San Francisco real estate |
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Q: I own a townhouse. I live in the top two floors and rent out the first floor. I am leaving this area, and want to sell my property. I have been fortunate and have made a sizable profit from this investment. Because I am single, and because the profit will be over $250,000, I will have to pay a lot of capital gains tax.
Is there any way that I can purchase a similar type of investment in the city where I will relocate, and combine a Starker-type exchange with the sale of my property? Can I immediately take out some cash from the sale so that I can buy a new principal residence?
A: The simple answer is yes, but it’s not easy.
First, let’s review two basic tax concepts.
When you sell your principal residence, if you have lived in the property for two years within a five year period prior to the sale, you can completely exclude for capital gains tax purposes up to $250,000 of your gain if you are single (or up to $500,000 if you are married and file a joint income tax return.)
When you own investment property, you can defer (not avoid) capital gains tax if you exchange that property for another investment property. Both properties have to be in the United States. The process is somewhat complex and the rules (as promulgated by the Internal Revenue Service) are strict.
Oversimplified, your current investment property is called the “relinquished property.” You do not sell that property – you exchange it for a “replacement property”. When the relinquished property is transferred to a third person, all of the net sales proceeds are placed in escrow with a qualified intermediary – a person or entity not related to the exchanger. Within 45 days from the date of the “sale” of the relinquished property, you have to identify the replacement property (or properties), and within 180 days from the “sale” you actually have to take title to this new property.
For tax computation purposes, the tax basis of the old property becomes the tax basic of the new property. Thus, when you ultimately sell the replacement property, your tax accountant (and the IRS) will compute your gain on the difference between your original tax basis, plus any improvements, and the sales price. In other words, the profit you have deferred as a result of the Starker exchange is ultimately taxed when you sell the replacement property.
You have owned a house that is of mixed use; two thirds of the property is – and has been – your principal residence, and the remaining third has been investment property.
Have you been keeping careful records? When you file your income tax return each year, have you advised the IRS of the rental income you have been receiving? Have you been depreciating the investment portion of your house?
If you have kept careful records – and have been honest in your income tax filings – then you should be able to combine the two concepts. If, on the other hand, you have not been reporting your investment to the IRS, then while you still can go forward with this plan, you subject yourself to scrutiny by the IRS and possible taxes, fines and penalties for non-reporting.
Since everyone of course is honest, here’s how it will work.
Let us assume that you purchased the entire property many years ago for $300,000 and it is now worth $900,000. (Note that I picked these numbers for the convenience of dividing by thirds).
Let us also assume that you did not make any improvements to the property, and that there is no mortgage on the property. Since two-thirds of the property is principal residence, here are the allocations::
| Principal Residence | Investment | |
| $300,000 (Purchase Price) | $200,000 | $100,000 |
| $900,000 (Sales Price) | 600,000 | 300,000 |
Sale of Principal Residence Portion
The gain from the principal residence portion is $400,000 (600,000 - 200,000). You can exclude $250,000 of this gain, and thus will have to pay capital gains tax on the $150,000 balance (at a 20 percent rate) in the amount of $30,000.
When you go to settlement, you can take from the settlement table two-thirds of the entire net sales proceeds -- or $600,000 less tw-thirds of the closing costs. You will have to pay the capital gains tax when you file your tax return next year.
Exchange of Investment Portion
Well in advance of settlement, you should discuss this entire plan with your tax advisors. There are a number of legal documents which are generally required when you do a Starker exchange. And these documents should be prepared even before you sign a contract to sell/exchange the relinquished property.
At settlement, the investment portion of the sale (namely $300,000 less one third of the closing costs) must be held in escrow by a qualified intermediary. Your attorney will be able to assist you with the selection of such an escrow agent. You will have 45 days in which to identify the replacement property. Let me caution you: if you plan to go this route, start looking for the replacement property now. It is often very difficult to locate replacement properties with the 45 day window, and these time limitations cannot be extended under any circumstances.
Then, within 180 days from the date of the “sale” of the relinquished property, you have to take title to the replacement property.(Note: if your tax return for the following year comes due within the 180 day period, you either have to complete the Starker transaction before you file your income tax or get an extension of your tax filing deadline.) The escrowed funds will be transferred to the settlement attorney who is handing that transaction. You cannot have access to those funds, unless you decide to forego the Starker exchange route. In that case, you will have to pay an additional $40,000 in capital gains tax ($200,000 x 20 percent). Depending on the circumstances, you may also have to pay a recapture tax of 25 percent on any depreciation you have taken over the years.
I suspect that there are a lot of homeowners who are in your situation, and clearly it makes sense to consider the game plan outlined above. But you have to plan ahead – before you even put your property up for sale.
When dealing with a Starker exchange (also called a 1031 exchange from Section 1031 of the Internal Revenue Code), form is really more important than substance. For all practical purposes, it looks like you are selling one property and buying another. But, with the proper legal documents, the transaction becomes an exchange, and you can defer having to pay the capital gains tax now.
Some people would prefer just to pay the tax, and not be a landlord anymore. Others just cannot bear to pour hard-earned dollars into the hands of the IRS. Clearly, the choice is yours, but you cannot accomplish a 1031 exchange after your relinquished property has been sold.
Disclaimer: The information provided in this article is general information on the legal issues presented and should not be regarded as a substitute for individual legal advice from an attorney.
The above article is presented as a community service with the permission of the author.
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