Q. We are selling our house in Virginia for approximately $200,000. We have lived here for many years, having purchased the property for $50,000. Since we are senior citizens, we are elgible for the once-in-a-lifetime exclusion of $100,000. However, since we are not going to be buying a new house, we have been told that we still have to pay some tax on the balance of the profit. Can you advise any way to avoid or defer the additional tax. We will take back financing to assist in selling our house in today's market.
A. I wish I could tell you that there is a way of avoiding the rest of the taxes, but unfortunately, the Internal Revenue Service only permits the once-in-a-lifetime $100,000 exclusion. To be eligible for this exclusion, the taxpayer must be at least 55 years of age before the sale, must have owned and used the property as his or her principal residence for a total of at least three years during the five-year period ending on the date of the sale of the residence. This is known as the Internal Revenue Code Section 121 exclusion, and it also applies to condominiums and cooperative housing stock.
You indicated that you will be taking back financing. The Section 121 exclusion is not exclusive. Recently, the Internal Revenue Service ruled that if a seller has a gain in excess of the $100,000 exclusion, he or she can combine that exclusion with use of the installment method to spread out any tax over a period of years.
Let us take the following example. You are selling your house for $200,000. The adjusted basis (the original cost of your house plus other allowable expenses) is $62,500. This leaves a profit to you of $137,500. Taking the $100,000 leaves you a taxable gain of $37,500.
Since the taxable gross profit is $37,500 and the sales price was $200,000, the percentage of each installment payment to be treated as taxable gain is 18.75 percent (37,500 divided by $200,000).
If, for example, you spread out the $200,000 sales price over a five-year period, under this illustration, you would be receiving approximately $40,000 (plus any interest) per year. Each year, you would report that $40,000 payment as follows:
$7,500 gain. This is based on 18.75 percent of each year's installment. You have to pay tax on this amount:
$12,500 is nontaxable return of the original basis;
$20,000 is the portion of the $100,000 exclusion which you are eligible to take each year.
This is quite complex. This illustration assumes that you owned your house free and clear of any mortgage and that you have found a buyer who is willing to give you five installments equalling $40,000. Obviously, any interest which you receive on your loan must be considered for your income tax computations.
From this complex formula, it must be obvious that when you are dealing with tax considerations of such proportion, you would be well advised to see your tax counselor before you sign your contract to sell your house.
Oversimplified, you have several options available to you.
First, you can sell your house for all cash, take your $100,000 exclusion, and pay a tax on the profit.
Second, if you buy a house equal to or greater than the revised adjusted sales price (in this case $87,500), the entire gain of $37,500 can be deferred.
Thirdly, you can combine your once-in-a-lifetime exemption with the installment method of payment, thereby spreading out the tax obligation over the period of the installment payment.
It must be pointed out that Congress in 1980 eliminated the longstanding requirement that no more than 30 percent of the selling price from the sale of real estate be received in the tax year of sale to qualify it for the installment method treatment.