Tax Loophole: Move Often to Make Money

The ink is barely dry on the 1997 tax law, but creative accountants and tax lawyers already have spotted ways for homeowners--and other real estate owners--to reap benefits beyond what even Congress may have contemplated.

Tops on the list: Call it the serial home-sale strategy. It could save some property owners hundreds of thousands of dollars over a period of years.

The technique has potential applicability to homeowners who also own a second house or condo, a vacation house or any rental residential property. Baby boomers who have racked up big real estate gains and are ready to downsize or retire are the likeliest beneficiaries. But anyone can use it.

Greg Jenner, a former Senate finance committee staff member who is now national director of tax policy for the accounting firm of Coopers & Lybrand, discussed the concept in an interview last week.

Now that homeowners who sell their principal residence can escape taxation on up to $500,000 of capital gains (if married and filing taxes jointly), or $250,000 (if single or married filing singly), the name of the game has become: How do you convert taxable gains you have in other real estate into tax-free home sale gains?

The answer, according to Jenner:

Once you sell your current home with zero federal taxes on your profits, you move into any second (or additional) residential property you own and make that property your principal residence. Under the new tax law, you need use the replacement home as your principal residence for only two years (out of a five-year period) for it to qualify for tax-free treatment at sale (up to the applicable $500,000 or $250,000 limit).

Although Jenner says he originally assumed that the concept would have prime value “to Daddy Warbucks types who own several houses,” he agrees that it would work for vacation homeowners or small rental home investors as well.

The only hitch for rental property owners, Jenner added, is that they’ll have to comply with the new depreciation “recapture” rules in the 1997 tax law, exposing them to a 25% tax liability on part of their gains when they sell.

Here’s how the serial sale technique would work for sellers in two situations:

Say you’re a homeowner and you’ve had outstanding luck with your real estate, chalking up big jumps in the resale values of your principal residence and your beach house. Under the revised federal tax law, the gains on your principal home qualify for the $500,000 tax-free treatment, but not the gains on your beach house. Assuming you’ve never rented it out or treated it as an investment property, the gain on the beach house if you sold it today would be exposed to taxation at the new 20% capital gains rate.

How to reduce that exposure to zero? Convert the beach house to your principal residence for two years--if that’s feasible for you-- and then sell. To avoid problems with the Internal Revenue Service, make sure that your move is bona fide.

That is, be certain that you do all the things the IRS looks for in audits to establish your true principal residence: change your voting registration to the new house, switch your auto registration to the new address and really live there. In short, don’t play games with Uncle Sam.

Here’s a second example, this time oriented to the homeowner who also owns a rental property.

The concept works the same as it would with a non-rental second home. You convert the rental home to your principal residence, taking over your existing tax “basis”--or cost for tax purposes--as your measuring point for computing gains.

For instance, if you bought a house for $75,000, made no improvements to it but took $15,000 in depreciation deductions during your ownership, you’d convert the property to your principal residence with a tax “basis” of $60,000 ($75,000 minus $15,000).

Two years after converting it to your principal residence, you sell the home for $225,000. That’s a $165,000 gain, given your $60,000 basis. Under the 1997 tax law, you’d have to slice your capital gain into two parts--the gain attributable to the depreciation you pocketed and the gain attributable to the home’s increase in resale value. Any depreciation you took on the property before May 7, 1997, would escape recapture and would be treated as capital gain. Depreciation taken after that date would be subject to a 25% recapture tax.

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If you took all $15,000 in depreciation after May 7, 1997, you’d pay 25% ($3,750) in recapture.

The rest of your gain--$150,000--would qualify as profit from the sale of a principal residence and escape taxation altogether.

So instead of paying 28% in federal taxes on your $165,000 gain, as you would have had to do before the 1997 tax law--a painful $46,200--you pay just $3,750, or even no tax if the depreciation was taken before May 7.

And if you happen to own another property that’s increased in value--and if your lifestyle can accommodate the change--you can convert that property into your residence and begin the tax-saving process all over again.

Distributed by the Washington Post Writers Group.