Q:

Subject: Primary residence tax exclusion Safe Harbor

 

Tax Guru,

Saw the articles on ‘Safe Harbor’ when selling a primary residence but see if you can answer this.  I have a rental property which I would like to move back into to get the 500K married couple no tax benefit.  This property is 15 miles south of where I live now.  Here’s the problem ; in order for me to live in that property and commute to work this must be done via freeway.  I have owned the property for 10 years but have since come down with a phobia about driving on freeways.  One to Two exits on a freeway and then I begin to get panic attacks while driving, therefore I have been treating myself by avoidance of using freeways.  To move back into this condo would cause me to have to commute via freeway which I physically can’t do.  How can I get a tax break if I can’t live there without losing my job due to my phobia of driving on freeways.   I don’t fit the Safe Harbor’s as described !

Help ……

A:

I can’t tell if you are trying to make a joke with this premise or are serious.

Giving you the benefit of the doubt that you are honestly trying to apply the health exception to the two year residency rule, such an argument would fail miserably on at least two counts that pop immediately to mind.

1.  The law allowing a sale in less than two years for health reasons is intended to cover health issues that arise after you begin living there; not something that you know full well about and are suffering from before taking up residence there.

2.  Even if you could justify using the pre-existing medical condition as a reason for selling before two years of personal occupancy, that only allows you a pro-rated tax free exclusion, not the full $500,000.  For a couple, that works out to about $685 of tax free gain per day of occupancy ($500,000 / 730).  If you never actually use the home as your primary residence, you have zero qualifying days of occupancy, which would give you an allowable exclusion of zero.

As I constantly have to remind people, I do not make the laws.  I do admire creative interpretations of the details and loopholes that are part of those laws.  However, your little stab at it here just doesn’t even come close.

If you truly do have $500,000 of potential gain in that rental property and want to dispose of it, you should be seriously evaluating using a 1031 (aka Starker) exchange to defer all or even part of the profit into other property or properties.   You can see the rules for that strategy at various sites around the web, including my wife’s company,Tax Free Exchange Corporation (www.TFEC.com).

Good luck.

Kerry Kerstetter

Proving once again how tax laws are so wide open to different interpretations, I received the following from a 1031 exchanger on the Left Coast in response to my earlier posting on this topic.

Hi, saw your post in the blog re the change in the new tax bill that just went into effect, disallowing the capital gains exclusion for sale of a personal residence within 5 years of its acquisition via 1031 exchange.  I am wondering how you interpret the language “…sales or exchanges after…” the effective date of the act.  Why mention exchanges?  Are they trying to say that if the exchange took place prior to the effective date, this doesn’t apply?  If the intent is to make it apply immediately to all such sales, regardless of when the 1031 exchange took place, why mention “exchanges” at all in this phrase?

Regards,

My reply:

I have to agree with the FEA‘s interpretation of this provision (which I will forward to you) that it would apply to any residence disposition after the 10/22/04 enactment date of the new law.  My guess is that the law mentions “sales or exchanges” in relation to the disposal of a residence in order to include non-cash transactions, such as someone swapping a residence for another property.  Such a deal would be considered a taxable event based on the fair market value of the other property received and would not be eligible for the Sec. 121 exclusion, even if the original property was acquired prior to 10/22/04.

It would obviously be nice if properties acquired prior to 10/22/04 could be grandfathered in and allowed to use the tax free exclusion; but I have never seen any language allowing that to happen.

I hope this helps. 

Kerry Kerstetter 

There are obviously tons of items in the just signed tax law that are of interest to various groups of people.

One that is of great interest to us has to do with people who sell homes that were originally acquired as part of a 1031 exchange. Effective tomorrow, the tax free exclusion of up to $250,000 of gain per person is only allowable if the property was originally acquired more than five years prior to the sale. The seller would also need to meet the test of occupying the property for the requisite two years.

Here is the actual text from the new law:

SEC. 840. RECOGNITION OF GAIN FROM THE SALE OF A PRINCIPAL RESIDENCE ACQUIRED IN A LIKE-KIND EXCHANGE WITHIN 5 YEARS OF SALE.

(a) IN GENERAL- Section 121(d) (relating to special rules for exclusion of gain from sale of principal residence) is amended by adding at the end the following new paragraph:

`(10) PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE- If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property.’.

(b) EFFECTIVE DATE- The amendment made by this section shall apply to sales or exchanges after the date of the enactment of this Act.

This doesn’t change or even codify how long a property has to be used for rental, business or investment purposes before it can be converted to a primary residence with no tax consequence. It only says that the Section 121 exclusion is not available if the home is sold in less than five years after its original acquisition.

This will put the property owners in a tricky situation. If it is being used at the time of sale as a primary residence, the entire gain will be taxable, including the deferred gain that had been rolled into the property via the 1031 exchange.

Since primary residences being disposed of are not eligible for 1031 exchange treatment, my initial reaction to this scenario would be to advise the property owners to consider converting the home back to rental usage for as long as possible prior to the sale and then set it up as a 1031 exchange into new rental property that can then be later converted into a primary residence.

