Swap, Convert   and Avoid a Tax Bill

For example, assume you and your spouse bought a nice home in an expensive area many years ago. The property's fair market value is $2.8 million, but its tax basis is only $450,000. So if you sell, the taxable gain would be $1.85 million ($2.8 million value minus $450,000 basis minus $500,000 federal gain exclusion for married sellers). Let's assume your combined federal and state tax capital gains tax rate would be 20 percent (15 percent federal plus 5 percent state). That translates into a $370,000 tax bill (20 percent tax rate times $1.85 million gain equals $370,000).

If you really don't want to pay that much tax, here's an IRS-approved four-step strategy:

Step 1

Convert your home into a rental property.

Step 2

Swap the home for income-producing real estate (such as a small apartment building or a percentage ownership interest in a shopping mall). If the swap is done properly, it will qualify as a tax-deferred like-kind exchange under Section 1031 of the Internal Revenue Code. So you avoid the large tax bill.

Step 3

 Take cash out of the deal up to the amount of profit you can shelter with your federal home sale gain exclusion (generally, up to $250,000, or $500,000 if you're a married joint filer).

Step 4

 If possible, hang onto the income-producing real estate until you die.

This "convert-and-swap" strategy avoids any immediate federal capital gains tax. Plus, it converts most of your home equity into an income-producing asset. Even better, you can collect a substantial amount of federal-income-tax-free cash thanks to the gain exclusion break. Last but not least, if you continue to own the replacement property (the income-producing real estate acquired in the like-kind swap) until you die, the property's tax basis will be stepped up to fair market value as of the date of death. This means your heirs can sell the replacement property with little or no federal capital gains tax hit (assuming the current date-of-death tax basis step-up rule, under Section 1014(a) of the Internal Revenue Code, will remain in the tax code through 2010 and beyond).

How to Convert Your Residence into a Rental Property

To make this strategy work, you must first be able to convince the IRS that you converted your former home into a rental property. After that objective is accomplished, you can swap your former home in a tax-deferred like-kind exchange. Why? Because the like-kind exchange privilege is only available when you trade business or investment property for other business or investment property. Therefore, if you fail to convert your former residence into a rental, your attempted like-kind exchange will be treated as a regular taxable sale with the resulting large tax bill. So how do you do convert your home into a rental property and meet all the tax law requirements? The IRS has answered that question in some recent guidance.

According to the IRS, you can convert a former personal residence into a rental by renting it out for at least two years before swapping it for the replacement investment real estate. (IRS Revenue Procedure 2005-14)  What about renting for one year or 18 months? That might be sufficient, but there's no guarantee, because the IRS has not provided any guidance beyond the two-year rental period mentioned in Revenue Procedure 2005-14. So the prudent action is to rent out your former home for a full two years at market rates before making a swap. That will lock in the desired tax-deferred like-kind exchange treatment.

Next, Combine the Two Breaks to Collect Tax-Free Cash

By carefully timing your transactions, you can also arrange to receive up to $250,000 of federal-income-tax-free cash as part of your property swap ($500,000 if you're a married joint filer). You accomplish this by combining the like-kind exchange break with the federal gain exclusion break. Using the above example, after converting your unmortgaged $2.8 million principal residence into a rental property, you could arrange a like-kind swap for an unmortgaged piece of income-producing real estate worth $2.3 million, plus $500,000 of cash ($2.3 million plus $500,000 equals $2.8 million). Assuming you qualify for the maximum $500,000 joint-filer gain exclusion, all the cash is federal-income-tax-free.

Here are the tax-law specifics behind this part of the strategy. In a like-kind exchange, your receipt of cash (called "boot") generally triggers taxable gain equal to the lesser of:

More Good News     In Revenue Procedure 2005-14, the IRS also explained how taxpayers can combine the like-kind exchange and federal gain exclusion in more complicated situations, such as when part of the residence was used as a rental property or a deductible office in the home. Your tax adviser can provide details if this applies to you.

• The inherent gain on your residence (fair market value minus your tax basis in the property).
• The amount of cash boot you receive in the exchange.

However, the IRS states in Revenue Procedure 2005-14 that you can use the home sale gain exclusion to shelter otherwise taxable gain from the receipt of cash boot. The three requirements to qualify for the gain exclusion are:

1. The property you are exchanging (your former principal residence) must have been owned by you for at least two years during the five-year period ending on the exchange date.

2. The exchanged property must have been used by both you and your spouse as your principal residence for at least two years during the same five-year period.

3. You must not have claimed an earlier gain exclusion within two years of the exchange date. The same goes for your spouse.

If you're unmarried, you must meet the first two standards to qualify for the smaller $250,000 gain exclusion amount (the third rule obviously doesn't apply).

So the trick here is to make sure you get the timing exactly right. Specifically, if you rent out your former principal residence for more than three years during the five-year period ending on the exchange date, you'll fail the second test and lose the valuable gain exclusion break. However, as explained earlier, it's prudent to rent the home for at least two years to clearly establish that you've converted it into a rental property for like-kind exchange purposes. In summary: Two years of renting is good, but more than three years is too long to preserve the gain exclusion privilege.

If you're interested in implementing this strategy for your greatly appreciated principal residence, consult with your tax adviser. Section 1031 like-kind exchanges are sophisticated maneuvers that generally require professional assistance. Your tax adviser can also answer any other questions you may have about the tax consequences of selling a home.