Author: Simon Filip

Simon Filip, CPA, MSPA, MST

Tax Implications on Sale of a Partnership Interest

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In determining gain or loss on sale of a partnership interest, taxpayers are often surprised to find they have a taxable gain.

For income tax purposes gain or loss is the difference between the amount realized and adjusted basis of the partnership interest in the hands of the partner.

Amount Realized

The amount the partner will realize will include any cash and the fair market value of any property received.  Further, if the partnership has liabilities, the amount realized will include the partner’s share of the partnership liabilities. If the partner remains liable for the debt, the amount realized will not include the partner’s share of the liability.Tax Implications on Sale of a Partnership Interest

Examples of Amount Realized:

Example 1 – Sale of Partnership interest with no debt:

Amy is a member in ABC, LLC which has no outstanding liabilities. Amy sells her entire interest to Dave for $30,000 of cash and property that has a fair market value of $70,000. Amy’s amount realized is $100,000.

Example 2 – Sale of partnership interest with partnership debt:

Amy is a member of ABC, LLC and has a $23,000 basis in her interest. Amy’s membership interest is 1/3 of the LLC. When Amy sells her 1/3 interest for $100,000 the partnership has a liability of $9,000. Amy’s amount realized would be $103,000 ($100,000 + ($9,000 x 1/3).

Gain Realized

Generally, a partner selling his partnership interest recognizes capital gain or loss on the sale. The amount of the gain or loss recognized is the difference between the amount realized and the partner’s adjusted tax basis in his partnership interest.

Example 1 (from above)- Sale of Partnership interest with no debt:

Assume Amy’s basis was $40,000. Amy would realize a gain of $60,000 ($100,000 – $40,000).

Example 2 (from above) – Sale of partnership interest with partnership debt:

Amy’s basis was $23,000. Amy would realize a gain of $80,000 ($103,000 realized less $23,000 basis).

Character of Gain

Partnership taxation establishes the general rule that gain on sale a partnership interest receives favorable capital gain treatment.  However, gains attributable to so-called “hot assets,” which include inventory, depreciation recapture, and accounts receivable of a cash basis partnership are taxed at less favorable ordinary income rates.

To the extent that a sale is attributable to the selling partner’s share of the hot assets, the resulting gain or loss is taxed at ordinary income rates. When real estate is sold to the extent the gain on sale is attributable to depreciation deductions, the resulting gain is treated as unrecaptured IRC §1250 section gain. §1250 gain is taxed at a flat 25% rate.

Like-Kind Exchange

It is important to note that in IRC §1031 (like-kind exchange), non-recognition treatment does not apply to exchanges of partnership interests.

We’ve Got Your Back

If you’re selling your partnership interest, we can help you plan the sale so that you pay no more tax than necessary. Contact Simon Filip, the Real Estate Tax Guy, at sfilip@krscpas.com or 201.655.7411 today.

Estate Tax Implications for Foreign Investors in US Real Estate

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Estate taxes for US persons

An estate of a US citizen or resident alien is subject to an estate tax based upon the value of the worldwide property, owned or subject to certain rights or powers by the decedent on the date of death. The estate tax rate for 2018 is 40% for taxable estates in excess of an $11.18 million exemption, which is adjusted annually for inflation.Estate Tax Implications for Foreign Investors in US Real Estate

A US estate may also deduct from the taxable estate a marital deduction equal to the value of property left to a surviving spouse. The amount of lifetime taxable gifts during the decedent’s life is also included in calculating the gross estate.

Non-resident aliens and their estate taxes

While US citizens and residents are subject to worldwide estate and gift taxation on their gratuitous transfers, non-residents (persons who are neither US citizens nor US domiciliaries) are only subject to the US estate tax on property that is situated, or deemed situated, in the United States.

The gross estate of a Non-Resident Alien (“NRA”) includes all tangible and intangible property situated in the US, in which the decedent has an interest at the time of his death or over which he has certain rights or powers.

