The lackluster housing market has many investors looking for bargain properties, sometimes in bunches. Buyers are getting more creative about funding their purchases, rethinking the role of real estate not only for their portfolios but also for their residences.

In a recent example, an older couple sold their home and purchased two Arizona golf-course condominiums with the proceeds — one for their primary residence and another as a rental — and still put some money in their pocket. What made the deal interesting was that they had purchased the original home six years ago via a tax-deferred exchange.

CORRECTION: This column has been updated with a correction. The Housing and Economic Recovery Act of 2008 amended Section 121 of the Internal Revenue Code. That section no longer permits homeowners to take the full tax-free exclusion on the sale of real property that was held and used as their primary residence if there was any nonqualified (rental) use of the real property prior to it being held and used as their primary residence.

The lackluster housing market has many investors looking for bargain properties, sometimes in bunches. Buyers are getting more creative about funding their purchases, rethinking the role of real estate not only for their portfolios but also for their residences.

In a recent example, an older couple sold their home and purchased two Arizona golf-course condominiums with the proceeds — one for their primary residence and another as a rental — and still put some money in their pocket. What made the deal interesting was that they had purchased the original home six years ago via a tax-deferred exchange.

While investors had turned rental properties into principal residences for years, the timing for claiming the $500,000 principal residence exemption ($250,000 for a single person) on a home acquired via an exchange wasn’t clarified until late 2004.

Before then, taxpayers were left to guess how long they had to hold an investment property before deeming it a primary residence — or when it was safe to sell it and pocket any gain.

The American Jobs Creation Act of 2004 spelled out the steps necessary to create a "safe harbor" with the Internal Revenue Service for investors who ended up living in one of their rentals. The key stipulation was the exchange property must be held for five years in order to qualify for the primary residence exemption. The five-year period curtailed people from buying investments, immediately moving into them and then quickly selling them simply to avoid a capital gains tax.

In order to qualify for the $500,000 exclusion ($250,000 for single persons) homeowners must own and use the property as a principal residence for two out of five years prior to the date of sale. Second, the owner must not have used this same exclusion in the two-year period prior to the sale. So, the only limit on the number of times a taxpayer can claim this exclusion is once in any two-year period.

Under the exchange rules, commonly known as 1031 exchanges or Starker exchanges, a taxpayer who exchanges property that was held for productive use or investment for "like-kind" property may acquire the replacement property on a tax-free basis. Because the replacement property generally has a low carryover tax basis, the taxpayer will have taxable gain upon the sale of the replacement property.

However, when the homeowner converts the replacement property into a principal residence, the taxpayer may shelter some or all of this gain from income taxation. The committee that drafted the five-year rule wrote that proposal "balances the concerns associated with these provisions to reduce this tax shelter concern without unduly limiting the exclusion on sales or exchanges of principal residences."

While the five-year requirement is a helpful guideline, it does not significantly extend the timeline for people who might consider moving into their own rental. That’s because an investment property needs to be rented (used as an investment) after an exchange to show the exchange was clearly an investment-for-investment transaction.

Accountants say the exchanged property should be held for at least two years as an investment property before an owner considers converting it to a primary residence.

The Housing and Economic Recovery Act of 2008 amended Section 121 of the Internal Revenue Code. Section 121 no longer permits homeowners to take the full tax-free exclusion on the sale of real property that was held and used as their primary residence if there was any nonqualified (rental) use of the real property prior to it being held and used as their primary residence. It will have to be prorated for the time period during which it was rented.

For example, if you rented a home for two years and then occupied it for two years, then sold — you will end up paying capital gain tax from 50 percent of proceeds.

Exchange facilitators and tax attorneys caution that all exchanges must meet the "facts and circumstances" test regardless of how much time has passed before converting an investment property to a personal residence. In a nutshell: It’s all about intent. If it’s clear at the time of the exchange that a taxpayer intended to use the exchange property as a primary residence, the exchange can be challenged.

While a tax-deferred exchange appears just like a "sale" for you, your real estate agent and parties associated with the deal, Section 1031 of the Internal Revenue Service code specifically requires that an exchange take place. That means that one property must be exchanged for another property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax-deferred transaction from a sale and purchase. The exchange is created by using an intermediary (or exchange facilitator) and the required exchange documentation.

If you’ve traded for a lakefront getaway condo and now think you would like to live there, make sure you own it for five years before attempting to pocket a principal residence exemption.

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