1031 Strategy clarification

[Jimmy Wilson]

I am unclear on a couple of items I have been discussing with a fellow RE investor.  Here is the situation:

Own (2) condos in Breckenridge, CO that are rental properties and owned for 12 years.  If sold, would net a $300K capital gain between the two.

Purchase vacation rental property in Hawaii for $400K, then do a reverse 1031 exchange by selling the (2) Breckenridge, CO condos.

After using the Hawaii vacation rental property as a rental for 3 years, live in it for the last 2 years.  Then, sell the vacation rental utilizing the Section 121 primary residence.

Here is the question:

- If the Hawaii vacation rental is sold utilizing the Sec 121 primary residence, the depreciation recaputure.  Would the depreciation recapture be ONLY for the 3 years the Hawaii vacation rental was in service and depreciated?  Or, would you also have to pay the depreciation recapture for the previous (2) Breckenridge condos that were 1031'd into this property?

Thanks in advance!

[Dave Foster]

@Jimmy Wilson, Beautiful strategy.  Remember that in a 1031 your adjusted basis simply carries forward into the new property.  So the depreciation and gain from the relinquished properties is still there in  your new property and there is a specific addition to the 121 statute the prohibits excluding gains from depreciation taken since May of 1997 when you convert a rental to your primary residence.  So you'll have the past depreciation and the depreciation from the 3 years of non-qualified use (rental).  But the good news is that you'll be able to exempt gain from the relinquished properties and gain from the qualified use (primary residence) as a proration between the time it was in service and the time it was your primary.  

So kick some possibilities - If you rent for two years (the IRS safe harbor) and then lived in it for 3 years as a primary you'd get to exempt 60% of the gain not attributable to depreciation up to the 250/500K max.  If you rented for 2 and lived in it for 8 you would get 80% of the gain.

Down the road, if the circumstances again warrant it you could do a reverse conversion and turn that property back into 1031 property so you could 1031 and take some boot out covered by the 121 exemption.   You could also buy two vacation properties and live in each of them for a period after satisfying your 1031.  Turn it into a retirement job - move into your really nice rentals one at a time and sell as you go taking less of a tax hit each time.

But I"m a little curious about your numbers - remember that to completely defer al tax you must purchase at least as much as your net sale and use all of the net cash in the purchase.  I doubt that your condos in CO could generate a 300K gain and yet be a net sale of only $400K would it?  If so you bought them way right!!  Take a look at that.  You may find that your reinvestment target is greater than that $400k and a second property is in the future as well.

Also, when you're ready to implement don't forget that a reverse exchange is still a very rigid IRS process.  It's not as simple as you simply buying and then later selling.  You've got to have a QI managing the process for you.