Episode Transcript
[00:00:00] Speaker A: Hey, guys, just real quick, I want to go over something that I've been getting a lot of questions about. And it relates to 1031 exchanges. Of course, everyone understands that a 1031 exchange is where you relinquish an investment property, real estate, and you replace it with another piece of investment real estate.
You can exchange residence for a rental home, for vacant land. You can exchange vacant land for a warehouse. You can exchange a hotel for a retail shopping center. So as long as it's land for land that is held for investment. And this is very important about what I'm getting ready to say.
It's a tax deferred exchange, meaning that all of the capital gains tax and depreciation recapture tax that you would normally incur when you sell that investment property is deferred. It carries over to the property that you're replacing the relinquished property with. So a little trick that a lot of our clients use is they will sell an investment property, maybe in a cold state, maybe in Minnesota or New York, and then they will buy a replacement property down here in Florida. Now, they may sell a little retail space, an office building or something like that. They had, let's say, in Pennsylvania, and they'd been renting it out for years. The depreciation was. Had been completed. They owned it for decades, completely depreciated it. And now they're selling it for a million dollars. And the capital gains, because they depreciated it down to zero, their capital gain would be a million dollars. Plus they're going to have a depreciation recapture of a million dollars. So if they sell it, their tax event, their tax consequence would be extremely high. They would have to spend a lot of money on taxes. So instead what they want to do is they go, fine, we're going to sell it for a million dollars. We're going to put that million dollars with a qualified intermediary. We have some names of those really good ones around the country. If you ever need an intermediary recommendation, just let us know. And we can send you some names or links to some really good ones that we trust around the country. And they will then use that money and buy a replacement property. So what a lot of our clients do is they sell that one in Pennsylvania and then they buy maybe a condo on the beach or a condo anywhere in Florida. And they want to eventually move into that condo as their retirement home. So what we tell them to do is go ahead and say, okay, fine, buy this property, but you must hold it for investment. Now, unfortunately, there is no hard and fast rule about how long you must hold the property for investment.
What we recommend is two tax years. That's typically safe, but again, there is no hard and fast rule from the IR's as to exactly how long you have to hold the property as an investment. But we recommend for two tax returns. This replacement property shows up for at least two tax returns as an investment property. Now holding as an investment property. What does that mean? Well, number one, it cannot be your second home. You cannot live in this property on a regular basis as a second home. And that's a whole other video explaining. And there's lots of other resources. And the IRS dot gov website has lots of information about what constitutes a second home. Because a second home is nothing, an investment property or a property held for investment that would qualify for a 1031 exchange. So that's, number one, it cannot be a second home. It must be an investment property. So when you buy this condo as a replacement, you must be able to show that you bought it with the intent of holding it for an investment. So you held it with the intent of renting it out. You cannot just let friends and family stay there week after week for free. That is not holding it for an investment. You can't even renting it to friends and family.
If it's not market rents, you're raising a red flag in an audit later.
So we've actually had clients and friends and family who have been audited for this issue. They have bought a replacement property and then they never advertised it. They just held onto it and they would spend maybe a week or two a year there, vacations, but otherwise the property just sat empty. Then later, when they moved into this property to make it their primary residence, after they had sold their other primary residence, they had a real problem because they got audited. The IR's goes, wait a minute, we've had two years of tax returns. We don't see any rental income from this property listed anywhere on your schedules of your tax return. And now you're saying that was your replacement property. So we're going to go back and we're going to now assess the depreciation recapture tax and the capital gains tax that we should have assessed two or three or four or even seven years ago. I've seen them go back seven years when you bought this, quote, replacement property, this replacement investment property that you never truly held for an investment. Now prove to us you held it for an investment. So when they went into the audit, they have to show, well, here's the ads. Here's everywhere. We advertised it, trying to rent it and we just couldn't get any renters.
Another thing is they had to show that, well, we were trying to rent it back then it was in newspapers and they didn't even really have the Internet. But now you have Airbnb, Vrbo, homeaway. You have lots and lots of different platforms where you can advertise this property for rent or rent it long term, rent it to snowbirds who are staying in it for three to seven months at a time. It's fine. You can do that as long as, if it's a condo, you have the permission and the ability to do that in that condominium association.
So anyway, you've got to hold it as an investment property. That's a big issue for everybody. For the IR's, again, we recommend holding it for two years. Once you have held that property for at least two years, then the thinking is fine, you can now move into it as your primary residence. So on your tax return, it will now be listed as your primary residence. So now you can live in that property for at least another two years. And assuming that the primary residence reporting requirement is still gone and capital gains exemption still applies, you could conceivably sell that property and a lot of capital gain at least would be wiped off by the primary residence deduction that you could use. So that's just a tip. It just came to mind this week because we've had a lot of questions about 1031 exchanges. We've had a lot of people who are looking to move from Florida up north, and they're selling investment property they have in Florida and they're moving up north and vice versa. They're selling investment property they hold up north and moving to Florida in a few years. This is a great retirement planning strategy, a great tax planning strategy, because as long as you live in a property as your primary residence and it's listed on your tax return and every other indication is it is your primary residence. It's where you vote, it's where your cars are registered, it's where you get your utility bills, everything else, that's your primary residence. If you live in that primary residence at least two out of five years, then you can sell that property and subject to certain limitations, you can prevent or avoid capital gains tax on a very large amount of capital gains that may be incurred whenever you then go to sell that property. So in a way, you're converting an old investment property that may have been a store or a hotel or a warehouse or whatever you sold at one point you turned it into a nice residential property that was held for investment. Then after a couple of years, you moved into that property. You lived there at least two out of the five years as your primary residence. Then you sell it, and now you've got the benefit of the primary residence exclusion. So that's just my two cent on this quick take. If you guys have any other ideas about tax savings or any other questions about tax savings when it comes to real estate, let me know. Or 1031 exchanges. Any more questions about those, feel free to ask. Work a lot with 1031 exchanges. Reverse 1031 exchanges, especially inside land trust. Again, I've done a whole video on that, so if you got any other questions, feel free to reach out. Direct message us, email us, call us, comment below and we'll see you later.
[00:09:04] Speaker B: Thanks for listening to this edition of trust this if you got something out of it, please press like and subscribe and give us a five star review to help us reach others who can benefit from this series. Until next time, keep aspiring to a better life.
