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How to Exchange Your Way to the Beach - 2007-11-10 |
Last week I mentioned a conference I attended on how to maximize benefits of vacation rental properties. One of the speakers outlined a strategy he called "How To Exchange Your Way to the Beach."
It goes something like this:
1. Let's say you have been a small-time landlord for the past decade, and you own about ten little rental houses that you bought for about $50,000 each, and now they are worth about $100,000 each.
2. If you sold today, you would make a long term capital gain of about $50,000 for each house, for a total of about $500,000 in capital gains. That would be taxed at 6% for Georgia and 15% for Federal capital gains tax, for a total tax bill of about $105,000.
3. In addition, you would have to pay a combined tax of 31% on the recapture of any depreciation you took over the years, and that could be substantial. But for the sake of illustration, let's say that the depreciation was a wash, meaning you got the benefit when you took it and now you are simply paying it back.
4. Your spouse is sick and tired of you managing these little rental houses, and if you get one more call about a stopped up toilet, you are going to start taking hostages. In addition, you're approaching retirement from your day job, and both of you are looking forward to slowing down a little.
5. Instead of selling off the ten houses and having to pay the tax, you sell all ten houses to another investor with the tenants in place. And instead of pocketing the profit of $500,000, you initiate an exchange. Your intermediary uses all that cash as a down payment on one nice rental cottage on Saint Simons Island, with a price tag of, let's say, one million dollars. You get a new loan for the remaining half million.
6. Properly structured, this transaction qualifies as a tax-deferred exchange under IRS section 1031, because you exchanged investment property for investment property, and you spent all the cash and you replaced the debt which existed on the properties you sold.
7. Because one of the requirements of an exchange is that you acquire only property held for trade or investment, you must demonstrate that your true intention was to acquire an investment. So you offer the cottage for rental for at least one year (two or three would be better). You show significant rental income on your Schedule E, and you might even make a little positive cash flow because you have a relatively low loan balance.
8. Because this is an investment property and not your principal or secondary residence, you strictly limit personal use to the greater of fourteen nights or ten percent of the total number of nights rented per calender year. In other words, you and your family and friends may use the cottage somewhere between 14 and 32 nights per year, depending on rental, but no more. Less is better. None is best.
9. If you heavily document the purpose of your trip, you may occupy the cottage for a few days devoted primarily to work related to the rental use of the property. These "work days" do not count as personal use. But if you are audited by the IRS, it is likely that these days will be challenged. You should keep solid documentation regarding your activities during these work days, and back them up with receipts, a contemporaneous log, and color photographs showing date and time of the work related activity. Less is better, none is best.
10. After you rent the property to renters for three years, you decide to retire to Saint Simons. The IRS says you have the right to "convert" your rental property to "personal use" simply by deciding to do so. IN this case, you actually occupy and live in the beach house, and you do the normal things that any reasonable person might do when they actually move to a different residence.
11. You live there two years, leaving no question in anyone's mind that the beach is now your principal residence. You are spending the majority of nights at this location.
12. After two years as your principal residence, you decide to sell for one million dollars. Let's assume your loan balance hasn't gone down very much in five years, and you have to pay off about half a million. You are left with the remaining half a million in profit.
13. Under IRS Section 121, you and your spouse now qualify to exclude up to $500,000 of capital gains on the sale of your principal residence totally tax free. You don't have to re-invest, you don't have to be a certain age, and you can do whatever you want with the money.
14. In order for this to work, you must own the house at the beach for a total of at least five years, but many investors are finding that this is a small price to pay for a major tax benefit. And you can take Section 121 as often as every two years. So if you had more than ten little rental houses to begin with, you could schedule a move every two years until you had converted all your taxable profits into tax-free personal residence gains.
I am aware that I glossed over the depreciation liability, but the amount involved is insignificant compared to the savings experienced. Even so, please talk to your own CPA before trying this plan. There are other rules and exceptions, and this example may not apply to your situation.
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