Real Estate: It worked for them
Deferring Capital Gains with 1031 Exchanges
By Lorraine Stuart Merrill
     
     THANKS TO SECTION 1031 of the Internal Revenue Code, Harrianne Kopel has quit waiting on tables. She now works for herself, managing her own real estate investments.

     A Brooklyn native, Harrianne settled outside Boston with friends after college. She supported herself as a costumed waiter, serving food while acting a part.

     In 1984, she was waiting on tables' garbed as a Pilgrim'in Plymouth, Massachusetts, when a persnickety landlady refused to let her put up shelves in her apartment. Harrianne was inspired to buy (for only $34,000) a run-down, 100 year-old cottage just a quarter mile from the beach in nearby Kingston.

     Ten years later, a worse-than-usual New England winter drove her to warmer climes. She rented out the cottage and moved to Arizona'Phoenix 'where she worked in a 50's diner, serving burgers while playing 'a whiny, caustic old New York lady dressed in housecoat, curlers, apron, and some of the ugliest earrings you have ever seen!' Then, in 1997, a tenant trashed the Massachusetts cottage. Sick of being an absentee landlord, she listed it for $97,500'but got no takers.

     Last year, she tried again. This time, it sold quickly'for $214,000, as part of a Section 1031 like-kind exchange. She'd already heard of 1031. Her tax preparer, also an absentee landlord, had been thinking of using a 1031 exchange to sell some property.

     Kopel decided to investigate.

     Section 1031 defers capital gains taxes essentially by shifting tax basis from a property sold to an acquired property of 'like kind.' For the purpose of Section 1031, the IRS treats any sort of real estate held for investment purposes as being of like kind to any other investment real estate.

     To qualify, advises attorney Richard Lipton, tax partner with Baker & McKenzie in Chicago, 'Property must be used in trade or business or held for investment.'

     A vacation home held for personal use does not qualify. But a vacation-home rental property does. But it can't be utilized for personal use more than 14 days a year, or ten percent of annual total rented days. While the IRS hasn't set a firm rule, Lipton advises a minimum of two years of rental history. He prefers five.

     Exchange transactions must conform to strict IRS rules. IRS guidance and clarification on the role of QIs and the exchange process has helped fuel the recent dramatic growth of 1031 exchanges.

     All exchange transfers and money must be handled through a disinterested, independent party, known as a 'qualifying intermediary' or QI. Property to be acquired by the taxpayer must be identified within 45 days of the transfer of the property being sold in the exchange. The entire transaction must be completed within 180 days.

     'I asked my real estate agent to handle it, but she kept dropping the ball,' Kopel says. 'It was my buyer's agent who connected me with Compass Exchange (qualified intermediaries).'

     She hadn't planned ahead to use Section 1031, so she had to move quickly to meet the deadlines. It was worth the rush. The 1031 exchange saved her $60,000 in taxes-money she'll eventually owe the IRS, but can use in the meantime.

     'I feel like I found that money-money I could never earn in my lifetime by waitressing.'

     Before selling her cottage, Kopel earned about $15,000 a year. Single and in her mid-50s, she saw little hope of ever retiring. After selling the cottage, she says, 'I was left with $180,000 in a fund to invest in an exchange.' With advice from a couple of real estate professionals, she bought a three-bedroom house on a greenbelt in Surprise, a fast-growing Phoenix suburb, and a two-bedroom condo-conversion in Phoenix. She's had no trouble renting the properties, and happily has traded her apron and menus for a used RV. She's doing some traveling.

     Kopel would recommend Section 1031 exchange to anyone who wants to sell rental property and invest the proceeds in real estate.

 

A qualified intermediary must hold the funds received on the sale until the exchange purchase is completed, and due diligence is advisable in selecting a QI. Check references and seek referrals from trusted accountants or attorneys. Kopel says her QI, Kim Borsari at Compass Exchange Advisors LLC in Kingston, Massachusetts, 'made me comfortable enough to ask stupid questions.' Borsari helped Kopel develop her plan, and sent reminders of all the deadlines and requirements.

