Is a 1031 Exchange allowed in this case, and if so, is it worth the hassle?

[Anca R.]

Posting for my elderly parents.

Background: my parents bought their house in 2001 for $355K. In 2016 they moved to a one story home due to aging and ended up renting their initial home. Every year the rental has been depreciated by $11,700/year, so for the past 9 years that would be about $105K in depreciation. They are getting ready to list this house for sale in the next few weeks, listing price is $1,075,000. The plan is to use the proceeds from this rental to buy another rental property for about $650-700K, plus to pay off the home that they live in now ($260K owed).

The dilemma is: 1. Would the IRS allow them to benefit from a 1031 Exchange if they would be "swapping" a million-dollar rental for one that is much lower in price? 2. If so, is it even worth it? Would they be able to defer a good amount in taxes, to be worth the hassles of the 1031 exchange and the time constraints on the purchase? 3. If they don't do a 1031 how much would they have to pay in taxes after selling their rental? Roughly? Their combined income is below $100K per year. If it matters, they now live in Oregon, current rental is in California, and the new rental will be purchased in Illinois. TIA

[George Skidis]

Not an attorney and don't play one on television. A 1031 must be for equal or greater value or the funds in excess of the value of the new purchase are taxable. The exchange must also be for like kind and quality. So house for house, apartment building for apartment building.

Have your parents considered renting the house they are living in for two years and moving back into the rental unit for 25 months. When a rental is taken out of service for personal use the accumulated depreciation goes away over a short period of time. 

After 25 months, If they can prove that they lived in the property for two of the past five years, they can sell it as an owner-occupied residence. That sale should qualify for the $500,000 sale of personal residence exemption for tax purposes. Then they could move back into their current home.