Realty Exchange News
By Bill Horan CES® –
This article is for the landlord who is working on a retirement plan and trying to decide where to retire. A common strategy is to convert an investment property to a principal residence. As part of the retirement plan a landlord can exchange their current investment real estate, which can be located anywhere in the US, to a great retirement place like the Outer Banks. Eventually they can convert the investment property to their retirement home. The objective is to let the investment property pay for the retirement place.
As an example, as part of their retirement plan, a married couple client of ours has decided to eventually retire in the Outer Banks. They have owned a rental townhouse in Reston, VA for years. They have decided to sell their rental townhouse and exchange it for a new rental ocean front condo. Their plan is to eventually move into the rental condo when they are ready to retire. By doing an exchange they are going to defer the taxes that normally would be due with the sale of the Reston townhouse. The gain they currently have in their Reston townhouse moves with them to their new ocean front condo. If they simply sold the townhouse in Reston the taxes would take almost 25% of their gain, meaning they would have a lot less money to buy their dream property in the Outer Banks.
They have concluded now is the time to sell in Reston, even if the sale price might be slightly lower than they had hoped, because they believe they are getting a great value by re-investing now in the Outer Banks. They would never have been able to afford the ocean front condo several years ago.
With this plan they will be taking advantage of three important tax provisions. Internal Revenue Code (IRC) section 1031 allows the exchange of investment property for new investment property. IRS Revenue Procedure 2008-16 is a Safe Harbor aimed specifically at “dwelling units” and outlines when it is safe to convert an investment to another use, i.e. a new home. IRC section 121 which governs principal residences.
By definition an IRC 1031 exchange is only for investment or business property, like a rental townhouse, warehouse, land, office building, etc. You can exchange for new replacement investment property(ies). Our client is exchanging their rental townhouse in Reston, VA for a new rental condo in the Outer Banks. A 1031 exchange is simply exchanging your current investment value to a new location(s). Think of an exchange as continuing your investment value but at a new address.
You must hold the new property as an investment. IRS Revenue Procedure 2008-16 outlines how long you must hold the new investment “dwelling unit”, how long you must rent and how many personal days you can use your property. The “safe” answer is at a minimum you must rent the property for at least two weeks each of the two years after you buy, and you must keep your personal use to two weeks or less each of the two years after you buy.
When you convert an investment property to personal use, or a principal residence there is no tax due. Our clients plan is to eventually sell their home in northern Virginia, and take advantage of IRC Section 121 which allows them to exclude up to $500,000 of gain on their home sale from taxes.
The plan will exchange a profitable investment in Reston to the Outer Banks without triggering taxes thereby giving them more money to invest. The new condo rental income will help support the property and they will be able to enjoy their investment property for up to two weeks a year. In a couple of years they will sell their primary residence and exclude up to $500,000 of gain. They will move into the ocean front condo converting it to a primary residence, all without triggering taxes. To look further down the road they plan to have their kids inherit the condo and get a step up in basis. In their particular situation there would be no taxes on the condo.
Their strategy takes advantage of several provisions of the tax code to accomplish their goal of retiring at the beach, keeping more of their hard earned money and leaving a beautiful beach property to the kids. Anytime you are dealing with taxes it is important to make sure you have experienced advisors to help. As plans change so do the tax rules, so you need to plan for other possibilities. We have written paper on the tax impact of eventually selling an investment property that you have converted to a home. (www.1031.us/Articles/Converting.html) The rules have changed over the last several years so you need to understand the tax impact of an eventual sale.
Article by Bill Horan, CES® (a Certified Exchange Specialist®), President of Realty Exchange Corporation, Gainesville, VA. 20155. Call 800-795 -0769 or e-mail firstname.lastname@example.org