Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)

Part III. Investment Income and Deductions

Interest, dividends, capital gains, long-term gains, short-term gains, original issue discounts, basis, dispositions, swaps, straddles, wash sales . . . the list of terms associated with investment taxation goes on and on. Fortunately, the list of ways to reduce your tax bill through investments is fairly extensive as well. Part III is the largest section of the book and it is fully devoted to the ways that investment income is taxed and the deductions and strategies that can be used to reduce that tax.

Tax planning and investment planning should go hand in hand. There are a great many tax considerations that should be understood and remembered as you make investment choices. With that said, it is also important to not let the tail wag the dog, so to speak. Taxes are only one of many things to consider when making an investment. However, they are an important factor and can make a significant difference in the net growth and income that you derive from your investments. Study the chapters in Part III to prepare yourself for a great investment strategy.

Chapter 10. Tax-Free Investment Income

Municipal Bonds, Roth Accounts, Your Residence, and Food

Very few sources of income are not taxed. In fact, I can’t think of one that is never taxed. However, some sources of income can be tax-free, as long as you follow all of the rules. Depending on your marginal tax bracket, this tax-free treatment of certain income sources can equate to a significant increase in the true value of that income, in comparison to income from other sources.

image   Example   Linda is the vice president of a large technology company and is paid a high salary. Her income places her in the 33% federal tax bracket, as well as in one of the highest tax brackets in her state of California, at 9.3%—bringing her total marginal tax rate to 42.3%. Linda has invested most of her savings in California municipal bonds, which pay her an average of 5.25% in interest per year on her investment. Because the interest from these bonds is tax-free at both state and federal levels, the 5.25% that she is earning is actually the after-taxequivalent of earning 9.1% interest from a taxable source. She would have to find a taxable investment that pays more than 9.1% in order to end up with a greater after-tax income than she gets from the 5.25% municipal bonds, because so much of the taxable interest is eliminated by the tax (9.1% taxable interest earned – 42.3% tax on that interest = 5.25% left after tax).

As you can see from this example, finding sources of tax-free investment income can result in a significant difference in the after-tax benefit of that investment, especially for those in higher tax brackets. The way that a particular income source will be taxed must weigh heavily on the decision of where to invest your money.

Tax-free income sources can affect your overall tax burden in an additional way as well. Tax-free income sources are not included in the calculation of your Adjusted Gross Income (AGI). As you learned earlier in this book, a large number of deductions and credits are limited (phased out) by a high AGI. The tax-free income sources discussed in this chapter are not calculated into many of those phase-out formulas, which can lower your taxes even more.

This chapter focuses on four sources of tax-exempt “investment” income. Two of these sources are traditional investment options, while the other two may not be thought of in that way. The four investment sources discussed are:

·     State and municipal bond interest

·     Roth retirement accounts

·     Home ownership

·     Agriculture and livestock development

Each of these investments has special rules that must be followed. When those rules are broken, the tax-free income source becomes taxable. If you learn how each of these sources of income is developed and taxed, then you will be on your way to fewer taxes.

State and Municipal Bond Interest

The interest that is paid on state-issued bonds and municipal bonds (those bonds issued by local governments, municipalities, and their agencies) is tax-free at the federal level. The interest is also tax-free in most states for bonds issued within their own state (i.e., a California bond is tax-free in California, but a Virginia bond would not be tax-free in California).

As nice as this tax-free income may be, you must be certain to follow the governing rules. If you are not careful there are three things that could trigger a tax on this “tax-free” income:

·     Capital gains tax

·     Social Security

·     The type of bond

Capital Gains Tax

Although the interest on municipal bonds is tax-free, any gains received from the sale of those bonds are subject to the capital gains tax. If, for example, you purchase a municipal bond for $1,000 and later sell it for $1,200, the interest that you earned while holding the bond would be tax-free, but the $200 gain will be taxed. In this way you can end up paying taxes on investments that you specifically chose to help you avoid taxes.

It is especially important to be aware of this factor when you purchase shares of a tax-free bond mutual fund. If the mutual fund manager sells bonds in the fund, a portion of the gains will be passed on to you at the end of the year. Even with funds that are geared toward minimizing such gains, neither you nor the manager can control the actions of the other owners in the fund. If those other investors withdraw their money (forcing the fund to sell some bonds) there will be capital gains (or losses) and a portion will be passed on to you.

