Act Changes Affect Investing in Real Estate
Stephen A. Wayner
2006 - In the 2004 election campaign, Congress closed a
little-known loophole in the IRC that some investors had
exploited to avoid paying capital gains taxes. This amendment
to IRC section 121 (which establishes the tax exemptions
for personal residences) was buried in section 840 of the
American Jobs Creation Act of 2004 (AJCA). This tax-free
loophole was also used by taxpayers conducting like-kind
exchanges under IRC section 1031.
Sections 1031 and 121
into law by President Bush on October 22, 2004, the new
regulation should not be viewed as a tax grab, although
some taxpayers and investors may see it that way. It is
a belated admission by Congress that a tax deferral strategy
had been turned into one of tax avoidance, by using IRC
section 1031 for deferral and then section 121 for avoidance.
section 1031 allows buyers and sellers of investment property,
or property used in a trade or business, to defer capital
gains taxes from a property sale by rolling the proceeds
into another investment, trade, or business property of
equal or greater value. The “1031 exchange”
has been part of the IRC, in one form or another, since
1921. Judicial decisions in the late 1970s and early 1980s,
known collectively as the Starker cases, caused the IRS
to create new rules in 1991 to govern 1031 exchanges. Among
other things, these rules mandated a 45-day time period
to identify up to three parcels of property to be purchased;
a 180-day time period to complete the transaction; and the
use of a qualified intermediary (independent third parties
recognized by the IRS as facilitators of 1031 exchanges)
to handle the details.
section 121, on the other hand, deals with property used
for residential purposes. It allows, under certain circumstances,
tax-free profits on income gained from the sale of property
if the taxpayer used the property as a principal residence
for two or more of the past five years.
can an average taxpayer or investor use both section 1031
and section 121? Consider, for example, an investor who
purchased a four-unit apartment building four years ago
for $150,000 that is now valued at $550,000. The investor
made a profit of $400,000 and would have to pay 15% ($60,000)
in long-term capital gains tax. He intends to use the proceeds
to purchase a $700,000 single-family home that he will use
as his personal residence in a couple of years. He uses
all of the proceeds from his sale of the four-unit apartment
building, and uses section 1031 to defer the $60,000 in
capital gains taxes. Under the old IRC section 121, he could
have moved into the single-family home two years later and
made it his personal residence. IRC section 121, as amended
by section 840 of the AJCA, now requires the use of the
replacement property for a combination of rental and personal
use of five years (e.g., rental three years, personal residence
two years). So the investor lives in the personal residence
for three years before selling it for $800,000, realizing
an additional profit of $100,000. Under this scenario, his
total profit of $500,000 would be tax free. If sections
1031, 121, and 840 are used and timed correctly, taxable
profit on the sale of property can be avoided entirely.
investors, such as the one in this example, learned long
ago that they could conduct a 1031 exchange and defer paying
taxes. Thereafter, upon the sale of their investment, once
converted to a personal residence, they could exclude up
to $250,000 in capital gains tax. Couples filing jointly
could save up to $500,000.
to October 22, 2004, as with any provisions of the tax code,
certain conditions had to be met to achieve these tax savings.
Most important, as in the example above, the investor had
to lease the property for a reasonable time (conservatively,
two years) before using it for two years as a personal residence.
all changed on October 22, 2004. The new section 840 of
the AJCA states: “If a taxpayer acquired property
in an exchange to which section 1031 applied, subsection
(a) shall not apply to the sale or exchange of such property
if it occurs during the 5 (five)-year period beginning with
the date of the acquisition of such property.” In
other words, the taxpayer must now hold the property for
five years, use it as an investment property for a portion
of the five years, and use it as a personal residence for
at least two years before selling it, in order to avoid
capital gains taxes.
newness of the amendment—and the lack of fanfare with
which it became law—may catch taxpayers off guard.
Tax preparers should be aware of the potential implications
and keep abreast of any further changes to the code or regulations.
motivation appears to have been to close a loophole it thought
subject to abuse. If taxpayers or investors are impatient
and forego the holding requirements, they will become liable
for capital gains taxes. Yet if the taxpayer or investor
follows all of the rules, including the new requirements,
then this loophole is still available. It will take just
a year longer.
A. Wayner, Esq., CES, is first vice president of
Bayview Financial Exchange Services, LLC, a Section 1031 Exchange
Qualified Intermediary, with 22 offices around the country
and its main processing office in Coral Gables, Fla.