Q. I am in the process of purchasing a new home and am deliberating on whether to keep my current home as an investment. I have owned the house for more than eight years and have approximately $40,000 in equity. I am in the 40 percent tax bracket. I originally planned to purchase a more expensive home using the equity in my current home, but after having my house on the market unsuccessfully for some time, I decided to purchase a more affordable home with a minimum down payment. Would it make sense to keep my current home from a tax investment point of view? Would I have to pay capital gains on the equity when I sell? Would I have 24 months to sell the house after I bought a new home and still not have to pay capital gains tax on the equity? Should I be concerned about paying capital gains tax? Please give me your advice.
A. I could not resist answering your question now because of the president's tax proposal pending in Congress.
Before the president proposed his major tax reform legislation, the question you have raised was perhaps one of the most difficult issues facing the American home buyer. The current law provides that if a homeowner buys another principal residence and sells his or her current home within 24 months from the date of the new purchase, any profit made on the old home can be "rolled over" into the tax basis of the new home. There are a number of limitations on this tax benefit, and they include:
*The new residence must be used by the taxpayer as his or her principal residence.
*The purchase price of the new residence must be equal to, or greater than, the sale price of the old home.
*No more than two years can elapse between the sale and the purchase of the two properties. However, you can sell your old house first and then buy the new one, or vice versa.
Let me give you an example of how this works. For simplicity's sake, let us assume that you paid $50,000 for your old house, and sold it for $100,000. You purchased a new home for $150,000 within the two-year period, and the old house is your principal residence. In this example, you have made a $50,000 profit. The tax basis for your new house is the purchase price (i.e., $150,000) less the profit you are rolling over (i.e., $50,000), and thus the new basis of your house is $100,000 ($150,000 minus $50,000). When you sell that new house in the future, although you really paid $150,000 for it, the tax laws treat the basis as being $100,000.
In this example, I have ignored the legitimate expenses that can be used to reduce the profits, such as real estate commissions, recordation and transfer taxes, and other similar closing costs.
If, on the other hand, you do not buy a house (or sell your old house) within the two-year period, then you are not entitled to rollover benefits. The two years is a mandatory statutory requirement, and cannot be waived.
If the two years have expired, you will have to pay a capital gains tax on the profit when you sell your house.
Currently, the capital gains rate permits an individual taxpayer to deduct 60 percent of the amount of the profit. The remaining 40 percent of the profit (gain) is subject to tax at ordinary income tax rates. Thus, if you are in a 40 percent tax bracket, you would have to pay 40 percent of the 40 percent in taxes. Clearly, this is considerably less than the current tax rate for non-capital gains.
This is but one element to be considered when deciding whether to sell your old house or to keep it as a rental investment.
Much, of course, depends on the condition of your house and on its location. If your house is in a good rental area, and if you believe that the house will appreciate in value, then it probably makes sense to keep the house as an investment. On the other hand, if you know that there are significant problems with the house (such as needing a new roof) or if the neighborhood does not command a good rental income, you probably would be better off selling the house and rolling over your profits.
It also should be pointed out that one of the tax benefits of rental real estate -- namely depreciation -- will not be as favorable to you under your circumstances. The basis on which you can depreciate your house will be based on what you originally paid for the property -- not what the property is currently worth when you first begin to rent it out.
There is no easy answer to your question. I have consistently taken the position that people should invest in real estate, and that real estate will continue to be a good investment. I suggest that you discuss the situation with your tax adviser, and let him or her run the numbers for you to determine what is in your best interest.
However, all of this is subject to a very large caveat -- namely the effect of the president's tax bill. While there will continue to be tax benefits available for residential real estate, Congress is attempting to change such items as the capital gains rate, income tax brackets and depreciation. You should analyze the tax bill carefully and keep this in mind as you make your decision.
In the final analysis, if you already have purchased your new house, you still have two years from the date of that purchase in which to sell your house to obtain the benefits of the rollover.