The only way to ensure that you pay no tax on your investment is to buy individual bonds and hold them to maturity.

Social Security

Tax-free bond interest income is generally not included in the calculation of AGI. However, the formula that determines the amount of Social Security income subject to taxation does include this interest. Because of this, “tax-free” interest income can result in additional Social Security income being taxed, which really amounts to an indirect taxation of “tax-free” bond interest. This is an important factor to consider in retirement planning. For more information on this indirect taxation of tax-free interest, see the portion of Chapter 7 that covers Social Security taxation.

The Type of Bond

The tax-free status of municipal bonds has been a part of the tax code since 1913. However, it has been modified in the last few decades. Today several types of municipal bonds are taxable, or can be taxable, so take care to verify the type of the municipal bond you are planning to buy and how it will interact with your personal tax situation.

A prime example of this is a new type of municipal bond that was created in the wake of the global financial crisis, between 2009 and 2010, in an effort to stimulate the economy. These new bonds are referred to as Build America Bonds and had special federal subsidies attached to them to help the bond issuers and insurers. These municipal bonds offer a higher interest rate than their counterparts, but they are taxable. Don’t make the mistake of buying this kind of municipal bond in hopes of earning tax-free interest. (However, you could buy these bonds in a tax-qualified account, such as an IRA, which would defer the tax on the interest until you withdraw funds from the account.)

Another instance in which “tax-free” bond interest can become taxable is found in a subset of municipal bonds known as “private activity” bonds. These are bonds that are sponsored by a government but are being used for a non-traditional government purpose, such as building a sports arena. If you are subject to the Alternative Minimum Tax (AMT), take extra care in choosing bonds (or bond funds) that do not include private activity bonds, because interest from those bonds is added to your income when the AMT is computed, potentially subjecting that interest to tax.

Icon   Note   In 1988 the U.S. Supreme Court ruled that the federal government is able to tax state and municipal bond interest (overturning a previous ruling from 1895 that made it unconstitutional to do so). Even so, Congress has continued to allow that interest to remain tax-free. In recent years, however, leaders in both political parties have indicated a willingness to begin taxing that income. It may be that the future lifespan of this prevalent tax strategy is limited.

Roth Retirement Accounts

Another source of tax-free income is found in Roth-qualified accounts. In a traditional qualified account—IRAs, 401(k)s, 403(b)s, and so on—you receive a tax deduction for the money that you contribute to the account, tax-deferred growth while the money remains in the account, and then you are taxed at ordinary income rates on any amount of money that you withdraw from the account. Roth-designated accounts work in the opposite way: you receive no tax benefit for contributing money to the account, but the growth in the account is not taxed while the money remains in the account and there is no tax on any money that you withdraw in the future (as long as you follow the rules). All income withdrawn from a Roth account is tax-free.

image   Example   A Roth account gives Linda more tax-free investment options than any other investment account. Investments held within a Roth account can be of any type—bonds, stocks, mutual funds, and so on—and their growth is tax-free. For Roth accounts, the after-tax rate of return is a moot point because all types of investments are on an equal playing field in regard to taxes. So, Linda does not need to find a 9.1% interest rate in order to beat the after-tax income of her 5.25% municipal bond—anything greater than 5.25% would be sufficient because the municipal bond holds no tax advantage over any other investment when held within a Roth account.

The benefits of this tax-free income strategy could be tremendous if you expect your tax rates in retirement to be higher than they are in the current year, whether that is from a higher income in retirement or from higher tax rates that come in future years. I have many clients whose effective tax rate is currently very low but who can expect their rates to be higher in future years as their incomes increase and their deductions go away (homes paid off, children gone, etc.). A Roth contribution strategy for future income is clearly beneficial for these clients.

image   Example   Sean and his wife Beth are 30 years old. Because of their large number of deductions and credits, their effective tax rate is close to 0%. As they observe the ever-increasing life spans of people as well as the increasing eligibility age for Social Security, they don’t anticipate entering into full retirement until they are 70. At their current income levels they are each able to make a $5,500 contribution to a Traditional IRA or a Roth IRA, for a total of $11,000. If we anticipate an average growth rate of 7% on their investment over the next 40 years (when they reach age 70) and a marginal tax rate of 25% in their retirement, the difference between a Traditional IRA contribution and a Roth IRA contribution is dramatic. The after-tax value of the Traditional IRA money after 40 years would be around $124,000. The value of the Roth IRA would be nearly $165,000. That is 33% more after-tax income available to them by choosing the Roth IRA, all else being equal.

