Business Management

Seeking a Silent Partner? I Know a Guy…

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9 Articles Written
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Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation.

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You might be surprised to learn that Uncle Sam can become your silent partner in real estate investing. Why would you want to partner with the government? Because using your own tax dollars creates the opportunity for exponential portfolio growth.

And why is the government willing to forgo tax dollars to provide capital for your ongoing real estate investing? In short, both home ownership and real estate investing support the U.S. economy.

The capital Uncle Sam invests with you is your own tax dollars. This capital is available either tax-free or tax-deferred when you sell your home or productive investment real estate. It’s all laid out in Internal Revenue Code (IRC) Sections 121 and 1031.

To demonstrate, this article provides a summary of the provisions and a couple of scenarios.

The Partnership Agreement

To understand this opportunity, you need to familiarize yourself with how the “partnership” will work.

These are the provisions in the tax code:

  • Section 121 offers a primary residence tax exemption to all U.S. homeowners. You simply have to own and live in your home for two years. Then, when you sell it, you can take up to $250,000 in profit tax-free. And it’s $500,000 if you’re married. You can read up on this and financing opportunities unique to this asset in my last article.
  • Internal Revenue Code (IRC) 1031 lets you defer capital gains taxes when you transition from one investment property to another. Following IRS guidelines, you can roll all of your sales proceeds into your next investment tax-free.

calculator with less tax and more tax buttons

They can work independently or together:

  • Section 121 and IRC 1031 can be combined if you have more than $250,000/$500,000 in profit in your primary residence. Section 121 allows you to take the tax-free portion of your profit as cash to invest without restriction. IRC 1031 lets you put all the remaining profit into a real estate investment.
  • IRC 1031 and Section 121 together can convert a real estate investment into your primary residence. Once you have demonstrated that your investment has been held for productive use in business or trade, its use can be changed. You must own the property for at least five years and live in it for at least two years. Then, you are allowed to receive a prorated share of the profit tax-free upon sale.

So, follow Uncle Sam’s rules and regulations and you get to keep the specified gain on your house tax-free and the rest tax-deferred. And there is your capital to reinvest, courtesy of the federal government.

Related: PSA: Taxes Are the Biggest Cashflow Killer (With Examples)

Partnership in Action

Here are a couple of ways I have personally taken advantage of the combination of these provisions.

Rehab to Rental to Primary Residence

  • Completed 1031 exchanges out of investment properties in former home city
  • Among other things, purchased distressed property held for renovation and rental near new home
  • Renovated and placed on rental market (clearly acted on my original intent)
  • Eventually moved into investment property and made it my primary residence
  • When this property sold, a prorated portion of proceeds was sheltered from tax under section 121
  • Purchased a sailboat!

Beautiful african woman happy and excited celebrating victory expressing big success, power, energy and positive emotions. Celebrates new job joyful, outdoor

Related: How to (Legally!) Avoid Capital Gains Taxes on Real Estate

Vacation Rental to Primary Residence

  • Completed 1031 exchange out of lease-purchase property as scheduled
  • Lived in the frigid Northeast at the time, so rolled all of the proceeds into a Florida vacation rental
  • Continuously held for rental (clearly acted on my original intent) but took full advantage of two weeks of personal use allowed annually (this was a deliberately selfish investment)
  • Reports and reviews from vacationers having fun in our house eventually made us question why we moved north not south (seriously, what were we thinking?)
  • Sold above-referenced property and converted vacation rental to primary residence by moving into it
  • After two years of occupancy, the tax began to disappear
  • But we had been paying dockage for our sailboat and found a home it would fit behind
  • So, moved into a new primary residence and converted it back into a vacation rental
  • Qualified for partial 121 exemption and partial 1031 tax deferral when sold within three years of moving to a new primary residence

Partnership With Flexibility

To summarize, keeping taxes working for your own benefit is key to maximizing returns. There are many ways to work investments and tax breaks to your advantage as indicated above. With Uncle Sam as your silent partner in this regard, I have repeatedly found that the benefits outweigh the inconvenience of rule-following.

Consider your personal tax bracket. Put that money to use in your own portfolio rather than building a bridge to nowhere.

[Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation.]

Do you have any questions about the strategies above? Do you plan to or have you successfully taken advantage of IRC Sections 121 and/or 1031?

Weigh in with a comment below. 

