How'd you like to buy your retirement home now, financed with IRS dollars? And while you're building up this nest egg, how'd you like to take legitimate allowable tax deductions for the cost . . . and never pay tax on any appreciation?
Sounds almost too good to be true. But it's quite legal. Indeed, the tax code practically encourages people to take advantage of the rules.
Congress has always loved real estate. Or, at least our representatives have been very receptive to the persuasive arguments of the real estate lobby. In any case, the Internal Revenue Code is replete with provisions favorable to those who invest in real estate.
The beauty of 1031 tax-free exchanges
One of these provisions in the IRS Code, Section 1031, provides that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business, or for investment, so long as the property is exchanged for like-kind property.There are lots of exceptions and limitations, but, for our purposes, all you need to know is that all investment real estate qualifies under this provision.
So,the bottom line for you is become a landlord. Buy a piece of rental property and rent it. Work either with a real estate broker or do it yourself with an ad in the paper. And then build up the investment until, finally, you end up with your dream home.
(I admit being a landlord takes some work and time, and you may not be up for the effort. Moreover, if you're close to retirement age, this strategy may not work for you because it requires some years to accomplish.)
I believe you should always buy a property you can watch. One of my New Jersey clients bought a house on the Outer Banks of North Carolina as a vacation rental. He couldn't understand why it was renting so poorly during high season until he made an unannounced visit and found his broker spending the summer living there. Happy ending: While he didn't get the rental income he had hoped for, the property sold for three times what he'd paid for it, and he had it for only two years.
Because this is rental property, you get to deduct all the expenses related to running the property. These include taxes, interest, insurance, repairs, utilities, supplies, cleaning, maintenance and any commissions you pay (to leasing agents and the like). You can also deduct any mileage you incur going to keep an eye on the property. For 2009, the rate is 55 cents a mile for business use.
Big bucks from depreciation
Hopefully, these out-of-pocket costs are offset by the rental income the property generates. But here's where the big bucks come from:You get to depreciate the cost of the property. You depreciate the building, not the land. Apply the percentage allocation on your real estate tax bill between land and improvements to find your depreciable basis. If 85% of the assessment is for improvements, 85% of your total cost for the property, including any capitalized closing costs (e.g. title insurance, legal fees etc.) is allowed as a deduction, spread over 27.5 years for residential rental.
Remember, this depreciation expense allowed on your tax return (Schedule E) is based on the total cost, not what you put down. If you buy a $120,000 rental property and put down 20% ($24,000), your depreciation is based on the whole cost -- $120,000. If 85% of your property-tax bill is allocated to improvements, assuming $2,000 in closing costs, your yearly deduction for depreciation is $3,771 (Add $120,000 and $2,000, multiply the sum by 0.85 and that result by .03636.) If you're in the 28% bracket, you save $1,056 in taxes. In the 25% bracket, the savings come to $943.
Remember, this depreciation expense is a pencil transaction. While you're taking a tax deduction for the "depreciation" of your property, it may actually be appreciating in value! (At least, that's our hope.)
Let's assume you bought this $120,000 property. After several years, it's now worth $200,000. If you've taken $40,000 in depreciation, your basis is reduced to $82,000. (Your original $120,000 plus $2,000 in closing costs less $40,000 in depreciation.) If you sold now, you'd have a taxable gain of $118,000. That's $200,000 less your basis of $82,000.
But if you immediately reinvest the $200,000 in another rental property, you can defer any tax. There are important rules to follow for the deal to qualify as a 1031 tax-free exchange, though:
- You must identify the new property within 45 days of the closing of the old, and settle the new deal within 180 days.
- You also can't touch the money except for the purchase of the new property. It must be held by a qualified third-party intermediary like an escrow company. That's a person or entity that's not controlled by or beholden to you. There are lots of companies that do this professionally, but you could just as easily use a friend you're not related to.
Ignoring closing costs, you should now have at least $104,000 in equity cash. That's the $24,000 you originally put up plus the $80,000 in real appreciation. With that much cash, and a 20% down payment, you can now buy a new rental property for as much as $520,000. (20% of $520,000 is $104,000.)
Repeat the process. Every time you sell, reinvest under Section 1031. All of your gains are tax-deferred.
About that castle in which you'd like to retire . . .
Note that this is a deferral, not exclusion. In theory, the time will come when you have to pay the piper. But here's where your retirement comes in.Your final property should be the castle you want to retire into. But you have to rent it first to qualify for the Section 1031 deferral.
How long do you have to rent it? While the code is silent, the IRS has validated a rental period of as little as two years. I suspect one year of rental may be sufficient. Then you move in.
Congress and the IRS like this provision. In 2002, the IRS drafted Revenue Procedure 2002-22 (.pdf file) to detail the obligations of the provision and to give you a road map to successfully meet them.
But what if you change you mind later about the retirement property? What happens to the deferred gain if you now sell your personal, noninvestment property?
Hopefully, you'd have at least given it a fair trial. And if it was your principal residence for two of the last five years prior to sale, you could exclude as much as $500,000 in real gain. The exclusion does not apply to any depreciation allowed after May 6, 1997 on any rental or business property.
For rental property leased after Dec. 31, 2008, there's a special new rule. Gain from the sale will not be excluded for any period the property is not used as a principal residence, known as "non-qualifying" use.
Say you bought a house on Jan. 1, 2009 for $400,000 and rent it for two years, taking $2,000 in depreciation. On Jan. 1, 2011, you move in and it becomes your principal residence. You move out Jan. 1, 2013, and sell the property for $700,000 on Jan. 1, 2014, for a $302,000 gain.
The rental period (2009-2010) is a non-qualifying use. You owned the property for five years (2009 through 2013). Forty percent of the gain (two years of the five owned), or $120,800, is taxable. The $20,000 gain attributable to the depreciation is recaptured at rates as high as 25%. As much as $181,200 in gain can still escape taxation.
Alternatively, if you like the property and stay there until death, the basis of the property is stepped up to fair market value and your heirs can sell it at no taxable gain -- assuming there still are estate taxes.
Not everyone has the discipline or the time to carry out this strategy. But if you're looking for a way to invest your way to a more secure retirement in the home of your dreams, take a look at it. It may prove worth your while.