Just follow the Safe Harbor Guidelines to convert the equity in your building into your Home Sweet Home
For those who’ve been around for a while, this headline might remind you of Maxwell Smart delivering one of his classic lines from the 1960s series, Get Smart. Hilarious humor from the minds of Buck Henry and Mel Brooks that is just as funny today as it was then. But, unlike that comedy series, our headline is not a joke. In fact, it refers to a little known IRS regulation that allows you to exchange your highly appreciated industrial building into your retirement dream home, fully tax-deferred.
Now this might sound a little too good to be true, but this is an exception to that wise old rule about such things. For those generally familiar with Section 1031 of the Internal Revenue Code, a qualifying exchange must be for properties of “like kind”, meaning for investment, trade or business. So, the 1031 exchange of an industrial building for a personal residence wouldn’t pass muster with the IRS. And that is true. However, there is a straightforward and completely legal way to exchange your investment property for a personal residence without disqualifying the exchange. You just need to follow a few simple rules and exercise a wee bit of patience to make the whole thing work out just the way you want it to. Let’s take a closer look.
The IRS’s Safe Harbor Guidelines (Revenue Procedure 2008-16) are the rules to follow. They require the following to ensure that your exchange into a personal residence is within the Section 1031 umbrella. They require that you:
- Hold the replacement property for at least 24 months immediately following the exchange.
- Use the property for rental purposes for at least 14 days in each of the two 12-month periods post-exchange.
- Limit personal use of the property to the greater of 14 days or 10% of the number of days the property is rented at fair market value each year.
If these conditions are met, the IRS will not challenge the validity of the 1031 exchange. However, it is important to follow the Safe Harbor rules explicitly and keep good records of your activities. Also, the rental income must be arms-length, meaning your kids or other relatives can’t be your renters. After two years from the close of escrow you can move on in and hang the Home Sweet Home sign over the fireplace.
While this approach might not be for everyone, it is right on the money for those of you who haven’t already decided where to call home in your retirement years. If you are like so many other industrial building owners out there, the bulk of your net worth is in your building rather than your business, mainly due to the prolific run-up in property values we experienced from 2011 to 2022, when property values essentially quadrupled. And if you bought your building in the mid 1990’s, it’s probably worth more than 6 times what you paid for it, plus or minus. Good for you. You deserve this unanticipated windfall that could drastically impact the quality of your retirement years, financially speaking.
As we have said many times in these pages, there are two main reasons why most building owners don’t sell: 1) they refuse to pay the whopping tax bill, and 2) they don’t know what to reinvest the money in. Sound familiar? But, The Ol’ Exchange into the Dream Home Trick solves both problems. It’s completely tax deferred if done correctly, and single-family residential real estate is a time-tested winner of an asset class to invest in. Then, after that last lap around the sun, the heirs get the dream home at a full step up in basis. The investor and the family win and the IRS never gets its hands on all that hard-earned wealth. Sounds like a winner to us. Let’s take a look at the concept by way of example.
Let’s say you bought your 15,000-square-foot building in Anaheim for $65 per square foot, or $975,000 in 1995. You are now ready to retire. You call us and we give you the good news that your building is worth $375 per square foot, or $5,625,000. Nice chunk of change you probably wouldn’t have dreamed possible. Again, good for you. You deserve it.
Let’s also say that you paid off your original loan and now own the property free-and-clear, as most long-term owners do. After closing costs from the sale, you net approximately $5,345,000. If you were selling outright, you’d have to pay roughly $1,650,000 in taxes, but you’re not. You’re exchanging into a big beautiful house of your choice with that $5,345,000 in proceeds and your tax bill is $0. You then lease the house for 2 years to a creditworthy renter at fair market value, which at today’s pricing, produces good cash flow during your 2-year waiting period. Now, you have met the Safe Harbor Guidelines and earned good income at the same time. Your tenant moves out and then you move into your dream home with your 1031 exchange intact.
Is it really that simple? Yes it is, at least as far as the rules go. Renting does have its associated risks, of course, but those with the ability to rent a high-end home are generally well qualified. All-in-all it beats paying $1,650,000 in taxes and you got to buy more house as a result.
On another note, you can buy more than 1 property using this process. Maybe you would prefer to buy your dream home and a second home on a lake or at the beach. Just follow the Safe Harbor rules. What is most important is to look at your unique circumstances and build a plan that supports your vision for your retirement years.
If you can’t tell already, we really like this idea. It fits the profile of so many of our owner clients, most of whom are just hardworking entrepreneurs like you who happen to be sitting on a pile of equity they never dreamed of having. If anything, we just wish more of them would let go of working so hard and start enjoying the benefits of decades of hard work. If the foregoing has you thinking, let us know. We’re here to help.