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Tax-free exchanging -- one of the most popular real estate strategies for investment property sellers -- just took a modest hit from the federal government.

Buried deep inside the $136 billion pre-election tax bill signed into law by President Bush are new restrictions on certain Section 1031 exchanges involving conversions of investment real estate into principal residences.

Section 1031 of the Internal Revenue Code allows tax-deferred swaps of investment and commercial real estate for other "like kind" properties. The concept dates back decades but recently has become a major activity for owners of everything from downtown office buildings to resort rental condominium units.

The new tax legislation, the American Job Creation Act of 2004 (H.R. 4250), takes aim at a loophole that has grown popular enough to nettle the IRS: Owners of investment real estate with substantial built-up gains have swapped their properties for real estate that can be readily converted into owner-occupied residential property. Having completed a tax-deferred Section 1031 exchange of investment property, the owners then convert the exchange-acquired real estate into their principal residences. They live in and use the properties as principal residences for a couple of years, and then sell.

Why? Here's the loophole: Under Section 121 of the Internal Revenue Code, principal residences qualify for the most generous breaks anywhere in the tax system -- tax-free exclusions of up to $250,000 (single tax filers) and $500,000 (married joint filers) in sale profits, provided the taxpayers own and use the real estate as their principal residence for an aggregate two out of the preceding five years.

Section 1031 allows owners of investment real estate to defer recognition of their capital gains via qualified exchange, but the gains ultimately are taxable whenever the property is sold for cash. Section 121, on the other hand, is more generous: It allows qualified sellers to pocket all their cash gains tax-free, up to the $250,000/$500,000 limits, as often as once every two years.

For some savvy investment property owners, the name of the game has become: How can I move my deferred Section 1031 exchange gains into Section 121 territory, where gains (up to the $500,000 limit) are potentially tax-free.

To illustrate, say you've owned a small office or apartment building for years and face substantial capital gains taxes (appreciation plus depreciation recapture) if you sell outright. So you opt for a Section 1031 exchange. But why not sweeten the pot by exchanging your investment property for real estate that has the potential to be converted into an owner-occupied principal residence? One way to do this: Swap your investment real estate for, say, a luxury rental villa at a golf resort community.

Once you've acquired the rental villa, you convert it to principal residence use by living in it for a couple of years. By the way, under IRS rules, that doesn't even mean you're required to be a full-time resident of the villa. You just have to live there a majority of the time during each tax year, and transfer your drivers license, banking and other indices of principal residence location as established by the IRS.

Once you've owned and used the villa for two years -- at least under the old loophole -- you'd qualify for the tax-free exclusions under Section121. Voila! Your formerly taxable investment property gains would be transformed by alchemy into non-taxable gains -- up to half a million dollars -- and you could sell the villa with limited or no tax exposure, depending on the amount of gain deferred via the earlier 1031 exchange.

Now for the new law: It narrows the loophole. It doesn't prohibit such tax-driven conversions outright, but it does require exchange property acquirers to own and use the real estate as their principal residences for five years, instead of the usual two years.

Exchange experts say the law could have been much worse. "There's a silver lining here," says Michael Phillips, a partner in the San Francisco law firm of Rocca and Phillips and vice president of Pacific Realty Exchange Inc. "By implication, the bill confirms that you can do" conversions of exchange-acquired investment real estate and subsequently use Section 121 to exclude some or part of the gains.

"As a practical matter," says Phillips, "it's not all that bad."

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