How to Avoid Paying Taxes When Selling Home

Virtually every homeowner has heard that there is a way to avoid paying taxes when selling the principal residence at a profit.

However, the details are often elusive and misunderstood. One costly mistake, and the tax you thought you were avoiding can become due.

Internal Revenue Code 1034, the “roll-over residence replacement rule,” is quite simple. It says a home seller must defer paying tax on the sale profit if a replacement principal residence of equal or greater cost is bought and occupied within 24 months before or after the sale.

This tax benefit is available to home sellers of any age. It can be used over and over without limit. However, it cannot be used more often than once every 24 months. But this rule can be used again within less than 24 months if the home sale involves a job location change that qualifies for the moving-expense deduction.

Sharp homeowners will readily see that they can use IRC 1034 to pyramid their wealth, starting out with a small home such as a cottage, selling it and buying a more expensive home, and then selling that home and buying a mansion, all without paying tax on the profit.

All that matters are your old residence’s net sales price (in tax talk it’s called “adjusted sales price”) and the replacement home’s adjusted cost basis, which includes most closing costs.

For example, if your old home sells for $108,000, but you only receive $100,000 after paying the real estate sales commission, transfer fees and closing costs, then $100,000 is your adjusted, or net, sales price. To defer the tax on your sale profit, you must buy a replacement home costing at least $100,000, including closing costs paid on the purchase.

However, if you acquire a less expensive replacement home, such as one for $90,000, in this example you would owe tax on up to $10,000 of your sale profit. But tax on any remaining profit is deferred. However, if you add at least $10,000 of capital improvements to your new $90,000-home within the 24-month replacement period, thus bringing your total purchase cost over $100,000, then you can defer tax on all your profit.

Please notice the rules say nothing about mortgages or about cash down payments. If you want to take tax-free cash out of the sale and replacement, the best way to do so is to sell your old home for cash and buy the replacement home for nothing down, such as with a VA mortgage. You can spend the tax-free cash as you wish.

This roll-over residence replacement rule is a very generous tax break. It allows home sellers to put tax-free cash into their pocket as they move up to nicer homes. However, this tax deferral rule has several pitfalls to anticipate and avoid:

1--If either the old or new home is not your principal residence, IRC 1034 does not apply. Vacation or second homes and rental houses are not eligible. If you own a rental house that you would like to qualify, before selling it, move into that house as your principal residence. The tax law does not specify any minimum occupancy time but most tax advisers suggest a minimum six to 12 months, preferably filing your income tax returns for at least one tax year from that address.

2--A currently owned home cannot qualify because it is not purchased within 24 months before or after the sale of the old home. For example, if you own a summer home that you want to winterize and move into as your principal residence, it won’t qualify unless you bought it within 24 months before or after selling your principal residence.

3--There is no provision in this tax law for extension of the 24-month replacement period. If you have not purchased your replacement home within 24 months after selling your old home, you will owe tax on your sale profit. The only exceptions occur if you are on active military duty or if you are residing overseas; then the time limits can be extended if you qualify.

4--If your old or replacement home is outside the United States, you can still defer your profit tax because IRC 1034 sets no geographical limits.

5--If you live in one apartment of a multiunit building that you own, the tax deferral only applies to the profitable sale of your personal residence apartment, and you will owe tax on the sale profit on the rental apartments. Similarly, if you are acquiring an apartment building, only the value of the apartment where you will reside counts as the replacement home’s cost, not the value of the entire property.

6--When April 15 arrives and your 1989 income tax returns are due, if you have not yet purchased your replacement home you can still defer your profit tax on the 1989 sale of your old home. Just report the sale on IRS form 2119 and indicate that you plan to buy a qualifying replacement principal residence. However, if you do not buy a home within 24 months after the sale, you will owe the tax plus interest.

For most taxpayers, the roll-over residence replacement rule is the most generous tax-saving rule available. While IRC 1034 is simple, your tax adviser should be consulted so you don’t make a costly mistake.