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In PLR 200730002, which was released on July 27, 2007, the IRS approved an arrangement between related parties and their exchange of different properties.  Under Section 1031(f)(2)(C), exchanges of undivided interests between related parties in different properties, which result in each taxpayer holding either an entire interest in a single property or a larger undivided interest in any of such properties, is NOT subject to the two year holding period. This is important in the partition of family properties, such as farms and other inheritances, as the heirs attempt to divide up their holdings. 

In PLR 200728008, the IRS reaffirmed that a sale to a related party is NOT subject to the two year holding rule. In this case, an exchanger sold two relinquished properties via qualified intermediaries to a related party in two separate reverse exchanges.  The IRS ruled that gain was not triggered under Section 1031(f)(1), since no related party swap had occurred.  The IRS issued this PLR, despite the representation that the related party intended to sell the relinquished properties within two years.  This PLR is similar to PLR 200712013, which was issued earlier this year. The IRS also ruled that Section 1031(f)(4) would not prevent non-recognition treatment because the transactions were not designed to avoid the purposes of Section 1031(f)(1), as no basis shift had occurred. 

PLR 200728008 reinforced the notion  that an exchanger can sell relinquished property via a qualified intermediary to a related party as long as no basis shift occurs.

In PLR 200728037 the IRS ruled that a like-kind exchange by an UPREIT, in which no boot was triggered, would not be treated as a sale of property. In addition, the IRS ruled that the relinquished property would not be treated as property sold for purposes of the seven property safe harbor in section 857(b)(6)(D)(iv).    This ruling was first articulated in PLR 200712013 and is virtually identical to PLR 200701008 also issued earlier this year. 

Rep. Adrian Smith of Nebraska (R) introduced HR 3039 in July, 2007.  This legislation would double the time period for the identification of potential replacement properties and the completion of a like-kind exchange, from 45 to 90 days and 180 to 360 days respectively.

EXIT STRATEGY FOR REAL ESTATE INVESTORS:
PART 1 OF 10

INVESTMENT PROPERTY CONVERTED TO PERSONAL RESIDENCE

• Exit Strategy #1
• What are the benefits of Real Estate Investors using the Exit Strategy?
• Limitations to Exclusion of Capital Gain for Converting Investment Property to Personal Use Pro
• perty
• Case Study: Mr. Alexander
  

Exit Strategy # 1. Section 121 ¹ provides an excellent opportunity for clients whose appreciated real estate assets are not substantial (e.g., under $2,000,000.00).  I will tell you that when I mention this strategy to clients, they either love the idea or hate it.

So, with that caveat,  here is the strategy.  Assume  that the Clients (husband and wife) own a farm worth $1,600,000, with a tax basis of $200,000.00. Assume that the Clients file their tax returns jointly for all years involved.

• First, the Clients sell their farm as part of a Section 1031 exchange.
• Second, the Clients could then acquire, as replacement property through a 1031 exchange, four houses (#1, #2, #3, #4), which are each worth $400,000.00.
• Third, the Clients would rent all four properties.
• Fourth, after a period of 2 years, the Clients would sell their existing personal residence and defer up to $500,000.00 ² of gain on the existing principal residence.
• Fifth, The Clients would move into House #1, and reside in the home for a period of at least 2 to 3 years.
• Sixth, the Clients would sell House #1 and defer the capital gain taxes up to $500,000.00.
• This process would be repeated for House #2, #3 and #4 every 2 years.

What are the benefits of Real Estate Investors using this Exit Strategy? The client has been able to exclude the original $1,400,000 of capital gains, as well as the capital appreciation over the next 10 years. This strategy primarily provides the clients with  three benefits: 

1. exit from the business of owning the farm land,
2. exclude the otherwise taxable capital gains, and
3. significantly augment the client’s assets for retirement.

The total estimated time for this transaction would be between 9 and 11 years.

Limitations to Exclusion of Capital Gain for Converting Investment Property to Personal Use Property.

