November 2018 Boerne Business Monthly Article written by Austin Lee, CPA, Tax Senior at ADKF, Certified Public Accountants
Diving in the lake; floating the river; cooling off with a snow cone on a park bench; laying under the stars while listening to the cicada’s tune; this is summer in Texas. In one of the fastest-growing regions in the country, summer also means people are on the move! Whether you are welcoming others to the Hill Country or saying “Happy Trails” on your way out, there are some important tax matters to consider when buying and selling your home.
Goodbye to home sweet home!
The sale of your principal residence can be considered a tax-free transaction under IRS code section 121. You read that right, TAX-FREE. This code section allows you to exclude up to $500,000 of the gain on the sale of your home for those that file married-filing-jointly and $250,000 for those that file single, if the following rules are met:
•Property has been owned and used as your principal residence for at least two of the five years preceding the sale date. Note that the two years do NOT have to be contiguous.
•The exclusion is available once every two years (so before you start your house-flipping dreams, be cautious of the timing!)
•When taking the $500,000 gain exclusion, both spouses must meet the two out of five-year rule. Otherwise, you may be limited to the $250,000 gain exclusion.
•There is flexibility for a partial exclusion exemption for situations involving employment, health, and unforeseen circumstances.
Keep in mind we’re referring to a “gain on sale” amount and not the total sales proceeds. The “gain on sale” is the sales proceeds less your cost in the home, which can turn out to be much more than your initial investment. The cost in the home can include improvements (kitchen remodel, adding a pool, new roof, etc.) as well as architect fees, surveys, and professional costs connected to the property.
If you sell your home for less than the gain exclusion, we would recommend you still report it on your tax return on Schedule D with the home exclusion code to match any reporting documents sent to the IRS during closing. Lastly, if you sell the home for a loss, the IRS does not allow you to take that as a deduction.
Let’s rent this place out!
Moving to a new home while converting your prior residence to a rental property is becoming more common with the growth of rental websites and the fact that Texas is a popular tourist destination. For code section 121 gain exclusion, rental property is considered “nonqualified use”. The gain exclusion will be adjusted based on the ratio of “nonqualified use” to total ownership years. Keep in mind that you can use the entire gain exclusion on this home if you meet the two out of five-year rule discussed above with an important note – depreciation. Depreciation taken in the past will be considered recapture income. Clients have attempted to avoid this issue in the past by not depreciating their rental home; however, this is not recommended because the IRS will treat the property as if it was depreciated regardless of whether a deduction was taken.
Time to sell the vacation home!
Selling any property that is not your principal residence (investment, rental, vacation) subjects you to paying income tax if there is a gain on sale as this property does not qualify for the two out of five-year exclusion. Keeping track of your costs in these properties is imperative as it will save you time, energy, and money in the future.
What about like-kind exchanges?
If you’ve listened to commercials about real estate investment, you’ve likely heard the term “1031 Exchange” or “Like-Kind-Exchange”. This topic can be more complex, and we highly recommend consulting with a professional prior to agreeing to a 1031 exchange. Here are a couple of common mistakes we see frequently:
1. Clients agreeing to a 1031 exchange without considering other factors outside of deferring the tax. Deferring tax may not always be the most beneficial route depending on the circumstances and your personal tax situation.
2. Clients not using a “Qualified Intermediary”. A Qualified Intermediary is a person or company that agrees to facilitate the exchange by holding the funds that can be transferred to the seller of the replacement property. Without a Qualified Intermediary, you are not eligible for a like-kind exchange.
3. Clients not acquiring a replacement property with enough value to defer the gain allowed under 1031 exchange.
Navigating real estate transactions, whether it be personal or business-related, can be a complex and daunting task. If you need assistance with this process, please feel free to contact ADKF. We have experienced advisors that are here to help!
To see the published article in the Boerne Business Monthly visit:
Austin Lee, CPA is a senior tax accountant at Akin, Doherty, Klein, & Feuge, P.C. (ADKF). Austin graduated from the University of Texas at San Antonio and has been at ADKF since 2012. Austin grew up in Boerne and graduated from Boerne High School. He’s married to his high school sweetheart and is raising a baby girl in San Antonio. In his free time, he enjoys playing golf and spending time with family and friends.