By Robert J. Bruss
Q: DEAR BOB: We own three houses, one of which is a rental. We have owned one house as our primary residence for 18 years. We want to sell it in 2006 to get the $500,000 tax credit. A second house has been owned for two years. We moved in during 2005 and want to sell it in 2008 to take the $500,000 tax credit. The rental house will be our last move if we can sell it in 2010 for the $500,000 tax credit. Can this be done? -- Lil H.
A: DEAR LIL: Yes. To qualify for the Internal Revenue Code 121 principal-residence-sale tax exemption -- this is not a tax credit -- up to $500,000 for a qualified married couple filing a joint tax return (up to $250,000 for a single homeowner), you must own and occupy your primary residence at least 24 of the 60 months before its sale.
I presume you meet the occupancy test for your primary residence so you can sell it in 2006 and claim up to $500,000 principal-residence-sale tax-free profits.As for house into which you moved in 2005, after 24 months of ownership and occupancy within the 60 months before its sale, it can also qualify for the tax exemption described above. That should work for you in 2008, as you plan.
IRC 121 can be used only once every 24 months. There is no limit to the number of times you can use this generous tax exemption. Therefore, you can again qualify to use IRC 121 for the sale of the rental house if it is your principal residence at least 24 of the 60 months before its sale and if you have not used IRC 121 for at least 24 months.
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DEAR BOB: In late 2004, I bought a second home in Hawaii. I have a partner who paid half the 20 percent cash down payment. He is on the title as joint tenancy with right of survivorship. We share expenses and will share the profit upon selling. The property is rented to a tenant, but the mortgage is in my name alone, since his credit was not as good as mine. Since the mortgage is mine, can I solely deduct the mortgage interest and all other tax deductions, or do I have to share with him? -- Richard P.
DEAR RICHARD: Your name on the mortgage is irrelevant to the situation. You are 50-50 co-owner partners. That means you and your co-owner should prepare a profit and loss statement for the property, showing all rent income received and all expenses paid. Be aware that only the mortgage income paid is a tax-deductible expense. The small principal payment is not a deduction.
Then divide the rent and expenses equally with your co-owner. Each co-owner then reports his half of the income and expenses on Schedule E of his income tax return. Consult a tax adviser for details.
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DEAR BOB: My late father and his wife owned and operated a bed-and-breakfast inn. After his death in 1993, his wife received a 50 percent ownership and we four children each received 12.5 percent. She continued to live in and operate the inn until she sold it in 2005. Each of us children received our 12.5 percent proceeds from the sale. Figuring out our capital gains tax has me baffled. Should we hire a local real estate agent to do a historical assessment to come up with a market value for our 1993 stepped-up basis? -- Sue B.
DEAR SUE: Determining the market value of a property 13 years ago is not easy, even for an experienced appraiser. It is definitely not a task for a real estate agent who specializes in estimating current market values.The Appraisal Institute in Chicago ( http://www.appraisalinstitute.com/ ) has a nationwide list of experienced appraisers who specialize in determining past real estate market values. I suggest that you contact that organization to see if it has a licensed appraiser who is up to your challenging assignment. Be sure to get the appraiser's fee in writing before you and the other heirs agree to hire that appraiser.
By determining the 1993 stepped-up market-value basis, that information will benefit all the heirs who should share in the cost of the appraisal. The higher the appraised stepped-up market value in 1993, the lower your taxable capital gain.
DEAR BOB: Can I deduct my expenses to visit and oversee my unimproved vacant lot in Georgia? The lot was bought two years ago with intent to build on it in five to 10 years when I near retirement. What if I decide to sell this lot and I want to buy a better one? -- Darlene W.
DEAR DARLENE: If you bought the lot for personal use and it does not produce rental income, unless you can prove that it was purchased for business or investment use, your travel expense to visit and inspect it is not an "ordinary and necessary" tax-deductible business expense.However, if the property is rented to tenants, your rental income must be reported on Schedule E of your tax returns, where you can deduct ordinary and necessary expenses to periodically inspect your rental property.
From your description, it appears that you made a personal non-business property purchase, so your travel expenses are not deductible. However, if you decide to make a trade of your lot for another "like kind" property, you might qualify for an Internal Revenue Code 1031 tax-deferred exchange. Consult a tax adviser for details.
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DEAR BOB: We're selling a house to a friend. The title company says it can handle the transaction for us without a real estate agent. Do you see any problems with this approach? We intend to get a professional inspection and appraisal and will complete all the required disclosures -- Susan D.
