Residence Exclusion: Involving Two-Units or a Vacation Home, upon Divorce;  Inherited IRA and Salary Bonus

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, May 31, 1998

Copyright 1998 Robert L. Sommers, all rights reserved.

Question: I am single and own a two-unit building with a potential capital gain of $500,000. I have lived in the top unit for 5 years. May I move into the bottom unit for 2 years, then sell the building and claim a $500,000 principal residence exemption ($250,000 for each unit)?

Answer: No. Although you’ll meet the new residency exclusion’s "ownership and use" test since you’ve owned and used the dwelling as your residence for 2 of the past 5 years, you only use the residency exemption only once every two years. Unfortunately, to accomplish your goal, you’ll need to use the exception twice within a two-year period.

Recommendation: You could sell the top unit now if it can be classified as a separate dwelling (a co-op or condo), move into the bottom unit, wait two years and then sell the bottom dwelling. Or, consider selling a 50% undivided interest in the property, coupled with an option to purchase the remaining 50% after two years. To avoid an IRS attack, the price for the remaining 50% interest should be either the current fair market value or the FMV at the time the option is exercised.

Question: I own a vacation home. May I use the new residence exception if I sell it?

Answer: No. The residence exception applies to dwellings used as a principal residence. Unfortunately, a vacation home used exclusively as a second residence is not investment property and does not qualify for the tax-free exchange provisions (Internal Revenue Code Section 1031).

Recommendation: You might qualify for a tax-free exchange if you convert the vacation home to rental property by renting it out at least 12 months prior to an exchange. Although there are no cases or rulings directly on point, the IRS has ruled that if property is converted from personal to investment use prior to the time of sale, it will be treated as investment property, thereby qualifying it for the tax-free exchange provisions.

Question: My former spouse and I equally owned our residence. My divorce decree allows my children and former spouse to live in the house for 5 years before we sell it. Upon its sale, we will split the proceeds. Are we each entitled to the $250,000 exemption?

Answer: Yes. Under the new residency exemption, if you own a residence and under the terms of a divorce decree your former spouse continues to live in the dwelling, you are permitted to add on your spouse’s continued use of the residence to your period of ownership. Consequently, upon the sale, you may each claim a $250,000 residency exemption. This is apparently so, even though you may have purchased and lived in another residence for more than two of the past five years.

Question: May I roll over an inherited IRA into my existing IRA?

Answer: No. As a beneficiary of the IRA, you cannot roll it over to your IRA or convert it to a Roth. If your mother died before her required beginning date ("RBD") for distributions (April 1st of the year after she reached age 70 ) or if you were designated the beneficiary at the RBD, usually, you’ll receive minimum distributions amortized (paid ratably) over your life expectancy. If you were named beneficiary after the RBG, then the IRA was in "pay" status and minimum distributions will continue as though your mother was receiving them. Finally, you may take more than the minimum distribution at any time.

However, all distributions are taxed at your current rates. Since the IRA’s value is included in your mother’s estate, often you’ll receive a tax deduction for any portion of the estate taxes allocable to the IRA.

Question: I received a bonus and relocation expenses from my employer, but am required to pay some of it back (on a pro-rata basis) if I leave my job within 24 months. Do I declare the money in the year I receive it or wait until the 24-month period has expired?

Answer: You must declare the money currently. If you pay it back, then you’ll be entitled to a deduction. You have an absolute right to the funds, subject to a potential contractual liability. You cannot wait until the liability lapses before declaring the income, otherwise, taxpayers could create contingencies to delay paying taxes on funds they have already received.




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