The Internal Revenue Service issued what appears to be a surprise box of Valentine’s candy for homeowners and investors seeking to use their former principal residence in a tax-deferred exchange.
However, much like a long-term relationship, the rules require a considerable amount of patience to understand.
On Feb. 14, new guidelines were adopted that would allow investors who kept their home and used it as a rental property under IRS Code 121 to eventually buy down and take cash out of the deal without facing federal income tax liability. This money, known as “boot” in tax circles, previously was taxed.
The new rule, which enables taxpayers to combine Code 121 with the popular Code 1031 for tax deferred exchanges, is retroactive to Jan. 27.
For example, let’s say Betty Booper bought a home in Skagit County for $150,000 in 1990, raised her large family there and then moved to Arizona in 2003 after her last child left home. She kept the large family home as a rental property, allowing members of her church to rent the place while they saved for a down payment on their own home. When the church family bought a home, Betty traded her home, now valued at $400,000 via a 1031 exchange, for an Arizona rental condo valued at $200,000, plus $200,000 in cash.
Betty owed no tax because she was able to receive her $250,000 exclusion of gain on the sale of her primary residence ($400,000 value minus $150,000 basis equals $250,000 gain exclusion) because she lived in the home two of the previous five years. However, before the new guidelines, Betty would have faced a tax liability for the amount of cash she put in her pocket, $200,000.
How does the new rule benefit consumers? For the first time, taxpayers are allowed to take tax-free cash out of a property exchange. It can also be a big help to folks who are confident their home is going to rapidly appreciate in the next few years and can afford to use their family home as a rental.
“For the first time, the IRS is allowing taxpayers to mix the rules on principal residences and investment property,” said Rob Keasal, real estate tax specialist with the accounting firm of Anderson ZurMuehlen &Co. “The new rules do not apply to all 1031 Exchanges, only those that feature the use of a taxpayer’s former primary residence.”
Under the popular like-kind exchange rules of IRS Section 1031, commonly known as a Starker exchange, no gain or loss is recognized on the exchange of property held for investment if the property is exchanged for another investment property of equal or greater value. If a consumer also receives cash or property that is not like-kind property (boot) in an exchange that otherwise qualifies as a like-kind exchange, the taxpayer recognizes gain to the extent of the boot. The like-kind exchange rules do not apply to property that is used solely as a personal residence.
However, the Feb. 14 ruling addresses a combination of the above with the ability to pocket $250,000 of gain for a single person ($500,000 for a married couple) on the sale of a primary residence. In order to qualify for the exclusion, homeowners must have owned and used the property as a principal residence for two out of five years prior to the date of sale. Second, the owner must not have used this same exclusion in the two-year period prior to the sale. So, the only limit on the number of times a taxpayer can claim this exclusion is once in any two-year period.
Here is an example of the new primary home-investment possibility provided by the IRS that includes depreciation deductions:
Fred purchases a house for $210,000 that he uses as a principal residence from 2000 to 2004. From 2004 until 2006, Fred rents the house and claims depreciation deductions of $20,000. In 2006, Fred exchanges the house for $10,000 of cash and a townhouse with a fair market value of $460,000 that he intends to rent to tenants.
Since Fred’s adjusted basis is $190,000, he realizes gain of $280,000. Fred applies the primary residence rule (Section 121) first to exclude $250,000 of the $280,000 gain before applying the non-recognition rules of Section 1031. He may defer the remaining gain of $30,000, including the $20,000 attributable to depreciation, under Section 1031.
Fred recognizes no gain for the $10,000 boot because boot is taken into account only to the extent it exceeds the amount of the gain excluded under Section 121. Fred’s basis in the replacement property is $430,000, which is equal to the basis of the relinquished property at the time of the exchange ($190,000) increased by the gain excluded under Section 121 ($250,000), and reduced by the cash Fred receives ($10,000).
If you can afford to keep your primary residence as a rental – especially if your neighborhood is going to appreciate – speak with your tax adviser about the new guidelines.
Tom Kelly can be reached at news@tomkelly.com.
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