Converting Investment Property to Your Primary Residence

Exclusion of Gain from Sale of Residence

Many people are aware that they can sell their primary residence and not pay taxes on a significant amount of gain.  Under Section 121 of the Internal Revenue Code, you will not owe capital gains taxes on up to $250,000 of gain, or $500,000 of gain if you are married and filing jointly, when you sell a home that you used as your primary residence for at least two of the previous five years. Taxpayers can take advantage of this exclusion once every two years. 

Property Converted from Investment to Primary Residence

Taxpayers used to be able to trade into a rental, rent the home for a while, move into it and then exclude all or some of the gain under Section 121.  Provided they lived in the home as their primary residence for at least two years, they could sell it and exclude the gain under Section 121 up to the maximum level of $250,000/$500,000.  In recent years Congress enacted two amendments to Section 121 in order to limit the benefits of Section 121 when the property has been used as a rental. 

First, if you acquire property in a 1031 exchange and then convert it to your primary residence, you must own it at least five years before being eligible for the Section 121 exclusion. 

Second, the amount of gain that you can exclude will be reduced to the extent that the house was used for something other than a primary residence during the period of ownership.  The exclusion is reduced pro rata by comparing the number of years the property is used for non-primary residence purposes to the total number of years the property is owned by the taxpayer.
 
For example, a married couple uses a tax deferred exchange under Section 1031 to acquire a house as investment property.  The couple rents the house for three years, and then moves into it and uses it as their primary residence for the next three years.  The couple sells the property at the end of year 6, netting a total gain of $800,000.  Instead of being able to exclude $500,000, the couple will not be able to exclude some of the gain based on how many years they rented the house.  Since they rented it for three years out of six, 50% of the gain, or $400,000, will not be able to be excluded.  Because of this new limitation, the couple will be able to exclude $400,000 of the gain rather than $500,000.
 

Exceptions

There are a couple of exceptions to this restriction.  If the house was used as a rental prior to January 1, 2009, the exclusion is not affected.  Using the example provided above, if the three year rental period occurred prior to January 1, 2009, the exclusion would not be reduced and the couple would be able to exclude the full $500,000.
 
Another important exception is that property that is first used as a primary residence and later converted to investment property is not affected by these restrictions on excluding gain.  For example, if you own and live in a house for 18 years and then you move out and rent the house for two years before selling it, you can receive the full amount of the exclusion.  Because your investment use occurred after the last day of use as a primary residence, all of the gain accumulated over your 20 year ownership of the property can be excluded, up to $250,000, or $500,000 for married couples.

Combining Exclusion with 1031 Exchange

Fortunately, the rules are favorable to taxpayers who have more than $250,000/$500,000 of gain and are looking to combine Section 1031 with Section 121 to both exclude and defer tax.  When the property starts out as a primary residence and then is converted into an investment property, you can exclude gain under Section 121, and then defer tax on the remaining gain, provided you comply with the requirements of both Section 1031 and Section 121.
 
The Internal Revenue Code still provides investors with favorable options for exclusion of gain and tax deferral.  The rules can be complicated, but with the right planning taxpayers can still make the most of their real estate investments.  For additional information about the 1031 exchange process or to open an exchange contact us at First American Exchange.
 
References:   Internal Revenue Code §121; Housing Assistance Tax Act of 2008 (H.R. 3221).

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Tax Record Keeping - What and How Long?

How much interest was paid on the mortgage?  Where are the receipts for our medical expenses?  Taxpayers ask questions like these every year as the tax filing deadline approaches (April 17th this year).

In addition to making it easier to prepare your tax return, good record keeping will help you manage your §1031 exchange transactions.  Proper records will help you support the items reported on your return, including the expenses incurred and how the basis was determined.

Record Storage - Whether you store records electronically or simply rely on your checkbook, keep your records in an orderly fashion and in a safe place.  In Revenue Procedure 97-22 the IRS requires that an electronic storage system ensure an accurate and complete transfer of the hardcopy records to an electronic storage media that will index, store, preserve, retrieve, and reproduce the electronically stored records.  Once you are in compliance with these procedures you may then destroy the original records.

What to Keep - In Publication 552, the IRS sets forth the basic records that everyone should keep for proof of income and expenses.  For items concerning your income you should keep:  Form(s) W-2, 1099, 2439 and K-1, as well as bank, brokerage and mutual fund statements.  With regard to expenses, keep: sales slips; invoices; receipts; canceled checks or other proof of payment; and written communications from qualified charities.  For your home, keep: closing statements; purchase and sale invoices; proofs of payment; insurance records; and receipts for improvement costs.

How Long? - Once you determine what records to keep, the next question is:  How long should you keep them?  In general, you must keep the records until the statutory limitations period runs out for that return.  The period of limitations is the time during which you can amend your return to claim a credit or refund or the IRS can assess additional tax.  In most cases the limitation period is three years.  There is no limit in the event you file a fraudulent return.

§1031 Exchanges - When you defer taxes through a §1031 exchange your basis in the property you receive is the same as the basis of the property you gave up, subject to some adjustments. You must keep the records on both the old and the new property until the period of limitations expires for the year in which you dispose of the new property in a taxable disposition.

Non-Tax Purposes – Think twice before disposing of your records.  Even though you may not need them for tax purposes, you may need them for other reasons, such as insurance or medical care.

Reference: IRS Publication 552 (January 2011); Revenue Procedure 97-22.