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Making Home Sale Capital Gains Disappear

Iíve always been enthralled with magic. Sleight of hand... illusion... call it what you will. But when these artists step on stage and make a dove, a rabbit, or even the Statue of Liberty disappear, Iím just completely amazed and astounded. Iíve always wanted to be able to do something like that myself. And now I can. And you can too.

With the right knowledge, information, and patience, you can make the taxable gain from the sale of a rental property or a vacation home completely disappearóstick the gain in your pocket and thumb your nose at Uncle Sammy. Poof... gone.

How? Simply convert the property to a primary residence, use it as such for the appropriate period of time, and then sell it for a tax-free gain. Simple as that. Well, itís a bit more complicated, but you can read more about the rules for tax-free treatment on the gain of a principal residence in my series of articles entitled Home Sale Exclusions in the Taxes FAQ area. Youíll also want to read more about the rules regarding the home sale gain exclusion in IRS Publication 523 to make sure that youíve got all your bases covered. If done correctly, there are some large tax-saving opportunities out there.

How It Works

The key to the entire plan is that you are allowed to sell a principal residence once every two years and exclude up to $250,000 ($500,000 for a married couple) of the gain on the sale. Many of you may be under the mistaken impression that the home sale exclusion is still only "once in a lifetime," or only available to those of a certain age, or only available if you buy a more expensive home. Those were the old rules, and they no longer apply. If you meet the two-year ownership and use tests for a principal residence, and donít sell more than one principal residence in any two-year period, you can exclude any gain on the sale (up to the $250,000 or $500,000 limits mentioned earlier). So, to get the maximum bang for your buck, youíll want to understand the rules and have the patience to wait out the two-year residence period. For those of you with substantially appreciated real estate in the form of investment properties or second homes, the tax savings could be worth the wait. Letís look at a few examples.

Rental Conversion

Mary has a principal residence and a rental property. Both have substantially appreciated in value. Mary sells her principal residence, takes her capital gain exclusion of up to $250,000 on that residence, and decides to move into the rental unit. The rental unit now becomes her principal residence.

Mary resides in the rental unit for another two years to qualify for the ownership and use tests. Mary then sells the property and realizes a substantial gain... of which up to $250,000 can be excluded under the law. Poof... gone.

It makes no difference that most of the appreciation on the second property was realized when it was a rental unit. It also makes no difference that much of the taxable gain is attributable to depreciation that Mary claimed as a deduction against the property in prior years. Mary met all of the tests to exclude the gain and is therefore eligible to do so. Mary has used the tax laws to her advantage. She planned her life to rid herself of some substantial taxes. Nothing illegal or immoral about that.

A Word on Depreciation

It should be noted that all of Maryís gain might not be excluded. Why? Because depreciation taken on the rental property after May 6, 1997 will be subject to "recapture" and tax. But only the depreciation taken after May 6, 1997 will be subject to recapture. Any depreciation taken before that date will be "forgiven" and will be available for the gain exclusion.

Even with this minor inconvenience of recognizing gain on the depreciation claimed after May 6, 1997, the conversion of a rental property to a principal residence likely still makes sense from a tax standpoint. Heck, it seems like a very small price to pay to exclude up to $250,000 (or $500,000 on a married/joint return) of gain.

Retirement Planning

Jack and Jill are thinking about retirement in the near future and want to relocate to a "dream" community in another part of the country. Theyíre afraid that if they wait until retirement to sell their current home, buy a retirement home, and move to the retirement community, that the "hot" real estate market might push the cost of their retirement home out of reach. So, they decide to purchase the property now and rent it out until they finally retire and move. Theyíll still receive the gain exclusion on their current home when they decide to sell, and they can move into their retirement home and establish it as their new primary residence.

If the retirement area isnít as "dreamy" as they first thought, all theyíll have to do is meet the two-year residence test before selling the property to exclude up to $500,000 of the gain (save for any depreciation taken) and move on. Poof... gone. They might make a mistake with the selection of their retirement home, but at least they wonít have to add insult to injury by paying any taxes on the gain.

The Reverse Rental Gambit

Bill originally bought his home in 1997 and relocates across the country in 2000 to take a new job stuffing those little fortunes into the cookies. Heís not sure if this new job will work out. So, instead of selling his current residence, he decides to rent it out. Bill figures that if he doesnít like stuffing cookies, he can always return to his old home, so renting his home provides a safety net.

Two-and-a-half years later (mid-2002), Bill has climbed the corporate ladder and is in charge of putting those little almonds on top of the cookies. He decides he likes his new job and location and wants to sell his old homeó the one that is now a rental. He does... and is able to exclude up to $250,000 of the gain on the sale (save for the depreciation taken). Poof... gone.

How is this possible? The law says that the property must be used as a principal residence for at least two years during the five-year period ending on the date of the sale of the residence. So even though Bill hasnít lived in the home for the last two-and-a-half years, he did use it as a principal residence for two years during the five-year period ending on the date of the sale. So Billís gain is subject to the exclusion. Sweet.

These are but a few examples of how the gain exclusion rules can work for you. There are many others. Tax-saving opportunities exist for married people living apart in two separate homes, for people contemplating divorce, for the elderly who may have moved into an extended-care facility for a period of time, and any number of other different combinations. So, make sure that you can be the best magician that you can be. Understand the rules regarding the sale of a principal residence and make those gains disappear. Poof... gone.

 From a MOTLEY FOOL newsletter.