| EXECUTIVE SUMMARY | | Many home sellers have seen rapid appreciation of their home’s value in recent years, leaving them vulnerable to capital gains beyond the principal-residence exclusion under IRC section 121of $250,000 for an individual or $500,000 for joint filers. If sellers buy another home, however, they may be able to defer tax on excess gain.
Under section 1031, property used in a trade or business or for investment can be exchanged for property of like kind that also will be held for trade, business or as an investment. Real estate parcels generally are of like kind, regardless of whether they are improved.
Deferral of gains under section 1031 extends until owners sell or otherwise dispose of the property and can be repeated in a subsequent sale. The section 121 exclusion also can be repeated, but generally can’t be claimed a second time within two years. Taxpayers who employ the dual-use strategy aren’t allowed to repeat it for at least five years after living in the new property as their principal residence, rather than the two years required for section 121 alone. To determine gain in a section 121 sale, add to the original purchase price the cost of improvements and eligible closing costs to determine basis. Depreciation claimed or claimable for dual-use property reduces basis as a section 1250 recapture. The excluded gain under section 121 can be included in the basis of the replacement property. Pamela S Weathers, CPA, is a manager with L. Paul Kassouf & Co., PC, in Birmingham, Ala. Her e-mail address is pweathers@kassouf.com . Jason E. Havens is an attorney with Havens & Miller, PLLC, in Destin, Fla. His e-mail address is jasonhavens@havensmiller.com . |
Once upon a time, a half-million-dollar home was a place of luxury. Or so it seemed in 1997, when Congress eliminated capital-gains rollovers on home sales and replaced them with a tax exclusion of $250,000 for individuals and $500,000 for married couples filing jointly. Nowadays, those amounts might get your clients a snug bungalow needing a lot of TLC in a place like Anaheim, Calif., where the median price of a home hit $726,200 last spring.
In this article, CPAs will learn how to advise clients who plan to buy another home to combine the IRC section 121 exclusion with a strategy to defer taxes on any remaining gain. The key is for sellers to qualify their principal residence for tax-deferred treatment as a property to be exchanged for one of a like kind under IRC section 1031. To do so, the sellers also must use the residence in business or as an investment. The strategy is most feasible for owners who live in second homes as their principal residence in a way that meets the requirements for the section 121 exclusion but use the homes at other times as business or investment property.
| Half Above Half Places where more than half of home sales were for more than a half-million dollars: | Metropolitan area | Median price | | San Francisco | $751,900 | | San Jose, Calif. | $748,200 | | Anaheim, Calif. | $726,200 | | Honolulu | $640,000 | | San Diego | $613,100 | | Los Angeles | $576,300 | | New York-White Plains | $549,200 | Source: National Association of Realtors, median sale price of existing single-family homes, second quarter 2006, www.realtor.org. |
DUAL-USE SYNERGY
To take advantage of the section 121 exclusion, taxpayers must have owned the property and used it as their principal residence for at least two of the previous five years. The two years don’t have to be continuous, but the exclusion generally can’t be used a second time within two years. Under IRC section 1031, property held for productive use in a trade or business or for investment can be exchanged for replacement property of like kind that also will be held for trade or business or as an investment. To defer 100% of the gain, the replacement property’s price must be at least as high as that of the property being sold. (For more on section 1031 exchanges, see “Home Sweet Home,” JofA, Apr.06, page 77; “The Best of Both Worlds,” JofA, Aug.05, page 43; “Reverse Exchanges Come of Age,” JofA, Aug.01, page 57; and “Beyond Section 1031,” JofA, Jul.00, page 61.)
