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Buying & selling: tax consequences for the homeowner.


The single most valuable investment for many taxpayers is a residence. During a lifetime, a taxpayer may engage in selling and buying a new residence, temporarily renting out a house, transferring a home as part of a divorce settlement and bequeathing a house to heirs.

Without careful planning and recordkeeping, part of the house's appreciation in value may be lost to federal income taxes imposed on each transaction. The purpose of this article is to explain how a taxpayer can structure transactions involving a residence so that taxes can be minimized and an investment in a home can be maximized.

Principal Residences

Statistics show that approximately 20% of Americans move each year.(1) If a taxpayer sells a home as part of the move, he may incur a gain or a loss on the sale of the property. The adjusted basis of a house is used to determine the gain or loss. Taxpayers should keep close track of the costs that can be included in the adjusted basis of the house so that a gain on the sale can be minimized. If a house is purchased or constructed, its adjusted basis includes cash or other property transferred to acquire it, the assumption of any indebtedness, acquisition expenses paid such as mortgage application and lawyer's fees, and title insurance.

Any improvements made to the house after its acquisition also become part of the adjusted basis. According to Regulation Section 1.263(a)-1(a), these are costs that add value to the property, substantially prolong its useful life or adapt the property to a new or different use. Examples of improvements are landscaping, replacement of a roof, installation of storm windows, paneling walls and building a deck or patio. Costs which improve a property's appearance and increase its value such as replacing the flashing around a roof are also capitalized. The costs of the improvement will be considered part of the adjusted basis only if the improvement is still part of the house when it is sold or depreciated. For example, if a homeowner installs storm windows at a cost of $1,000 and several years later replaces all of the windows with thermopane windows which cost $5,000, the $1,000 cost of the storm windows would not be permitted as part of the adjusted basis of the house.

Expenditures for the incidental repair and maintenance of a home are not added to the cost. Examples of these costs, which according to Regulation Section 1.162-4 keep the home in efficient, operating condition, include cleaning carpets, fertilizing lawns and replacing furnace filters.

Real estate taxes are not generally added to the adjusted basis of a residence. In the year of the purchase, however, an exception applies. According to Regulation Section 1.1012-1(b), if the buyer pays or becomes liable for real estate taxes which are considered imposed on the seller, those taxes are added to the adjusted basis of the buyer's house. The seller is liable for any property taxes accrued to the day before the date of the sale, which is usually the closing date.

For example, assume a taxpayer purchases a house for $50,000 on October 1, 1990, and agrees to pay all of the $2,000 property taxes due on December 31, 1990. The taxpayer would capitalize $1,496 of the taxes ($2,000 x 273/365) and would treat the balance as an itemized deduction if he is able to itemize his expenses. The adjusted basis of the taxpayer's home would be $51,496.

Real estate taxes imposed as a special assessment to fund improvements such as sidewalks and streets are also treated as a capital expenditure and not as an itemized deduction. Special assessments are defined as taxes that provide a local benefit that tends to increase the value of the property, even if it does not actually increase the value. If the special assessment is levied for repairs, maintenance or interest, the cost is deductible and is not added to the basis of the house.

Homeowners need to keep receipts for and records of the improvements they make to their homes so that the costs will be allowed as an addition to basis. In the absence of substantiation, the IRS may permit an estimate of the cost of improvements if it can be determined from evidence provided by the taxpayer that improvements were actually made.

Deferring Gains on Sales

A gain on the sale of a principal residence is calculated by deducting from the selling price both selling expenses such as real estate commissions, advertising expenses and lawyers fees and the adjusted basis of the house. If the taxpayer realizes a loss on the sale, the loss is not deductible and cannot be netted against any capital gains that the taxpayer may have realized. Regulation Section 1.165-9(a) stipulates that since the transaction was not entered into for profit, the loss is not deductible even though a gain on the sale of the residence is taxable. There are ways to convert the residence to income producing property so that all or part of the loss will be deductible, and these procedures will be discussed later.

