A man’s home may be his castle, but
given the escalation in residential
real estate values in Orange County over the last few years, the castle’s sale may
generate a substantial capital gains tax bill.
While recent changes in the real estate
market have slowed the rate of increase in
the average home price, several years of
double-digit increases have left many
Orange County residents with homes that
have more than doubled in value.
At the time it was instituted, the Taxpayer
Relief Act of 1997 brought what was thought
to be welcome relief for taxpayers. It allows
homeowners to exclude up to $250,000 of
personal property gains for single individuals or up to $500,000 for married couples filing jointly from capital gains taxes. Subject
to a two-year waiting period, the exclusion
can be used over and over again.
A seller looking to downsize or sell before
the two-year waiting period has expired, as
in the case of a transfer or promotion, may
be in for a surprise.
“I think some people may be startled if
they have been carrying forward prior unreported gains resulting from the sale of one
or more homes,” says Ryan Woodhouse,
tax manager with Haskell & White LLP. “In
that case, the $500,000 exclusion may not
be adequate, so reducing taxes will call for
some planning and creativity.”
Smart Business spoke with Woodhouse
about the changes in the way home appreciation is handled for capital gains tax purposes and a creative solution to the problem.
What changes are there in the rollover residence replacement rule?
The main difference has to do with the
deferral provision of the old pre-May 1997
rollover residence rule versus the exclusion provision currently in place.
The best way to illustrate this is through
an example. Let’s say that a married couple
here in Orange County has purchased and
sold homes prior to May 1997, which created deferred capital gains of $20,000,
$45,000 and $70,000, for a total of $135,000.
Because they always bought a more
expensive home, the gain is deferred and
they avoided any tax consequence from
the sale under the pre-May 1997 rule. Now,
they want to sell their present home, which
they purchased in 2000 for $500,000. It has
a current market value of $950,000.
Calculating the tax under the post-May
1997 new rule requires subtracting the previous deferred capital gain of $135,000
from $500,000 to arrive at an adjusted cost
basis of $365,000.
After adjusting for improvements and
deducting the cost basis from the sales price
of the present home, the gain will most likely exceed the $500,000 deduction, and the
balance will be taxed as capital gains.
What is the property exchange solution to
capital gains taxes, and how does it work?
If the sellers are to realize gain in excess
of the exclusion amount and do not immediately need all of the equity in their homes,
such as in the case of trading down residences, converting the property from a primary residence to investment property status may offer an alternative to large capital
gains taxes.
IRS 1031 (Like-Kind Exchange Rules)
allows for exchanges of investment property without recognizing gain or incurring capital gains tax. The idea is to convert the
property from its primary residence status
to a property held for investment. Then the
owner can either continue to hold it for the
production of income, or exchange it tax-free for another income-producing property.
What steps do you need to take to qualify for
a property exchange?
The first step is to make your intentions
to change the status of the dwelling from
primary residence to investment property
clear by leasing the property for a period of
time, ideally for a minimum of two years
but no longer than three. Once it is clear
that the home is now an investment property, it can be exchanged for another
income-producing property.
Under the rules of IRS 1031, when a former principal residence is exchanged for a
like-kind property, any cash received in the
transaction first qualifies under the
$500,000 exclusion, and the balance is
excluded from capital gains assessment.
What constitutes a like-kind property
exchange?
Generally, this means that income-producing property has to be traded for another
income-producing property, such as another residential rental house. One option
would be to trade for a similarly priced
property that can generate more revenue.
For example, if your home is worth $1.1
million, it is likely that the net income that
could be derived from rental of the high-priced residence is substantially less than
the net income that could be derived from
a small apartment building that could be
acquired in a swap with the $1.1 million
equity value of the residence. If the owner
wished to avoid involvement with management of real estate, a trade of the property
for high-quality net leased property could
be arranged.
All tax laws are complex, and 1031 is no
exception. Be certain to consult with a tax
professional and evaluate all of your
options for dealing with capital gains taxes.
RYAN WOODHOUSE is a tax manager with Haskell & White
LLP. Reach him at [email protected] or (949) 450-6341.