The taxable estate of an NRA is taxed at rates up to 40% of the value of estate in excess of a $60,000 exemption. Additionally, the estate of an NRA is generally not allowed a marital deduction unless the surviving spouse is a US citizen.

US property included in an NRA’s estate includes US real property owned or under his control and interests in US partnerships (including those holding positions in real property).

It is important to note the US does have estate tax treaties with multiple countries including Canada, France, Germany, Greece, Italy, Japan, and the UK, amongst others. These treaties may provide estate tax relief to residents of treaty jurisdictions.

Non-citizen spouse

When your spouse is not a US citizen, the unlimited marital deduction is unavailable. This is true regardless of whether or not the decedent is an American citizen. The result is the $11.18 million exemption is unavailable and the entire estate transferred to a non-citizen spouse would be subject to estate tax. With advance planning, the non-citizen spouse estate tax implication can be reduced or eliminated.

Planning to reduce estate taxes

There are several structures that will avoid or minimize the US estate tax of a Non-Resident Alien:

  1. The property can be held in the name of a foreign corporation.
  2. The property can be held in an irrevocable trust or a trust whose assets would not be included in the settlor’s gross estate for US estate tax purposes.
  3. The title can be held in a two-tier structure with the property in the name of an American company (US real property Holding Corporation) whose shares are held by an offshore company.

Although these structures are intended to avoid the US estate tax, the structures may result in the unintended consequence of higher taxes on sale, rental income, and, in some jurisdictions, franchise taxes.

We’ve got your back

If you are a Non-Resident Alien, we can help you plan so that your estate pays no more tax than necessary, while avoiding those unintended consequences. Contact Simon Filip, the Real Estate Tax Guy, at sfilip@krscpas.com or 201.655.7411 today.

Qualified Opportunity Zones under the Tax Cuts and Jobs Act

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QO Zones offer incentives for investment in low income communities

Qualified Opportunity Zones under the Tax Cuts and Jobs Act

The Qualified Opportunity Zone Program (“QO Program”) enacted as part of The Tax Cuts and Jobs Act is a new incentive designed to promote investment in low-income communities by allowing taxpayers to defer, reduce, and potentially exclude gain recognition on certain investments made in Qualified Opportunity Zones (“QO Zones”).

Qualified Opportunity Funds (“QO Funds”)

Investors wishing to utilize the Opportunity Zone Program must invest their gain in a QO Fund. In order to meet the criteria of a QO Fund, 90% of the assets held by the vehicle on the last day of the fund’s taxable year (and the last day of the first six month period of the fund’s taxable year) must be qualified opportunity zone property (“QOZ Property”) within a QO Zone acquired after December 1, 2017.

The Act requires the Treasury Secretary to establish guidance for the certification process of QO Funds, which will likely be administered by the Department of Treasury’s Community Development Financial Institutions Fund (“CDFI Fund”).

What are QO Zones?

The QO Program requires a QO Fund to make direct or indirect investments in a QO Zone. Qualified Opportunity Zones (QO Zones) are defined as certain low-income communities that are experiencing uneven economic development, resulting in pockets of disinvestment and unemployment.

In New Jersey, Governor Murphy nominated 169 low-income tracts in 20 counties for designations a QO Zones. On April 9th, the U.S. Department of Treasury approved Governor Murphy’s designation of such tracts as QO Zones.

Tax Benefits of Investing in Opportunity Zones

The QO Program offers three tax benefits for investing in low-income communities through a QO Fund:

  1. A temporary deferral of inclusion in taxable income for capital gains reinvested in an Opportunity Fund. The deferred gain must be recognized on the earlier of the dates on which the opportunity zone investment is disposed of or December 31, 2026.
  2. A step-up in basis for capital gains reinvested in an Opportunity Fund. The basis is increased by 10% of the investment in the Opportunity Fund is held by the taxpayer for at least 5 years and an additional 5% is held for at least 7 years, thereby excluding up to 15% of the original gain from taxation.
  3. A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in an Opportunity Fund if the investment is held at least 10 years. This exclusion only applies to gains accrued after an investment in an Opportunity Fund.

