Planning Opportunities for the Sale of Appreciated, Dual-Use Property under Rev. Proc. 2005-14

A married client, C, intends to sell her primary residencea three-story townhouse she has owned for nine yearsand seeks advice in devising a tax-advantaged strategy for disposing of the now significantly appreciated property. For the first six years, she rented the townhouse and lived in another home, which she still owns but currently leases to a tenant. For the last three years, beginning with her marriage, she and her husband have occupied the townhouse as their primary residence. Also, for the last two years, the client operated a law practice from the first floor of the townhouse, while continuing to occupy the upper two floors.

Applicable Provisions

Because the clients property is both her primary residence and her place of business (dual-use property), two separate Code provisions apply:

• Sec. 121(b) generally allows the client to exclude up to $250,000 of gain ($500,000 on a joint return) on the sale of her primary residence, as long as certain basic conditions are met. She cannot have excluded gain from the sale of another home in the last two years; see Sec. 121(b)(3). In addition, she must have owned her home and occupied it as her main home for two of the last five years, under Sec. 121(a). If she owns more than one home, only her main home qualifies. Finally, Sec. 121 does not apply if she acquired her residence in a Sec. 1031 like-kind exchange and her sale of the residence occurs within five years of this acquisition; see Sec. 121(d)(10).

• Sec. 1031 allows the client, for Federal tax purposes, to defer gain recognition from the sale of her investment property (i.e., the first floor of the townhouse), if it is properly structured as a like-kind exchange. To qualify, she must either directly trade the property for a different but like-kind property or sell it through an exchange facilitator; see Regs. Sec. 1.1031(b)-2(a). The facilitator must then reinvest the proceeds in a different but like-kind property within 180 calendar days of closing; see Sec. 1031(a)(3). Further, the replacement property must be identified within 45 days of the sale of the relinquished property; see Regs. Sec. 1.1031(k)-1(b)(2)(i).

Rev. Proc. 2005-14

Prior to Rev. Proc. 2005-14, considerable uncertainty existed as to the proper treatment of gain that qualified for exclusion under Secs. 121 and 1031. Recently issued Rev. Proc. 2005-14 was effective Jan. 27, 2005. However, taxpayers may apply it in tax years for which the period of limitation on refund or credit under Sec. 6511 has not expired. If the sale of a taxpayers residence qualifies for gain exclusion under Secs. 121 and 1031, the taxpayer can apply both provisions, as follows:

1. Begin by applying Sec. 121 to the realized gain on sale; it preempts Sec. 1031, according to Rev. Proc. 2005-14, Section 4.02(1). Note: if the residential and business portions of the property are located in a single dwelling unit, the entire property is considered the personal residence for Sec. 121s two-year residency requirement. The taxpayer does not have to consider the business portion of the residence as a separate property; see Regs. Sec. 1.121-1(e). If the business portion is located in a separate dwelling unit (such as a guesthouse), the gain on this portion is only excludible if the taxpayer has also met the two-year residence use provision for this portion of the property; see Rev. Proc. 2005-14, Section 2.03.

2. Calculate the gain attributable to depreciation on both the business and personal portions of the residence since May 6, 1997. Under Sec. 121(d)(6), the Sec. 121 exclusion does not apply to gain attributable to such depreciation. However, the taxpayer may defer recognition of the business portion of the gain under Sec. 1031; see Section 4.02(2).

3. Calculate the amount of any boot (i.e., non-like-kind property, such as cash or personal property, or operating expenses paid from proceeds) the taxpayer receives as a result of the transaction. Boot is taxable income only to the extent that it exceeds the gain excluded under Sec. 121; see Section 4.02(3).

4.  Under Section 4.03, calculate the stepped-up basis of property received in the like-kind exchange. In general, Sec. 1031(d) provides that the basis of the property received equals the basis of the property sold, decreased by the net amount of money and other non-like-kind property received, and increased by the net amount of money and additional debt contributed and any recognized gain. (In most instances, the basis of the replacement residence equals fair market value.) Under Rev. Proc. 2005-14, Section 4.03, the gain excluded under Sec. 121 is recognized for Sec. 1031 purposes. This amounts to a tax-free step-up in basis, which can be allocated to the business portion of a dual-use residence if the Sec. 121 exclusion is not fully used on the personal portion.

Example: C, married filing jointly, sells her dual-use townhouse in 2006 for $1.2 million. She replaces it with business property valued at $1.25 million and a separate residence valued at $750,000. The gain on the residence portion of Cs townhouse is only $466,667. She applies the remaining $33,333 of her $500,000 exclusion to the sale of the business portion of her townhouse, reducing its potential gain. As a result, by using both the Sec. 121 exclusion and the Sec. 1031 deferral, C saves $111,737 in taxes ($70,000 on the personal portion and $41,737 on the business portion). She also gains a substantial basis step-up in her residence and business property. The stepped-up basis for the business property results from a combination of the Sec. 121 exclusion and Cs choice to shift $166,667 in proceeds from the sale of the residence to the purchase of the business replacement property.

Rev. Proc. 2005-14s effect on the sale of the townhouse is shown in the exhibit; see the procedure, Section 5, for several detailed examples illustrating how to treat gain from the sale of a residence and how to calculate the new propertys basis.

Planning Tips

In advising clients on tax-advantaged strategies for the sale of a home, the following should be considered:

1. Sec. 121 is elective. A client can always choose not to claim the exclusion and to recognize the gain in gross income. For example, Cs other home will qualify for the exclusion because she occupied it as her primary residence for two of the last five years. If she decides to sell it soon, and that home has a larger gain, the option to recognize gain might be to her advantage. However, she can exclude only $250,000 in gain (not $500,000), as that home was never her husbands primary residence. Choosing not to claim the exclusion could also be advantageous if a client has expiring net operating loss carryforwards that would shelter any such gain. However, a client can change a decision about a Sec. 121 election within three years of the due date of the tax return for the sale year.

2.  Sec. 1031 is not elective, and there can be significant costs associated with it. A client can always choose not to qualify for Sec. 1031, by ceasing business use of the property before the sale or by failing to replace it with like-kind property within the required time. Depending on the size of the gain to be deferred under Sec. 1031, the client may find that the additional exchange costs do not justify the potential tax benefits of qualifying under Sec. 1031. These costs include both transaction costs (e.g., legal fees and facilitation charges), as well as additional compliance costs (including the fees charged by the tax adviser).

From Scott Usher, MST, CPA, Bader Martin Ross & Smith PS, Seattle, WA