No easy way to avoid tax on profitable vacation-home sale

Principal-residence restrictions get in the way
By: Robert J. Bruss: Inman News
DEAR BOB: After about 14 years of very enjoyable vacation-home ownership, my wife and I have concluded it is time to sell. Market values have greatly appreciated in the vicinity. We can earn at least a $300,000 net profit if we sell now. Realty agents are constantly hounding us to sell. But we only paid about $46,000 so we will have a tremendous tax to pay. Because this is not our principal residence, nor do we rent it to tenants when we aren't using it, how can we avoid tax when we sell? – Wayne T.

DEAR WAYNE: There are several possibilities. One is for you and your wife to move into the vacation home full-time as your principal residence for at least 24 of the 60 months before its sale. Then you can qualify for up to $500,000 principal-residence-sale tax-free profits.

If that doesn't interest you, another alternative is to rent your vacation home before its sale, perhaps on a lease with option to purchase. Then you can sell your rental property and qualify for an Internal Revenue Code 1031 tax-deferred exchange for another qualifying rental property of equal or greater cost and equity.

That's it. If you don't like either of those alternatives, you'll just have to resign yourselves to paying the current 15 percent federal capital gains tax rate, plus any applicable state tax where your vacation home is located. For full details, please consult your tax adviser.

$500,000 PRINCIPAL-RESIDENCE-SALE TAX BREAK CAN BE USED AGAIN

DEAR BOB: We plan to sell our home and use the $500,000 tax exemption that you often discuss. When we purchase our next home, can we take that exemption again after five years? – Leslie R.

DEAR LESLIE: Yes. But you don't have to wait five years to use the Internal Revenue Code 121 principal residence sale tax exemption again.
This wonderful tax break can be used over and over again without limit. However, it cannot be used more frequently than every 24 months.

After you buy your next home, if you have owned and occupied it at least 24 months before its sale, you can use your principal residence sale exemption again to shelter up to $250,000 (up to $500,000 for a qualified married couple filing a joint tax return) tax-free profits. For full details, please consult your tax adviser.

CARRY OVER UNDEDUCTED "SUSPENDED" REALTY TAX LOSS

DEAR BOB: On my recently filed 2004 income tax returns, I had about $34,000 tax loss from my rental property. But the tax law allows me to only deduct up to $25,000 of that loss against my ordinary taxable income from my job. Do I lose the undeducted $9,000 of my tax loss? – Martha W.

DEAR MARTHA: No. You have a "suspended" tax loss. That means your excess $9,000 tax loss from your rental property, probably due to the wonderful non-cash tax deduction for depreciation wear, tear, and obsolescence, must be saved for use in future tax years.

Keep careful track of your suspended, unused tax losses from your rental property. You can deduct such suspended losses in future tax years. Or, as happened to me when I sold some of my rental properties, I used my suspended tax losses to avoid tax on my capital gains. For full details, please consult your tax adviser.

The new Robert Bruss special report "How to Get Started Investing to Earn Big Real Estate Profits" is now available for $4 from Robert Bruss, 251 Park Road, Burlingame, CA 94010 or by credit card at 1-800-736-1736 or instant Internet download at http://www.bobbruss.com/. Questions for this column are welcome at either address.

For more information on Bob Bruss publications, visit his Real Estate Center.