Such dual-use property also provides synergy in other ways: Gains from unrecaptured section 1250 depreciation after May 6, 1997, ordinarily taxed at 25%, can be deferred under section 1031. Also, the section 121 exclusion amount is included in the basis of the replacement property, reducing taxable gain when the replacement property is in turn sold. STILL A RECKONING TO COME
CPAs should advise homeowners that they’re not eliminating tax liability under section 1031 but rather deferring it until they sell or otherwise dispose of the property received in the exchange. Also note that homeowners may not employ the dual-use strategy again unless they live in the new property as their principal residence for at least five years, rather than the usual two years under section 121. If the taxpayer dies, his or her estate doesn’t have to pay the deferred tax, and the property’s basis is increased to its market value at the time of the taxpayer’s death. Further guidance on dual use can be found in revenue procedure 2005-14 (Internal Revenue Bulletin 2005-7). Example 1. The Browns, who are retired, have owned a beach cottage in Florida that they have rented out to vacationers since June 1997. They sold their principal residence in Michigan three years ago and moved to a rented home nearby. In January 2003, the Browns began using the Florida beach cottage as their primary residence for seven months of each year but continued to rent it during the other five months. In 2006, they decided to buy another vacation home in the mountains of North Carolina. After living in the Florida beach cottage for three months that year, they accumulated the required 24 months of principal residency there.
The Browns have a tax basis in the Florida beach cottage of $200,000 before depreciation and have taken depreciation deductions of $42,000. At sale, they expect to receive $800,000 and pay $38,000 in closing costs (see “The Basics on Basis”). They plan to exchange the cottage for the home in North Carolina, where they’ll continue living part-time and renting to vacationers the rest of the year. They’ll pay the same amount for the North Carolina home as they receive for the Florida one, though they’ll also pay $15,000 in closing costs. There is no mortgage on the beach cottage, and they won’t have one on the North Carolina home. Their first $500,000 of gain from the sale will be tax-free under the section 121 exclusion, and tax on the remaining $104,000 in gain will be deferred under section 1031. They save or defer $94,800 in taxes. | | The Basics on Basis To claim the section 121 exclusion, taxpayers must first determine realized gain, which is the home’s sale price less their adjusted basis in it. From the sale price they can deduct selling expenses such as commissions, advertising, deed preparation and other legal expenses, as well as loan charges such as placement fees or points. To determine basis, total the original purchase price of the home plus the cost of any improvements made to it that have a useful life of more than one year, such as adding on a room, patio, deck or garage or finishing a basement or attic. Replacing major systems such as heating or cooling, a roof, plumbing or wiring can qualify, as can outdoor improvements such as new landscaping, paving, sprinkler systems or fences. Additions to basis also may include special assessments from homeowners’ and condominium associations for improvements such as a street or sidewalks, swimming pools, tennis courts or security gates. Some expenses paid to buy the home also can be added to the basis, including attorney’s fees, abstract fees, owner’s title insurance, recording fees and transfer taxes, but not fire or FHA insurance premiums, nor charges connected with obtaining a mortgage, such as for credit and appraisal reports. Basis reductions also can apply. An important one for a residence used in a business or for investment purposes is depreciation allowed or allowable. Sellers who must pay tax on gain representing post-May 6, 1997, depreciation of business or investment property report that gain on form 4797. The gain is taxed at 25% as unrecaptured section 1250 gain. However, that tax can be deferred under section 1031.
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Example 2. Rental property isn’t the only business purpose that can qualify for section 1031 treatment. Mary Banks, an interior designer who works from her home, added space onto the house to create an office and showroom for her design business. Mary receives clients in her home office regularly. She wants to exchange her home for one principal residence and one separate property she will use as an office and showroom. Since she uses a portion of her home as her principal residence and another portion as her business office and showroom, the exchange will qualify for both the principal residence exclusion and a like-kind exchange, assuming all the requirements of sections 121 and 1031 are met.
Combining the section 121 exclusion of gain on the sale of a principal residence and deferral of gain under section 1031 is a tax-saving strategy CPAs can recommend to their clients. With proper planning and implementation, your clients can receive immediate and long-term benefits through tax savings and accelerated cash flow. | |  Because improvements can add to the basis of a home, advise your clients to save all records documenting the costs of any improvements they make.
Let baby boomers and their elderly parents know now that they might face a gain beyond the principal residence exclusion so they can begin planning and it doesn’t come as a shock when they decide to sell.
Taxpayers can repeat section 1031 exchanges any number of times. | | |
Federation of Exchange Accommodators, 
