Tax Reform Multiplies Second Home Possibilities (Part 2)

Building Blocks to Wealth

Many taxpayers, including seniors who have already used the one-time over-55 $125,000 exclusion, do not realize they are eligible to sell their primary home again - and do it every two years - under the Taxpayer Relief Act of 1997. The 1997 law repealed all former tax laws on primary residences and significantly changed the role of the home in regard to financial planning. Here are the keys to one of the best ways the average homeowner can now accumulate more wealth for retirement and an explanation of why the home has become the largest piece in the average taxpayer’s financial puzzle:

In order to qualify for the $500,000 exclusion ($250,000 for single persons), you must have owned and used the property as your principal residence for two out of five years prior to the date of sale. Second, you 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. (As outlined in Report # 101 –“A New Ownership Strategy for Second Homes,” you can sell your primary home, then move into your rental or vacation home – stay two years – and sell it without paying tax on either sale.)

What is often misunderstood is that both the earlier one-time exclusion of up to $125,000 in gain for persons over age 55 and the deferral of all or part of a gain by purchasing a qualifying replacement residence are gone. You no longer can utilize parts of either portion and you absolutely do not have to buy a replacement home. Persons who used the $125,000 can make use of the new exclusion if they meet the two-year residency test. The law enables seniors to “buy down” to less expensive homes without tax penalties.

For example, Michael and Kathleen Roberts could not wait to be 55-years old and claim that one-time exclusion. Now, the couple, and a growing number of adults like them, is looking at renewing their financial life every two years – or preparing a place to land before they jump. That’s because the Taxpayer Relief Act of 1997, allowed the Tampa, Florida, couple to keep up to $500,000 on the sale of a primary residence every two years. (As mentioned, that amount slides to $250,000 for single persons). The secret sauce in the Roberts’ recipe contains the following ingredients: three rental homes, the ability to “move in” to each one of them every two years, and the option of selling each property via a 1031 Exchange. (See Report #101 - “A New Ownership Strategy for Second Homes”).

The Roberts took their “one-time exclusion” of $125,000 in 1995 when they both turned 55. They sold their large family home overlooking the water near Tampa and bought a small home in a golf course community not far from the sand of St. Pete Beach. They had charted their financial course well and put down $50,000 of the gain on a condominium near Park City, Utah. They discovered the area seven years before when visiting one of their children in graduate school at the University of Utah. They love the slopes and the summer hiking and mountain biking. They now rent the condo for a majority of the snow-skiing months, yet retain at least a week for themselves for a family reunion during an extended President’s Day Weekend. The rental income covers the mortgage and maintenance, the renters are helping to pay off the debt, and the unit is appreciating every year. They could easily sell the St. Pete Beach house (pocket up to $500,000 in gain tax free) and move into the condo - now worth far more than the debt owed. If they tire of the snow, they can sell the condo in two years (pocket up to $500,000 in gain again), and head to another property.

What’s extremely enticing is the fact that the average homeowner does not have to own three rentals to attain a similar goal. While you could conceivably live off appreciation if you were smart enough to predict rising home values in specific markets by moving there and then selling, tremendous flexibility comes from owning one tiny, seemingly worthless, rundown rental now and using it to achieve that sunny recreational place or retirement oasis. In fact, we’ll show you how to find a good deal in Report # 111 - “Where to Buy? Evaluating Second Home Prospects” and then give you some creative ways to finance in Report # 105 - “Seven Sensational Solutions to Funding a Second Home.”

For gains greater than the exemption amounts, a 15 percent capital gains tax usually will apply. If your profits are less than the exemption amounts, you probably will not have to keep tax records and account for the profits at tax time. Homeowners with potential gains larger than the excludable amounts should keep accurate records in an attempt to reduce their gains by the amount of all eligible improvements.

To qualify for the full exclusion, either married spouse can meet the ownership requirement, but both must meet the use requirement. Although exclusion can be used only once in each two-year period, a partial exclusion may be available if the sale results from a change in place of employment or health, or unforeseen circumstances. If you have owned the house fewer than two years, you would receive a proportional amount of the maximum exclusion under special situations. For example, if you owned a home for one year and made a $45,000 profit, the entire $45,000 would be tax free because your total exclusion was chopped in half to $125,000 from $250,000 because of the one-year time frame. Consumers can turn vacation homes (plus yachts and recreational vehicles) into principal residences simply by meeting the residency requirements. Divorced or separated spouses also are not out in the cold. If an “ex” lived in the home for two of the five years before the sale, that person is able to use the exclusion. However, nothing changes on the loss side of the primary home sale ledger – losses on the sale of the primary home still are not deductible. If a non-deductible loss seems unavoidable, it might be a good idea to convert the house to a rental property (where losses are deductible) but you would have to be able to prove the move was not just to avoid taxes. If depreciation were claimed on a property, the maximum capital gains tax liability would be 25 percent to the extent depreciation was claimed.

For married taxpayers who file a joint return, only one spouse need meet the two out of five-year ownership requirement, but both spouses must meet the two out of five-year use requirement. That is, if the husband has owned and used the house as his principal residence for two of the past five years, but his wife did not use the house as her principal residence for the required two years, then the exclusion is only $250,000.

For those who leave their home because of a disability, a special rule makes it easier to meet the two-year requirement – especially if you were hospitalized or had to spend a significant period in a similar facility. In such cases, if you owned and used the home as a principal residence for at least one of the five years preceding the sale, then you are treated as having used it as your principal residence while you are in a facility that is licensed to care for people in your condition. This rule enables the family to sell the home to raise cash for the expenses without incurring a large tax bite.

