The topic this week is tax matters!

We are not talking here about any huge new law, but refreshing all my readers’ memories of a law that was (and is) very favorable to many of your customers, but has been of little or no consequence during the past Recession, now long before our current COVID situation. It regards capital gains taxes and primary residences. I know I have your attention now as this affects all of you and most of your customers as we have had a huge increase in market values since that last recession.

You may want to save this information in your library as the first part DOES go over, in pretty good detail, the actual rules, but there were a few changes that occurred as late as “The Housing Assistance Tax Act of 2008” that are probably new to most of my readers as we were all focused on other matters back in 2008-2014. Listen up, if you rent out your properties at some point in time as these rules (well, new as of 2008) can affect how much capital gains tax exclusion you can take if you have a property with what we called “blended-use” that is partly owner-occupied and partly non-owner occupied property.

 

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 homeowners 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 POSSIBLY YOU?

For those who invest in real estate, this special tax code creates potentially wonderful tax planning opportunities. Imagine if you will, you want to convert your 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 you as a property investor.

Sorry. You weren’t the first to look at this opportunity. In fact, this whole scenario goes back many years ago when this whole exemption came into being. However, there are still opportunities but read on. Congress has made some changes:

A. They in the past did preclude depreciation recapture from being eligible for favorable homeowner 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 back in 2008, 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)…

Let's talk about the basic rules of the homeowner's exemption. It was created in 1997 by 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 the 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 a 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 previous 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 you do not meet the two (2) year rule, still talk with your tax counsel as you 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 EXEMPTION and not a deferral. You don’t have to account for that accrued gain afterward as 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, 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 were attributable to depreciation taken would 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 was 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. Congress deemed all gains were occurring pro-rata during the whole period of ownership whether owner-occupied or not. Periods, when the property was owner-occupied, are “qualifying”. Periods, when used for investment, were “non-qualifying”. Non-qualifying gains are not exempt!

LET’S TALK ABOUT THIS WHOLE SUBJECT AND TAX DEFERRED EXCHANGES…

Now tax exchanges are back in full swing. This issue of blended property or converting rental property or investment property into a primary residence is a big issue for discussion. Folks this is huge.

 

Notably, there is an additional “anti-abuse” rule that applies to rental property converted to a primary residence that was previously subject to a 1031 exchange. For instance, let’s imagine a situation where an individual completes a 1031 exchange of a small apartment building into a single-family home; rents the single-family home for a period of time; then moves into the single-family home as a primary residence; and ultimately sells it (trying to apply the primary residence capital gains exclusion to all gains cumulatively back to the original purchase, including gains that occurred during the time it was an apartment building!). Does this sound like you?

To limit this activity, Congress created “The American Jobs Creation Act of 2004” (now IRC Section 121(d)) affecting specifically tax-deferred exchanges. That Act stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange.

The strategy to exchange an investment rental for a new investment rental in a location where you may wish to retire takes some advance planning but will maximize your tax savings in the end. When one exchanges their current investment rental property into a new investment rental property, they defer the tax they would normally have to pay on the gain. This is reflected in the lower basis assigned to their new replacement property. This, of course, is basic Section 1031 knowledge.

When you sell your current principal residence, you may exclude the gain up to the Section 121 limits. Then, after you convert your replacement property into their new principal residence, you become eligible once again for exclusion of up to $250,000/$500,000 of gain after you have owned the replacement property as primary residence for five years. The five-year ownership rule on a principal residence only applies to properties that have come to you from an exchange. Capital gains tax will be due on gains above the Section 121 limits and any depreciation taken (that is “recapture) after May 6, 1997.

If you just acquired a property by doing a like-kind exchange, you must hold the new property as an investment, rental, or business property in order to qualify for the exchange itself. We look at the facts and circumstances surrounding the exchange at the time of the acquisition. No one can tell you how long the exchange replacement property must be held in investment status before you convert it to personal use, but most attorneys recommend not less than two (2) years. IRS issued Revenue Procedure 2008-16 which defines a safe harbor and includes a two-year holding period of limited personal use and a rental period if you want to be safe.

