The start of a new year often inspires reflections on the past, with renewed effort to apply any lessons we've learned to try to anticipate
Exchange Ideas
Published Date : January 29, 2025
In many parts of the country—including the Bay Area—house prices have increased dramatically over the past few decades, leading to significant wealth accumulation. Many people have been nicely rewarded by simply owning a house for a long time while often raising a family and staying put in the same neighborhood and local schools. But at a certain age, usually closer to retirement, some might want or need to change locations, perhaps to be near where grandchildren are being raised or to find a more affordable area. For those looking to downsize or move elsewhere, such sizable unrealized house gains could present unwanted or even difficult tax liabilities. While IRS Section 121 offers generous exemption of gain on a primary residence—and California conforms to this—up to $500,000 for married couples (or $250,000 for individuals), this offset has not been adjusted for inflation since 1997 and hence has not kept adequate pace with relative house values. And yet, this is probably the simplest action for most people thinking of moving; that is, selling outright and utilizing the offset. For some, gifting to the next generation could possibly make sense too, but in California, the rules have tightened up recently, requiring the recipient to make it their primary residence to inherit the typically attractive existing property tax, which is not always feasible.
Another potential interesting idea in the right situation could involve first converting the home to an investment property and either just leaving it at that, or in turn possibly doing a 1031 exchange into another investment property in a different location; but this approach takes time, effort, and careful attention to many details to succeed and is obviously not appropriate for everyone. Converting a home to an investment property also depends upon whether other separate resources are available to either directly buy a replacement house elsewhere (likely at a lesser “downsizing” cost) or to have sufficient funds to pay rent on a new residence, to allow the proper conversion of the old house into an investment rental property, because it will need to be used expressly for that purpose. No personal use. The IRS does not explicitly state how long it takes, but the general rule of thumb is that one should rent out a house for at least two years to “season” it and qualify it as investment property. Of course, the new rental income will help too (though no guarantees that one will easily find tenants, let alone keep them).
One compelling benefit of owning investment property is that multiple 1031 exchanges (referring to a section of the IRS code) can be accomplished over many years or even decades, allowing an owner to sell and swap into like-kind investment properties and defer taxes on such sales. At some point, an exchanged property could even turn out to be a place that one might want to occupy as a personal residence—perhaps a home that could better serve as a new gathering spot to be collectively enjoyed by an extended family—but one needs to be very careful about this concept because the IRS might challenge it. Strict rules need to be followed to show intent to both buy and hold an exchanged property for investment purposes only, and then hold it for the required period and conditions before changing it into residential property. If done properly, one could conceivably convert 1031-exchanged investment property back into a primary residence and qualify once more for the Section 121 exemption, but a relatively new rule now requires occupying and waiting five years to achieve that. This article is broad brush, and professional help and advice should be sought for any further consideration.
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