Another benefit of Roth-based plans is that you are not required to withdraw the money at any certain time in the future. You can let the money stay in the account and grow tax-free until you die, if you wish. In contrast, with traditional qualified accounts you are required to start taking minimum withdrawals from the account (and pay taxes on those withdrawals) once you reach the age of 70½ (see Chapter 7 for details on Required Minimum Distributions). No requirement for distributions from Roth accounts gives a much greater flexibility and control to you over those funds and how and when you use them in the future.

image   Tip   Because you are never required to make withdrawals from Roth accounts, they are an excellent tool for passing on an inheritance to your heirs. The money you put in a Roth IRA can grow for as long as you live and is then passed on to your heirs tax-free.

In addition, you are allowed to contribute funds to a Roth account no matter how old you are. With a Traditional IRA you are not allowed to make contributions after age 70½. Once you reach that age you are required to start taking withdrawals and so the government does not allow you to offset those withdrawals, making deductible contributions. With a Roth IRA you don’t face that limitation. In this way you could continue to add to the amount available in the account as a tax-free inheritance for your heirs.

For a number of years the only Roth account available was a Roth IRA. Recently, Congress has allowed other types of qualified accounts to accept Roth contributions, such as Roth 401(k)s, 403(b)s, and 457(b)s. The same principles of tax-free growth and withdrawals apply to all Roth accounts, regardless of which type. However, the employer-sponsored plans have different rules than Roth IRAs relating to the amount of contributions you can make per year, as well as whether those contributions are limited by your income.

The Nuts and Bolts of How Roth Accounts Work

If you have a Roth contribution option available to you through your employer’s retirement plan, there is no income-based limit on the amount that you can contribute to the plan each year. In contrast, your ability to invest in a non-employer–sponsored Roth IRA is limited by your Modified Adjusted Gross Income (MAGI). For example, in 2014 a single taxpayer whose MAGI is less than $114,000 can contribute the full amount allowable for the year. However, once that individual’s MAGI goes above $114,000 her contributions are limited to a lesser amount. Her allowable contribution is eventually reduced to zero once her MAGI reaches $129,000. The formula that determines MAGI is below:

+ Adjusted Gross Income (AGI)

+ Social Security or Railroad Income not included in AGI

+ Deductions Taken for Traditional IRA Contributions

+ Deductions Taken for Student Loan and Tuition Expenses

+ Excluded Foreign Income and Foreign Housing Deductions

+ Excluded Interest from Education Bonds

+ Employer-paid Adoption Expenses

+ Deductions Taken for Domestic Production Activities

– Income from a Roth IRA Conversion

= Modified Adjusted Gross Income (MAGI)

As you can see from the formula, nearly every adjustment made to Gross Income in determining AGI is added back into the formula for MAGI. However, there are two very important exceptions worth noting. Any money that you contribute to a Health Savings Account (HSA) or to an employer-sponsored retirement plan—401(k), 403(b), 457(b), SEP IRA, etc.—reduces your AGI but is not added back into your MAGI. So, if your MAGI is within the phase-out ranges for a Roth IRA contribution, one of the best strategies for reducing your MAGI it is to contribute to an employer-sponsored retirement plan or to an HSA. Doing so could make a difference in the amount that you are allowed to contribute to a Roth IRA.

The phase-out is prorated evenly over the entire range. For example, the phase-out range in 2014 for a single individual is between $114,000 and $129,000, or a range of $15,000 ($129,000 – $114,000 = $15,000). If that individual’s maximum allowable contribution were $5,500 for the year, the phase-out would limit that maximum contribution by $1 for every $2.73 that his or her MAGI is above $114,000 ($15,000 phase-out range ÷ $5,500 max contribution = $2.73 of excess AGI per $1 limitation). If a single taxpayer had an MAGI of $114,273 ($273 past the start of the phase-out), the maximum contribution would be reduced by $100 to $4,900. The phase-out ranges for Roth IRA contributions are shown in Table 10-1.

Table 10-1. Phase-Out Ranges for Roth IRA Contributions


If your MAGI is below the phase-out thresholds, you are allowed to contribute a maximum dollar amount to a Roth IRA per year. That maximum amount is adjusted each year by the IRS, based on inflation (as long as you have earned income equal to or greater than the amount of the contribution). As mentioned previously, there is no income limit imposed on the employer-sponsored plans.

