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Merlo
Merlo, Accountant
Category: Tax
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Experience:  25+ years tax consulting. Specializing in returns for US citizens living abroad
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I am in a divorce proceeding in Pennsylvania. We own a marital

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I am in a divorce proceeding in Pennsylvania. We own a marital residence (which will go to my spouse) and a rental property (which will go to me). Both properties are now in both of our names. The rental property is two units and one unit is moving out July 3 2009. After I take ownership of the property I want to sell it and buy a single family home. Currently I am scheduled to move into an apartment on 6 July. From a capital gains tax point of view;
1) How can I avoid paying a capital gains tax on the rental property?
2) Should we sell it now before the equitable distribution gives me ownership?
3) Can I move into for a period of time and then claim it as my residence and then sell it without capital gains tax implications?
4) We will continue to file a joint return in 2008 and most likely in 2009 - How do the legal costs of the divorce (which are high) enter into offsetting the capital gain (if we sell)
Submitted: 5 years ago.
Category: Tax
Expert:  Merlo replied 5 years ago.
Hello pam,

1. There is no way to avoid paying capital gains tax on your rental property. You can delay the tax if you sell the property and participate in a 1031 exchange. What that means is that you use the proceeds from the sale of the rental property to purchase another like-kind rental property. This does not avoid the tax on the sale, but it delays paying the tax until such time as the second rental property is sold. If the first property is sold and the proceeds are not re-invested in another rental property through a 1031 exchange, then tax becomes due in the year of the sale.

2. Selling the property now as opposed to after you have 100% ownership will have no affect on the amount of tax that is due. The only advantage to you may be to sell it while you are still filing a joint tax return, if you and your spouse will be equally liable for the taxes that will be due.

3. Moving in to the rental property for two years would give you a partial exclusion on the gain from the sale. But there are new rules that went in to effect as of 1/1/09. The new rule is that you must own the property for at least 2 years and you must use it as your primary residence for at least 2 of the last 5 years preceeding the sale. If you satisfy those rules, then you may exclude a percentage of the gain, based on the years you actually lived there. The exclusion which is offered is $250,000 for a single person. So as an example, if you owned the property for a total of 10 years, and used it as a rental for the first 8 years and then as your primary residence for the last 2 years, your period of use as a primary residence is 20%, and you would be allowed 20% of the exclusion amount, or a total of $50,000.

4. Your legal costs for the divorce are never tax deductible.

If this was helpful please press the Accept button. Positive feedback is also appreciated.

Thank you pam.

Customer: replied 5 years ago.

Hello Merlo,

Given the limited information that you have and the following options what would you advise me to do;

 

1) I need to move out of my home by 6 July and have found a house to rent. I could move into the rental and find another tenant for my jointly owned rental property and simply maintain it as a rental property until ownership is granted to me. At that time I can choose to sell it and pay the taxes to buy a single family home or use the equity to take out cash and use that as a down payment for a single family home or move into it.

 

2) I can get out of the lease I just signed and hope the realtor is easy on me for the deposit and then move into the marital rental unit. Then after ownership is granted to me I can either stay for two years and use it as a residence without any portion being rented or live in one unit and rent the other unit.

 

3) If I chose option 2 can I live in the unit for two years and not rent out either unit and then sell it to avoid paying the capital gains tax.

 

House ownership history is as follows;

1) I purchased in 1983 for $50k

2) I lived in one unit and rented the other starting in 1983

3) Wife moved in in 1985

4) We lived in one unit and rented the other from 1985 to 1992

5) In 1993 both units have been rental units

6) The property was appraised in Nov 2008 for $190k

7) It has been depreciated on all tax returns since 1983.

Expert:  Merlo replied 5 years ago.
Hello again pam,

The problem here is that regardless of whether or not you actually move back in to the rental unit, you are still going to end up paying tax on most of your gain from this sale, even if you live there for 2 years.

As I explained earlier, the laws regarding the exclusion you may claim on your primary residence were changed on January 1st of 2009. It used to be that you could exclude $250,000 from the gain on your primary home, as long as you had owned it for 2 years and lived there for 2 of the 5 years preceeding the sale. That is no longer the case. Under the new laws which went in to effect on 1/1/09, you still have to own the property for 2 years and you still have to live there for 2 years preceeding the sale, but you are no longer automatically allowed the full $250,000 exclusion. You are only allowed to exclude a percentage based on the number of years you actually lived there.

Your case is a little more difficult to figure, because part of the time you lived in one unit, and then part of the time you rented both units. So you would have to do a separate calculation for each unit. But basically you have owned this property for 26 years. You lived in one of the units until 1992, or for 9 years. For the remaining 17 years of ownership, both units were rented.

If you now move back in and live in one of the units for 2 years, then by that time you will have owned the property for 28 years and you would have lived in one of the units for a total of 11 years.
So your percentage of actual ownership use on that one unit would be 39%. The other unit was 100% rental.

So when you go to sell this property, half of the sale price attributable to the unit which was always rented, is totally subject to tax. The other half of the sale price you would be able to exclude 39% from the gain.

You also have to keep in mind that this property is now fairly close to being fully depreicated, or at least a good portion of it is. And you must reclaim that depreciation when you sell, regardless of whether or not you move back in to that property.

The botXXXXX XXXXXne is that if you do move back in to one of these units, then the longer you live there, the larger percentage you would be able to claim as a deduction once you sell. But since one unit was always a rental, and since you will still have to recapture the depreciation you have claimed over the years, you would likely have to live there for quite some time before your exclusion amount was really anything significant.

That being the case, you should probably just make your decision based on whether or not you really want to spend any significant amount of time living in this property, because unless you do, it is not likely to make any significant change in your tax situation.

If this was helpful please press the Accept button. Positive feedback is also appreciated.

Thank you pam.


Merlo, Accountant
Category: Tax
Satisfied Customers: 9783
Experience: 25+ years tax consulting. Specializing in returns for US citizens living abroad
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