Sale or Exchange of Primary Residence (Home)

One reason real estate is such a good investment is the capital gains tax advantage offered over other investment classes.  With stocks and bonds, all long-term gains are now taxed at 15 percent. With a sale of principal residence (home), individual sellers can exclude the first $250,000 in profit from taxes.  Married couples filing jointly can exclude $500,000.

To qualify, a taxpayer must have owned the house for at least two years and used it as a principal residence for two out of five years before it was sold.  The two years don't need to be consecutive.

A homeowner who may exclude income taxable gain from a sale of their primary residence (IRC 121) may also benefit from a deferral of gain from a like-kind exchange (IRC 131) with respect to the same property.

IRS Revenue Procedure 2005-14 provides guidance to taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the sale of a personal residence under section 121 and the non-recognition of gain on exchange of like-kind property under section 1031.

Background:

1. Section 121(a) provides that the income taxpayer may exclude gain realized on sale of property if the property was owned and used as the taxpayer’s principle residence for at least 2 of the proceeding 5 years as of the date of sale. Excluded gain is limited to $250,000 for individual and $500,000 for joint filers.

2. Section 121(e) provides that a taxpayer who uses a portion of a property for residential purposes and a portion of the property for business purposes is treated as using the entire property as the taxpayer’s principal residence. The business portion cannot be a separate dwelling for this application. Any depreciation taken against the office in the home is not excludable from the gain.

3. Section 1031(a) provides that no gain or loss is recognized on the exchange of property held for production use in a trade or business for a like-kind property.  Cash or other non like-kind property received in the trade is taxable.

Taxpayers within the scope of this revenue procedure may apply both the exclusion of gain from the exchange of a principle residence under section 121 and the non-recognition of gain from the exchange of like-king properties under section 1031.

Examples:

A. Taxpayer resides in principle residence for at least two years.  Taxpayer then rents the property for 3 years or less. Taxpayer’s property qualifies for principle residence and rental. Taxpayer will exclude gain as primary residence of up to $250,000 ($500,000 of filing jointly with another) first.  The remaining gain may be exchanged (tax-deferred into new like-kind property).

B. Taxpayer resides in principle residence for at least two years of proceeding five years. Taxpayer has office in the home. Taxpayer buys replacement residence that will also have an office in the home. Taxpayer will exclude gain from sale of original primary residence of up to $250,000 ($500,000 joint filing) first.  Any gain above the excluded amount attributable to the office in the home can be exchanged (tax deferred) in to the new office in the home. Any previous depreciation taken against the office in the home is not excludable gain and must be exchanged or taxpayer will pay tax on depreciation taken.

C. Same example as B above except office in the home is separate dwelling. Taxpayer cannot exclude gain on separate dwelling. Separate dwelling must be exchanged in its entirety in order to defer taxes.

Effective date: This revenue procedure is effective January 27, 2005.  However, taxpayer may apply this procedure in taxable years that the period of limitation on refund or it has not expired.

Warning:  People who buy and sell investment real estate should get competent tax advice before concluding a transaction.

Attribution: Orange County Association of Realtors, September 2005.

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The information contained herein is not the providing of legal services or services of an accountant.  If a person wants or needs such professional services, he or she must contact and retain counsel or a certified public accountant.  There are risks associated with the acquisition and ownership of real estate.