In addition, if you’re 50 years old or older you are allowed to make an extra contribution of $1,000 over the normal maximum, which is known as a “catch-up contribution” to a Roth IRA. For the employer-sponsored Roth accounts the catch-up contribution amount is $5,500. The maximum allowable contributions to all Roth account types for 2013 are listed in Table 10-2.

Table 10-2. Maximum Allowable Contributions to all Roth Account Types


In order to contribute to a Roth account you must have “earned” income (income from employment) that is equal to, or greater than, the amount that you have contributed. For example, you cannot put $5,500 into your Roth IRA when you had only $3,000 of earned income for the year. This rule would preclude a person who is fully retired from transferring investments into an IRA each year.

image   Tip   For parents and grandparents (or other relatives) who would like to help a child save for the future, there is an interesting planning technique based on these rules. The person contributing funds does not have to be the owner of the Roth IRA. If a child has earned income, another person can contribute money to that child’s Roth account. For example, if a child earns $3,000 from a summer job, the child can keep the money for other uses and a relative can contribute up to that $3,000 maximum (based on the earned income) to the child’s Roth IRA. It could be your family’s personal “matching” program, helping the child save for a better future. (Also don’t forget that “earned” income can come from the child doing legitimate work in a family business.)

Roth accounts have very specific rules about when you can withdraw money. You may not take withdrawals before you are 59½. You must also have the Roth for five years (even if you are older than 59½) before you take any withdrawals. This five-year period begins with the oldest Roth account that you own, meaning there is not a separate five-year period for each account (except in the case of Roth IRA conversions). If you break these rules you will be taxed on the proportion of the withdrawal that represents growth at ordinary income rates, plus an additional 10% penalty tax. (There are often state taxes and penalties associated with unqualified withdrawals, as well, increasing the total penalty paid.) There are a few exceptions to these rules, which allow for penalty-free withdrawals, which are detailed in Part 7 of this book.

image   Example   Several years after Sean and Beth contributed $10,000 to their Roth IRAs the account value has doubled. When they see their account values at $20,000 they can’t resist the impulse to withdraw the money and go on their dream vacation. They are in their 40s, so the growth in the account will be taxed and will also receive a penalty tax. If they are in the 25% tax bracket they would pay $3,500 in taxes and penalties on the $20,000 withdrawal [$10,000 growth withdrawn × (25% income tax + 10% penalty) = $3,500].

Converting a Traditional IRA into a Roth IRA

If you have money in a Traditional IRA that you wish were in a Roth, or if your income is above the phase-out thresholds for Roth IRA contributions but you would like to contribute if you could, there is a way available for you to put money in a Roth. You are allowed to change (convert) a Traditional IRA into a Roth IRA. You will need to pay income tax on the money that you move from a Traditional IRA to a Roth, but once the money is converted, it will have tax-free growth and withdrawals from that point forward (assuming you follow the rules).

image   Example   Because Linda’s income is far above the contribution threshold, she cannot contribute new money to a Roth IRA. However, she can still fund a Roth IRA by converting money she holds in a Traditional IRA into a Roth IRA. If she chooses to do this, the amount she converts to a Roth IRA will be added to her income for the year and be taxed at ordinary income tax rates—which in Linda’s case adds up to 42.3%, considering both federal and state taxes. That may be too steep a price to pay for it to be a worthwhile decision for Linda, but for others in a lower bracket it could prove to be a great decision. Linda will need to determine if she has sufficient time for the investments to grow in order to make up for the taxes paid and the lost growth potential of the funds she used to pay the taxes, as well as estimate her future tax rates in comparison to her current rates.

image   Tip   When deciding to convert a Traditional IRA into a Roth IRA, consider whether the additional income may push you into a higher marginal tax bracket. If the new tax bracket is 5% or 10% higher than your current bracket, it could really affect the results of your calculations in determining whether the conversion is advisable.

