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Real Property Law: Tax

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Converting Personal Residence to a Rental — The Super Tax Break
Mary Kay Kennedy, Vice President and Counsel, First American Exchange Company, LLC, San Jose
E-mail: mkkennedy@firstam.com

Introduction
Case Study – Converting Property to a Rental
Revenue Procedure 2005-14
Summary

Introduction
Did you know that you can avoid paying tax on more than $500,000 of gain on your home? Many people are aware of the advantages of Internal Revenue Code Section 121, which allows a married couple to exclude up to $500,000 of gain on the sale of their personal residence ($250,000 for a single taxpayer). Although this amount of gain is generous in most areas of the country, in California and a few other states, many people expect to receive more than $500,000 of profit when they sell their home.

What is much less understood in the real estate world is that a homeowner can avoid paying all of the tax on their home by converting it to a rental. Once the home is converted to a rental, the owners can sell it and use both the Section 121 exclusion of gain and the Section 1031 deferral of gain provisions to exclude some of the gain and defer paying tax on the rest.

Case Study — Converting Property to a Rental
Let’s go through an example to better understand how this works. John and Mary Smith have lived in their home for twenty years. They acquired it for $100,000 and it is now worth $1 million, so if sold, they would have $900,000 of gain. If they sell it without converting it to a rental, they would be able to exclude $500,000 of gain but would have to pay state and federal capital gains tax on the additional $400,000 of gain.

John and Mary Smith decide, however, to convert their property to a rental. After renting it for a year or two, they sell it for $1 million. Since they used the home as their personal residence at least two of the past five years, they are able to exclude $500,000 of the gain. They can then use the remaining funds to acquire replacement investment property and defer paying tax on the balance of the gain.

In order to completely defer the remaining gain, how much must the Smiths invest in the new property and what is the minimum purchase price they must pay? Let’s assume that several years ago they refinanced their house. The loan balance is approximately $200,000, which means they have about $800,000 of equity immediately before the sale.

In order to completely defer the remaining $400,000 in gain, the Smiths must acquire replacement property that is equal or greater in value to the property sold, less the $500,000 of excluded gain (in other words, a property worth at least $500,000 which is computed by taking the $1 million fair market value of their home and subtracting the $500,000 of excluded gain).They must invest at least enough equity in the replacement property such that it is equal to the equity received from the sale of their home, less the $500,000 of excluded gain. In other words, they must invest at least $300,000 which is computed by taking the $800,000 of equity from the sale of their home and subtracting the $500,000 of excluded gain.

Although the new property must be investment property, the Smiths can decide later to move into it, and if they live in it a minimum of two years and own it for at least five years, they can exclude up to $500,000 of gain on the sale of that property.

Revenue Procedure 2005-14
Of course, investors need to comply with all of the rules of Sections 121 and 1031 in order for this to work. The IRS recently published Revenue Procedure 2005-14, which explains how the two statutes may be combined for one property. This includes guidance not only on the situation mentioned above, but also on a sale of personal residence with a home office or separate guest house that is rented.

Industry Response

• To take advantage of the $500,000 exclusion ($250,000 for single taxpayers), you must own and have lived in your home for at least two of the past five years;
  
• Section 121 doesn’t allow you to exclude any gain attributable to depreciation deductions taken since May 6, 1997, but that gain can be deferred under Section 1031; and
  
• To take advantage of the deferral of gain under Section 1031, all or a part of the property you sell and the property you acquire must, at the time you sell and acquire them, be used in connection with your business or held for investment.

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