Protect Against Residence Capital Gains Tax
(UPDATED) IRS RULED THE USE OF PATS ARE NO LONGER A VALID TAX PLANNING VEHICLE.
The Private Annuity Trust (PAT) is an annuity trust that allowed property owners to accomplish the deferral of capital gains tax and depreciation recapture without entering into a risky installment sale. There is no maximum transaction size and the PAT could be used on any kind of real estate such as a primary residence, rental properties, vacation homes, commercial properties, and raw land. However, per the update, this is no longer the case.
IRS Relaxes Sale Exemption Requirements
Until 2003, business use including home office, day-care, and partial rental activity limited capital gain exemptions on the sale of a residence. Business use no longer puts constraints on home exemption rules – as long as use falls within the primary residence (as opposed to a separate structure).
Additionally, IRS offered guidance on unforeseen circumstances – allowing partial exemption. Background: In order to qualify for full exemption limits, homeowners must occupy the residence for 24 months within a five-year period prior to date of sale.
If occupancy requirements are not met, several safe harbor rules now provide partial exemption. 1) Loss of employment 2) divorce or legal separation 3) multiple births from single pregnancy 4) man-made or natural casualty 5) death. Other exceptions include job change, poor health and partial sales.
Real Estate Professionals
Real property professionals who satisfy certain participation requirements are entitled to offset wage and other non-passive income with their rental real estate losses. However, real estate appraisers and mortgage brokers are excluded from the unlimited rental loss deduction. Qualifying taxpayers must meet the following criteria annually:
- Actively engaged in real property trade/businesses defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
- Expend more than 750 service hours in your real estate business activities.
- More than 50% of your services must be performed in real estate businesses and meet “material participation” guidelines as defined by the IRS. Material participation often disqualifies taxpayers that don’t elect to aggregate each rental property into one activity. Consult your advisor for elections and rules pertaining to your situation.
Transferring Property Tax Basis
Many homeowners, when they become age 55 or older decide to sell their residence and move into a smaller home. California permits homeowners at least age 55 or disabled to transfer their existing property tax-base to the replacement residence. Like all loopholes, there are burdens and constraints that must be satisfied to achieve the tax-base transfer. For instance, county-to-county transfers are allowable but only among 10 counties; the replacement home purchase price may not be greater than 110% of the original property sale price (105% if the replacement residence is purchased within the first year following the date of sale), and the replacement home purchase must be completed within two years (from the original sale date). The state’s backlog for evaluating applications currently exceeds six months.
Maximizing Use of Capital Losses
You can deduct capital losses from sale of investment assets to the extent they equal your capital gains. If your losses exceed your capital gains, you can only deduct up to $3,000 of those losses in a given tax year against ordinary income, with the excess carried over to subsequent years. Due to the change in the capital gains tax rules, you may want to consider disposing of your capital losses only in the years when you have little or no capital gains, or only short-term capital gains. For taxpayers in the highest tax bracket, the capital losses are better used to offset ordinary income rather than long-term capital gains, which are taxed at 15%.
Like Kind Exchanges
There is a misconception among some taxpayers that a tax-free like-kind exchange simply means the sale of property followed by reinvestment into another piece of property within a designated period of time.
While this may be the case in certain situations, there are more specific rules to follow in order to protect the tax-free nature of the transaction. A simple like-kind exchange exists when two individuals exchange pieces of property with no additional payments. More sophisticated transactions involve the exchange of liabilities or unlike property in addition to the like-kind property. If a sale of property followed by the repurchase of new property is to qualify as a like-kind exchange, an intermediary (third party) must be involved to orchestrate the exchange. The transferor must not receive the cash from the transaction and use it to purchase new property. If cash or unlike property is received, the smaller of the gain on the exchanged property or the value of the cash or property received will be taxable.
The tax-free treatment will only apply when the property is used for the business or investment purposes. The property must be of like kind based on the IRS classification of depreciable assets. The real property category is far more generous than other categories. Under the real property designation, land may be exchanged for an apartment house or a storefront and still qualify as a tax-free exchange.
The time period associated with the tax-free exchange refers to an exchange where the transferor gives up a piece of property and must identify the property to be exchanged within 45 days. The exchange must be completed within 180 days to insure tax-free treatment. If a third party is not involved, the exchange may take place simultaneously.
The key issue to remember is that if a transferor takes physical or constructive possession of sale proceeds, a like-kind exchange will not exist.
“Secure” That Home Mortgage Interest Deduction
To deduct interest as a home mortgage interest expense, the underlying loan must be secured by your residence; if it isn’t, the interest deduction may be disallowed. In some instances, case law has refuted IRS regulations if the taxpayer can prove benefits and burdens of home ownership.
Real estate holding in an IRA
Can you do it? Yes, but you must comply with several restrictions. A minor deviation can cause the entire IRA to be assessed for income tax and penalties. Disallowed transactions include holding property for personal use such as a principal residence or vacation home. Beyond that, you need an IRA custodian willing to purchase and manage investment property. You’re also required to fund the IRA with sufficient assets not only to purchase the property, but cover unanticipated expenses (since your annual contributions are limited). Should all that work out, you may end up increasing your tax liability. You’ll defer income and capital gains tax, but when distributions commence, all proceeds will be taxed as ordinary income. Since a substantial part of rental property gains are likely to be long-term and taxed at 20%, you may be converting capital gain income to ordinary income – taxed at 35%. FOR INVESTORS LOOKING TO ADD REAL ESTATE TO THEIR IRA PORTFOLIO, consider professionally managed real estate investment trusts or REITs as a viable alternative; they avoid tax pitfalls and allow for meaningful diversification within the sector.