Strategy: 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 equity. Then, you exchange the old home for another rental property. It can even be an apartment building, warehouse or other commercial or investment real estate.
Provided you meet all the tax-law requirements, you can 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 due on the exchange until you sell the new property, if ever.
This tax-break combo is sure hard to beat. Best of all, the IRS gave thumbs up to the parlay in a 2005 ruling. (IRS Revenue Procedure 2005-14)
Here’s a quick recap of the two key tax provisions.
Tax break No. 1: If you have owned and used your home as your principal residence for at least two of the past five years, you can exclude up to $250,000 of gain from tax ($500,000 for joint filers). You can use this tax break multiple times. Note: Any gain attributable to depreciation for a portion of the home used for business after May 6, 1997, is taxable at a maximum rate of no more than 25%.
Tax break No. 2: If you own business or investment property, you can arrange to exchange it tax-free for other “like-kind” property. Any “boot” received in the deal, such as cash or assumption of a mortgage, is currently taxable. But the IRS takes the boot into account only to the ruling, the IRS applies the home-sale exclusion before the rules for like-kind exchanges. You must adjust the basis in the new rental property to reflect the exchange. The IRS treats the amount excluded under the home-sale tax break as gain on the exchange. That effectively increases the new property’s basis.
Tip: The IRS now requires certification that none of the gain from a home-sale exchange meeting the two-out-of-five-year requirement is taxable. (IRS Revenue Procedure 2007-12)
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