How the IRS Treats Sale of Second Home
QUESTION: How does the Internal Revenue Service treat the capital gain or loss on a second home? I have a second home that I plan to sell. May I purchase another house as my second home and apply the gain from the sale to it to defer taxation on the gain? --N. R.
ANSWER: No. The sale of a second home is not treated the same as the sale of a primary residence, and you may not simply defer taxation on your gain by purchasing another vacation house of equal or greater value. However, if your second home is a piece of investment property that generates rental income or is specifically held to realize appreciation, it can--and this is an all-important word--qualify for a tax-deferred exchange upon sale.
When is a second house an investment and not a vacation retreat? Well, if you bought the property solely with the intent of letting it appreciate in value and used it sparingly as a vacation retreat, your claim would probably withstand scrutiny from the IRS, our experts say. The IRS requires that personal use be no more than 14 days a year, or 10% of the time if the house is rented. So, if you don’t rent the second home at all, you may use it up to 14 days annually and retain its investment property status.
However, if you have deducted mortgage interest on your second home as “personal mortgage interest,” as is allowed by law, you have little chance of passing it off as an investment. (But if you deducted mortgage interest payments as investment interest to the extent allowed, your claim that the property is an investment would be strengthened.)
The law outlining the requirements for tax-deferred exchanges of investment property is contained in Section 1031 of the Internal Revenue Code, which is why these transactions are sometimes referred to as “1031 exchanges.” Under current law, a seller has 45 days after closing on the sale of his initial property to identify the real estate he wishes to acquire through a tax-deferred exchange. He must complete the acquisition of that property within 180 days of the closing of the first sale.
Because of the strict regulations surrounding tax-deferred exchanges, you should get help from a qualified third-party “accommodator” before attempting one of these transactions. Your real estate broker, escrow officer or family attorney should be able to steer you to an independent professional who has been trained to act as an accommodator. For additional information, see Internal Revenue Service publications No. 17, “Your Federal Income Tax,” or No. 544, “Sales and Other Dispositions of Property.”
One additional note: Current law permits tax-deferred exchanges among a broad variety of investment properties. For example, you may now exchange an apartment house for a shopping center, or a piece of vacant land for an office building. However, a bill pending in Congress would limit exchanges to properties of similar use: office building for office building or shopping center for shopping center, for example. Under current versions of this proposed legislation, the restriction would be retroactive to July 11, 1989. But there is no reason to panic. These provisions are included in the same legislation with the proposed new capital gains tax, and, as you well know, the outcome of that bill is still very much uncertain.
Income Averaging and Pension Money
Q: In February, 1986, I quit my job and took a lump sum distribution of my pension account. At that time, I rolled it over into a four-year individual retirement account. This account is now about to mature and I would like to take the principal, which was the lump sum pension distribution, and treat it to 10-year averaging on my income taxes. I know I meet the age qualification to take advantage of the averaging, so may I do it? --P. W.
A: It depends. By depositing your pension distribution in an IRA account, you basically lost your right to take advantage of the 10-year income averaging allowed pension distributions. However, our experts say there may be a way around your problem.
First, we have to find out if your IRA is “pure”--that is, it doesn’t contain any funds other than your pension distribution and the interest earned on that amount. If it is pure, then you could roll the account back into a qualified pension plan, take a distribution from it and then take advantage of the 10-year income averaging.
If you are still employed, find out if you can make a contribution to your personal account in the pension fund your company operates. Or, if you want, you could start a consulting business, open a Keogh account and transfer your pension funds into it. The bottom line is that your funds must be withdrawn from a qualified pension plan in order to take advantage of the income averaging.
There is one caveat, however: You may be required to keep your funds in the second pension or Keogh account for five years to qualify for the income averaging. Consult your accountant for advice, because there has been no official ruling from the IRS.
Tax-Free Bonds
Q: I purchased three California municipal bonds earlier this year and paid “accrued interest” of $325 to the seller. Is this interest deductible as an interest expense on my income taxes? And, if so, what section of the form do I use? I normally use the standard deduction method of filing my taxes. --R. W. E.
A: Although accrued interest payments made in conjunction with bond purchases are usually deductible, your $325 payment is not. Why? Because you purchased municipal bonds whose interest is tax free to you. So, in instances where your interest income is tax free, any interest payments are not tax deductible.
However, in cases where the bond interest is taxable, you would simply deduct the accrued interest you paid when you purchased the bond from any interest you receive during the year, and enter that “net” figure on Schedule B of your tax return as your bond interest income for the year.
Converted AT&T Stock
Q: We owned shares in American Telephone & Telegraph at the time of the breakup in 1984 and were given shares in the regional telephone operating companies in exchange for our AT&T stock. The stock of some of these “baby bells” has since split a few times, and we do not know how to figure our gain of the shares if we should ever decide to sell them. Can you please help us? --A. J.
A: Your situation is a common one and the IRS has issued guidelines on how to handle it. The guidelines, as well as a worksheet on how to figure your gain, are contained in IRS notice No. 86-8, which should be available from your local IRS office.
Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Please do not telephone. Write to: Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, Calif., 90053.
