1031 Mistake - Oops!

[Holly Barrett]

So I made a mistake.

We sold a rental property and I assumed that we had to do 1031 exchange to avoid capital gains tax. My bad. I didn't double check for exceptions.

$850 later, thinking I was so smart for doing 1031, I hear about the 2 out of 5 year rule exception on Bigger Pockets. No! 

See we lived in the home the first 2 of the preceding 5 years. We wouldn't have had to pay capital gains anyway! Grrrr... Lesson learned. I'll never forget it. 

Moral of the story, don't expect your real estate agent or 1031 exchange group to catch exceptions for you. Ultimately it was my responsibility to double check and not make that assumption.

From TheBalance.com: 

"The exclusion depends on the property being your residence, not an investment property. You must have lived in the home for a minimum of two out of the last five years immediately preceding the date of the sale.

The two years don't have to be consecutive and you don't actually have to live there on the date of the sale. You can live in the home for a year, rent it out for three years, then move back in for 12 months. The IRS figures that if you spent this much time under that roof, the home qualifies as your principal residence."

[Toni Baca]

Hi Holly, 

Thanks for sharing your experience, I personally plan to use Section 121 to avoid capital gains tax on my first home. (I will live in for 2 and rent for 3 years before selling)

I also am a Qualified Intermediary and can say that one plus side of doing the 1031 exchange is that you also were able to defer your Recaptured Depreciation. This is taxed at the highest rate of 25% Federal + State Tax, and tends to sneak up on most people. Based on the price of your property and the depreciation allowance, the 1031 could have still been in your favor. With that being said, a good QI should be able to tell you your tax consequences and what the most advantageous situation for you is, even if it means losing the business. :) 

One thing I ask our clients, is for ALL the information of their investment property. How long it has been a rental and if it was ever your primary? Plus what is your long term goals? When working with a QI in the future giving as much information as possible can help your QI decide what is the best situation for you. 

Hope this helps and good luck on your next rental!