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Minimizing Home Sale Capital Gains

This article discusses strategies for minimizing capital gains taxes when selling your home, and a new law that may affect investors who own rental or income properties.

Section 121 of the Internal Revenue Code allows individuals to sell a principal residence as often as once every two years, while excluding up to $250,000 ($500,000 for a married couple) of the gain on the sale; the home must have been the primary residence for two of the previous five years. For example, if you had a residence and a rental property, you could sell the primary residence, take your capital gain exclusion of up to $250,000, and then make the second property your primary residence. You could then sell your new primary residence after two years and exclude another $250,000 of capital gainÉ even if most of the appreciation on the second property was realized when it was a rental unit, or if much of the taxable gain was attributable to depreciation claimed as a deduction against the property in prior years.

One way investors accumulate rental properties is through 1031 Exchanges. Under Section 1031 of the Internal Revenue Code, no gain is recognized and no tax is paid if the investor exchanges one piece of real estate for another and complies with rules spelled out by the IRS. Although a 1031 (Starker) Exchange requires exchanges of Òlike-kind,Ó investors do not have to exchange for exactly the same type of property as relinquished. Any of the following can be considered Òlike-kindÓ property exchanges: a duplex for a fourplex, bare land for improved property, a rental house for a retail center, or an apartment building for an office building. Examples of items NOT considered Òlike-kindÓ include stocks, bonds, securities or property outside the United States.

The benefits of exchanging can be considerable. If one investor sells property with a gain of $200,000 and has to pay taxes of $80,000, they will only have $120,000 left to reinvest in a new property. On the other hand, an investor who uses a Starker Exchange will pay no capital gains tax, and have the entire $200,000 to reinvest. The investor who exchanges will have much more purchasing power than the investor who sells.

On October 22, 2004. President Bush signed into law H.R.4520 (American Jobs Creation Act of 2004), which includes a provision specifying a five year holding requirement for investors who want to exclude capital gains pursuant to a 121 Exclusion from the sale of a personal residence originally acquired as rental property as part of a 1031 Tax-Deferred Exchange. Prior to H.R.4520, an investor who owned rental property could sell the rental property and acquire another rental property (typically a single family residence) through a 1031 Exchange. After renting the property for 12 months or more, the investor would move into the rental property and convert it into his or her primary residence. Once the investor had lived in the property as his or her primary residence for at least 24 months, the investor could sell the property and exclude up to $250,000 in capital gains (up to $500,000 if married). Under the new law, investors are now required to hold the property for five years before they can exclude capital gains under a 121 Exclusion if the property was acquired as part of a 1031 Tax-Deferred Exchange. The provisions of this new law are effective for personal residence sales occurring on or after October 22, 2004.

Please consult a lawyer or CPA before acting on the information contained in this article.

sherrybenninger@grubbco.com

The GRUBB Co., 1960 Mountain Blvd., Oakland, CA 94611

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