1 property in a 1031 exchange to 2 properties possible?

Question

Bill Exeter · Answer

Hi @David MIller,

Is this your mother's primary residence or is it rental property?  The sale of her primary residence would fall under Section 121 of the Internal Revenue Code ("121 Exclusion").  She can exclude up to $250,000 from taxable gain if she is single ($500,000 if married and filing a joint income tax return) as long as she can say that she has owned and lived in the property as her primary residence for at least a total of 24 months out of the last 60 months (2 years out of the last 5 years).

The sale of a rental property would fall under Section 1031 of the Internal Revenue Code ("1031 Exchange").  She could defer the payment of her taxable gain by structuring a 1031 Exchange by acquiring other replacement properties.  Yes, she could sell one and buy two or more if she wanted to do so.  It is a great way to diversify her investment property portfolio.  The relinquished property and the replacement properties must be held for rental, investment or business use.

The more properties involved in the 1031 Exchange the more complicated the transaction gets, but it is done all the time.  The 1031 Exchange is a great way to diversify, consolidate or reposition real estate investments without incurring taxable gain.

John Thedford · Answer

p.s.---is this her homestead? 1031 is for investment properties.

Pete Mitchell · Answer

Check out www.DeferCapitalGainsTaxes.com....this might be an option/alternative for you...

Robin Boyer · Answer

In the motion of doing our first 1031 exchange can't wait to see how it goes. I am looking at possibly 3 properties.

Thomas Rutkowski · Answer

@David MIller - It's one of several strategies based on a Section 453 installment sale. If you sell on a 30-year, interest-only installment sale, all of the taxes are deferred until there is "constructive receipt" (the last and final payment with principal).

The main concern with seller financing, of course, is the default and prepayment risk. And you have to live off the payments. Most of the strategies around Section 453 deal with reducing the default and prepayment risk. The monetized installment sale goes further to put cash in hand.

The installment sale is coupled with a monetization loan to put cash in your pocket at the time of closing. The interest coming in from the sales contract is offset by the interest you owe on the monetization loan. The result is that you walk away from the closing with cash in your pocket and a 30-year tax deferral.

With this strategy you can take your cash out of real estate when the market is high and sit on the sidelines in safer investments with lower risk.

The secret is in making sure that the monetization loan does not violate the IRS's pledge rule. You cannot pledge the contract as collateral.

David MIller · Answer

@Dave Foster @Bill Exeter that clears a lot of what I was wanting to know, thanks!

She would easily burn through the 250k exclusions, that is why I thought of the 1031 exchange since I had heard about it so much on the podcast.

@Thomas Rutkowski what is a Monetized Installment Sale? I've never heard of that before.

Thomas Rutkowski · Answer

@David MIller -  A lot of California sellers are using Monetized Installment Sales instead of 1031 Exchanges. With the high property values out there, it is easy to burn through your $250K/$500K exclusions.

With a Monetized Installment Sale you can get cash at closing and still get 30 years of tax deferral. This solves a lot of the issues associated with a 1031 exchange. A 1031 exchange is only for investment property, not for personal residences.

Bill Exeter · Answer

Hi @David MIller,

The sale of her primary residence would then fall under the 121 Exclusion.  If the gain is greater than the $250K/$500K 121 Exclusion limit, then she may want to convert to rental/investment property in order to qualify for both the 121 Exclusion and a 1031 Exchange.  This would allow her to get the $250K/$500K tax-free exclusion and defer the balance through a 1031 Exchange.

She would have to rent the property long enough to be able to demonstrate that she did in fact have the intent to convert and hold the property for rental, investment or business use.  The code, regulations and rulings do not have any specific holding period.  She would just need to demonstrate that she had the intent to hold for rental or investment purposes.  Advisors often recommend 12 to 24 months, but in this case since she has lived there for so long, I would be more conservative and lean more toward the 24 month holding period, which would straddle three (3) income tax returns/periods.

The relinquished properties and replacement properties must all be held for rental, investment or business use.  You could change your intent down the road, but initially you must be able to demonstrate your intent to hold for rental purposes.

The identification period and related rules/exceptions are the challenge.  The vast majority of investors use the three (3) property identification rule since most investors are trying to trade up in value.  You can identify up to but not more than three replacement properties.  Generally, those who are looking to diversify, identify more than three replacement properties, will look at the 200% of Fair Market Value Rule.

Dave Foster · Answer

@David MIller,

1. There's no statutory holding period for her in converting her house to "investment".  The bar she has to cross is that of "intent" - that her intent in converting the house was to hold it for productive investment use.  Most folks feel pretty good at 1 - 2 years.  A lot depends on the individual situation.  One year puts income on a tax return.  That's hard to argue with.  Two years puts it on two and probably gets you the safe harbor of Rev Proc 2008-16.  But one year and a month also puts income on two consecutive tax returns.  Her legal and financial advisor will probably have a preference.

In the above scenario it's going to be because her gain would exceed the $250/$500K limits of sec 121.  So she'll need to make sure that she both satisfies the intent of conversion and yet sells the property so that she can still claim that she lived in it for two out of the previous 5 years.  So I think you'll probably land somewhere in between one and three years for the conversion.

2. You got it!  It's not what she purchases that creates the limitation.  It's what she identifies.  So if she sells for 1.5 and wants to buy one for 1.5 then she'll only be able to identify up to three $1.5 properties.  If she names four then the total value of the list can't be more than $3 mil so four $1.5 properties wouldn't work.

3. Since she will be doing a 1031 at this point she must purchase investment property.  But she could purchase a really nice investment property that she then "reverse converts" back into a primary residence in a year or two.  The conversion process works both ways and again, "intent" is the standard.

The greatest benefit that High Net Worth individuals have in situations like this is that there are usually multiple residences or options for living arrangements while the investment properties are seasoning.  In your mom's case she could also take the tax free money from the first sale and use some of it to rent something really nice for a couple of years.  Or buy a 2-3 year primary residence and once again sell it and take the gain tax free right before she moves into the reverse converted property.  When you've got patience and flexibility on your side it's amazing the tax planning you can do - in conjunction with all of your regular professionals of course!

1 property in a 1031 exchange to 2 properties possible?

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