1031 Exchanges & 1034

[Daniel Patterson]

Hello everyone,

Looking to learn a little bit more about 1031 exchanges and and 1034..

First off, can both of these tax exemption strategies be utilized in tandem? 

Secondly, does the QI pay your taxes on the house? or do the taxes just disappear? I'm confused how the QI takes on that role and all you have to do is pay them a fee.

Third, say if you decide to stop investing and you finally pull yourself out of the chain, do you have to pay taxes on everything that you used the exchange on in the past? or do you only pay taxes on the most recent closing?

A side note question.... Isn't there some other type of tax strategy where if you live in a home for a year first before reselling it? I forget the name of that one and how it exactly works.

If you have any thoughts on one of these questions it will be greatly appreciated!

Thanks!

[Dave Foster]

@Daniel Patterson, Huge topic with many many what ifs and applications that can be specific to your situation.  Generally though

1. Yes both Sec 121 (the primary residence exclusion) and sec 1031 tax deferred exchange can be used together or leveraged off of each other.  Some examples

a. Owning a duplex living in half and renting half.  When you sell 50% of the gain is apportioned to your primary residence and the first $250K/$500K if married in gain from the half you lived in would be tax free and you could 1031 exchange the half that is investment.

b. You live in a house that you have more than $500K in gain on.  So you move out and turn it into a rental for a year or so and then sell doing a 1031 exchange but taking 500K in taxable boot from the exchange.  Normally that 500K would be taxable but because you have also lived in the property for 2 out of the previous 5 years that 500K becomes tax free by virtue of your sec 121 primary residence exclusion.

c. You 1031 exchange several small rental properties and consolidate into one really nice SF rental.  After using that new property for investment purposes for a year or so you convert it into your primary residence by moving in.  Now the rules of sec 121 again apply with a couple of twists because it was originally a 1031 property.

d. You 1031 properties into three or four beautiful vacation rentals all next door to each other.  One at a time you move into each one and live there until it's time to redecorate and then you move into the next one instead and take the tax free opportunities of sec 121 on your sale (again there's some limitations on the exemption because of the 1031 but still tax free benefit available.

e. Using favorable FHA financing buy a property that would make a good rental and honor the financing guidelines and live in it. Then buy another, move out, rent the old one and repeat. Sell the investment properties and 1031 as necessary.

2. The 1031 exchange is a procedure that in essence is a sale of investment real estate followed by a purchase of real estate.  The QI acts to provide documentation of the exchange portion of the closings.  The QI also provides custodianship of the proceeds from sale until used for the purchase since you cannot touch the money either actually or by constructive receipt.  

The QI also guides you through the rigorous guidelines necessary to have a successful 1031 including some valuation issues, use of proceeds, a 45 day identification period and 180 day exchange period and some titling guidelines. 

Part of the process is that the contract rights for the sale are transferred to the QI from you but the property is deeded directly to the buyer from you.  When you buy the same thing happens in reverse.  The QI does not pay taxes determine taxes or document taxes.  You do this with your financial advisors.  Your accountant will have your adjusted cost basis for the properties and will file a form 8824 for every property you exchange.

3. There's really four ways to get off the 1031 train.

     1. Sell and pay the tax (including the tax that has been deferred through the years and exchanges.

     2. Keep exchanging until you finally consolidate your holdings into larger more passive investments that are providing income without management including income from the deferred taxes you haven't paid over the years.

     3. Do what was suggested above and combine sec 121 and 1031 to mitigate a great deal of the tax burden through selective primary residence exclusions.

     4. Die ( I really don't recommend this one).  But if you do your heirs get your properties at what is called a step up in basis.  Essentially the properties are appraised as of the day you die and your heirs inherit the property as if they paid that value for the properties.  So in essence all the gain disappears into your estate.

Whew!! This is just a very cursory look at some of the opportunities and everyone has quirks, nuances, advantages and disadvantages.  A good team of legal, financial, and QI folks can help you get wherever you want to go.  It's just about knowing where you want to go and exploring the opportunities.