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1031 exchange

Q&A: Selling a house? Don’t confuse the tax rules

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Dear Liz: We read your recent column about capital gains and home sales. Our understanding is that if you sell and then buy a property of equal or greater value within the 180-day window, the basis for tax purposes is the purchase price, plus the $500,000 exemption, plus the improvements to the property, minus the depreciation, whatever that number comes to, and then the profit above that has to be reinvested or it is subject to capital gains. We talked to our CPA about this and he referred us to a site that specializes in 1031 exchanges.

Answer: You’ve mashed together two different sets of tax laws.

Only the sale of your primary residence will qualify for the home sale exemption, which for a married couple can exempt as much as $500,000 of home sale profits from taxation. You must have owned and lived in the home at least two of the previous five years.

Meanwhile, 1031 exchanges allow you to defer capital gains on investment property, such as commercial or rental real estate, as long as you purchase a similar property within 180 days (and follow a bunch of other rules). The replacement property doesn’t have to be more expensive, but if it’s less expensive or has a smaller mortgage than the property you sell, you could owe capital gains taxes on the difference.

It is possible to use both tax laws on the same property, but not simultaneously.

In the past, you could do a 1031 exchange and then convert the rental property into a primary residence to claim the home sale exemption after two years. Current tax law requires waiting at least five years after a 1031 exchange before a home sale exemption can be taken.

You can turn your primary residence into a rental and after two years do a 1031 exchange, but you would be deferring capital gains, while the home sale exemption allows you to avoid them on up to $500,000 of home sale profits.

Gifting home creates unnecessary tax bill

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Dear Liz: My wife and her brother are selling their parents’ home. The parents transferred the deed to their children’s names years ago. My wife should receive about $85,000 from the sale. Our yearly income (one salary; she’s a stay-at-home mom) is around $75,000. My wife is worried about capital gains taxes and wants to reinvest in another real estate property because she’s heard that that will eliminate the capital gains tax. Is that correct? I would really rather invest that money in our current home (finish the basement into a family room, update some items) and pay off our car loan than worry about another property to take care of. What do you think?

Answer: A 1031 exchange is a tax maneuver that allows owners of business or investment property to swap the real estate they have with another property, a transaction that can defer (but not necessarily eliminate) capital gains taxes.

It’s questionable whether your in-laws’ home would qualify as business or investment property, said Mark Luscombe, principal federal tax analyst for tax research firm CCH.

“Were the parents paying rent to the children after the title was passed to the children? If the kids owned the property and the parents were living there without paying rent, I do not think that would constitute investment property,” Luscombe said. “Perhaps if the parents were still paying upkeep expenses and real estate taxes, that might approach the equivalence of rent.”

If there’s a chance the property might qualify, your wife should consult a tax pro experienced with 1031 exchanges for details. Otherwise, she’ll need to write some good-sized checks to the tax authorities. Currently the federal capital gains tax rate is a maximum of 15%, although it will rise to 20% on Jan. 1 if Congress doesn’t reach a compromise on the so-called fiscal cliff. Add to that any state or local taxes on capital gains.

You may think of these taxes as a small price to pay compared with the risk of owning a piece of rental property. Your wife may have another concern that she has not voiced, however: She may not want this legacy from her parents to disappear into the general family budget. She may feel an obligation to preserve and try to grow the money, rather than sinking it into home improvements and other consumption. Legally, gifts and inheritances are considered separate property owned only by the spouse to whom they were given, even in community property states where most other assets are considered jointly owned.

If she wants to keep this money separate, in other words, that’s her right. It would be nice if she carved out a small chunk for family consumption, but she’s under no obligation to do so. If a 1031 exchange isn’t possible or feasible, then she could consult a fee-only planner about other ways to invest the money for the future.

By the way, it needs to be said: This tax bill was avoidable. If your in-laws had, instead of gifting the property, waited and bequeathed it at their deaths, the home would have received a so-called step-up in tax basis. Such a step-up in effect eliminates the need to pay capital gains taxes on any home price appreciation that occurred during the parents’ lives. Any parent thinking of adding a child’s name to a real estate deed should first consult an estate planning attorney to understand the ramifications, since gifting property this way can be an expensive mistake.