1031 can make sense in residential sale

BOULDER — As Greg and Donna Porter approached retirement age they began to think about downsizing and making their lives easier.

They had a big house with lots of stairs on a large lot in North Boulder that they really didn’t need now that the kids were grown up. They had a number of Longmont rental properties that weren’t producing much cash flow and were a hassle to maintain. Selling the rentals and their residence would make their lives easier, but they would take a huge capital gains tax hit.

To solve both the downsizing and tax problems the Porters (not their real name) went the 1031 exchange route.

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A 1031 exchange is a real estate transaction that allows a taxpayer to sell income, investment or business property and replace with it like-kind property without having to pay federal income taxes on the transaction. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges, hence the name.

The transaction has been possible since the inception of the tax code in 1923, but until recently there were no guidelines. It started to become popular after the Internal Revenue Service issued “safe-harbor” regulations in 1991 that established approved procedures for 1031 exchanges. The regulations call for a “qualified intermediary” to expedite the transaction including holding funds and deeds temporarily if needed. Prior to the issuance of these regulations, exchanges were subject to challenge under examination on a variety of issues.

The Porters sold their Longmont four-plexes and bought their dream retirement home — a small ranch house on a tiny lot near downtown Boulder. But they didn’t move in right away. Instead they rented the ranch house to a tenant — thus “trading” like-kind properties and avoiding capital gains tax on the sale of the Longmont rentals. The qualified intermediary they used recommended waiting two years to fully establish it as rental property in the eyes of the IRS.

The Porters were further able to cut their tax losses when they sold the house in North Boulder and moved downtown by taking advantage of the new tax rules established in 1997 for sale of a personal residence. The rules allow a $500,000 tax-free gain for married joint tax filers as long as they have lived in the residence for any two out of the previous five years.

Richard Levy of Boulder-based 1031 Solutions LLC acts as a qualified intermediary. Levy, who is a commercial real estate attorney with a post-law degree in tax, said he got out of law and into real estate because it’s much more fun. Prior to the 1991 tax regulations he helped a client do a 1031 exchange.

“It was a big process where you had to do research, and it cost thousands of dollars, and you had to give a disclaimer on the legality of it.”

The 1991 regulations coincided with the beginning of the Boulder housing boom, but “most people didn’t know about these exchanges,” Levy said. His practice grew from one or two a month to 10 or 15, he said. “It really just took off with the boom in Colorado real estate.”

The primary advantage of the new regulations was “the ability to structure one of these deals out of the stratosphere for big players down to the point where it’s a cookie-cutter transaction,” Levy said. “Now moms and pops can afford to do this type of transaction.”

Larry Jensen, of Longmont-based 1031 Corporation Exchange Professionals, said his five-employee firm does about 100 exchanges a month.

Although there are no licensing requirements for intermediaries, Jensen said there are qualifications consumers should look for — experience and membership in a professional association.

Jensen is a certified public accountant and his staff consists of “experienced title professionals and exchange professionals,” he said. He and his staff belong to the Federation of Exchange Accommodators, a Sacramento, Calif.-based national trade organization that promotes the establishment of ethical standards of conduct, offers education to both the exchange industry and general public, and works toward the development of uniformity of practice and terminology within the exchange profession. According to Jensen, the federation is developing a certification exam for intermediaries.