It’s a sign of the times: Many homes are taking longer to sell, and sellers are accepting less than they imagined.
While it’s often critical to pull out the equity in a primary residence in order to buy another primary residence, the Internal Revenue Service provides a relatively new advantage for homeowners who must rent out their property now because of a slow sales market. Instead of selling it later and paying a capital gain as an investment property sale, owners can take out tax-free cash and defer the remainder via a tax-deferred exchange.
The rules need a considerable amount of patience and understanding, but they also can help bridge the gap until the housing market eventually rebounds. Housing is cyclical and while this down cycle will loom longer than anticipated, it will eventually rebound.
Three years ago, guidelines were adopted that allow homeowners 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 had come with a tax tag. The strategy enables taxpayers to combine Code 121 with the popular Code 1031 for tax-deferred exchanges.
For example, let’s say Elaine Cooper bought a home in Snoqualmie, Wash., for $150,000 in 1990, raised her large family there and then moved to Arizona in 2003 after her last child left home. She could not sell the house at the time, so she used her savings as a down payment on the Arizona house. She kept the Snoqualmie home as a rental property, allowing members of her church to rent the place while they saved for a down payment for their own home. In 2005, when the church family bought its own home, Betty traded (sold) her Snoqualmie 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 2005 guidelines, Betty would have faced a tax liability for the amount of cash she put in her pocket ($200,000).
How does the rule benefit consumers? Taxpayers are now 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.
"The IRS is allowing taxpayers to mix the rules on principal residences and investment property," said Rob Keasal, accountant and real estate tax specialist. "The 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 2005 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.
If you can’t sell your home — and can somehow afford to keep it as a rental — speak with your tax advisor about possible selling strategies.
To get even more valuable advice from Tom, visit his Second Home Center.
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