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My parents owned and lived in their house for 25+ years. After a job change, they moved about 10 miles away, and decided to rent out the old place. At the time, their plan was to eventually move back into the original for at least 2 years, so that they could have the tax benefit on this home that had appreciated roughly $500k while they owned it.

Now, 2.5 years after moving to the new place, they've decided that they love their home and don't want to eventually move back. But, prices are down now and the market is slow, so they wouldn't get as much as they would like especially if they had to lower the price further to make sure it sold in the next 6 months.

I hate to see them have to pay an additional $75k in taxes, or $100k if the LTCG rate goes back to 20%. In December I was toying with the idea of buying it from them, but luckily I never mentioned it to them, as it's not really in the cards right now during the market dip.

Are there any options such as selling part or all of it to a relative, or putting part or all of it into a trust? Or any other workarounds that might be feasible?

It sounds like they are willing to take the $75k hit in order to wait out the real estate dip, but if there is a creative (but legal) way to avoid missing out on the tax exclusion in the first place I would like to be able to look into it.

Thanks

Aaron
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Your parents are being extremely foolish, and not Foolish. They should sell now for whatever the current market price is for their house. Not only are they risking 75K or more in taxes, they must continue paying the monthly carrying costs on the house - real estate taxes, utilities, insurance, maintenance, perhaps a mortgage.

IIRC, the last time housing prices slumped (around 1987) it took as long as a decade for prices in some areas to return to their pre-slump levels.

Ira
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They should sell now for whatever the current market price is for their house. Not only are they risking 75K or more in taxes, they must continue paying the monthly carrying costs on the house - real estate taxes, utilities, insurance, maintenance, perhaps a mortgage.

While I agree, and felt that way 2.5 years ago too, they have renters in there that they don't want to kick out, and are making a profit each month even when considering your mentioned carrying costs. Unlike some areas, this is in the SF bay area with currently plenty of jobs in the area, and so should come back quicker than many other areas around the country.

Back to taxes, is there a way to transfer the property in part or full to a relative or trust and get the tax exclusion?

Thanks

Aaron
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Back to taxes, is there a way to transfer the property in part or full to a relative or trust and get the tax exclusion?

It seems to me that the question could more accurately be stated thus: "Is there any way to pretend to sell the property to capture the tax-free gain while retaining the benefits of owning the property?" When phrased that way the answer is clearly "no." Even if someone could dream up some way to make it look like they had sold, the courts have held that substance trumps whatever machinations people have come up with to make something look like what it isn't.

Phil
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It seems to me that the question could more accurately be stated thus: "Is there any way to pretend to sell the property to capture the tax-free gain while retaining the benefits of owning the property?" When phrased that way the answer is clearly "no."

I enjoy reading this message board; I learn something almost every day.

I always chuckle when reading a post that would be better suited for a "Tax Evasion" board rather than a "Tax Strategies" board. No offense to OP, of course; I'm all for utilizing all legal techniques to minimize my tax obligation. It never hurts to ask the question!

ETR
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With Phil's thoughts about tax avoidance clearly in mind, let me address your question directly.

Your parents would need to sell the property to get the exclusion. The buyer can be a related party - a relative.

But the buyer would need to enjoy the benefits and bear the burdens of ownership. IOW, the buyer would get the gains in value or suffer any further losses in value. Those could not be passed back to your parents. So because the market is currently somewhat depressed, they're not going to get as much for the property as they would have a year or two ago. They could have sold then, but didn't. Now the loss in value is their problem. That was a risk of hanging on instead of selling.

One possible scenario would be for a friendly buyer to buy now, with some seller financing. It sounds like the existing loan on the property is either not large if there is one at all. The price could be somewhat generous in exchange for favorable financing terms from the seller.

The downside here is in the intertwining of family finances, and the impact on relationships if things don't work out. Particularly if the buyer doesn't make payments on time.

--Peter
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It seems to me that the question could more accurately be stated thus: "Is there any way to pretend to sell the property to capture the tax-free gain while retaining the benefits of owning the property?" When phrased that way the answer is clearly "no." Even if someone could dream up some way to make it look like they had sold, the courts have held that substance trumps whatever machinations people have come up with to make something look like what it isn't.

