Whether you’re self-employed, a wage earner or own your own business, you know that Uncle Sam, through the Internal Revenue Service, is your silent partner. It’s no different when you sell your Silicon Valley home. When you sell it for more than you paid (or rather “net”), you create a taxable gain. However, just as you were able to take deductions on your tax return for the interest you paid while living in your home, Uncle Sam has created some wonderful tax benefits when you sell your home.
Please be aware we are not providing tax advice. (In fact, the opposite – please read “Why Good Realtors Refer Buyers and Sellers to Lawyers and Tax Professionals for Some Questions“.) As we said at the beginning of this book, we’ve tried, we really have tried to be as accurate as possible when it comes to what works and what doesn’t in selling a home. In this section we will talk about how the tax laws work in your favor as a home seller. We have attempted to ensure that everything said here is accurate and relevant, but laws change, circumstances vary and there is always the possibility for error. Using the guidance offered here, along with your selection of a competent tax professional, whether a Certified Public Accountant or a tax attorney, you should feel confident in selling real estate and legally avoiding taxes on any gain you may have created. If your situation is complicated by any of a number of factors—if the property is classed as a business, farm, ranch or multi-unit residence—please consult a tax professional who specializes in that area.
Let’s start with the first tax advantage: It used to be that if you sold your home and purchased another, all gain from the appreciation in the value of your old home could be transferred to your new one without owing current income or capital gains taxes, provided you rolled that gain over into a new home within 24 months of selling your old one. This was under IRS Code Section 1034, prior to the Taxpayer Relief Act (TRA) of 1997. Section 1034 also replaced IRS Code Section 121, which was designed for taxpayers who were over age 55 and allowed a $500,000 exclusion for married couples or a $250,000 exclusion for a single person on the sale of their principal residence. Now you no longer need to buy another house of equal or greater value to claim the exclusion.
You can take advantage of the new law over and over again (although not more than once every two years), but there are certain guidelines. First, the property must be your principal residence and not a second home or rental property. Second, it may be a detached house, a mobile home, a co-op apartment or a condominium, but you cannot have more than one principal residence at the same time. Third, you must have lived in the house for at least two of the last five years prior to the sale. There is even a benefit to a spouse who is not living in the house at the time of the sale; they can claim up to $250,000 of tax-free profits, provided they too lived in the home for two of the last five years. This also applies to two co-owners who are not married, as long as they meet the occupancy rules.
Even if one spouse dies, these tax benefits are available. The surviving spouse, whether widow or widower, is allowed to claim the full $500,000 exclusion if the home is sold in the same year that the spouse died.
Section 1034 eliminates most of the record-keeping requirements if you know that your gain will be less than $250,000. By the way, the gain you are allowed to exclude is the lesser of your gain or $250,000. In other words, if your gain is $100,000 on the sale of your home, you do not get to take a $250,000 deduction. In the past, your escrow company had to file a Form 1099-S and report your taxable gain to the IRS. This is no longer required. However, if you take a loss on the sale of your home, you can’t deduct that loss; remember, you had been getting an interest deduction.
Investment Property Relief
Tax deferral is also available when you sell a rental home or an apartment building if you follow the guidelines in IRS Code Section 1031. This is called a 1031 taxdeferred exchange, and is a powerful way to create wealth through real estate. You can sell investment property and transfer all of the gain to another larger investment property and defer the taxes that would have been due on a straight sale.
Here’s how it works: An investor/taxpayer can avoid the taxes on the sale of investment property and qualify for exchange treatment if the property was held as investment property, or for use in a trade or business, and was exchanged from property that was like that which was sold. This is called like-kind. However, prior to the sale of the old property the seller must enter into an exchange agreement with a qualified intermediary. This person or company structures the exchange transaction to meet all of the IRS Code requirements.
What Is a Qualified Intermediary?
A qualified intermediary is also known as a facilitator or accommodator. This is a person or company who holds the funds from your sale and structures the transaction to meet IRS requirements. Unfortunately, there are no federal or state laws that govern an accommodator. Anyone can claim to qualify; however, it cannot be anyone close to you, such as your accountant, attorney, banker, employee or family member. You must confirm that they are qualified, that they have the knowledge, experience and credentials to perform for you. Also, since they will hold your money, you want to be sure they don’t take an extended trip to a country without an extradition treaty.
Ask the accommodator if they pay interest on your funds. Ask for their fee structure and whether there are extra charges if you require additional consultations. Verify that they are members of the national organization for qualified intermediaries, the Federation of Exchange Accommodators (FEA). Confirm that they carry an independent bond issued by an insurance company that specializes in this type of coverage. This is one of the most import ant items. You don’t want to be left emptyhanded if your money is stolen by the intermediary or one of their employees.
There are three basic guidelines set out by the IRS to qualify for exchange treatment. First, the purchase price of the replacement property must be equal to or greater than the property you sold.
Second, the debt on the replacement property, the mortgage, must be equal to or greater than the debt held on the property you sold. There should be no relief of your debt.
Third, all of the net proceeds, the total amount you received for your property, must be used to buy the replacement property.
If you don’t follow these three guidelines, you can still complete the exchange, but you may have taxes to pay. As an example, if you hold out $100,000 from the exchange (this is called boot), it will be taxed. When attempting a partial exchange it is crucial you get competent tax advice.
Like-kind refers to the type of property involved in an exchange. According to the IRS this is “any property held for productive use in a trade or business or held for investment purposes.” As an example, you can exchange an apartment building for a commercial building, or a rental single-family home for an apartment building or a shopping center. Even raw or vacant land and a leasehold for 30 years or more count under exchange rules.
The following property is not considered real estate, and therefore does not count as exchange property: money, stocks, bonds and notes. Also, limited partnerships and your primary residence do not qualify.
Most exchanges occur as delayed exchanges, and there are two key deadlines to keep in mind. The first is the 45-day period to identify the property you want to acquire after the close of escrow on your property. The second is the 180-day period by which you must close escrow on your replacement property. There are no exceptions or extensions.
You have two choices when it comes to identifying your replacement property. The first is the three-property rule, and the second is the 200 percent rule. The threeproperty rule allows you to identify up to three properties that you want to acquire as an exchange. You may purchase one or all of the properties to complete your exchange as long as they follow the IRS guidelines described earlier. If you choose to purchase more than three properties, you must qualify under the 200 percent rule, which allows you to identify as many properties as you want as long as the total market value of all the identified properties is less than 200 percent of the value of the sold property. You will need to complete an identification notice for your qualified intermediary to comply with the IRS rules.
Most often, when sellers consider a tax-deferred exchange they are dealing with large amounts of money. Competent advice is suggested because the penalty for failure to follow the rules is substantial. Please consult qualified professionals.
Client comment from 2004
Mary is connected. She is almost “wireless.” As an engineer, I don’t want to have to technically train experts in their field on the systems they use to do their work. In my search for a home I was very specific in my requirements. The tool most Realtors® use to sort through houses for sale (the Multiple Listing Service) seems to confuse and confound many Realtors®, but not Mary! I’ve seen ¼ acre properties listed as 44 acres, two car garages listed as one car garages, incorrect school codes, and poor descriptions for great properties. From a buyer’s perspective, she knows the territory and can spot the errors. From a seller’s prospective, Mary knows the best way to present your home. She knows the process and systems and works them to her client’s advantage.