexibility

To summarize, keeping taxes working for your own benefit is key to maximizing returns. There are many ways to work investments and tax breaks to your advantage as indicated above. With Uncle Sam as your silent partner in this regard, I have repeatedly found that the benefits outweigh the inconvenience of rule-following.

Consider your personal tax bracket. Put that money to use in your own portfolio rather than building a bridge to nowhere.

[Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation.]

Do you have any questions about the strategies above? Do you plan to or have you successfully taken advantage of IRC Sections 121 and/or 1031?

Weigh in with a comment below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.