Tom Kelly: Timeline for ‘exchange’ residents confusing

The lackluster housing market has many investors looking for bargain properties, sometimes in bunches. The ways of funding the purchases also have become more creative as buyers rethink the role of real estate not only for their portfolios but also for their residences.

In a recent example, an older couple Stanwood had sold their home and purchased two Arizona golf-course condominiums with the proceeds – one for their primary residence and another as a rental – and still put some money in their pocket. What made the deal interesting was that they had purchased the original home six years ago via a tax-deferred exchange.

While investors had turned rental properties into principal residences for years, the ability of when the principal residence exemption of $500,000 ($250,000 for a single person) could be taken on a home acquired via an exchange was clarified in late 2004.

Before then, taxpayers were left to guess how long they had to hold an investment property before deeming it a primary residence – or when it was safe to sell it and pocket any gain.

The American Jobs Creation Act of 2004 spelled out the steps necessary to create a “safe harbor” with the Internal Revenue Service for investors who ended up living in one of their rentals. The key stipulation was the exchange property must be held for five years in order to qualify for the primary residence exemption. The five-year period curtailed people from buying investments, immediately moving into them and then quickly selling them simply to avoid a capital gain tax.

In order to qualify for the $500,000 exclusion ($250,000 for single persons) homeowners must have owned and used the property as a principal residence for two out of five years prior to the date of sale. Second, the owner must not have used this same exclusion in the two-year period prior to the sale. So, the only limit on the number of times a taxpayer can claim this exclusion is once in any two-year period.

Under the exchange rules, commonly known as 1031 Exchanges or Starker Exchanges, a taxpayer that exchanges property that was held for productive use or investment for “like-kind” property may acquire the replacement property on a tax-free basis. Because the replacement property generally has a low carry-over tax basis, the taxpayer will have taxable gain upon the sale of the replacement property.

However, when the homeowner converts the replacement property into a principal residence, the taxpayer may shelter some or all of this gain from income taxation. The committee that drafted the five-year rule wrote that proposal “balances the concerns associated with these provisions to reduce this tax shelter concern without unduly limiting the exclusion on sales or exchanges of principal residences.”

While the five-year requirement is a helpful guideline, it does not significantly extend the timeline for people who might consider moving into their own rental. That’s because an investment property needs to be rented (used as an investment) after an exchange to show the exchange was clearly an investment-for-investment transaction.

Accountants say the exchanged property should be held for at least two years as an investment property before an owner considers converting it to a primary residence. In addition, once the homeowners move in to the new primary residence, they must stay at least two years before qualifying for the $500,000 exclusion.

When you add the suggested two years as investment property with the two years required under the residency guideline, that’s four years minimum needed to reach the five-year safe harbor status.

Exchange facilitators and tax attorneys caution that all exchanges must meet the “facts and circumstances” test regardless of how much time has passed before converting an investment property to a personal residence. In a nutshell – it’s all about intent. If it’s clear at the time of the exchange that a taxpayer intended to use the exchange property as a primary residence, the exchange can be challenged.

While a tax-deferred exchange appears just like a “sale” for you, your real estate agent and parties associated with the deal, Section 1031 of the Internal Revenue Service code specifically requires that an exchange take place. That means that one property must be exchanged for another property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax deferred transaction from a sale and purchase. The exchange is created by using an intermediary (or exchange facilitator) and the required exchange documentation.

If you’ve traded for a lakefront getaway condo and now think you would like to live there, make sure you own it for five years before attempting to pocket a principal residence exemption.

Tom Kelly’s new E-book “Bargains Beyond the Border: Get Past the Blood and Drugs: Mexico’s Lower Cost of Living Can Avert a Tearful Retirement” is available online at Apple’s iBookstore, Amazon.com, Sony’s Reader Store, Barnes & Noble, Kobo, Borders Books, Diesel eBook Store, and Google Editions. It mirrors a recent article by CNN on the benefits of the country, including increased rental possibilities.