Other Highlights

Some important items to note under the QO Program:

  1. Gains must be reinvested within 180 days in order to qualify for tax deferral under the QO Program.
  2. There is no “like-kind” requirement as part of the program. An investor could sell a mutual fund and reinvest gains into a QO Fund that will develop real estate in one of the selected census tracts.
  3. The program is still being formulated. The next step is for the Treasury Department to promulgate regulations for the establishment of Opportunity Funds, the vehicles which QO Zones investments will be made.

We’ve got your back

Like many other aspects of the new tax law, QO Zones can get complicated. With Simon Filip, the Real Estate Tax Guy, on your side, you can focus on your real estate investments while he and his team take care of your accounting and taxes. Contact him at sfilip@krscpas.com or 201.655.7411 today.

Tax Cuts & Jobs Act and Section 199A

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Tax Cuts & Jobs Act and Section 199AFor taxable years beginning after December 31, 2017 and before January 1, 2026, non-corporate taxpayers (individuals, trusts, and estates) may take a deduction equal to 20 percent of Qualified Business Income (QBI) from partnerships, S corporations, and sole proprietorships.

QBI includes the net domestic business taxable income, gain, deduction, and loss with respect to any qualified trade or business.

The deduction is available without limitation to individuals as well as trusts and estates where taxable income is below $157,500 if single and $315,000 if married filing jointly. There is a phase-out when taxable income from all sources exceeds $157,500 to $207,500 for single filers and $315,000 to $415,000 if married filing jointly. The deduction is 20 percent of the qualified business income, further limited of 20 percent of taxable income.

For example: Amy is a small business owner and files a schedule C.

  • Amy made $100,000 net income from her business in 2018.
  • Amy files a single return and her taxable income is $70,000.
  • Amy’s Sec. 199A deduction is 20% of $70,000, or $14,000.

QBI is determined for each trade or business of the taxpayer. The determination of accepted trades takes into account these items only to the extent included or allowed in the taxable income for the year. This figure cannot be deducted on the business return. There are two different categories in which trades and business can classified, Specified Service and Qualified.

Specified service means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architecture, originally included as specified service trades or businesses, were omitted in the final version of the TCJA.

Qualified means any trade or business other than a specified service trade or business and other than the trade or business of being an employee. Industry types include manufacturing, distribution, real estate, construction, retail, food and restaurants, etc.

The Section 199A deduction for individuals above the taxable income threshold is limited to the greater of either:

  • 50 percent of the taxpayer’s allocable share of W-2 wages paid by the business, or
  • 25 percent of the taxpayer’s allocable share of W-2 wages paid by the business plus 2.5% of the taxpayer’s allocable share of the unadjusted basis immediately after acquisition of all qualified property

Taxpayers should run the numbers through both provisions to ensure they received the best possible deduction.

We’ve got your back

The new tax code is complex and every taxpayer’s situation is different – so don’t go it alone! Contact Simon Filip at sfilip@krscpas.com or 201.655.7411 to discuss your situation.

What You Need to Know About Individual Tax Extensions

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What You Need to Know About Individual Tax ExtensionsBasic Rules for Individuals

For individual taxpayers, the Internal Revenue Service (IRS) grants a six month extension to file your taxes each year as long as you complete Form 4868.

Filing an extension does not remove a taxpayer’s obligation to pay their income tax by April 15th. Taxpayers are expected to pay income tax to the IRS on time or they will be subject to late fees, penalties, and interest. This means taxes owed should be remitted by April 15th, regardless of an extension request.

Taxpayers have a few extra days this filing season. April 15th falls on a Sunday and Emancipation Day in the District of Columbia is observed on April 16th, resulting in a due date of April 17, 2018 for 2017 returns.

The extension allows taxpayers to gather all information needed to file a complete and accurate return without being assessed a late filing penalty. Taxpayers with complicated tax returns and those who have invested in partnerships or S Corporations and do not receive their K-1s until after the original April 15th due date should request extensions. The entities may have extended their own due dates, resulting in returns not being required to file until September 15th, with extensions.