DEAR SUSAN: The primary reason to hire a listing agent is to find a buyer. You've already done that, so you don't need a professional agent. Just be sure you make all the written seller disclosures required where the house is located. You might want to hire a real estate lawyer to be certain you comply with all the local requirements.
Thousands of home sales are completed every day without a licensed agent. In most situations, after all the disclosures and inspections are completed, a local title or escrow firm can easily handle the details of the title transfer.
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DEAR BOB: After my husband died in 2004, I sold our home and received about $600,000 tax-free cash. I decided to move near my two daughters and my wonderful grandchildren. I found what I thought was a perfect new condominium for which I could have paid cash, but I remembered your advice. I had no trouble qualifying for the developer's 10 percent down-payment plan. Shortly after moving in early in 2005, I discovered many problems and misrepresentations. My son-in-law, a lawyer, tried to help, but it is now clear that the developer took advantage of the buyers. The condo complex is a disaster with lots of problems, such as bad construction and uncompleted amenities. Only about 70 percent of the units are sold and many owners have stopped paying their monthly fees. The developer is either broke or on the edge of bankruptcy. Because the mortgage lender was in on the developer's dirty tricks, my lawyer son-in-law suggests I walk away and buy in an established nearby condo complex that we know is superb. Do you agree? -- Lucy T.
DEAR LUCY: I am sorry to learn about your bad condo experience, but I am glad you didn't tie up a large amount of cash in what now appears to be an unsalable condo. Of course, I can't advise you on when it is time to bail out of your bad condo. I would never advise ruining your credit by stopping payments on your mortgage unless you have no other alternative.I suggest that you, or your lawyer son-in-law, contact the mortgage lender to see if it will accept a "deed in lieu of foreclosure" to your bad condo. If the lender agrees, be sure you have a written agreement in advance that the lender won't report anything negative on your credit reports.
Your situation is a classic example of why I always suggest that house and condo buyers obtain a 70 to 80 percent mortgage at the time of purchase. If everything turns out well and there is no mortgage prepayment penalty, the mortgage can be paid off after a few years. But I hate to see buyers pay all cash for a house or condo, especially new construction, that turns out badly.
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DEAR BOB: In July 2005, I traded my rental condo for a house where I ultimately want to retire. I know Internal Revenue Code 1031 tax-deferred exchange rules require me to rent the house to tenants, which I have done. My question is, how long must the house be rented before I can evict my tenants and move in? -- Alan E.
DEAR ALAN: Nobody knows for sure. Your question is frequently asked. I have asked your question of IRS officials, and they refuse to answer. The reason is there are no regulations or tax court decisions on this issue.
If the IRS should audit your tax return, all you must prove is rental intent at the time of your tax-deferred trade. Most accountants and tax advisers suggest renting the acquired property at least six to 12 months before converting it into your personal residence. Consult a tax adviser for details.
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DEAR BOB: In early 2005, we bought a house that we rented to our son and daughter-in-law, who were having financial problems. Since then, our son got a great job, his wife became pregnant and they had a child. Title to the house is in our names, but our son and daughter-in-law pay all the expenses, such as mortgage payments, property taxes and maintenance. We don't need the tax deductions. How can we transfer those deductions to our tenants for 2005, since they badly need more tax deductions? -- Rodney R.
DEAR RODNEY: You can't. Although your son and daughter-in-law paid the mortgage payments, property taxes and other expenses, their names were not on the title, nor did they have a legal right to buy the house, such as with a contract for deed, installment land contract, or other document. However, for 2006, you could entitle them to claim the tax benefits for the tax-deductible expenses they pay by adding their names to the title to the house. Consult a tax adviser for details.
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Q: DEAR BOB: If I move for 24 months into a rental house I've owned for 15 years, can I then sell it as my principal residence to avoid the recapture tax on all the depreciation I've deducted?
-- Elinor W.
A: DEAR ELINOR: Sorry. The only way to avoid the dreaded federal depreciation recapture tax is to make a tax-deferred exchange for a qualifying replacement investment or business property of equal or greater cost and equity.
Converting a rental house into your principal residence will avoid capital gain tax on up to $250,000 (up to $500,000 for a qualified married couple filing a joint tax return). However, the portion of your capital gain that is attributed to the depreciation you deducted during your ownership years remains taxable at the special 25 percent federal recapture tax rate when you sell the property. For details, consult a tax adviser.
