Tom Kelly: Rent out your home to get best of cash, tax worlds

If you are concerned about Uncle Sam taking a chunk of your home sale and you have the wherewithal of renting out your primary residence for two or three years, there could be a tax-free strategy in your future.

Last week, we addressed the concerns of “Ruth from Seattle,” a senior widow who telephoned a call-in radio show about the tax liability on the sale of her primary residence.

Ruth said the $100,000 home she bought 35 years ago was now worth about $825,000. If she sold and took her $250,000 exclusion for a single person ($500,000 for a married couple) she would be required to pay capital gains tax on the difference – $475,000.

Ruth wanted to know the possibility of the exclusion being raised or the chance she could trade the ability to pocket the gain every two years for a greater, one-time exclusion. Given the history of home sale exclusions, the possibilities of an increase in the next few years are remote.

Ruth’s concerns have been voiced by other sellers – especially seniors who view their home as their only real asset. Not only has the real estate market rocketed higher since the tax law changed nine short years ago, but the once-generous exclusion now seems quite ordinary in most of the country’s expensive markets.

However, there is a strategy sellers can use to pocket their exclusion and roll the difference into another real estate investment that might help generate additional income or equity.

Last year, guidelines were adopted that would allow investors who kept their home and used it as a rental property to take the exclusion without facing federal income tax liability. This money, known as “boot” in tax circles, previously had come with a tax tag.

For example, let’s say Ruth rented out her $850,000 home and moved to Arizona and lived with her sister. She continues to rent the home for two years. Then, she sells her home and takes $350,000 cash free. She can take the remainder ($475,000) and roll it into another piece of investment real estate – perhaps a share of an apartment building. She can derive income from the investment during her lifetime and then eventually place it in a charitable trust to avoid future tax liability.

In order to qualify for the exclusion, 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.

“The IRS has allowed taxpayers to mix the rules on principal residences and investment property,” said Rob Keasal, partner in the Seattle accounting office of BDO USA LLP. “The rules do not apply to all 1031 Exchanges, only those that feature the use of a taxpayer’s former primary residence.”

Under the popular “like-kind” exchange rules of IRS Section 1031, commonly known as a Starker Exchange, no gain is recognized on the exchange of property held for investment if the property is exchanged for another investment property of equal or greater value. (When Ruth converts her home to rental status, it becomes investment property). If a consumer also receives cash or property that is not like-kind property (boot) in an exchange that otherwise qualifies as a like-kind exchange, the taxpayer recognizes gain to the extent of the boot. The like-kind exchange rules do not apply to property that is used solely as a personal residence.

However, the 2005 ruling addresses a combination of the above with the ability to pocket $250,000 of $500,000 of gain on the sale of a primary residence.

If you want to sell your home and have another place you can call home for a couple of years, take some time to gauge the positives and negatives of renting out your home. The strategy could net you enough cash and save on taxes.