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Q. My husband and I always enjoy reading your columns and have read with great interest the information about 1031 exchanges. We have owned a second home in Mammoth for many years and now want to purchase something in a warmer climate. But our accountant says our home doesn't qualify for an exchange even though we thought it would. What do we do now?
A: Okay disclaimers first. I'm not an accountant so I'm not licensed to give tax advice. But my business is real estate and there are so many tax ramifications to buying, owning and selling real estate that I'm always exposed to different scenarios and am forced to educate myself. Kind of like years ago when I was a property manager, I wasn't a plumber but I had to learn a lot about toilets.
One way that I have educated myself about tax scenarios is to play a little game. I advise my clients to talk to their accountants about potential transactions and then report back to me. Sometimes I even give them a list of questions or hypothetical ideas. What I get back is a whole spectrum of answers. Some are interesting and stimulating. Some are just "the standard answer", and some tell me they might as well have asked the garbage man. Like most professions, experience, expertise and familiarity go a long way to achieving successful results. (Which is why having your broker from Los Angeles tell you what property to buy in Mammoth is such smart thing.)
Another observation is that some accountants are liberal, some creative, and some conservative. Some are extremely knowledgeable in the 1031 exchange area and some have very little experience with them. Over the years I have found that attorneys who specialize in tax law and occasionally act as accommodators in 1031 exchanges are the most knowledgeable and certainly the most creative. In more complicated cases, consulting with one of them is well worth the time and money.
To your specific question, what your accountant is most likely telling you is that your second home has been "treated" as a true second on your tax returns. You have probably taken some mortgage interest deduction over the years. In fact, that interest deduction (as well as a passion for skiing) may have driven your accountant to advise you to purchase this second home.
The problem is that your second home is not considered a "property held for investment" by the Internal Revenue Code. A true second home doesn't fall under the rules of Section 1031 (properties held for investment) or Section 121 (primary residences.) You are not alone in thinking that your second home would qualify for a 1031 exchange. I have seen many true second homes sold and entered into tax-deferred exchanges in the past few years. Sometimes my company has represented these clients and sometimes it is another brokerage. Occasionally, when the topic is broached the response from the client is "my accountant said 'he'll take care of it'". My impression is that many of these exchanges have gone unchallenged or that indeed the accountant has indeed "taken care of it".
The "taken care of it" part is what intrigues me. As we learned with the tax code revisions of 1997, namely the elimination of Sec.1034, the old rules regarding the sale of primary residences and the creation of Sec.121, the new and current rules for primary residences, there are always undefined scenarios that come with these changes. It takes time for the IRS, the legislature, and even court cases to figure them out. Creative, aggressive accountants and their like clientele will push the interpretation of the new law.
Late last year the IRS redefined some of those 1997 changes. One of those areas had to do with "conversion". What people were doing was converting "property held for investment" into their primary residences and then selling the properties under the new Sec.121 rules that allows for the $250,000/$500,000 tax-free exclusion every two years. For instance, a little duplex in L.A. could be sold and involved in a tax-deferred exchanged for a nice home here in Mammoth. The owner rents the home in Mammoth for a couple of years and then moves into it and claims it as their primary residence. After living in it for a couple of years they sell it for a tax-free gain under the Sec. 121 rules.
Some people believed this to be an undefined area of the rules. Accountants who directly inquired with the IRS were told that the depreciation from the original property (the duplex in L.A.) and the couple of years the home was treated as a rental property had to be recaptured as well as the capital gains paid from the original basis (of the duplex) to the point of conversion (to primary residence.) But some investors and some (liberal) accountants believed all of this would get lost in the paperwork and it was a great opportunity.
Late last year the IRS tried to clarify some of this. Converted properties now have to be lived in for 5 years before they can qualify for the Sec 121 exclusion. There are still some undefined areas, especially depending on what side of the accounting fence you sit on.
So what does this all have to do with you? The operative concept is conversion. Now people in your position (true second home, lots of appreciated equity, desire to move the equity to another location, etc.) are thinking of converting their true second homes to rental properties so they can qualify for 1031 exchanges. My guess is that most accountants would want to show the conversion for at least two tax returns, and then you can pull the trigger. Or just ask your accountant if he can "take care of it". Ultimately, you need to find an accountant or tax attorney that can help you structure this transaction to make this work without a heavy tax burden. And obviously defend it.
As we say around our office, this is a quality problem. Things like this were easier when there was no appreciation in the marketplace and capital gains weren't a problem. Back when the County had a hard time paying for things like paramedic services and guardrails on roads along steep cliffs. But that's progress.
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