The Ultimate Tax Shelter

WHY EXCHANGE INSTEAD OF SELLING REAL ESTATE? The obvious reason for trading investment or business property, instead of selling it, is to avoid the capital gains tax on the profit. But there are at least 10 other reasons to exchange.

They include (1) pyramid your investment property equity without tax erosion of your sale profit, (2) minimize or eliminate the need for new mortgage financing on the property acquired, (3) acquire more desirable property to replace an undesirable property, (4) increase your depreciable basis, (5) acquire a property that better meets your investment or business needs, (6) partially defer your profit tax while trading down to a smaller property that is easier to manage, (7) avoid the dreaded 25 percent depreciation recapture tax when selling an investment or business property,(8) refinance either property before or after (but not during) the exchange to take out tax-free cash,(9) accept an unexpected desirable purchase offer to sell a currently-owned property and avoid capital gain tax, and (10) completely avoid capital gains tax by still owning the last property in your pyramid chain of tax-deferred trades when you die.

HOW TO MAKE A TAX-DEFERRED TRADE FOR YOUR ULTIMATE DREAM HOME. Savvy real estate investors, especially those desiring to retire, tried to figure out how to make tax-deferred exchanges of their investment or business properties for their ultimate dream homes. However, as explained earlier, personal residences don't qualify for IRC 1031 tax-deferred trades because they are "unlike property."

The simple solution is to make a tax-deferred exchange up for your ultimate dream home. However, because a personal residence can't qualify, the acquired property must be a rental at the time of the trade. Most tax advisers suggest renting it to tenants for at least 12 months before converting it to the investor's personal residence.

In 2004, Congress plugged a big loophole in this scheme where an investor could move into a dream home acquired in a trade by living in it for at least 24 months before selling it and claiming the generous Internal Revenue Code 121 principal residence sale tax exemption up to $250,000 for a single owner or up to $500,000 for a qualified married couple filing a joint tax return.

After Oct. 22, 2004, for sales of a principal residence acquired in an IRC 1031 tax-deferred exchange, the home must be owned at least 60 months before sale (rather than the minimum 24 months of ownership ordinarily required). At least 24 of those 60 months must be owner-occupied to qualify for the IRC 121 exemptions.

THE ULTIMATE TAX SHELTER OF ALL. However, if you acquired your ultimate dream home, and perhaps millions of dollars of investment property, in tax-deferred exchanges, which you still own at the moment of your death, you will have achieved the ultimate tax shelter of all.

Uncle Sam will be so overcome with grief at your passing, he will completely forgive any capital gain tax or depreciation recapture tax that would have become due if you sold your real estate the day before your death.

However, the net worth of your real estate (market value minus secured debt) will be included in your estate. For deaths after Jan. 1, 2006, total estate net assets less than $2 million are fully exempt from federal estate tax. Also, assets left to a surviving spouse are free of the federal estate tax.

To make matters even better, your heirs will be overjoyed to learn they will receive a new "stepped-up basis" to market value on the date of your death for the assets they inherit. For complete details, please consult your personal tax adviser.