Professional Real Estate Advisors, Inc.
HOW TO SELL YOUR PRIMARY RESIDENCE
AND FARM WITHOUT¹
PAYING CAPITAL GAINS TAX
Most homeowners are familiar with the changes created by the 1997 Taxpayer Relief Act. This Act repealed the old §1034 rollover provision and one-time exclusion of $125,000 at age 55. Although the revisions to §121 are a tremendous benefit to property owners, it is very tricky when farmers sell their land on which their primary residence (home) is located. Here are some frequently asked questions of the new primary residence rules:
A. Couples filing a joint tax return can exclude up to $500,000 of the capital gain on the sale of their primary Residence, and single filers can exclude up to $250,000 if they live in the residence for two of the last five years.
B. The exclusion is available once every two years without limit to the total number of times utilized.
C. Capital gains in excess of $250,000/$500,000 are taxed at the applicable tax rates (15% Federal plus 8.97% New York State tax).
FREQUENTLY ASKED QUESTIONS (FAQ’s)
Q. Do the two of the last five years have to be consecutive?
A. No, you can live in the property for one year and rent for one, then live there one year or you can live in their as a primary residence for 24 out of the last 60 months or 730 days of the last 1825 days.
Q. Can I convert my primary residence to a rental for more than three years, can I take advantage of the tax exclusions under §121 as well as do a tax free §1031 Exchange if the taxable amount exceeds my personal §121 Primary Residence Exemption?
A. Yes. According to Rev. Proc. 2005-14, the IRS will permit both.
Q. Can my home be depreciated during the rental period and still qualify for the §121 exclusion?
A. Yes, however, depreciation taken after May 6, 1997 must be recognized in the year of the sale.
Q. If I convert my primary residence to a rental, how long does it have to be rented to qualify for a §1031 tax deferred exchange?
A. There is no definitive answer in the tax code that directly addresses this question. Under §1031, an exchanger may defer capital gain taxes when like-kind properties, which are “held for investment,” are exchanged. Many tax and legal advisors consider at least one (1) year of ownership is a reasonable minimum time frame.
Firstly, you divide the value between your residence and your farm which is termed “Bifrucation”. This calculation may be based on the acreage that the home is situated, or you may use the percentage that your accountant attributes to each on your Federal Tax Return From 1040. The major problem is when you try to sell your farm with your primary residence located on it, how much acreage do you attribute to the home? The best way to calculate the acreage and get the maximum allowable §121 exclusion is to determine the value of the home at the time of purchase or construction plus any capital improvements. You then deduct the value of the home, if it pre-existed at time of purchase, from the total price of the farm. For example, if the 100 acre farm was purchased for $110,000 and the value if the house was $10,000, hence, the value of the property was $1,000 an acre when purchased. If you made $100,000 in capital improvements to the house while you lived in it, the original cost basis of the house is $110,000 ($10,000 purchase price plus $100,000 capital improvements) but there is still no land value established. Let’s say that you have a buyer for the farm at $12,000 per acre (i.e. $1,200,000 total including house valued at $200,000), then the land is technically worth $10,000 per acre. Since the appreciated value of your home is $200,000 plus you paid $100,000 in capital improvements, your new appreciated cost basis is $300,000. Assume you are a married couple filing jointly, you have an allowable $500,000 §121 exclusion. Hence you may attribute up to $200,000 in land (i.e. $500,000 minus $300,000 cost basis) associated with your home. Since the value of your appreciated land is $10,000 per acre, you may associate 20 acres with your home.
The best way to legally associate the land (i.e. 20 acres) with your home is to file an informal subdivision map with the local building department. It only costs a few hundred dollars and gives you a clear definition of how you determined your §121 exclusion should you ever get audited by the IRS. To define the 20 acres on which your home is situated, take out your survey and photocopy it. Draw an area totaling 20 acres around the house including your driveway. Use this to file your informal subdivision map. Therefore, when you sell your farm and home, you can take $500,000 TAX FREE which is the allowable §121 exclusion and do a 1031 Exchange with the remaining $700,000 ($1,200,000 sales price less $500,000 §121 exclusion).
The closing agent should prepare two closing statements, one for the value and adjustments relative to the personal residence, and one for the remainder of the property. The exchange accommodator (i.e. qualified intermediary) will prepare exchange documents which describe only that portion of the property that is being exchanged. When the monies are disbursed at closing, the funds that relate to the personal residence portion (i.e. §121 exclusion ) of the property are disbursed directly to the taxpayer. The remainder of the funds are disbursed to the exchange accommodator (i.e. qualified intermediary) who processes the exchange. Rev. Proc. 2005-14, the IRS provides 6 examples that illustrate the treatment of depreciation and boot and can be accessed at http://www.irs.gov/irb/2005-07_IRB/ar10.html#d0e1789. The guidance set forth by the IRS allows for advantageous tax benefits in the sale of properties that have been used consecutively or concurrently as a home and a business.
The author, Paul White, president of Professional Real Estate Advisors and Certified Exchange Specialist (CES®), has been implementing 1031 Exchanges for over 35 years. For more free information on 1031 Exchanges or to receive a complimentary consultation and 1031 Exchange manual, contact Mr. White at 800-748-5720.
Pursuant to U.S. Treasury Regulations, any tax advice contained in this article is not intended to be relied upon, and cannot be relied upon, as substantial authority to avoid penalties under the Internal Revenue Code. Paul White is a New York licensed real estate broker working for his own brokerage company, White Realty Inc. 100 Hartman Hill Road, West Hills (Huntington), NY 11743. ¹ In accord with today’s tax code, Capital Gains Tax and Federal Depreciation Recapture tax are deferred throughout the 1031 Exchanger’s lifetime and their heirs never pay the deferred taxes upon inheritance.