A Federal income tax extension is good for six months, which extends an individual taxpayer’s filing deadline from April 15th to October 15th.

Penalties

Regardless of when an individual files a tax return, if the tax owed is not paid by the original  filing deadline (April 15th for individuals), the IRS will assess penalties.  The IRS will charge 0.5% each month of the amount of tax owed after the deadline.

When a taxpayer fails to file a return by the extension date, the penalty increases to 5 percent per month and subject to a maximum penalty of 25 percent.

State Extensions

The rules on state extensions are similar to those of the Federal. If the taxes are not paid by the original due date, there may be late payment penalties and interest. Some states do not require a separate extension to be filed if there is no tax due. For example, New Jersey grants an automatic extension of 6 months if there is no balance due and a Federal extension is filed. New York, on the other hand, requires an extension filing even if there is not a tax due with the return.

If you’re interested in learning more about how to manage your taxes, contact KRS today for a complimentary initial consultation.

The New Tax Law and Business Interest Expense

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The New Tax Law and Business Interest Expense

The tax legislation known as the Tax Cuts and Jobs Act (the Act) places a new limit on the amount of interest expense businesses can deduct on their tax returns. This new limit will punish over-leveraged companies and discourage companies from becoming too leveraged.

Starting in 2018, businesses can only deduct interest based upon a formula contained within the act.

Business Interest Deduction

Under the new tax law, a business’s net interest expense deduction is limited to 30 percent of EBITDA (Earnings before Income Taxes, Depreciation, and Amortization). Beginning in 2022 the net interest expense deduction limitation is 30 percent of EBIT (Earnings before Income Taxes).

Businesses with average annual gross receipts of $25 million or less for the prior three years are exempt from this provision. The amount of business interest not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year. Business interest may be carried forward indefinitely, subject to certain restrictions.

Real Estate Exception

Real estate is both illiquid and capital intensive, making leverage and the ability to deduct interest important to the industry.  A real property trade or business can elect out of the net interest expense deduction limitations if they use the Alternative Depreciation System (ADS) to depreciate business-related real property.

Taxpayers electing to use the real estate exception to the interest limit must depreciate real property under longer recovery periods prescribed by ADS. Those recovery periods are 40 years for nonresidential property, 30 years for residential rental property, and 20 years for qualified interior improvements. This is compared to recovery periods of 39 years for nonresidential property, 27.5 years for residential rental property, and 15 years for qualified interior improvements.

Application to Partnerships

Most real estate investment vehicles are structured as pass-through entities. The limitations on current interest expense is applied at the operating entity level, and any allowable deduction is included in the non-separately stated income or loss on each partner’s Form K-1. However, any disallowed interest will be carried forward at the partner level.

Aggregation Rules

In groups of related entities, it appears aggregation rules will apply in determining whether the $25 million gross receipts threshold has been exceeded. Additional guidance is anticipated on calculations of the limitation as well as explanations as to how this section will interact with other sections of the Internal Revenue Code.

We’ve Got Your Back

Rather than guessing at how the business interest rules apply to your situation, why not let the experts at KRS CPAs help? Check out the New Tax Law Explained! For Real Estate Investors page and then contact partner Simon Filip at sfilip@krscpas.com or 201.655.7411 for a complimentary initial consultation.

The Tax Cuts and Jobs Act (TCJA) and Code Section 1031

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The Tax Cuts and Jobs Act (TCJA) and Code Section 1031The Tax Cut and Jobs Act (TCJA) was signed into law on December 22, 2017, and took effect on January 1, 2018. Included in the political promise of tax simplicity and historically large tax cuts to middle-income households were amendments to existing tax code, including Code Section 1031. Investment property owners will continue to be able to defer capital gains taxes using 1031 tax-deferred exchanges, which have been in the tax code since 1921.

What changes under the new tax law?

