Capital Gain on Your Apartment Sale

Some of our international clients who currently live in NYC for their job but might move back to their country later on, ask us about the tax advantages of an investment property with the hope that once they move back to their country they will rent their NYC apartment. In this article we will delve into how the tax code treats residential and investment properties for capital gain purposes.

SECTION 121: The tax provision to know when selling your principal residence

Section 121 of the Internal Revenue Code (IRC) is a highly beneficial tax provision that allows homeowners to exclude a significant portion of the capital gain from the sale of their principal residence from their gross income. This means they don't have to pay taxes on that excluded amount.

Here are the key aspects of Section 121:

Exclusion Amounts:

• $250,000 for single filers (or married individuals filing separately).

• $500,000 for married couples filing jointly.

  
  

Eligibility Requirements (Ownership and Use Tests):

To qualify for the full exclusion, you must meet both an "ownership test" and a "use test" during the 5-year period ending on the date of the sale:

• Ownership Test: You must have owned the home for at least 2 years (24 months) during the 5-year period.

• Use Test: You must have used the home as your principal residence for at least 2 years (24 months) during the 5-year period.

  
  

Important Notes on the Tests:

• The 2 years of ownership and 2 years of use do not have to be consecutive. For example, you could live in the home for a year, rent it out for three years, and then move back in for another year before selling.

• For married couples filing jointly, only one spouse needs to meet the ownership test, but both spouses must meet the use test (unless a special rule applies, like a surviving spouse).

• You generally cannot use this exclusion if you have excluded gain from the sale of another home within the 2-year period prior to the current sale.

  
  

What is a "Principal Residence"? 

The IRS determines your principal residence based on a facts-and-circumstances test. Factors include:

• Where you spend the most time.

• Your mailing address for bills and correspondence.

• The address listed on your driver's license, voter registration, and tax returns.

• The location of your family's principal place of abode.

  
  

Depreciation Recapture:

If you used any portion of your principal residence for business or rental purposes (and took depreciation deductions) after May 6, 1997, any gain attributable to that depreciation cannot be excluded under Section 121. This portion of the gain is subject to depreciation recapture tax rates.

Partial Exclusion: 

Even if you don't meet the full 2-year ownership and use tests, you may still qualify for a partial exclusion if the sale is due to:

• A change in place of employment.

• A health issue.

• Unforeseen circumstances (as defined by the IRS).

1031 EXCHANGE : The tax provision to know when selling your investment property

When it comes to selling an apartment, many investors seek ways to maximize their profits and minimize their tax liabilities. One effective strategy is the 1031 exchange, a powerful tool that allows property owners to defer capital gains taxes.

What is a 1031 exchange

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows real estate investors to sell a property and reinvest the proceeds into a new property while deferring capital gains taxes. For example, if someone were to sell his property with a gain of $200,000, under the 1031 exchange, these $200,000 wouldn't be taxed. This provision is particularly advantageous for those looking to upgrade or diversify their real estate portfolio without incurring immediate tax liabilities.

To successfully execute a 1031 exchange when selling an apartment, investors must adhere to specific guidelines:

Like-Kind Property

The properties involved in a 1031 exchange must be of "like-kind." This means that both the sold property and the new property must be investment or business properties. For example, selling an apartment can be exchanged for another apartment, a commercial building, or even raw land.

Timing Rules

There are strict timelines that must be followed in a 1031 exchange:

Identification Period: After selling the apartment, the investor has 45 days to identify potential replacement properties. You are allowed to identify up to 3 properties regardless of their value, or an unlimited number of properties as long as their combined fair market value does not exceed 200% of the relinquished property's value. A lesser-used "95% rule" also exists, requiring you to acquire at least 95% of the fair market value of all identified properties.

Exchange Period: You must complete the purchase of the new property within 180 calendar days of the sale of your original property, or by the due date of your tax return for the year the relinquished property was sold (including extensions), whichever comes first. Both the 45-day and 180-day periods run concurrently and are strict, with no extensions for weekends or holidays.

