With residential real estate markets on the upswing, many individuals once again own principal residences that are worth far more than they cost. These homes, if sold, could trigger gains far in excess of the federal home sale gain exclusion (up to $250,000 for unmarried owners; $500,000 for joint-filing married couples) with resulting substantial tax liabilities (federal plus state, if applicable).

Principal Residence Gain Exclusion Qualification Rules

An unmarried seller of a principal residence can exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. Of course, there are some limitations. You must pass the following tests to qualify.

1. Ownership Test: You must have owned the property for at least two years during the five year period ending on the sale date.

2. Use Test: You must have used the property as a principal residence for at least two years during the same five-year period (ownership and use periods need not overlap).

3. Joint-Filer $500,000 Exclusion Test: To be eligible for the maximum $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.

4. Previous Sale Test: If you excluded gain from an earlier principal residence sale, you generally must wait at least two years before taking advantage of the gain exclusion again. If you are a married joint filer, the larger $500,000 exclusion is only available if neither you nor your spouse claimed the exclusion privilege for an earlier sale within two years of the later sale.

Waiting Period If Principal Residence Was Acquired in Earlier 1031 Exchange

Legislation enacted in 2004 included a little-noticed, unfavorable change to the principal residence gain exclusion rules. Under it, you can't claim the gain exclusion for the sale or exchange of a principal residence that was acquired in an earlier like-kind exchange if the transaction occurred within the five-year period beginning on the acquisition date. In effect, this rule imposes a five-year waiting period before you can take advantage of the gain exclusion break. If you think this rule might apply, consult with your tax adviser.

Can anything be done to avoid that fate? Possibly.

One idea is to combine the tax-avoidance advantage of the gain exclusion privilege (under Section 121 of the Internal Revenue Code) with the tax-deferral advantage of the like-kind exchange privilege (under Section 1031 of the Internal Revenue Code). With proper planning, this can be done with IRS approval, thanks to IRS Revenue Procedure 2005-14.

However, this IRS guidance only offers the taxpayer-friendly outcome to property owners who can successfully arrange exchanges that satisfy the requirements for both:

1. The principal residence gain exclusion break and

2. The tax-deferral break for like-kind exchanges.

Therefore, the favorable guidance in Revenue Procedure 2005-14 is only available to taxpayers who can meet the requirement that their former principal residence has been converted to property "held for productive use in a trade or business or for investment."

According to Revenue Procedure 2005-14, such a conversion apparently takes two years of business or rental use.

Timing is everything if you want to combine a like-kind exchange with the federal gain exclusion on a principal residence. Miss certain deadlines and you lose out on the savings.

Here is what you need to know, along with some necessary background information.

Gain from Relinquished Former Principal Residence

Under Revenue Procedure 2005-14, the principal residence gain exclusion rules must be applied before the like-kind exchange rules when you are able to combine both breaks. If you receive boot in the exchange, it triggers taxable gain only to the extent the boot exceeds the amount of gain that is excluded under the gain exclusion rules. Boot is non-like-kind property, such as cash. You are also deemed to receive boot if the debt on the relinquished property is more than the debt on the replacement property when the exchange occurs.

The principal residence gain exclusion privilege cannot be used to shelter gain attributable to depreciation deductions for periods after May 6, 1997 with respect to the business or rental use of a residence. However, such gain is potentially eligible for deferral under the like-kind exchange rules.

In applying the like-kind exchange rules, boot (cash or other non-like-kind property received in exchange for the relinquished property) is taken into account only to the extent it exceeds the gain that is excluded under the principal residence gain exclusion rules.

Basis in New, Replacement Property

In calculating your basis in the replacement property (the property received in the like-kind exchange), any gain excluded under the principal residence gain exclusion rules is treated as gain recognized by you. Therefore, you're allowed to increase the basis of the replacement property by the amount of the excluded gain even though no tax is paid on that gain.

Helpful IRS Examples

The preceding rules may be difficult to understand. Fortunately, the IRS provides examples that illustrate how they work. In the following examples, adapted from the Revenue Procedure, the taxpayer is assumed to be an unmarried individual. In each example, the taxpayer's relinquished property is assumed to have been used as a principal residence as required under the gain exclusion rules and used in the taxpayer's business or held for investment within the meaning of the like-kind exchange rules.

Example 1: Former Residence Converted to Rental Before Exchange. You bought a house for $210,000 that was used as your principal residence during all of 2008 through 2010. During all of 2011 and 2012, you rent the house out to tenants and claim $20,000 in depreciation deductions. In 2013, you exchange the house (the relinquished property) for $10,000 plus a townhouse with fair market value (FMV) of $660,000 (the replacement property). You intend to rent out the townhouse rather than live in it.

You realize a $480,000 gain on the exchange [proceeds of $670,000 ($10,000 plus $660,000) minus basis in relinquished property of $190,000 ($210,000 minus $20,000)].