A gain on the sale of a residence can be deferred under Section 1034 if the house is the taxpayer's principal residence and a new principal residence is purchased within a period beginning two years before the sale and ending two years after the sale. The nonrecognition rules can be used only once during each replacement period. If, however, a second sale within the two-year period is the result of a work-related move that satisfies the time and distance requirements for moving expense deductions, the second sale will also qualify for nonrecognition.(2) The two-year period is suspended if the taxpayer is on extended active duty with the armed forces. The suspension, however, cannot extend for more than four years after the sale. Regulation Section 1.1034-1(g) defines extended duty as active duty in excess of 90 days or for an indefinite period.

A principal residence is the property the taxpayer occupies for a majority of the time during the tax year. If, for example, the taxpayer lived in a condominium in Florida for seven months during the year and spent five months in a cottage in Maine, the condominium would be considered his principal residence.

The principal residence can change from year to year and is not necessarily a house. Regulation Section 1.44(5) indicates that a residence can include a single family structure, condominium, cooperative apartment, duplex, house trailer, mobile home or house boat. The taxpayer must have a legal interest in the property for it to be considered a principal residence. The property can be located in the United States or a foreign country.

The gain realized on the sale of a residence is not recognized to the extent that the taxpayer invests the adjusted sales price received from the sale in a new principal residence during the replacement period. In other words, the gain is recognized to the extent that the taxpayer has not reinvested the adjusted sales price and has funds left to pay taxes. The adjusted sales price is the selling price less selling expenses and fix-up costs. Fix-up costs are expenses incurred to make the house saleable but which cannot be capitalized because they are not improvements. Costs included in this category are carpet cleaning, painting and driveway sealing. In order to be treated as a fix-up cost, the expense must be for work performed within 90 days before the sales contract is entered into and the expense must be paid within 30 days after the sales date. A sale occurs when control and possession of the property passes to the buyer. The taxpayer must file Form 2119 with his Form 1040 to report the sale and purchase of the new residences.

To illustrate, assume that a taxpayer bought a principal residence in 1980 for $60,000 and added a porch in 1985 at a cost of $5,000. The interior of the house was painted in September 1990 at a cost of $500 and the house was sold on October 1, 1990, for $100,000. The realtor received a commission of $7,000 and the taxpayer bought a new residence on November 15, 1990, for $120,000. The taxpayer realized a gain of $28,000 on the sale but will recognize no gain since the adjusted sales price of $92,500 was reinvested in a home that cost $120,000.
 $100,000 selling price
 - 7,000 selling expenses
 =$ 93,000 amount realized
 - 65,000 adjusted basis

($60,000 cost + $5000 improvement)
 = $28,000 Gain Realized
 $93,999 amount realized
 - 500 fix up costs
 = 92,500 adjusted sales price
 -120,000 cost of new residence
 = 0 Gain Recognized

If the taxpayer had reinvested only $80,000 in a new residence, $12,500 of the $28,000 gain would be recognized ($92,500 adjusted sales price minus $80,000 cost of new residence).

Section 1034 simply defers the gain realized on the sale of a principal residence, it does not make the sale permanently tax free. The gain is deferred by reducing the adjusted basis of the new principal residence by the amount of gain not recognized on the sale of the former residence. In the first example, the adjusted basis would be $92,000 ($120,000 cost less $28,000 gain not recognized). In the second example, the adjusted basis would be $64,500 ($80,000 cost less $15,500 gain not recognized). If the taxpayer sells the second residence and does not replace it with another principal residence, the cumulative gain on both sales would be recognized.

Sales of Lots and Acreage

A sale of a residence includes the sale of the land on which the home is located. If a taxpayer sells a vacant lot, the sale is not considered to be a sale of a residence and any gain realized must be recognized. If the lot is contiguous to the land on which a principal residence is located and the lot is sold at the same time as the residence or in a series of transactions which also include the sale of the residence, the entire property sold can qualify for nonrecognition of gain.

