Changing tax status on residence can provide benefits to owners

Mike and Claudia McIntosh have not spent one night in their mountain cabin in 2010. One of their sons was married in June, Claudia’s family held a reunion in Michigan in late July, and Mike plans to take time off from work to move his mother into a retirement home in August. So, there has been no time to get to the cabin.

“We’ve heard for years about people who don’t use their second home, and now we are those people,” Mike said. “I think we would probably sell the place, but we always stop ourselves when we think about paying a capital gains tax on the place.”

One viable option is to convert the cabin to investment-property status, rent it out for a couple of years, then sell it via a 1031 tax-free exchange to acquire another investment property closer to home that could produce a monthly cash flow, supplementing household income. The new property could ultimately be placed in the couple’s estate or in a charitable trust.

One of the more underestimated financial bonuses available to the average consumer is the ability to convert a primary residence or a second home into a rental property, and vice versa.

Let’s look at the McIntosh family’s situation from another angle. The couple converts the mountain cabin to an investment property and rents it out for two years. During that time, they hear of a bargain property in Arizona that has the amenities they require for a retirement home, but they are unsure if they would truly want to live there. They could sell the mountain cabin via a 1031 exchange, buy the Arizona property and rent it out.

Tax-free exchanges must involve investment properties. If you eventually decided to live in the “replacement property” of the exchange – as a primary residence or second home – it would be difficult for the Internal Revenue Service to question. In this case, that’s because the McIntoshes were unsure they wanted to live in the Arizona home when the exchange was made.

If an exchange is contested, the IRS will examine the “objective manifestations of your intent” at the time you conducted the exchange to determine what the intention truly was.

According to several accountants, the only gray issue is how long the property must be held as rental property before the coast is clear to deem it a primary residence. A home that has been a rental nest egg for decades is not an issue, those that have been acquired in the past three years via a tax-free can be. That’s because no specific hold times have ever been written. Remember, intent at the time of the exchange should be toward another investment property.

If taxpayers are going to convert the use of homes, it’s best to have at least two tax years in the books. Let’s say if the McIntoshes were to buy an Arizona rental in August 2010, it would best to keep it a rental at least through 2011. That way, the conversion would not appear on a tax return until the 2011 return, and then actually be viewed sometime in 2012.

Since the Arizona home was acquired via a tax-deferred exchange, the McIntoshes will have to wait five years from the date of purchase to claim the $500,000 ($250,000 for a single person) tax-free exemption on the sale of a principal residence.

Typically, in order to qualify for the $500,000 exclusion ($250,000 for single persons) home owners must have owned and used the property as a principal residence for two out of five years prior to the date of sale. And, the owner must not have used this same exclusion in the two-year period prior to the sale.

However, a 2004 law limited the scope because legislators did not believe the principal residence exclusion “was appropriate for properties that were recently acquired in like-kind exchanges.” When homeowners convert the exchange property into a principal residence, the taxpayer often shelters some or all of the gain. Legislators were concerned about tax abuse and adopted the five-year law for exchange properties because it “balances the concerns associated with these provisions to reduce this tax shelter concern without unduly limiting the exclusion on sales or exchanges of principal residences.”

You have tax options with both your investment properties and your primary residences. Make sure you understand all the possibilities before you sell.