The tax law repealed 1031 exchanges for all other types of property that are not real property. This means 1031 exchanges of personal property, assets that can no longer be exchanged including collectibles, franchise licenses, and patents, aircraft, machinery, boats, livestock, and artwork.

What didn’t change for 1031 exchanges?

Real estate exchanges are subject to the same rules and requirements as prior law. Taxpayers must still identify their replacement within 45 days and exchange within 180 days. All real estate in the United States, improved and unimproved, also remains like-kind to all other domestic real estate.  Foreign real estate continues to be treated as not like-kind to real estate.

Are there timing considerations?

Pursuant to the transition rules, a personal property exchange to be completed in 2018 would be afforded tax deferral under the prior law if the relinquished property was sold or the replacement property was acquired by the taxpayer prior to December 31, 2017.

What about cost segregation?

A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income taxes. Taxpayers entering into a 1031 exchange who are contemplating a cost segregation study, need to consider the disallowance of personal property as like-kind to real property. Reclassifying asses to shorter recovery periods will increase annual depreciation deductions, but can potentially cause gain recognition from the exchange.

We’ve got your back

The new tax code is complex and every taxpayer’s situation is different, especially when real estate is involved – so don’t go it alone! Check out the New Tax Law Explained! for Individuals and then contact me at sfilip@krscpas.com or 201.655.7411 to discuss tax planning and your real estate investments under the TCJA.

 

The Tax Act and the Real Estate Industry

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The Tax Act and the Real Estate IndustryTax Cuts and Jobs Act (“TCJA”)

On December 20, 2017 Congress passed the most extensive tax reform since 1986, which was subsequently signed into law by President Trump. Included in the TCJA are changes to the Internal Revenue Code (“Code”) that impact taxpayers engaged in the real estate business, and those who otherwise own real estate.

Individual tax rates

The TCJA lowers the marginal (top tax bracket) tax rate applicable to individuals from 39.6% to 37%. The net investment income tax (NIIT) and Medicare surtax of 3.8% and 0.9%, respectively, remain. The reduction in tax rates is not permanent like the corporate tax rate reduction, and is scheduled to expire after 2025. The tax rates applicable to long-term capital gains of individuals remains at 15% or 20%, depending on adjusted gross income (AGI).

Deduction for qualified business income of pass-through entities

The TCJA creates a new 20% tax deduction for certain pass-through businesses. For taxpayers with incomes above certain thresholds, the 20% deduction is limited to the greater of (i) 50% of the W-2 wages paid by the business, or (ii) 25% of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis, immediately after acquisition, of depreciable property (which includes structures, but not land).

Pass-through businesses include partnerships, limited liabilities taxed as partnerships, S Corporations, sole proprietorships, disregarded entities, and trusts.

The deduction is subject to several limitations that are likely to materially limit the deduction for many taxpayers. These limitations include the following:

  • Qualified business income does not include IRC Section 707(c) guaranteed payments for services, amounts paid by S corporations that are treated as reasonable compensation of the taxpayer, or, to the extent provided in regulations, amounts paid or incurred for services by a partnership to a partner who is acting other than in his or her capacity as a partner.
  • Qualified business income does not include income involving the performance of services (i) in the fields of, among others: health, law, accounting consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or (ii) consisting of investing or investment management, trading, or dealing in securities, partnership interests or commodities.
  • Qualified business income includes (and, thus, the deduction is applicable to) only income that is effectively connected with the conduct of a trade or business within the United States.
  • The deduction is limited to 100% of the taxpayer’s combined qualified business income (e.g., if the taxpayer has losses from certain qualified businesses that, in the aggregate, exceed the income generated from other qualified businesses, the taxpayer’s deduction would be $0).

Interest expense deduction limitation

For most taxpayers, TCJA disallows the deductibility of business interest to the extent that net interest expense exceeds 30% of Earnings before Income Taxes Depreciation and Amortization (EBITDA) for 2018 through 2022, or Earnings before Income Taxes (EBIT) beginning in 2022. An exemption from these rules applies to certain taxpayers with average annual gross receipts under $25 million.

