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Tax Issues When Selling Your B&B

March 23, 2005

by Kit Cassingham

Learn the tax ramifications of selling your bed and breakfast before you start selling. There may be ways you can minimize your tax liability -- if you plan ahead. What will your capital gains tax be? Can you do a 1031 tax exchange? What else can you do?

Like a number of us in the B&B industry, we started the B&B in our home. The big issue comes from when it is time to sell your B&B/Home. As you should know, if you have lived in your home for two of the last five years, you may deduct for a couple, up to $500,000 of profit on the sale, tax free.

Now here comes the kicker. If you have declared a business use for the house and lets say 60% of the premesis is declared for B&B use, when you sell, 60% of the profit will be taxable!

Example; if you made a $200,000 profit on the sale, you would now be responsible to pay the tax on a $120,000 gain which at 15% (long term capitol gain) it would amount to $18,000.

The other side of this is that even if you sold your place for what you paid for it, any depreciation will be recaptured as profit which means that you now have to pay your uncle (bad uncle!!!) back for the tax on your income you didn't pay while you were in business.

I'd love to hear from some tax people or attorneys on this subject and maybe some information on how to take title to maximize the amount of money you keep in your pockets and if there is any way around losing your tax free profit exemption when you sell your home which you used for a B&B.

-Terry

Comments

The price of doing business can be very expensive. I feel your pain.

Capital gains used to be 20% for Federal taxes, plus whatever you state charged (Colorado was 5%). But in May 2003 the Federal rate dropped to 15%. But, capital gains taxes aren't as straightforward as you'd like. There are four rates; know which one you are in before you sell.

One way of deferring your capital gains is to do a 1031 Tax-deferred exchange. There are very specific rules for how you do that so check with someone who's very familiar with the rules before acting. You have to think about this *before* you list your property, to be on the safe side. You want to have a paper trail showing your intention that you are going to do a 1031 exchange. Don't be caught off guard at the last minute! There are also timing rules about when you have to declare your replacement property and close on it to stay qualified for your exchange.

We're generally talking about a substantial amount of money, so do your homework early. Don't let Uncle Sam take your hard-earned money.


On IRC 1031 exchanges, they can be a good thing but they can also bite you in the A.. When we sold our B&B in Hawaii, we did a 1031 exchange and your tax advisor will tell you what you need to do. Only a protion of our property (the part we claimed for the B&B was allowed to be exchanged and the rest was to our personal residence. When you list your property for sale you must put in the listing agreement "subject to" a 1031 exchange. This shows intent. You can still do it on accepting an offer but it is better to let the buyer know that if you don't find a replacement property, you are not obligated to close the sale.

You will need an Exchange Facilitator. Do not let your realtor, attorney or anyone else act in this position as they most likely will screw it up. There are several companies that do this and I can highly recommend a company in California who does it all over the country. It is called Starker Services. I have used them several times and they do the exchange letter perfect. Everything is done on time and without errors. Their fee is only $750.00 and if you fail to complete an exchange, you get a refund of $500.00. When you consider the pile of paperwork generated, this is a bargain.

One kicker about an exchange though. From the close of your escrow, you have 45 calendar days to designate the "replacement like kind property" (Starker will help you with this in counseling you as to whether the replacement property qualifies for the exchange) You may designate up to 3 properties and purchase all three or any one of them (see rules).
But if you don't close on at least one of them in 180 days from the close of your escrow, the exchange is considered to have failed.

There are downsides to this too.

When we sold( exchanged) our last business, We had only two properties designated and both of the people backed out the day our 45 day identification period expired. We got caught with our pants down and our exchange failed.

Now the bad news.

Not only do you owe all the taxes on your sale that have been deferred, but the exchange facilitator by law, has to hold all your funds for the 180 day period before they can be returned to you. This can effectively prevent you from moving on unless someone you find after the 180 day period is willing to have a long escrow. This can cause severe hardship if you don't have a job ( like we didn't) or any cash in the bank to tide you over until you can have access to your funds.

A lot to think about but if you can do an exchange, the end results are that you can defer all your taxes up to your death and then your heirs can deal with it when your estate is settled and they still get the exemption of inherited property so most likely everyone wins.

Another disadvantage is that if your B&B is also your house, you can't take advantage of your capital gains exemption on the sale of your home which could be up to a $500,000 profit in 2 years tax free.

Terry





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