Why Selling Your Home Could Cost You!
The residential real estate market has cooled down a little in recent months but home values still remain at – or near – all time highs in many areas. If you’ve owned your home for a long time, it could be worth a lot more than you paid for it originally and selling it to take advantage of the market probably seems like an amazing opportunity right now.
We only have one question for you, though. Do you know what the federal home sale gain exclusion is?
Essentially, any gain from the sale of your home that exceeds $250,000 (or $500,000 for married couples filing jointly) triggers a federal income tax bill.
What can you do to avoid this?
DOUBLE TAX SAVINGS
One option is combining the principal residence gain exclusion break with the tax-deferral advantage of a Section 1031 like-kind exchange. This one takes a little bit of planning but it can be done with IRS approval.
The basis of this exchange is rooted in the idea that both the relinquished property (the home you’re selling) and the replacement property (one that you would purchase) are used for business or investment purposes. You have to show that you have converted your former principal residence into property held for productive use in a business or for investment before you can make the exchange.
The downside to this option is that it usually takes a minimum of two years for a property to qualify under these guidelines.
PRINCIPAL RESIDENCE GAIN EXCLUSION
The principal residence gain exclusion must be applied before the Sec. 1031 exchange rules when you’re trying to combine both tax breaks. In the rules for a 1031 exchange, you can potentially be taxed when you receive “boot” in exchange for your relinquished former personal residence.
Boot is a legal term that just means cash or property other than real estate that you receive in exchange.
This boot is only considered to the extent that it exceeds the gain that you can exclude under the principal residence gain exclusion rules.
BASIS IN REPLACEMENT PROPERTY
When determining the tax basis in the replacement property (the property that you would purchase in exchange), any gain that you exclude under the principal residence gain exclusion rules is added to the basis of the replacement property. Any boot you receive is subtracted from this.
The gain that is deferred under the Section 1031 exchange rules is also subtracted from this basis in the replacement property. That’s alright, though, because at this point you’ve successfully deferred what would have been a taxable gain.
CONVERSION TO RENTAL PROPERTY
To cash in on the combination of these two tax breaks, you must convert your highly appreciated principal residence into a rental property before swapping it in the 1031 exchange. It’s an unwritten rule that the IRS requires a two-year safe-harbor rental period rule – meaning it needs to be rented for at least two years. Anything less and the IRS might challenge the exchange.
Alternately, you also can’t rent it for MORE than three years since you need to have lived in the principal residence at least two years during the five-year period ending on the exchange date.
IS THIS RIGHT FOR YOU?
Under the right circumstances, combining these two tax breaks can result in major tax savings. If you think it might work for you, we suggest you reach out to a tax advisor for consultation.
Information provided in part by Kane & Associates, Certified Public Accountants.