It’s so Confusing That We’ll Explain IRS Replacement-Home Rules Once Again

QPlease help me understand how the Internal Revenue Service rules work on replacement homes. If I purchase a lot on Jan. 1, 1997, and by Jan. 1, 1999 (24 months later), I build a home on the lot and move into it, by what date must I sell my previous residence in order to qualify to roll over any gain into the new residence?

Also, my brother has owned a condominium for 20 years. It was his residence for six years before he turned it into a rental. Now he has moved back into it. How long must he live in it for it to be considered his personal residence and for him to qualify for the rollover provisions on any profit he realizes from its sale?

--A.C.D.

*

A All right, all right. For the second time in as many months, I’ll tackle this thorny but all-important matter.

Basically, IRS rules on replacement residences allow homeowners to defer taxation on profit generated by a home sale if they purchase and move into a replacement principal residence within a specified period after the sale of the original home. The period, called the “replacement period” by the IRS, starts two years before

and ends two years after the sale of the original home.

How do these rules affect you? According to our experts, you should have until Jan. 1, 2001, to sell your home. However, the facts in your case are decidedly different from those of the average home seller because your case involves the construction of a home as well as a lot purchase, a process that extends over many months. The amount of money you are deemed to have spent on the replacement residence within the allotted replacement period may well depend on the pace of construction as well as the rate at which your money is spent on the project.

In the end, and, again, depending on how long it takes you to move into the new house, you may well have to treat the lot purchase and the construction expenses separately. Counsel from a trusted financial advisor is in order.

As to the matter of the condominium, the IRS has no strict rule governing the issue of how long you must live in a home to consider it your personal residence. To be safe, your brother should live there at least a year. But remember: To qualify for the one-time exclusion of $125,000 in profit from a home sale that is available to homeowners over age 55, you must have lived in the home for three of the last five years. (This requirement is only an issue if your brother wants to invoke the $125,000 exclusion.)

In addition, your brother must deduct from his tax basis in the condo any amount he claimed for depreciation when it was a rental. This will have the effect of increasing his taxable gain on the sale. But it’s fair because he has already had the advantage of deducting that depreciation from his rental income.

Point About DRIPs Is Who’s Investing Q Come on! Why are you so tough on DRIPs, or dividend reinvestment plans? The whole point of these programs is not to time the market to get in or out when things are in “rapid flux,” but to stick with high-quality investments. You’re supposed to use your dividends to buy additional shares, much as you would if you were systematically buying according to the “dollar cost averaging” system--that is, slowly accumulate them at a variety of prices with the express understanding that you are buying to hold, not to play the market. Now what do you have to say?

-- D.S.

*

A DRIP investors from all over skewered me for gently knocking these programs in a recent column because the programs don’t allow quick, easy access to your holdings. But it’s true: DRIPs aren’t designed for investors interested in regular trading. Rather, the whole point of such programs is to invest slowly and painlessly with the expectation of holding the shares for a long period, not to time your entrances and exits by the stock’s performance.

Many investors willingly give up access to their holdings for the benefits of commission-free purchases, fractional-share purchases and the ease of an automatic quarterly savings program. However, although these programs are easy to join and participate in, they do require some effort to withdraw from. And you should not underestimate the amount of time you will need. As a result, your DRIP holdings are not as liquid as other stock investments.

That said, reader David Bryant says he has solved this problem by asking the transfer agent for the DRIP programs he’s enrolled in to send him stock certificates when he accumulates 50 or 100 shares. Then he stores the certificates in a safe deposit box or with his broker for ready access when he wants to sell or pledge the shares as security for margin loans.

Apparently no slouch at playing all the angles, Bryant says he’s even been able to generate some extra income by selling covered calls against some of these dividend reinvestment shares on which he holds the certificates.

However, this last trick shouldn’t be attempted unless you’re prepared to lose the shares you’ve slowly accumulated through a DRIP. In other words, playing the put and call game isn’t for the faint of heart.

*

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or send e-mail to carla.lazzareschi@latimes.com