Using Real Estate to Avoid Tax
“Show me the incentive and I’ll show you the outcome.”
Back when the British ruled India, there was concern among Delhi government officials regarding the number of cobras in the city.
To solve the growing concern, they implemented a bounty on cobra skins.
To their surprise, the bounty worked!
After a few short months, cobra skins were being traded in by the thousands and government were pleased with their efforts and its outcome.
But there was one problem:
Opportunists saw through this bounty as a means to exploit the system and breed cobras to trade in for money.
As government officials heard word of what was happening, they immediately shut down the bounty to not be taken advantage of any further.
With the breeders no longer having an incentive to trade in the Cobras, they let them lose - creating a problem that was twice as bad as before.
No loophole goes unexploited.
Similarly, the government creates incentives in the tax code to steer investors decisions.
One of those decisions is investments in real estate.
IRC section 121 allows a taxpayer to exclude a portion (or all) of the capital gain from the sale of their principal residence.
For single filers this is limited to $250,000 of gain.
For married filing joint tax filers this is limited to $500,00 of gain.
To qualify, you must live in your home at least two years during the five-year period leading up to the sale.
This rule applies the day the home is sold.
The IRS defines principal residence broadly which could include a boathouse or trailer.
The home that you use the majority of the time will be considered your principal residence.
Let’s consider an example:
For the period 2017 to 2023, Bob is married and owns a home in Delaware and Florida (which he rents when he’s not there).
For each year leading up to the sale, Bob lives in Delaware for seven months and Florida for five months.
Bob has had his eye on moving to a large lake house in Colorado, so he decides to sell both homes in 2023 and purchase the home in Colorado.
Only the Delaware home Bob sells will qualify for the home sale exclusion because he lives in Delaware for the majority of each year.
Further Bob met the 5 year rule so $500,000 of his gain will be excluded from tax. Bob’s Florida home will be subject to capital gains tax and depreciation recapture.
It’s important to note, the gain is the appreciation over and above what you paid for the house.
If Bob bought his Delaware home for $1,000,000 then later sells it for $1,300,000, Bob would only have a $300,000 gain (which would be wiped away since he qualifies for the exclusion).
If Bob sold his Delaware home for $1,700,000, then Bob would have a $300,000 gain (after taking into consideration the $500,000 exclusion).
If you’re someone looking to sell your primary residence, this home sale exclusion is a great tool to completely avoid paying capital gains tax on the sale of your home.
You will still need to report this to the IRS to report the sale.
This is completed with Form 8949, which then flows through to your Schedule D to report the capital gains or loss.
If Bob’s Colorado property was going to be an investment property (not a primary residence) he could use IRC code section 1031 also known as a like-kind exchange or a starker exchange.
1031 exchange allows an investor to defer paying capital gains when they sell an investment property and reinvest the proceeds from the sale within a certain time limit in another property or properties of like kind and equal or greater value.
Instead of realizing the capital gains, depreciation recapture, & likely net investment income tax with each property sale, a 1031 exchange allows you to defer the capital gains (& free up cash flow not paid on taxes due from sale).
If you’re looking to:
Purchase a new property with higher return potential
You want to consolidate several properties into one or divide a single property into several properties.
Reset the deprecation clock
Then a 1031 exchange is worth looking into.
When using a 1031 exchange you want to make sure you have a 1031 agent to act as a qualified intermediary to hold the proceeds in escrow while you identify the replacement property.
The sale proceeds must be transferred to the qualified intermediary, otherwise, you violate the requirements of 1031 and trigger a taxable event.
Starting on the closing date of the property you’re selling, you have 45 days to identify a potential replacement to be purchased.
From the same closing date of the property you sold, you have 180 days to complete the acquisition of your replacement property.
There are a couple rules to follow to ensure your repayment property is valid:
Three-property rule: You may identify up to three different properties within the 45-day window.
200% Rule: Alternatively to the rule above, you can have an unlimited number of replacements as long as the total fair market value doesn’t exceed 200% of the value of all property being sold.
95% Rule: The last alternative is you may identify alternative properties as long as you receive at least 95% of the value of all identified properties before the end of the exchange period.
To successfully avoid any adverse tax consequences from this transaction, you must ensure your replacement property is equal or greater value.
Further, debt on the new property should be equal or greater value.
If you do not fully exhaust the proceeds into a replacement property you have boot.
& no -
Boot is not something we were on our feet.
There are two kinds of boot:
Cash boot
Mortgage boot
Cash boot is when the seller receives cash as part of an exchange or doesn’t deploy the full sale proceeds into a new property and has cash leftover.
Mortgage boot is when the seller’s debt on a replacement property is less than the debt which was on the relinquished property. This can happen if you’re “trading down” in the exchange.
After the 180 window, the unused sale proceeds (or debt relief) are taxable.
There is one underutilized and underappreciated tax saving strategy:
Taking your 1031 exchange with you to the grave (AKA swap until you drop).
Why?
Your heirs that inherit property through a 1031 exchange are “stepped up” to fair market value upon the date of death.
The result?
$0 tax due on your tax-deferred real estate capital gain & depreciation recapture!
HUGE TAX SAVINGS!