By Larry Weiss

The Internal Revenue Service has good news for property owners: A taxpayer may now exclude $250,000 ($500,000 for certain joint filers) of capital gains realized and defer other capital gains through a 1031 Exchange on a single property. The new procedure applies to homeowners who use their property as their personal residence and also use the property for “investment business purposes.” Investment business purposes could include a home office or rental of a portion of the property.

Examples of property owners who could benefit:

• Personal Residence/Rental Property. Many people have converted their personal residence to a rental property in recent years. The IRC Section 121 requires a taxpayer to have lived in the residence in two of the last five years to be eligible for the Capital Gains Exclusion. Thus, taxpayers who have converted their home to a rental property may take advantage of the Capital Gains Exclusion and the 1031 Tax Deferred Exchange.

• Combination Property. A taxpayer owns a property that includes his/her personal residence and another unit held for business purposes. Part of the property is eligible for Capital Gains Exclusion and the other structure is eligible for Capital Gains Tax Deferral. A simple example would be a property with a home and guest house. The rented guest house would constitute a property held for business purposes. Each component would be accounted as a separate property in an exchange.

• Dual-Use Property. A taxpayer owns a house that constitutes a single-dwelling unit. In an example from the IRS, two-thirds of the home is used as a personal residence and one-third as an office in the taxpayer’s trade or business. A dual-use property can benefit from both Capital Gains Exclusion and Capital Gains Deferral.

In the past, most properties were classified as either personal residences eligible for Capital Gains Exclusion treatment or investment properties eligible for 1031 Exchange transactions. Properties were rarely eligible to take advantage of both Section 121 and Section 1031 Exchanges simultaneously. The recent IRS Revenue Procedure (2005-14) has expanded the opportunities to utilize both Section 121 and 1031 in one exchange.

The great appreciation in Peninsula real estate has provided unique planning opportunities to people who own property for business and residential purposes. IRS Revenue Procedure (2005-14) provides six different examples. Careful consideration to each individual’s circumstances and tax needs is essential. Individuals should always consult a qualified tax professional to review the different options when considering the sale of real estate.

Larry Weiss, CPA, is a tax professional in Los Altos. He can be reached at 962-8457.