New IRS Rule For 1031 Exchange
Ask the Real Estate Lawyer: Real Estate Law Q&A
REM # LAW 675
By Ilyce R. Glink and Samuel J. Tamkin
Summary: Using a 1031 exchange and purchasing
a residence can be tricky. The IRS has recently changed the 1031 law to include
a 5 year ownership requirement. Ilyce and Sam suggest consulting a good accountant
when using a 1031 exchange.
Q: I purchased my home four years ago and used a 1031 exchange to buy it. I
have now sold my home.
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While reading the newspaper I found out that I have needed to have kept the
home at least five years to avoid paying taxes on the gain.
I tried getting the buyers to release me from my contract, but they wouldn’t.
I tried to get my buyers to allow me to delay the closing, but they wouldn’t.
Before listing my home for sale, I talked to my accountant about it and he didn’t
say anything about the new law.
I would have delayed the sale if I had known about the five year waiting period.
I want to be able to get the $25,.000 exemption on the sale of my home. What
should I do?
A: First of all, we have to take a step back. There are two pressing issues
raised by your question. The first one has to do with 1031 exchanges relating
to investment property and the other with excluding up to $250,000 in gains
from the sale of a primary residence.
Typically, an owner would use a 1031 exchange to defer gains and other tax
payments upon the sale of an investment property. To defer these taxes, the
seller of an investment property buys a replacement property of equal or higher
The seller has to satisfy timing requirements and other rules, but if those
are met, he or she is able to sell an existing investment property and then
buy a new property without having to pay the IRS any taxes. One of these requirements
is that the new property purchased must be used for investment purposes.
In some cases, some real estate practitioners have stated that the safety time
period that the new property must be owned and used for investment purposes
must be two years.
Some people have taken the process a step further and have sold an investment
property – a property that has gone up in value substantially –
and instead of buying a replacement investment property, they buy a new home.
They use this home as their own residence.
The purpose of the 1031 exchange is to facilitate a tax-free exchange for investment
property owners. It does not permit homeowners to benefit from the deferral
of the payment of taxes on appreciated home value.
Instead, homeowners get their own tax break. When they sell, they benefit by
being able to exclude up to $250,000 (or if they are married, an exclusion of
$500,000) in profits when they sell their primary residence and they have lived
in that residence for at least two out of the prior five years.
The rule is rather simple and gives homeowners a great break on homes that
have appreciated in value.
While the rules for 1031 exchanges have not changed, the IRS took notice of
the fact that people were selling commercial properties, buying a home, using
the home as their residence, then taking the exclusion and not paying any taxes.
The IRS did not outlaw what some people were doing – it just made it
harder to comply with the existing 1031 exchange rules.
For example, if the owner of a property had initially owned the property for
investment purposes for at least two years, and then converted the property
to his or her personal use for another two years to get the benefit of the primary
residence exclusion on the taxes, that’s a total of four years of ownership.
But the period of time which is called the “safety” period has been
described as five years.
When you sell the home and later file your tax return, the IRS may disallow
the exemption and you may have to pay taxes on any gain you have on the sale
of the home.
If the IRS deems that you have capital gains (from the sale of what was once
investment property), you may have to pay tax of up to 15 percent, depending
on your income. You may also have to pay taxes on any depreciation you previously
took on the commercial property you owned. Your accountant should be able to
help you out in this regard.
It is regrettable that your accountant did not advise you of current tax law
and how it would apply to your situation. Your accountant probably was not focusing
on your situation or perhaps he has a different view as to how he is going to
treat the sale of your home. Your accountant might treat your sale aggressively
and perhaps believes that you will be able to exclude the gains due to the fact
that you have owned the property and lived in it for the last four years.
You need to sit down with your accountant and go over these issues fully in
order to understand what he has in mind for you. If you don’t feel that
he has your best interests in mind or that his information isn’t quite
up to date, you should look for another accountant to help you out.
Samuel J. Tamkin is a Chicago-based real estate attorney. Ilyce
R. Glink’s latest book is 50 Simple Steps You Can Take To Sell Your
Home Faster and For More Money In Any Market. If you have questions for
them, write: Real Estate Matters Syndicate, PO Box 366, Glencoe, IL 60022
or contact them through Ilyce’s website www.thinkglink.com