Revenue Ruling 76-541, 1976-2 CB 246 dealt with a taxpayer whose home was located on 10 acres of land. The taxpayer sold the house with three acres of land and then sold two of the remaining seven acres before the end of the tax year. The IRS ruled that the two acre portion remained part of the old residence for the two-year replacement period and, therefore, the sale of the land as well as the house qualified for nonrecognition under Section 1034. A taxpayer considering selling a home and vacant land should time the sale of the land within the replacement period so that any gain on the land can be deferred along with the gain on the sale of the residence.

Construction of a New


Replacement property under Section 1034 includes residences purchased by the taxpayer as well as houses constructed or reconstructed by the taxpayer as long as they are occupied within the two-year replacement period. Code Section 1034(c)(2) permits construction to begin before the two-year replacement period but restricts the costs that qualify as replacement to those incurred during the replacement period. For example, assume that a taxpayer bought a lot on June 1, 1988, for $20,000, had a basement excavated and poured in July 1988 at a cost of $10,000, and spent $70,000 more between August 1988 and December 1988 to complete the house. The taxpayer moved into the new house on January 1, 1989, and sold the old house in August 1990. Since the $30,000 for the lot and basement were incurred earlier than two years before the sale of the principal residence, it will not be considered part of the replacement cost which totals only $70,000.

Taxpayers who sell their principal residences and move into vacation homes that they previously purchased may be able to defer the gain on the sale of the principal residence. If the vacation home was purchased during the two-year replacement period, its cost would qualify as a replacement cost. If the home was purchased before the two-year period, it would have to be partially or totally reconstructed to qualify as a replacement. Only the costs incurred for reconstruction and not for a mere improvement can be used to defer the gain.

To illustrate, assume that a taxpayer owned a house in New York which cost $70,000 and a second house in Florida which cost $50,000. Both houses were purchased 10 years ago. If the taxpayer sold the house in New York for $100,000 and moved into the Florida home, the $30,000 gain on the sale could not be deferred. If he used the $100,000 sales proceeds to reconstruct or make an addition to the Florida house, none of the $30,000 gain would be recognized. If $75,000 of the proceeds were used for reconstruction, then $25,000 of the $30,000 gain would be recognized since $25,000 of the sales proceeds were not reinvested.

Married Homeowners

The nonrecognition rules apply to single and married taxpayers. If married taxpayers own a residence as tenants by the entirety, sell the house and then separate, each spouse can use the nonrecognition provisions if each buys replacement property. For example, assume that a couple sold a house for $200,000, realized a $90,000 gain, separated and divided the proceeds equally. Half of the gain would be allocated to each spouse and could be postponed if each spouse reinvested at least $100,000 in a new principal residence. If the husband reinvested $120,000 and the wife reinvested only $85,000 in a new principal residence, the wife would be required to recognize $15,000 ($100,000 minus $85,000) of her $45,000 share of the gain.

The nonrecognition rules can also apply if two single taxpayers sell their homes, marry and invest the proceeds in one house that they own jointly. As long as the cost of the new house equals or exceeds the total adjusted sales price of the two residences, both gains can be postponed.

If a taxpayer transfers a home to a spouse in connection with a divorce after July 18, 1984, no gain or loss is recognized on the transfer. The nonrecognition rule applies to sales between the spouses as well as transfers and applies regardless of whether the house was separately owned by the transferor or was a division of community property. The basis of the house to the recipient or transferee spouse is the basis in the hands of the transferor spouse and is used by the transferee spouse in determining gain or loss on a subsequent sale of the property.

To illustrate, assume that a taxpayer owns a house with an adjusted basis of $65,000 and a market value of $100,000. If the taxpayer transfers the residence to his spouse as part of a divorce, he recognizes no gain on the transfer and his former spouse takes an adjusted basis for the house of $65,000. If his spouse purchased the house from him for $100,000, he still would not recognize any gain and his spouse would use an adjusted basis of $65,000 even though she paid $100,000 for the house. If she later sold the house for $100,000 or more, she would realize a gain of at least $35,000. In effect, her former spouse has shifted his gain to her.

