1031 from One Property to Four Question

[Tony T.]

I have a small apartment building worth 1.4 million and wonder if it's possible to do a 1031 exchange for, say, 4 houses for around the same dollar amount. Then sell each one after living in each for 2 years to avoid paying capital gains and depreciation taxes.

I'm just starting to look into how 1031 exchanges work, so I'm new at it, but wanted to see if there's a flaw in that plan. I'm pretty sure it's common to live in a property for 2 years to avoid capital gains, I just wonder if there's a problem doing it after a 1031.

Thank you for any input!

[Dave Foster]

@Bill B. thanks for the shout out.  @Tony T. Unfortunately I am one of those investors that was able to take the full primary residence exemption out in the early 2000s several times.  And that's how we bought our sailaway home.  So, I like your plan but it won't work quite as well now for a couple of reasons.

1. The 1031 will defer all tax and depreciation recapture.  But the 1031 is the sale of investment property and the purchase of property you intend to use for investment (stay tuned for a sec and we'll talk about how long).

2. In order to get the full primary residence the property must have been purchased as your primary residence.  Live in it for 2 out of the 5 years prior to sale and you get the first $500K in profit (if married) tax free.  And you can do this once ever two years.

3. The result of 1 and 2 above is that you are buying an investment property and then later converting it to your primary residence.  Nothing wrong with that at all.  No  statutory holding period.  But There is a safe harbor from the IRS at 2 years under certain circumstances.  

Here's the new rules which are a result of the Housing Assistance Act of 2008.  If you have converted a property to your primary residence and it was once the subject of a 1031 then the following has to be met in order to get a partial 121 exemption.

a. You must have owned the property for at least 5 years.

b. You must have lived in the property for 2 out of the 5 years prior to sale.

c. You will get to prorate the gain between periods of qualified use (as your primary) and non-qualified use (as investment).  the qualified use period is tax free to the $500K limit.  the non-qualified use period is taxable.

d. And you have to recapture all depreciation.

So it's not as sweet.  But Here's what some of my clients are doing (particularly if they want to do a retirement move).

1. Position your 4 properties where you want (I have a realtor on St. Pete Beach that has 3 identical condos on the same floor).  

2. When you're ready sell your current home and take that money tax free.

3. Move into the first of your 4.  Once you have owned it for 5 years and lived in it at least 2 (or if it's time to redecorate) sell it and take the partial primary exemption.  If you did the 1031 and then rented for 2 years and lived in it for 3 you would get 60% of the gain tax free.  

4. Move into the next one and live in it for a while.  Every year. you live in it adds to the tax free gain.  So it's kind of like waiting to collect social security.  You're rewarded for ever year you delay :)

5. Plan on dying before your last move.  Your heirs get all the rest of your property at a stepped up basis so the tax disappears for them.

It take a little effort and planning.  But hey, tax free was worth it to me!!

If you sell your apt building at 1.4 you can name more than 3 properties on your list as long as their total value doesn't exceed 200% of that or 2.8 mil.  So you'll have plenty of room to name a few $400K houses to get into.  And probably still some room to get another cash flow property or invest in some passive real estate ownership opportunities.

And one last word on PA.  At this time PA does not honor 1031 exchanges at the state level.  So if you sell and 1031 in PA you'll still have to pay them 3.01% on the gain for state tax.