Capital gain on sale of principle residence

[Scott Forbes]

I have a question regarding the IRS exclusion of taxes paid on the sale of a principle residence.

Here is the scenario: Tenant has been renting a condo for 7 years and it has been their principle residence.

The landlord has decided to sell this condo to the tenant. After the closing takes place, the title will be transferred giving ownership to the tenant. The tenant now wishes to sell this property taking full advantage of the exclusion of capital gain taxes on the sale of a principle residence as it has been their primary residence for the last 7 years. The conservative profit is estimated to be $40k.

Because the tenant is now the "owner", do they still get any credit for this being their primary residence for the last 7 years, OR does the clock get reset? I'm thinking because the tenant did not "own" the property until recently, the IRS will require the new owner must meet the 2 year criteria all over again. If this is the case and if the owner sells before the new 2 year criteria is met, to avoid the tax consequence, they would want to consider a 1031 exchange.

Your thoughts

[Jon Holdman]

The sale from the current owner to the tenants and then the tenant to someone else are two entirely separate transactions, each with their own gain or loss. 

The current owner could sell to the tenant and use a 1031 to invest the proceeds in another investment property.  That has no bearing on the tenant/buyer, nor does the fact the owner is selling to the tenant affect his or her ability to use a 1031 to defer taxes on the gain.

Once the current tenant buys the place they must live there for at least two years before they can take advantage of the exclusion on gains on the sale of a primary residence.  However, be aware that the "basis" for the property is the price the new buyers pay, plus costs.  The seller's gains (from when they bought it until the sale) are irrelevant for the new buyer's gains.  So, if the tenant buys the property and quickly resells it they will not have any capital gains unless the seller just plain gives away part of the equity in the property.  For that matter, if the tenant buys at a market price then turns around and sells at (roughly the same) market price, they will have a significant loss due to the transaction costs.

Here are some sample number.  Lets assume the current owner bought seven years ago for $100K and paid $2K in closing costs.  They have done no capital improvements.  They would have taken (or been allowed to take) about $20K in depreciation.  Their basis is $82K.  They sell it to the tenant for $140K and have $3K in closing costs.  The current owner's gain is $140K - $3K - $82K = $55K.  They could 1031 that into another property.  If not they pay a combination of tax on unrecaptured depreciation and capital gains tax.

The tenant and now buyer just paid $140K for the property and have about $3K in closing costs so their basis starts at $143K.    If they turn around and sell it with an agent for $140K they will have about $12K in closing costs.  So they will have a loss of about $15K.  In order to break even they would need to hold and hope for at least $15K in appreciation.

Now maybe you're thinking the current owner will give them a great deal and sell it to them for $100K.  Why the owner would do this I have no idea.  Always better to earn something and pay part of it in taxes than to earn nothing.  Now the seller has about $2K in closing costs, so their gain is $100K - $2K - $82K = $16K, which they could 1031 into another deal or pay tax on.  The buyer buy for $100K plus $2K in closing costs.  Now the buyers turn around and sell retail with an agent for $140K as above.   Their gain is $140K - $12K - $102K = $36K.  That would be taxable unless they live there for two years.