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Tax-Free Combinations

Kelson noted there are strict deadlines in both the residence exclusion and 1031 exchanges, so you should take care to be sure you can meet them.

Now, with those rules in mind, imagine a couple who own an $850,000 house, which they bought for $50,000 many years ago. They'd now like to sell it and move into something smaller. By playing their cards right, they can exchange the house for $500,000 in cash and a $350,000 condo -- without paying tax.

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After having lived in the house for the requisite number of years, they move out and rent the house to tenants.

After renting the house for two years, they sell it for $850,000. Their "realized gain" is $800,000, which is the $850,000 sale price minus the $50,000 they originally paid for it (called their "basis").

They exclude $500,000 from tax as the tax code allows, because it had indeed been their principal residence. They also buy a condo -- which they then rent out -- using $350,000 from the house, which was, remember, a rental property at the time of the sale, while being careful to comply with the rules of Section 1031. Those forbid them from ever having possession of the money that goes from their house into the new rental property and limit the amount of time they have to find and buy the new rental.

They now have $500,000 cash and the condo, in which their "basis" is the same $50,000 that they had in their house. If, after a few years, they move into the condo and live there for at least two years and until five years have elapsed since they bought it -- three years of rental and two years of residence would do it -- they can sell the condo and again exclude up to $500,000 of gain. At that point they will have extracted their entire $800,000 profit from their original house tax-free, along, possibly, with some appreciation in the condo.

If for some reason the couple wanted to take less cash on the first sale, they could do so and apportion more to the condo, increasing its basis and potentially reducing the later gain on it when sold.

Schachat also noted that if the couple wanted more of their money out of the condo sooner, they could place a mortgage on it without waiting the five years to sell.

And he said it would be possible to trade up to a more expensive property as well as down to a less expensive one.

The Treasury guidance, known technically as Revenue Procedure 2005-14, also specifies that combined residence-1031 deals are allowed for property that has been part rental and part residence -- a townhouse with a basement rental unit, for example. In such a case, the owner can apply the exclusion to the part he or she lived in and the deferral to the basement, apportioning it based on the square footage of each unit.

Of course, all this fancy footwork would be unnecessary for most people. That's because the amount of potentially taxable gain on the sale of a residence is the selling price minus the purchase price and the cost of any improvements. Unless that gain exceeds $250,000 (single) or $500,000 (couple), the exclusion alone will wipe out the tax. Many homeowners therefore won't need to bother with a combined transaction.

Plus, there are also a number of pitfalls in the combined deals to watch out for. For example, landlords normally take depreciation deductions on rental property. However, any depreciation taken after May 6, 1997, does not qualify for exclusion from tax on sale of a principal residence, though tax on it can be deferred through a 1031 exchange.

Sellers who have rented their house only for a couple of years likely would face only a modest amount of tax from the recapture of the depreciation. But suppose you had a rental property, moved into it for two years to get the residence exclusion and then put it back into rental before selling. You'd likely have taken a lot of depreciation write-offs in the first rental period. You could roll them into the new rental property without tax, but if you ultimately sold that, you could face an unexpected tax bill.

And just as there are big tax savings from these deals if they are done right, there are big potential hits if you mess up. So it's a good idea to consult with an attorney or accountant who is up to speed on them.

Even the Treasury has trouble with all of this. Revenue Procedure 2005-14 was originally published Jan. 27, but it omitted reference to the new five-year waiting period after a 1031 exchange. An updated version was released last week and will be published in Internal Revenue Bulletin 2005-7 on Feb. 14.

A California businessman who had refused to withhold and transfer to the government income and Social Security taxes on his employees was convicted Friday of 13 criminal tax charges, the Internal Revenue Service said.

Walter A. Thompson, 58, owner of Cencal Sales, an aviation flight bag manufacturer, who removed his employees from taxpayer rolls in 2000 by no longer withholding employment taxes from wages and salaries, was also convicted of filing false tax returns and refund claims of his own, the IRS said. His actions allegedly cost the government $256,000 in revenue. He faces a possible 63 years in prison and fines of more than $3 million, the agency said. Sentencing is set for April 13.


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