How can I defer the taxes on the sale of my residence or vacation home?
We recently had a client move out of California and purchase a new residence in another state. They want to sell their California residence AND their vacation house that is also in California. Both properties have taxable gains of more than $1 million each.
In this post we will cover if, and how, they can defer the gain on these two properties.
When you sell your primary residence that has only been used as a personal residence you are only allowed to utilize the $250,000/$500,000 exclusion that is available through IRC 121. In our client’s case this will only help offset a portion of the tax on the primary residence and none of the tax related to the vacation home.
The typical way to defer the gain on the sale of real estate is by utilizing what is referred to as a 1031 exchange. Under the rules of IRC section 1031 you are allowed to defer the gain on the sale of real property if you meet certain conditions of reinvestment into real property. In our client’s fact pattern their primary residence has only been used as personal property. As it relates to their vacation home, it has only been used as personal property and has not generated any rental income. The way the tax code reads, in this situation the gain on both properties are taxable with the exception of the $250,000/$500,000 allowed on the personal residence.
How do we navigate these rules for a more favorable result using a 1031 exchange?
Let’s first consider the primary residence. If the property is mixed-use, personal and investment, gain may be excluded using a combination of IRC 121 and IRC 1031. To qualify for the 1031 exchange the taxpayer needs to be able to demonstrate that the primary residence was also utilized as investment property.
The tax code does not specifically state how long the property should be held for investment/rental purposes. Typically, a taxpayer would want to demonstrate that the property was rented at fair market value for at least two years to establish a bona fide investment asset. The IRS is clear on two points:
- Merely declaring the primary residence as a rental property is not enough.
- You can’t live in your home at all while it’s a rental, and you must rent it out.
We recently had another client who converted their primary residence to a rental for about 2 ½ years and then sold it to purchase investment property outside of California. Further in the post we will address an issue with deferring gain using 1031 in California and investing those proceeds outside of California.
Using IRC 1031 to defer the gain on the second residence/vacation home is less ambiguous. The IRS has published safe harbor rules specifically for this situation. The qualifying use standards are:
- Relinquished property. A dwelling unit that a taxpayer intends to be relinquished property in a § 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:
(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the “qualifying use period”); and
(b) Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
- (i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
- (ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).
- Replacement property. A dwelling unit that a taxpayer intends to be replacement property in a § 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:
(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and
(b) Within the qualifying use period, in each of the two 12-month periods immediately after the exchange,
(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
(ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
For this purpose, the first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.
Will California allow for the deferral of taxes on the gain of California real property invested outside of California?
Like Massachusetts, Montana, and Oregon, the State of California Assembly passed a bill which added new sections to the California Tax & Revenue Code beginning on January 1, 2014. These sections provide that taxpayers in a 1031 Exchange that sell California property and purchase NON-California replacement property will be required to file an annual information return with the California Franchise Tax Board (FTB), reporting this NON-California property. The California state taxes that were previously deferred will be due when, and if, taxpayers sell their new properties and elect to take their profits rather than continuing to defer taxes through another 1031 Exchange. If taxpayers fail to file the annual return, the FTB may estimate taxes due and assess tax, interest, and penalties. You can see from these rules that California expects you to track your deferral and eventually pay the tax.
In the specific case of our client, they have moved out of California and have established residency elsewhere. They are going to sell both of their California properties and don’t plan on re-establishing residency here in California. According to the rules set forth by the California Franchise Tax Board, they are deemed to have a tax filing requirement in the future to track the deferred gain for California purposes.
As you can see from reading this post, the rules around selling personal use real property and deferring the tax gain are complex. If you would like assistance navigating these waters, please feel free to reach out to us.