This game plan would obviously be a lot of hassle; but the taxes could be substantial if these steps aren’t taken. Obviously, the property owners should work with their personal tax advisors to crunch their exact numbers to see if it makes sense.

A number of issues came up in this email I received recently.

hello, i am writing from rural grayson county, virginia (mouth of wilson 24363). i own 3 small tracts of land. i would like to sell about 2 1/2 acres off 2 of these (5 – 6 A total)to get cash to begin restoring an old log house on one of them. it will either become my primary residence or a rental property. can i take profits from the sale of the land and put them into restoration and avoid capital gains? even though this is small stuff every penny counts!

also, the 3rd lot (2 acres) i just purchased last spring to protect the view from the old house–can one take capital gains exchange retroactively?

if so, for how long?

thanks for your help1 i am a wee small citizen who knows naught about this stuff.

My Reply:

I’m afraid I have to be the bearer of bad news in regard to your proposed plans.

1. The one kind of real estate that is absolutely not eligible as a replacement property is one that will be used as a primary residence.

2. Reinvesting exchange proceeds into improving existing structures is not allowable either. In some cases, the exchange proceeds may be able to be used to construct an entirely brand new structure on property that was previously owned; but even that is a gray area of 1031 exchanges.

3. Reverse exchanges, where the replacement property is acquired before disposing of the old one, are possible. There are different ways to structure them, including the IRS’s safe harbor of parking the new property with an unrelated third party. Whichever way is used, it must be set up ahead of time. If you have already taken title to the property, it is too late to try to go back and change that to be part of a 1031 exchange. IRS calls that an “afterthought” because you thought of doing the reverse exchange after you had already bought the new property.

I’m sorry to spoil your plans. Remember that I don’t make the tax laws. I just do my best to interpret them for real people in the real world.

You can see many more details on how to properly set up a legal 1031 exchange at www.TFEC.com

Good luck.

Kerry Kerstetter

Q:

Dear Guru,

We had a good year in the business, and with no other equally plain and speedy remedy, have utilized the section 179 business equipment section to shed some excess income. We have purchased a good, but big, vehicle for business use. It burns a bunch of gasoline, and though it is a perfectly good vehicle in all other respects (Lexus), it is not at all fuel efficient. How long do we have to keep this vehicle? Does the IRS care?

A:

If you have a profitable business, you really should have a personal tax pro who can advise you.

In regard to disposing of your gas guzzler, the issue isn’t how long you own it. If you deducted its full cost under Section 179, it now has an adjusted cost basis (aka book value) of zero. Whatever you sell it for, at any time, anything you receive for it will be taxed as ordinary income as depreciation recapture.

There is a way around this. If you trade the vehicle in on a new one valued at least as much as this one is worth, and don’t receive any money back, you can roll the gain over into the new replacement vehicle. This would be a Section 1031 tax deferred like kind exchange, reported on Form 8824.

Good luck.

Kerry Kerstetter

As I have written on several occasions, I have long been a big fan of the QuickFinder reference books. I’ve been buying them for myself and my staff for well over the last 20 years. Every so often, they add a new book to their library. This year’s new offering is called Tax Planning For Individuals QuickFinder Handbook. I recently received my copy of the 2004 printed edition, and had a chance to look through it over the past few days as I’ve been waiting for my computer and network problems to work themselves out. I must say they have hit another home run with this book.

It is jam packed with reference materials and tips for just about every aspect of individuals’ lives, including small businesses. The tabs include:

Tab 1: Tables and Worksheets

Tab 2: Form 1040 Roadmap

Tab 3: Residences and Vacation Homes

Tab 4: Sole Proprietors

Tab 5: Compensation

Tab 6: Stocks, Bonds and Mutual Funds

Tab 7: Real Estate (including a lot of info on 1031 exchanges)

Tab 8: Children and Education

Tab 9: Divorce

Tab 10: Charitable Giving

Tab 11: Retirement Plans

Tab 12: Alternative Minimum Tax

Tab 13: Elderly

Tab 14: Estate and Gift Tax

I wholeheartedly recommend any tax practitioner add this new book to their library and if you are like me, it will be right next to your desk and referred to several times a day. For nontax professionals, it is a super bargain for all of the useful information it contains. At just $43 (less if multiple books are ordered), it costs the same as about 13 minutes of my time; so if it answers one question that you would normally have to pay your advisor for, it’s paid for itself. I’ve never understood why books such as the J. K. Lasser tax guides are big sellers every year, when the QuickFinder books are so much more useful.

I also ordered the CD-ROM versions of all the books for this year. None of them have arrived yet, but I’m looking forward to that. I haven’t been using the CD-ROM versions as often as the paper versions. However, there are often times when clients ask questions about certain topics and it’s easier for me to cut and paste from the CD version into an e-mail or a letter than to make photocopies from the printed version.

