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Author: Bob78164 Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 120800  
Subject: Re: Far future tax planning Date: 5/1/1999 4:50 PM
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I call it the "Shore sale" . . . .

It's a tax avoidance technique, available one time only in 2001, with the potential of saving homeowners as much as $100,000. Thanks are due to TMFTaxes for his past and future comments on my reasoning and for invaluable research pointers. Of course, any mistakes are entirely my own responsibility.

On that subject (mistakes), an important cautionary note is in order. It is always true on these boards that everything should be taken with a large grain of salt. It's particularly true here. I am a general business litigator (emphasizing a high technology practice), NOT a tax lawyer. Tax issues are wholly beyond my professional competence. You (whoever you are) are not my client, and I am not your lawyer. By policy, I NEVER take on a client without FIRST getting a written and signed engagement letter. Do NOT rely on my analysis; I could easily be wrong, and if I am, you may pay as much as $100,000 in unnecessary and unexpected taxes. If you plan to execute a "Shore sale," get professional advice first. If you don't (or even if you do) and I AM wrong, then (to put it bluntly) it's your problem, not mine. I apologize for the plain speaking, but I trust (and regret) that the necessity is obvious.

Background

Section 311(a) of the Taxpayer Reform Act of 1997 (the "Act"), codified at I.R.C. § 1(h), provides for an ultra-long holding period of 5 years. If the holding period began no earlier than 2001, then the maximum capital gains rate on "qualified 5-year gain" is 18%, rather than the current 20%. But property acquired on or before December 31, 2000, is not eligible for the 18% rate.

To provide relief, Congress also adopted section 311(e) of the Act, which is apparently uncodified. It provides (in relevant part) that "[a] taxpayer other than a corporation may elect to treat . . . any . . . capital asset [other than a readily tradable stock] . . . held by the taxpayer on January 1, 2001, as having been sold on such date (and having been reacquire on such date for an amount equal to such fair market value). Any gain "shall be treated as received or accrued on the date the asset is treated as sold . . . and shall be recognized notwithstanding any provision of the Internal Revenue Code of 1986" (emphasis added). Any loss is gone for good. In other words, if you're willing to pay the tax on your gain through January 1, 2001, you can qualify property for the 18% rate.

The Shore Sale

It occurred to me to wonder how this provision (which I learned about through TMFAnnC's Daily Dow article a couple of weeks back) interacts with the $250,000/$500,000 exclusion available to the sale of a principal residence under I.R.C. § 121. I believe that the answer is: "very well indeed." There is no question that the principal residence is a capital asset under I.R.C. § 1221. I think that most homeowners (those who qualify for the exclusion and are willing to risk the chance that they may need it again in 2002) should elect to treat their principal residence as having been sold and repurchased on January 1, 2001. Selling the house triggers a capital gain, which will be excluded (up to the statutory limit). Repurchasing the home gives you a new and higher basis. As I read the Code, the result is to reset your basis to its fair market value on January 1, 2001, without paying a cent of tax on the first $250,000 or $500,000 (depending on filing status) of gain.

Could I Be Wrong? Absolutely!

TMFTaxes asks whether the "notwithstanding" clause puts the kibosh on this theory. I don't think so (but I could easily be wrong here -- remember, tax law is outside my professional competence). As I understand it, the term "recognized" has a technical meaning in tax law. For example, a tax-free exchange under I.R.C. § 1031 is tax-free because the income isn't "recognized." But income can be "recognized" without being taxable, by being "excludable." As I read the Code, the income from a qualified sale of a principal residence is recognized, but excluded from gross income. In fact, another "nonrecognition" event, under I.R.C. §1036(a), is the exchange of stock for stock in the same corporation. My guess is that the "recognition" provision was intended to take section 1036 out of play.

Who Should Consider a Shore Sale?

Most homeowners should consider a Shore sale in light of their own personal circumstances, although many may find it more trouble than it's worth. Establishing a fair market value on January 1, 2001, might require a formal appraisal. My hope is that a comparative market analysis will suffice, but I guess the IRS will let us know. However, advance planning is probably necessary, becaue I would not want to try to reconstruct the house's January 1, 2001, fair market value in April 2002.

However, if your home has decreased in value, you probably should not use a Shore sale, because you will reduce your basis with no apparent benefit. (Or might the decrease help with depreciation issues?) If you have (or could have) depreciated part of your home, be aware that the depreciation will be recaptured at 25%, with potential impact on estimated tax or withholding issues. And if you use the section 121 exclusion in 2000 (another planning issue -- get your sale closed in 1999, if possible), or think that you might before 2003, you probably don't want to use a Shore sale, because you can only use the section 121 exclusion once every two years.

On the other hand, if you live in an area (such as Southern California in the 1980s) with rapidly appreciating property values, you may be an excellent candidate for a Shore sale. Here's an example: Assume that you're single, your basis in your house is $50,000, and the fair market value on January 1, 2001, is $300,000. If you execute a Shore sale, you will recognize $250,000 in gain, which you can exclude pursuant to section 121. You then will have a $300,000 basis in the house. If you later sell for as much as $550,000, you still (Congress willing) will owe no taxes. If you had not executed a Shore sale, though, your tax bill would be $50,000.

I can think of at least one other circumstance where the Shore sale may save you a LOT of money. If you have moved out of your house but still meet the 2-of-the-last-5-years test on January 1, 2001, the Shore sale lets you take advantage of the section 121 exclusion, where you would otherwise lose it due to the passage of time.

There may also be scenarios where an impending change of marital status (and consequent reduction in the excludable gain) make a Shore sale advisable. If the technique works, whether to use it is something for you to evaluate in light with the help of your tax advisor in light of your personal situation. I hope that I've given you food for thought, though, and in some way repaid some of the help that I've received (and will continue to request) from time to time in Fooldom. --Bob
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