Free Cash or The Principal Residence Exclusion.

What Does that Spell? 

The Good Life.

 I recently wrote an article that predicted Congress, with their need to create money to pay off the national debt, would compromise the step up in cost basis upon the death of a property owner. Currently, when you die, your property is transferred to your kids at its true market value vs. its original cost basis. That may no longer be true and your heirs may get stuck with a hefty tax bill. So, suggesting that this may happen, what should you do?

What many people don’t know is that you can use the exclusion several times as long as you did not take the exclusion on another residence in the prior two years. You may use it on new acquisitions and properties converted from rentals to principal residences. If you understand the nuances of the exclusion, given time, and some moving about, you can literally back yourself out of significant capital gains tax. Here are some things you need to know.

First, just because you have multiple houses doesn’t mean that one of them is your principal residence. The IRS has ruled that you must demonstrate that you comply with several “facts and circumstances” regarding your principal residence. Here are the questions you need to ask:

ü Where do you spend most of your time?

ü Where is your place of employment?

ü What is the address on your federal and state tax return?

ü Where do you vote?

ü Where do you have your car(s) registered?

ü Where is your mail sent?

ü Where do you have your principal banking relationships?

ü Where do other family members live?

ü Where do you belong to social or religious organizations or clubs?

Now, of course, there are ways to work around these guidelines? It is understanding them that makes the difference.

 Secondly, with the boom of residential development, we have been asked several times, “what about our fifty acres we sold with our home to the developer?” The answer is that if you sell the vacant land within two years before or after the sell of your home and the land is contiguous to the house, you may include it in the exclusion. However, with the prices developers are paying, this may not be enough. In that case, we suggest two escrows where one is for the house and some land and call that your principal residence and the other is investment property where you do a 1031 exchange. After all, the balance of the land that you bought with the house was for investment purposes, right?

 For those of you that carried on a business in your home and took depreciation for that use, you will pay tax on the gain for that portion that you depreciated, however you may exclude any additional gain up to the maximum amounts permitted. If, for example, your business purposes were located in a separate building that was on the property you divided off for your 1031 exchange, that depreciation would transfer with your cost basis onto your replacement property of your exchange. This maximizes the exclusion on the gain of your principal residence and transfers the depreciation over to your investment property.

 Thirdly, if you convert a rental home to your principal residence, you must hold the property for the full five years to qualify for the exclusion. Remember the rule is two nonconsecutive years out of the last five. You can move in and out of your rentals over the five year period or you can move from one to the other, one at a time.

 To illustrate the potential of this tax strategy, let me outline a scenario that significantly eliminates the payment of capital gains tax. 

EXAMPLE:

Bill and Ruth own a home in Portland, Oregon worth $675,000. They bought it 20 years ago for $150,000. Bill started acquiring rental homes and duplexes in the surrounding area and now has 4 properties all worth $450,000. He bought them for $100,000 each and they are now fully depreciated. Bill and Ruth have two children. Their daughter lives in San Diego and their son lives in Seattle. Bill is retiring in four years. Bill and Ruth want to start downsizing and preparing for retirement.

If they sell their house and take the exclusion, they will walk away with $650,000 (net) cash and no tax. If they sell their rentals, they will pay $432,000 in capital gains tax plus depreciation recapture. Instead, Bill and Ruth sell their home and put the money in a safe investment that generates them 7.5% or $4,062.50 in monthly income from the interest alone. It is taxed at the ordinary income rates. Bill and Ruth then move into their favorite rental and exchange two rentals for a small but comfortable home in Seattle and a condo in Orange County, together averaging $2,000 per month net income. Two years

go by and Bill and Ruth now sell the property they are living in for $525,000 (net) and take the principal residence exclusion, leaving a capital gains tax (15% federal and 9% state) of approximately $6,000. ($525,000 - $500,000 = $25,000 x 24% = $6,000) Bill and Ruth invest the $519,000 at 6% and receive $2,595 monthly interest only payments. Now they are earning $8,657.50. ($4,062.50 + $2,595 + $2,000 = $8,657.50)  Another two years goes by and Bill and Ruth sell their house again, this time for only $475,000 (net). They pay no capital gains. They are a little more aggressive this time and place their money in an investment that generates 8% or $3,166 interest only monthly payments. Their monthly income is now $11,824.16. Bill and Ruth flip a coin. Seattle wins. They move into the rental in Seattle, enjoy their grandchildren and sell it in two years for $650,000 (net), having owned it for six years. They reinvest their free money ($500,000) at 6% or $2,500 per month ($13, 324.16 total monthly income) and set up college funds for their grandchildren with the balance of $127,500 ($650,000 - $500,000 = $150,000 x 15% = $22,500) Now it is time to move to Orange County. Two years go by and they sell their condo for $750,000. After paying capital gains tax on $250,000 (15% federal, 9.3% state), they have put the $189,250 into the college fund. 

Is this where the story ends? Not exactly. Obviously, there could be many variations to the story, but in the end, Bill and Ruth then took the $500,000 they earned on the sale of the Orange County condo and bought a fully furnished hacienda in Mexico, complete with swimming pool, ocean view, a summer breeze and a full time cook and gardener. Bill and Ruth can afford to fly their children in two or three times a year since they are now living on a monthly income of $12,324.16 and $2.15 million earning interest in secure US investments.

Mark C. Hughes is President and CEO of Virtuosity Unlimited, LLC which operates with a team of advisors to help those with highly appreciated assets or lucrative businesses to downsize or transition their equity into viable options without paying unnecessary taxes in the process. Mark can be reached at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it or visit www.virtuositypro.com. Mr. Hughes and Virtuosity Unlimited, LLC publishes the VirtuosityPro eNewsletter as a service to its clients and their advisors. While we make every effort to ensure the accuracy and reliability of the information published, we do not warrant or guarantee the accuracy of the information or its fitness of purpose.