Article:
Plan Opportunity For Sale Of Residence
by Paul H. Roskoph
July 1, 2006
The Internal Revenue Code (Section 121) has taken various routes to provide a degree of tax deferral or tax savings on the sale of a personal residence. Under the earlier provisions, a homeowner was entitled to "roll over" a gain on a residence if a new residence was acquired of equal or greater value. Many people think this is still the law. It is not.
Section 121 of the Code now provides a $500,000.00 exemption (for a married couple) or a $250,000.00 exemption (single person or married filing separately) if the home was the principal residence in two of the five years immediately preceding the date of sale. Many young couples are able to use this appreciation without tax to acquire a more expensive residence. (Of course, Prop. 13 taxes will increase the property tax unless the homeowner is eligible for the "carry over" at age 55 or over. (See article on Prop. 13 issues.)
The Internal Revenue Code also allows deferral of gain on property held for investment (Section 1031). Each of these Code Sections is a reasonably well known opportunity for owners of real estate.
In a surprising ruling, the IRS declared in Revenue Ruling 2005-14 that a taxpayer can use both Sections 121 and concurrently Section 1031 under appropriate circumstances. This approach requires that the property be converted from a personal residence to a rental property and, further, that the qualification of the two year ownership during the preceding five years is still satisfied.
Let's put this into numbers. If you purchased your home for $300,000 and it currently has a fair market value of $1,300,000, and sell it as a principal residence, the one million dollar gain will be taxable, but if the two of five year requirement is satisfied, and the owners are married, there is a $500,000 exemption and the remaining $500,000 will be subject to capital gain tax. The current federal rate is a favorable 15%, but beware of the Alternative Minimum Tax).
If, however, rather than sell the property as a principal residence, it is converted to a rental property, the IRS has ruled that the remaining gain of $500,000 may be deferred through a 1031 Exchange if an investment property is acquired.
For individuals who have already relocated from their principal residence and have converted the prior residence into an investment property, the tax benefits may be significant. The $500,000 Section 121 personal residence exemption can be used and the tax on the balance deferred. This property may subsequently be rolled into another investment property and the tax permanently deferred for lifetime. At the death of the owner, the property may be eligible for a new basis equal to fair market value at date of death.
Word of warning: there are specific rules relating to income tax consequences if at the date of exchange or sale the amount of the mortgage exceeds the adjusted income tax basis for the property. These matters should always be reviewed before entering into any sale transaction. Many taxpayers who have lived in their residences for 20 or 30 years may not have a mortgage; on the other hand, many taxpayers are refinancing their residence so that the mortgage greatly exceeds the original cost basis plus any improvements that have been made.
If you would like further information or this technique or these rulings, please contact our office by email or at (650) 470-5300.
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