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Tax-Free Combinations

By Albert B. Crenshaw
Sunday, February 6, 2005; Page F01

Got an expensive house you want to sell but don't want to pay a bunch of tax on the profit? The Treasury Department has got a deal for you.

Resolving questions that have been circulating ever since Congress changed the law in 1997, the department has concluded that homeowners can combine the capital gains exclusion available on the sale of a principal residence with the tax deferral available when an investment property is exchanged for another of "like kind."

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And, said Robert Schachat of the Washington office of accounting firm Ernst & Young, it does so in a way that allows "the most beneficial combination" of the two provisions.

The interpretation comes at a perfect moment for aging baby boomers living in areas like Washington where home prices have gone off the top of the charts. It could give new meaning to the term house-proud.

In essence, the Treasury has said that if a homeowner lives in a house (Property A) long enough to meet the principal-residence requirements, he or she may then rent it out for a year or two (presumably during a two-year sabbatical in Tahiti), and then -- by jumping through certain hoops -- sell Property A, invoke the principal-residence exclusion to keep the first $250,000 of profit tax-free if single, $500,000 for a married couple, and plow any remaining profit into another rental property, Property B, postponing tax on that part of the gain.

And though the Treasury stops at this point, accountants say it should be possible for the original homeowner to move into Property B eventually, live there for the required time, and then sell it, qualifying for yet another homeowner exclusion.

"You have to be pretty disciplined, and flexible in your living accommodations," said Jeffrey Kelson of accountants BDO Seidman LLP in New York, but "this thing's got a lot of potential."

Complying with all the rules isn't simple (such as figuring out how to finagle that sabbatical in Tahiti, or at least find a place to live while you rent out your homestead), but many homeowners may find the tax savings worth the headache.

First, you have to meet the requirements of the principal-residence exclusion. The main one is that you have to have lived in the house full time for at least two of the five years immediately preceding its sale. And Congress added a new requirement last fall: A home doesn't qualify for the exclusion if it has been involved in a like-kind exchange within the previous five years. This comes into play only if you want to sell the second property.

Then, you have to meet the requirements for a tax-free exchange, also known as a Section 1031 exchange. Although these deals are referred to as exchanges, outright swaps between two parties are rare. Instead, the owner sells an investment property, but makes sure that all the cash in the deal goes not to him but directly into an escrow account held by a third party, known as a "qualified intermediary." Then the seller identifies a new property and closes on it, with the qualified intermediary transferring the cash from the first sale to pay for the new property.

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