Tax & Business Insights

Tax-Free Land Combo

Volume 17 Issue 1 --  January/February 2005

Many people, like Mr. and Mrs. K. Lever (“Klev”), purchased homes years ago only to find out that 20 years later the homes are worth a lot of money.  Can some or all of the gain on the sale of a house and adjacent land that has appreciated immensely be avoided?  The answer in some cases is Ayes.”

Let=s say that the Klevs purchased eight acres in 1965 for $80,000.  They used six of the acres for a commercial horse stable and the remaining two acres for their residence.  Fortunately, because they received good advice, they treated the six acres as business property and paid taxes and expenses out of a separate bank account for the stable.

In 2005, their property is worth $880,000.  Since their basis was $80,000 (ignoring improvements and depreciation), their gain would be $800,000 if they sold the property.  Using a 20% combined state and federal tax rate, their potential income tax would be $160,000 ( ignoring depreciation). 

Using two separate Internal Revenue Code provisions, one that allows excluding gain on sales of principal residences (' 121) and one that defers gain on exchanges of business and investment property (' 1031), the Klevs may be able to avoid paying tax on all of the $800,000 B legally.

Suppose their $80,000 basis was allocated 40% to the residence ($32,000) and 60% to the stable ($48,000). Instead of selling the property for $880,000, they exchanged it for a residence worth $350,000 and another investment property worth $530,000.

Under recent IRS guidance, the “gain” on the residential portion, $320,000 (40% of the $880,000 received, less the basis of $32,000), is essentially tax-free under ' 121.  The $480,000 “gain” on the stable portion of the property can be deferred if the requirements of ' 1031 are satisfied.

One mistake some people make is to fail to treat the horse stable as commercial or investment property. (See Newland=s Business Notes, “Reconstructing You,” January/February 2002)  This six acres should be handled as investment property and any improvements (stables) should be depreciated.  Note, in order to make our example simpler, depreciation on the stables has been ignored.

The IRS has recently blessed the use of this combo tax-deferral mechanism. In such cases, part of the gain is allocated to the residence and excluded from income as gain from the sale of a residence, while the remainder of the gain is allocated to the business use property and deferred using the like-kind exchange provisions.

Some commentators have even suggested that individuals should move out of their residence all together and rent it for two years prior to the sale of the property. The two-year wait for conversion of rental property to personal use is not part of tax law, but is often recommended because of certain IRS rulings stating that conversion from trade or investment use to personal use after two years is acceptable and does not defeat the tax-deferral mechanism of  ' 1031. 

Doing this would, some commentators say, allow more of the gain to be avoided or deferred, using a combination of the two Code sections, ' 121 and ' 1031, than would be possible under ' 121 alone. While this is a possibility, few couples may want to move out of their house for an extended period of time before selling it. 

Using the combo approach, gain in excess of the ' 121 limit ($500,000 for a married couple) would have to be invested in business or investment property which qualifies under  ' 1031.  The replacement property in a like-kind exchange can be vacant land or improved property for business or rental use.  In other words, any real estate investment will suffice under the like-kind exchange regime.

The tax law was changed in 2004 to require a five-year wait between acquiring property in a like-kind exchange and then selling the property claiming the ' 121 exclusion. This does not mean that individuals cannot convert what is rental property to personal use or vice versa. The conversion is permissible, but if a sale occurs within five years of the acquisition of the ' 1031 replacement property, then the exclusion of the $250,000 or $500,000 of gain (depending on the marital status) is not allowed.

While some writers are trumpeting the use of these Code sections, ' 121 and ' 1031, with the budget crunch now facing this country, there is a risk that ' 1031 might be repealed or limited by a revenue hungry Congress. For those who want to avail themselves of like-kind exchanges, perhaps they should not wait too long. Please contact us if you need help. 

Copyright 2005
By Tax and Business Professionals, Inc.
9837 Business Way
Manassas, VA 20110
(800) 553-6613

While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.

Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.