For individuals whose income precludes them from contributing to a Roth IRA and from taking a deduction for a Traditional IRA, there is an interesting strategy available for getting money into a Roth. Even when your income is too high to get a deduction for Traditional IRA contributions, you may still contribute to one without receiving the deduction (whereas with a Roth IRA this is not the case). When you make a non-deductible contribution to a Traditional IRA it creates a “basis” in that IRA, which means that when you withdraw money you will not be taxed on the portion that represents that non-deductible contribution. If you choose to convert the IRA (rather than make a withdrawal), you are not taxed on the basis portion of that conversion.

What if the only money that you had in a Traditional IRA was the amount that you contributed as non-deductible basis, and then you rolled that entire amount over to a Roth IRA? In that case, the conversion would be non-taxable. In essence, you would be making a Roth IRA contribution (which you are not allowed to do directly) by taking an extra step.

If you already do have money in a Traditional IRA and part of the money represents non-deductible contributions and the other part of it comes from growth or deductible contributions, then when you convert some or all of the money to a Roth the conversion will be prorated as part tax-free and part taxable.

image   Example   Linda has made non-deductible contributions to her IRA for many years. The total of all her non-deductible contributions is $20,000. The actual value of all her IRA accounts combined is $100,000. So, the $20,000 in non-deductible contributions represents 20% of her IRA account value. If Linda decided to convert $40,000 of her IRA account into a Roth IRA, only $32,000 of that conversion would be taxable because 20% (the proportion of non-deductible contributions to total account value) would be considered non-deductible contributions.

Icon   Note   Beginning with 2010, everyone is allowed to make a Roth IRA conversion. Before then, high-income earners and those who file separately were not allowed to make a Roth IRA conversion.

For a person with a large amount of money in Traditional IRAs, the non-deductible contributions to conversion strategy may not be very effective because the proportionate share of non-taxable contributions may be very small and not save much in taxes on the conversion. However, there is one other strategy that may work for this situation. If you have an employer-sponsored plan available to you—such as a 401(k)—you may be able to roll your IRA into the employer account. At that point you would not have any IRAs and could begin the non-deductible contribution to conversion strategy.

If you have a large Traditional IRA, it may not be wise to convert all of it to a Roth in one year because doing so could bump your total income into a higher tax bracket. Keep in mind that you need not convert all of the money in your IRA accounts. It is possible to do a partial conversion if that works best in your tax picture. You can choose to spread the total conversion out over many years. For some taxpayers, spreading the conversion out over many years can prove to be very rewarding.

image   Example   Dan has quite a bit of money saved in an IRA but requires very little income to live on in his retirement. In fact, Dan pays no income tax each year because his income is lower than his exemptions and deductions. Each year Dan has me calculate how much money he can convert from his Traditional IRA to a Roth IRA before the additional income causes him to owe tax. I estimate as closely as I can the amount he should convert, and he then converts that amount, tax-free. By the time he reaches age 70½ and is required to make distributions from his IRA, he will have significantly reduced the amount he will have to take out, as well as reduced his taxes. He will also have never paid taxes on the money he converted from his Traditional IRA—he received a deduction when he put the money in a Traditional IRA, paid no taxes on the conversion, and he will pay no tax on that money or on the growth as he takes it out of the Roth IRA.

Icon  CautionIf you are younger than 59½ when converting an IRA to a Roth IRA, be sure to have the money available, outside of the IRA account, to pay the taxes on the conversion. If you use the money from the IRA to pay the taxes and convert only the net amount, you will be subject to an additional 10% penalty tax on that amount for taking an early withdrawal.If you are 70½ or older and are subject to Required Minimum Distributions (RMDs) from your retirement accounts, you must still make an RMD in the year you convert a Traditional IRA to a Roth IRA. Be sure to withdraw the amount required, and do not contribute it to the Roth IRA with the rest of the conversion, unless you do it separately as a “new” contribution for the year.

If you make an IRA conversion in one year and later decide it was not a good idea, you can change your mind and switch it back. Although the initial conversion must be made by December 31, you can change your mind up to October 15 of the following year (assuming you file an extension) and revert the funds back into a Traditional IRA, in effect creating a situation as if nothing ever happened. The technical term for this is “recharacterization.”

Why would you choose to do this? There are a few possible reasons. One would be if the money invested in the new Roth IRA declined significantly in value. You wouldn’t want to pay taxes on a $50,000 conversion when the account is now worth only $25,000. Another possibility is that you may realize later (when preparing your tax return) that the tax consequences are more severe than you originally anticipated. I recently helped a client recharacterize a conversion that the client’s investment advisor recommended because the tax consequences would have been devastating.

