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How to Reduce the Taxes Due on the Sale of Highly Appreciated Real Estate

Last update on: Oct 17 2017
Estate Tax

Many Americans on the coasts or in resort areas are selling homes for far more money than they ever imagined. Their gains often exceed the tax-free limit under federal tax law. In some cases, the home sellers are looking at paying more capital gains taxes than their homes initially cost.

There are strategies for reducing the taxes from the sale of a highly appreciated home. The IRS added a valuable strategy to the list with a ruling early in 2005.

The basic rules are that a taxpayer can exclude from income up to $250,000 of gain from the sale of a principal residence. The exclusion is $500,000 if the seller is married. The couple does not have to be joint owners of the home to qualify for the $500,000 exclusion. The home must have been the seller’s principal residence for at least two of the five years preceding the sale, and the seller must have owned the home for at least two of the five preceding years. The residence and ownership periods do not have to be identical. A partial exclusion is available for those who do not meet the full two year residence and ownership periods.

The exclusion applies only to a principal residence. Second homes and vacation homes get no exclusion.

Since the law was changed in 1997, there is no requirement to reinvest the sale proceeds in a new home. You get the exclusion regardless of what you do with the proceeds. Of course, you also cannot increase the exclusion by re-investing in another residence.

Take the case of Max Profits. He purchased a home for $50,000 decades ago. He is ready to sell, and real estate agents tell him the home could fetch $850,000. This gives Max a gain of $800,000. Max is married to Rosie, so they can exclude $500,000 of the gain. That leaves a taxable gain of $300,000, for a tax of $45,000.

Max might be able to exclude even this $300,000 from income by combining the home sale exclusion with the like-kind exchange, also known as the section 1031 exchange. This is the strategy the IRS approved in Revenue Procedure 2005-14.

In a 1031 exchange, a business or investment property is traded for another business or investment property of equal or greater value. There is no gain on the transaction, but the new property has the same tax basis as the old property. In other words, the gain is deferred until the second property is sold.

As a practical matter, properties rarely are exchanged. Instead, before Max sells his home he would contract with an intermediary that specializes in like-kind exchanges. The sale contract would provide that $300,000 of cash is paid to an escrow account controlled by the intermediary instead of being paid to Max. When Max finds a new property he likes, he directs the intermediary to buy it and transfer title to Max.

To qualify for a 1031 exchange, Max would have to rent his home to tenants before the sale. Two years is the recommended rental period. Notice that a two-year rental period does not keep Max from qualifying for the home sale exclusion. Max then sells the home in a combination sale and like-kind exchange.

Max can do whatever he wants with $550,000 from the sale. With the other $300,000, he buys another home or condo that is rented to tenants. This unit carries over the tax basis of $50,000. Max could buy a more expensive property and increase its basis by allocating more cash from the sale to the rental unit. Or Max could generate more cash by placing a mortgage on the rental unit. (The numbers actually would be a little different. During the rental period, Max would depreciate the first home. That would reduce the basis a bit and increase the gain.)

After renting the new property for at least one year, Max has several options. He could continue to rent the property indefinitely. Or he and Rosie could move into the property and establish it as their principal residence. Eventually they could sell that property and exclude the gain. But because they used a like-kind exchange, they cannot use the home sale exclusion until they have owned the new home for at least five years. After meeting all the time qualifications, they could exclude up to another $500,000 of gain and end up excluding all the gain from the original home plus the gain from the new property.

A section 1031 exchange has a number of very specific requirements. Max should not attempt this strategy without the help of a professional experienced in exchanges.

It is possible to qualify for a 1031 exchange without renting the original house. Part of the home will be considered a business or investment property if it has a qualified home office. The home office portion of the home is considered a business or investment property and can be exchanged for another business or investment property.

This strategy is not for everyone. It requires some flexibility and planning. But people with highly appreciated homes who want to cash out tax free can use it. Other strategies were presented in our November and December 2004 issues. The articles also are in the Tax Watch section of the Archive on the web site.

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