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What you should know about capital gains, rental deductions

Benny Kass
Inman News®

DEAR BENNY: We own a small single-family home (800 square feet) located on the property adjacent to our primary home. We purchased it using a Starker exchange about 15 years ago. We stopped renting it out eight years ago, when the mortgage was paid off. We now use it as an extension of our primary home, with the living room as a game room, garage and basement as storage, one bedroom as an office, and the other as a guest bedroom.

If we were to sell it, would the Starker exchange come back into play? What would happen with the deductions taken during the "rental phase"? --Jim

DEAR JIM: When you did the Starker (Section 1031) exchange, you sold one property (called "relinquished") and exchanged it for another (called "replacement"). You were able to avoid paying capital gains tax, but the tax basis of the relinquished property became the tax basis of the replacement.

You have now abandoned the investment. The bad news is that you cannot take advantage of the up-to-$250,000 exclusion of gain (or if you are married and file taxes jointly up to $500,000) for any property that you exchanged.

So while you may be able to claim the exclusion on your principal home (assuming you owned and used it for two out of the five years before sale), you will have to pay capital gains on the portion of the property that was exchanged.

But to calculate gain, you must remember that the basis of the replacement property is not what you paid for it, but what the basis was for the relinquished property.

You may also have to recapture any depreciation that you took while it was investment property.

You really should discuss this with a tax accountant to make sure you file the correct documentation. We know that the IRS is always on the lookout regarding these kinds of exchanges.

DEAR BENNY: I have been trying to get rid of my time share for the past two years and have hit a few roadblocks. I would really appreciate your advice on finding an attorney within the Chicago area who may be able to help me. I am a co-owner and am unable to find the other owner since he has changed all of his information about his whereabouts. Any sort of information you may have will be helpful. --Kassie

DEAR KASSIE: If you do not have the name of an attorney in your area, you should contact the local bar association: in your case, the Chicago Bar Association. It is my understanding that most (if not all) bar associations have a lawyer referral program, where lawyers with different specialties can be retained to assist you.

As to finding your co-owner, have you contacted the time-share management company? Perhaps it has this information. Otherwise, you may have to file a lawsuit known as a "quiet title" complaint. You advise the court that you have made a diligent search for your co-owner, but have been unable to find him/her, and ask the court to declare that you are the owner who has the authority to do what you want to do: sell, rent, mortgage, etc.

Such a quiet title lawsuit can be time consuming and expensive, and it may not be worth pursuing for the time share. But talk with an attorney for specific guidance.

DEAR BENNY: My wife inherited her sister's house when she died last year. We want to allow our two oldest daughters to live there rent-free. The house will remain in my wife's name. My daughters have agreed to pay all future taxes, mortgage insurance and any costs that come due. The house is valued at $180,000. Please set me straight as to what effect this will have on us as parents? --C.D.

DEAR C.D.: In effect, you and your wife will be renting your house to your daughters. And while you indicate it will be "rent-free," in reality (since they will be paying all of the expenses) it is not rent-free. The Internal Revenue Service could consider these funds as taxable rental income to you.

Even though these are your daughters, I would recommend having them both sign a lease, spelling out customary terms and conditions. You should check with your state and/or local government to determine if you have to obtain a rental license. And the income you receive will be taxable to you, although you should be able to depreciate the property. Talk to your financial advisers about your proposal, as I cannot provide specific legal or financial advice to my readers.

I do have, however, a couple of suggestions: First, make sure that you have adequate hazard insurance. Next, have you considered adding your name to the title, so that you and your wife could hold the property as tenants by the entirety?

And finally, you can gift each of your daughters, tax free to everyone, up to $13,000; your wife can also make that same gift. Let's say the yearly expenses that your daughters will be paying add up to $24,000 -- covering the mortgage, real estate tax, insurance and basic upkeep. If you give each of your daughters $12,000 yearly, and then they pay you back with your gift, then the transaction truly is "rent free" for them. You would still have to declare the moneys you receive as income, because even though it seems like it's your own money, the IRS treats it as a gift. It's no longer your money.