Q. I would appreciate a definitive answer to a question I have. The Internal Revenue Service has given me two different answers to the same question. In order not to pay capital gains tax on the sale of a permanent residence, I understand a replacement home must be purchased within a two-year period. If the new home costs $100,000, and the old home sold for $110,000, will the capital gains tax be paid on the difference -- $10,000? I have been told it is necessary to purchase a residence costing $110,000 or more in order not to pay any capital gains. The capital gain on my home was about $50,000. I have previously taken the once-in-a-lifetime exemption for an earlier home.
A. Well, let me try to give you what might be a third answer.
The tax laws permit two special benefits for taxpayers who sell their personal residence. One is available to those who sell the old residence and, within a two-year period, buy or build a new residence. This tax benefit is applicable to all taxpayers regardless of age, and is referred to as a "rollover."
The second applies to taxpayers who are 55 years of age or older. If they have lived in their principal residence for a total of three years during the five-year period ending on the date of sale of the residence, they are entitled to a once-in-a-lifetime exclusion of up to $125,000 of the profit from the sale.
You have indicated that you have taken the one-time deduction on a previous residence. It is too late for you, but let me caution other readers not to be too hasty in taking the once-in-a-lifetime $125,000 exemption. I sense from the limited information I have been given for this question that the taxpayer would have been better off rolling over the profit rather than taking the once-in-a-lifetime exemption. Each homeowner must carefully analyze his or her situation and consult with advisers before committing himself to one particular tax benefit.
With respect to your situation, because you cannot take the once-in-a-lifetime exemption, you are eligible only for the rollover. But the additional rule on using the rollover is that the gain on your house is postponed if the cost of your new house exceeds the adjusted sales price of your old house. It should be noted that the rollover does not permit an exemption of the tax, but rather a deferral. When you ultimately sell your last house, to the extent that your gain exceeds $125,000 (that which you are entitled to exempt), you have to pay the tax on the balance of the profit. Now, let's get down to specifics.
First, you indicated that the old home sold for $110,000. Is this an adjusted sales price, or was it the gross sales price? The difference is important. According to the tax law, the new house must exceed the adjusted sale price of the old house. If, for example, you sold your home for $110,000 and paid a 6 percent real estate commission and other closing costs, you have to deduct the commission and the other closing costs to reach the "adjusted sales price." It might be, from your example, that the adjusted sales price is less than $100,000 -- the purchase price of your new house.
But even if it is not, the specific answer to your question is that you have to pay tax only on the difference between the adjusted sales price of your old house and the cost of your new house. In your example, if $110,000 was in fact your adjusted sales price, because you purchased your new house for $100,000, your gain on which you have to pay tax is $10,000. This is called the "recognized gain."
Because you had a gain of about $50,000 and are not eligible for the once-in-a-lifetime exemption, the balance of the gain, (in your case, $40,000) is rolled over into the purchase price of the new house.
In more simple terms, because you paid $100,000 for your new house and sold your old house for $110,000, you have to pay tax on a $10,000 gain. The balance of the gain, $40,000, is put into the new purchase price, so the adjusted price of your new house is $60,000 ($100,000 minus $40,000).
The tax laws are confusing. It is unfortunate that the Internal Revenue Service cannot -- or will not -- give you a definitive answer.