Icon  Caution   If converting a Traditional IRA to a Roth IRA, do not withdraw money from that new Roth IRA within the first five years, or it will be subject to the 10% penalty. This five-year period for converted Roth IRAs is calculated separately for every conversion made and is not based on the oldest Roth IRA as it is for regular Roth IRAs. This could make things very tricky if you make partial conversions of your Roth IRAs over a number of years. I strongly recommend very accurate record keeping and separate accounts for each conversion, at least until the fifth year of the youngest converted account has passed.

Home Ownership

There is a significant opportunity in home ownership to achieve a tax-free return on your investment. Generally, any time that you purchase an asset for a given price, and then later sell it for a greater price, taxes are levied on that gain (the difference between the purchase and sale price). The tax code provides an important exception (or exclusion) to this rule when it comes to your personal residence. If you meet certain guidelines, the gain that you receive when selling your home can be tax-free. Many people have used this exclusion to periodically capture a tax-free gain from selling their home and, over time, use those gains to eventually pay for their new home entirely out of their tax-free gains, resulting in a huge cumulative tax savings.

image   Example   Chris and Courtney bought their first home for $150,000 shortly after they were married. Six years later they sold the home for $200,000 and purchased another home for $200,000, using the $50,000 gain as a down payment. Seven years later they sold the home for $300,000 and purchased a new home for the same price, rolling the cumulative $150,000 gain into the new home as a down payment. Five years later they sold the home for $400,000 and moved to a new area where they could buy a similar home for $250,000— an amount equal to the tax-free gains that they had accumulated through the three home sales. They paid cash for the home using only the gains, and never paid tax on any of that gain “income.” If they had needed to pay tax on the gain with each sale it would have cost them $37,500 in taxes on those three sales, at a capital gains tax rate of 15%. That is a significant amount of money saved over time.

Three main guidelines must be met in order to achieve tax-free status on the sale of your residence. First, you must have lived in the home as your principal residence for two of the previous five years (from the date of the sale). The two years do not need to be continuous, as long as the home has been your principal residence for 730 days (365 days per year × 2 years = 730 days) of the previous five years.

Second, you must have owned the home for two of the previous five years. That may seem redundant, but it is possible to have lived in the home two years but not owned it for that long. This ownership test follows the same 730 guideline as mentioned earlier. Interestingly, the two years of ownership and two years of residence tests do not need to have happened at the same time—only within the last five years. So, you could have lived in it for two years, then purchased it and moved away for two years, and then sold it and you would have met both tests.

Third, you cannot claim this exclusion more than once in a two-year period. So, you cannot own two homes and meet the residence guideline by trading off living in each one six months at a time over four years and then sell both in the same year and claim exclusion for both homes.

Icon   Note   This has been a very popular strategy with several people I have known, especially with those who are in the construction industry. They will build a home on the side, move into it for two years, then sell it and move into another home that they have built. It is sort of a slow, tax-free, home-flipping strategy.

The maximum gain exclusion per individual is $250,000, which translates to $500,000 for a married couple. Any gain on the home greater than the maximum exclusion amount would be taxed. For married couples, the ownership test need be met by only one of them, but to claim the $500,000 exclusion, the personal-residence and one-exclusion-every-two-years tests must be met by both (otherwise it would be a $250,000 exclusion if only one spouse meets the tests).

image   Tip   A surviving spouse may claim the full $500,000 exclusion if three conditions are met. First, the home must be sold within two years of the date of death. Second, both spouses must have met the eligibility requirements of principal residence and no other exclusions within two years before the date of death. Finally, one of the spouses must have met the two-year ownership test before the date of death (the living spouse can claim the deceased spouse’s length of ownership).

There are many additional rules and exceptions that apply—most of which are limited to very narrow circumstances. Most of these narrow exceptions are beyond the intended scope of this book and can become very complicated, but if you think you may have a special circumstance that would allow you to claim the exclusion, even though you do not meet the strict interpretation of the guidelines, it would be worth talking to a tax professional. There is a decent chance that your situation could meet the exception. With that said, there are three exceptions to the rules that apply to a sufficient number of people to warrant covering at this time.

First, the exclusion applies only to the use of the home as a personal residence. If during the previous five years you have used it as a rental property, or some other nonqualified use, the gain exclusion is prorated to the amount of time that it was your principal residence.

