Keep the Tax Man Away
From a Property Profit

Question: My husband and I are active-duty military personnel. We bought a home in Charleston, S.C., years ago, but were transferred to another state shortly thereafter. We have kept that house as a rental property since 1991, but we never returned to the area to utilize the home as our residence. The house is now paid for and we are ready to purchase a retirement home. Can the equity from our original home be rolled into a new one? Is there any way to avoid capital-gains taxes so that we don't lose so much of our investment?

-- Susan, Biloxi, Miss.

Susan: The rules for excluding as much as $500,000 per couple in gains from a personal residence are clear: You must have lived in the home for two of the past five years. Since you didn't do that, I don't see how you can qualify for the exclusion. (There may be a special circumstance involving military service, but because it has been 11 years since you lived in the home, I doubt it would apply.)

However, there may be another answer. You say your home is currently a rental. It might be possible to orchestrate a Section 1031 tax-deferred exchange for another home to which you would eventually retire. In other words, you could trade this house for another and, in effect, roll over the capital gain. The catch is that these sorts of trades must be for "like kind" property, which means the house that you buy also must be held for investment purposes as a rental. But after a period of time -- perhaps a year or more – of holding it as a rental, you may be able to convert it to a personal residence and move in, thus deferring payment of the capital-gains taxes even further.

If it sounds complex, that is because it is. Tax-deferred trades are tricky. Consult with your tax professional before taking any action.

-- Mr. Irwin has more than 25 years' experience as a Los Angeles-area real-estate broker. He is the author of more than two dozen books about real estate and is recognized as one of the most knowledgeable writers in the real-estate field. Mr. Irwin's most recent book is "Tips and Traps When Renovating Your Home," (McGraw-Hill, 2000).

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