1. The Replacement Property must be initially used as trade or business property within the meaning of Section 1031(a)(1). ³
2. The Residence must be subsequently used as the client’s Principal residence. ⁴
3. Gain:  Where the investment property, which was converted to personal use, contains both non personal use property (e.g. stables and barns) as well as excess acreage, gain from the sale of the non personal use property and the excess can NOT be excluded.  1.121-1(b)(4) examples 1-3.
4. Recapture of Post May 1997 depreciation. ⁵
5. Time frame for Section 1250 property: As a caveat, if a taxpayer acquires Section 1250 property in a tax deferred transaction, the Section 1250 property should be held for 12 months and a day.  Otherwise, all prior depreciation will be treated as additional depreciation  for purposes of Section 1250(b)(3).  All depreciation recapture from 25% capital gains will be converted into ordinary income.

Case Study: Mr. Alexander.  Let’s apply this same strategy to a person who owns an apartment building, and the property was depreciated. Mr. Alexander owns an apartment building with a fair market value of $3,000,000.00 and a tax basis of 1,000,000.00.  Mr. Alexander enters into a Section 1031 exchange and purchases 6 single family homes.  Each home is worth $500,000.00, and will be known as X-1, X-2, X-3, X-4, X-5 and X-6. 

Mr. Alexander rents these six properties on a full time basis. The principal residence of Mr. Alexander is worth $650,000.00, with a tax basis of $200,000.00. In Year #3, Mr. Alexander sells his existing residence and excludes the $450,000.00 of gain on his federal tax return, which is filed jointly with his wife.

Mr. Alexander and his wife move into House #1 (X-1) and live there for 36 months.

They sell X-1 for 600,000 with a tax basis of $150,000.00. Of the $450,000.00 gain, $16,666 is treated as post 1997 depreciation and $433,333.00 is excluded.

Mr. Alexander repeats this strategy 5 more times over the next 10 years.

Assuming that the gains are exactly the same, although we know they will not be, this results in the permanent elimination of approximately $ 3,050,000.00 in capital gains.  

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¹ Section 121(a) provides that gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years [ defined to mean 24 months or 730 days as well as 2 calendar years]  or more.

² Section 121(b) provides that the maximum amount of gain that excluded is 250,000, in the case of a single individual and 500,000 in the case of a married couple filing jointly.

³This is tested by taxpayer intent at the time of the purchase, and not by a bright line time test. Since it is not common for taxpayers to provide a brain scan of their intent at the time of the purchase, this must be tested with objective evidence of their intent by looking at all the facts and circumstances.

If the taxpayer is not willing to rent the property for at least 2 years, then the taxpayer is not a god candidate for this strategy.

⁴ Treasury Regulations 1.121-1(b)(2) provide, that where a taxpayer is using more than one property as a residence, whether  the property is the taxpayer’s principal residence, will be based on an analysis of all the facts and circumstances.  This includes: The taxpayer’s place of employment; Length of stay in each residence;  The state in which the taxpayer claims legal residence.  The principal place of abode for the taxpayer’s family members; The address used on  federal and state tax returns, driver’s license,  automobile registration,  correspondence and bills, and voting records and location of bank, clubs and religious organizations

⁵ The Treasury Regulations 1.121-1(d) provide that any depreciation taken post May 6, 1997 must be taken into income upon the sale of such property, regardless of whether the property has been converted to be used as a personal residence. Such gain is taxed at 25% capital gain rates. Section 1(h)(1)(D). [see (what??) example] Curiously, Section 121(d)(6) provides that the depreciation to be recaptured is the amount equal to such depreciation adjustments.  This is defined in Section 1250(b)(3), and is attributable to periods after May 6, 1997. However, for property placed in service after 1986, residential rental property is required to be depreciated over 27.5 years over a straight line basis, thereby eliminating potential recapture under Section 1250. The additional depreciation was an amount deductions taken in excess of straight line. It would seem that logical that the amount of Section 1250 “additional depreciation adjustments” after 1997 would be nominal at best.