A homeowner may exclude up to $250,000 of gain from the sale or exchange of a home if he owned and used it as his principal residence for at least two of the five years before the sale or exchange took place.The maximum exclusion is $500,000 for joint filers, if certain conditions are met. A taxpayer who uses a property partially as a principal residence and partially for business purposes is treated as using the entire property as his principal residence for purposes of the two-year use requirement if the residential and business parts are within the same dwelling unit. The exclusion doesn't apply, however, to the gain resulting from depreciation taken for partial business use of the residence after May 6, 1997.

Recognition of gain or loss is deferred if property held for productive use in a trade or business or for investment is exchanged solely for property of like kind that also is to be held either for productive use in a trade or business or for investment. Gain or loss will not be recognized until the property received in the exchange is sold or exchanged in a taxable transaction.

However, even if an exchange qualifies as a like-kind exchange, a taxpayer must recognize gain to the extent that she receives cash or property (boot) that is not of a like kind. Gain may not be deferred by a taxpayer on the exchange property that she was using as a principal residence at the time of the exchange.

In Rev. Proc. 2005-14, 2005-7 IRB, the Internal Revenue Service shows how the exchange of certain properties can qualify for both the homesale exclusion and deferral of gain under the like-kind exchange rules. To qualify for both benefits, the property must be exchanged for property to be held for investment or to be productively used in a trade or business, and the exchanged property must:

* Have been used as a principal residence for at least two of the five years before the exchange, but also must have been used in a business or held for investment at the time of the exchange (e.g., this requirement would be met if the property was used first as a principal residence and then was converted into rental property); or,

* A part of the property was used as a principal residence and a part was used as home office, but part would have had to be used as a home office at the time of the exchange.

Although no allocation of gain is required for such a property, gain isn't excludible to the extent of any post-May 6, 1997, depreciation. However, gain is allocated if the part of the property for which the use requirement isn't met is separate from the dwelling unit.

Where an exchange qualifies for both the homesale exclusion and deferral of gain recognition under the like-kind exchange rules, gain is computed as follows:

1. The homesale exclusion rules must be applied to gain before applying the like-kind exchange rules.

2. Even though the homesale exclusion does not apply to gain attributable to depreciation deductions for periods after May 6, 1997, deferral of recognition of such gain may be available under the like-kind exchange rules.

3. In applying the like-kind exchange rules, boot received in exchange for property used in the taxpayer's trade or business or held for investment (the relinquished business property) is taken into account only to the extent that the boot exceeds the gain excluded under the homesale exclusion rules with respect to the relinquished business property.

In determining the basis of the property received in the exchange to be used in the taxpayer's trade or business or held for investment, any gain excluded under the homesale exclusion rules is treated as recognized gain. Thus, the basis of the replacement business property is increased by any gain attributable to the exchanged property that is excluded under the homesale exclusion rules.

Example 1: On March 1, 1998, your client, an unmarried taxpayer, bought a house for $300,000 that she used as her principal residence until Jan. 1, 2003. On that date, she rented the entire house to a tenant and continued to rent the house to a tenant until she exchanged it on Feb. 15, 2005, for cash totaling $15,000 and another house with a fair market value of $605,000. She claimed depreciation deductions of $20,000 for the period she rented the house. She intends to rent the entire house she received in the exchange to one or more tenants.

Your client realized a total gain of $340,000 on the exchange ($620,000 amount realized [value of replacement property of $605,000 plus cash of $15,000] less adjusted basis of $280,000 [$300,000 cost less depreciation of $20,000]).

Since your client used the house as her principal residence for at least two years in the five-year period before she exchanged it, she is able to exclude $250,000 of the gain on the exchange from her gross income. Since the house was investment property at the time of the exchange, she is entitled to defer the gain realized under the like-kind exchange rules. Thus, she is able to defer recognition of the $90,000 gain ($340,000 less $250,000) in excess of the amount she can exclude under the homesale exclusion rules.

Even though your client received $15,000 of cash (boot) in the exchange, she is not required to recognize gain, because the boot is taken into account for purposes of the like-kind exchange rules only to the extent that it exceeds the amount of excluded gain.

Your client's basis in the replacement property is now $515,000, which is equal to the basis of the relinquished property at the time of the exchange ($280,000), increased by the gain excluded under the homesale exclusion rules ($250,000), and reduced by the cash she received ($15,000).

