When can my rental become my dream home

Clearing up confusion over 1031 property exchanges


By Benny L. Kass
Inman News

DEAR BENNY: In a recent column, I read that 1031 property transfers had to be held for a period of one to two years to establish "intent." I thought that a law was passed in October 2004 that stated the "intent" period was five years. I bought a 1031 property in California in 2005 and would appreciate this being clarified. Thank you for column! --Nancy M.

DEAR NANCY: The column was correct and so are you -- but you both are referring to different aspects of a 1031 (often called a "Starker") exchange.

Issue #1: Here, too, there are two issues: (a) How long can you hold the replacement property before you can exchange it again? and (b) How long do you have to keep the property as investment before you can move into the property and treat it as your principal residence?

As for (a), the statute clearly says that in order to get non-recognition of gain, you have to keep it for at least two years. As to (b), as that recent column properly stated, there is absolutely no IRS official guidance. Some tax lawyers take the position that one year and one day (i.e. go through one tax year) is sufficient. Others rely on what we call the "old and cold rule," namely that if the transaction took place more than two years ago, the exchange will generally not be reviewed by the IRS.

I have lots of clients who exchanged their investment rental property for a retirement home in Florida or Nevada, and want to know how long they must rent it before they can move in and establish it as their principal residence. The safe harbor is two years.

Issue #2: That leads us into the second part of your question. You are correct in that Congress a couple of years ago made some changes to 1031 exchanges. If you do an exchange and then convert it to your principal residence, in order to take advantage of the up-to-$250,000 exclusion of gain ($500,000 if you are married and file a joint tax return), you have to own the property for a full five years before it is sold. You also have to meet the two-year occupancy requirement. The actual text of the law reads as follows:

PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE -- If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the five-year period beginning with the date of the acquisition of such property.

I hope this clarifies the confusion.

DEAR BENNY: My wife and I and another couple are in the middle of buying a condo together and should be closing this month. The other couple has already been preapproved for 100 percent financing. We've been told that since they are already approved that they should go ahead and buy the condo and then amend the title while we're in escrow and add my wife and I to the title. I was curious as to whether this would work. --Josh

DEAR JOSH: I don't think so. Your friends have been approved for a loan, but you have not. At closing (you call it escrow) the lender will give specific instructions that will include that your friends will have to sign the promissory note and deed of trust. I seriously doubt that the escrow company will permit you and your wife to be added without the approval of the lender.

Can you qualify for the loan? Have you discussed the situation with the lender? The lender may also want to consider this an investment loan, which could result in an increase in the mortgage. Your friends could, of course, add your name to the title after escrow, but that might be grounds for the lender to call the loan based on the "due on sale" clause that I am sure will be in their deed of trust (the mortgage document).

So, I suggest that you talk to the lender and see what can be done between now and the escrow date.

But, your question raised two additional issues that concern me. First, you state that the loan is 100 percent. I don't know your financial situation (or that of your friend) but such loans have recently been associated with the many foreclosures that are taking place throughout the country. Have you -- or your friend -- carefully examined the terms of that loan? At some point, that loan will change whereby you will have to start paying principal and interest -- but at what interest rate? I am not a fan of such 100 percent loans.

Of equal importance, do the four of you have a written agreement as to how you will handle the property? What if you and your wife want out of the deal? What if someone dies? What if one of the partners gets divorced? What if someone cannot pay his or her share of the monthly mortgage payments?

All of these issues must be reduced to a written partnership agreement. The time to resolve these issues is when you are talking to each other.

DEAR BENNY: My wife and I are considering helping our son buy his first house. He is a recent college graduate with a well-paying professional job. He has been working for about a year, with about four months in his current job. He is living in our home paying some rent while saving the bulk of his paycheck. Given the cost of homes in the area and his lack of credit history, my wife and I figure he would need our help to buy his own home. Do you have any suggestions on how to approach this situation? We are not crazy about the idea of co-signing, as we consider that a risky proposition, but would be more amenable to co-ownership. Even if we agree to co-ownership, how can we protect our interest if the property is not maintained properly? Any tax consequences for us? --Steve

DEAR STEVE: Good question and very timely. As you suggest, property values nowadays are out of reach for many young adults.

There are several ways to approach this. First, do you have the money to buy the house and then rent it to your son? Every year, you and your wife could gift him up to $24,000 of the value of the house (you can gift up to $12,000 per person tax- and gift-tax free). You will need an attorney to assist you with this arrangement.

Next, can you be the bank? Can you lend him all the money and take back financing? He would pay you a fixed interest rate, which could even be greater than you are currently getting from your investments.

Finally, you could enter into what is known as a "shared-equity" arrangement. For example, you and your wife would own 50 percent of the property and your son would own the other half. You have to discuss with your attorney how title will be taken. But with a shared-equity arrangement, you both pay your share of the mortgage, taxes and insurance, and your son pays you rent for the half of the house that you own.

You need a written agreement, which will spell out all of the terms and conditions regarding the property. You asked about maintaining the property; the agreement will include provisions that should give you the protection you need.

There are two benefits for a shared-equity arrangement. Many lenders will give you a loan based on a personal residence rather than as an investment loan. Thus, you would get the benefit of a lower interest rate. Second, while you would have to pay tax on the rental income you receive from your son, you will also be able to deduct for tax purposes your share of the mortgage interest and real estate tax. You should also be able to take depreciation on the portion of the property that you rent to your son.

DEAR BENNY: What is a "hard-money lender"? I have read that they are entities that lend money out at 10 to 12 percent interest. They stay in business because the people who borrow their money will pay the higher interest to get the money faster and without a credit check.

Do people who buy at foreclosure sales or get involved with short sales use this as a means of financing these properties? Where do I find these "hard-money lenders"? --John

DEAR JOHN: There are good and bad hard-money lenders. These lenders usually make short-term, high-interest loans, and often they are "bridge loans.. For example, you want to buy a new house but have not yet been able to sell your current one. You have sufficient equity in your house, so you borrow money using your house as collateral. You hope that your house will sell quickly and thus are not concerned that the interest rate is higher than you can get from a commercial lender.

Usually, these hard-money lenders rely on the equity in your house rather than on your financial ability to pay.

But that's where problems start. Too many lenders make such loans knowing that the borrower will not be able to make the monthly payments, and thus the lender will ultimately foreclose on the property. In effect, these loans are designed to fail. They are called "predatory lenders."

You can find hard-money lenders just by typing those words in your favorite Internet search engine. But they should be the "lender of last resort." If you have to rely on a high-interest, short-term loan, maybe you are not ready to make that purchase.