Schemers Beware: The Capital Gains Tax Man Is Not Easily Fooled

Q: My husband and I have owned our home for more than five years. We purchased it at $460,000, and find its value today is around $960,000, putting us at the $500,000 gain mark. We are not interested in moving to a different home now, but likely will want to sell our home in 15 years when our children are grown and we are getting ready for retirement. I dislike the idea of having to pay taxes on any gain we receive, assuming our selling price in the future will be more than $960,000.

As we understand the law, if we would sell our house today and buy the house next door for $960,000, then in 15 years we would be able to sell that home for at least $1.46 million without having to pay any taxes on the gain. That would allow us to use our $500,000 tax exemption today on this house, then again on the future home, in effect getting $1 million of gain tax-free. If, however, we do not move and we sell our current home in 15 years for $1.46 million, assuming the tax law does not change, we would owe capital gains tax on $500,000 of our $1 million gain.

Could we sell our current home to my parents for $960,000, report the $500,000 gain as tax-free, then a week (or month) later, purchase the home back from them for $960,000? Then in 15 years when we sell, our basis in the home would be $960,000, ensuring that a selling price of $1.46 million would give us another $500,000 of gain tax-free? The only downside I see to doing this is the costs associated with the paperwork (mortgages, etc). Does anything in the law prevent this transaction, and what are your thoughts?

A: Nice try, but I don't think your plan will work.

You are correct in your understanding of current tax law. Because you and your husband file a joint tax return and have lived in the house for two out of the previous five years, you can exclude up to $500,000 of gain. In your example, you could sell your house for $960,000 and not have to pay a single penny of tax.

One thing to take into account, though: Is this your first house? Many people have owned a succession of homes over the years, under two separate sets of tax rules. Before 1997, many of them used the old "rollover" rules to defer taxes. That needs to be taken into account now.

Let's say you bought your first house in 1980 for $100,000, and sold it for $200,000 in 1984. As the law then encouraged, within two years from the date of that sale you purchased another principal residence for $300,000. Under the rollover rules, you deferred $100,000 worth of profit, and thus for tax purposes the basis of this new house was $200,000 rather than $300,000. In 1996, you again sold your house, this time for $400,000, and then bought your current house, for which you paid $460,000.

In this situation, the tax basis of your house is not the amount you paid for it. Because you made $200,000 when you sold the previous residence, but did not pay any capital gains tax, the basis of your house would be $260,000 ($460,000 minus $200,000).

Thus, in your example, if you were to sell your current house for $960,000, your total gain would be $700,000. You could still exclude $500,000 of this gain, but would have to pay capital gains tax on the $200,000 difference. At the 15 percent federal tax rate, you would owe the government $30,000, and also would have to pay state tax at whatever rate the state imposes.

However, let's assume that you didn't own a house before 1997, so only the current tax laws apply and you don't have a rollover problem to consider.

You propose selling the house to your parents or to a third-party holding company and then buying it back.

There is a legal concept in tax law that you must consider, called the "step transaction" doctrine.