Real Estate investors often ask about income tax strategies that can allow them to eliminate or reduce the income tax burden on the sale or disposition of their real estate assets. These tax strategies include Sections 1031, 1033, 721, 1034, and 121 of the Internal Revenue Code (IRC).
The strategies that follow outline the basic approaches and often require additional analysis based on your circumstances.
Section 1031 – Tax Deferred Exchange of Real Property Used in Business or Held for Investment or Rental Purposes.
Section 1031 of the IRC provides that real property held as rental, investment or for business use can be exchanged for “like-kind” real property also held for rental, investment or business use. Typically, the property has appreciated and outright sale would result in immediate recognition of gain and, therefore, capital gains tax and potentially other taxes. Section 1031 exchange treatment affords the investor an opportunity to defer federal and possibly state income tax liabilities resulting from the disposition. The Section specifically excludes gains from stocks, bonds, and other properties, although securitized assets re not excluded.
Please note that 1031 exchange transactions are tax-deferred exchanges as opposed to tax-free exchanges. Any resulting capital gain tax and potential depreciation recapture income tax are postponed – possibly indefinitely – into like-kind properties acquired as part of similar 1031 exchange transactions. Thus, tax deferral can become tax reduction or elimination depending on one’s time frame.
The tax deferral advantages of 1031 exchanges allow investors to dispose of real property without reducing the total cash or other basis in the asset that would result if the taxes were paid in a standard sale or disposition. This approach provides the investor a way to maintain an asset position without additional infusions of cash and therefore an affords an opportunity to grow the asset base tax free during a certain period while pursuing appreciation opportunities in other markets or locations.
What is like kind? Like-kind property is generally property of the same nature or character, even if it differs in grade or quality from the property being replaced. Personal properties of a like class are like-kind properties. Personal property used predominantly in the United States and personal property used predominantly elsewhere are not like-kind properties. Real property generally is of like kind, regardless of whether the property is improved or unimproved. However, a real property within the United States and a real property outside of the United States are not like-kind properties.
Section 1033 – Property That As a Result of Its Destruction, Theft, Seizure, Requisition or Condemnation or Threat or Imminence thereof is involuntarily converted.
Section 1033 of the Internal Revenue Code provides that real property that is or will be the subject of a compulsory or involuntary conversion either from an Eminent Domain proceeding or condemnation or destruction by an act of God such, in whole or in part, can be exchanged on a tax-deferred basis for like-kind real property that is similar or related in service or use to the property that was involuntarily converted.
Period Limitation Applies. Generally, a 2 year limitation applies. It begins on the date of destruction or conversion or – if earlier – on the date such disposition or threat thereof becomes evident.
Section 721 – Nonrecognition of Gain on Contribution of Property to a Partnership
According to Section 721, no gain or loss is recognized when property is contributed to a partnership. Neither the partners nor the partnership will recognize gain or loss when property is contributed in exchange for an interest in the partnership. The nonrecognition provision does not apply to a partnership deemed an investment company that is incorporated. In addition, the gain or loss may have to be recognized when it is to be included in a foreign person’s gross income.
An interesting application of this section for investors is the possibility of transferring real property interest with built in gains – or of replacement property in a 1031 exchange – to a real estate investment vehicle, typically a real estate investment trust (REIT). The investor recognizes no gain upon the transfer but can subsequently dispose of shares in the REIT. The advantage of REITs is that the market for its shares may be a lot more liquid than for real estate allowing for a quicker sale than would be the case if the investor held onto the original or a 1031 replacement property. The holding period of the replacement property of the 1031 exchange must be observed in order to preserve the tax advantage of gain recognition deferral.
Section 121 – Capital Gain Exclusion on Sale of Primary Residence
Section 121 is a wonderful tool and with adequate understanding of its provisions substantial gains on sale of at least one residential property at a time can be excluded. This section, which replaced the repealed Section 1034, states that gross income shall not include gain from the sale or exchange of primary residence. The requirements are that during the 5-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as the taxpayer’s principal residence and the period of such use equaled or exceeded 2 years.
Generally, a Taxpayer can sell real property held and used as his or her primary residence and exclude from gross income up to $250,000 in capital gain tax if the taxpayer is single and up to $500,000 for joint filers. The two year period can accrue in increments over 5-year period. In addition, there are certain exceptions to the 2-year residence requirement such as due to change of employment, health, and other events and circumstances beyond investor’s control.
I must note that in order for join filers to qualify for the higher exclusion amount of $500,000 the following requirements must be met. Either spouse must meet the ownership requirements (primary residence) with respect to the property; both spouses meet the use requirements of subsection with respect to the property; and neither spouse is ineligible for the benefits with respect by reason of not meeting the ownership and use requirements.
From an investment standpoint, the 2-year holding period can be repeated indefinitely. The primary residence would preserve the tax free exclusion of the capital gain every two year period.
In cases where the potential realized gain on sale of primary residence exceeds 250,000/500,000 scenario, there are planning opportunities that should be reviewed periodically with your tax advisor. Tax deferred exchanges may allow the investor to sell the primary residence assuming the investor first converts the property to rental or business use for sufficient amount of time to satisfy the deferred exchange section requirements. Typically, we must examine the investor’s specific circumstances as there are multiple restrictions and limitations under each strategy.
Section 1034 – Repealed — Nonrecognition of Gain on Sale of Principal Residence
This strategy applies to an individual selling his or her principal residence who purchased property on which to construct a new principal residence (within the meaning of such section) on which the construction commenced during the year, or the construction of which was terminated before completion, (and who brought an action, and obtained a judgment, against the builder who commenced construction of the new residence but failed to complete it).
It also applies to those who suspended construction of such residence so that the partially constructed residence could be used as evidence in connection with the prosecution of the builder, and who failed to meet the requirements of such section with respect to occupancy of the new principal residence because of such suspension of construction.
This Section has been repealed and a more effective and, in our opinion, section 121 was enacted.
This article contains only general information and O’Brien & Panchuk is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for professional advice or services, nor should it be used as a basis for any decision or action that may affect your business or individual financial position. Before making any decision or taking any action that may affect you or your business, you should consult a qualified professional advisor. We shall not be responsible for any loss sustained by any person who relies on this article.
