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Selling an Investment Property: Taxes

So you’ve made the decision, it’s time to sell an investment property. You want to pull your trapped equity to reinvest in other opportunities. What is your net profit going to look like these days? Today we will look at various rates and tools for the 2014 tax year.  (As a discussion, this is not a solicitation of tax advice.)

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While this can become a complicated subject, we will stick to a basic example through the discussion: our client is single, with one home that was not originally purchased as an investment. However, it has been a rental for three of the last four years. What options are available to someone in this scenario?  In seeking information, our client in this example wants to maximize his return and minimize his tax liability.

A 1031 Exchange is out of the question because he is not interested in maintaining an investment property any longer. This vehicle works to defer gains as long as proceeds are invested in “like” property. A cottage industry exists in defining “like for like” changes to fall within the rules of an exchange, and this can get sticky for those looking to push the envelope with this tax vehicle. You wouldn’t think off the top of your head that someone could roll equity from a vacation home into, say a helicopter. But that “like for like” depends on the initial use by those pushing the legal bounds. We have tried to follow the logic used, but by attempting to say the vacation home was a recreational vehicle somehow bridges the gap to a helicopter… If an RV can be a second home, why can’t a vacation home be a “recreational vehicle?” While this argument is as strained as traffic at the 5/805 merge, it continues: since the helicopter in question would be used as a recreational vehicle, it only makes sense that “the home be an equivalent use.” Hope these people have a good tax attorney!

A more likely outcome is to look at the legal use of a “primary” residence regarding capital gain tax. A quick look at 26 U.S. Code § 121 – Exclusion of gain from sale of principal residence says:

“(a) Exclusion Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.”

Those two years of residency do not need to be continuous. Any time period adding up to two years in the previous will do according to this information. IRS Publication 523  gives you the granular details defining “primary residence.”

 

Back to our example client: after purchasing his home in 2010, he happily enjoys his new home for one year. A new employment opportunity presents itself, which requires a relocation. That brings us to today in the chronology: he has occupied the property as a primary residence for only one of the last four years. To qualify for the two year exemption, he would have to move back to live another year as a principal residence. This isn’t possible for him. If he were to get married, it would change his income rate cap from $36,900 to $73,800 to qualify for 0% cap gain tax. Any income above those levels means 15% capital gains taxes are owed in this scenario as it stands.

 

As you can see from our example, options are available with careful planning and timing. As the saying goes, only two things in life are guaranteed: death and taxes. At least the tax code has some wiggle room!

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