So, you just sold your Benicia home for a significant gain! (The good news) Now, the question is, how much of that gain is reportable as taxable income to the Internal Revenue Service? (the bad news)
One client recently told me he had sold his home and needed a “replacement” property that was at a cost “equal to” or “greater than” the cost of his previous home, so as to avoid taxes on the sale. What surprised me about his comment was that he seemed to be referring to the old tax law, and not the relatively new IRS Code 121 exclusion governing personal residence sales.
Under I.R.C. 121, a homeowner can now exclude from income up to $250,000 of gain from the sale of a personal residence as often as every two years. If married, the exclusion increases to $500,000. No longer does the homeowner need to look for replacement property as under the old law. What’s fantastic about this is that the proceeds from the sale can be used for anything – an around the world cruise, a lifetime trip to Vegas, plastic surgery – there are no restrictions. However, to take advantage of I.R.C. 121, the taxpayer must meet the following two tests:
1) Ownership and Use. The homeowner(s) must have owned and used the home as a principal residence for at least two out of the five years prior to the sale.
2) Frequency limitations. The exclusion applies to only one sale every two years.
The IRC 121 combined $500,000 exclusion even applies to a married couple where only one spouse holds title, provided the non-title holder satisfies the occupancy test above. Property held in a living trust also qualifies. However, if two unmarried people are co-tenants in the property, then both must be on title to take advantage of the $500,000 exclusion. This unmarried rule also applies to domestic partners since federal law does not recognize state domestic partnership laws.
The IRS allows the I.R.C. 121 exclusion provided that the owner occupied the residence for at least 24 months at anytime within the 60-month period. The use period doesn’t need to be consecutive, nor does the period need to immediately precede the date of sale. If this use-test is met, the exclusion is allowable. This is particularly beneficial to individuals who convert a rental property to their personal residence for at least two years prior to the property’s sale.
One interesting aspect of IRC 121 relates to divorcees. Where one spouse moves out of the community property and the other remains to raise the kids, if the I.R.C. 121 requirements are satisfied, the non-resident ex-spouse may exclude half of all gain (not to exceed $250,000) even if the property is sold many years after the 60-month period.
Another exception is for those who had a spouse die during 2007. The surviving spouse is eligible to take advantage of the combined I.R.C. exclusion of $500,000 even though the other spouse is deceased. For the surviving spouse to take advantage of this exception, the spouse must sell the property no later than December 31 in the year of the spouse’s death. After December, the surviving spouse is only eligible for a $250,000 exclusion. There are many non-tax reasons why a surviving spouse may choose not to sell the property at year-end, but this option certainly provides an incentive to do so.
Many clients seek to sell a residence in which their gain far exceeds the I.R.C. 121 exclusion. What then? One way to legally avoid any gain is to convert the primary residence into a rental property before sale. This allows the property owner to take advantage of the I.R.C. section 1031 tax-deferred exchange, also known as the “Starker Exchange.” With a Starker exchange, when an investment property is sold, all of the taxable gain can be deferred provided the owner identifies “like-kind” replacement property of “equal to” or “greater than” the value of the first property within 45 days of the initial sale, and the escrow is completed within 180 days. There is no limit to the number of times the owner may exchange into other properties, nor any time limits for the tax deferral. Note that a rental can be converted back into a primary residence should it become necessary to do so though there may be significant tax implications associated with such a transfer.
When taking advantage of IEC 121 and 1031, a property owner could potentially defer capital gains tax forever. With the estate tax exception currently expected to be repealed in 2010, the property owner just might get away without ever paying Uncle Sam for any capital gains from the sale or exchange of real property. Maybe you really can “take it with you” after all!
