Tax Advantage?

[pinkerton 0]

Hi Dave,

 

This being tax time, I'd like to run something past you...

 

I believe there's a two year window for reinvesting the profit from a sale of a residence. Namely, if Seller repurchases within two years, then there are no, or reduced tax consequences regarding profit from the sale.

 

True? If true, or close to it, what is the exact rule and its parameters and limitations?

 

If true I'm wondering if this can be somehow distilled into a sound-bite for a radio ad...with the usual admonition of "consult your tax advisor." What do you think?

 

Regards,

 

Mike P.

The Legal Eagle

[CC Rider - MI 0]

I'll take a stab at this, based on what I've read.

 

Generically, a properly structured 1031 like-kind exchange allows owners to defer gains on the sale of property by using the proceeds to purchase a similar type of property. What this means is from primary residence to primary residence, or investment to investment, you can keep deferring your cumulative gains.

 

I believe that owner-deferred gains are just about the default mode in a typical sale of your current home, purchase of your next home. And it may not usually be called a 1031 exchange either, but most owners would want this deferral.

 

As I understand it, to have the gains deferred in your primary residence you must have owned it for the last 2 years, and it must have been your primary for two of the last 5 years. [Perhaps these rules are a special variation of the 1031 exchange rule?? Either way, deferred gains are allowed.]

 

Hopefully Dave can address the exact timeframe during which an owner selling a home needs to purchase the next.

 

Now your question is actually important for a very subtle reason. In our lease purchasing arrangements, the homeowner may purchase his next home two to three years PRIOR to acually selling the first. Perhaps this is why the wording of "within X years" is used so that the sale can occur either before or after the new purchase. I'd like to have a little clarification on that myself whether the window is equal both ways (buy new then sell old / sell old then buy new).

 

Maybe my response muddied the waters more than it helped

[Dave T 0]

Mike,

 

The two year residence replacement rollover, AND, the over age-55 $125K capital gains-once-in-a-lifetime exclusion were both repealed in 1997 and replaced with the two year rules we now have in Section 121 of the Internal Revenue Code.

 

Under the current provisions of the tax code, to use the capital gains exclusion:

 

During the five-year period ending on the date of the sale or exchange, the taxpayer must have owned and used the property as a principal residence for periods aggregating two years or more (Sec 121(a)).

 

The ownership and use tests do not have to be met simultaneously. However, satisfaction of both conditions must occur within the five-year period ending on the date of sale or exchange. In other words, a tenant who purchases the home can count the time as a tenant as part of the use requirement. Also, a homeowner can rent out his or her home and still count that time toward the ownership requirement [Rev Rul. 80-172, 1980-2 CB 56].

 

Only one year is required for the physically or mentally incapacitated. The two-of-last-five-year rule was liberalized to include a taxpayer who, during the five-year-period (1) owns and uses the residence for at least ONE YEAR, and, (2) becomes physically or mentally incapable of self-care during the five years, thereafter residing in a state-licensed facility (including a nursing home)[sec 121(d)(6)].

 

The Tax Technical Corrections Bill of 1997 clarified that if the reason the homeowner cannot comply with the two year rule is because of (1) change of place of employment, (2) health, or (3) other unforseen circumstances to the extent provided in future IRS regulations [sec 121(c )(2)], the homeowner may still exclude that portion of his gain which is less than the prorated exclusion. For the proration ratio, the numerator is the shorter period of (1) the use period or (2) the period between the two sale dates, and the denominator is two years (or 730 days).

 

I think this might be pretty tough to distill into a sound bite. My opening paragraph with the appropriate admonition to consult your tax advisor may work for you. I hope my outline of the rules with specific citations is what you were looking for.

[Dave T 0]

Maybe my response muddied the waters more than it helped 

CC Rider, your response does contain some common errors and misunderstandings. Perhaps I can address some specific points to put everyone on the right track.

 

Generically, a properly structured 1031 like-kind exchange allows owners to defer gains on the sale of property by using the proceeds to purchase a similar type of property.  What this means is from primary residence to primary residence, or investment to investment, you can keep deferring your cumulative gains.

A properly structured 1031 like-kind exchange allows owners to defer capital gains taxes on the sale of investment property or property used in the taxpayer's business. A homeowner's primary residence is personal use property -- not investment or business use property -- and is not eligible to participate in a 1031 exchange. Note that the IRS definition of "investment use property" is property held for the production of income or for future appreciation. An example of property used in a business would be the building that houses a manufacturing plant.

