Housing Counsel: Avoiding Capital Gains Tax

Written by Posted On Sunday, 27 November 2005 16:00

Question:I lived in my primary residence for many years. Because I was having marital problems, my father bought a condominium in his name for me to live in. When my divorce was finalized, the marital home was sold and I received a cash settlement of $200,000. My father then prepared a Quit Claim deed and put the condominium into my name. I lived there for more than two years and paid all of the expenses.

About three years ago, I bought a new house, and have been renting the condominium since then. It has appreciated significantly. I would like to sell the condominium unit.

Is there any way that I can avoid paying capital gains tax on that sale?

Answer:The first thing you should do is determine what your profit will be if you should sell the unit. In your case, your basis for tax purposes will be that of your fathers. Let's look at this example. Your father bought the condominium unit for $150,000 several years ago. Assuming that he made no improvements to the property his tax basis is $150,000. When he transferred the property to you, his basis became your basis. An important aspect of tax law is that the basis of the giver of property becomes the basis of the recipient.

Now, the property is worth $300,000. Did you depreciate it when it was rented? If so, you may have to recapture this depreciation. But your gain -- your profit -- is $150,000. Under current federal law, you would have to pay tax on 15 percent of this gain, or $22,500. Additionally, you will probably have to pay a state capital gains tax as well.

There are a couple of ways that you can either avoid or defer paying this tax.

First, under current federal law, if you live and own your house for 2 out of the previous five years before it is sold, you can exclude up to $250,000 of gain. In other words, up to $250,000 (or $500,000 if you are married and file a joint tax return) is tax-free.

You state that you have been renting the property for a number of years. If you want to avoid paying the capital gains tax, and if you can make the arrangements and meet the statutory time limitations, you should consider moving back into the condominium, live there for two full years, and then sell it. It should be noted that the two years does not have to be continuous. If, for example, you owned and lived in the condominium for the year 2002, rented it out in years 2003, 2004 and 2005, but move in and live there during 2006, you may be able to meet the two-out-of- five year rule.

You can also consider doing a like-kind (Starker) exchange. The condominium is rental and thus meets the requirement for such an exchange. If you sell this property -- which is referred to as the "relinquished" property, you cannot have any access or control over the net sales proceeds. The money must be placed with an escrow agent, who is called an "intermediary." Within 45 days from the day you go to settlement on the relinquished property, you must identify the replacement property. You have the right to designate up to three such replacement properties. You can designate more than three properties, but their combined value must be less than 200 percent of the value of the relinquished property.

And, you must go to closing on the replacement property within 180 days from the day you settled on the relinquished property. All of the sales proceeds from the first property must go directly into the purchase of the replacement property. Otherwise, you will have to pay tax (called "boot") on any money which you take away from the first sale.

When you do a Starker exchange, oversimplified, the basis of the relinquished property becomes the basis of the replacement property. This is one drawback to a 1031 exchange. Another possible drawback is that the replacement property must be used for investment property -- at least for a year or so. Do you really want to be a landlord again?

The advantages, of course, are that instead of paying the IRS the capital gains tax, you can plow those funds into another investment property.

But in the final analysis, the decision is yours to make. It might also make sense to pay the tax and pocket the rest of your sales proceeds.

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Benny L Kass

Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of KASS LEGAL GROUP, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts.

Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.


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