Over the years, real estate has proven to be a lucrative investment for many households. And, in some parts of the country, current market values have surpassed levels seen prior to the 2008 financial crisis.
If your principal residence has appreciated significantly in value, you may be subject to capital gains tax when it’s sold. If your gain will be too big to be sheltered by the federal home sale gain exclusion, you might consider a tax-deferred Section 1031 like-kind exchange. However, this strategy isn’t for everyone, and executing it requires some proactive planning.
Timing is Critical
Substantial tax savings can be reaped on the sale of a highly appreciated principal residence when you can combine the home sale gain exclusion and Section 1031 like-kind exchange breaks. To cash in, a former principal residence must be properly converted into a rental property; then it must be swapped for replacement property in an exchange, as described in the main article. This strategy can’t be done overnight. Without explicitly saying so, IRS guidance on like-kind exchanges has apparently established a two-year safe-harbor rental period rule. A shorter rental period might work, but it could be challenged by the IRS. Time is also limited to the rental period. That is, a former principal residence can’t be rented out for more than three years after you vacate the premises. To qualify for the home sale gain exclusion, a property must have been used as the taxpayer’s principal residence for at least two years during the five-year period ending on the exchange date.
Avoid Tax with the Home Sale Gain Exclusion
If you have a capital gain from the sale of your principal residence, you may qualify to exclude up to $250,000 of that gain from your federal taxable income, or up to $500,000 of that gain if you file a joint return with your spouse.
To qualify for this exclusion, you must meet both the ownership and use tests. In general, you’re eligible for the exclusion if you’ve owned and used your home as your main residence for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different two-year periods. However, you must meet both tests during the five-year period ending on the date of the sale.
Generally, you’re not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.
Defer Tax with a Like-Kind Exchange
If your gain exceeds the $250,000/$500,000 home sale gain exclusion, you might consider combining the exclusion tax break with a Sec. 1031 like-kind exchange. With proper planning, you can accomplish a tax-saving double play with full IRS approval.
This strategy is available to homeowners who can arrange property exchanges that satisfy the requirements for both the principal residence gain exclusion break and tax deferral under the Sec. 1031 like-kind exchange rules. The kicker is that like-kind exchange treatment is allowed only when both the relinquished property (what you give up in the exchange) and the replacement property (what you acquire in the exchange) are used for business or investment purposes.
That means you must show that you have converted your former principal residence into property held for productive use in a business or for investment before you make the exchange. According to IRS guidance, such a conversion takes two years.
Important note: The Tax Cuts and Jobs Act disallows Sec. 1031 like-kind exchange treatment for exchanges of personal property (not real estate) that are completed after December 31, 2017. However, properly structured exchanges of real property completed after that date still qualify for tax-deferred Sec. 1031 treatment.
According to the IRS, the principal residence gain exclusion rules must be applied before the Sec. 1031 like-kind exchange rules when you’re able to combine both breaks.
In applying the Sec. 1031 rules, “boot” (meaning cash or property other than real estate received in exchange for your relinquished former personal residence) is taken into account only to the extent the boot exceeds the gain that you can exclude under the home sale gain exclusion rules.
In determining your tax basis in the replacement property, any gain that you can exclude under the principal residence gain exclusion rules is added to the basis of the replacement property. Any cash boot that you receive is subtracted from your basis in the replacement property.
The gain that’s deferred under the like-kind exchange rules is also effectively subtracted from your basis in the replacement property. But that’s OK because you’ve successfully deferred what would have been a taxable gain upon the disposition of your former personal residence.
Let’s Look at an Example
To illustrate how this strategy works, suppose you and your spouse have owned a home for several years. Your basis in the property is $400,000. But, it’s worth $3.3 million today, so you’re rightfully worried about the tax hit when you sell.
Rather than sell now, you decide to convert your home into a rental property. You rent it out for two years, and then exchange it for a small apartment building worth $3 million plus $300,000 of cash boot (paid to you to equalize the values in the exchange).
When the property is sold in 2021, you realize a $2.9 million gain on the exchange. That’s equal to the sale proceeds of $3.3 million (apartment building worth $3 million plus $300,000 in cash) minus your basis in the relinquished property of $400,000.
On your joint federal income tax return for the year of the exchange, you exclude $500,000 of the $2.9 million gain under the principal residence gain exclusion rules.
Because the relinquished property was investment property at the time of the exchange (due to the two-year rental period before the exchange), you can defer the remaining gain of $2.4 million under the Sec. 1031 like-kind exchange rules.
You aren’t required to recognize any taxable gain, because the $300,000 of cash boot you received is taken into account only to the extent it exceeds the gain you excluded under the principal residence gain exclusion rules. Since the $300,000 of both is less than the $500,000 excluded gain, you have no taxable gain from the boot.
Tax results from the exchange can be summarized as follows:
|Less basis of relinquished property||($400,000)|
|Home sale gain exclusion||($500,000)|
|Deferred gain under Sec. 1031||$2,400,000|
Your basis in the apartment building (replacement property) is $600,000 ($400,000 basis of relinquished former principal residence plus $500,000 gain excluded under principal residence gain exclusion rules minus $300,000 of cash boot received). Put another way, your basis in the apartment building equals its fair market value of $3 million at the time of the exchange minus the $2.4 million gain that’s deferred under the like-kind exchange rules.
Important note: Tax on the gain has only been deferred, not avoided. You’ll owe tax on the $2.4 million gain when the property is eventually sold (unless you execute another like-kind exchange, which further defers the tax hit). However, if you hang on to the replacement property (the apartment building in the example) until you die, the deferred gain will be eliminated thanks to the date-of-death basis step-up rule.
Under that rule, the basis of the building is stepped up to its fair market value as of the date of your death (or the alternate valuation date, which is six months after you die). So, your heirs could sell the building shortly after you pass away and owe little or no tax on the sale. They would owe tax only on post-death appreciation if any.
Right for You?
Under the right circumstances, combining the home sale gain exclusion with a tax-deferred Sec. 1031 like-kind exchange can save significant taxes if you plan to sell a highly appreciated principal residence. If you think this strategy might work for you, consult your tax advisor to discuss the right time to convert your home into a rental property. He or she can help execute this strategy under current tax law.