Tax Break on Capital Gains Narrows – More details on the new changes to the tax free home sale rules.

Q:

Subject:  Sale of residence

I am a tax preparer with a small office in MI and am wondering if you would give me your opinion on a transaction.  I have a client who leased a former residence to someone for up to five years, with an option to buy at any time during the lease period.  The buyer/tenant assumed all practical ownership responsibilities for maintenance, paid a higher than market rent during the 5 years so that a portion of the rent was applied to the option sale price and a portion of the “rent” was designated as property tax and insurance reimbursement.  The buyer was trying to work out of some personal tax liens and they took most of the five years to do so. My client did not want to sell on a land contract because it would be harder to evict the buyer if the personal tax issues could not be resolved and third party financing obtained. The sale was completed in 2007.

My client, the seller, received a 1099 for the 2007 closing and they would like to exclude the gain on sale, other than depreciation recapture.  Their contention is they really sold the property in 2001 when the lease/option started.  The lease payment was equal to a reasonable interest rate, plus tax and insurance escrow and the amount applied to the down payment amount.  While the title did not transfer in 2001, the client’s contention is there was basically a land contract sale in 2001, at which time they met the ownership and occupancy requirements. All payments received during the almost five year period have been reported as rent and the property was depreciated- perhaps not the right thing to do (in hind sight).

I have not found anything right on point so I am wondering if you would give me your thoughts on this.  Thanks for taking the time to read this and I look forward to reading your response

A:

I am assuming that your client didn’t report the sale of his primary residence, with the Section 121 tax free exclusion, on his 2001 1040, which is where it should have been shown if he wanted to claim it as such.  Trying to recategorize the sale from a normal lease-option (which it seems like to me) to a primary residence sale six years after the fact, when the statute of limitations bars any changes to his 2001 1040, is crazy and not something that would have any chance of standing up to the slightest bit of IRS scrutiny.

In addition, if he has been claiming depreciation since 2001, that also completely undermines his argument that he actually sold the property back then.  Having his cake and eating it too seems to fit that scenario.

I am also assuming that your client hadn’t been reporting any interest income from the buyer’s payments; another contradiction to the argument that there was a 2001 sale.

Based on your description, your client had a standard lease option with a 2007 sale of a rental property.  He could have obviously done a 1031 exchange into new rental property during 2007, but it is too late now to make that kind of change in the type of transaction he had.

If you’ve read much of my postings, you know that I have very little sympathy for people who are too short sighted and/or cheap to consult with a professional tax advisor before the consummation of a potentially taxable transaction and then cry about the consequences when their 1040 is prepared.  The proper time for your client to consult with you would have been before the 2007 closing of the sale.  You may have advised to set it up as a 1031 exchange or even as an installment sale if he could have afforded to carry back some of the sales price.  Now, it is too late to set those things up and he has a fully taxable sale of a rental property.

That’s how I see it.  I hope this helps.

Kerry Kerstetter

Q:

Subject: claim multiple primary residences

I have been told that people are able to claim multiple primary residences, since we did not use a second property as a second home.  In fact we used it as our primary residence 2 or 3 days a week on the average, due to operation of the business in another town, for the last 5-6 years; not vacationing.

 

Thanks,

A:

You appear to be mixing up the issue of multiple primary residences.  At any point in time, each person can only have one primary residence for IRS purposes based on such items as time spent, mailing address, voter registration, driver’s license, etc.

With a married couple, it may be possible for each spouse to have his/her own primary residence if they do in fact live in separate locations.  As with all tax matters, the burden of proving the legitimacy of such a classification rests with the taxpayers.  IRS does not have to prove it it isn’t valid.  You have to be able to prove that each spouse has his/her own separate primary residence.