Dave Foster, real estate investor and qualified intermediary, has 20 years of experience working in all phases of real estate investing, from large scale development to single family homes and vaca...
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    JL Hut Investor from Greenville, Michigan
    Replied about 1 year ago
    Dave, Your the man, you have fun playing the game with Uncle Sam. Every few years you just say, play it again Sam.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    Once you understand the rules and strategy, it's an economically advantageous game to play. Here's looking at you, kid!
    Brian D'Agostine
    Replied about 1 year ago
    For those of us just starting out who would prefer to purchase out first investment property as a primary home for better terms, I would add another step in front: Purchase home, live in it 2 years, or whatever the terms require, then convert it into a rental and proceed per your plan. Purchasing it as a primary allows you to get a better interest rate and put less of a down payment in. After the 2 years you can use the equity to buy another home but convert the first into a rental. The caveat I believe is that you will eventually need to move back into the home and live in it before you sell it, Correct?
    Dennis Smith from Odessa, Florida
    Replied about 1 year ago
    No, the rule is it would have to have been your primary residence 2 out of the last 5 years to qualify for the exemption. So after 2 years as your primary, you could rent for technically another 3 years, but you’d need to build in time to lease and time to sell, so most likely rent it out for roughly 2 years total
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    Spot on Dennis. But the nice thing is that if you overshoot the 5 year look back because the property didn't sell you do still have the option to defer all gain and depreciation recapture by doing a 1031 since the current use of the property at that point is investment.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    You've got it just about perfect Brian. Except you don't need to move back in. The requirements to get those tax free dollars are that you have lived in the property for 2 out of the 5 years immediately prior to sale. So you can do exactly what you're thinking - take advantage of primary residence financing and live in it for 2 years. The move out and rent it selling it while you're still in that 5 year look back. All of the profit would be tax free up to the $250K/$500K maximums. But you would have to recapture depreciation. Great Plan
    Daniel Gengaro from Bloomsbury, NJ
    Replied about 1 year ago
    This really helped me understand both provisions much better. Thanks for the great info Dave
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    Glad it was helpful Daniel!
    Latunya Smith Flipper/Rehabber from Fayetteville, NC
    Replied about 1 year ago
    As far as I am concerned, this is one of the best avenues to begin the investment journey. Thank you for the refresher!
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    I think so too Latunya. I've been using 1031 exchanges for myself and others for over 20 years. Works great!!! Dave
    Andrew DeWeerd Rental Property Investor from Sarasota, Fl
    Replied about 1 year ago
    Are there any time length requirements that after a 1031, when rolling the funds into the new rental property, that it must be rented before you can move back into it as a personal residence? You just kept mentioning that you "acted with your original intent" but didn't specify any time requirements. For instance, owner occupied financing you must live in it a year to fulfill that Fanny requirement. Thanks in advance!
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    Great question Andrew. I don't mention a specific time frame because there isn't one. This question gets asked a lot if someone is wanting to do a 1031 into a property that they may want to convert later into their primary residence. The statute doesn't dictate a time period. But it does say that it must have been your intent to hold that property for investment use. The IRS requires you to be able to demonstrate that intent. There is a safe harbor from the IRS with some other requirements at 2 years. But there could always be circumstances where a shorter (or longer) hold period could be used. Fuzzy, I know. Welcome to the Gummit!!
    Katie Rogers from Santa Barbara, California
    Replied about 1 year ago
    Given the time constraints for a 1031 exchange , too many investors have been unable to find a reasonable deal withing the allowed time period, and often end up settling for a bad deal just to get it done.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    You're absolutely right Katie, One of the biggest challenges so successfully navigating a 1031 exchange is adhering to the tight time constraints. A good QI and a proactive client can overcome those obstacles easily. Of the over 500,000 1031 exchanges performed every year only very small fraction actually fail because of an inability to find suitable replacements. Our direct experience in 2019 has been that fewer than 3% of all of our exchanges have failed this way. It's really more perception than reality. But working with a QI who can coach you around those obstacles is the key. Thanks for your feedback
    Katie Rogers from Santa Barbara, California
    Replied about 1 year ago
    Maybe the deal doesn't fail, but because the tax consequences make failure not an option. However, a bad deal can destroy future profit.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    Thanks Katie, that's a valid thought. One of the beautiful things about the 1031 exchange is that there is no penalty for starting but not completing a 1031 exchange. Because of how the statute is structured your 1031 will always be over by the time of your next tax filing. So if you don't complete the 1031 you pay the tax you would have anyway. I agree with you that there are people out there who are too desperate to save taxes that they don't adequately compare the cost of paying taxes vs completing a bad deal. It's many fewer than you would think. Investors by and large are pretty savvy and this doesn't happen very often. More often it's a question of "this is an OK deal and...I'm saving a ton of taxes". I guess where I'd challenge you Katie is that if the tax consequences make failure not an option then why would someone ever not attempt the 1031? If the tax consequences make failure not an option then a 1031 is a must. And it's up to the investor to always make sure that their replacement property is appropriate. If the available replacements are all that bad then I'd say that failure of the 1031 is not only a viable option but the right option!. Paying a $700 - $1000 exchange fee for the right to try to alleviate tax consequences so severe that "failure is not an option" seems like a pretty cheap entry fee! Great comment - Thanks.
    Katie Rogers from Santa Barbara, California
    Replied about 1 year ago
    I am gong by my experience as a tax advisor. I have seen a lot of people get burned, that's all. I can tell you that all your words mean nothing to them.
    Guy Yoes Rental Property Investor from Springfield, Mo
    Replied about 1 year ago
    Katie- I've done 2 1031X this year alone and will do several more next year as I sell more properties and move into nightly rentals. All of my 1031 exchanges have gone smoothly with absolutely no problems. When you say " I have seen a lot of people get burned," are you referring to your clients? Why are they having so many problems that other investors are not? My TA is a big fan of exchanges and so are the members of our REI club. I have never heard any of them say they regretted doing the 1031X. As Dave said, there are two choices. #1. Sell the property and pay the tax. #2. Plan ahead and do the exchange and defer the tax. It's really that simple. They have the option of doing a reverse 1031x if that works better. There are no guarantees in real estate or life. I've lost money on deals, some my fault and some not. It's just the way things are. If Dave is right that less than 3% of exchanges fail, I'd take that risk in a minute because all I would lose would be the taxes I would have to pay regardless.