Avoid Losing Your Principal Residence Benefits

QUESTION: I have been trying to sell my condominium unit for some time. The market is poor, and I have had no success. However, we recently purchased a new house, and we must shortly move into that home. If I cannot sell the condominium, I intend to rent it out until it is sold.

Is there any problem with this arrangement with regard to not paying tax on capital gains for the condominium? I have bought a house, which costs more than the condominium, and I do intend to depreciate the condominium for tax purposes, as well as declaring rental income.

ANSWER: The roll-over benefits under the tax laws are mandatory. No more than two years can elapse between the time you buy your new property and sell your old one. It is possible to take advantage of the roll-over if, for example, you buy your new house in August of 1990, rent out your old one for a period of time, but sell it no later than August of 1992.

Conversely, you can sell your condominium in August of 1990, and you have two years in which to buy another property.

If you put your current house on the rental market, the tax laws will continue to protect you only if you have made a good-faith effort to sell your house first but without success. Obviously, you meet that test. But the mandatory two-year requirement cannot be waived.

Keep in mind that when you rent out your house, you no doubt will take a tenant for at least a year. That will give you only one additional year in which to sell your house. Most people do not want to buy a house that is tenant-occupied, and thus if you were to extend a one-year lease for another year, you might have significant problems in trying to market the condominium.

Thus, the timing and the logistics of this transaction are quite important.

Additionally, although you did not indicate your age, you can also take advantage of the once-in-a-lifetime $125,000 exemption if you have lived in your condominium three out of the last five years and are over the age of 55. In other words, if you have lived in the house for three years, and now you rent it out in August of 1990, as long as you sell the property by August of 1992, you are entitled to take advantage of the once-in-a-lifetime exemption.

And as this column has reported on many occasions, you certainly have the right to couple the roll-over with the once-in-a-lifetime exemption.

However, keep in mind that you may not want to use up the once-in-a-lifetime, since as the name suggests, you only can take this exemption once. It may very well be that the new home will appreciate faster than your old one, in which case you may want to consider ignoring the once-in-a-lifetime on your condominium, and taking it instead on the new property when you ultimately sell that one.

There is one additional aspect to be considered, and that is the availability of the like-kind exchange. If, for example, you rent your condominium and more than two years have elapsed, the condominium is now considered investment property, rather than your principal residence. Under this approach, you can no longer take either the once-in-a-lifetime exemption or the roll-over.

However, now that the property is investment property, you have the right, under Section 1031 of the Internal Revenue Code, to use the so-called “tax-free exchange.”

Under this scenario, when you decide to sell the condominium, you can exchange it for another investment property, and this will accomplish the same results as if you had taken the roll-over. In other words, a like-kind exchange defers tax, and gives you the opportunity to use more money (i.e. the tax savings) to invest in additional investment property.

These issues are often complex, and you must discuss your particular situation with your tax adviser.