Timing Critical to Defer Capital Gains Tax

This couple in their ‘30’s, we can call them Brett and Sara, came in to discuss a “tax-free” exchange of real estate they own in Seattle. Brett said he wanted to buy apartments in Anchorage. He said he would bring Sara because she would be a “hard sell” on owning rentals.

We met and went around and around on their options for over an hour. By the end of the discussion they found they had a lot to talk about beyond real estate. Like their life plan. Real estate, as represented by one’s home and one’s investments, has a tendency to broaden the mind and relationships.

First it was important to clarify the term “tax-free” exchange. The correct phrase is “tax-deferred”. The tax code permits investors to move equity and debt from one piece of investment real estate to another without the need to pay the tax on any gain that builds up. When the investor is done with the game and sells outright, however, all the tax becomes due on all that gain. The gain can be substantial, since it can include the investor’s experience with a string of properties. The gain consists of increases in value plus all depreciation written against property income over the years.

So the first question for Brett and Sara was how big a tax bite they were looking at that might diminish their estimated proceeds of $115,000 from disposing of the Seattle property. If they planned an exchange they would have all their $115,000 to reinvest. If there was going to be a tax bill of $25,000 or more, they would have less to work with and might not be able to afford an adequate replacement property.

The Feds have long wished that tax-deferred exchanges didn’t exist, or were more restrictive. The current rule permits exchanging any real estate for any real estate, as long as it’s not personal property. The motivation has to be investment. The tax people would like to get their money sooner. The Clinton administration’s balanced budget proposals earlier this month proposed limiting exchanges to properties that are more similar, like apartments for apartments, land for land, and farms for farms. Fortunately for investors, the proposal is reportedly getting a cool reception in Congress.

We started to put pencil to paper with Brett and Sara to calculate their gain and potential tax bill. Everything changed when Sara piped up. “Our proceeds might be more than 115,000,” she said. “Brett’s employer pays the real estate commissions and normal closing costs. That would give us an extra $20,000 to reinvest.” Brett confirmed this information, adding that he had to sell the Seattle property by this fall, two years from when he started work in Alaska.

“Why would your employer pay closing costs on the sale of your investment property?” I asked. “They always do,” Brett replied. “It’s an employee benefit when you move from one city to another. I just don’t want to pay tax on the gain since it went up in value a lot while I lived there.”

“Lived there? Whoa, we are off on the wrong track altogether if this was your home,” I said. “Well, it’s actually a duplex,” Sara said. “There’s a basement apartment in it.” Up to this point all the advice they had received, from real estate agents in Seattle and mortgage lenders and agents in Alaska focused on exchanging investment real estate and how to do it. It turns out that most of this asset, about two-thirds by floor space and three-quarters by value, is a personal residence.

“Where do you live now?” was the next question. “We bought a new home last year,” Brett said. Thank goodness they have not been living there more than two years. The tax rule for personal residences is different. It’s about the only free lunch in the tax code. A true “tax-free” exchange, Brett and Sara can simply avoid the tax on most of their gain by closing on a sale of the Seattle duplex within two years of closing on their present home in Eagle River.

Brett and Sara can keep up this exchanging technique, as long as they spend as much or more on each subsequent home, until one of them turns 55. After that, once in their lives, they can sell a home and avoid tax on $125,000 of gain. There are heavy pressures on Congress to increase that amount, since the strong lobby of home owners believes that profits built up over years as one of life’s most important savings techniques.

“But we don’t like our house much,” Sara complains. “Do we have to keep living there? Can’t we build ourselves a nicer home?” After some more discussion it comes out that the Eagle River house has already been reported on their tax return as a principal residence, with a deduction for mortgage interest. So the right thing to do is go ahead with the sale of the Seattle property, taking advantage of the employer’s help with closing costs and rolling over the gain to the Eagle River home. Then move the gain from Eagle River to the new home.

Some of the gain does produce a tax under this scenario. The part that was rental property in Seattle gets prorated and treated by the tax rules for investment real estate. Brett and Sara can make any reasonable allocation between personal and investment portions. They could do a tax-deferred exchange for the investment portion, but I suspect the tax bill will be too small to make it worth it. Better to pay the tax and put the balance to work in their home or elsewhere.

“We are going to wind up with as much as $135,000, considering the employer reimbursements. Don’t we have to put it all down on our house?” Brett asked. No, that’s confusing the tax rules for investment property with the tax rules for personal property. With investment property all the cash has to move from the disposition to the replacement properties, usually through an intermediary. This means the taxpayer never has “constructive receipt”. In Brett and Sara’s case, most of the $135,000 is from the personal residence part, so most of it is not taxed and all the balance can be reinvested as they please. They already own their home so there’s no reason to make a further investment in it unless they want to pay down the mortgage balance.

This opens up every option for Brett and Sara. They can buy apartments, as Brett would like, since he believes this move fits with his retirement objectives. They can build a new home, as Sara would like, on the theory that they have worked hard and are well-enough off to want to spend some money on themselves. How this will turn out is anybody’s guess. I was the real estate counselor who helped recognize that they need to sell the Seattle property soon, or generate as much as $25,000 in taxes and lose $20,000 in employer-paid closing costs. The rest of the work may need to happen in the office of their marriage counselor.