TAX ISSUES, BUY LOW & SELL HIGH

A California couple who sold their home for about $300,000 at a profit of about $150,000 and moved to Washington where they bought a much nicer home for around $200,000. The question is : "Will they have to pay tax on the sale profit?" The answer is : "As always, it depends."

Their are two basic home sale tax rules. One or both may apply to this very common situation where a home seller acquires a less-expensive replacement principal residence.

Rollover Residence Replacement
The Rollover Residence Replacement Rule is found in Internal Revenue Code 1034, and applies to home sellers of any age who sell their principal residence and buy a replacement principal residence within 24 months before or after the sale.

Equal Price
This rule says home sellers who buy a qualifying replacement home which costs at least as much as the adjusted (net) sales price of the old home must defer their profit tax. In our example, if the sellers buy a replacement home in Washington costing at least $300,000, then all their profit tax will be deferred.

Taxing The Difference
This rule also says that home sellers who buy a less-expensive replacement principal residence within 24 months before or after the sale of the old home must pay tax on their profit up to the difference in the two prices. Using our example, our couple will owe tax on $100,000 of their profit ($300,000 sale price minus $200,000 purchase price).

Defer The Tax
However, they can defer their tax on the remaining $50,000 of their $150,000 profit. The mortgage balances and the amount of sale cash reinvested in the replacement home does not matter. Only the net (adjusted) sales price of the old principal residence and the purchase price of the replacement home is of importance.

For example, sellers can sell the old home for all cash and buy a replacement home of equal or greater cost for nothing down, such as with a VA mortgage, and spend their tax-deferred cash as they wish. Incidentally, buying two homes (such as a winter home and a summer home) won't help defer tax because only one replacement principal residence is allowed.

Before leaving this rule, a special provision allows home buyers who purchase a less-expensive replacement home to avoid profit tax if they make enough capital improvements to the replacement home to bring its total cost, purchase price plus improvements, up to at least the adjusted or net sales price of the old home.

Improvements Raise Sales Price
To illustrate, if the couple who buys the $200,000 Washington house adds at least $100,000 of capital improvements to bring the total cost up to the old home's $300,000 adjusted sales price, then they can defer tax on their entire sale profit. However, the improvements must be completed within the 24 month replacement period.

Over 55 Rule
The second home sale tax-saving rule is the "over 55 rule" $125,000 tax exemption found in Internal Revenue Code 121.

This tax break is available to principal residence sellers who:

• Are 55 or older on the day of title transfer,

• Have owned and lived in their principal residence any three of the five years before the sale, and

• Have never used this tax break before.

Who's Disqualified
In second marriages, if one spouse previously used this tax break, the new spouse is automatically disqualified. If you are planning on marrying someone who has already used their "over 55 rule" exemption and you plan to sell your home to claim the $125,000 exemption, sell the home before getting married. Because only one $125,000 exemption is available per marriage, just one spouse need be 55 or older if that spouse is also on the title to the residence.

However, if spouses are 55 or older, are planning a divorce, and the home sale profit will be more than $125,000, then the sale should be delayed until the divorce is final. Then each ex-spouse can claim a $125,000 tax exemption, for total tax-free profits up to $250,000. This same $125,000 benefit would apply to each of two unmarried co-owners, such as two sisters, who are eligible for this tax break.

Combining Breaks
If at least one of the sellers of the $300,000 southern California home in our example qualifies for the over 55 rule, then it can be combined with the rollover residence replacement rule. When using the $125,000 home sale tax exemption, it is subtracted from the home's adjusted (net) sales price to arrive at the "revised adjusted sales price." Subtracting $125,000 from the $300,000 sales price produces a $175,000 revised adjusted sales price.

Planning Brings Savings
Careful tax planning can result in avoidance of tax on all or at least part of the profit from the sale of your principal residence. For full details, please consult your tax adviser before selling your home.