1031 Tax-Free Exchange May Help Delay Capital Gains

Added May 13, 2005 by Ilyce R. Glink

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Summary: When you rent out rooms in your home, you're not only living in your primary residence but you're also conducting business. When you're renting out rooms and later decide to sell what taxes do you have to pay? You may owe taxes on the depreciation you claimed and capital gains tax on the investment portion of the property.

Q: I have lived my home for the past five years but also rent rooms and take depreciation and deductions.

Can I sell the home and buy another without paying the capital gains or other taxes?

A: In general, when you sell your primary residence, you are entitled to keep up to $250,000 in profits (up to $500,000 if you're married) tax free. What complicates your situation is that you've used a portion of your personal residence for business purposes. That means your property is partly an investment property.

If you do nothing, and sell the property outright, you may owe tax for the depreciation you previously took, as well as tax on the profits from the sale on the investment portion of the property.

But you may be able to benefit by combining the $250,000 exclusion to which you're entitled on the sale of a primary residence you've owned for at least 24 months with a 1031 tax-free exchange. A 1031 tax-free exchange allows you to buy a replacement investment property (provided it costs at least as much as the property you're selling, among other rules) and defer any taxes owed.

You should talk to a knowledgeable accountant who can help you figure out how you would structure this deal so that you could defer paying taxes.

In general, if you have investment property and choose not to do a 1031 tax-free exchange, you'd have to pay tax on the recapture and on any capital gains generated by the property's sale.

May 13, 2005.

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