The Formula for Figuring Tax Liability on Home Sale

Question: I am angry and perplexed. Over the years, when reading articles in the paper concerning the formula for figuring out if you have any tax liabilities, I have always thought it worked this way (in my case):

In 1970 we purchased our home for $35,000. Over the years we have added $25,000 in improvements. That would make our net investment in the house $60,000. We sold the home this year for $298,000 and had selling costs of $18,000, which reduced the net to us to $280,000. From this I subtracted the net cost of $60,000 to arrive at a net profit of $220,000. We purchased a new home for $240,000.

This, I thought, left us with no tax liability because we were replacing a $220,000 home with a more expensive, $240,000 home. Now I find out differently: You only use the sale price of the house ($280,000) and the purchase price of the new house ($240,000), which leaves me with a tax liability on the difference.

I am over 55 years old and know about the one-time, $125,000 exemption, but had hoped to use this at some later time. I have two daughters. Can my wife and I give each daughter a percentage of our equity over a period of time to reduce our tax liability?--B.M.

Answer: Both Rob Giannangeli of the Internal Revenue Service’s public affairs office and I think that you’re probably right in your suspicion that you are not alone in misunderstanding how the deferred-gain gimmick works.

Essentially, you’re right in your computations, Giannangeli says, in arriving at the gain you have in the house you sold. You do, indeed, take the base price of $35,000 and add to it the $25,000 in capital improvements (these, of course, have to be genuine improvements that have increased the value of the house). This increased your base price to $60,000.

And, he adds, you were correct too in subtracting your costs of selling the house ($18,000) from the selling price of $298,000. This lowered the selling price of the home, sure enough, to $280,000, and by subtracting from this the adjusted base price of $60,000, you do, indeed, have a profit in the house of $220,000. Unfortunately, though, Giannangeli continues, the deferment of gain by buying a replacement home of similar, or greater, value “isn’t based on the gain in the residence but on the amount realized.” And the amount realized was $280,000, not $220,000.

Because your replacement home is $240,000 it leaves you with a taxable gain of $40,000. You might want to take another look at that one-time, $125,000 exemption for those over the age of 55, because you can combine it with the standard replacement-deferment.

In this case, Giannangeli adds, the $220,000 gain does come into play. And, by taking the $125,000 exemption off the top, you reduce your gain to $95,000 and wipe out your tax liability this year. The base price on your new home is then reduced by $95,000, from $240,000 to $145,000, which is the figure you will use in your computations when you ultimately sell it.

I appreciate the fact that you wanted to save the one-time exemption for use at some later time. But here we have a bird-in-hand situation: an immediate cash savings on a liability of $40,000, which could be anywhere from $11,000 to $13,000-plus out of pocket.

There is, remember, a time value to money, and taking the savings now could be far more valuable than a comparable savings 10 or 15 years down the road. You can go back and amend your return by filing Form 1040X.

Could you and your wife give your two daughters an equity in the property? Sure, but remember that it only applies to your new home. You and your wife can give a total of $10,000 apiece a year to the daughters without even having to file a gift-tax return. But it’s not easy--you’d have to get a lawyer to re-record the home every time you made such a gift. “And,” Giannangeli adds, “he could never in the future use the one-time exemption that he’s trying to save.”