In the waning days of the last presidential election campaign, Congress closed a loophole in the Internal Revenue Code that some investors had exploited to avoid paying capital gains taxes. But when asking most accountants about it, do not be surprised if he or she looks at you quizzically.
That is because the amendment to IRC §121, which establishes the tax exemptions for personal residences, was buried in Section 840 of the American Jobs Creation Act of 2004. If that does not muddle things enough, try to bear in mind that this tax-free loophole was used by taxpayers conducting like-kind exchanges under the Code’s Section 1031.
Signed into law by President Bush on Oct. 22, 2004, the new regulation should not be viewed as a tax grab, though impatient taxpayers and investors may see it that way. It is a belated admission by Congress that a tax-deferral strategy had been turned into one of tax avoidance, by first using Section 1031 (for tax deferral) and then using Section 121 (for tax avoidance).
Section 1031 allows buyers and sellers of investment property, or property used in a trade or business, to defer capital gains taxes from a property sale by rolling the proceeds into another investment or trade or business property of equal or greater value. The 1031 exchange, as this transaction is known, has been a part of the Code, in one form or another, since 1921. A series of judicial decisions in the late 1970s and early 1980s, known collectively as the Starker cases, caused the IRS to create new rules in 1991 that govern 1031 Exchanges today. These rules mandated, among other things, the 45-day time period to identify up to three parcels of property to be purchased; the 180-day time period in which to complete the transaction; and the use of a qualified intermediary (independent third parties recognized by the Internal Revenue Service as facilitators of 1031 exchanges) to handle the details.
Section 121, on the other hand, deals with property used for residential purposes.
It allows tax deferral on income gained from the sale or exchange of property after a five-year period of ownership if the taxpayer used the property as a principal residence for two of those years or more.
How, then, can an average taxpayer or investor use both Sections 1031 and 121? Say an investor purchased a four-unit apartment building four years ago for $150,000 and the property is now valued at $550,000. The investor has made a profit of $400,000 and would have to pay 15 percent, or $60,000, in long term capital gains tax. He now wants to use the proceeds to purchase a $700,000 single family home. In a couple of years, he will use that single family home as his personal residence. He uses all of the proceeds received from his sale of the four-unit apartment building and uses Section 1031 to defer the $60,000 in capital gains taxes. Under the old Section 121, he could move into the single family home two years later and make it his personal residence. Now, Section 121 and its amendment, Section 840, require a three-year residency. So, the investor lives in the personal residence for three years before selling it for $800,000, realizing an additional profit of $100,000. Under this scenario, his total profit of $500,000 would be tax free. The trick is to time and use Sections 1031, 121 and 840 correctly. Doing so can turn property that should be taxed into property that will not be taxed.
Savvy investors such as the one cited in this example learned long ago that they could conduct an exchange under the conditions of IRC §1031 and defer paying taxes. Thereafter, taxpayers on the sale of their investment, when converted to their personal residence, could exclude up to $250,000 in capital gains tax on their profits from the sale of their principal residence. Couples filing jointly could save up to $500,000.
As with any provisions of the tax code, certain conditions had to be met to achieve these tax savings. Most importantly, as with the hypothetical situation described above, the investor had to lease the property for a reasonable time (conservatively, two years) before using it for two years as a personal residence.
That all changed on Oct. 22. The new Section 840 states: “If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the five-year period beginning the date of the acquisition of such property.” In plain English, it means that the taxpayer must now hold the property for five years and use it as a personal residence for at least two years before selling it and saving on capital gains taxes.
In cases such as this, ignorance is not bliss. The newness of the amendment – and the lack of fanfare with which it became law – may catch taxpayers and accountants off guard. Since the new regulation will not be readily available until the IRS publishes its updated Code next year, most people continue to operate under the assumption that the old rules still apply.
Sounds like a congressional tax grab, you say. Congress was really trying to close a tax loophole and thereby retain more taxes. If the taxpayer/investor is impatient and decides to forego the holding requirements, they will become liable for capital gains taxes. Yet if the taxpayer/investor follows all of the rules, including the new change (Section 840), then this loophole is still available. It just takes a year longer. Congress may, in fact, be telling taxpayers/investors what their advisors have been telling them for years: invest for the long term.
This article should not be considered tax, accounting or legal advice. Readers are urged to seek advice from their accounting or legal professional before taking action.