     Bob and Mary Connolly of Tom's River, New Jersey, were nervous at first about using 1031 in 2002 when selling a Long Beach Island duplex they'd originally used themselves and then rented out when the children were grown and far away.

     Bob first learned of 1031 years ago when he sold a business. Back then, 1031 provisions were very more restrictive. But, now, their 2nd home was being bought by someone who was using it as part of an exchange. Many restrictions had been lifted and, Bob and Mary knew they wanted to reinvest the proceeds in quality vacation rentals.

     They've long had an attachment to the Jersey Shore. But more than that, they discovered they enjoyed renting a beach house to guests. They understood the business, too. 'Instead of putting the money in the bank at two or three percent, we could invest in real estate,' Mary says. 'We don't know a lot about the stock market, or things like REITs (real estate investment trusts).'

     'We thought the best investment would be the Shore, because people love it,' Bob added. But the retired couple needed rentals closer to their primary home and easier to take care of than the duplex they were selling. Their accountant and attorney connected them with a QI.

     Because they hadn't planned in advance, they, too, had to scurry to find properties within 45 days'they ended up with two condos with beautiful views, just a short walk from the beach, and $35,000 in deferred tax savings.

     Located in one of the nation's hottest vacation home markets, the two properties have skyrocketed in value in just three years.

     Now, the Connollys have an eye on a larger apartment'with even better views'in one of their condo buildings. If they buy, they'll do another exchange'selling one of the two smaller condos to buy the bigger one.

     David Kuns is a certified exchange specialist. He's vice president of Starker Services, Inc., a national qualified intermediary firm specializing in 1031 exchanges, headquartered in Los Gatos, Calif. While he emphasizes that 1031 doesn't apply to personal-use 2nd homes, his firm is doing 'quite a few' exchanges of vacation home rentals. Hotspots for vacation property 1031s include resort areas like Lake Tahoe, northern California's Lake Almanor, and Destin in the Florida panhandle.

     'It's the Baby Boom,' Kuns says.

     Homes may be used by their owners occasionally. Or may have been converted from personal to rental use. Kuns says owners can only use a home just 14 days a year'or up to 10 percent of the number of days it is rented at fair market rent. If a home is rented for 250 days, then up to 25 days personal use may be allowed and still qualify for Section 1031, he explains. Personal use includes use by a relative'unless the relative pays fair market rent.

     Converted uses and multiple-use properties are more complicated, but may also provide 1031 exchange opportunities.

     'We're seeing a lot of tax planning,' says Kuns, who is a director of the Federation of Exchange Accommodators. 'People are selling a true rental property'in say, New York, and buying another in Florida. They will rent that property out for one year, and then move in as a vacation or retirement home.' Starker Services and some other QIs recommend at least one year of renting a property acquired through 1031 exchange before converting to personal use, but some QIs recommend two years, or longer. At this time, no rule has been adopted, but says Kunsz, the IRS has twice asked Congress for a minimum one-year holding period for property to qualify.

     Once a home has been a principal residence for two years out of the previous four, the owner qualifies for a Section 121 capital gains exclusion of up to $250,000, if single, or $500,000, if married and filing jointly. 'If you lived in a house for three years, then rented for two years,' says Kuns, 'you can sell it as principle residence and take the Section 121 exclusion'and do a Section 1031 exchange on anything above that.'

     Financial planners like Seth Pearson CFP, principal of Pearson Financial Services in Dennis, Mass., also advise clients of Section 1031's usefulness as an estate-planning tool. Property acquired through an exchange can be held-or exchanged again, any number of times. Then at death, the property gets a step-up in basis and heirs can sell tax-free.

     While Kopel and the Connollys made good use of Section 1031 without advance preparation, they wish they'd had more time to find properties and plan the transactions. More complicated situations, like those described by Kuns and Pearson, absolutely demand advance planning and professional advice.

     'Everything requires advance tax planning,' says Kuns. 'Don't wait to call just before the sale.'