Deferred Exchange is Really a Sale

A tax-deferred exchange (commonly known as IRS Section 1031 Exchange) is really "legally sanctioned fiction,’’ according to Richard Morse, a Bellevue, Washington-based attorney who specializes in the exchange process. The transaction will proceed just as a “sale” for you, your real estate agent, and parties associated with the deal. However, provided you closely follow the exchange rules, the IRS will "sanction” the transaction and allow you to characterize it as an exchange rather than as a sale. Thus, you are permitted to defer paying the capital gain tax. (Sample forms are provided in the Appendix).

Section 1031 specifically requires that an exchange take place. That means that one property must be exchanged for another property rather than sold for cash. The exchange is what distinguishes a Section 1031 tax-deferred transaction from a sale and purchase. The exchange is created by using an intermediary (or exchange facilitator) and the required exchange documentation. Here’s how it works.

First: You (Taxpayer) receive an acceptable offer for your property.

Second: You assign your seller's rights in the relinquished property purchase and sale contract to the buyer. The buyer gives “your’ cash to the Intermediary. This is the first leg of the exchange.

Third: You make an acceptable offer to acquire the replacement property.

Fourth: You assign your purchaser's obligations in the contract to the Intermediary

Fifth: The Intermediary acquires the relinquished property and instructs the Seller to deed it directly to you to complete the trade.

The “Like-Kind’’ Requirement

In an exchange, you must trade an interest in real estate (sole ownership, joint tenancy, tenancy in common) that you have held for trade, business, or investment purposes for another "like-kind" interest in real estate. The like-kind definition is very broad. You can dispose of and acquire any interest in real property other than a home or a second residence. For example, you can trade raw land for income property, a rental house for a multiplex, or a rental house for a retail property.

“The 1031 is absolutely my favorite part of the entire tax code – bar none,’’ said Robert M. Levenson, Vice President of Land America 1031 Exchange Services, a member of the Land America Financial Group. “It is flexible, it is versatile, and it offers both sophisticated investors and everyday consumers terrific financial opportunities. It is a valuable, under-used instrument. While more and more taxpayers are discovering it everyday, most of them don’t know how adaptable it can be to many situations.’’

The “No-Touch” Rule: If the taxpayer actually receives the proceeds from the disposition of the relinquished property, the transaction will be treated as a sale and not as an exchange. Even if the taxpayer does not actually receive the proceeds from the disposition of the property, the exchange will be disallowed if the taxpayer is considered to have “constructively” received them.

The code regulations provide that income, even though it is not actually reduced to a taxpayer’s possession, is “constructively” received by the taxpayer if it is credited to his or her account, set apart for him or her, or otherwise made available so that he or she may draw upon it at any time. In a nutshell: “If you touch it (or even get too close), they will come.”

On February 14, 2005, new guidelines were adopted that would allow investors 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 (explained later), previously had come with a tax tag.

However, much like a long-term relationship, the rules need a considerable amount of patience and understanding.

The new rule, which enables taxpayers to combine Code 121 with the popular Code 1031 for tax-deferred exchanges, is retroactive to January 27, 2005.

For example, let’s say Betty Booper bought a home in Dallas for $150,000 in 1990, raised her large family there, and then moved to Arizona in 2003 after her last child left home. She kept the large family 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 her 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 new guidelines, Betty would have faced a tax liability for the amount of cash she put in her pocket ($200,000).

How does the new rule benefit consumers? For the first time, taxpayers are 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.

“For the first time, 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 new 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, see explanation below) 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 February 14 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 owners 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.

Here is an example of the new primary home-investment possibility provided by the IRS that includes depreciation deductions.

Fred purchases a house for $210,000 that he uses as a principal residence from 2000 to 2004. From 2004 until 2006, Fred rents the house and claims depreciation deductions of $20,000. In 2006, Fred exchanges the house for $10,000 of cash and a townhouse with a fair market value of $460,000 that he intends to rent to tenants.

Since Fred’s adjusted basis is $190,000, he realizes a gain of $280,000. Fred applies the primary residence rule (Section 121) first to exclude $250,000 of the $280,000 gain before applying the non-recognition rules of Section 1031. He may defer the remaining gain of $30,000, including the $20,000 attributable to depreciation, under Section 1031.

Fred recognizes no gain for the $10,000 boot because boot is taken into account only to the extent it exceeds the amount of the gain excluded under Section 121. Fred’s basis in the replacement property is $430,000, which is equal to the basis of the relinquished property at the time of the exchange ($190,000) increased by the gain excluded under Section 121 ($250,000), and reduced by the cash Fred receives ($10,000).

If you can afford to keep your primary residence as a rental – especially if your neighborhood is going to appreciate – speak with your tax advisor about the new guidelines.

In order for an exchange to be completely tax deferred, the replacement property must have a fair market value greater than the relinquished property and all of the taxpayer’s equity or more must be used in acquiring replacement property. This is known as trading up in value and up in equity, and it is essential for a totally tax-deferred exchange.

A true exchange – like a straight swap in baseball – rarely occurs. That’s because two people rarely come together and look to deal properties of exactly equal value. Most of the time, the parties do not know each other and their properties often are in different states. There are a number of different ways tax-deferred exchanges can be structured. They may involve two, three, or four parties and they may be quite simple or very complex. Typically, an exchange involves four parties - the exchanger (the taxpayer), a buyer for the relinquished property, a seller of the replacement property, and the intermediary who plays a key role, similar to the manager of a baseball team.

Tax Reform Part 3

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