As some people may know, the original founder of the QuickFinder company passed away a few years back and there were concerns about whether the company would stay in business and the quality would stay as high as it’s been, especially after it was purchased by Thomson PPC a short while ago. This newest book is the first one I have received that has the Thomson PPC logo on it. You literally cannot tell that there was a change of any kind of the ownership or management of this company. The format and layout, even the little cartoons, are exactly how they’ve always been shown. There is definitely no slippage in quality.

The biggest problem in any forward looking tax book is the cloudiness of the crystal ball, especially in light of the expiring tax provisions and even the recently passed extender bill. Many of the 2005 and beyond figures will have to be revised in this book. QuickFinder has been great about putting updates on their web site, which I try to check at least once every couple of days.

Sherry has posted another warning for our Realtor clients on how important it is to be aware of when a client should consider disposing of a property as a tax deferred 1031 exchange. It is not an exaggeration to say that sellers who are not informed of 1031s will be upset next tax time and could actually sue the Realtor, and even their tax advisor, for not recommending it.

I received the following email:

Hi, you seem to know what you are talking about and I keep getting different opinions, so is there any way I do not have to pay long term capital gains on the following situation:

I bought 36 acres, w/house, barn,workshop, in 1983 for $165,000. We have probably put $50,000 into it over the last 20 years. We sold 15 acres of it in March. for $225,000. We are now selling the remaining acreage and house for $650,000. This closes in 30 days. Total $875,000. I think we can take the $500,000 deduction plus the amount we paid on the house, plus improvements. Is there anything we can do to keep from paying capital gains on the remainder? Does the 15 acres sold in March go; with the primary residence since it was originally bought together?

I would love to get your help !!!!

Thanks,

My Reply:

I’m assuming that none of the acreage was used for farming or other business activities for more than three years out of the five years prior to the sale. If it was, you would need to do a 1031 exchange on that portion of the property sold.

IRS allows primary residences that include acreage to be sold in multiple transactions and counted as the sale of the same primary residence, as long as all portions are sold within two years of each other. In your case, as long as you sell the second portion by March 2006, you’re okay.

Using rough numbers, it sounds as if your basis in the property as a whole is $215,000 (165 + 50). With a combined selling price of $875,000, you have a net profit of $660,000. The tax free exclusion for a married couple is $500,000; so the additional $160,000 would be taxable as long term capital gain.

I really doubt if your profit will be that much, unless you are selling the place on your own with no expenses. Selling costs, such as inspections, Realtor commissions, transfer taxes, repairs and escrow fees, reduce your profit.

If your expenses for both transactions are less than $160,000 in total, I would advise doing a little more reflection on the cost of all the improvements you made to the property over the past 20 years. Unless you’ve been keeping a tight set of books, most people short-change themselves when figuring up how much they have invested into their home. The best way to do this is to get a pad of paper, pull out your old photos and start jotting down each of the things you did to your home from the very beginning, along with your best recollection of what it cost. IRS will accept this kind of reconstruction of costs, as long as they sound reasonable. For example, if you built a deck 10 years ago, you need to use the lumber and contractor costs from back then; not today’s prices. The one thing you cannot include is your own time (aka sweat equity). You can only include what you paid other people.

Good luck. I hope this helps.

I have added the info on selling a residence in multiple transactions to the page on primary residence sales on my main website.

Brown In Jail – I have to admit that I’m surprised how quickly this case was wrapped up. With all of the legal maneuvers possible, it was looking like this case could take years before Dian Brown received any punishment for stealing money through her Harrison Abstract business.

We’re hoping this puts an end to comments Sherry has received from local Realtors and investors who complain about the fees she charges for 1031 exchanges with “Dian Brown charged a lot less.” Having seen some of the incompetent exchange paperwork prepared by Dian Brown and her Harrison Abstract staff, it’s obvious that her legal headaches are far from over. Any of her exchange clients who are examined by IRS will have excellent grounds for legal action to recoup their additional taxes, penalties and interest charges when their exchanges are disallowed. Somehow, the old “you get what you pay for” standard fits so well here. Saving a few hundred dollars by using an incompetent exchange service can very easily cost hundreds of thousands down the road when IRS catches up.

I’m not sure why this person thought there was a way to avoid taxes on the sale of some highly appreciated real estate without doing a 1031 exchange; but I guess it doesn’t hurt to ask.

I Bought a piece of land I thought we would build on. But plans have changed. I can now sell it for 2ce as much as I paid for it just a few months ago. How can I avoid capital gains and not do a 1031? Or if I have to pay capital gains what is the %?

thank you,

My Reply:

If you don’t want to do a 1031 exchange, you will be forced to report the profit, which will be taxed at your normal income tax rates since you have owned the property for less than 12 months. Your actual tax rates (Federal + State) will obviously depend on your other levels of income.

You can spread the tax hit out over a number of years if you carry back part or all of the sales price. You can then use the installment method to report the gain each year as you receive the principal payments.

Your personal tax advisor should be able to help you with this. It’s very basic taxation law.

Good luck.

Kerry Kerstetter