Editorial Staff
style='font-size:12.0pt;mso-bidi-font-size:10.0pt'>By:2'> R. Scott Cameron, CCIM and Cherie M. Embree
One of the most effective ways to accumulate wealth in real estate is the Internal Revenue Code (IRC) 1031 tax deferred exchange. And these types of exchanges continue to increase in popularity throughout Florida as more investors discover this powerful technique. Section 1031 of the Internal Revenue Code allows an investor to exchange out of property “held for investment” and defer paying federal and state capital gain taxes if they acquire a “like-kind” replacement property within a maximum of 180 calendar days. Florida investors are discovering that the real power of a tax deferred exchange is not just the tax savings, it is the tremendous increase in purchasing power generated by the tax savings. With the advantages of leverage, every dollar saved in taxes allows a real estate investor to purchase two to three times more real estate.
normal'>Rental Vacation Homes
Do vacation homes qualify for tax deferral under IRC 1031? Although rental income helps support that a property was held for investment, some tax advisors believe it is possible to complete an exchange on vacation property which has no rental history, but which can still be considered “held for investment.” In Private Letter Ruling 8103117, the IRS did allow for tax deferral when a property owner intended to acquire property for personal enjoyment and as an investment. The PLR stated, “…the house and lot you acquire in this trade will be held for the same purposes as the properties exchanged: to provide for personal enjoyment and to make a sound real estate investment.” Property owners who have not rented their real estate at a vacation destination, but who can substantiate that they acquired and held the property primarily because they expected it to increase in value, may be able to qualify for a 1031 tax deferred exchange. Consulting with your tax advisors and reviewing IRC 165 and IRC 280 (which address when losses may be deducted on vacation homes), can provide additional guidance.
normal'>Rental Property to Primary Residence Conversion
The 1997 Taxpayer Relief Act repealed the old 1034 rollover provision and created tremendous benefits to owners of primary residences. The tax exclusion available under IRC 121 (the current primary residence rules) enables a couple filing a joint tax return to exclude up to $500,000 of the capital gain on the sale of their primary residence, and single filers can exclude up to $250,000.
An increasing number of Florida investors have exchanged into a house they initially intended to hold for investment, but at a later date, moved into their house, thus converting their former rental into a primary residence. After living in their former rental for a minimum of two years, they can sell their property and receive exclusion from capital gain taxes as detailed above -- this represents one of the most popular trends because it allows:
tab-stops:.25in'>10.0pt;font-family:Symbol'>· Home owners (“empty nesters”) to downsize without a huge tax penalty
tab-stops:.25in'>10.0pt;font-family:Symbol'>· The potential for tax-free dollars to be used for the purchase of investment property
tab-stops:.25in'>10.0pt;font-family:Symbol'>· The conversion of a vacation home into a primary residence with tax exclusion in two years
tab-stops:.25in'>10.0pt;font-family:Symbol'>· “Serial homebuyers” can buy and live in a “fixer home” for two years and keep the profit
normal'>Improvement Exchanges
The improvement (also known as a construction or build-to-suit) exchange, is an advanced strategy which enables an exchanger, through the use of a qualified intermediary, to complete improvements on a replacement property using exchange equity. Improvement exchanges offer a wide array of benefits, which often result in a better investment than properties currently available. The improvement exchange is commonly utilized in the following scenarios:
tab-stops:.2in'>10.0pt;font-family:Symbol'>· The property to be acquired in the exchange is not of equal or greater value to the property being sold.
tab-stops:.2in'>10.0pt;font-family:Symbol'>· To build a new investment from the ground-up.
tab-stops:.2in'>10.0pt;font-family:Symbol'>· The new investment is of equal or greater value but needs refurbishment.
To fully defer the entire capital gain, the exchanger must: (1) spend the entire exchange equity on the completed improvements or down payment by the 180th day (exchange period), (2) receive substantially the same property that was identified during the 45-day identification period, and, (3) the replacement property must be of equal or greater value than the relinquished property at the time of transfer to the exchanger. The final value of the replacement property is the combination of the original purchase price plus the capital improvements made to the property during the exchange period.
normal'>“Reverse” Exchanges
Reverse exchanges are becoming more popular because many investors need to quickly close on excellent purchase opportunities. A reverse exchange is needed whenever an Exchanger must close on a replacement property prior to closing on the sale of the relinquished property. In the past, the IRS had not taken an official position concerning reverse exchanges, thus many tax advisors were cautious in recommending this format to their clients. The lack of clear guidance for the reverse format may be changing very soon. According to recent comments made to the American Bar Association by the IRS's Special Counsel, a revenue procedure for reverse exchanges should be finalized this fall. Reverse exchanges are to become much more common than they are at present, after the revenue procedure is finalized.
normal'>Refinance Opportunities
Some Florida investors never consider an exchange because they mistakenly believe the equity must always remain tied up in real estate. An investor can exchange into a more desirable property, thus preserving all the equity and then refinance the replacement property to obtain cash. The cash received from the refinance of the replacement property can then be used for whatever purpose the investor chooses.
A real estate investor should not refinance the relinquished property and shortly thereafter perform a tax deferred exchange, unless it can be established that the debt incurred prior to the exchange had “independent economic substance.” In most circumstances, an attorney or CPA will recommend refinancing the replacement property after the exchange transaction is complete and that any refinancing should not be included on the replacement property closing statement. Through a refinance of the replacement property, an investor can diversify their investments and meet two important objectives: (1) preserve equity through full tax deferral, and (2) after refinancing the replacement property, diversify investments into the stock market or any other attractive investment opportunities.
A real estate investor should always consult with tax and legal advisors, along with an experienced qualified intermediary, before proceeding with a tax deferred exchange. Investors who understand the exchange trends highlighted in this article will be able to utilize these strategies to accomplish huge tax savings.
normal'>R. Scott Cameron, CCIM, is President of Cameron Real Estate Services, Inc. Cherie M. Embree is a division manager for Asset Preservation, Inc. Cameron and Embree are members of RealSource Group, an alliance of commercial real estate professionals representing their individual markets throughout the eastern United States.