Second, if you have claimed depreciation on the house, the depreciation must be recaptured (and taxed) before applying the exclusion to any remaining gain.

image   Example   Vince purchased a home for $200,000 and rented it out for two years. During that time he claimed $15,000 of depreciation on the home. After renting it for two years he moved into the home as his principal residence. He lived in the home for three years and then sold it for $300,000. At the time of the sale, the basis in his home was $185,000 ($200,000 purchase price – $15,000 depreciation = $185,000 basis). The total taxable gain on the home is $115,000 ($300,000 sale price – $185,000 basis = $115,000 gain). $15,000 of that gain represents the depreciation that he claimed and is taxed at ordinary rates. Of the remaining $100,000 of gain, $40,000 is taxable and $60,000 is eligible for the exclusion. This is because two of the five previous years (40%) were non-qualified use (rental property) and three of the five years (60%) qualify for the exclusion (personal residence).

The third exception applies to those who must leave their home due to a change of employment, a medical condition, or an involuntary or unforeseeable circumstance. For the change of employment exception to be met, the new job must be 50 miles farther away from the previous residence than the old job. For the health exception to apply, the move must be made in order to obtain, provide, or facilitate the medical care of oneself or a relative. For the unforeseen circumstance exception to apply, it must be for one of the following:

·     Natural or man-made disaster damaging the home

·     Condemning of the property by a government

·     Death of the home owner

·     Involuntary loss of employment, or change in employment status, making the owner unable to pay for the home

·     Divorce or legal separation

·     Multiple births from a single pregnancy

·     Other similar circumstances may be considered.

This third exception (or group of exceptions) does not entitle an individual to the full exclusion amount. Rather, it allows him or her to claim a prorated amount of the exclusion, based on the amount of time that he or she met the guidelines.

image   Example   Lance meets the ownership and residence requirements for one year (half of the two that are needed for the full exclusion), but is then transferred to a different part of the country by his employer. He qualifies for the change-of-employment exception, so when he sells his house 50% of the gain exclusion amount is available to him. This would mean that $125,000 in gains (one half of the full $250,000 exclusion) could be excluded from tax (or $250,000 if he were married).

Finally, the fourth exception is for those serving overseas. If an individual (or spouse) is on extended duty (greater than 90 days, or indefinite) outside the country, serving on official business for the military, foreign service, Peace Corps, or intelligence, the two-out-of-five–year rule can be suspended for up to ten years.

Agriculture and Livestock Development

If you have ever felt the inclination to grow your own food or raise your own livestock, maybe this “loophole” in the tax code will give you the final incentive that you need to become a part-time farmer. For a long time, gardening has been one of the most popular hobbies in the United States. More recently, a focus on organic and “local” foods has encouraged many people to take their gardening to the next level—creating mini-farms on their land and raising chickens for eggs. In addition to the health benefits, personal satisfaction, and taste-bud-pleasing attributes that this pastime can bring, there are also some rarely-thought-of tax savings that come from raising your own food.

image   Example   The Johnson’s monthly food budget is $750, which translates to $9,000 per year. Over time they develop fruit and nut trees, a substantial vegetable garden, and some egg-laying chickens. Before they know it, their mini-farm is producing enough food for their family to reduce their food purchases at the store by $4,000 per year. That reduction in the amount they have to spend on food is the equivalent of getting a $4,000 raise at work because they now have $4,000 more money available to use than they did before. The great thing is that the additional $4,000 in their pocket is tax-free (whereas the raise would not be). If they were in the 25% federal tax bracket and had a 7% state tax and 8% in payroll taxes (for a total tax of 40% of the $4,000 raise), $1,600 of that raise would go to taxes. By producing their own food they have saved $1,600 in taxes, or—put another way—they received a $4,000 tax-free return on their investment. Of course, there are costs in raising a garden, but you can buy a lot of seeds and trowels for $1,600 a year.

If you come to the point where you are producing more than you can eat, you can offer some of your tax-free “income” to your neighbors. Or you (or your children) can start a side-business offering locally grown organic fruits, vegetables, and eggs. Maybe you can sell just enough to cover your costs. Or perhaps you will dream big and realize that investing in an orchard or herd that grows over time can be a great tax-deferred investment (learn more about this idea in Chapter 15). Whatever the case may be, raising your own food can bring satisfying results to your table and to your pocketbook.