THIS HOMEOWNER EXEMPTION IS BETTER THAN SLICED BREAD…
The exclusion of up to $500,000.00 of capital gains tax as a result of the sale of one’s primary residence can be a great tax benefit to home owners especially since they only use the exemption a few times during their lives.
We, as real estate professionals, ALWAYS need to encourage all of our customers to seek legal or tax advice as all areas of taxation are complicated and there can be traps for the unwary. The goal of this article is to address some of those traps.
LET’S TALK ABOUT THOSE WHO INVEST IN REAL ESTATE…IS THAT POSSSIBLY YOU?
For those who invest in real estate, this special tax code creates potentially wonderful tax planning opportunities. Imagine if you will, your customer (or you) wants to convert their rental property into a primary residence in an attempt to take advance of the primary residence tax exclusion and preclude, not only the capital gains as the property was held as an investment, but to tack on along the time period of the primary residence holding. When combined with the fact that this exemption can be used every two (2) years, this could be wonderful for a property investor.
Sorry. You weren’t the first to look at this opportunity. In fact, this whole scenario goes back as far as about 15 years ago when this whole exemption came into being. However, there are still opportunities, but read on. The Congress has made some changes:
A. They in the past did preclude depreciation recapture from being eligible for favorable home owner exemption treatment.
B. They required a longer holding period (5 years) in a Section 1031 tax deferred exchange for those parties who converted the use of their investment property.
C. More recently (2008), the Congress has forced gains to be allocated between periods of “qualifying” use and periods of “non-qualifying” use of the property.
THE NUTS AND BOLTS OF THE HOMEOWNER EXEMPTION…(SECTION 121 OF THE TAX CODE)…
I think most of my readers have a pretty good understanding of the basic rules. It was created in 1997 by our Congress. No longer do we have to buy a new property [That was an old law]. No longer do we have a once in a life-time $125K exemption [That is also old law]. Our current law is called: “The Taxpayer Relief Act of 1997” and has been modified ever since then.
There are lots of special rules within it and the devil can be in the details. The Publication from the IRS for layman is not a walk in the park, but PUBLICATION 523 can be a great help to understand some of the nuances. Just Google Publication 523 and you can download and print it out. Again, this short article does NOT replace a good consultation with your tax attorney.
That Act allows a homeowner (individual) to exclude up to $250K of capital gain on the sale of a primary residence ($500K for a married couple) so long as the property was owned and the party used the property as their primary residence for at least two (2) of the last five (5) years.
PRACTICE POINTER: Keep in mind that BOTH SPOUSES don’t have to own the house even though this is a community property state. One of the two can own, but BOTH must live at that property to qualify for the $500K exclusion. Isn’t that cool?
One does not have to occupy the property at the time of sale. It is just 2 of the last 5 years. In other words, the time does not need to be even continuous. We just need 720 days in the last 5 years to qualify. If one moves out after qualifying for the initial two (2) years, then one has three (3) years to then sell the property and take advantage of the exclusion rule. Make sure you understand this clearly as it creates many misunderstandings among professionals and homeowners alike.
PRACTICE POINTER: If a seller does not meet the two (2) year rule, still have them talk with their tax counsel as they can get a partial prorated exemption if a change in place of employment, change in health, or “unforeseen circumstances” all of which require a tax attorney or tax counsel to review and advise. As the economy improves folks, sellers will soon again be experiencing this type of issue.
LIMITATION ON USE OF THE EXEMPTION…ONCE EVERY TWO YEARS…
This exemption can be used once every two (2) years. Remember, so long as the requirement is met there is no limit to the number of times an individual can use that exemption during his or her life. I wonder how many of our customers out there want to move every two years?
VARIATION ON THE THEME…WHAT ABOUT RENTAL PROPERTY?
Most of our customers are not real estate investors. They use this tax savings tool as they move through their life growing a family and later getting smaller as their families mature and move on. During the “good times of rapid appreciation” prior to the recession, many of my clients would “buy up” over time and take advantage of this exemption over and over again. Remember that this is an EMEMPTION and not a deferral. You don’t have to account for that accrued gain afterward like you do in a tax deferred exchange.
Those same people would many times also own rental property and would creatively attempt to move into their rental property taking advantage of the holding period and then excluding ALL of the gain (not only the gain while they lived in the property as well as the gain while it was used as an investment property). Pretty great ideas!!!! In addition, because of depreciation the gains in the investment part would generally accrue faster and thus a pretty good bang for their tax savings buck if they could pull it off!
WHAT IS TOO GOOD TO BE TRUE IS GENERALLY TOO GOOD TO BE TRUE…ALONG COMES CONGRESS…
Over a period of time, the Congress modified Section 121 (the residence exemption rule) to limit those strategies. The initial rule eliminated the exemption to apply to any gains attributable to depreciation taken on the property when it wasn’t being used as a primary residence. This came into effect on May 6th, 1997 when the original exclusion rule came into effect. So even if you have a blended property and you meet the two year residence rule, that portion of the capital gains that is attributable to depreciation taken will be subject to recapture at generally 25% rates. However, one must read on.
IN 2008, CONGRESS PASSED FURTHER LIMITATIONS…HOUSING ASSISTANCE TAX ACT OF 2008...
So we have to read what happened above and understand that in 2008 Congress further limited the use of this wonderful exemption (in Section 121(b)(4)) specified that the exemption is only available when we have the property ACTUALLY used as a primary residence. The date of that Act is January 1st, 2009.
So this is interesting. The Congress deemed all gains are occurring pro-rata during the whole period of ownership whether owner occupied or not. Periods when the property is owner occupied are “qualifying”. Periods when used for investment are “non-qualifying”. Non-qualifying gains are not exempt!
This is where it can get complicated and this is where it is best to consult with your local attorney.
Today's blog courtesy of Ed McFerran, McFerran & Burns