My friend, Maria, asks the following questions:

Hi Tom, we are exploring 1031''s. How long should our current primary residence be a rental property before it can qualify for an exchange? Is it possible to leverage the equity in this property to a property with more cash flow without a cash outlay? If so, how?

A: Let's start with the second question. Suppose you had a building that was worth $2,000,000 and your loan was $1,200,000. What are the restrictions on what you can buy in a 1031 (i.e., like-kind) exchange. The general rule is that when you sell a property, you recognize taxable gain for the difference between the sales price and your adjusted (i.e., net of depreciation) cost. Under IRC Section 1031, if you follow the rules, you can defer any gain if you exchange your property for another "like kind" property.

The rules for Section 1031 are complex and detailed. But there are a couple of simple rules of thumb you can rely on to answer some of the general questions before going to your CPA for more detailed answers. First, so long as the new property costs more than the property you sell, you should not have to recognize gain (again, as long as you follow all of the other rules). So, in the example, so long as the new property costs at least $2,000,000, you should not have to recognize gain on the sale of the old property.

Your old property has a loan equal to 60% of the value of the property. Let's say that you find a bank that is willing to loan 80% of the value of the new property. That means that with your $800,000 of equity in the old property, you should be able to purchase a new property costing 5 times this amount or $4,000,000. There is no maximum value of the new property from a tax standpoint. The only real restriction is the bank's lending requirements.

Now let's look at question number 2. Suppose you turn your personal residence into a rental property. How long do you have to rent it out before you can do a 1031 exchange? The IRS guidelines say that you need to hold the property as a rental property for one year and a day. If you do that, they will not challenge you. Even if you hold it as a rental property for less than a year and a day, however, you may be able to do a 1031 exchange. See your CPA for the detailed rules about this and the related risks. If your CPA does not specialize in real estate, call the ProVision office at 866.467.5809 and schedule an appointment to speak to one of our real estate tax experts (all of whom own investment real estate).

One other question that comes to my mind is how you changed the property from a personal residence to a rental property? Did you know that you could have excluded as much as $500,000 of gain permanently if this was done the way we would recommend at ProVision? This could have eliminated entirely the need for a 1031 exchange and created a permanent tax benefit. For more on this and other tax saving strategies, call us or enroll in our School of Tax Strategy at http://www.provisionwealth.com/products.

Warmest regards,

Tom