Almost everyone knows the value of single-family homes has appreciated dramatically in Southern California in general and San Diego in particular. There are now a number of homeowners with highly appreciated personal residences that, if sold, would trigger gains far in excess of the $250,000 or $500,000 home sale gain exclusion.
What, if anything, can be done about this situation?
It's a common scenario: Many taxpayers who own such properties are getting along in years and believe the time is right to sell. They may need to move into a retirement community or find the work associated with their long-time residences to be too much at their current point in life. Or, they may have tired of being house-rich and cash-poor and simply want to convert their substantial amount of home equity into income-producing assets.
To maximize their returns, these homeowners would prefer not to pay the income tax hit that would result from an outright sale. Even with today's favorable maximum federal rate on long-term capital gains and the generous Section 121 gain exclusion allowance, selling a greatly appreciated personal residence can create a large tax bill.
Example: A married couple, in their late 60s, owns a nice home. The property's fair market value is $3 million. The tax basis is low in comparison, $400,000. If the home were sold, the taxable gain would be $2.1 million ($3 million FMV minus $400,000 basis, minus $500,000 joint-filer gain exclusion). The combined federal and state tax rate would be about 24 percent (15 percent federal plus 9 percent state). Thus the tax liability is around $504,000 (24 percent x $2.1 million).
Not surprisingly, their initial reaction is generally one of surprise followed by a desire to seek other options. One such solution is generally not well received: Under IRS code section 1014 a taxpayer will get a step-up in basis to fair market value of the property at the date of death of one of the spouses. As drastic as it is to pay a large tax, it's still less drastic than dying to avoid tax. So unless one or both are in poor health, holding the residence until one of the spouses passes is not a viable choice.
The homeowner could convert the home into a rental property. After doing this, the property owner might find rental income to be too low for the value of the property. A solution to this issue would be for the owner to exchange the former residence for another piece of income-producing real estate in a tax-deferred Section 1031 like-kind exchange. Done properly, this transaction avoids any immediate tax hit, and it converts the home equity into an income-producing asset. Additionally, the investment real estate received in the like-kind exchange will also qualify for the tax basis step-up at death.
With careful planning, the property owner could even arrange to receive up to $500,000 of cash, income tax-free, as part of the like-kind exchange. Nothing prevents a taxpayer from claiming the Section 121 gain exclusion for otherwise taxable boot, such as cash or other property received in a like-kind exchange. In fact, the only eligibility requirements for the $500,000 joint-filer gain exclusion are:
1. The property being sold or exchanged must have been owned by the taxpayer for at least two years during the five-year period ending on the sale date (the ownership test).
2. The property must have been used as a principal residence by both taxpayer and spouse for at least two years during the same five-year period (the use test).
3. The taxpayer or taxpayer's spouse must not have claimed a Section 121 gain exclusion within two years of the sale date.
A common question is how long must the homeowner "rent out" his or her former residence for it to be converted into rental property. Unfortunately there is only the faintest hint of guidance on how long a former personal residence must be rented out for purposes of qualifying for a subsequent Section 1031 exchange. This is an important consideration, because such a conversion must take place before a like-kind exchange can occur. This is because Section 1031 only covers swaps of business or investment property for other business or investment property.
The courts have provided some "negative" guidance on when a personal residence can be considered converted into a rental for purposes of the following:
1. Claiming a deductible capital loss for a property that has declined in value.
2. Claiming deductions for operating expenses and depreciation after the taxpayer has moved out.
The courts have ruled that a former personal residence can't be converted into a rental property by simply holding it out for rent or renting it for less than market value while it's also being marketed for sale. Renting a former personal residence on and off while trying to sell doesn't work either. The courts have said these actions are mere attempts to reduce the owner's out-of-pocket costs of holding the property for sale after it has been abandoned as a personal residence, as opposed to legitimate for-profit rental activities.
Therefore it seems clear the homeowner must not:
1. Hold the former personal residence out for sale during rental periods.
2. Fail to rent the property as regularly and continuously as market conditions allow.
3. Rent to friends, relatives, business associates or anyone else for less than market value.
Unfortunately, there is very little in the way of "positive" guidance. In a Private Letter Ruling, the IRS ruled that a taxpayer's swap of a rental beach house for another home would qualify as a Section 1031 like-kind exchange as long as the replacement property would be rented out for at least two years after the deal. However, private letter rulings cannot be cited as a general IRS position. There is also some statutory guidance for the two-year standard. In IRC Sec. 1031(f)(1)(C), a two-year holding period is required for exchanges between related parties.
While not completely settled, the convert-and-exchange strategy is a viable option in the current market place.
Burson is a partner with Grice, Lund & Tarkington LLP.