As a mortgage professional, your job is to understand a client?s full financial situation and needs. You need to be part mortgage professional, part attorney, part CPA and part financial advisor. The more you know, and the more you bring to the table, the more you can help. And the more you help, the more loyalty you will see from your clients. With that in mind, I would like to focus on two financial vehicles ? 1031 exchange and its lesser known cousin, the 121 exclusion. Both deal with the profit (capital gains) from the sale of property and both can be used to the benefit of your client. 1031 Exchange Section 1031 is a tax vehicle used to defer capital gains taxes when selling an investment property to buy a new investment property. What does that mean? It means that if a person is selling an investment property where they?ve made a profit (capital gain), and they?re using the money to buy a new investment property, they can push off any taxes owed on the profit until they sell the new property. If the person never sells the new property, or sells the new property to buy an additional property (and uses a 1031 exchange), they may never need to pay the capital gains taxes. Here are some key points to remember: ? 1031 exchange is for investment to investment only. You cannot use it on a primary or second home. ? Capital gains taxes are deferred, not excluded. If someone sells the new property and does not buy an additional property utilizing a 1031 exchange, he/she will need to pay the taxes. ? The borrower must identify the new property to be used in the exchange within 45 days of when the initial property was transferred. ? The borrower must complete the exchange within 180 days of when the initial property was transferred. ? A qualified intermediary must be used to hold funds used in the transfer and exchange. ? The new property must be considered an ?investment? for 1 year from the completion of the exchange before you can convert it to ?primary?. 121 Exclusion Section 121 is another tax vehicle used to deal with capital gains taxes when selling one property to buy another. There are three major differences between a 1031 exchange and a 121 exclusion. First, where a 1031 only deals with investment properties, a 121 only deals with primary properties. This means that a person must be selling his/her primary home and, if exchanging, must be buying another primary home. Second, where a 1031 defers the capital gains taxes, a 121 completely excludes all, or a portion, of the capital gains (see below for the specific amounts). This means that the taxes that the borrower pays on profit from the sale of his/her primary residence can be greatly reduced, if not eliminated. Lastly, this is a permanent tax deduction on the sale of a primary residence. An exchange is not required. Here are some key points to remember: ? 121 exclusion is for primary residence only. You cannot use it on an investment property or second home. ? Capital gains are excluded from the borrower according to IRS filing status: o $250,000 can be excluded for a person filing ?Single?. o $500,000 can be excluded for a person filing ?Married, filing jointly? ? The borrower must have lived in the existing property for 2 out of the last 5 years. ? The borrower must wait 2 years to use Section 121 again. ? If the primary residence was acquired as a part of a 1031 exchange, and was converted to a primary residence, the borrower must own the property for 5 years to exclude capital gains under Section 121. Income Tax strategies using both Sections With proper planning, a borrower can use a combination of Section 1031 and Section 121 to avoid paying capital gains taxes on the sale of an investment property (speak with a qualified CPA for details). Here are three ways: Investment property acquired WITH NO 1031 exchange and converted to primary residence: If the investment property was acquired without a 1031 exchange, it can be converted immediately to a primary residence. However, in order to use Section 121 to exclude capital gains, the borrower must live in the residence for at least 2 years. After 2 years, they can use Section 121 to exclude the capital gains. Investment property acquired WITH 1031 exchange and converted to primary residence: If the investment property was acquired with the use of a 1031 exchange, it can be converted to a primary residence. However, the borrower must wait 1 year from the time of the exchange in order to make the conversion. Once converted, they must have held the property for 5 years in order to use Section 121. Using this method, Section 1031 will allow the borrower to defer the taxes until the new property is sold. But the property will be converted to primary and Section 121 will be used to exclude any capital gains that were deferred from the 1031 exchange. Primary residence converted to investment property and then sold to purchase a new investment property: In this scenario, it?s possible to use both Section 1031 and Section 121. In this case, once you convert the primary residence to an investment property, the borrower needs to hold the property as an investment for a ?sufficient period of time? to prove that the borrower intended to use it as an investment property (generally, 12 to 18 months). Once the property has been held for the sufficient period of time, it can be sold and Section 121 can be used to exclude capital gains. If the capital gains exceed the allowable amount of Section 121, Section 1031 can be used to defer the remaining capital gains. Knowledge is Power. The more you know, the more you can educate your clients. And the more educated they are, the more loyal they will be to the person who taught it to them. Bio Michael Deutsch is President of Vare Solutions, Inc. Vare Solutions is a full service processing company whose primary goal is to increase the number of closed loans by strengthening its client?s business processes. Michael has many years experience on the wholesale side of the business in both sales and operations. If you have any questions or comments for Michael, he can be reached at 877-552-5777 or by email at [email protected]. Please note that information provided in this article is intended for general knowledge purposes. For specific scenarios, please seek advice from a qualified CPA.
