Working around home-sale time limits

Dear Tax Talk,
I want to sell the rental house I bought on Oct. 23, 1993. I lived in it until March 10, 2002, and it has been rented since then. I now want to sell it, but want to avoid paying capital gains on it. I know that if I lived in it two out of the last five years, I only have to pay on profit greater than $500,000 since my wife and I owned it. Since I only have until this March 10th to sell it, what would happen if I sell it three or four months later than that date? Will I have to pay capital gains taxes since I only lived in it for one year and eight months? I am thinking it will bring in $160,000 or so profit. Your help will be very much appreciated.
-- Carlos

Dear Carlos,
If you sold it three or four months later you'd be too late, but fortunately you wrote in early enough to get some help.

When Congress changed the rules on home sales a few years back, it left some room for folks that may want to try to rent their property but later change their minds. However, whether intentional or not, they created a disincentive to extend the rental period.

If you had sold the house at the time you moved, you would not have paid any taxes because the gain would have been sheltered by the $500,000 exclusion. Since you owned the home so many years, a lot of the gain you will realize now could have escaped taxation. This creates an unfair situation, and I don't believe it was done with the intention that everyone should sell so as to avoid gains. What the law lacks is a mechanism that would allow you to have the gain forgiven within the $500,000 limit available had you sold when you moved out.

Accountants and attorneys have given this some thought and believe that there is a way around this situation by changing the ownership so as to recognize that gain before the expiration of the time limits. For example, since you intend to sell shortly, but may not make the deadline of March 10, you could structure a sale to a trusted relative such as your parent before the deadline passes. This relative would pay the current market price so that when it's sold shortly thereafter, he or she would not have any gain or loss. You would either receive cash at closing from the relative, or if cash is not available, you could take back a mortgage, which would be paid off on the subsequent sale.

While some conservatives would consider this aggressive tax planning, it does not run contrary to the current law and regulations.

-- Posted: Jan. 26, 2005