Taxpayers Age 55 or Older

Taxpayers who are 55 or older can exclude, not just defer, up to $125,000 of the gain on the sale of a principal residence. The $125,000 exclusion can be used in conjunction with the deferral rules discussed earlier. Code Section 121 permits a taxpayer to use this exclusion once in his lifetime if he meets ownership and occupancy requirements on the date of the sale.

To qualify for the exclusion, the taxpayer must have reached age 55 before the date of the sale. If a taxpayer is married, only one of the spouses needs to meet the age requirement. The taxpayer must also have owned and occupied the property as his principal residence for at least three of the five years prior to the sale. The ownership and occupancy rules need not be met simultaneously but both must be met during the five-year period.

To illustrate the exclusion, assume that a taxpayer sells a house with a $50,000 adjusted basis for $145,000. The taxpayer realizes a $95,000 gain which he can defer by investing the $145,000 in another principal residence. If he is 55 or older, he can elect to exclude the $95,000 gain without investing the proceeds in another residence.

The exclusion is elected by attaching a signed statement to the return for the year of the sale. The statement is not required if the taxpayer files Form 2119 with his Form 1040.

The election to exclude the gain can be used only once in a taxpayer's lifetime even if the amount excluded is not the full $125,000. If a taxpayer is married, the exclusion does not apply separately to each spouse. If a married couple uses the exclusion and later divorces or a spouse dies, no further election can be used by the taxpayers (or their new spouses if they remarry).

Taxpayers must carefully plan the use of the exclusion in light of this inequitable treatment. For example, if a taxpayer who has not used the exclusion and intends to sell his home plans to marry a widow who has used the exclusion, he should sell his home and elect the exclusion before the marriage. Once he marries the widow, he will be barred from using the exclusion as long as he remains married to her.

The one-time only restriction also applies to two taxpayers who own separate homes before their marriage and sell the houses after the marriage. Gain can be excluded on only one of the houses, not both, even if the combined gain on the two houses totaled $125,000 or less. The taxpayers must sell their houses before the marriage in order for both to use the exclusion.

If a taxpayer is married and files a separate return, the maximum that he can exclude for the lifetime exclusion is only $62,500. It might appear that filing separately would be a way for taxpayers to use the election twice on two different houses, but that is not the case. Regulation Section 1.121-4(a) stipulates that if a taxpayer is married, both spouses must agree to the election for the exclusion even if they file separately. By agreeing to the exclusion, both are considered to have used the election even if only one spouse received the benefit.

Although an exclusion can be used only once in a lifetime, more than one exclusion can be used on a single residence if title to the property is held as joint tenants or tenants in common. To illustrate, assume that two unmarried individuals own a house that cost $40,000 and was sold for $25,000. Each of the taxpayers would be allocated half or $105,000 of the $210,000 gain ($250,000 selling price less $40,000 adjusted basis) which they could each exclude using their lifetime exclusions.

The lifetime exclusion can be used with the deferral provisions of Section 1034 to maximize nonrecognition. The taxpayer first reduces the realized gain and the adjusted sales price by the $125,000 exclusion and then can defer any net gain by investing the net adjusted sales price in a principal residence within the rollover period.

To illustrate, assume that a taxpayer sells a house with an $80,000 adjusted basis for $240,000. Of the $160,000 gain, $125,000 can be excluded by making the lifetime election. The remaining $35,000 gain ($160,000 gain less the $125,000 exclusion) can be deferred if the net adjusted sales price of $115,000 ($240,000 adjusted sales price less the $125,000 exclusion) is reinvested in a principal residence. If the taxpayer invested $80,000 or less in a new residence, the $35,000 remaining gain would be recognized since $35,000 of the adjusted sales price was not reinvested ($115,000 adjusted sales price less $80,000 cost of new residence).

Inherited Property

If a taxpayer acquires a residence through inheritance, the adjusted basis of the house is not the basis in the hands of the decedent. Instead the basis is the fair market value (FMV) on the date of the decedent's death.(3) Therefore, any appreciation in value above the decedent's adjusted basis is spared taxation. If the beneficiary sells the house for more than the fair market value on the date of death, the gain must be recognized unless he used the property as a principal residence and qualifies for deferral or exclusion of the gain.

