More viewer mail:
I read your post on converting ordinary income to capital gains. I have a question. Can you use a 1031 exchange to eliminate capital taxes on the sale? For example, a $100k property depreciated at 10% yearly with breakeven rents. According to your post, if sold for $200k minus Adjusted Basis $0, I would owe capital gains on the full price ($200k). Would a 1031 exchange wipe out the capital gain tax?
I bought a duplex for $95,000 in 1995. I rented this out for ten years (approx) taking $9500 in depreciation deductions annually on my taxes - effectively lowering my income by that amount. At the time, I was making well over $100,000 a year, so this knocked down my taxes quite a bit (I also had two other rental properties), as I was in the 35%+ bracket. In effect, this was converting my ordinary income into capital gains and then deferring the tax until years later - if ever.
I then sold the property for $250,000 which would have been 100% taxable gains as the property was "fully depreciated". Instead, I did a Starker-type deferred exchange or a 1031 as is now called, and bought two condos in Florida. I rented these out but could not depreciate them, as the purchase price was equal to the un-taxed gains I used to purchase them. If I had bought a $350,000 condo and kicked in my own cash (or got a mortgage) I could have depreciated another $100,000 - plus deducted the mortgage interest of course!
What I did with one of the condos, as I recall, was declare it as my primary residence, lived there for three years, and then sold it tax-free. Yes, this is actually legal. Or at least it was - in 2009 they changed the law and adjust the gains based on the number of years it was rented. So this "loophole" has been partially closed.
I had to pay all the capital gains taxes on the other one, though. But considering I put nothing down on the purchase of the original duplex and then folded that into the condos and then sold those for twice what I paid for them, I am sure you feel sorry for me that I had to pay capital gains on $250,000 of income when I realized $500,000 gain from the overall sale.
There is another way to avoid paying the capital gains taxes entirely - DIE. If you die, the property transfers to your heirs tax-free (to them) and they get a stepped-up basis to the retail value, so if they sell it right away, they pay no capital gains tax. The rich get richer, and heirs inherit tax-free.
So you can avoid the tax on the gains two ways - convert to primary residence (which used to be a freebie, but now is not as great a deal) or DIE, the latter being less advantageous.
But even if you don't avoid the capital gains tax entirely, if you delay it, you come out ahead, and by reducing a corresponding amount of your ordinary income and "converting" it to a capital gains, you come out ahead.
Consult your tax adviser for details - there are a lot of forms and conditions with a 1031 exchange and deadlines as well. And as you can see, the rules are changing all the time. So it pays to pay someone to assist you with this - as I did.
Weird system, no? Sort of favors people with money.