Tax Strategy for Your Highly Appreciated Primary Residence

Primary residence home ownership has long been supported by the Federal Government. Homeowners benefit from tax incentives such as the mortgage interest deduction and lending programs like the FHA First Time Homebuyer Program. Additionally, the IRS Section 121 exemption allows homeowners who have experienced appreciation in the value of their home to realize up to $250,000 (if a single taxpayer) or $500,000 (if married-filing-jointly) of appreciation tax-free. What an incentive that is!

Most US homeowners will never come close to exceeding their Section 121 exclusion, but we live in the Puget Sound and at times it seems our property values play by different rules than most. According to an August 2017 Zillow Research report, Seattle is home to 22 “million-dollar neighborhoods” – 9 of which were added in 2017 alone. In Seattle, there are thousands of homeowners who would exceed their Section 121 exclusion of $250,000/$500,000 if they sold their home today.

Long-Term Capital Gains and often the Net Investment Income Tax are applied to any appreciation above the exempt amount, resulting in an effective tax rate as high as 23.8% and quite possibly a significant tax bill, even with the exclusion. However, with some foresight and planning, it is possible for owners of highly appreciated primary residences to receive $250,000/$500,000 of cash proceeds and defer all taxes by combining a Section 121 exemption with a 1031 tax-deferred exchange.

The steps for this combination tax strategy are as follows:

  • The home must be the designated primary residence of the owner/taxpayer for two of the last five years preceding the sale.
  • The home must be rented out in an “arm’s length” transaction (meaning market rates and not to immediate family) for generally the year preceding the sale.
  • Upon the sale of the home, a desire to perform a 1031 exchange must be noted and included in the Purchase and Sale Agreement.
  • Different than a standard 1031 exchange where all sales proceeds must go directly from escrow to the Qualified Intermediary, the seller can withhold cash up to their Section 121 exclusion amount of $250,000 or $500,000 depending on filing status.
  • Standard 1031 exchange guidelines are then applied to the remaining funds held by the Qualified Intermediary.

Most homeowners are not aware of this very viable approach, however, the opportunity to extract liquidity and defer taxes makes it a very attractive strategy. Many investment property owners we work with reside in King County neighborhoods that have appreciated significantly over their ownership years. A strategy such as this can be an extremely effective tax-deferral option as owners consider downsizing their primary residence or relocating either locally or outside the area.

If you have an issue or a concern relating to your investment property ownership, contact Austin Bowlin, CPA and Partner at Real Estate Transition Solutions to schedule a complimentary consultation.  Austin provides exit strategy analysis, execution, income and equity replacement options for investment property owners and can be reached at 206-686-2201 or email him at aabowlin@re-transition.com.

The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Such offers are only made through the sponsors Private Placement Memorandum (PPM) which is solely available to accredited investors and accredited entities. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million dollars exclusive of primary residence) and accredited entities only.  If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Diversification does not guarantee profits or guarantee protection against losses. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor.  This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Real Estate Transition Solutions is independent of CIS and CAM.