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

The doctrine, which is not in the tax code but has been developed by the courts, allows the Internal Revenue Service to analyze all the steps in a transaction to determine how to treat that transaction. In effect, the IRS can look at all of the steps to determine whether each stands alone or whether they will all be treated as part of one single occurrence.

In your proposal, you plan to sell the property to a friendly third party, and then shortly thereafter buy it back at the same price. I suspect that the IRS will use the step doctrine and collapse all of the steps. In other words, they will see a pre-arranged plan to avoid having to pay capital gains tax. Your plan may very well be disallowed.

If the IRS audits and rejects your plan, you not only would have to pay the tax on the $500,000 that you attempted to shelter -- $75,000 -- but you also might have to pay a penalty and interest.

You can avoid a negative response from the IRS by crafting a completely arms-length transaction with your parents. Let them buy the house for your purchase price. You will then be able to exclude your $500,000 gain.

But if you plan to stay in the property, you should sign a standard residential lease, whereby you pay your parents a fair market rent for a long period of time. There should be no mention -- in writing or orally -- that your real objective is to get the house back as soon as possible.

A few years from now, your parents can sell the property back to you, but it would have to be at the then-fair market value (less the amount of any real estate commission, which will not have to be paid).

You should understand, however, that if your parents sell the house back to you at a profit, they will have to pay a tax, in an amount that is dependent on whether the gain is short-term or long-term.

In my opinion, it is not worth the effort unless you have a true arms-length transaction with your parents.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.