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DEAR BOB: My fiance and I built our home about a year ago. He has since changed jobs and moved to Arizona. I am still living in our house. We are not married, but we own the house 50/50. He wants to sell it. The market value has greatly appreciated because it is a one-of-a-kind custom home on a beautiful lot. I can't afford to live in it alone and wait another year for that $250,000 tax exemption, which requires two years of owner occupancy. But I hate the thought of paying capital gains tax. What should I do? -- Deborah E.
DEAR DEBORAH: You, but not your fiance, may be eligible for a partial $250,000 principal-residence-sale tax exemption due to "unexpected circumstances" as allowed by Internal Revenue Code 121, even though you did not meet the minimum 24-month ownership and occupancy test.If I understand your e-mail correctly, you alone have lived in the house since its completion about 12 months ago. You can probably qualify for a financial hardship exception to IRC 121, allowing you to claim up to $125,000 tax-free capital gains for your share of the profits.But your fiance can't qualify for any tax exemption since he didn't live in the house. That means he pays capital gains tax on his profit share without any exemption. For details, consult a tax adviser
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DEAR BOB: I am a widow, 74, who plans to move to an assisted-living center in a few months. I want to give my house to my daughter and her husband, who would live in it. They have been kind to me during several recent illnesses. My free-and-clear house is worth about $575,000. However, a friend says I will owe a huge gift tax. The primary reason I want to give the house away now is my son, a lawyer, has not been nice to me and I don't want him to inherit anything after I die. I have sufficient income so I don't need to sell the house. Will I owe a large gift tax? -- Elsa W.
DEAR ELSA: Unless you have made total nonexempt lifetime gifts exceeding $1 million, you won't owe any gift tax. However, you must file an IRS gift tax return when you deed the house to your daughter and son-in-law. After you die , your $575,000 lifetime real estate gift will be subtracted from your federal estate tax exemption -- $2 million if you die in 2006.Consult a tax adviser for details.
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DEAR BOB: The title to my home is held in my living trust. If I name a living trust beneficiary who is not a relative, what are the tax implications for the beneficiary after they inherit my home and after they sell it? Are the taxes the same as for a relative? -- Ms. B.W.
DEAR MS. B.W.: Unless the home is in one of the few states with an inheritance tax, the tax implications for a noncreative inheriting your home are no different than for a relative.If your total estate is less than the current $2 million federal estate tax exemption, no federal estate tax should be due after your death. Your living trust beneficiary will receive a new "stepped-up basis" of market value on the date of your death so only the capital gain exceeding that valuation will be taxed when he sells the house.
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DEAR BOB: Sixteen years ago I set up an irrevocable trust to provide for my two daughters. The trust assets included several properties, common stocks and other assets. The result is it made my daughters rich snobs. Their husbands married them for their money, not for love. One has since divorced. The other stays married for the children. Is there any way I can undo this irrevocable trust, which did no good and created unhappiness for all concerned, especially me? -- Evelyn H.
DEAR EVELYN: Unless you were incompetent at the time you created the irrevocable trust, I am not aware of any way to undo the trust. There were probably tax advantages that might have motivated your creation of the trust.Your sad situation shows why irrevocable trusts are rarely desirable. You can consult a lawyer, but don't get your hopes up.
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DEAR BOB: I admit it. I like younger women. I am 74 and my wife of 12 years is only 58. She makes me happy and I hope I make her happy. However, we could use some increased income. I have followed your reverse mortgage articles with great interest. Because my wife is a co-owner of our house, I am told we cannot obtain a reverse mortgage. Is this true? -- Rolf R.
DEAR ROLF: Yes. Your young co-owner wife disqualifies you from obtaining a senior citizen reverse mortgage.
The minimum age is 62. However, if she will quitclaim her title to you, then you alone can obtain a reverse mortgage. Eligibility is based on the age of the youngest co-owner and the market value of the residence. At age 74, you can qualify for a substantial reverse mortgage.
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DEAR BOB: In 1990 we bought a rental condo on which we deducted depreciation over the years. In January 2003 we made the condo our primary residence. We sold it last July. Then we moved into a house we had bought in July 2000. If we sell this house now and close the sale in June 2006, can we sell without paying capital gains tax?
-- Lucy M.
DEAR LUCY: No. Speak with a tax adviser -- it appears you are about to make a costly mistake. If I follow your letter correctly, you lived in the former rental condo as your principal residence for at least 24 of the 60 months before its sale. Therefore, its sale qualifies for the Internal Revenue Code 121 principal residence sale tax exemption up to $250,000 (up to $500,000 for a qualified married couple filing a joint tax return in the year of the home sale). However, the depreciation you deducted during the condo rental period will be "recaptured" and taxed at the special 25 percent federal tax rate, plus any applicable state tax.
