THE "GREAT" REAL ESTATE TAX BREAK
Combining a Like Kind Exchange and the Principal Residence Exclusion
In the Taxpayer Relief Act of 1997, Congress passed a major tax break for everyone
who owns their home. When the like-kind exchange rules and the
homeowner exclusion rules are both used, taxpayers
can achieve a very significant tax break.
Q. What is the principal residence exclusion rule?
A. Married couples filing jointly can exclude up to $500,000 of gain when they sell their principal residence. Single taxpayers can exclude up to $250,000 of their gain. To qualify for the exclusion, you must have owned and used the home as a principal residence for an aggregate of two years out of the five years before sale.
Q. Can I exchange our current rental, investment or business property for a home in a location where we rent it out, then convert the replacement property to our new principal residence?
A. Yes. This approach will maximize your tax savings. When you transfer your current investment, rental or business property as part of a like kind exchange, you defer the tax on the gain. This is reflected in the lower basis assigned to your replacement property. When you sell your current principal residence, you exclude the gain. Then after you convert your replacement property to your new principal residence, you become eligible once again after two years for exclusion of up to $500,000 of gain.
Q. When can I convert my investment, rental or business property to personal use?
A. You can convert a rental, investment or business property to personal use at anytime you desire without paying any tax at that time. If you just acquired the property by doing a like kind exchange, you must hold the property as an investment, rental or business property. No one can tell you how long the exchange replacement property must be held in that status before you convert it to personal use, but most tax experts recommend not less than one year.
Q. If we convert our rental property to our principal residence, how long must we live there before selling it and claiming the exclusion once again?
A. The rule is similar to the above, whereby you must live in the property for two years. However, the ownership period is extended to five years. You can then sell the property and again exclude up to $250,000 or $500,000 of your gain. Tax will be due only on any depreciation taken after May 6, 1997.
Q. Must you buy another property to get the exclusion?
A. No. The previous law (IRC 1034), which required you to purchase another property to "rollover" your gain, was abolished in 1997.
Q. Can you combine the principal residence exclusion and like kind exchange on the same property?
A. Yes. If you own a property, part of which you use as your principal residence and the remaining part as an investment, rental or business property, then you may use both the principal residence exclusion and a 1031 like kind exchange. An easy-to-understand example is when you sell a duplex in which you lived in one-half as your primary residence and you rented out the other half as a rental property, the gain on the portion in which you lived can be excluded and the tax on the gain of the part you rented out may be deferred using a like kind exchange.
Q. Are there any exceptions to the principal residence two year rule?
A. Yes, you may get a reduced exclusion if you must sell due to a job location change that qualifies for the moving expense tax deduction, health reasons, or unforeseen circumstances.
Q. How old must you be to claim the exclusion?
A. There is no age restriction. The previous requirement to be 55 or older to get a "once in a life time" exclusion of $125,000 was also abolished in 1997.
Q. Do both married taxpayers have to own the property to exclude up to $500,000 of gain?
A. No. Only one spouse may own the property, but both must have lived in the property for two years and file a joint return for the year of sale to claim the $500,000 exclusion.
Q. How often can you sell your principal residence and exclude the gain?
A. Once every two years. You cannot exclude the gain on the sale of your principal residence if, during the two year period ending on the date of sale, you sold another principal residence at a gain and exclude all or part of the gain. To exclude up to $500,000 of the gain, neither spouse can have excluded the gain from the sale of a principal residence during the past two years.
Q. If I rented out my principal residence for a while, do I have to claim any gain?
A. The gain to be excluded must be reduced by the amount of depreciation taken after May 6, 1997. This gain is then reported on IRS Form Schedule D. (See example in IRS Publication 523)
Q. May the time we were away from our principal residence on vacation still be counted toward the two years we must live in the house to qualify for the exclusion?
A. Yes. Short temporary absences for vacations or other seasonal absences, even if you rent out the property during the absences, are counted as periods of use.
Q. If I use part of my property for business purposes, such as my garage, may I still exclude the gain on that part of the property?
A. If, during the past five years, that part was used as part of your principal residence for at least two years, then you may exclude the gain on that part of the property, except for the depreciation taken.
Q. Where can I get more information?
A. Get a free copy of IRS Publication 523, Selling Your Home, by calling (800) 829-3676; call us at (609) 391-1031 for a free copy of our information package on How To Do a Tax Deferred Exchange Using a Qualified Intermediary; and contact your tax adviser.
This publication is designed to provide accurate information on tax deferred exchange. The publisher is not engaged in rendering legal or accounting services. If legal or tax advice is required, the services of a competent accountant or tax attorney should be sought. |