Another issue we need to revisit in relation to tax-deferred exchanges is that effective January 1, 2009, the IRS Section 121 was changed to require parties whether inside or outside an exchange to allocate gain based upon use. Before the President signed H.R. 3221, the Housing Assistance Tax Act of 2008, on July 30, 2008, a revenue-raising provision first promoted by Representative Charlie Rangel (D, N.Y.) was included by the conference committee as Section 3092 of the bill. This provision was an amendment to Section 121 and has had a major impact on small landlords and taxpayers who were planning to convert their rental or second home to a principal residence and then exclude any gain from their income when they sell the property.

The term “Period of Non-Qualified Use” referenced in the amendment is very important and means any period during which the property is not used as the principal residence of the taxpayer, the taxpayer’s spouse, or a former spouse. Importantly, the period before January 1, 2009, is excluded. January 1, 2009, is the date upon which this statute became law.

In addition, subsection (4)(C)(ii) of the amendment provides additional exceptions to the Period of Non-Qualified Use. These exceptions are (1) any portion of the five-year period (as defined in Section 121(a)) which is after the last date that such property is used as the principal residence of the taxpayer or spouse, (2) any period not exceeding 10 years during which the military or foreign service taxpayer, or spouse, is serving on qualified official extended duty as already defined, and (3) any other period of temporary absence (not to exceed a total of two years) due to change of employment, health conditions, or such other unforeseen circumstances as may be specified by the HUD Secretary.

The amendment states “gain shall be allocated to periods of non-qualified use based on the ratio which (i) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to (ii) the period such property was owned by the taxpayer.”

How does this affect your planning?

EXAMPLE FOR ILLUSTRATION: Suppose the married taxpayer exchanged into an investment property and rented it for four years. They moved into it at that time and lived in it for two additional years. The taxpayer then sold the residence and realized $300,000 of gain.

Under prior law, the taxpayer would be eligible for the full exclusion and would pay no tax. Under the new law, the exclusion will have to be prorated as follows: four-sixths (4 out of 6 years) of the gain, or $200,000, would be taxable and thus would be ineligible for the exclusion. Two-sixths (2 out of 6 years) of the gain, or only $100,000, would be eligible for the exclusion.

Importantly, non-qualified use prior to January 1, 2009, is not taken into account in the allocation for the non-qualified use period but is taken account for the ownership period.

EXAMPLE FOR ILLUSTRATION: Suppose the taxpayer had exchanged into the property in 2007, and rented it for three years until 2010, and then converted the property into a primary residence. If the taxpayer sold the residence in 2013, after three years of primary residential use, only one year of rental, 2009, would be considered in the allocation for the non-qualified use. Thus, only one-sixth (1 out of 6 years) of the gain would be ineligible for the exclusion. Why? The period before 2009 is not counted as the law was not in effect until 2009.

 

SPECIAL RULES FOR PRIMARY RESIDENCE CONVERTED TO RENTAL PROPERTY

In general, the allocation rules only apply to time periods prior to the conversion into a principal residence and not to all-time periods after the conversion out of personal residence use. Thus, if you convert a primary residence to a rental and never move back in, but otherwise meets the two-out-of-five year test under Section 121, the taxpayer is eligible for the full exclusion when the rental is sold. This rule only applies to non-qualified use periods within the five-year look-back period of Section 121(a) after the last date the property is used as a principal residence. The rule allows the taxpayer to ignore any of the non-qualifying use that occurs after the last date the property was used as a primary residence although the 2 out of the last 5 rules must be satisfied.

EXAMPLE FOR ILLUSTRATIVE PURPOSES: You own a primary residence. You bought it and lived in it since 2008. You get a job offer from California in 2014, but the economy is still in recession and you decide NOT to sell then but to hold on until the market improves. You rent it out in 2014 and take depreciation on the house. It is now 2015 and you want to list the property with me for sale. Can you take advantage of Section 121 or will you be a landlord or will you be required to allocate your gain?

Even though there have been one (1) or potentially two (2) years of non-qualifying use as a rental it won’t count against you and all amounts will be excludable except for depreciation recapture. Even though you do not live in the house as a primary residence, you have still used the property as a primary residence for two of the last five years (as you lived there in 2012 and 2013 before renting in 2014).

Shane

Shane Klinkhammer
REALTOR®
RE/MAX Northwest Realtors
M: 253-227-1609

www.hammersellshomes.com
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**This information is not to be used in lieu of direction by a professional real estate attorney. Most of this information was shared, with permission, from McFerran Law, P.S., and can be contacted for further discussion and representation.