A real property trade or business can elect out of the new business interest disallowance by electing to utilize the Alternative Depreciation System (ADS). The ADS lives for nonresidential, residential and qualified improvements are 40, 30, and 20 years, respectively.  All of which are longer lives, resulting in lower annual depreciation allowances.

Immediate expensing of qualified depreciable personal property

The TCJA includes generous expensing provisions for acquired assets. The additional first year depreciation deduction for qualified depreciable personal property (commonly known as Bonus Depreciation) was extended and modified. For property placed in service after September 27, 2017 and before 2023, the allowance is increased from 50% to 100%. After 2022, the bonus depreciation percentage is phased-down to in each subsequent year by 20% per year.

Expansion of Section 179 expensing

Taxpayers may elect under Code Section 179 to deduct the cost of qualifying property, rather than to recover the costs through annual depreciation deductions. The TCJA increased the maximum amount a taxpayer may expense under Section 179 to $1 million, and increased the phase-out threshold amount to $2.5 million.

The Act also expanded the definition of qualified real property eligible for the 179 expensing to include certain improvements to nonresidential real property, including:

  • Roofs
  • Heating, Ventilation, and Air Conditioning Property
  • Fire Protection and Alarm Systems
  • Security Systems

We’ve got your back

The new tax code is complex and every taxpayer’s situation is different, especially when real estate is involved – so don’t go it alone! Contact me at sfilip@krscpas.com or 201.655.7411 to discuss tax planning and your real estate investments under the TCJA.

An Update: Real Estate Professionals and Passive Losses

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Dreaded Passive Losses

An Update: Real Estate Professionals and Passive LossesA passive loss from a real estate activity occurs when your rental property’s expenses exceeds its income. The undesirable consequence of passive losses is that a taxpayer is only allowed to claim a certain amount of losses on their tax return each year.

When income is below $100,000, a taxpayer can deduct up to $25,000 of passive losses. As income increases above $100,000, the $25,000 passive loss limitation decreases or “phases out.” The phase out is $0.50 for every $1 increase in income. Once income increases above $150,000, taxpayers are completely phased out of deducting passive losses.

Rentals are passive, unless they aren’t

The general rule is that all rental activities are, by definition, passive. However, the Internal Revenue Code created an exception for certain professionals in the real estate business.

Who is a real estate professional?

As discussed in a previous post, for income tax purposes, the real estate professional designation means you spend a certain amount of time in real estate activities.

According to the IRS, real estate professionals are individuals who meet both of these conditions:

1) More than 50% of their personal services during the tax year are performed in real property trades or businesses in which they materially participate and

2) they spend more than 750 hours of service during the year in real property trades or businesses in which they materially participate.

Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operations, management, leasing, or brokerage trade or business qualifies as real property trade or business.

Can I qualify as a real estate professional?

I get these questions quite often from taxpayers:  Do I qualify as a real estate professional?  If not, how can I qualify?

There have been many cases that appear in front of the Tax Court where a taxpayer argues they qualify as a real estate professional and the IRS has disallowed treatment and subjects the taxpayer to the passive activity loss rules of Code Sec. 469.

A recent case held that a mortgage broker was not a real estate professional (Hickam, T.C. Summ. 2017-66). The taxpayer was a broker of real estate mortgages and loans secured by a real estate. Although the taxpayer held a real estate license, he did not develop, redevelop, construct, reconstruct, operate, or rent real estate in his mortgage brokerage operation.

The taxpayer argued that his mortgage brokerage services and loan origination services should be included for purposes of satisfying the real estate professional test. The Court held that the taxpayer’s mortgage brokerage services and loan origination services did not constitute real property trades or businesses under Code Sec. 469(c)(7)(c).

We’ve got your back

If you invest in real estate, it can be difficult to keep track of tax laws and how they impact you. At KRS CPAs, we stay on top of all the laws – especially the changes under the new tax reform – and can help you avoid tax problems. Contact me at sfilip@krscpas.com or 201.655.7411 for a complimentary initial consultation.