Nope, I have no interest in suggesting to them ways to pretend to sell it to capture the portion of tax free gain. It's been suggested to me by multiple people that they could pretend to live in it for 2 years at a later date, especially since their new place is so close to the old, but I don't feel comfortable with that and I know they wouldn't either.

As I said in the original post, I am only looking for legal ways to do this. I have seen and heard lots of people moving things into trusts, and if it is a legal way to capture that gain then this is yet another reason to look into it.

Likewise, in researching foreclosures to purchase I have come across partial sales, where multiple people (related by name or not) own a portion of a property. I'm going to hold off from buying the house in full, but if I could buy a portion of the house then that would be something to consider.

Thanks for any info on the limitations of the tax law that you can give.

Aaron
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As I said in the original post, I am only looking for legal ways to do this.

And I in no way meant to imply otherwise. My point was that you are reaching for a brass ring that's out of reach. As Peter noted a different way, if they divest themselves sufficiently to meet the statute, they also lose the future benefit of "good" things that could happen.

I have seen and heard lots of people moving things into trusts, and if it is a legal way to capture that gain then this is yet another reason to look into it.

Lots of people move lots of things into trusts, for lots of reasons. Most of my assets are titled to a trust. But a trust which your parents controlled would be disregarded by tax law.

Likewise, in researching foreclosures to purchase I have come across partial sales, where multiple people (related by name or not) own a portion of a property. I'm going to hold off from buying the house in full, but if I could buy a portion of the house then that would be something to consider.

They could sell a partial interest and, if they didn't use up the entire exclusion in that sale, use the remainder of the exclusion amount when they sold the balance. However, this wouldn't get rid of the time limit for completing the sale, so they'd have the same problem they have now.

Phil
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Here's a legal option that may help. If they really want to keep holding the house, and they hold it until they pass on, then it passes to you (or whomever its' given to in the will) at the current value at that time. So when you (or whomever) then sells it, there's no gain.

If their wealth is high enough then they'll pay estate tax on the value, so that may be a consideration if they're in that situation.

But there's no way for them to sell it during their lives, after the two years, without moving back in for two years, and avoid taxes. Other than the two years thing, the only other clause you could alter is not selling it until "after their lives".
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Keep in mind that if they're waiting out a dip in the market they'll have to make up both the amount of the dip and the $75k in taxes. They'll need 15% appreciation alone from $500k just to break even on their tax liability. And it sounds like the price has declined...so it'll need to appreciate how much from the current price just to break even on taxes? 18-25% potentially? And then they also want to recover the decline from $500k too?

Unless they plan to hold for a good chunk of time, maybe a decade or more, this doesn't seem advisable. I had a stock that was up to $40 and held it all the way down to around $10. Doesn't really matter what it WAS worth, chasing down a peak that is gone and in the past doesn't make sense.

There may be legit other reasons to keep the house but if they planned to sell and are only holding off due to the housing market it probably isn't going to benefit them.
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...and are making a profit each month even when considering your mentioned carrying costs.

So why are they anxious to sell? Unless they are needing the money now, if they are making a profit (and, I would assume, taking the tax write-offs associated with a rental), can they wait out the downturn?

If they do sell it, since it is now rental property, a section 1031 exchange would allow them to defer part or all (depending on the price of the replacement property) of their gain. Not as easy as just taking a $500K exclusion, but it could work out better than just selling outright.

By the way, in figuring what they'll owe in taxes, don't forget state income taxes and the fact that $500K will likely put them on the other side of all the phase outs for Schedule A, personal exemptions, and whatnot.

Kathleen
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As Peter noted a different way, if they divest themselves sufficiently to meet the statute, they also lose the future benefit of "good" things that could happen.
...
Lots of people move lots of things into trusts, for lots of reasons. Most of my assets are titled to a trust. But a trust which your parents controlled would be disregarded by tax law.
...
They could sell a partial interest and, if they didn't use up the entire exclusion in that sale, use the remainder of the exclusion amount when they sold the balance. However, this wouldn't get rid of the time limit for completing the sale, so they'd have the same problem they have now.


Ok, that was exactly what I was wondering. In all cases my expectation, and your confirmation, is that if they sell or transfer a partial or full ownership, whether to a relative, individual, or trust (that they don't control), then they could use part to all of the tax exclusion.

On a partial sale or transfer, would the tax exclusion be limited to the fraction that they sell.

