Suppose you are getting ready to downsize from a country estate. A big spread is likely to fetch a good price, especially if the land in your area is desirable.
Of course, you can qualify for the home sale gain exclusion, but this tax break may not shelter the full amount of your gain if you sell the property in several pieces.
Strategy: Subdivide the property and sell the parcels separately. Just make sure to sell the land parcels and the parcel that includes the residence within a two-year period. You can shelter up to $250,000 in combined gains or $500,000 if you are a married joint-filer. It doesn’t matter how many parcels you sell as long as they are all sold within the two-year period.
Here’s the whole story: Joint filers can exclude tax on up to $500,000 of gain from a home sale ($250,000 for single filers). To qualify, the home must have been owned and used as your principal residence for two of the last five years.
But the exclusion doesn’t apply if you’ve sold another principal residence within the past two years. Thus, you could theoretically qualify for the home sale exclusion every two years.
The IRS recently issued regulations that give taxpayers plenty of leeway when they sell vacant land surrounding a home.
Example: You and your spouse own a principal residence sitting on 15 rural acres. With real estate developers clamoring for the land, you agree to sell off two five-acre lots for a gain of $100,000 per lot. Subsequently, you sell the remaining five-acre lot, which includes the house, at a gain of $275,000. All the sales occur within a two-year period.
Under the IRS regulations, the sale of the vacant land qualifies for the home sale exclusion as long you meet the tax law requirements (see box below). So does the sale of the remaining lot which includes the home.
Payoff: You pocket $475,000 in gains without paying any federal income tax. If your gain exceeds $500,000, the excess gain is taxed at the prevailing long-term capital gain rates.
However, if your home has been used for business or rental activity, including a deductible home office, you must recapture gain attributable to depreciation deductions claimed for the business or rental usage after May 6, 1997.
The recaptured gain is taxed at a maximum federal rate of 25%.
What happens if you can’t meet the two-year requirement for the home sale exclusion?
If you’re running out of time, sell the remaining parcel to an S corporation or limited liability company (LLC) that you control.
Technically, the sale meets the two-year requirement, even though you’re still living there. When the S corp or LLC eventually sells the home, the gain is passed through to you as a capital gain. But you won’t owe tax on most of the home’s appreciation since you’ve owned it.
Tip: Have the entity hold the parcel for more than one year. Otherwise, the gain on any subsequent appreciation will be taxed at ordinary income rates.