Where you may be confused is the fact that each taxpayers is allowed to exclude up to $250,000 of profit from the sale of a primary residence each two years.  Before May 1997, the tax law had included a once in a lifetime exclusion of gain from a primary residence sale.  The liberalization of the law to allow multiple usage of this tax free break has been a great opportunity for tax free serial home selling, such as with rental properties that are converted into primary residences.

I have some info on home sales on my website.  

Before undertaking any transaction related to this area of taxation, you should consult with a professional tax advisor.

I hope this helps.

Good luck.

Kerry Kerstetter

Q:

Subject:  Buying a new home, 2 tax questions

1)      is the sale of my current home a tax-exempt event?  We’re in our 40’s and are moving to a larger house (if any of that affects the answer)

2)      at closing, the sellers will bring prop taxes up to date (a little over a year’s worth of taxes).  Shortly after that, spring 08 taxes will be due and paid by us.  Do we get to deduct that property tax payment on Schedule A?  Do the taxes they gave us at closing to get current count as income or offset the prop tax payment?

Thx

A:

Whether any or all of the gain on your home sale is taxable will depend on a number of factors that you need to review with your own personal professional tax advisor.

To get yourself up to speed on the rules, you should check out this article on the rules for home sales. 

You will see that both your age and your plans to buy a new home are completely irrelevant to the taxability issue.

Settlement statements from both property purchases and sales are filled with tax deductible items, such as loan costs and property taxes.  This is why any good professional tax advisor will request that you supply him/her with copies of those statements.  S/he will know who to report the prorated taxes.

I hope this helps.  Good luck.

Kerry Kerstetter

Follow-Up:

Thx for the quick response!

Q:

I came across your information on the web and was wondering if you could clarify what the pro-rated capital gains exclusion (amount) is for selling your primary residence less then 2 years. Is this $342.47 per day, per person for the length of time that you lived in the house before selling?

I would be happy to compensate you for your advice.

Thanks

A:

The tax free gain does work out be $342.46 per day that you both owned and lived in the home as your primary residence.  This is $250,000 divided by 730 days.

IRS has a worksheet for calculating the reduced excludable gain in Publication 523 on their website.   

Most professional tax software has the capability to calculate this based on the number of qualifying days; so be sure to give that figure to your personal professional tax preparer.

Good luck.

Kerry Kerstetter

Q:

 Subject: 1031 question

 Hello,
 I know you deal in the 1031 exchange field and I also know from reading your blog your deal with tax issues in a liberal reading. So I feel you are a good person to get an open minded view from.Is there a way to use someone else’s 2 out of 5 years? Drew Miles, Tax Attorney claims there is a way/program to do this. Is this something you have heard about? Can you guide me to some references.
Thanks,

A:

The only way I am aware of for one person to benefit from someone else’s time in a home in terms of qualifying for the $500,000 tax free exclusion, is with spouses.  IRS allows the full exclusion if either spouse owns the home for at least two out of the previous five years. However, they require both spouses to use the home as their primary residence in order to exclude the full $500,000.  Shorter times as a residence by each spouse would require prorated adjustments in the excludable gain.

In regard to being able to walk in and assume the tax benefits of an unrelated person’s use of a home as if they were yours, I don’t see how that is possible.

I checked Drew Miles’ various websites and see nothing other than his vague promises of tax savings secrets, with no mention of this issue.  I would be interested in seeing what you are referring to before concluding that you are misreading it.

Kerry Kerstetter

Q:

Subject:  Primary residence tax question

This morning I was speaking to a friend who is a local REALTOR.  She is suggesting that some people seem to be under the impression that if the Democrats win this election, this tax law could be changed or eliminated.  What is your impression or awares on this subject.

 

Thank you for your time,

A:

If you’re referring to the Section 121 $250,000 tax free gain rule, I haven’t noticed any discussion of anyone suggesting repealing this.

The Dems are seriously discussing several other huge tax hikes, such as allowing the Bush tax cuts to expire in a few years, removing the special lower tax rates for long term capital gains, and no repeal of the Estate Tax.

