Tax Act Changes Affect Investing in Real Estate

By Stephen A. Wayner

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IRC Sections 1031 and 121

Signed 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.

IRC 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.

IRC 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.

How 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.

Savvy 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.

Prior 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.

Section 840

This 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.

The 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.

Congress’ 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.