IS IT POSSIBLE TO DEFER GAIN ON A PRIMARY RESIDENCE?


Shawn A. Goldfaden, Esq.
Division Manager for Asset Preservation, Inc.
Maryland State Counsel for Stewart Title Guaranty Company

Although IRC Sec. 121 permits taxpayers to exclude up to $250,000 if single and $500,000 if married filing jointly of the capital gain on the sale of the taxpayers primary residence if at least one of the homeowners has used the property as their primary residence for 24 out of the last 60 months, homeowners are increasingly seeing proceeds from sales in excess of such exemption. As such, homeowners must look for ways to defer the tax on gain. One method of accomplishing this goal would be for the taxpayer to establish a new primary residence, convert the existing property into an investment opportunity and hold on to it for the requisite period before utilizing a §1031 exchange (most tax advisors believe that renting the property for one or two years is sufficient). Once the one or two year rental term expires, the taxpayer can segregate their tax liability by using IRC §121 and §1031 to exclude the first $250,000 or $500,000 and defer taxes on the remainder of the proceeds by using the excess proceeds in a §1031 exchange transaction (ex.: home bought for $500,000, sold for $2 million, §121 exclusion on $500,000 and §1031 deferral on remaining $1 million). Of course the couple will have to follow the required rules of §1031 exchanges in order for them to leverage their capital gain tax deferral, substituting their property with a “like-kind” asset which will hopefully be worth considerably more than the tax on their gain.

Another opportunity exists for those taxpayers who own property as a home and as a business proportionately appurtenant. For instance, a duplex in which the owner resides in one section of the property, by rents out the remainder or uses that portion as a home office may qualify for a segregated §1031 exchange. IRS private letter ruling 2005-14 makes it clear that the exchange of a home can qualify for both the Code §121 home sale exclusion and Code §1031 like-kind exchange deferral. This can occur where the property was used as a principal residence and a business consecutively (e.g., use as a principal residence followed by rental of the property) or concurrently (a portion of the home used as a principal residence and a portion used as a home office). Make sure your clients understand that an accountant is generally needed to determine the value allocated to the residence portion and to the remaining units held for investment. A tax professional may use factors such as the square footage or the quality and value of improvements to each unit in determining what percentage is considered the primary residence and what percentage is allocated to the exchange portion. [Note: Proper closing techniques must also be applied.

Caveat: Private letter rulings are based upon very specific scenarios and are not to be interpreted or applied broadly.