DEAR BOB: Last summer, we made $78,000 profit on the sale of our large home which sold for about $198,000 net after paying expenses and the realty sales commission. We plan to buy a smaller house for about $140,000. (1) Is there any way we can avoid paying tax on our $78,000 profit? We are not yet age 55. (2) If we add a swimming pool to our new house, will this cut our profit tax? (3) Do we have to reinvest $78,000 cash in our new home? Mrs. D. W., Arlington.
DEAR MRS. D.W.: By careful planning you can avoid tax on much of your $78,000 home sale profit by using the tax deferral rule of Internal Revenue Code section 1034.
It says a principal residence seller must defer paying profit tax if a replacement home of equal or greater cost is bought within 18 months before or after the sale. If a less costly replacement is purchased (that's your situation), the profit is taxable up to the difference in the two prices.
(1) Subtracting your replacement home's $140,000 cost from the $198,000 net sales price of your old home means about $58,000 of your $78,000 profit is potentially taxable. If you owned your old home over 12 months, only 40 percent of that $58,000 will be taxed because it's a long term capital gain.
(2) However, the cost of captial improvements added to the replacement home, within 18 month time limit, count as part of its cost. In other words, you can reduce your taxable profit by the cost of capital improvements added to the replacement home within the 18 month time limit.
(3) No, you need not reinvest $78,000 cash in your replacement home to defer the profit tax. There is no minimum cash reinvestment requirement.