Tax-sidestep moves for homeowners and investors Home-sale exclusion offers new opportunities

Nation's Housing

March 08, 1998|By Kenneth R. Harney

CREATIVE homeowners and small-scale real estate investors are coming up with new money-saving twists on Congress' 1997 changes to the Internal Revenue Code.

Among the most ingenious, according to accountants and lawyers, are those that maximize the benefits of the most generous real estate change in last year's law -- the $250,000 (for single filers) and $500,000 (joint filers) capital-gains exclusions for home-sale profits. Even more clever are concepts that meld the new exclusions with tax-deferred real estate exchanges under Section 1031 of the code.

Here's a sample of the ideas property owners and their advisers already are using:

* Tax-free retirement planning with the help of an exchange. Say you and your spouse own not only your home, but also a rental house that's built up a sizable taxable gain because of appreciation and your depreciation write-offs. With the help of a professional exchange "intermediary," you can swap your rental home for a house in a resort location to which you might enjoy moving as you head toward retirement. You rent out this "replacement" property to tenants. Via the exchange, you escape federal taxation on the gains you've built up in your original rental house. Your tax cost or "basis" in that property moves to your new rental.

A few years later, when you're ready to make your retirement move, you sell your principal residence (pocketing up to $500,000 in gain tax-free) and move into your replacement rental house at the resort, converting it to your principal residence. Once you live in that residence for two years or more, your taxable gain from what had been rental investment real estate turns into gain on a principal residence, and is subject to the new $250,000/$500,000 exclusions.

Your combined tax-free profits from the capital-gains exclusion on your first home and the deft use of Section 1031 to acquire a second -- assuming that you did the exchange with competent professional guidance -- could total as much as $1 million.

* Slice-and-dice to save taxes. San Francisco lawyer and intermediary Michael K. Phillips says he sees many situations where property owners can save big dollars by simply dividing their real estate into its functional pieces.

One client found that the taxable gain on her 35-acre home and country acreage would exceed the new $500,000 exclusion cap. The solution: Treat the property as having two constituent parts. The home itself sits on a 5-acre parcel that's long been fenced off from the other 30 acres, which are rented out to graze cows.

If sold separately from the 30-acre agricultural-use parcel, the house-sale gain would be under the $500,000 limit. The remaining acreage -- a potential subdivision site -- could then be exchanged for other like-kind investment real estate, with all taxes on the gain attributable to the acreage deferred indefinitely.

The same slice-and-dice concept works in numerous other situations, according to Phillips. Say you own two rental condominiums. If you're facing a big capital-gains tax bite on them, you can consider moving into one for two years as your principal residence. The second remains a rental. All the taxable gain attributable to the unit converted to principal residence -- including all depreciation you took prior to the May 7, 1997, effective date of the law change -- thereby escapes taxation if it's under the $250,000/$500,000 limit. Then you can convert the second unit to principal residence use after selling the first, live in it for two years, and sell it tax-free as well.

In fact, anyone with multiple rental units with large capital gains could become a serial home seller, converting successive rental properties to personal residential use every two years.

Though the tax-saving possibilities here are impressive, Phillips warns that IRS rules in this whole area can be stringent. For instance, you can't just exchange your rental condo for a retirement house, and move in shortly thereafter. Section 1031 requires that rental real estate be swapped for like-kind real estate, not personal-use property.

How long must you rent out your replacement property after an exchange to establish it as investment real estate? Phillips says a full year should be the minimum, "two years if you want to be safe."

Pub Date: 3/08/98

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