David and Tom Moore, the 1031 Exchange Brothers, have played a significant role in assisting the homeowners in the complex procedures of real estate, particularly utilizing a 1031 Exchange for minimizing tax liabilities. One of the major matters that are often discussed is the $500,000 exemption under Section 121 of the Internal Revenue Code, which has not been amended for nearly 30 years. The outdated exemption might cause many homeowners to be faced with large tax bills upon selling their primary residences.
The Power of the $500,000 Exemption
Homeowners under Section 121 are allowed to exclude capital gains from the sale of their primary residential dwelling up to a figure of $250,000 or up to $500,000 for the couples borrowing afresh jointly as long as they live in the residence for two of the 5 years right before the sale. A sad reality is that most of the homeowners do not know that they can change their primary home into a rental property taking the advantage of both this exemption and of a 1031 exchange.
Converting Your Home to a Rental
One of the commonly adopted strategies that homeowners should look at for the purpose of avoiding massive tax liabilities is to change their primary residence to a rental property. This way, they can rent it out for two or three years, thereby qualifying it for both the Section 121 exemption and the 1031 exchange. This approach requires adherence to certain important steps:
- Live in the home for at least two years within the five-year period before selling.
- Rent the property at fair market value to establish it as an investment property.
- Be mindful of the IRS regulations regarding personal use versus rental use.
Why the Conversion Matters
This transformation is crucial as it opens doors for the homeowners to save more on taxes. To illustrate, consider a scenario where a homeowner opts to sell a house for $500,000 but had bought it for only $200,000. In that case, this property selling transaction brings forth a gain of $300,000. But, due to the Section 121 exemption, they can leave out $250,000 of that gain, thus, they will be left with a taxable gain of merely $50,000, which can then be deferred with the help of a 1031 exchange.
Example Scenario
Envision a solitary homeowner who resided in his house for all the years of 2018 to 2022 and afterward, for the time being, turned it into a rental property from the year 2022 to 2024. They will possibly sell the house in the year 2024 by which they will be able to exclude a considerable part of their earnings under Section 121 and at the same time, defer the rest by a 1031 Exchange. This story illustrates the power of strategic decision making that can benefit you with huge tax savings.
Key Considerations
Although changing a primary residence into a property is a tax move that can gain you a lot, you need to realize that there are some antiphons that you should know about first:
Non-Qualified Use
A duration of time that the property was not being used as the main home of the taxpayer may be regarded as non-qualified use. This might influence the exclusion given in Section 121.
Fair Rental Value
When renting to family members, it is important to comply with the fair market rental rate. Renting a property at a below-market rate can prompt questions from the IRS, which may come to your 1031 exchange be in a risky situation.
Documentation and Recordkeeping
Complete documentation is crucial. To support its eligibility for a 1031 Exchange during an IRS audit, it is advisable to have the records of rental periods, rental income, and personal usage of the property.
Transforming a primary residence into a qualifying property for the 1031 Exchange transaction is a feat that requires meticulous planning and strict compliance to IRS directives. When dwelling owners acquaint themselves with the set standards and steer clear of the possible pitfalls, they can successfully postpone the capital gains tax and embrace their investment potential fully. If you’re considering selling your principal residence, consult with qualified tax professionals to navigate this complex landscape.
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The Guys With All The Answers…
David and Thomas Moore, the co-founders of Equity Advantage & IRA Advantage
Whether working through a 1031 Exchange with Equity Advantage, acquiring real estate with an IRA through IRA Advantage or listing investment property through our Post 1031 property listing site, we are here to help Investors get where they want to be. Call them today! 503-635-1031.
