The home sale gain exclusion is one of the biggest federal income tax breaks around. However, the gain exclusion may not be big enough to shelter all of your gain from tax if you sell a highly appreciated home.
Strategy: Follow a two-step approach. First, convert your principal residence into a rental property. If you need cash to buy a new home, you can refinance to pull out some of the equity. Second, exchange the old home for another rental property. It can be an apartment building, warehouse or other commercial or investment real estate.
As long as you meet all the tax law requirements, you’re able to max out on the home sale exclusion, even though you technically haven’t sold the old home. At the same time, you defer any taxable gain that is due on the exchange until you sell the new property.
Here’s a quick recap of the two key tax provisions.
Tax break 1. If you have owned and used your home as your principal residence for at least two of the past five years, you can elect to exclude up to $250,000 of gain from tax ($500,000 for joint filers) from the federal income tax. This tax break can be used multiple times by homeowners. But any gain attributable to depreciation for a portion of the home used for business after May 6, 1997, is subject to recapture.
Also, under a recent tax law change, any appreciation attributable to “nonqualified use” of a principal residence isn’t eligible for the home sale exclusion. Nonqualified use includes use of the home as a rental property.
Tax break 2. If you own business or investment property, you can arrange to exchange it tax-free for other “like-kind” property. The IRS takes a liberal approach to the definition of like-kind property. Any “boot” you receive in the deal, such as cash or assumption of a mortgage, is currently taxable. But the boot is taken into account only to the extent it exceeds any gain under the home sale exclusion.
Of course, your basis in the new rental property you’re acquiring must be adjusted to reflect the exchange. The adjusted basis is equal to the relinquished property plus the exclusion amount. In effect, the amount excluded under the home sale tax break is treated as gain on the exchange. This effectively increases the basis of the new property.
Example: There's no place like home
Suppose you are an unmarried individual who bought your principal residence 18 years ago for $200,000. You begin to rent out the home this year, converting it to investment use.
After claiming depreciation deductions of $25,000 over two years, you exchange the home for a townhouse you intend to rent out and $10,000 in cash. The fair market value of the townhouse at the time of the exchange is $500,000.
Because your adjusted basis in the old house is $175,000 ($200,000 cost – $25,000 depreciation), you will realize a gain of $335,000 ($500,000 value + $10,000 cash – $175,000 basis).
Here’s how the tax calculation works according to a previous IRS ruling. (IRS revenue procedure 2005-14)
You’re eligible to claim up to $250,000 tax-free under the home sale exclusion, but now the maximum exclusion must be reduced due to two years of nonqualified use to $225,000 (90% of $250,000 based on 20 years of ownership).
Next, you defer the remaining gain of $110,000 gain ($335,000 – $225,000), including the $25,000 attributable to depreciation, as a like-kind exchange. Although you’re also picking up $10,000 in boot, you don’t have to pay any current tax on that amount. Reason: It doesn’t exceed the amount of the excluded gain.
Finally, your adjusted basis in the townhouse is adjusted to $390,000 ($175,000 + $225,000 excluded gain – $10,000 cash received). If you eventually sell the place for, say, $500,000, your taxable gain is only $110,000 ($500,000 – $390,000 basis).
Tip: Under the 2005 ruling, the IRS requires you to certify that none of the gain from a home sale exchange meeting the two-out-of-five-year requirement is taxable.
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