The IRS Helps Cut Taxes
When Selling Your Home

February 16, 2005 -- A recent decision by the Internal Revenue Service could provide considerable relief to many homeowners facing huge price gains when they sell.

The sharp appreciation of house prices in recent years means many people could face steep capital-gains taxes. But in late January, the IRS put forth new guidelines that allow certain homeowners to defer paying taxes on a significant portion of those gains.

The new break doesn't apply to all homeowners, only to those who have home offices, or those who convert their house -- or a portion of it -- into a rental. The deferral applies only to the portion of the house used for commercial purposes.

Still, that affects a substantial amount of people. According to the IRS, the number of individual tax returns filed claiming deductions for home offices rose to about 2.5 million in 2002, the latest data available, from about 1.7 million in 1997. In a 2004 survey, the National Association of Realtors found that 12% of respondents said they were buying other houses, but keeping their existing homes -- presumably for investment purposes.

Some observers say the IRS's move will lead more people to rent their homes or set up a home office -- or lead people who already have such offices to report them. "People in the past would always question whether it was worth it to deduct a home office," says Julie A. Welch, an accountant and director of the tax department at Meara, King & Co., a Kansas City, Mo., auditing and accounting firm. "But now with this new pro-taxpayer guidance, it makes a whole lot more sense. If you structure it right, you can exclude or defer gain in almost all cases."

Next week, the IRS is scheduled to formally publish the new guidelines. Previously, homeowners weren't sure which circumstances allowed them to defer or exclude the gains from the "commercial" parts of their residences.

The guidance comes at a time when many homeowners, especially those who have lived in their houses for a number of years, are sitting on huge price gains. Home prices in the U.S. have risen 63% from the third quarter of 1999 to the third quarter of 2004, according to home-price research company Fiserv CSW Inc., of Cambridge, Mass. A number of housing markets have seen increases far beyond that.

Given the complexity of the guidelines, known as Revenue Procedure 2005-14, it makes sense to consult with a lawyer or tax adviser before attempting to take advantage of them.

For one thing, the IRS has complex rules on claiming expenses for business use of your home. In general, you must use part of the home "exclusively and regularly" as your principal place of business, or exclusively and regularly as a place to meet or deal with patients, clients or customers in the normal course of work -- or for rental use. If you are an employee, your business use must be for your employer's convenience, not yours.

Additionally, in order to take advantage of the deferral, the owner must purchase another property through what is called a 1031 "like-kind" exchange, and it must be either a commercial property or have a commercial component equal or greater to the value of the commercial portion of the property being sold.

For people selling a home, the top capital-gains rate, currently 15%, typically applies to profits of more than $250,000 for most single people and $500,000 for married couples filing jointly. For owners who bought in fast-appreciating markets five years ago, the profits from a sale could easily exceed those limits, meaning they would have to pay capital-gains taxes. When the current limits were set in 1997, lawmakers assumed few people would cross the profit threshold.

Here is how it works: If a married couple sells for $900,000 a house that cost, say, $200,000, the couple can exclude $500,000 of their $700,000 gain. Assuming they had rented the entire house before the sale, they could defer paying taxes on their remaining $200,000 gain by buying a replacement commercial property costing at least that much through a 1031 exchange.

If the couple had instead maintained a home office that was valued at $75,000, they could defer paying taxes on that amount if they purchased a commercial property of the same or greater value.

"It's a good thing for homeowners who also have a home business because it clarifies that they can later sell the house and still use the principal residence exclusion for the entire house, even if they were using part of it for business," says Randy Markowitz, an accountant and partner with FGMK LLC, in Bannockburn, Ill.

Another benefit: The couple also can defer back taxes on any depreciation deduction they took earlier on the commercial part of the property. Gains from depreciation deductions are taxed at 25%, much higher than the 15% capital-gains tax.

While the new guidance helps homeowners, it also can open up a legal and accounting minefield. "Trouble could come from trying to claim the home-office treatment when it's not eligible, claiming too large a percentage of a residence as a home office, or not satisfying the highly technical 1031 rules," says Louis S. Weller, of Deloitte & Touche LLP's national real-estate tax services group in San Francisco.

Some homeowners may find the road to qualifying for this new break a little daunting. For example, when trying to sell a home and defer the gains on the commercial portion, it no longer is simply selling a house but structuring an exchange transaction, which means filling out more tax forms and adhering to strict deadlines and rules. It is more akin to being a commercial investor than a homeowner.

In a 1031 exchange, the replacement property has to be identified within 45 days, and the exchange has to be completed within 180 days, or the tax deferral is forfeited. A specialized 1031 intermediary has to be retained to handle the transaction. Fees for intermediaries run as much as $1,000.

"If you don't set it up as an exchange, then you won't get the tax-deferral treatment," says Adam Handler, of the like-kind exchange services group with PricewaterhouseCoopers in Los Angeles. "Most people, if they're thinking about selling a house, are not thinking about the exchange machinery."

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