Investor gets bad news about tax strategy

No profit doesn't mean no taxes


By Robert J. Bruss
Inman News

DEAR BOB: I bought a rental property in 1991, which I sold for $450,000. To avoid capital gain tax, I used an Internal Revenue Code 1031 tax-deferred exchange to buy another rental property for $450,000. After renting it for 12 months, I moved in and have lived in it for 24 months. If I sell this property at the same $450,000 price, will I owe any capital gain tax since I made no profit? Is this a good way to avoid capital gain tax? --Sim Y.

DEAR SIM: Nice try! But Uncle Sam is way ahead of you.

Your adjusted-cost basis for the $450,000 rental house you acquired in the Internal Revenue Code 1031 tax-deferred exchange was not $450,000.

Instead, it was your $450,000 purchase price minus the deferred capital gain on your old rental property minus the depreciation you deducted on the acquired property during the 12-month rental period before you moved in to make it your principal residence.

Although you owned and occupied the acquired property as your principal residence for the last 24 months, if you wish to claim the Internal Revenue Code 121 tax exemption up to $250,000 (up to $500,000 for a married couple filing jointly) you must own the acquired property at least 60 months before sale.

I hate to break the bad news, but the depreciation you deducted will be taxed at the special 25 percent federal "depreciation recapture" tax rate when you sell your current property. For full details, please consult your tax adviser.

HOME SELLER RENT-BACK MUST BE REPORTED ON TAX RETURNS

DEAR BOB: We recently bought a house and let the sellers rent it back for a month for which they paid us rent. Does this rent-back count as rental income on our income tax return? Does having them live in our house affect deducting mortgage interest for that month? --Robert R.

DEAR ROBERT: Your mortgage interest and property taxes are always tax-deductible.

However, the rent you received, because the rental term exceeded 14 days, must be reported on Schedule E of your federal income tax return where you can also deduct the applicable expenses for the rental period. Your tax adviser can give you more details.

LIFE ESTATE DOESN'T HAVE MUCH VALUE

DEAR BOB: My husband died about two years ago. He left me a life estate in his house. I am 68, but I want to move to Georgia to be near my children and grandkids. A neighbor offered me $1,000 for my life estate. Isn't it worth much more than that since I am in excellent health and my family members live into their 80s and 90s? --Maida T.

DEAR MAIDA: Please read the exact terms of your life estate. Some life estates specify that if the life tenant permanently moves out, the life estate terminates. That means your life estate becomes worthless when you move out of the house.

However, if your life estate doesn't terminate until you die, you can sell your life estate interest to the neighbor so he can rent or occupy the house. But that buyer shouldn't pay very much because when you die, the life estate terminates.

Although you say your family members live into their 80s and 90s, you could get hit by a truck while crossing the street, thus terminating your life estate in the house. For full details, please consult a local real estate attorney.