Tax Guru – Ker$tetter Letter

Helping real people win the tax game.

Residence Converted From Rental

Posted by taxguru on August 20, 2006

 

Q-1:

Subject: 1031/primary residence
 
Dear Mr Kerstetter,

I very much enjoy reading your information and I have a question about Primary/1031 combo.

We moved into one of our rentals just over one year ago (7/05) and now my husband has a job offer in TX.

My tax man says if we sell now we must recapture $27K and have a cap gains around $100K . Since we have not had the property for 5 years. Since we have not lived in it for 5 years the 2 year exemtion does not even come into play, not even a portion.

Is this your take on the IRS ruling?  If not what is the ruling?

More Info Please:

Was the former rental property that you are now living in acquired as a replacement property in a 1031 exchange

The answer to that will determine my response to your query.

Kerry Kerstetter

Q-2:

Mr. Kerstetter,

Yes we did a 1031 in 7/03 then moved into the house in 7/05.

I did read your information on resident/1031 and see that it agrees with our accounting that we need to keep it 5 years. So here is the final link to the question. Since we will be moving out before our 24 months in the property due to a new job in TX and this does fit into the exclusion. How long is the exclusion recognized. Can we move out before our 24 months under the exemption and then keep it until our 5 years is up and then sell it and use the exemption at that time? Or do we need to rent it and then 1031 into another rental.

 

A-2:

You are feeling the effect of the recent law limiting the use of the Section 121 exclusion for homes that were originally acquired as part of a 1031 exchange.  This means that the home you are currently occupying is statutorily ineligible for the tax free exclusion if it is sold any time before July 2008, five years after you acquired it.  This provision of the law does not allow for the pro-rated exclusion, which would be available to you if you had just purchased the home directly instead of as a part of a 1031.

As I’m sure your tax advisor showed you, a sale of this home before that date would not only subject the gain on this home to taxation, but all of the previously deferred gains from the earlier properties as well.  This will include the higher rate on depreciation recapture, as well as California state taxes.

There are some different options for you to consider.  Holding onto the house until July 2008 and then trying to use the Section 121 exclusion is a slight possibility; but not a completely safe one.  As you can see in IRS Pub 523,  most of the language describing qualifications for the reduced exclusion mention a job related sale and not a job related change in occupancy.  It’s obviously a fine distinction, but one that could cause problems with a sale so long after you vacate the home.

Depending on how much your gain is, the pro-rated exclusion maximum may not be enough to shelter all of the profit.  However, if the Texas gig doesn’t last long and you move back into the Calif home, you have a potential to meet the 2 out of 5 year rule for real.

You would also still have some depreciation recapture to pay taxes on.  You also need to decide what you will do with the Cal home while you wait out the time until July 2008.  If you rent it out, you will add to the depreciation recapture, plus make the property’s character more positively appear as rental than personal.  For example, if you were to sell it in late 2008, looking back five years previously, most of the time would have it used as rental, with a small percentage as your primary residence.

If, on the other hand, you leave it empty as a personal second home, you may have a cash flow problem if there are mortgage payments to make.

While there is obviously no perfect answer to this quandary, you may want to give serious consideration to converting your home back to rental and then disposing of it via a 1031 exchange into rental property or properties in Texas, which will be easier for you to manage.

Anyway, those are the thoughts that came to me as I reviewed your emails.  I hope they help you work out a suitable strategy.  Good luck.

Kerry Kerstetter


Q-3:

Good Morning Mr. Kerstetter,

My husband and I are amazed at how simply and complete you have made the explanation so we can understand our options. Thank you.

Now maybe I have one other option. The house is free and clear! I am a real estate broker here in CA, so I list the property but it does 
not sell for 1.8 years. As you know our market is very slow. In my neighborhood we have only had one closed escrow this year.So before we move I list the property and rent it to a tenant with the understanding that it is on the market for sale. But do to the market the house does not close escrow until July or Aug of 2008. Would that show our intent to sell the house upon acceptance of the job but market trend did not allow us to sell. Would that show intent to keep the use of Section 121?

Even if the job in TX does not last we intend to keep TX as our primary do to no State Tax we are both 58 and our $$ is in bank accts. and not all our rentals have been 1031 into TX. We will come back and buy a condo in CA for a 2nd home in a few years when the market settles.

PS. Are you sure you don’t have room for one more client. My tax man says I am always coming up with situations that challenge him.

A-3:

You can try that approach; but you had better maintain extra tight documentation of the fact that you were honestly trying to sell the home for a reasonable price for the area.  As you should know, the burden of proof that you are entitled to use the reduced Sec. 121 exclusion rests completely with you; so you need to feel very confident that you have plenty of documentation to support your case.  Your tax advisor should be able to help you compile that documentation so that it is sufficient to provide him/her with the confidence to be able to claim the exclusion.

You should clarify with your current tax pro the meaning behind his comment.  A good tax advisor should welcome challenging issues such as yours.   They are what help us learn and grow as tax practitioners.  I learn new things about the tax laws every single day, from work with my clients, as well as from emails from readers.  If your current advisor is telling you that because he doesn’t want to have to deal with anything new, it is time to find a new tax pro.  If he is saying that to point out that you are making him stretch his brain, that’s not a reason to be concerned.  I say that a lot to some of my clients whose transactions force me to delve into new and interesting areas of taxation that I would never otherwise be involved with.

Good luck.

Kerry Kerstetter

Follow-Up:

Thank you for all your advise and information.
 
 

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