For example, let's say the basis plus deductible expenses were $100k, and the house is valued at $700k, for a total potential gain of $600k. If they sell a 50% share for $350k, could they then have the $300k gain excluded. Or is there a special rule in fractional sales where they would only get up to the fraction excluded, so 50% * $500k, for a max of $250k?

It seems to me that there wouldn't be any special rules on it, but I wanted to check while we're on the same page.

Thanks

Aaron
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On a partial sale or transfer, would the tax exclusion be limited to the fraction that they sell.

For example, let's say the basis plus deductible expenses were $100k, and the house is valued at $700k, for a total potential gain of $600k. If they sell a 50% share for $350k, could they then have the $300k gain excluded. Or is there a special rule in fractional sales where they would only get up to the fraction excluded, so 50% * $500k, for a max of $250k?


On a joint return they could exclude $300K.

Phil
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One more possibility to ponder.

Since the property is a rental, it could be exchanged for another piece of real estate in a 1031 exchange.

If I remember the ordering of things, they could use the $250k/$500k exclusion first, then defer the taxation of any remaining gain. Providing the sale portion of the exchange happened within the 3 year window, they'd get the benefit of the tax break. Plus, if they purchased another property in the same general market, they could maintain their real estate investment and should get appreciation (or depreciation) that would be similar to the property they gave up in the exchange.

And now for the fun kicker.

IF they picked a replacement property that they might enjoy living in for retirement, they could convert the exchange up-leg (the replacement property) from a rental back to personal use after a number of years using it as a rental. And if they lived there for at least two years after that, they'd get some more tax free gains.

--Peter
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IF they picked a replacement property that they might enjoy living in for retirement, they could convert the exchange up-leg (the replacement property) from a rental back to personal use after a number of years using it as a rental. And if they lived there for at least two years after that, they'd get some more tax free gains.

It's not quite that simple. If you convert a 1031 exchange property back to personal use, you have to wait a full 5 years before you can exclude the gain. I think that was included in one of the technical corrections of the past few years.

Ira
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On a partial sale or transfer, would the tax exclusion be limited to the fraction that they sell.

For example, let's say the basis plus deductible expenses were $100k, and the house is valued at $700k, for a total potential gain of $600k. If they sell a 50% share for $350k, could they then have the $300k gain excluded. Or is there a special rule in fractional sales where they would only get up to the fraction excluded, so 50% * $500k, for a max of $250k?


On a joint return they could exclude $300K.


Although I can't find a reference to either confirm or refute my recollection, I thought that you could only exclude the gain if you completely disposed of your ownership interest in the property.

Ira
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If you convert a 1031 exchange property back to personal use, you have to wait a full 5 years before you can exclude the gain.

Ummm. Yeah. I knew that. It was ... just ... a typo.

Yeah. That's it. A typo. The 2 is just below the 5 on the keypad. Yeah. A slip on the keypad.

;-)

--Peter <== wondering if anyone will notice that I spelled out "two."
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Here's one reference to it--didn't look hard enough to find the actual text of the bill. http://www.taxformprocessing.com/tax/news/AJCA/index.htm

Kathleen
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I am confused.

Don't they only have to live in the house 2 years out of the last five years?

I read it as they moved out of the house 2 1/2 years ago, so they have lived in the house for 2 years out of the last 5 years.

What am I missing?
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I read it as they moved out of the house 2 1/2 years ago, so they have lived in the house for 2 years out of the last 5 years.

That they don't immediately plan on selling.

Debra
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Although I can't find a reference to either confirm or refute my recollection, I thought that you could only exclude the gain if you completely disposed of your ownership interest in the property.

I remembered that partial sales were covered in the final reg, but I couldn't remember what it said, so I checked. I think I interpreted it correctly.

Phil
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When they both pass away, the house will come to you with an adjusted basis to the value at the time of the last parent's death. There will be no capital gainst taxes to pay. You can then live in the house for two years as your primary home and sell with the tax exclusion benefit going to you.

Why go through the personal use? As you note, inherited property comes with current FMV basis. If they sold shortly after inheriting, they'd likely have a long-term capital loss roughly equal to the expenses of sale. If they moved into the property they'd be lucky to realize enough appreciation in the two years to make up for the expenses of sale, and if they wound up with a paper loss it would be disregarded.

Phil
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