California 2013 Tax Law: Homeowner Exclusion & 1031 Exchange Interplay

Strike While the Iron’s Hot

The local real estate market is rising. With limited inventory and a huge influx of buyers and investors, many with all cash offers, it’s now a “seller’s market” in the Bay Area. Cha-Ching! The turn-around has sparked your desire to retire. Your Santa Clara home is worth a million more than when you and your wife bought it 20 years ago. You’ve already found your dream home in Hawaii. Strike while the iron’s hot and sell now, right? Not exactly. By utilizing California 2013 tax law – homeowners exclusion and 1031 tax deferred exchange – you can eliminate your tax costs and help to ensure a comfortable financial retirement. There are a few catches though. The Hawaii and Santa Clara properties have to be rented out for a time. So, put down the golf clubs for now. Don’t fret. You’ll be basking in the sun and sipping on Pina Coladas with a 2 handicap before you know it. Move over, Mr.  Couples.

Intertwining Use & Benefits of California 2013 Tax Law

Homeowners Exclusion

California 2013 tax law provides that married couples filing joint tax returns that live in their homes for 2 years in a 5 year period can exclude up to $50o,ooo of any “gain” (i.e. profit) earned from the sale of their home from capital gain taxation. A word of caution to high income earners expecting gains above the exclusion amount. In addition to the new California 2013 tax law, a new federal tax law imposes a special 3.8% medicare surtax on investment income (capital gains from sale of real property) of singles with adjusted gross incomes over $200,000 (married – $250,000).

1031 Tax Deferred Exchange

In a previous post we learned that if you own a rental real property and wish to defer the gain you can “exchange” it for another rental home “tax free” by following the five guidelines of IRC 1031. You can’t do this alone. These guidelines are technical and require the assistance of qualified counsel and third party intermediary (such as Fidelity Exchange).

Case Example

The strategy and interplay between California 2013 tax law – homeowner’s exclusion and IRC 1031 – starts with the time period the homeowner holds the personal residence. Remember. To qualify as a principal residence (and homeowner’s exclusion) the homeowner must live in the home for a 2 out of 5 year period before the sale.

You bought your home in 1993 for $350,000. You’ve lived exclusively in the home for 20 years (i.e. principal residence). It’s now worth $1,350,000 in 2013. If you and your spouse sell the home for cash, the IRS and California 2013 tax law provides that you would incur a reportable capital gain of $500,000 as follows:

* For ease of explanation, we assume no closing costs & adjusted gross income is the same as the capital gain.

Result. The taxes owed on the gain of $500,000 on the Santa Clara home is completely excluded. What does this mean? You don’t have to pay any taxes. Why? You lived in the home for at least 2 of the last 5 years as your personal residence. Long-standing IRS and California 2013 tax law rules allow you to claim the full amount of the homeowner’s exclusion ($500,00 for married couples filing jointly – $250,000 for individuals) to exclude the gain.

The transaction will qualify as a “tax free” exchange if both properties are used as “rental properties” for the requisite time period. This means you will acquire the Hawaiian investment property tax-free. Mahalo! Additionally, utilizing California 2013 tax law homeowners exclusion allows you to avoid paying a cent on the $500,000 gain on the Santa Clara home.

Who said you can’t have your cake (or poy as the case may be) and eat it too..!