I had a client who was buying a property via a 1031 tax-free exchange. First of all, it’s actually a tax-deferred exchange, not tax-free. You might hear someone call it a like-kind exchange or a Starker exchange.
What is a 1031 tax exchange?
A 1031 tax exchange is one where investment property is being sold and a replacement investment property is being purchased, and you use pertinent IRS tax code to defer the capital gains. Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale and hence defer any capital gains taxes otherwise due.
An real life example
This client of mine was selling land on the West Coast that was income-producing and buying a single family home with an in-law suite on the East Coast. A single family home with an in-law suite is not unlike a duplex. But the lower unit does not have a Certificate of Occupancy so it is not called a formal duplex. It is instead called a single family home with an in-law suite.
She said she was going to rent the lower unit and live in the upper unit. At first blush, this did not sound right to me. How can you sell an investment property, and then buy something as a primary residence that you are going to live in? Even if it were going to have partial rental income and still use a 1031 exchange, that sounds incorrect. I always assumed if the old property was 100% rental property, the new one had to be as well. I was partly correct, and I was partly wrong.
The buyer insisted that their accountant told them this strategy was OK and didn’t want to discuss it further. Well, who am I to know more than an accountant? Right or wrong, I decided to look into it further anyway, even though the client told me not to.
I research it further
I have a friend who used to be a 1031 exchange specialist. It was all he did. I asked him about this. He told me to do a search on “bifurcating” a 1031 exchange. The new replacement property is divided by square footage as to what percentage is income-producing and what percentage is owner-occupied. And you can exchange the percentage that is income-producing on the new home. Assume the new home that was $500,000 was a total of 5,000 square feet. If the lower unit that was to be rented was 1,000 square feet out of 5,000 square feet total, the replacement property would only be able to exchange $100,000 worth of the profit from her old investment property. A $500,000 purchase price x 20% which is the amount of the space to be used as an investment= $100,000. A tax lawyer and my own accountant confirmed this was correct.
I thought that if she bought the place as a 100% investment property and said she was going to rent out both spaces in her home that she could then exchange all her proceeds from the sale of her old investment property. And not just $100,000 of her proceeds. And she will be renting it out fully as she is a Foreign Service Officer and being assigned abroad soon.
Although her interest rate was higher to buy the new home as an investment property, it only caused her monthly payment to increase by $120 a month or $1,440 a year. And we have to remember the increased interest payment is also tax deductible. She planned to own this home for about 10 years so that would increase her carry cost by $14,400 over a decade. However, avoiding the capital gains taxes on $400,000 saved her $60,000 today! Investing that $60,000 over the next decade will also net her more profits via dividends and interest. So my further research into this issue netted her massive savings.
The tax lawyer I consulted said her accountant gave her incorrect advice. He said my idea of restructuring this as an investment purchase will allow her to 1031 exchange all of her proceeds. My own accountant told me that the Internal Revenue Code strictly states: “Property used primarily for personal use does not qualify for like-kind exchange treatment. Also that an in-law suite is not a detached property, and is treated differently than say a formal duplex with a Certificate of Occupancy where you have two separate living areas.”
Here’s to independent thinking and more research! Will most loan officers go to this level of research and dedication? When choosing a lender, think about this story, and use your best judgment. Pick a professional. You never know what side benefits you may get, maybe $60,000 worth! Do me a favor and subscribe to my newsletter, too. I do not send it out often, only 1-2 times a year. I like to send out useful info like this and I’d love to see your comments when I do.