If you once owned a home that at one point was your principal residence, but was later rented out, the IRS may just have given you some good news. Depending on the facts of your situation -- and the timing -- you may be able to combine the principal-residence capital gains tax exclusion of up to $500,000 with a tax-deferred exchange, and pay no federal tax at all when you sell your house.
Let's first review some basic principles of real estate tax law.
Under Section 121 of the Internal Revenue Code, if you have lived in your principal residence for two out of the five years before it is sold, you can exclude from capital gains tax up to $500,000 of your profit (if you are married and file a joint return) or up to $250,000 of your gain (if you file a separate tax return). Your house has to be your principal residence.
Under Section 1031 of this same tax code, if you exchange one piece of investment property (called the relinquished property) for another (called the replacement property), you may be able to defer all of the profit you have made when the relinquished property is sold. There are specific time limits on a 1031 exchange, also known as a Starker exchange: You must identify one or more replacement properties within 45 days from the day you sold the relinquished property, and you must actually go to closing on that replacement property (or properties) within 180 days of that earlier settlement.
But if you lived in your house for three years and rented it out for two years, how do you treat the profit you make when it is sold? This becomes especially important if you have made more than $500,000 in profit from the time you first purchased your house. Up until recently, it was assumed that if you made more than the exclusion, you had to pay capital gains tax on this additional amount of gain.
The IRS, on Feb. 14, issued Revenue Procedure 2005-14, which specifically allows taxpayers to combine the home-sale exclusion with the Starker exchange rules.
Here is an example provided by the IRS:
Edward Exchangor buys a house for $210,000 in 2000, and uses it as his principal residence until 2004. From 2004 to 2006, he rents the house to tenants. Because the property is now rental property, he takes depreciation deductions of $10,000 for each rental year -- a total of $20,000.
In 2006, he exchanges this property for $10,000 in cash and a townhouse with a fair market value of $460,000. Edward intends to -- and does -- rent out this new property.
According to the IRS example, Edward has realized gain in the amount of $280,000 ($460,000 plus $10,000 cash equals $470,000, less the $210,000 purchase price, plus $20,000 in depreciation).