Let Uncle Sam help fund a retirement home

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 immediately reinvest the $200,000 in another rental property, you can defer any tax. There are important rules to follow for the deal to qualify as a 1031 tax-free exchange, though:

• You must identify the new property within 45 days of the closing of the old, and settle the new deal within 180 days.

• You also can't touch the money except for the purchase of the new property. It must be held by a qualified third-party intermediary like an escrow company. That's a person or entity that's not controlled by or beholden to you. There are lots of companies that do this professionally, but you could just as easily use a friend you're not related to.

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 in which you'd like to retire . . .

Note that this is a deferral, not exclusion. In theory, 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 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.

Congress and the IRS like this provision. In 2002, the IRS drafted Revenue Procedure 2002-22 (.pdf file) 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, noninvestment 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, 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.

For rental property leased after Dec. 31, 2008, there's a special new rule. Gain from the sale will not be excluded for any period the property is not used as a principal residence, known as "non-qualifying" use.

Say you bought a house on Jan. 1, 2009 for $400,000 and rent it for two years, taking $2,000 in depreciation. On Jan. 1, 2011, you move in and it becomes your principal residence. You move out Jan. 1, 2013, and sell the property for $700,000 on Jan. 1, 2014, for a $302,000 gain.

The rental period (2009-2010) is a non-qualifying use. You owned the property for five years (2009 through 2013). Forty percent of the gain (two years of the five owned), or $120,800, is taxable. The $20,000 gain attributable to the depreciation is recaptured at rates as high as 25%. As much as $181,200 in gain can still escape taxation.

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. It may prove worth your while.

Updated July 6, 2009

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