Rollover: Homeowner’s Best Protection : Taxes: Under certain circumstances, the capital gains levy on the sale of a principal residence may be deferred.
For the homeowner, the most important provision in the Internal Revenue Code may be the “rollover.”
A rollover occurs when a taxpayer sells his principal residence and buys another principal residence that is equal to or greater than the selling price within two years before or two years after the sale.
In the rollover, the tax on the profit from the sale is deferred. In IRS jargon, this is known as “non-recognition of gain.” It does not mean that the profit the taxpayer made is not taxed; it is only deferred until the taxpayer sells his or her last house.
On the last sale, if you cannot take advantage of other tax benefits--such as the “once-in-a-lifetime” exemption--the profit is taxed as capital gains, which is now no more than 28%.
To see how the rollover works, let’s look at the following situation:
Suppose you bought your house many years ago for $30,000 and put in $20,000 worth of improvements. You now want to sell your home for $200,000 and buy another principal residence for $250,000.
Forgetting the realtor commission and fix-up expenses for the sake of this discussion, your selling price is $200,000, and since your adjusted purchase price was $50,000, your profit (the gain) is $150,000.
Since you will be buying a new house for $250,000, the adjusted basis of your new residence will be $100,000. You obtain this new basis by taking your purchase price of $250,000 and subtracting the non-recognized gain of $150,000.
But keep in mind that net cost is used to determine a basis in property. Certain items such as real estate commissions, closing costs and other expenses related to the purchase or sale of your property must be taken into consideration in figuring basis.
Tax experts disagree on whether you can deduct a real estate commission for determining rollover issues.
However, a careful reading of the tax code seems to suggest that while the expense of the real estate commission is certainly an item reducing your profit, it cannot be taken into consideration when determining the basis for the rollover.
The question is always raised as to whether you are eligible for a rollover when you buy a new house that costs less than the selling price of your old house.
The answer is quite clear that the gain is recognized to the full extent of the difference between the selling price and the purchase price, but the tax basis would be reduced by the amount of the unrecognized gain.
This is illustrated by the following example:
Instead of buying your new house for $250,000, let us assume that you paid $175,000 for it. Remember that you have made a profit of $150,000 when you sold your old house ($200,000 minus $50,000 basis).
In this example, the adjusted sales price of the first house is $200,000. If you purchase a new residence for $175,000 you have only a recognized (taxable) gain of $25,000. There will be a $125,000 gain realized but not taxed at this time. That non-taxable gain is rolled over into your new house, and accordingly, the adjusted basis of your new residence would be $50,000 ($175,000 minus $125,000).
In other words, you will have to pay tax on the $25,000 worth of recognized gain, but you are rolling over (not recognizing) $125,000 of the profit from your previous home.
The rollover is mandatory--you must take it when you sell one principal residence and buy another principal residence. However, there are some important limitations on using this rollover.
Although no limit is imposed on the number of times the rollover may be used, its use is limited to once within a 24-month period.
For example, suppose you sell your principal residence in 1990 and immediately buy house A. You then sell house A in 1991 and buy house B in the same year. Because both purchases occurred within a 24-month period, the capital gain from the sale of your original principal residence can, under the law, only be rolled over into house B, the last house purchased. If you made a profit on the sale of house A, it is taxable as capital gain.
If, however, the taxpayer is relocating and purchases a principal residence more than once during the two-year period, and if this is because of employment, under certain circumstances the additional rollover will be permitted. The IRS has ruled that the new job must be at least 35 miles farther from the old house than the old job was.
The two-year period is also mandatory, with one very important exception that is timely today.
If, after the sale of the old house, the taxpayer or spouse serves on extended active duty with the armed forces of the United States, the two-year mandatory rollover period is suspended during the time the person serves on active duty, except that the time cannot be suspended for more than four years after the sale date of the residence.
However, if the homeowner, at the time of the sale, is on active duty and stationed outside the United States, the replacement period may be extended to a maximum of eight years. This is an important protection for members of the armed forces currently serving in the Persian Gulf.
And given today’s slow real estate market, there is another rollover angle that might be pertinent for some homeowners.
Suppose you have bought your new principal residence, and you are having trouble selling your old one. If the end of the two-year period is rapidly approaching, you might want to consider selling your old principal residence to a wholly owned Subchapter S corporation that you would create for that purpose at a nominal cost.
You would then legally sell the house to the corporation, which meets the rollover test. Then the corporation can sell the house. If it makes a profit, the corporation will have to pay ordinary tax. But this permits the homeowner to take advantage of the rollover, thereby avoiding a capital gain.
The IRS indicated in a private letter ruling several years ago that this would be an acceptable way of meeting the two-year requirement. While a private letter ruling is not binding on the IRS, it certainly indicates the agency’s thinking process. You may want to explore this possibility if you run up against the deadline.
There are common-sense rules dealing with husband-and-wife ownership cases.
If two single people marry and sell their separate personal residences to buy a house together, they can merge their individual gains and roll them over into the jointly held house.
Similarly, if husband and wife divorce and the family house is sold, the law permits each spouse to roll over his or her share of the profit into the purchase of an individual residence. In this case, generally each spouse would be entitled to roll over half of the overall sale price into his or her own house.
The rollover is an important provision of the tax law, and you are advised to seek competent financial and tax advice before entering into any transaction that might have taxable consequences for you.
