Rolling Your Condo into a New Development -- Tax Free!

You own a condo in a nicely situated, but somewhat dated, building. Dave Developer comes to you and offers to buy your unit for a reasonable price. What Dave wants to do is gut the building and rebuild it into a modern condominium complex. Or maybe Dave even wants to tear down the building and build a new condominium tower.

You don't mind selling but you don't want to pay tax on the sale. What you would really like to do is buy one of the new units when he gets his development completed in a year or two. How do you do this and not pay the capital gains tax?

Probably the most common and most popular way to get to where you want to be without paying tax is to do a Section 1031 exchange. What is a 1031 exchange and how does it work?

There are six critical parts to a 1031 exchange. The first of these is that both the Old Property you are selling, and the New Property you buy, has to be held for investment or business use. Are vacation condo's investment property? [1031 vacation home update: May 2007] Yes and No. The IRS has a ruling that says that a vacation condo qualifies for a 1031 exchange even if it has never been rented provided you can show some investment intent. An easy way to do this is to rent, or try to rent the property. If you are uncertain how to prove investment intent, talk to your CPA.

The second critical rule is that you have to make a list of the properties you might buy as your replacement. You have exactly 45 calendar days, from the date you close the sale of your Old Property, to make this list, and you typically want three properties or less on the list. So you have to decide pretty quickly what you want to do.

Critical rule number three says that, again from the date you close the sale of the Old Property, you have exactly 180 days to close on the purchase of whatever you are going to buy, and what you buy has to be on your 45-day list. This can be a problem if you want to buy one of Dave Developer's new units -- but I'll show you how to deal with this in a minute.

Rule number four says that you can not touch the money in between the sale of your Old Property and the purchase of your New Property. You must use an independent third party, called a qualified intermediary, like our firm, to handle your exchange. (You sell your Old Property to Dave and the cash from the closing is sent directly to your intermediary who holds it until the closing of the purchase of your New Property.)

Rule number five says that the same taxpayer that owned the Old Property has to take title to the New Property. If you and your wife own the Old Property, the two of you have to go into title on the New Property. If this rule is an issue, call us and we'll help structure your individual transaction with its unique challenges.

The last rule says that in order to pay zero tax, you have to do two things: you have to buy equal or up, and you have to reinvest all the cash. If you sell for $100,000, the New Property has to cost $100,000 or more. If it only costs $90,000 you will pay tax on the $10,000 buy-down -- and all of the $10,000 is taxable regardless of the amount of your own cash you have previously put into the property. And you have to reinvest all the cash. So, after loan payoffs, closing costs, etc., if $60,000 goes to the qualified intermediary, you have to invest all of this into your New Property -- regardless of the amount of cash you have invested in the Old Property. If you spend less than this amount, you pay tax on it.

So, you still want to sell your condo to Dave Developer, How do we make this work within the confines of a 1031 exchange? First, when you talk to Dave Developer about him buying your old unit, if he is agreeable, you will do a 1031 exchange from your Old Unit (say, Unit #203) into an "undivided X % fee simple interest, tenants-in-common" in his development. The amount of your interest (X %) will depend on the value of your Old Property and the total value of his new development. If you sell your Old unit for $225,000 and the entire new condominium complex will be $7,500,000, then your undivided interest will be 3% ($225,000/$7,500,000). An important point, you need to make sure that you take title to your New unit the same as you held title to your Old unit -- you cannot take a partnership share or interest in Dave's development. Make sure your QI is knowledgeable about this aspect.

You will hold this interest in the development until Dave has completed the building and at that time you will do another 1031 exchange from your ownership of an "undivided 3% interest tenant-in-common" into a deed for fee simple (specified) interest in the New Unit, say, #605.

There are a couple of things you have to watch for (you want to work with your attorney on these): you don't want to become a part of Dave's construction loan -- because you don't want the lender to come after you if Dave gets sideways on the loan. And you also want to protect yourself if there is an accident during construction so that you don't get dragged into litigation. Your attorney can help you with this.

From Dave Developer's standpoint, he is going to want to retain full control of the development -- so don't expect that you will have any say in the development. And Dave won't want your ownership interest impacting his construction loan, so don't be surprised if the lender insists on you subordinating your interest to the construction loan.

All of these issues are things that can be worked out, and with a good QI you should be able to navigate them so that you can truly go from your old condo into a brand new condo tax free!