Example 2: Your clients, a married couple who file a joint return, bought a property for $600,000 on July 1, 1999. The property consisted of two separate dwelling units, a house and a guesthouse. From the date of purchase until the property was exchanged on March 1, 2005, for other properties, your clients used the house as their principal residence and used the guesthouse as an office in the wife's business. Based on the square footage of the respective parts of the property, your clients allocated three quarters of the basis of the property to the main house ($450,000) and one quarter to the guesthouse ($150,000).

On March 1, 2005, your clients exchanged the entire property for a residence and a separate property that the wife intends to use as an office. The total fair market value of the replacement properties is $1,200,000. The fair market value of the replacement residence is $900,000, and the fair market value of the replacement business property is $300,000, which is equal to the fair market value of the relinquished business property, i.e., the guesthouse. The wife claimed depreciation of $50,000 for the business use of the guesthouse. Your clients realized a total gain of $650,000 on the exchange (fair market value of $1,200,000 for the replacement properties, less basis of relinquished properties of $550,000 [$450,000 for house, and $100,000 for the guesthouse after deducting $50,000 of depreciation]).

Under the current homesale exclusion rules, your clients may exclude the entire gain of $450,000 on the exchange of the house ($900,000 fair market value of the replacement residence less $450,000 basis of the exchanged house), since they met the ownership and use requirements for that part of the property.

Since the guesthouse is business property separate from the dwelling unit, and your clients have not met the use requirements for the guesthouse, they may not exclude any of the gain allocable to the guesthouse under the homesale exclusion rules. However, because the fair market value of the replacement business property is equal to the fair market value of the relinquished business property and your clients receive no boot, they may defer recognition of the remaining gain of $200,000 ($300,000 fair market value of the replacement business property less $100,000 adjusted basis of the exchanged guesthouse).

Your clients' basis in the replacement residence is $900,000 ($450,000 basis in exchanged residence, plus $450,000 gain excluded under the homesale exclusion rules). Their basis in the replacement business property is $100,000, the same as their adjusted basis in the exchanged guesthouse.

Example 3: On Aug. 1, 2000, your client, a single taxpayer, bought a property for $480,000. The property consisted of a house that is a single dwelling unit for purposes of the homesale exclusion rules. From the date of purchase until March 10, 2005, when your client exchanged the property for a residence and separate property, your client used two thirds of the house (based on square footage) as his principal residence, and used the other one third as an office in his business. Your client also intends to use the separate property received in the exchange as an office in his business.

The total fair market value of the replacement properties is $750,000. The fair market value of the replacement residence is $500,000 and the fair market value of the replacement business property is $250,000, which is equal to the fair market value of the business part of the relinquished property.

Your client claimed depreciation of $60,000 for the business use of the relinquished property. Your client realizes a gain of $330,000 on the exchange (fair market value of the replacement properties of $750,000 less the adjusted basis of the relinquished property of $420,000 [cost of $480,000 less depreciation of $60,000]).

Under the homesale exclusion rules, your client may thus exclude the gain of $180,000 allocable to the residential part of the house ($500,000 [two thirds of $750,000 amount realized on the exchange] less $320,000 [two thirds of the original cost of $480,000]), because he met the ownership and use requirements for that part of the property.

The remaining gain of $150,000 ($250,000 [one third of $750,000 amount realized] less the $100,000 adjusted basis [$160,000 (one third of $480,000 cost) less depreciation of $60,000]) is allocable to the business part of the client's house. Your client may exclude $70,000 of this gain (the balance of the $250,000 homesale exclusion available), since this is less than the $90,000 of the remaining gain not allocable to depreciation ($150,000 less $60,000), because the client's office and residence are part of a single dwelling unit. Your client may defer the $80,000 balance of the gain (including the $60,000 attributable to depreciation) under the current like-kind exchange rules.

Your client's basis in the replacement residential property is the fair market value of the replacement residential property at the time of the exchange ($500,000). His basis in the replacement business property is $170,000, which is equal to his adjusted basis in the relinquished business property at the time of the exchange ($100,000), increased by the gain of $70,000 excluded under the homesale exclusion rules.

Caution: For sales or exchanges of a principal residence after Oct. 22, 2004, the homesale exclusion doesn't apply if the home was acquired via like-kind exchange within the five-year period preceding the sale. (See my article in the Dec. 20, 2004-Jan. 9, 2005, issue of Accounting Today.)

Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.

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