Real estate values have recovered since the crash at the end of the last decade and I have noticed many clients are contemplating selling appreciated real property. Doing so has the potential to generate large federal and state tax liabilities. There are many provisions in the tax code that allow for partial or complete exclusions or deferrals of the tax.
Example
Under Code Section 121, taxpayers can exclude the gain of up to $250,000 for single filers or $500,000 for married filers on the sale of a primary residence once every two years if certain ownership and use tests are met. Factors that the IRS uses to help determine the ability to exclude gain include but are not limited to:
- S. Postal Service address, voter registration card, tax returns for proof of your main home
- Location of your work
(See IRS Pub 523 for more information)
However, even this favorable provision of the tax code is fraught with traps and pitfalls that can hold some nasty surprises for the unwary. Some or all of the exclusion of gain can be disqualified if the property was ever:
- rented,
- Used in a trade or business, or
- Acquired in a like-kind exchange.
Thus, it is extremely important to involve your tax advisor in any decisions involving the sale or purchase of real property. Doing so can save you tens of thousands of dollars.
Example
I recently received a call from a client contemplating the sale of a substantially appreciated rental property they owned in another state that would have generated a tax liability well in excess of $100,000. These taxpayers were not even aware of the ability to defer some or all of the tax by entering into a like-kind exchange under Code Section 1031. In this instance, a residential rental property can be sold and replaced with another piece of real property that must be used in a trade or business, held for investment purposes or the production of income, but can not be used for personal purposes. However, this type of transaction requires careful planning, generally requires a facilitator that specializes in 1031 transactions, and has strict timing requirements.
Call Your Tax Professional
There are many complicating factors that need to be considered in the sale of real property. The gain might not be as simple as taking the sales price less the purchase price. Certain things can increase the gain, such as the recapture of tax benefits like depreciation claimed on a rental or trade or business, basis reduction from excluded cancellation of debt income, etc. With careful planning, the resulting tax on any gain can be greatly reduced, deferred, or even excluded. Think about it, just a few hours of time with your tax advisor can save you many hour of grief and stress later on.