There are two basic methods to consider when trying to avoid paying capital gains tax on the sale of your home.
METHOD #2 — THE $250,000 AND $500,000 PRINCIPAL RESIDENCE SALE TAX EXEMPTIONS. Most homeowners are aware of the very generous tax exemptions of Internal Revenue Code 121, enacted by Congress in 1997 to repeal the old (a) $125,000 tax exemption for senior citizen home sellers over 55, and (b) the “rollover residence replacement rule” which required buying a replacement principal residence of equal or greater cost to qualify for tax deferral. Those old tax breaks were repealed!
Instead, IRC 121 now entitles principal residence sellers to a $250,000 tax exemption (up to $500,000 for a qualified married couple filing a joint tax return in the year of home sale). To qualify, the principal residence seller(s) must have owned and occupied their primary dwelling an “aggregate” 24 of the 60 months before its sale.
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In the case of a married couple, title to the principal residence can be held in the name of one spouse alone, or in the name of both spouses, but both spouses must meet the 24-out-of-last-60-month occupancy test to qualify for the full $500,000 exemption. However, it is usually best to have title held in the names of both spouses so a surviving spouse can get the stepped-up basis inheritance benefits. If the name of the deceased spouse was not on the title, the surviving spouse didn’t inherit anything so the stepped-up basis rules don’t apply.
Partial exemptions after less than 24 months of principal residence occupancy are available if the principal residence sale is due to (a) health reasons, (b) change of employment location qualifying for the moving expense tax deduction, or (c) “unforeseen circumstances” explained in the IRS regulations.
METHOD #3 — INTERNAL REVENUE CODE 1031 TAX-DEFERRED EXCHANGE OF REAL ESTATE HELD FOR INVESTMENT OR USE IN A TRADE OR BUSINESS. The major method of avoiding capital gains tax when selling property held for investment or used in a trade or business, such as apartments, rental houses, warehouses, shopping centers, vacant land, and office buildings, is to make an IRC 1031 tax-deferred “like kind” exchange for another qualifying property.
The general rule is to make a tax-deferred exchange, you must trade equal or up in both market value and equity. That means if any cash is taken out of the trade, called “boot” or unlike kind personal property, that boot is taxable to the exchanger. However, the balance of the exchange remains tax-deferred.
Today, most tax-deferred exchanges are made under IRC 1031(a)(3). They are known as Starker delayed exchanges. After the sale of the old property, the Starker exchanger has 45 days to designate the qualifying replacement property of equal or greater cost and equity (known as the “up leg” in the exchange). Meanwhile, the sales proceeds must be held by a qualified third-party intermediary accommodator beyond the “constructive receipt” of the exchanger.
However, the possible disadvantage of tax-deferred exchanges is the investor will be acquiring more rental or investment property. Personal residences and “dealer property,” such as a home builder’s inventory of new houses, are not eligible for tax-deferred exchanges.
To overcome this disadvantage, many longtime investors are making IRC 1031 tax-deferred exchanges for their ultimate dream homes. Since personal residences are not eligible for exchanges, the dream home must be a rental at the time of the exchange. Most tax advisers suggest renting the acquired property at least six to 12 months before making a tax-free conversion to the owner’s personal residence.
However, effective Oct. 22, 2004, Congress said a personal residence acquired in an IRC 1031 tax-deferred exchange via this conversion route cannot use the generous IRC 121 principal residence sale $250,000 or $500,000 exemption until after the residence has been owned at least 60 months. But the homeowner is only required to occupy it for 24 of those 60 months as their principal residence.
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