Two Easy Ways To Save Your Buyer Money On Closing Costs
New York is used to coming in number one in lots of contests. And in the competition for highest closing costs, it does not disappoint, consistently having the highest average closing costs of any city in the country year after year.
But a couple of rules about how certain closing costs are calculated can save the smart buyer – or the buyer with a smart broker – some quick money.
Would you pay $625 to borrow $1? Apparently lots of people would. The mortgage recording tax in the five boroughs requires the borrower to pay a tax for the privilege of recording a mortgage against their real property. Of course the bank lending the money requires the mortgage to be recorded, so the tax must be paid at the time of the closing. The tax law requires a payment of 1.80% of the face value of the mortgage if the total mortgage is less than $500,000. But the moment the total mortgage is equal or greater than $500,000, the tax on the entire mortgage changes to 1.925%. A review of the mortgages filed in NYC during the last week shows more than 10 that were exactly $500,000 in face value. The recording tax on those loans would have been $9,595.00 (1.925% of $500,000, less a $30 credit under the statute). But by simply reducing the loan amount by one dollar to $499,999, would result in the tax being reduced by $625! So tell your buyers who are considering a mortgage of around $500,000 to get it under that magic number and save some hefty recording taxes on just a few dollars of lent money.
One of the hidden benefits of doing a Section 1031 exchange is that the code permits the taxpayer to change the use of the replacement property without triggering a realization of the deferred gain that was accumulated into it!
But, like so many other rules in this area, strict compliance with the guidelines are required.
Remember, all replacement property must be acquired and held for productive use in business, trade or investment. As such a “holding period” is recommended to ensure that the use is consistent with this intention. Some tax advisers counsel a one year hold, while the IRS itself provides guidance that two years is sufficient.
Once the property is held for the requisite time period, the taxpayer may, if they then elect, change its use to a principal residence. But how will the gains analysis be impacted when the property is then sold?
Sales of principal residences under section 121 of the IRC provides generous tax exclusions with respect to payment of capital gains. A taxpayer selling a property that was his principal residence for a combined 24 of the previous 60 months prior to closing is entitled to exclude the first $250,000 of the gain for individuals, and the first $500,000 of the gain for married couples filing jointly. The 24 month period does not need to be consecutive, and it does not need to occur at any particular time within the 60 month lookback period.
If the property sold was previously acquired as a replacement property in a 1031 exchange, two additional rules are implicated.
First, taxpayers may only elect to exclude gains on the sale of a “converted” 1031 replacement property under section 121 principal residence exclusion if the property being sold was owned for 5 years or more.
Second, property that was previously used for business, trade or investment is “limited” when using a section 121 principal residence exclusion. The exclusion is reduced pro rata by the number of years it was used for non-principal residence divided by the total years of ownership. But investment use prior to January 1, 2009 is not counted in this reduction, and commercial use after the last date of principal residential use is also not counted.
Let’s take a couple of examples.
Example 1: Bob sells a rental property and properly defers the gain of $100,000 by purchasing another rental unit as a replacement using a 1031 exchange. The replacement property was purchased on January 1, 2008 for $300,000. He uses it for rental use until January 1, 2011, when he begins to use it as a principal residence. He then sells it outright on December 1, 2013 and realizes a total gain of $300,000.. Bob is unmarried.
Analysis: Since Bob is selling a property that was his principal residence for 24 of the 60 months prior to the date of sale, he is entitled to use section 121. But since this property was acquired as a replacement property in a 1031 exchange, he is limited to property that he owned for at least five years. Since he owned it for more than five years, he meets this test. However, the amount of the exclusion ($250,000 for single persons) is reduced by the ratio of years of non-qualifying use (the time period the property was rented) divided by the total years of ownership. But non-qualifying use prior to January 1, 2009 is not counted. So the 12 months of rental use in 2008 is not included here, and his non-qualifying use would be from January 1, 2009 until January 1, 2011, or 24 months. His total period of ownership was 71 months. So the exclusion of $250,000 is reduced by 24/71 or 33.80%. Now he is entitled to exclude $165,492, and must recognize a gain of $134,508.
Example 2; Joy buys a principal residence on January 1, 2007. She lives in it until January 1, 2010, when she then converts it to a rental property. On January 1, 2013 she sells it, realizing a gain of $400,000, and successfully defers the gain by purchasing a 1031 replacement property which she also uses as a rental. Joy is not married.
Analysis: At the time of sale Joy can utilize section 121 since the property being sold was her principal residence for 2 of the 5 years immediately prior to the sale (January 1, 2008 until January 1, 2010). Her exclusion is not limited since the non-qualified use (the rental period beginning on January 1, 2010) occurred after the last date of residential use (December 31, 2009). Thus, she can exclude $250,000 of the $400,000, and the remaining $150,000 is deferred through the successful 1031 exchange.