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Deferring and Potentially Avoiding Taxes on the Sale of Your Primary Residence – Part 1

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We frequently receive questions from owners of appreciated personal residences who ask us if it is possible to defer taxes on the sale of their personal homes using the 1031 Exchange. The answer which may surprise some readers is a conditional “Yes” – provided several important steps are followed which we will generally outline in this blog.
 
Rental property owners often utilize Internal Revenue Code Section 1031 (“1031 Exchange”) to defer taxes that would otherwise be due upon the sale of their business properties. The original 1031 Exchange rule dates to 1921 and has been used by many thousands of investors to defer and potentially avoid taxes and has the support of the IRS provided that specific rules are followed. 
 
Use of the 1031 Exchange to defer taxes is limited to the sale and subsequent purchase of business properties that are deemed to be “like kind.” Fortunately, the definition of “like-kind” is very broad and exchanges from most forms of business real property into other business real properties are allowed. Examples of permitted “like-kind” exchanges can include a single-family rental to an apartment or retail store, raw land into a rental property, etc. Essentially, any income property can be exchanged into any other income property or other permitted ownership structure such as Delaware Statutory Trust (DST).
 
If you are planning the sale of an appreciated personal residence, it may be useful to see if you can benefit from the process outlined below. Note that these steps have been simplified to convey the general concepts and you should seek the advice of qualified tax and real estate professionals based on a comprehensive analysis of how this strategy may apply in your personal situation. 
 
Step 1
 
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The first step is to convert your personal residence into an income property. This is done by moving out of the personal residence and then renting it out and receiving income from it for some period time. While IRS does specify a minimum rental period, many tax advisors suggest a minimum holding period of 1 to 2 years prior to selling and exchanging the property. 
 
Step 2
 
You obviously need to find a new place to live. Any net cash flow that you receive from the rental of your former residence can be used to either pay rent on a new residence – or make mortgage payments if you choose to buy a new residence rather than rent. In some areas of the US e.g., San Francisco Bay area, rental rates have escalated to a point where the income from a previous residence may be more than enough to rent a smaller residence in the same area – or allow you to move to a less costly area and enjoy the added income. 
 
Step 3
 
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With careful planning, a homeowner may be able to combine the potential benefits of a 1031 Exchange with a personal home tax exemption. Section 121 of the Internal Revenue Code allows a taxpayer to exclude the first $250,000 (if single) or $500,000 (if married) of the gain from the sale of a personal residence provided that the taxpayer owned and occupied the property as a principal residence for two of the five years immediately before the sale. Therefore, if you have lived in a primary residence for a minimum of two years and then rented it for no more than three years, you may be eligible to utilize Section 121 to exclude up to $250,000/$500,000 of gain and defer further gains via a 1031 Exchange (!). 
 
Step 4
 
When you sell your former residence, which has now been converted into a rental property, you will need to reinvest the proceeds into “like-kind” investment properties to take advantage of a 1031 Exchange tax deferral. Finding suitable investment properties can be one of the most challenging steps in this process. Most homeowners have little experience managing rental properties and do not want the hassle of dealing with the responsibilities and liabilities of rental properties. Rental properties structured as a Delaware Statutory Trust (DST) may be an attractive option. DSTs can qualify as “like-kind” properties and are managed by a trustee who is responsible for day-to-day management and who is the sole borrower on the property (if there is a loan). DSTs can provide relatively hassle-free, stable monthly income which can be partially sheltered from taxes through deprecation and expense write-offs.   
 
The 1031 Exchange also permits heirs to inherit properties on a “stepped-up” basis meaning that the value of their inherited property is adjusted to the then current fair market value at the time of the inheritance and no taxes are owed on the previous gains. This can be a very powerful estate planning tool to maximize the transfer of wealth to one’s heirs.
 
Homeowners who are selling properties with large gains i.e., generally greater than $1 million are most likely to derive possible tax savings. Section 121 exclusions of $250,000/$500,000 may offset smaller gains without the need to utilize a 1031 Exchange. Rather than paying taxes on their appreciated gains, many homeowners may be able realize significantly higher income through reinvesting all/most of their appreciated taxable equity into suitable “like-kind” investment options via the steps outlined above.  
 
In a future blog, we will discuss other tax deferral strategies based on installment sales including both the Monetized Installment Sale and the Deferred Sales Trust. 
 
For further information, please contact us at 866 398-1031 or send us an email at info@FirstGuardianGroup.com.

BIO : Paul Getty

Paul Getty is a licensed real estate broker in the state of California and Texas and has been directly involved in commercial transactions totaling over $2 billion on assets throughout the United States. His experience spans all major asset classes including retail, office, multifamily, and student and senior housing.Paul Getty’s transaction experience includes buy and sell side representation, sourcing and structuring of debt and equity, work-outs, and asset and property management. He has worked closely with nationally prominent real estate brokerage and investment organizations including Marcus Millichap, CB Richard Ellis, JP Morgan, and Morgan Stanley among others on the firm’s numerous transactions.Paul Getty also maintains a broad network of active buyers and sellers of commercial real estate including lenders, institutions, family office managers, and high net worth individuals.

Prior to founding First Guardian Group/FGG1031,Paul Getty was a founder and CEO of Venture Navigation, a boutique investment banking firm specializing in structuring equity investments made by institutions and high net worth individuals. He possesses over 25 years of comprehensive worldwide business management experience in environments ranging from early phase start-ups to multi-billion dollar corporations. His track record includes participation in IPOs and successful M&A activity that has resulted in investor returns of over $700M.

Paul Getty holds an MBA in Finance from the University of Michigan, graduating with honors, and a Bachelor’s Degree in Chemistry from Wayne State University. He is a member of Institute of Real Estate Management (IREM), a Certified Property Manager Candidate (CPM), and a member of the US Green Building Council.Paul Getty holds Series 22, 62, and 63 securities licenses and is a registered representative with LightPath Capital Inc, member FINRA /SIPC .

Paul Getty is a noted speaker, author, and actively lectures on investments and sales and management related topics. He is author of The 12 Magic Slides ,Regulation A+: How the JOBS Act Creates Opportunities for Entrepreneurs and Investors , and Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST), available on Amazon and other retail outlets.



Disclaimer
There is no guarantee that any strategy will be successful or achieve investment objectives. All real estate investments have the potential to lose value during the life of the investments. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please be aware that this material cannot and does not replace the Memorandum and is qualified in its entirety by the Memorandum.

This material is not intended as tax or legal advice so please do speak with your attorney and CPA prior to considering an investment. This material contains information that has been obtained from sources believed to be reliable. However, FGG1031, First Guardian Group, LightPath Capital, Inc., and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) and 1031 Exchange properties. These include, but are not limited to, tenant vacancies, declining market values, potential loss of entire investment principal.

Past performance is not a guarantee of future results: potential cash flow, potential returns, and potential appreciation are not guaranteed in any way and adverse tax consequences can take effect.  The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All financed real estate investments have a potential for foreclosure. Delaware Statutory Trust (DST) investments are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits.

IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, you should consult your tax and legal professional for details regarding your situation. Securities offered through registered representatives of LightPath Capital, Inc. Member FINRA / SIPC. FGG1031, First Guardian Group, and LightPath Capital, Inc. are separate entities.

DST 1031 properties are only available to accredited investors (generally described as having a net worth of over one million dollars exclusive of primary residence) and accredited entities only (generally described as an entity owned entirely by accredited individuals and/or an entity with gross assets of greater than five million dollars). If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney prior to considering an investment. You may be required to verify your status as an accredited investor. Member of LightPath Capital, Inc.