As for your house that you want to sell in June, it cannot qualify for the IRC 121 tax exemption. That's because you used IRC 121 for the July 2005 sale of your condo principal residence. IRC 121 can only be used once every 24 months. You cannot use your tax exemption again until July 2007. If you sell your house in June 2006, your capital gain will be fully taxable.
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DEAR BOB: Are there any potential tax problems in converting a rental house, acquired in an Internal Revenue Code 1031 tax-deferred exchange, into my personal residence? -- William D.
DEAR WILLIAM: Converting the property from a rental into your personal residence is not a taxable event. The reason is that there has been no property sale. However, because the property was acquired in an Internal Revenue Code 1031 tax-deferred exchange, you must own it at least 60 months before you can sell it and claim the Internal Revenue Code 121 principal residence sale tax exemption up to $250,000 (up to $500,000 for a married couple filing jointly). That's presuming that you own and occupy the home for at least 24 months during the 60 months before sale. Consult a tax adviser for details.
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DEAR BOB: I own a six-unit apartment building, in which my wife and I have a large profit. If we make an outright sale, we will owe a huge capital gain tax. My wife remembered an item in your column saying we could make a tax-deferred trade of the apartment building for our "ultimate dream home," and then we could sell the house in a few years to claim $500,000 tax-free profit. Is there a minimum holding time for the house? -- Harold J.
DEAR HAROLD: You first can make an Internal Revenue Code 1031(a)(3) Starker tax-deferred exchange of your apartment building for your dream home. However, remember the basic Starker exchange rules: You must trade equal or up in both price and equity; if you take any "boot" such as cash or net mortgage relief out of the trade, that will be taxable; sales proceeds from the apartment building must be held by a qualified third-party intermediary accommodator; you have only 45 days after the sale to designate the replacement property; you must complete the title acquisition within 180 days; and the house you acquire must be a rental at the time of acquisition.
Although there is no official IRS answer, most tax advisers suggest renting the acquired residence at least six to 12 months (to show investment intent) before converting it into your personal residence.To qualify for the Internal Revenue Code 121 principal residence sale tax exemption up to $250,000 (up to $500,000 for a qualified married couple filing a joint tax return), you must occupy the principal residence at least 24 of the 60 months before its sale. For residences acquired in an IRC 1031 tax-deferred exchange, effective Oct. 22, 2004, you must hold the principal residence at least 60 months to qualify for the IRC 121 exemptions.
This five-year rule only applies to residences acquired in a tax-deferred exchange. For other principal residence sales, the minimum holding time is only 24 months, presuming the owner occupied the principal residence for the same period.
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DEAR BOB: Can I sell my house, plus my rental house, and buy one house for my children and me to live in a better neighborhood without having to pay capital gain tax? -- Amelia A.
DEAR AMELIA: Thanks to Internal Revenue Code 121, if you have owned and occupied your principal residence at least 24 of the 60 months before its sale, you can sell it and claim up to $250,000 tax-free capital gains (up to $500,000 if your spouse also meets the 24-month occupancy test and you file a joint tax return in the year of home sale).
However, the only way to defer capital gain tax on the sale of your rental house, and to avoid the dreaded 25 percent "recapture tax" on depreciation you have deducted, is to make an Internal Revenue Code 1031 tax-deferred exchange for another "like kind" rental or investment property of equal or greater cost and equity. Consult a tax adviser for details.
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DEAR BOB: My mother, 88, wants to sell her home so she can move to an assisted living residence where several of her friends live. I am 100 percent in favor of the move so someone will be watching out for her and I can stop worrying about her. But my problem is that my name was placed on her title, upon the advice of her lawyer and tax adviser, about 10 years ago. The reason was because I paid her property taxes and mortgage payments. By being on the title, I could deduct the interest and taxes paid. When she sells her house, will I be taxed on part of her profit (about $175,000)? -- Jonathan H.
DEAR JONATHAN: You can simply sign a quitclaim deed to get your name off the title to her home before the sale. Your tax adviser might suggest filing a federal gift tax return, although no gift tax will be due if your lifetime non-exempt gifts are less than $1 million.
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Readers with questions should write Robert J. Bruss at 251 Park Rd., Burlingame, Calif. 94010 or contact him via his Web page,http://www.bobbruss.com
Copyright© 2006 The Washington Post Company
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