Excluding Gain on the Sale of a Principal Residence

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Excluding Gain on the Sale of a Principal ResidenceOne of the most valuable assets a taxpayer will ever sell is their personal residence. Under IRC Section 121 of current tax law, a taxpayer can exclude up to $250,000 ($500,000 if married, filing jointly) of gain realized on the sale or exchange of a principal residence.

Any loss on a principal residence is deemed a personal loss and non-deductible.

What is a principal residence?

The determination whether a property is used as a taxpayer’s principal residence depends on a variety of factors. Some of these factors include:

  • Principal place of abode for the taxpayer’s family members
  • Address on the taxpayer’s driver’s license, automobile registration, and voter registration
  • Mailing address for bills and correspondence
  • Location of taxpayer’s banks
  • Location of religious organizations and recreational clubs with which the taxpayer is affiliated
  • Location of the taxpayer’s doctors
  • Taxpayer’s place of employment

If a taxpayer uses more than one property as a residence, the property that checks the most boxes will likely be assessed as the primary residence. If a taxpayer alternates between two properties, the property used the majority of time during that year will be considered the principal residence for purposes of the IRC Section 121 exclusion. A houseboat, trailer, or apartment a taxpayer is entitled to occupy in a cooperative housing corporation (co-op) may also qualify as a principal residence.

How is gain or loss computed?

Gain (or loss) is computed based upon the selling price less expenses of the sale and the taxpayer’s adjusted basis in the residence. Adjusted basis is original cost plus the cost of improvements (not repairs) made to the residence and reduced by any depreciation claimed on the property.

Gain exclusion requirements

Taxpayer’s must meet three tests for the full gain exclusion to apply:

  1. Ownership – the taxpayer must have owned the residence for at least two years during the five years ending on the date of the sale or exchange. Tip – The measuring period is the actual time between sales, not taxable years.
  2. Use – the taxpayer must have occupied the residence as a principal residence for periods adding up to at least two years within the five-year period ending on the date of sale or exchange.
  3. One Sale in Two Years – the exclusion under Section 121 does not apply to any sale of a principal residence if, during the two-year period ending on the date of sale, the taxpayer sold their principal residence in which gain was excluded under section 121.

Example: A taxpayer sold a principal residence on March 1, 2016 and excluded the gain under Section 121. The taxpayer would not be eligible to claim the exclusion under Section 121 until April 2, 2018.

It is important to note The Tax Cuts and Jobs Act proposed increasing the length of ownership and use from two out of five years to five out of eight years. This was removed from the final version of the bill.

Property used partially as business and partially as principal residence

The IRS takes the position that the Section 121 exclusion is not available for any portion of the residence used for business purposes during the qualifying use period. Thus, if a portion of the property was used as a principal residence and a portion separate from the dwelling unit was used for non-residential purposes, only the gain allocable to the residential portion is excludable. However, no allocation is required if both the residential and nonresidential portions are within the same dwelling unit (commonly seen in home offices). It is important to note gain attributable to depreciation claimed after May 6, 1997 is not eligible for exclusion.

Example – Home office impact on gain exclusion

Jeff, an accountant, purchases a house in 2014. The house is a single unit, but Jeff has one room that is used exclusively for the accountant practice until the property is sold in 2017. Jeff claims depreciation of $3,000 attributable to the portion used as a home office. Upon the sale in 2017, Jeff realized a gain of $75,000.

Since Jeff’s home office is part of the dwelling, no allocation is required. However, Jeff must recognize $3,000 of the gain as unrecaptured Section 1250 gain (currently taxed at 25%), the depreciation claimed for the business portion of his home. The remaining $72,000 is excludable under the Section 121 exclusion.

Selling your principal residence? Get the advice you need for smart tax decisions

For more about how the sale of your principal residence can affect your tax situation, please contact me at sfilip@krscpas.com or (201) 655-7411.