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Have we held the rental property
long enough?
Dear Dollar Diva,
We purchased a rental in December 1998 using a Section 1031 tax-free
exchange. We are selling our residence and would like to move into
the rental with the intention of selling it after living there two
years.
Have we held the property as a rental long enough
to satisfy the tax laws?
The Diva will help you understand the rules involved
in converting a Section 1031 rental to a permanent residence, but
she urges you to tread carefully.
If you get audited and the IRS determines that it
looks like the exchange was made to acquire a personal residence
rather than investment property, you're going to have a lot of explaining
to do.
Section 1031 tax-free exchange
A Section 1031 exchange, also known as a like-kind
exchange, can only be made with business or investment property;
and there are rules galore. Generally, a 1031 exchange is allowed
for real estate and vehicles, but not for stocks, bonds and inventory.
IRS
Publication 544, Sales and other dispositions of assets, will
tell you what qualifies for the exchange and what doesn't.
Two-year holding period
A two-year holding period is required if the Section
1031 exchange was between related parties, such as a member of your
family or a corporation or partnership in which you own more than
a 50 percent interest.
If the property was not acquired from a related party,
there is no specified period for holding the property. However,
the Diva reminds you that if the exchange looks like it was made
to acquire a personal residence rather than a rental property, be
prepared to explain the transaction to the IRS.
Converting business or investment property to personal
use
In your case, once the rental converts to your "home
sweet home," it loses its investment status, and the capital gains
that were deferred in 1998 have to be recognized on the tax return
filed for the year the conversion took place.
Once you and your spouse make the rental your home,
the rules for the sale of a primary residence kick in; if you own
the home and live there for two of the five years prior to the sale,
you get to exclude up to $500,000 in capital gains. Read the Diva's
"Home sales
and the tax man" for more on this.
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DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting,
from the Kellogg Graduate School at Northwestern University in Evanston,
Ill. Rosen has more than 15 years of experience in the financial arena, serving
in Illinois and Florida as a certified public accountant, financial consultant,
expert witness and educator. She is owner of Dorothy Rosen, CPA, a public
accounting firm that serves individuals and small businesses.
