Like many of my professional colleagues, I continue to be baffled by the misinformation that seems to prevail among homeowners who are getting ready to make that big move for reasons such as job relocation or simply moving upward.
Consider this all-too-common hypothetical: Greg, a successful executive, and his wife, Judy, had recently lost patience with the struggling real estate market and they decided to rent out the place they had called home for the past 15 years.
In their haste to relocate the family to a larger house with more land, they decided to rent - rather than sell - as part of their planning strategy. When asked if he had seriously considered the potential tax consequences that might be faced when the property was eventually sold, Greg responded disbelievingly. "What tax?"
"We plan to re-invest every dollar that we'll get out of the old place into our new homestead - and plenty more besides."
Surprise! The old "re-investment" rules don't apply anymore. Greg's response was uncannily similar to the reactions of many homeowners who mistakenly believe that no taxes will be owed if you simply take the proceeds from the sale of your primary residence and replace it with another within a prescribed time period.
Interestingly, this old-familiar "re-investment" strategy continues to be thought of as an acceptable tax loophole among business-savvy individuals even though the rules have been changed for more than a decade.
The only real loophole with the sale of your home is the special exclusion. Regardless of what Greg (or anybody else) does with the proceeds from the sale of their home, the only real tax benefit that now exists is the one that allows you to exclude up to $250,000 in gain ($500,000 for married folks).
In general, to be eligible for the exclusion, you must be able to show that you physically occupied the house as your primary residence for "two out of the last five years prior to the sale."
Special Exception: If for some reason you used your residence for less than two years, you might still be eligible for a reduced exclusion. This could apply if the primary reason for selling your home was a change of employment, health reasons or "unforeseen circumstances" (clearly an increase in a liberalized IRS policy).
Here's an illustration:
Greg and Judy rented out their former residence for three full years (Jan. 1, 2007 through Dec. 31, 2009) before it was sold for $650,000.
Because they had invested $100,000 in their home, a gain of $550,000 was realized at the time of sale on Dec. 31, 2009.
Also, on Dec. 31, 2009, they went to settlement with the purchase of their new $750,000 home - using the proceeds from the sale of the old house.
Observation: Although Greg and Judy had invested more in their new home than they received on the sale of their former residence, it did not provide them any tax benefit whatever. Fortunately, however, since they did occupy the home for two full years (out of the last five) they were eligible for the special $500,000 exclusion - with a minor adjustment for depreciation.
What to do if you are caught in the down-market dilemma and are forced to rent? If you, like Greg, are forced to temporarily rent before you could find a buyer, you need to first keep in mind that renting for too long a period could make you ineligible for the special exclusion.
In addition, you should check with your financial pro to see if there are any advantages in converting your home to a rental property as a longer-term investment. For one thing, there just might be some economic benefits for adding a rental income plan to your investment strategy. In addition, you may be surprised to learn that there are potential tax advantages as well.
Once a so-called conversion is made to rental property, you become eligible for a variety of business tax deductions in connection with maintenance, upkeep, depreciation, etc.
And in a worst-case scenario (especially with today's real estate market) you might be eligible for a major tax write-off if the converted property is eventually sold at a loss - a tax advantage that would otherwise not exist when a personal residence is sold.
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Thomas J. Stemmy of Annapolis, CPA, CVA, EA is a partner with Stemmy, Tidler & Morris in Greenbelt. He is the author of "Top Tax Saving Ideas for Today's Small Business." E-mail him at TStemmyCPA@Yahoo.com.
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