Tax Strategy for Your Highly Appreciated Primary Residence

Educational Article Series for Owners of Investment Real Estate

Roger W. Bowlin | Real Estate Transition Solutions, LLC

Primary residence home ownership has long been supported by the Federal Government. Homeowners benefit from tax incentives such as the mortgage interest deduction and lending programs like the FHA First Time Homebuyer Program. Additionally, the IRS Section 121 exemption allows homeowners who have experienced appreciation in the value of their home to realize up to $250,000 (if a single taxpayer) or $500,000 (if married-filing-jointly) of appreciation tax-free. What an incentive that is!

Most US homeowners will never come close to exceeding their Section 121 exclusion, but we live in the Puget Sound and at times it seems our property values play by different rules than most. According to an August 2017 Zillow Research report, Seattle is home to 22 “million-dollar neighborhoods” — 9 of which were added in 2017 alone. In Seattle, there are thousands of homeowners who would exceed their Section 121 exclusion of $250,000 / $500,000 if they sold their home today.

Long-Term Capital Gains and often the Net Investment Income Tax are applied to any appreciation above the exempt amount, resulting in an effective tax rate as high as 23.8% and quite possibly a significant tax bill, even with the exclusion. However, with some foresight and planning, it is possible for owners of highly appreciated primary residences to receive $250,000 / $500,000 of cash proceeds and defer all taxes by combining a Section 121 exemption with a 1031 tax-deferred exchange.

The steps for this combination tax strategy are as follows:

The home must be the designated primary residence of the owner / taxpayer for two of the last five years preceding the sale.

The home must be rented out in an “arm’s length” transaction (meaning market rates and not to immediate family) for generally the year preceding the sale.

Upon the sale of the home, a desire to perform a 1031 exchange must be noted and included in the Purchase and Sale Agreement.

Different than a standard 1031 exchange where all sales proceeds must go directly from escrow to the Qualified Intermediary, the seller can withhold cash up to their Section 121 exclusion amount of $250,000 or $500,000 depending on filing status.

Standard 1031 exchange guidelines are then applied to the remaining funds held by the Qualified Intermediary.

Most homeowners are not aware of this very viable approach, however, the opportunity to extract liquidity and defer taxes makes it a very attractive strategy. Many investment property owners we work with reside in King County neighborhoods that have appreciated significantly over their ownership years. A strategy such as this can be an extremely effective tax-deferral option as owners consider downsizing their primary residence or relocating either locally or outside the area.

Roger W. Bowlin, President of Real Estate Transition Solutions, LLC, provides exit strategy analysis, execution, income and equity replacement options for investment property owners. If you have questions relating to your investment property ownership, please email him at: RWBowlin@RE-Transition.com or call (206) 755–7068.