Debits & Credits

New IRS Ruling Helps Sellers of Income Property

by Douglas Schultz & Alexander Yarmolinsky

Q. I bought my house in San Francisco in 1997 for $600,000. I used it as my principal residence from 1997 to 2001. I moved to a new residence in Mill Valley in January 2002 and rented out my San Francisco home from 2002 through 2004. If I sell my San Francisco property now, I will have a gain of over $500,000. I would like to exchange it for another rental property, but I would also like to take $200,000 in cash out of the deal. Can I do this without paying any income tax?

A. Yes. Under a new IRS ruling (Rev Proc 2005-14), a homeowner may use the personal-residence exclusion ($250,000 for single taxpayers, $500,000 for married couples who file jointly) and also apply the tax-deferral rules of a like-kind exchange.

This ruling, issued in late January, could provide substantial relief for many Bay Area homeowners who face huge capital-gains taxes when they sell their residences. The new IRS ruling, however, does not apply to all homeowners, but only to those who have home offices or who convert their homes, or portions of them, into rentals. The deferral applies only to the portion of the home used for commercial purposes.

Background
Generally, a homeowner may exclude up to $250,000 ($500,000 for joint returns) of gain from the sale or exchange of a home. The homeowner must have owned and used the property as his or her principal residence for periods aggregating two years or more, during the five-year period that ends on the date of the sale or exchange. Owners of property held for productive use in a trade or business may defer gain from the sale of such property if they follow the like-kind exchange rules of Internal Revenue Code Section 1031 (commonly referred to as Section 1031 exchanges).< While property used solely as a home would not constitute business property, many homeowners have home offices or have rented all or a portion of the home. The home-sale exclusion might apply to a home office or other business portion of a home, but it does not apply to depreciation from the business use of the home. On the other hand, a business property owner may defer gain upon the exchange of his business property for like-kind replacement property.

The new revenue procedure provides that, in certain cases, a homeowner may benefit from both the home-sale exclusion and a like-kind exchange deferral. The new ruling clarifies that a homeowner can defer taxes on any depreciation deductions that they took earlier on the commercial part of the property. This is beneficial because gains from depreciation deductions are taxed at 25%, much higher than the 15% capital-gains tax.

Example
The facts in the question above illustrate how this new procedure will work. Our homeowner, whom we will call Mel, wants to take advantage of the homeowner gain-exclusion and the like-kind exchange rules. If Mel follows the rules of the new procedure, he can do an exchange and take cash (often referred to as boot) out of the transaction without paying the current year’s tax.

Let’s take a closer look at the numbers. Mel bought his San Francisco home in 1997 for $600,000 and lived in it as his residence for five years. In 2002, he rented the house to tenants and claimed cumulative depreciation deductions of $70,000 for the years 2002, 2003 and 2004.

In December 2004, Mel exchanges the house for $200,000 cash and a townhouse worth $850,000 that Mel intends to use as a rental property. Mel’s exchange of a principal residence—one he occupied as a residence for two of the last five years—for both a townhouse he intends to use as a rental and also for cash satisfies the requirements of the principal-residence gain-exclusion rules and the Section 1031exchange rules. Mel’s realized gain on the exchange is $520,000 ($850,000 value minus $530,000 [$600,000 purchase price minus $70,000] depreciation equals $320,000 plus $200,000 cash).

Under the principal-residence exclusion rules, Mel can exclude $250,000 of gain. In addition, since the house is investment property at the time of exchange, Mel may defer gain under Section 1031. Therefore, Mel may defer the remaining gain of $270,000, including the $70,000 of gain attributable to depreciation under Section 1031. Perhaps the best part of all is that, although Mel received $200,000 of cash (boot) in the exchange, he is not required to recognize gain because the boot is subject to tax only to the extent the boot exceeds the amount of excluded principal-residence gain. In this case, the excluded gain was $250,000, greater than the amount of boot Mel received. So there is no current year tax for Mel.

It is Important to Follow the Rules
For the Section 1031 exchange part of the transaction to qualify for tax-deferred treatment, the replacement property has to be identified within 45 days, and the exchange has to be completed within 180 days. You must use a qualified intermediary to handle the transaction. The fee for an intermediary can run up to as much as $1,000. Revenue Procedure 2005-14 provides six examples of how to apply the combination of gain exclusion and deferral of gain, including rules on how to handle dual-use and combination properties. The revenue procedure also provides guidance with respect to computing basis in the replacement property and recognition of gain on the receipt of boot. Given the complexity of these guidelines, you are wise to consult with a tax advisor before attempting to take advantage of them.

Conclusion
The steep appreciation of home prices in the Bay Area in recent years means many people could face large capital-gains taxes when they sell. The new Revenue Procedure issued by the Internal Revenue Service could provide considerable relief to homeowners who have home offices or have used their home as a rental. The ruling provides that it is acceptable to combine the principal-residence gain-exclusion rules with the like-kind exchange rules to reduce or eliminate taxes.

The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or the San Francisco Apartment Magazine. Doug Schultz is a CPA and partner in the tax practice at Burr, Pilger and Mayer. Alex Yarmolinsky is a CPA and a manager in the tax practice at Burr, Pilger and Mayer. Both can be contacted at (415) 421-5757. Copyright © 2005 by the San Francisco Apartment Magazine. All rights reserved.