You don’t often get the opportunity to even consider making a tax-saving double play. But your personal residence combined with a desire for a rental property can provide just such an opportunity.
The tax-saving strategy is to combine the tax-avoidance advantage of the principal residence gain exclusion break with the tax-deferral advantage of a Section 1031 like-kind exchange. With proper planning, you can accomplish this tax-saving double play with full IRS approval.
The double play is available if you can arrange a property exchange that satisfies the requirements for both the principal residence gain exclusion break, and tax deferral under the Section 1031 like-kind exchange rules.
The kicker is that tax-deferred Section 1031 exchange treatment is allowed only when both the relinquished property (what you give up in the exchange) and the replacement property (what you acquire in the exchange) are used for business or investment purposes (think rental here).
Let’s say your principal residence—owned for many years by you and your spouse—is worth $3.3 million. You convert it into a rental property, rent it out for two years, and then exchange it for a small apartment building worth $3 million plus $300,000 of cash boot paid to you to equalize the values in the exchange.
Your basis in the former residence is only $400,000 at the time of the exchange. You realize a whopping $2.9 million gain on the exchange: proceeds of $3.3 million (apartment building worth $3 million plus $300,000 in cash) minus basis in the relinquished property of $400,000.
Now, let’s check on your tax bite. You can exclude $500,000 of the $2.9 million gain under the principal residence gain exclusion rules. So far, so good!
Because the relinquished property was investment property at the time of the exchange (due to the two-year rental period before the exchange), you can defer the remaining gain of $2.4 million under the Section 1031 like-kind exchange rules. Nice! No taxes on this deal.
Pay No Income Taxes Ever
If you hang on to the apartment building until you depart this planet, the deferred gain will be eliminated from federal income taxes thanks to the date-of-death basis step-up rule. Under the date-of-death rule, the tax code steps up the basis of the building to its fair market value as of the date of your death.
Example. You die. Your heirs inherit the building at its new stepped-up basis. They sell the building for its date-of-death fair market value. Presto, no income taxes.
Of course, you do need to consider estate taxes if your estate is greater than $11.4 million.