Understanding Basics of Rollover Lets You Delay Paying Profit Tax

Perhaps the most important provision in the Internal Revenue Code affecting homeowners is the concept of a “rollover.”

The simple definition of a rollover is that the taxpayer sells his principal residence and buys another principal residence that is equal to or greater than the selling price. No more than two years can elapse between the sale and the purchase, although it makes no difference which comes first.

If you meet the legal requirements spelled out in the Tax Code (Section 1034), the tax on any profit from the sale of your home is deferred. This is known as “non-recognition of gain.” It must be pointed out that the profit the homeowner makes is not forgiven; it is only deferred until the taxpayer sells his or her last house.

On the final sale, assuming no other tax benefits are available (or that the homeowner has exhausted all of the other applicable benefits), the homeowner pays a capital gains tax on the total profit, which currently is capped at 28%.

Example: Many years ago you bought your house for $25,000, and put in $30,000 worth of improvements. You now want to sell your house for $250,000, and buy another principal residence for $300,000.

Ignore for this example the realtor commission and any fix-up expenses which you made prior to the sale. Your selling price is $250,000, and since your adjusted purchase price was $55,000, your profit (gain) is $195,000.

When you buy a new house for $300,000, the adjusted basis of that new property will be $105,000. You calculate this new basis by taking your purchase price of $300,000, and subtracting the non-recognized gain of $195,000.

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 seem to disagree on whether you can deduct a real estate commission for determining rollover issues.

A careful reading of the Tax Code, however, seems to suggest that while the expense of the real estate commission is an item reducing your profit, it cannot be taken into consideration when determining the basis for the rollover.

The rollover is mandatory. You must take it when you sell one principal residence and buy another. However, there are some important limitations on using this tax savings device.

Although no limit is imposed on the number of times the rollover may be used within a homeowner’s lifetime, its use is limited to once within a 24-month period.

Example: You sell your principal residence in 1990 and immediately buy house “A.” In 1991, you sell house “A” 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 only be rolled over into house “B”--the last house purchased. If you were fortunate to have made a profit on the sale of house “A,” it is taxable.

If the taxpayer is relocating and purchases a principal residence more than once during the two-year period, and if the move was due to employment circumstances,

the additional rollover may be permitted. Before you make any employment-related moves, however, check with your tax advisers. In the past, the IRS has ruled that the new job must be at least 35 miles farther from the old house than the old job was.

For U.S. military personnel on active duty, the two-year time limitation is also modified. Depending on whether you are stationed within the United States or not, the replacement period can be extended for a period between four years up to eight years. Again, a tax adviser should be consulted if you or a member of your family are on active military duty.

What if you buy a new house within the two-year period that costs less than the selling price of your old house?

Under these circumstances, 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.

Example: Instead of buying your new house for $300,000, you paid $200,000 for it. Remember, that you have made a profit of $195,000 when you sold your old house.

In this example, the adjusted sales price of the first house is $250,000. If you purchase a new residence for $200,000 you have only a recognized (taxable) gain of $50,000. There will be a $145,000 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 $55,000 ($200,000 minus $145,000).

In other words, you will have to pay tax on the $50,000 worth of recognized gain, but you are rolling over (not recognizing) $145,000 of the profit from your previous home.

The rules sound simple, but clearly everyone has different factual circumstances. Here are two helpful suggestions:

1--The question is always raised as to how much money has to go into the purchase of the new house. The answer is that none of the sales proceeds from your previous residence must be used to purchase the new property. For example, you sell your old house for $200,000, and obtain net proceeds of $100,000. Even if you finance a substantial portion of the new $300,000 house, you still take the rollover even though you are pocketing a substantial portion of your previous sales proceeds.

2--If husband and wife divorce, and the family home 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, each spouse would be entitled to roll over half of the overall sales price into his or her own house. If, for example, the family home was sold for $300,000, if either or both husband or wife purchased another property within two years that cost at least $150,000 each, they both qualify for the rollover.

It is strongly recommended that you consult your tax and financial advisers before entering into any binding, legal contracts for the sale or purchase of real estate.

Next: The once-in-a-lifetime exemption.