The past two installations in this column sought to explain the 1031 Exchange and the Reverse
1031 Exchange. As a result of these articles, I received a number of follow up questions. Rather
than explore a new topic, I thought I would first attempt to wrap up and address some of the
lingering issues of the 1031 Exchange.

As we now know, the term 1031 Exchange refers to that section of the Internal Revenue Code
that allows investors to defer depreciation recapture and capital gain taxes upon the sale of
property “held for productive use in a trade or business or investment” if the investor reinvests
the sale proceeds into another investment property of equal or greater value.

There were four questions that were presented. It is my hope that the answers will prove to be

1.)    Q: I want to sell my apartment building and buy a house. If I rent the house for a
       while then convert the house to my principal residence can I sell the house and use
       the capital gain tax exclusion for the sale of a personal residence?

Answer #1:
In short, Yes. An investor can indeed defer the gains on their investment property and then cash
out- capital gains tax free - if the investor exchanges into a rental house and then converts the
replacement property into a principal residence. But, there are a couple of laws that affect rentals
converted into principal residences.

The first law is Internal Revenue Code Section 12, which before October 22, 2004, allowed
investors to excluded capital gains on the sale of their personal residence of either $250,000 or
$500,000 – depending upon marital status- if the residence had been owned and used by the
taxpayer as their principal residence for two of the five years preceding the sale.

Now, because the U.S. Treasury perceived this tax-planning strategy as a loophole, Congress
recently enacted the American Jobs Creation Act of 2004 (HR4520). Included in this Act was a
provision that mandated a five-year holding period before a rental house previously used as a
replacement property could be sold under Section 121. So now investors who plan to convert a
rental into a principal residence should be prepared to hold and use the new property a minimum
of five years from the date of acquisition through an exchange.

The second rule affecting converted property is the rule of “intent”. The IRS mandates that an
investor must have the “intent” at the time of purchase to use the replacement property for
investment purposes and not for a principal residence. That means that the investor should rent
the house for at least a sufficient amount of time to demonstrate that the “intent” was not to
purchase the house as a principal residence. While this time has not been established with
absolute certainty, the consensus among exchange attorneys is that you should rent the house for
at least a year before attempting to convert the property from a rental into principal residence.

2.)    Q: Can I sell my apartment building to buy a house and let my daughter live there
       and not really collect any rent?

Answer #2
No. Although most parents want to help their children - particularly in this challenging housing
market - there is absolutely no wiggle room within the 1031 regulations for any special
arrangements. The rent for this house must be in accord with comparable units in the immediate
area. In fact, many investors in this situation use an independent appraisal firm to ascertain
market rent in order to be certain the rent charged to a relative is arms-length and within
appropriate limits.

3.)    Q: Are security deposits tax-deferred in a 1031 exchange?

Answer #3
Generally, No. Seller’s receive security deposits directly from tenants and usually put those
deposits into a bank account. Yet, those same deposits are not generally transferred to the new
buyer from the seller’s bank account. Instead, security deposits are generally transferred to the
buyer from the seller’s proceeds at closing. Accordingly, since the seller effectively repays the
security deposits to the buyer from capital gain and not from their own bank account; those
transferred security deposits amount to “boot” and therefore those deposits are not tax-deferred.

This situation is important to understand. Recently, I represented an owner who was selling her
apartment building and trading into a multi-family tenant-in-common property. In determining
the amount of equity available for this exchange, she naturally looked to the figure on her final
settlement statement: net proceeds due to seller.

Unfortunately, this was not the actual amount available for tax-deferral. The framers of the 1031
exchange intended to allow investors to defer taxes on their appreciation because they sought to
encourage and promote investment in real estate-not to pay for security deposits.

Luckily, the seller had the security deposit funds in her bank to pay the buyer. By transferring
money for the security deposits from her bank rather than from her proceeds, the seller was able
to defer the entire net proceeds from taxation. The lesson to be learned here is to make sure you
have enough money to cover the security deposits. Otherwise, be prepared to pay tax on those
4.)    Q: What is an improvement exchange and how does it work?

Answer #4
An improvement exchange occurs when the investor wants to acquire replacement property and
improve it during the exchange period. This usually occurs when an investor determines that he
will have more exchange funds than of the cost of the replacement property.

In the improvement exchange, an investor must identify all the items that will be constructed on
their replacement property within 45 days after closing on their sale. The construction does not
need to be completed during the statutory 180 days but the exchange does have be completed
within that time. The improvement exchange is a handy tool for the “value-added” investor who
wants to buy and restore a distressed property.


The 1031 exchange and its multiple variations are all important tax planning vehicles that
investors should be aware of. While, I’m certain I have not covered all the issues with respect to
the 1031 exchange-- I am hopeful that this three part series has helped to demystify the process
for some.

Benjamin S. Marcus
Apartment Broker
CB Richard Ellis, Inc.

Telephone: 510/874-1977
Email: benjamin.marcus@cbre.com
Web: http://www.cbre.com/benjamin.marcus

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