As I posted in my blog recently, in California, the Dems are attempting to remove the deduction for home mortgage interest, which could be an indication of how DC Dems might move.  There’s always a chance that they could scale back the limit on how large deductible home mortgages could be from the current million dollar level.

It’s all speculation and conjecture at this point, but as much as I fear the Dems’ tax hiking urges, I’m not very worried about them removing the tax free home sale rule.  Luckily, it’s not part of the Bush temporary tax cuts, so it will live on until enough of our rulers in DC decide to attack it.

Worst case scenario that I could imagine would be for them to scale its savings opportunities back a bit, such as by making it a once in a lifetime deal, as the previous law was, instead of the current ability to use it every two years.

There’s also the possibility that they could reduce the amount of tax free gain from the $250,000 per person level.  However, since that amount was established in 1997 and has no provisions for any inflation adjustments, I don’t see that happening either.

That’s how I see it.  Thanks for writing.

Kerry Kerstetter

Q:

We owned our home for more than five years and had it rented until 9/1/05 when it become our primary residence?  The IRS is asking us how many days we lived in California?  Before I put the answer on my tax form I would like to know if we spent approximately tow month traveling to our second home in Texas will it disqualify us for the exclusion?  We had to sell the home because of financial reasons.  This property become our primary residence on 9/1/05 to 11/8/07.  We had all our mail there, utility bills, bank accounts and registered to vote.  Thank you for your help as I am worried about this.

A:

You really need to be working directly with a tax pro to make sure everything is handled properly rather than trying to work through the rules on your own.

You are obviously trying to see if you qualify for the ownership and occupancy test of two out of the previous five years in order to be able to qualify for the full tax free exclusion.  You seem to be confused as to whether visiting your second home doesn’t allow you to count that time as part of your time in the primary home.

As any competent professional tax advisor should be able to tell you, the occupancy rule doesn’t require that you actually be physically present in that house for 24 hours of every single day or even every single day that you are counting.  Real life for most people does include time spent away from their main home for various reasons, be they business, medical or purely personal.  As long as your primary residence is still considered your main base of operations, time you spend away temporarily at another location, including your own second home in another state, shouldn’t count against you.  As long as you don’t take any of the steps to change your official primary residency away from the one you have had, you should be able to count that time as part of your ownership and occupancy.

Besides dealing with this issue, you will also need the assistance of a good tax  professional to help you calculate the proper adjusted cost basis of your old home, including adjusting it for deprecation, to see if the exclusion will be enough to cover your paper gain.

Good luck.

Kerry Kerstetter

Follow-Up 1:

Thank you for your reply.  I will contact a CPA and have him do our taxes.  I appreciate your advise.  The only reason that I became paranoid is the form ask” how many days did you spend in California.”  We spent two years less about 90 days that we spent in our second home.

Follow-Up 2:

Thank you for your time in answering my question.  I have made an appointment with a CPA.
Sincerely,

Q:

Subject: capital gains dilemma

I’m not sure if you answer questions or not but I’ll shoot an quick email to find out.

 

I have a question on capital gains. I bought a condo in Boston in 1998 and lived in my condo until January 2006 in which I started to rent it. Since then I got married and we bought a house in June 2006.  Even though we both work our mortgage is high and money is too tight and am considering selling my condo to put towards our mortgage to reduce payments. 

 

I am trying to learn about capital gains and have read if you live in your property that you are selling for 2 of the 5 years before the sale you would not have to pay capital gains.  Can you tell me if I am eligible to avoid capital gains.

 

Thank you,

A:

You should qualify for up to $250,000 of tax free gain, and possibly a little more for your husband on a joint 1040. A little twist will be the recapture of depreciation claimed on the condo during its use as a rental.

I have a lot of the details explained on my website. 
 
You should go over the specifics of your unique situation with your own personal professional tax advisor.

Good luck. I hope this helps.

Kerry Kerstetter