1031 Exchange, house paid off

[Jenesis Fonder]

My parents have owned a home in Minneapolis for 20+ years and the mortgage has been paid off for a few years now. For the past few years, my partner and best friend and I have been renting out this home and paying rent to my folks etc. Now, we are getting ready to move out and move into our first multifamily rental property, but my parents don't want to continue renting out the house and they're thinking about selling it. I brought up a 1031 exchange since it's always been a goal of my parents to have two cabins on one lot near a lake in MN, one cabin being for family and the other being used as a rental property.

Is there anybody with more knowledge surrounding the 1031 exchange process that could explain how/if this might work?

[Tracy Ose]

A 1031 exchange is a very powerful real estate exit strategy as you can defer capital gains taxes while increasing your portfolio, helpful in a situation where there is a lot of equity on the line. However it is important to do it correctly as a failed 1031 exchange will lead to making the sale taxable.

Generally this includes the following: 
1. Engaging a qualified 1031 intermediary (note you do not want to personally receive proceeds from the exchange as they may be taxable or even disqualify the transaction. Let your QI handle all the cash.)
2. Formally identifying replacement property (up to 3) within 45 days of selling the relinquishing property
3. Closing on the replacement property within 180 days from the sale (or due date of tax return for the year you sold the property, whichever is earlier),
4. Engaging a tax professional to correctly report the transaction and your basis in the new property.

Please keep in mind that this strategy is only available for rental real estate, not primary homes. So neither the replacement property or relinquished property can be a primary home. In your parent's case, since the primary home was converted to a rental, this can work for exchanging to another rental/ investment property. Keep in mind you can exchange to any real property of like-kind held for income or investment, not just single family homes - but commercial property, multifamily, land, farm, etc. (just can't exchange for non-US property).

However, assuming that they owned the home as a personal residence for at least 2 out of the last 5 years, they may want to consider the home sale exclusion where $500,000 in capital gain is excluded from tax (not just deferred like a 1031 exchange) for married couples/ $250,000 for a single individual for the sale of a principal residence. I'm not sure of the numbers for your situation, but perhaps this may help avoid a tedious 1031 exchange process, or at least a combination of the home sale exclusion and the like-kind exchange to reduce some of the capital gain that is deferred. 

Here are some resources to what I summarized above: https://www.irs.gov/businesses...
https://www.1031exchange.com/f...

These are just a couple options, there are actually many more exit strategies that you may find that may make more sense for you! Feel free to reach out to me and we can discuss more of your options.