Understand Rules on Converting Property
It is often a question of what you want something to be, not necessarily what it is. The IRS has provided different tax codes for the disposition of different forms of property. If we look at real estate, for example, section 121 applies to the sale of a primary residence, section 1031 applies to real property held for investment and section 1033 that applies to property involuntarily converted—just to name a few. Each section contains positives and negatives. Each time you consider selling a property, you should look at the opportunities each may offer you.
Typically speaking, advanced planning oftentimes allows one to minimize tax consequences through the use of one or more tax sections. The IRS realizes that a person’s circumstances may change; therefore, it is okay for property to change in character overtime. This means an investment property can eventually become a primary residence, a vacation home an investment property, a primary residence an investment property, and so forth.
There may be a few additional rules when property is converted. Consider the following opportunities.
Exchanging from one investment property into another that may at a future date become a primary residence.
The government has acknowledged the possibility of this scenario by creating a special rule that applies specifically to it. When a property has been acquired through a 1031 Exchange and later converted to a primary residence, the owner faces a mandatory five-year hold period before having the ability to sell obtaining the Section 121 exclusion. The taxpayor still must satisfy the minimum two of five-year occupancy as primary residence.
Utilizing both Section 121 and Section 1031 when the property value is greater than the exclusion.
Many taxpayers wonder what options they have when considering the disposition of a primary residence and the gains fall outside the $250k individual or $500k married exclusion limits. In 1997, when section 121 was installed, home prices were significantly lower than they are today and limits that once seemed reasonable, today fall short. One option the owner has is to move out of the primary residence and establish the property as an investment. After a reasonable seasoning period it is then possible to sell the investment home utilizing section 1031. In fact, if the investment properties sale happens in a time period that section 121 can still be applied, the government has allowed the application of both tax codes. This makes it possible to take the exclusion and to merely exchange the residual amount using section 1031.
Applying Section 1033 when the city wants to acquire a property from you for future development.
It is possible for the city to acquire property you have held for investment, allowing you the opportunity to utilize a 1031 Exchange. Or, it may be possible for the city to acquire the property through involuntary conversion, allowing you to utilize Section 1033. While Section 1031 may offer greater flexibility of like-kind requirements, section 1033 offers benefits in time requirements and allows receipt of sales proceeds.
As you can see, it is often not the question of what something is, it is a question of what you want it to be. When considering the disposition of an asset, it is critical you consult appropriate tax counsel to review your opportunities. Equity Advantage is here to work with your tax and legal team. Call us for a brief review of the opportunities that may be available to you.