and Avoid a Tax
you own a principal residence that has appreciated
tremendously since you purchased it. You would now like to
unload the property and convert your big equity stake into
some sort of income-producing investment. Perhaps you are
approaching retirement age and want to replace earnings from
your job or business. Or you may want to convert your home
equity into an asset that generates positive cash flow.
It's a good idea — but be careful of the tax bill.
Some of the gain will be tax free if you meet certain
qualifications but if the profit on the home is large enough,
some of it will also be taxed.
Timing is everything
if you want to combine a like-kind exchange with the
federal gain exclusion on a principal residence. Miss
certain deadlines and you lose out on the
For example, assume you and your spouse bought a nice home
in an expensive area many years ago. The property's fair
market value is $2.8 million, but its tax basis is only
$450,000. So if you sell, the taxable gain would be $1.85
million ($2.8 million value minus $450,000 basis minus
$500,000 federal gain exclusion for married sellers). Let's
assume your combined federal and state tax capital gains tax
rate would be 20 percent (15 percent federal plus 5 percent
state). That translates into a $370,000 tax bill (20 percent
tax rate times $1.85 million gain equals $370,000).
you really don't want to pay that much tax, here's an
IRS-approved four-step strategy:
your home into a rental property.
Swap the home
for income-producing real estate (such as a small apartment
building or a percentage ownership interest in a shopping
mall). If the swap is done properly, it will qualify as a
tax-deferred like-kind exchange under Section 1031 of the
Internal Revenue Code. So you avoid the large tax bill.
cash out of the deal up to the amount of profit you can
shelter with your federal home sale gain exclusion
(generally, up to $250,000, or $500,000 if you're a married
possible, hang onto the income-producing real estate until
This "convert-and-swap" strategy avoids any immediate
federal capital gains tax. Plus, it converts most of your home
equity into an income-producing asset. Even better, you can
collect a substantial amount of federal-income-tax-free cash
thanks to the gain exclusion break. Last but not least, if you
continue to own the replacement property (the income-producing
real estate acquired in the like-kind swap) until you die, the
property's tax basis will be stepped up to fair market value
as of the date of death. This means your heirs can sell the
replacement property with little or no federal capital gains
tax hit (assuming the current date-of-death tax basis step-up
rule, under Section 1014(a) of the Internal Revenue Code, will
remain in the tax code through 2010 and beyond).
to Convert Your Residence into a Rental Property
To make this strategy work, you must first be able to
convince the IRS that you converted your former home into a
rental property. After that objective is accomplished, you can
swap your former home in a tax-deferred like-kind exchange.
Why? Because the like-kind exchange privilege is only
available when you trade business or investment property for
other business or investment property. Therefore, if you fail
to convert your former residence into a rental, your attempted
like-kind exchange will be treated as a regular taxable sale
with the resulting large tax bill. So how do you do convert
your home into a rental property and meet all the tax law
requirements? The IRS has answered that question in some
According to the IRS, you can convert a former personal
residence into a rental by renting it out for at least two
years before swapping it for the replacement investment real
estate. (IRS Revenue Procedure 2005-14) What
about renting for one year or 18 months? That might be
sufficient, but there's no guarantee, because the IRS has not
provided any guidance beyond the two-year rental period
mentioned in Revenue Procedure 2005-14. So the prudent action
is to rent out your former home for a full two years at market
rates before making a swap. That will lock in the desired
tax-deferred like-kind exchange treatment.
Next, Combine the Two
Breaks to Collect Tax-Free Cash
By carefully timing your transactions, you can also arrange
to receive up to $250,000 of federal-income-tax-free cash as
part of your property swap ($500,000 if you're a married joint
filer). You accomplish this by combining the like-kind
exchange break with the federal gain exclusion break. Using
the above example, after converting your unmortgaged $2.8
million principal residence into a rental property, you could
arrange a like-kind swap for an unmortgaged piece of
income-producing real estate worth $2.3 million, plus $500,000
of cash ($2.3 million plus $500,000 equals $2.8 million).
Assuming you qualify for the maximum $500,000 joint-filer gain
exclusion, all the cash is federal-income-tax-free.
Here are the tax-law specifics behind this part of the
strategy. In a like-kind exchange, your receipt of cash
(called "boot") generally triggers taxable gain equal to the
Procedure 2005-14, the IRS also explained how taxpayers
can combine the like-kind exchange and federal gain
exclusion in more complicated situations, such as when
part of the residence was used as a rental property or a
deductible office in the home. Your tax adviser can
provide details if this applies to
- The inherent gain on your residence (fair market value
minus your tax basis in the property).
- The amount of cash boot you receive in the exchange.
However, the IRS states in Revenue Procedure 2005-14 that
you can use the home sale gain exclusion to shelter otherwise
taxable gain from the receipt of cash boot. The three
requirements to qualify for the gain exclusion are:
property you are exchanging (your former principal
residence) must have been owned by you for at least two
years during the five-year period ending on the exchange
exchanged property must have been used by both you and your
spouse as your principal residence for at least two years
during the same five-year period.
3. You must not
have claimed an earlier gain exclusion within two years of
the exchange date. The same goes for your
If you're unmarried, you must meet the first two standards
to qualify for the smaller $250,000 gain exclusion amount (the
third rule obviously doesn't apply).
So the trick here is to make sure you get the timing
exactly right. Specifically, if you rent out your former
principal residence for more than three years during
the five-year period ending on the exchange date, you'll fail
the second test and lose the valuable gain exclusion break.
However, as explained earlier, it's prudent to rent the home
for at least two years to clearly establish that you've
converted it into a rental property for like-kind exchange
purposes. In summary: Two years of renting is good, but more
than three years is too long to preserve the gain exclusion
If you're interested in implementing this strategy for your
greatly appreciated principal residence, consult with your tax
adviser. Section 1031 like-kind exchanges are sophisticated
maneuvers that generally require professional assistance. Your
tax adviser can also answer any other questions you may have
about the tax consequences of selling a home.