Capital gain concerns

Published 9:00 pm Saturday, December 24, 2005

Question: I own 50 percent of a house that I built and lived in for four years while I lived in Alaska many years ago. I also own a home in Marysville, and I’m in the process of purchasing raw land to build a retirement home. Can I make use of the 1031 tax-free exchange program to avoid paying capital gains tax on the sale of the rental house in Alaska with the intent to build my retirement home?

G.K., Marysville

Answer: The short answer is: It depends.

First, a little background: Internal Revenue Code Section 1031 allows real estate investors to roll profits from one investment property into another investment property of equal or greater value without paying capital gains tax on the profit from the sale of the original property. The capital gains tax can be deferred indefinitely through a series of exchanges until the investor eventually cashes out. The IRS has strict rules that must be followed exactly in order to qualify for a tax-deferred exchange:

* The equity (property value minus loan balance) in the new property must be equal to or greater than the equity in the old property.

* The replacement property must be identified within 45 days after closing the sale of the old property.

* The purchase of the new property must be completed within 180 days after closing on the sale of the original property.

The investor cannot have constructive receipt of the sale proceeds at any time during this exchange period, or the money instantly becomes taxable income. This problem is usually avoided by paying a professional exchange facilitator to act as a middle man who holds the sale proceeds and executes the exchange documents.

Now, let’s look at your specific situation.

Your question is really two questions in one. The first answer is, yes, you can exchange your interest in the Alaska rental house for raw land, providing that the value of the land is equal to or greater than the value of your equity interest in the house, and you meet all of the other requirements listed above. IRC Section 1031 allows investors to exchange improved properties for raw land, and vice versa. But to qualify for a tax-deferred exchange, you must trade “like kind” properties, which means both the old and new properties must be held for investment or use in a trade or business.

On to the second part of your question: Are you really exchanging like kind properties? While you can legally exchange a rental house for raw land that is held for investment, you cannot exchange an investment property for your primary residence.

In other words, if you do a tax-deferred exchange and use the sale proceeds from your Alaska rental house to buy raw land, and then use that raw land for your personal residence, the IRS would probably declare the exchange invalid, and you would owe capital gains tax on the profits from the sale.

You might be able to accomplish your goal by doing a tax-deferred exchange for the raw land, building your retirement home and then renting the house out for a couple of years to establish its use as an investment property. You could later move into the rental house and convert it to your personal residence.

The problem is, there are no set IRS guidelines to follow. It’s hard to know exactly how long you must hold the replacement property as an investment before you can safely convert it to personal use without triggering a capital gains tax liability. The IRS looks at each exchange on a case-by-case basis. Consult an accountant who is familiar with tax-deferred exchanges before deciding how to proceed.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com