Tom Kelly: Some owners of fire-destroyed properties finally get a break

As I listened to a lifelong friend explain how a horrendous California fire was finally extinguished a few blocks from his property, the unfathomable idea of losing the family home and all of its contents surfaced again. It now is a real, annual occurrence for a growing number of residents.

What is new is a tax code ruling that assists some owners whose one-time principal residences were turned into investment homes and destroyed by fire and then subsequently sold. These owners can now exclude the gain not only on the home but also on a vacant land directly adjacent to the house even though they were not sold at the same time.

“This ruling can be a big help in many ways,” said Rob Keasal, real estate tax expert in the Seattle office of BDO USA LLP, formerly Peterson Sullivan LLP. “First, it points out that the gain on a vacant lot next to the house can be sheltered by the primary residence exclusion if the residence is sold within two years before or after the vacant lot.

“Second, even though the property had been converted to a rental and was thus investment property, it could still qualify for the primary residence gain exclusion.

“And third, that the land and building having been converted to investment property by being rented, could qualify for an exchange under 1031 to defer the gain in excess of the gain exclusion amount.”

Here’s an example provided by the IRS: The owners of a property are a married couple. The husband had purchased the property to use as a principal residence when he was single, and when the taxpayers married, they continued to use the property as their principal residence. Eventually, the couple moved into a new residence and their old residence was then rented out. The rental use ended when the property was destroyed by fire.

Following the fire, the taxpayers received insurance proceeds for the destroyed residence. Within two years after receiving the insurance proceeds, they sold the land without rebuilding the residence. The following year, they sold the adjacent lot.

The sale of the former dwelling unit destroyed by fire and then the sale of the adjacent land, although occurring in different tax years, were treated as one sale or exchange. The IRS noted that when applying the limitation on the amount of gain that could be excluded from income ($500,000 for a married couple), the gain from the sale or exchange of the dwelling unit should be excluded first. The IRS ruled “it was reasonable to apply those same requirements” to a sale of vacant land on which the dwelling unit used to be located.

The IRS also found that since the taxpayers held the destroyed property for investment, they could defer all or a portion of the remaining gain via a 1031 exchange.

In order to qualify for the $500,000 exclusion ($250,000 for single people), homeowners must have owned and used the property as a principal residence for two out of five years prior to the date of sale. Second, the owner must not have used this same exclusion in the two-year period prior to the sale. So, the only limit on the number of times a taxpayer can claim this exclusion is once in any two-year period.

Under the exchange rules, commonly known as 1031 Exchanges or Starker Exchanges, a taxpayer that exchanges property that was held for productive use or investment for “like-kind” property may acquire the replacement property on a tax-free basis. Because the replacement property generally has a low carry-over tax basis, the taxpayer will have taxable gain upon the sale of the replacement property.

The bottom line, according to Keasal, is an owner could keep some cash on the sale equal to the exclusion amount for a primary residence, and then defer the rest of the gain via a 1031 exchange.

“This is a win-win for taxpayers,” Keasal said.