Q:

I have a friend that is going through a very nasty divorce in the state of Georgia.  The divorce has been made more complicated by a joint interest held in a beach house with another couple.  They are going through negotiations at this time to liquidate their interest in the beach house, but they aren’t sure how that liquidation is going to be taxed.  Husband makes 80k, wife makes 50k.  They are jointly to receive 115k (57.5k each) from the sale of their interest in the beach house.  They arrived at this figure by having the house appraised (450k) less the note still remaining on the house (200k) dividing by two since there are two couples co-owing the home and then dropping the price 10k to motivate the other couple to buy them out.  
 
I am nowhere near an accountant and don’t claim to be but have done some online research for my friend and as I understand it…..since the house was appraised with contents, that amount along with other landscaping improvements can be deducted from the amount of the capital gains.  And then if I am reading your site correctly, the remaining amount would be taxed at 15%.  Now….big question is, is the sale also included in their “income” which would put the wife in a higher tax bracket?  Or, is it simply noted somewhere else as capital gains?
 
I would appreciate any light you could shine on this question.  Thank you so much for your help!

A:

There are several issues that “your friend” needs to cover in regard to this matter when consulting with a tax pro, such as the following.

How was the beach property being used?  If it was rental property, there are issues of depreciation recapture and the possibility of using a tax deferred 1031 exchange to reinvest the proceeds into new real estate.

If it was only used personally, there won’t be any depreciation recapture and it doesn’t qualify for a 1031 exchange.

As you describe it, the husband is selling a 25% share of the property and the wife is selling a 25% share.  Using your figures, each would be reporting a sales price of  $107,500.  IRS treats the $50,000 relief of debt that each will be receiving the same as cash.

You didn’t say how much the property cost.  When calculating the gain on the sale, you need to properly determine your cost basis in what is being sold.  This would start from 25% of the original purchase price, plus any capital improvements, as well as any furnishings and appliances that were purchased and included with the property.  Depreciation that had been, or could have been, claimed reduces the basis.

The effective tax rates on the gain will be affected by their other income.  A lot of other income could very easily push part or all of the gain into the higher 15% Federal rate, and would be calculated using the worksheets on page 2 of Schedule D. 

There will also be Georgia income tax to pay.

A tax pro can give more precise advice based on your friend’s particular circumstances.

Good luck.

Kerry Kerstetter

Q:

I read with interest your answers to questions concerning 1031 exchanges, particularly converting a rental home to personal use.

I have a rental home acquired in May 2004 thru a 1031 exchange. Due to some unforeseen circumstances, I may need to move into this home and make it my personal residence as of  August  2005. My tax preparer indicates to me that if I live in it for 2 years I will be able to use the tax free exclusion due to the fact that the exchange was done before October 2004 when the 5 year rule was put in place.He indicates  that any exchanges or sales done before October 2004 are covered by the old 2 year rule.

I would appreciate your opinion on this matter.

A:

I covered this here:
http://www.taxguru.net/2004/10/selling-converted-exchange-property.html

Kerry Kerstetter

A reminder to please use the search tool at the top of this page to see if I have already discussed a topic before sending me questions.  I use it all the time myself to go back over the several years of postings.  I do not have time to repeat myself or send everyone the links to individual postings.