A month or so ago I attended the monthly Silicon Valley broker’s meeting of my company. They always have a speaker every month, and last month it was a gentleman from First American Exchange Company. He gave an interesting (if you can believe it!) presentation on Avoiding Capital Gains Tax upon Sale of your Home.
Now that home prices have recovered – nearing, hitting or exceeding their all-time peak values in many areas of northern California – many home owners are facing a bit of a tax dilemma. Most home owners are aware that they enjoy a tax exclusion on the gain from the sale of their primary residence: up to $250,000 for single individuals, and up to $500,000 for married couples. It’s one of the best tax loopholes available to middle class Americans. With home values again soaring, a good number of home owners are finding that if they were to sell their house, they’d have a gain which exceeds the exclusion limit, and will potentially be faced with paying significant capital gains taxes.
Would it surprise you to know that you can avoid paying tax on more than $500,000 of gain on your home? This can be accomplished if a homeowner converts their residence to a rental. Once the home is converted to a rental, the owners can sell it and use both the Section 121 exclusion of gain and the Section 1031 deferral of gain provisions to exclude some of the gain and defer paying tax on the rest.
How it Works
Let’s say that Bob and Susie Jones have lived in their home for twenty years. They bought it decades ago for $100,000 and it is now worth $1 million. If sold, they’d have a $900,000 gain. If they sell it without converting it to a rental, they’d be able to exclude $500,000 of gain but would have to pay state and federal capital gains tax on the additional $400,000 of gain. Ouch!
Bob and Susie decide, however, to convert their property to a rental before selling it. After renting it out for a year or two, they sell it for $1 million. Since they did use the home as their personal residence at least two of the past five years, they’re able to exclude $500,000 of that gain. They can then use the remaining funds to acquire replacement investment property and defer paying tax on the balance of the gain (the $400,000).
In order to totally defer the remaining gain, the traditional rule is that the investor must acquire property with a fair market value equal to or greater than the relinquished property. This may mean you will need to invest additional cash or secure financing for the replacement property, as it may need to cost more than the gain you wish to defer.
To be sure that they’ll defer all of the remaining gain, the Jones should consult with their tax advisor before setting up the exchange. Although the new property must be investment property, the Jones can choose later to move into it. If they live in it a minimum of two years and own it for at least five years, they can exclude up to $500,000 of gain on the sale of that property.
Naturally, investors have to comply with all of the rules of Sections 121 & 1031 for this to work. The IRS recently published Revenue Procedure 2005-14, which explains how the two statutes may be combined for one property.
Some of the requirements to note are:
- To take advantage of the $500,000 exclusion ($250,000 for single Taxpayers), you must own and live in your home at least two of the past five years
- You can only take advantage of the section 121 exclusion once every two years
- Section 121 doesn’t allow you to exclude any gain attributable to depreciation deductions taken since May 6, 1997, but that gain can be deferred under Section 1031
- To take advantage of the deferral of gain under Section 1031, all or a part of the property you sell and the property you acquire must at the time of sale be used in connection with your business or held for investment