You Made
A Profit, You Will Have To Pay The Tax
by Benny L.
Kass
Question: I 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 exemption. Can I
"roll-over" the remaining $250,000 by purchasing 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?
Answer: No. Section 1034 of the Tax Code
was repealed several years ago when Congress enacted and President Clinton
signed into law the Taxpayer Relief Act of 1997. Prior to 1997, if within two
years before or after you sold your existing home you purchased a new principal
residence -- 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 of your house was rolled
over into the purchase price of the new property. This was known as the
"roll-over."
Note that I used the word
"defer." Ultimately, when you sold your last house, there were
taxable consequences.
Today, under the new law,
there is no more roll-over. Instead, you can completely 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 a
five year period before it is sold.
Your question, however,
confused me. 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
scenarios, but first we need to define some basic tax terms:
·
Basis. This is the initial cost of the
property.
Scenario One -- Sale Price $500,000
You purchased your house many years ago for $50,000, and
made $50,000 of improvements. Your adjusted basis is $100,000. You now sell the
house for $550,000, and after deducing real estate commissions and settlement
charges, you will walk away with $500,000.
Thus, your capital gain is $400,000 (500,000 - 100,000).
You are not married, but have owned and lived in the house
for two out of the past five years prior to sale.
The tax laws allow you to completely exclude (not defer)
$250,000 of the profit you have made when you sold the house. The remaining
profit of $150,000 (400,000 - 250,000) will be taxed, and the current federal
tax rate is 15 percent. Thus, you will have to pay Uncle Sam approximately
$22,500. You will also have to pay the applicable State tax in the jurisdiction
where you live.
You cannot roll over this taxable gain into a new
principal residence.
Scenario Two -- Capital Gain $500,000
Here, instead of selling the house for $550,000, you get
lucky and sell it for $650,000. Since all other factors remain the same, in
this example you have made a capital gain of $500,000.
Once again, you can exclude up to $250,000 of this gain.
You cannot roll-over the balance, but instead will have to pay tax on this
profit. At the current federal tax rate, your taxable consequences will be
$37,500 (15 percent of $250,000).
As you can see, although Congress in 1997 gave homeowners
a considerable tax break, it was not a carte blanche to completely avoid paying
any 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."
There is one way to defer the balance of the capital gains
tax, but I do not believe it is applicable to your situation.
Let us assume that you have a legal, rental apartment in
your home. For many years, you have carefully documented this investment, by
reporting to the IRS the income each year, and depreciating the portion of your
house which has been used for investment purposes.
In this situation, it is possible to combine the principal
residence exclusion with a like-kind "Starker" exchange.
How does this work? Let's take another example. For many
years, one quarter of your house has properly and officially been used for
investment (rental) purposes. You sell the property for $500,000. Three
quarters of this can be claimed as a principal residence, and you can take your
percentage of the $250,000 based on this portion of the property.
However, since you have carefully documented that one
fourth of your house has been investment property, you can exchange it for
another property whose cost is at least $125,000 (i.e. 25 percent of $500,000).
There are strict rules regarding such a Section 1031 (Starker) exchange, and
you must talk with your tax advisors about this before you even consider
selling your house.
There is one important point which every homeowner should
know. Be careful when you calculate your basis. Let's look at scenario one
again, but with one additional fact. Before you purchased your present house,
you owned another one. You bought that for $25,000 and sold it for $50,000.
Because it was before 1997, you were able to roll over your $25,000 profit into
the house that you currently own. (For this discussion, I am ignoring costs and
improvements.) Although you paid $50,000 for the current house, in fact the
roll-over caused your basis to drop down to $25,000 (50,000 - 25,000). 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).
This is something which everyone who took advantage of the
roll-over should know and should plug these numbers into your calculations of
gain.
The bottom line however: You have made a lot of money on
your investment. You will have to pay your fair share of the capital gains tax.
Published: July 5, 2004