LET UNCLE SAM HELP FUND A RETIREMENT HOME

The tax code allows you to buy a rental now, write off the expenses and trade up, tax-free, to a grander place you can later use for your retirement.

How’d you like to buy your retirement home now, financed in a major way with IRS dollars? And while you’re building up this nest egg, how’d you like to take legitimate allowable tax deductions for the cost . . . and never pay tax on any appreciation?

Sounds almost too good to be true, doesn’t it? But it’s quite legal. Indeed, the tax code practically encourages people to take advantage of the rules.

Congress has always loved real estate. Or, at least our representatives have been very receptive to the persuasive arguments of the real estate lobby. In any case, the Internal Revenue Code is replete with provisions favorable to those who invest in real estate.

The Beauty of 1031 Tax-Free Exchanges

One of these provisions in the IRS Code, Section 1031, provides that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business, or for investment, so long as the property is exchanged for like-kind property.

There are lots of exceptions and limitations, but, for our purposes, all you need to know is that all investment real estate qualifies under this provision.

File Form 8824 with your tax return for the year in which you take advantage of Section 1031. Although this kind of arrangment has been available for many years, in 2000 the IRS finally formalized the procedure for securing the arrangement. You might want to take a gander at the IRS Revenue Procedure (Rev. Proc. 2000-37, 2000-2 C.B. 308 [Internal Revenue Bulletin 2000-40, page 308]).

So, the bottom line for you is — become a landlord. Buy a piece of rental property and rent it. Either work with a real estate broker or do it yourself with an ad in the paper. And then build up the investment until, finally, you end up with your dream home.

(I admit being a landlord takes some work and time, and you may not be up for the effort. Moreover, if you’re close to retirement age, this strategy may not work for you because it requires some years to accomplish.)

I believe you should always buy a property you can watch. One of my New Jersey clients bought a house on the Outer Banks of North Carolina as a vacation rental. He couldn’t understand why it was renting so poorly during high season until he made an unannounced visit and found his broker (of all the nerve!) spending the summer living there. Happy ending: While he didn’t get the rental income he had hoped for, the property sold for three times what he’d paid for it, and he only had it for two years.

Because this is rental property we’re talking about here, you get to deduct all the expenses related to running the property. These include taxes, interest, insurance, repairs, utilities, supplies, cleaning, maintenance and any commissions you pay (to leasing agents and the like). You can also deduct any mileage at the standard mileage rate that you incur going to keep an eye on the property. Not to mention, of course, depreciation. We would be remiss not to also tell you to deduct not-so-obvious management costs, such as advertising, legal expenses (like, for evictions, process service, etc.) and lodging and meals in the course of your inspections. Don’t forget accounting and tax preparation fees!

Big Bucks From Depreciation

Hopefully, these out-of-pocket costs are offset by the rental income the property generates. But, here’s where the big bucks come from:

You also get to depreciate the cost of the property. You depreciate the building, not the land. Apply the percentage allocation on your real estate tax bill between land and improvements to find your depreciable basis. If 85% of the assessment is for improvements, 85% of your total cost for the property, including any capitalized closing costs (e.g. title insurance, legal fees etc.) is allowed as a deduction, spread over 27½ years.

Remember, this depreciation expense allowed on your tax return (Schedule E — you probably also need to prepare Form 4562) is based on the total cost, not what you put down. If you buy a $120,000 rental property and only put down 20% ($24,000), your depreciation is based on the whole cost — $120,000. If 85% of your property-tax bill is allocated to improvements, assuming $2,000 in closing costs, your yearly deduction for depreciation is $3,771 (Add $120,000 and $2,000, multiply the sum by .85 and that result by .03636 or divide it by 27½ years.) If you’re in the 28% bracket, you save $1,056 in taxes. In the 25% bracket, the savings come to $943.

Remember, this depreciation expense is a pencil transaction. While you’re taking a tax deduction for the “depreciation” of your property, it’s actually appreciating in value! (At least, that’s our hope. In Denver, Colorado where I live that hope is often demolished!)

Let’s assume you bought this $120,000 property. After several years, it's now worth $200,000. If you’ve taken $40,000 in depreciation, your basis is reduced to $82,000. (Your original $120,000 plus $2,000 in closing costs less $40,000 in depreciation.) If you sold now, you’d have a taxable gain of $118,000. That's $200,000 less your basis of $82,000.

But if you reinvested the $200,000 in another rental property (or lived in it yourself for 24 of the preceding 60 months), you’d defer any tax (or, if you lived in it, possibly eliminate it altogether). But there are important rules to follow for the deal to qualify as a 1031 tax-free exchange:

Ignoring closing costs, you should now have at least $104,000 in equity cash. That’s the $24,000 you originally put up plus the $80,000 in real appreciation. With that much cash, and a 20% down payment, you can now buy a new rental property for as much as $520,000. (20% of $520,000 is $104,000.)

Repeat the process. Every time you sell, reinvest under Section 1031. All of your gains are tax-deferred.

About That Castle to Which You Would Like to Retire . . .

Note that this is a deferral, not an exclusion. At some point, the time will come when you have to pay the piper. But here’s where your retirement comes in.

Your final property should be the castle you want to retire into. But you have to rent it first, in order to qualify for the Section 1031 deferral.

How long do you have to rent it? While the code is silent, the IRS has validated a rental period of as little as two years. I suspect one year of rental may be sufficient. Then you move in.

In 1999 108,100 individual tax returns showed Section 1031 exchanges. If we add corporations and partnerships, the number jumps to 193,200 returns with property worth $53.8 billion, and deferred taxes of $38.3 billion.

Congress and the IRS like this provision. In 2002, the IRS drafted Revenue Procedure 2002-22 to detail the obligations of the provision and to give you a road map to successfully meet them.

But what if you change you mind later about the retirement property? What happens to the deferred gain if you now sell your personal, non-investment property?

Hopefully, you’d have at least given it a fair trial. And, if it was your principal residence for two of the last five years prior to sale (actually, the rule is any 24 months of the preceding 60 months), you could exclude as much as $500,000 in real gain. The exclusion does not apply to any depreciation allowed after May 6, 1997 on any rental or business property.

Alternatively, if you like the property and stay there until death, the basis of the property is stepped-up to fair market value and your heirs can sell it at no taxable gain — assuming there still are estate taxes.

Not everyone has the discipline or the time to carry out this strategy. But if you’re looking for a way to invest your way to a more secure retirement in the home of your dreams, take a look at it. Real estate is a favored sector in our tax code. As House Ways and Means Committee member Fortney H. (Pete) Stark, D-Calif., pointed out, “It’d take a moron to invest in real estate and pay taxes.”