Under these facts and Revenue Procedure 2005-14, the exchange of your former principal residence for a townhouse you plan to use as a rental property satisfies the requirements of both the principal residence gain exclusion and the like-kind exchange gain deferral. Here's why.

  • The gain exclusion rules don't require the relinquished property to be the taxpayer's principal residence on the exchange date. In general, they only require that you must have owned and used the property as your principal residence for at least two years during the five-year period ending on the exchange date (see right-hand box). Since you meet that requirement, you can exclude $250,000 of otherwise taxable gain from the exchange under the principal residence gain exclusion rules.
  • The relinquished property was also investment property at the time of the exchange (because it was rented out for the requisite two years before the exchange). So you're also able to defer otherwise taxable gain under the like-kind exchange rules.

According to Revenue Procedure 2005-14, you must first apply the principal residence gain exclusion rules to exclude $250,000 of your $480,000 realized gain. Next, you apply the like-kind exchange gain deferral rules. You don't recognize any taxable gain under those rules because the $10,000 of cash "boot" you receive is taken into account for this purpose only to the extent it exceeds the $250,000 of gain that can be excluded under the principal residence gain exclusion rules. Since the boot is well below the excluded gain, there's no taxable gain from it. Therefore, under the like-kind exchange rules, you can defer the remaining $230,000 gain (total realized gain of $480,000 minus excluded gain of $250,000).

Your federal income tax results from the exchange can be summarized as follows:

Amount realized in exchange $670,000
Minus adjusted basis of relinquished property (190,000)
Realized gain $480,000
Minus gain excluded under gain exclusion rules ($250,000)
Minus gain deferred under like-kind exchange rules (230,000)
Taxable gain $0

Your basis in the townhome (the replacement property) is $430,000 (FMV of $660,000 minus $230,000 gain deferred under the like-kind exchange rules).

Example 2: Hugely Appreciated Residence Converted to Rental Before Exchange. Assume the same basic facts as Example 1, except this time the former principal residence is worth $3.25 million and you exchange it for a small apartment building worth $3 million plus cash of $250,000. In this example, you realize a $3,060,000 gain on the exchange [proceeds of $3.25 million ($3 million plus $250,000) minus basis in the relinquished property of $190,000 ($210,000 minus $20,000)].

You can exclude $250,000 of gain under the principal residence gain exclusion break. You can also defer otherwise taxable gain under the like-kind exchange rules because the relinquished property was investment property at the time of the exchange (due to the two-year rental period before it).

According to Revenue Procedure 2005-14, you first apply the principal residence gain exclusion rules to exclude $250,000 of the $3,060,000 realized gain.

Next, you apply the like-kind exchange rules. You aren't required to recognize any taxable gain under those rules because the $250,000 of cash boot you receive is taken into account for this purpose only to the extent it exceeds the gain excluded under the principal residence gain exclusion rules. Since the $250,000 of boot exactly equals the $250,000 excluded gain, there's no taxable gain from it. Therefore, under the like-kind exchange rules, you defer the remaining $2,810,000 gain (total realized gain of $3,060,000 minus excluded gain of $250,000).

The federal income tax results from the exchange can be summarized as follows:

Amount realized $3,250,000
Minus adjusted basis of relinquished property (190,000)
Realized gain $3,060,000
Minus gain excluded under gain exclusion rules ($250,000)
Minus gain deferred under like-kind exchange rules (2,810,000)
Taxable gain $0

Your basis in the apartment building (the replacement property) is $190,000 (FMV of $3 million minus $2,810,000 gain deferred under the like-kind exchange rules).

Important: If you hang onto the apartment building until death, the deferred gain is eliminated thanks to the date-of-death basis step-up rule. So your heirs could sell the property and owe little or no federal income tax. (Tax would only be owed on appreciation occurring after the date of death.)

Converting Former Principal Residence into Rental Property

As Example 2 illustrates, the biggest tax savings can be collected when the principal residence gain exclusion and like-kind exchange gain deferral breaks are combined to reduce or eliminate really large gains. To cash in, however, it's critical to successfully convert the appreciated former principal residence into a rental property before swapping it in a like-kind exchange. Without explicitly saying so, the IRS apparently establishes a two-year rental period rule in Revenue Procedure 2005-14.

Warning: If you want to claim the valuable principal residence gain exclusion break, the former principal residence cannot be rented out for more than three years after you vacate it (because you would fail the two-out-of-five-year residential use test). In other words, while at least two years of renting is good for purposes of converting a former residence into a rental property to accomplish a like-kind exchange (according to Revenue Procedure 2005-14), three years of renting is too long if you also want to benefit from the gain exclusion break.

Conclusion

Lots of rules must be satisfied to successful arrange a tax-deferred like-kind exchange. This article only covers one rule: the requirement that both the relinquished property and replacement property must be held for business or investment purposes. Consult with your tax adviser for full details about combining the principal residence gain exclusion break with the tax-deferred like-kind exchange break. It's complicated, but could be a big tax-saver in the right circumstances.

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