Retirement Planning With a 1031 Exchange

With a large population of baby boomers reaching retirement age it becomes extremely important to plan and take advantage of all the tax-saving strategies that are available. Most investors think about the immediate tax benefits of completing a 1031 exchange but may not consider the additional long-term benefits of the tax deferral. An exchange provides the opportunity to apply pre-tax dollars towards replacement property and put that money to work. The additional money can help investors acquire a more valuable replacement property that may yield a higher annual return on investment and may reap greater long-term appreciation. Exchanges also provide the opportunity to diversify real estate holdings, consolidate investments and acquire property that is less management intensive. Your real estate investments can be a vehicle that can help you plan for retirement; especially with the options available through a 1031 tax-deferred exchange.

1031 Exchange and Step up in Basis

A 1031 exchange is a tax-deferral strategy, but there are ways to defer the tax indefinitely. If an investor’s strategy is to always exchange and never cash out - when that investor passes away, their heirs inherit the property with a stepped up basis, and this means the basis is adjusted to the fair market value at the time of death. A stepped up basis eliminates the tax liability on the deferred gain. Keep in mind, depending on the size of the estate, there may be estate taxes due, and investors would be wise to work with a financial advisor to do some advanced estate planning to minimize the tax consequences for their heirs. 

Convert Investment Property to Primary Residence

There are other ways to avoid tax liability on some of the gain. Under the rules of IRC Section 121, you will not owe capital gain taxes on up to $250,000 of gain (or $500,000 of gain if you are married and filing jointly), when you sell a home used as a primary residence for at least two of the previous five years. The two-year period does not need to be consecutive to qualify for the exclusion, and you are allowed to use this provision every two years. With this exclusion there is no requirement to reinvest in other property. This is important to know because there is a way to take advantage of Section 121 when selling property acquired in a 1031 exchange.

For example, a married couple uses a tax-deferred exchange under Section 1031 to acquire a house used as a rental. The couple rents the house for three years, and then decides to retire and move into it and use it as their primary residence. If they stay in the home until their death, their heirs could inherit the property with a step up in basis as discussed earlier. 

If the couple decides to sell the property at the end of year six, after renting it for three years and living in it for 3 years, they can then take their primary residence exclusion. However, as of January 1, 2009, the amount of gain that can be excluded was reduced to the extent that the house was used for something other than a primary residence during the period of ownership.

Under the rules with the example above, if the couple has $800,000 of gain, instead of being able to exclude the full $500,000, the couple would only be able to exclude some of the gain based on the number of years they rented the property. Since they rented it for three years out of six, 50% of the gain, or $400,000, will not be able to be excluded. Because of this limitation, the couple will be able to exclude $400,000 of the gain rather than $500,000.

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