From a home to a rental
If you are concerned about Uncle Sam taking a chunk of your home-sale profit and you can rent out your primary residence for two or three years, there could be a tax-free strategy in your future.
Take “Ruth from Seattle,” a senior widow who telephoned a call-in radio show about the capital gains tax liability on the sale of her primary residence.
Ruth said the $100,000 home she bought 35 years ago was now worth about $825,000. If she sold and took her $250,000 exclusion for a single person ($500,000 for a married couple), she would be required to pay capital-gains tax on the difference -- $475,000, less realty commissions.
Ruth wondered whether the government was possibly going to raise the exclusion or whether she could trade the $250,000 exclusion, which is available once every two years, for a larger onetime exclusion. Given the history of home-sale exclusions, the possibility of an increase in the next few years is remote.
Ruth’s concerns have been voiced by other sellers but especially seniors who view their home as their only real asset. Not only has the real estate market rocketed since the tax law changed nine short years ago, but also the once-generous exclusion now seems quite ordinary in most of the country’s expensive markets.
However, there is a strategy sellers can use to pocket their exclusion and roll the difference into another real estate investment that might help generate additional income or equity.
Last year, guidelines were adopted that allow investors who keep their home and use it as a rental property to take the exclusion without facing federal income tax liability. This money, known as “boot” in tax circles, previously came with a tax tag.
For example, let’s say Ruth moves to Arizona and lives with her sister and rents out her $825,000 home for two years. Then, she sells her home and takes $350,000 tax free (her original $100,000 purchase price plus $250,000 capital gains exclusion.) She can take the remainder ($475,000) and roll it into another piece of investment real estate -- perhaps a share of an apartment building. She can derive income from the investment during her lifetime and then eventually place it in a charitable trust to avoid future tax liability.
“For the first time, the IRS has allowed taxpayers to mix the rules on principal residences and investment property,” said Rob Keasal, real estate tax specialist in the Seattle-based accounting firm of Anderson Zurmuehlen & Co. “The new rules do not apply to all 1031 exchanges, only those that feature the use of a taxpayer’s former primary residence.”
Under the popular “like-kind” exchange rules of IRS Section 1031, commonly known as a Starker Exchange, no gain is recognized on the exchange of property held for investment if the property is exchanged for another investment property of equal or greater value. (When Ruth converts her home to rental status, it becomes investment property.) The like-kind exchange rules do not apply to property that is used solely as a personal residence.
The 2005 ruling addresses a combination of the above with the ability to pocket $250,000 or $500,000 of gain on the sale of a primary residence.
To qualify for the capital gains exclusion, homeowners must have owned and used the property as a principal residence for two out of five years before the date of sale. Also, the owner must not have used this same exclusion in the two-year period directly before the sale. So, this limits the number of times a taxpayer can claim an exclusion to once in any two-year period.
“Taxpayers should research all of the options before actually paying the tax on real estate,” said Tacoma attorney Thomas Oldfield, a tax-deferred exchange specialist. “The property can usually be exchanged for another that can grow over time. The idea of ‘I’ve got to pay the tax sometime’ should really be explored. There are some very attractive and acceptable ways to avoid the gain altogether.”
If you want to sell your home and have another place you can call home for a couple of years, take some time to gauge the positives and negatives of renting out your home. The strategy could net you cash and save on your tax bill.
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