 

I believe that owner-deferred gains are just about the default mode in a typical sale of your current home, purchase of your next home.  And it may not usually be called a 1031 exchange either, but most owners would want this deferral.

 

As I understand it, to have the gains deferred in your primary residence you must have owned it for the last 2 years, and it must have been your primary for two of the last 5 years.  [Perhaps these rules are a special variation of the 1031 exchange rule??

Section 121 of the tax code applies to the sale of a primary residence. These rules have nothing to do with Section 1031 of the tax code. The two sections are mutually exclusive.

 

See my earlier response to Mike in this same thread. The general rule is that the taxpayer must have owned his home for two of the five years prior to the sale AND must have occupied his home as his primary residence for two of the five years prior to the sale. The two years of ownership and the two years of occupancy do not have to be concurrent, but the taxpayer must satisfy both to be eligible to exclude capital gains on the sale of his primary residence from taxes.

 

Now your question is actually important for a very subtle reason.  In our lease purchasing arrangements, the homeowner may purchase his next home two to three years PRIOR to acually selling the first.  Perhaps this is why the wording of "within X years" is used so that the sale can occur either before or after the new purchase.  I'd like to have a little clarification on that myself whether the window is equal both ways (buy new then sell old / sell old then buy new).

There is no requirement for the taxpayer to replace his primary residence. The capital gains exclusion is only linked to the sale of the primary residence without any requirement to purchase a replacement home. The taxpayer is free to use his tax free capital gains in any way he chooses.

 

The two of five year rule does open a window of opportunity not previously available to the homeowner. Congress did recognize that market conditions may not be optimal for the homeowner who is forced to sell. When a personal residence is listed for sale in a slow market, the homeowner might opt to rent the house until it is sold. Under the previous law, the homeowner had to take active measures to insure that the property retained its personal residence character and did not convert to rental status.

 

The new Section 121 rules, now allow a homeowner to rent his former primary residence for up to three years while attempting to sell it. Homeowners now have the luxury of waiting up to three years for someone to meet their asking price instead of accepting a lower counteroffer. Additionally, there is no need to keep the property listed for sale during the rental period, as was required under the prior law.

[pinkerton 0]

Hi Dave,

 

As always, thanks for your prompt, succinct responses.

 

A question regarding 121 transactions. You reference the Revenue Ruling which allows the owner to rent the residence and still satisfy the two year requirement. Would this also apply to leases?

 

Get where I'm headed? If leases count, then it could be pitched that an owner who hasn't lived in the residence for two years could do a lease purchase and take advantage of the favored capital gains treatment when the option is exercised after the two years has run...and take advantage of the other tax advantages of onership in the meantime. Make sense?

 

What think thee?

 

Mike P.

The Legal Eagle

[Dave T 0]

Get where I'm headed?

Mike,

 

I am not sure where your question is headed.

 

The ownership and use tests of the two year rule do not have to be met simultaneously. However, satisfaction of both conditions must occur within the five-year period ending on the date of sale or exchange. In other words, a tenant who purchases the home can count the time as a tenant as part of the use requirement. Also, a homeowner can rent out his or her home and still count that time toward the ownership requirement

 

As a homeowner who has owned and lived in my primary residence for two years, I have three years to sell my primary residence and still take advantage of the capital gains exclusion. During those three years, I am free to use the property as a rental, or sell on a lease-option or lease-purchase. As long as the tenant-buyer exercises the option within my three year window, my entitlement to the capital gains exclusion is preserved.

 

On the flip side, if I am the tenant-buyer leasing the property for two years before I exercise my option to purchase, I satisfy the occupancy requirement of the two year rules, but not the ownership requirement. After I purchase the property, I am now free to continue to occupy the property as my primary residence for another two years (to satisfy the ownership requirement) OR to convert the property to a rental for two years. After I have completed two years of ownership, I now have one year (in this scenario) to sell the property and preserve my entitlement to the capital gains exclusion.

 

Does this answer the question?

[pinkerton 0]

Dave,

 

YES! It does help. I wanted to know if leased time can be used to satisfy the "use" requirement in 121.

 

Since it can, the challenge is distill this to a "bite-size" marketing message which will contain the appropriate "consult your tax advisor" caveat.

 

Thanks for the help!

 

Mike P.

The Legal Eagle