A great article on deferring capital gains on your primary residence. Check out our more formal analysis: 1031-121 Analysis Link
2/10/05 Wall St. J. D1
2005 WL-WSJ 59840615
The Wall Street Journal
(Copyright (c) 2005, Dow Jones & Company, Inc.)
Thursday, February 10, 2005
IRS Decision Aids Home Sellers
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Recent Move Allows Those With Home Offices, Rental Units, to Defer Taxes on
Some Gains
By Ray A. Smith
A RECENT decision by the Internal Revenue Service could provide considerable relief to many homeowners facing huge price gains when they sell. The sharp appreciation of house prices in recent years means many people could face steep capital-gains taxes. But in late January, the IRS put forth new guidelines that allow certain homeowners to defer paying taxes on a
significant portion of those gains. The new break doesn't apply to all homeowners, only to those who have home
offices, or those who convert their house -- or a portion of it -- into a rental. The deferral applies only to the portion of the house used for
commercial purposes.
Still, that affects a substantial amount of people. According to the IRS, the number of individual tax returns filed claiming deductions for home offices
rose to about 2.5 million in 2002, the latest data available, from about 1.7 million in 1997. In a 2004 survey, the National Association of Realtors
found that 12% of respondents said they were buying other houses, but keeping their existing homes -- presumably for investment purposes.
Some observers say the IRS's move will lead more people to rent their homes or set up a home office -- or lead people who already have such offices to
report them. "People in the past would always question whether it was worth it to deduct a home office," says Julie A. Welch, an accountant and director of
the tax department at Meara, King & Co., a Kansas City, Mo., auditing and accounting firm. "But now with this new pro-taxpayer guidance, it makes a
whole lot more sense. If you structure it right, you can exclude or defer gain in almost all cases."
Next week, the IRS is scheduled to formally publish the new guidelines. Previously, homeowners weren't sure which circumstances allowed them to
defer or exclude the gains from the "commercial" parts of their residences.
The guidance comes at a time when many homeowners, especially those who have lived in their houses for a number of years, are sitting on huge price
gains. Home prices in the U.S. have risen 63% from the third quarter of 1999 to the third quarter of 2004, according to home-price research company Fiserv CSW
Inc., of Cambridge, Mass. A number of housing markets have seen increases far beyond that.
Given the complexity of the guidelines, known as Revenue Procedure 2005-14, it makes sense to consult with a lawyer or tax adviser before attempting to
take advantage of them. For one thing, the IRS has complex rules on claiming expenses for business
use of your home. In general, you must use part of the home "exclusively and regularly" as your principal place of business, or exclusively and regularly
as a place to meet or deal with patients, clients or customers in the normal course of work -- or for rental use. If you are an employee, your business
use must be for your employer's convenience, not yours.
Additionally, in order to take advantage of the deferral, the owner must purchase another property through what is called a 1031 "like-kind"
exchange, and it must be either a commercial property or have a commercial component equal or greater to the value of the commercial portion of the property
being sold. For people selling a home, the top capital-gains rate, currently 15%, typically applies to profits of more than $250,000 for most single people
and $500,000 for married couples filing jointly. For owners who bought in fast-appreciating markets five years ago, the profits from a sale could
easily exceed those limits, meaning they would have to pay capital-gains taxes. When the current limits were set in 1997, lawmakers assumed few people would
cross the profit threshold.
Here is how it works: If a married couple sells for $900,000 a house that cost, say, $200,000, the couple can exclude $500,000 of their $700,000 gain.
Assuming they had rented the entire house before the sale, they could defer paying taxes on their remaining $200,000 gain by buying a replacement
commercial property costing at least that much through a 1031 exchange.
If the couple had instead maintained a home office that was valued at $75,000, they could defer paying taxes on that amount if they purchased a commercial
property of the same or greater value.
"It's a good thing for homeowners who also have a home business because it clarifies that they can later sell the house and still use the principal
residence exclusion for the entire house, even if they were using part of it for business," says Randy Markowitz, an accountant and partner with FGMK
LLC, in Bannockburn, Ill.
Another benefit: The couple also can defer back taxes on any depreciation deduction they took earlier on the commercial part of the property. Gains
from depreciation deductions are taxed at 25%, much higher than the 15% capital-gains tax.
While the new guidance helps homeowners, it also can open up a legal and accounting minefield. "Trouble could come from trying to claim the
home-office treatment when it's not eligible, claiming too large a percentage of a residence as a home office, or not satisfying the highly technical 1031
rules," says Louis S. Weller, of Deloitte & Touche LLP's national real-estate tax services group in San Francisco.
Some homeowners may find the road to qualifying for this new break a little daunting. For example, when trying to sell a home and defer the gains on the
commercial portion, it no longer is simply selling a house but structuring an exchange transaction, which means filling out more tax forms and adhering to
strict deadlines and rules. It is more akin to being a commercial investor than a homeowner.
In a 1031 exchange, the replacement property has to be identified within 45 days, and the exchange has to be completed within 180 days, or the tax
deferral is forfeited. A specialized 1031 intermediary has to be retained to handle the transaction. Fees for intermediaries run as much as $1,000.
"If you don't set it up as an exchange, then you won't get the tax-deferral treatment," says Adam Handler, of the like-kind exchange services group with
PricewaterhouseCoopers in Los Angeles. "Most people, if they're thinking about selling a house, are not thinking about the exchange machinery."
New Tax Break
A new decision by the IRS could help cut your taxes when you sell your home.
Here's who benefits:
-- You must have lived in your house for at least two of the past five years.
-- The profit on the sale of your home must be greater than the capital- gains tax exclusion -- $500,000 for married joint filers.
-- You must have established a home office or converted your home into a rental property, and you must purchase a similar property when you sell.
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How to Lower Your Home Capital-Gains Taxes
New guidance from the IRS clarifies how to avoid or defer paying capital- gains taxes on the sale of your primary residence.
-- Set up a home office or rent out your property. To qualify for a federal home-office tax deduction, you must use part of the home exclusively andregularly as your principal place of business, meaning for administrative or
management activities; as a place where the owner meets or deals with patients, clients or customers in the normal course of trade or business; or
for rental use.
-- Make sure you file Form 8829 to claim the home-office deduction, or the IRS may not recognize the office portion of your home.
-- When you re ready to sell, you can claim the standard capital-gains tax exclusion, up to certain limits: $250,000 (for most singles) and $500,000
(for joint filers). To qualify for the full exclusion, you must have lived in the home and used it as your primary residence for at least two of the five
years prior to the sale. If your gains exceed those limits due to the commercial portion, you can defer taxes on those gains by buying another commerical
property, if that property is worth as much or more than the value of the commercial portion of the house you are selling.
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