QI plan to sell my house this fall. I am unmarried and have lived in my house as my principal residence for many years. I believe that I will realize $500,000 from the sale. I understand that I can shelter $250,000 by taking the capital gains tax exemption. Can I roll over the remaining $250,000 by buying a new principal residence of equal or greater price? I have heard that section 1034 of the Internal Revenue Code would permit that. Am I correct?
ANo. Section 1034 of the tax code was repealed when the Taxpayer Relief Act of 1997 became law.
Before 1997, if you bought a new principal residence within two years before or after selling your existing home, and the purchase price of the new property was equal to or greater than the sales price of the older home, you were able to defer any capital gains tax because the profit you made on the sale was rolled over into the purchase price of the new property. This was known as the rollover.
Note that I used the word "defer." Under the old law, ultimately, when you sold your last house, there were taxable consequences.
The current law does not allow rollover. Instead, you can exclude up to $250,000 of gain (and up to $500,000 if you are married and file a joint tax return) if you have owned and used the house as your principal residence for two out of five years before it is sold.
Your question confused me somewhat. What exactly do you mean when you say you will "realize" $500,000? Does that mean that you will have made $500,000 in profit, or that the sales price will be this amount?
Let's analyze both. But first we need to define some basic tax terms:
* Basis: The initial cost of the property.
* Adjusted basis: Your basis plus the cost of any improvements you have made over the years.
* Gross profit: The difference between your adjusted basis and the sales price.
* Net profit: Gross profit minus any real estate commissions paid when you sold the property, any seller credits given to your purchaser, and certain fix-up costs. The net profit is also called capital gain.
Depending on exactly what you meant in your question, the amount of tax you would owe varies.
Scenario one: Sale price $500,000. You bought your house many years ago for $50,000, and have made $50,000 in improvements. Your adjusted basis is $100,000. You now sell the house for $550,000 and, after deducting real estate commissions and settlement charges, you walk away with $500,000.
Thus, your capital gain is $400,000 ($500,000 minus $100,000).
You are not married but have owned and lived in the house for two out of the five years prior to sale.
The tax laws allow you to exclude (rather than defer) $250,000 of the profit you make when you sell the house. The remaining profit of $150,000 ($400,000 minus $250,000) will be taxed. The current federal tax rate on capital gains is 15 percent. Thus, you will have to pay Uncle Sam about $22,500. You will also owe the applicable state tax.
You cannot roll over this taxable gain into a new principal residence.
Scenario two: Capital gain $500,000. Let's say that instead of selling the house for $550,000, you get lucky and sell it for $650,000. Because all other factors remain the same, in this example you have a capital gain of $500,000.
Once again, you can exclude up to $250,000 of this gain. You cannot roll over the balance; you have to pay tax on this profit. At the current tax rate, your taxable consequences will be $37,500 (15 percent of $250,000).
One important reminder: Be careful when you calculate your basis. Many homeowners took advantage of the rollover before the tax law changed. While the rollover no longer exists, it can still affect your tax bill.
Let's look at the first scenario again, but with one additional fact. Before you bought your present house, you owned another one. You bought that for $25,000 and sold it for $50,000. Because the sale was before 1997, you were able to roll over your $25,000 profit into the house that you now own. Although you paid $50,000 for the current house, the rollover caused your basis to drop to $25,000 ($50,000 minus $25,000), and your adjusted basis to $75,000. Thus, in our example, your capital gain is increased by $25,000, and you will have to pay $3,750 more in federal income tax (15 percent of $25,000).
As you can see, although Congress in 1997 gave homeowners a considerable tax break, it was not a carte blanche to completely avoid paying capital gains tax. As a congressman once told me: "My constituents back home have not had the benefit of the phenomenal real estate increases as we have here in Washington. I have made a lot of money on my house, and I will have to pay my fair share of my capital gains tax."
And that's the bottom line: You have made a lot of money on your investment. You will have to pay your fair share of the capital gains tax.
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.