Use of Qualified Intermediary

To facilitate a 1031 exchange, it's necessary to engage a qualified intermediary (QI). The QI will hold the proceeds from the sale of the apartment and will use those funds to acquire the new property, ensuring that the seller does not take possession of the cash during the exchange.

Benefit of a 1031 exchange work

Utilizing a 1031 exchange when selling an apartment offers several key advantages:

Tax deferral

The primary benefit is the ability to defer capital gains taxes. This allows investors to reinvest their profits into new properties, potentially increasing their overall wealth without the immediate tax burden.

Portfolio Diversification

A 1031 exchange can be an excellent opportunity to diversify an investment portfolio. Investors can sell an apartment and use the proceeds to acquire different types of properties, reducing risk and enhancing potential returns.

Increased Cash Flow

By exchanging into a property that generates higher rental income or has greater appreciation potential, investors can enhance their cash flow and overall investment returns.

Leverage Opportunities

Investors can use a 1031 exchange to leverage their investment. By acquiring a more valuable property with additional financing, they can increase their investment exposure and potential returns.

Depreciation Reset

While depreciation recapture is a consideration, a 1031 exchange can effectively "reset" the depreciable basis of your investment, allowing for new depreciation deductions on the replacement property.

The Hybrid Strategy: Converting the Primary Residence to an Investment Property or Vice Versa

While you cannot directly 1031 exchange your primary residence, a powerful strategy emerges when a property converts from one use to another.

Scenario 1: Converting a Primary Residence to a Rental Property (and then 1031 Exchanging it)

This is where the magic can happen. Imagine you've lived in your home for many years, benefiting from significant appreciation. If you decide to move, instead of selling immediately, you could convert it into a rental property.

• The Conversion Period: The IRS doesn't specify an exact timeframe for how long a property must be rented out to be considered an investment property. However, generally, tax professionals recommend renting it out at fair market value for at least two years to establish a clear intent of rental use. During this time, you would collect rent, report it as income, and deduct rental expenses. Your personal use of the dwelling cannot exceed 14 days or 10% of the number of days the property is rented at fair market value during each of the two 12-month periods immediately preceding the exchange.

  
  

• The Sale and 1031 Exchange: After a suitable period as a rental, you could then sell the property and initiate a 1031 exchange. The proceeds would be used to acquire another investment property, deferring the capital gains tax on the appreciation that occurred during its time as a rental property.

  
  

• Combining with Section 121: Here's the brilliant part: if you owned and lived in the property as your primary residence for at least two out of the five years preceding the sale, you can still utilize the Section 121 exclusion for the portion of the gain attributable to its time as a primary residence. This allows for a powerful one-two punch: tax-free gains on your primary residence portion, and deferred gains on the investment property portion. However, it's crucial to understand the "non-qualified use" rules introduced in the Housing Assistance Tax Act of 2008, which can limit the Section 121 exclusion for periods the property was not used as a primary residence after 2008.

  
  

Scenario 2: 1031 Exchanging into a Property You Later Convert to a Primary Residence

This scenario is also possible, though with stricter rules. You could perform a 1031 exchange, acquiring a property that you initially intend to hold as an investment (e.g., a rental). After holding it as a rental for a period, you could then move into it and convert it into your primary residence, eventually taking advantage of the Section 121 exclusion when you sell it in the future.

If you acquire a property through a 1031 exchange and then convert it to your primary residence, the IRS generally requires you to hold it as a rental for at least 18 months before moving in. Furthermore, to qualify for the Section 121 exclusion, you would then need to live in the property as your primary residence for at least 24 months, and hold the property for a total of five years before you can claim the Section 121 exclusion on its sale. The intent for its initial use as an investment property is critical for the 1031 exchange to be valid.

Conclusion

Section 121 and a 1031 exchange are powerful tools of their own but even more beneficial when combined. The use of both strategies is particularly relevant for individuals who currently live in the US but who have plans to move to a different countries later on.