Real Estate Strategic Investment - Combining Code Section 1031 and 121: The Best of Two Worlds
Real Estate has always been a safe investment, specially in cities such as Los Angeles and New York it is an ever-thriving investment and at some point you will see yourself investing in real estate.
There are two tax codes that every real estate savvy investor is very familiar with, and if you own a real estate or think about investing in one, you must know them as well. They are IRC Code Section 1031 and 121.
IRC Code Section 1031 (AKA Like-Kind Exchange) allows you to defer paying taxes on the gain from your capital asset if it is held for productive use in a trade or business or for investment. To qualify for this you must Exchange your capital assets (i.e. real estate) with another "like-kind" capital asset. As you see, this code section applies to all capital assets, but for the purpose of this article, we focus only on the real estate capital asset. From the day you sell your real estate you have 45 days to identify the new property that you are going to buy. As mentioned earlier, this property must be like-kind (i.e. if your first real estate was a multi-family rental property, the new property that you buy must also be a multi-family rental property). Another important deadline to remember is that you also must close the deal within 180 days to qualify for this "like-kind" exchange. By doing so, you will defer the gain from on your first real estate property to such a time that you sell your real estate without using the like-kind exchange.
For example, you bought rental property A back in 2008 when the real estate market crashed for $6 million. Now the fair market value of property A is $10M. If you simply sell your property, you will recognize a $4M capital gain on it and must pay roughly $950K tax on it (4M x 23.8% long-term capital gain tax rate). Now instead of just selling property A, within 45 days of the sale you identify a new property (property B) and within 180 days you close the deal. Property B's fair market value when you bought it was $11M. So you pay all the proceeds from the sale of property A and add another $1M to buy property B. In this case, you won't pay any taxes upon the sale of property A, and your basis in property B is $7M ($6M from property A carry forward plus $1M cash that you added). Keep in mind that you can use the like-kind exchange for property B to buy property C, D, ... and technically can defer paying tax on any gain on these properties indefinitely.
Now that you mastered Code Section 1031, let's go over Code Section 121: Exclusion of gain from sale of principal residence.
This code section applies only to your principal residence. To qualify, you must have lived there at least 2 years within the 5 years prior to the sale of your home. If you meet this requirement, as a single person you can exclude $250,000 of your gain and as a married couple you can exclude $500,000 of your gain. Please note that you can use this code only once every two years.
For example, you and you wife bought your principal home in 2013 for $2M. Today the fair market value is $3M. If you sell your home today, you will recognize $1M gain, and by using Code Section 121, you can exclude $500K of that. So on your tax return you will report only $500K of long-term capital gain and will pay tax on that.
But wait! If you do not need the cash from the sale of your house, you do not have to pay tax once your sell your house. How? By combining Code Section 121 and 1031.
Here is how it works: Same example as above, you and your wife purchased your home in 2013 for $2 million and have been living there since. In 2019 you decide to sell the house and use the proceeds for investment. Instead of selling your house in 2019, you can move out and rent it for at least a year (so it becomes an investment property as opposed to principal residence that it currently is). After a year of renting out your house, you sell it for $3.2M and recognize $1.2 million of gain on it. Since at the time of sale you have lived in that house for at least 2 years within the prior 5 years and it was your principal residence, you qualify for Code Section 121. Therefore you permanently reduce your gain from $1.2M to $700,000. Now if within 45 days from the date of sale you identify another single family rental property and within 180 days close the deal, you won't be paying any tax on that $700K of gain, because you qualify for like-kind exchange (Code Section 1031) and defer that tax payment to future for whenever you sell your investment without using a like-kind exchange.
To have a personalized plan to combine these two code section in a way that benefit you the most, please contact us.
There are two tax codes that every real estate savvy investor is very familiar with, and if you own a real estate or think about investing in one, you must know them as well. They are IRC Code Section 1031 and 121.
IRC Code Section 1031 (AKA Like-Kind Exchange) allows you to defer paying taxes on the gain from your capital asset if it is held for productive use in a trade or business or for investment. To qualify for this you must Exchange your capital assets (i.e. real estate) with another "like-kind" capital asset. As you see, this code section applies to all capital assets, but for the purpose of this article, we focus only on the real estate capital asset. From the day you sell your real estate you have 45 days to identify the new property that you are going to buy. As mentioned earlier, this property must be like-kind (i.e. if your first real estate was a multi-family rental property, the new property that you buy must also be a multi-family rental property). Another important deadline to remember is that you also must close the deal within 180 days to qualify for this "like-kind" exchange. By doing so, you will defer the gain from on your first real estate property to such a time that you sell your real estate without using the like-kind exchange.
For example, you bought rental property A back in 2008 when the real estate market crashed for $6 million. Now the fair market value of property A is $10M. If you simply sell your property, you will recognize a $4M capital gain on it and must pay roughly $950K tax on it (4M x 23.8% long-term capital gain tax rate). Now instead of just selling property A, within 45 days of the sale you identify a new property (property B) and within 180 days you close the deal. Property B's fair market value when you bought it was $11M. So you pay all the proceeds from the sale of property A and add another $1M to buy property B. In this case, you won't pay any taxes upon the sale of property A, and your basis in property B is $7M ($6M from property A carry forward plus $1M cash that you added). Keep in mind that you can use the like-kind exchange for property B to buy property C, D, ... and technically can defer paying tax on any gain on these properties indefinitely.
Now that you mastered Code Section 1031, let's go over Code Section 121: Exclusion of gain from sale of principal residence.
This code section applies only to your principal residence. To qualify, you must have lived there at least 2 years within the 5 years prior to the sale of your home. If you meet this requirement, as a single person you can exclude $250,000 of your gain and as a married couple you can exclude $500,000 of your gain. Please note that you can use this code only once every two years.
For example, you and you wife bought your principal home in 2013 for $2M. Today the fair market value is $3M. If you sell your home today, you will recognize $1M gain, and by using Code Section 121, you can exclude $500K of that. So on your tax return you will report only $500K of long-term capital gain and will pay tax on that.
But wait! If you do not need the cash from the sale of your house, you do not have to pay tax once your sell your house. How? By combining Code Section 121 and 1031.
Here is how it works: Same example as above, you and your wife purchased your home in 2013 for $2 million and have been living there since. In 2019 you decide to sell the house and use the proceeds for investment. Instead of selling your house in 2019, you can move out and rent it for at least a year (so it becomes an investment property as opposed to principal residence that it currently is). After a year of renting out your house, you sell it for $3.2M and recognize $1.2 million of gain on it. Since at the time of sale you have lived in that house for at least 2 years within the prior 5 years and it was your principal residence, you qualify for Code Section 121. Therefore you permanently reduce your gain from $1.2M to $700,000. Now if within 45 days from the date of sale you identify another single family rental property and within 180 days close the deal, you won't be paying any tax on that $700K of gain, because you qualify for like-kind exchange (Code Section 1031) and defer that tax payment to future for whenever you sell your investment without using a like-kind exchange.
To have a personalized plan to combine these two code section in a way that benefit you the most, please contact us.
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Phone: (424) 888-3878