Losses on Sales of


It was noted earlier that a loss on the sale of a principal residence cannot be recognized because the transaction is not entered into for profit. If a residence is converted into income producing property, a loss on its sale can be deducted. One method of converting the property is to hold it as rental property. The taxpayer must be careful about how long he rents out the property when trying to convert it to rental property. Regulation Section 1.1034-1(c) states that all the facts and circumstances will be looked at including the taxpayer's good faith. If a taxpayer buys a new residence before he sells the old house and rents out the old house while waiting for a sale, he will not be viewed as holding the property for income producing purposes. The rental will be viewed simply as an effort to sell the old residence.

There have been recent reports of homeowners abandoning their houses and mortgages in areas of the country that are experiencing real estate slumps. The abandonment might appear reasonable since a loss on the sale is not deductible and making payments on a debt that cannot be recovered seems senseless. Unfortunately, abandoning a mortgage can actually result in a taxable gain to the homeowner. Regulation Section 1.1001-2(a)(2) treats the debtor as having sold the property for its cash equivalent and applying the cash to the debt payment. Therefore, gain is realized by the taxpayer equal to the fair market value of the house less its adjusted basis. In addition, Regulation Section 1.61-12(a) stipulates that if the fair market value of the property is less than the debt, the excess debt discharged results in debt cancellation income.

To illustrate, assume that a taxpayer purchased a home for $50,000 and refinanced it for a total mortgage of $150,000. The new mortgage was not used to make improvements to the home. If the house declines in value to $140,000 and the debtor abandons the house and mortgage, he would recognize a gain of $100,000, $90,000 for exchanging the house's FMV for the debt ($140,000 FMV less $50,000 adjusted basis) and $10,000 of debt cancellation income ($150,000 debt canceled less $140,000 FMV transferred).

Maximizing Annual Tax


Home ownership can result in tax advantages other than deferral or exclusion of gain. Currently, interest on debt incurred to buy, construct or substantially improved a qualified residence is deductible if the taxpayer itemizes his deductions. The maximum amount of qualified residence debt on which interest can be deducted is $1 million ($500,000 if a married individual files a separate return). A qualified residence includes the taxpayer's principal residence and a second residence as long as the residence is not rental property. The property must be used as security for the debt. If the debt was incurred prior to October 13, 1987, there is no limit on the amount of indebtedness.

Taxpayers can also deduct interest on up to $100,000 of home equity loans. The amount of acquisition debt and home equity debt, however, cannot exceed the fair market value of the house. The home equity loans, which must be obtained after October 13, 1987, need not be used to acquire, construct or improve a residence. As a result, the proceeds can be used to finance a car, pay off a student loan, provide a vacation, etc. Taxpayers should give serious consideration to home equity loans since, beginning in 1991, interest on credit cards, auto loans, student loans and other personal loans will no longer be deductible. If a home equity loan is used to pay off those debts, the interest incurred will be deductible.

The tax benefits of home ownership may be reduced for some taxpayers as a result of the Revenue Reconciliation Act. of 1990. Beginning in 1991, a taxpayer with adjusted gross income (AGI) in excess of $100,000 must reduce his itemized deductions, which include mortgage interest, points and property taxes as well as other deductions, by 3% of the AGI in excess of $100,000. The $100,000 threshold is the same for single and married individuals filing jointly. If a taxpayer has $12,000 in mortgage interest and property taxes and AGI of $130,000, the $12,000 itemized deductions will be reduced by $900 ($30,000 excess AGI x 3%).


There are many ways for a taxpayer to use a residence to minimize taxation. Interest and property taxes paid on a residence can help reduce the tax liability of individuals who itemize deductions. Taxpayers can also shield the appreciation on their homes from taxation by reinvesting the proceeds from a sale in another principal residence or electing the once in a lifetime exclusion. Homeowners need to keep adequate records of their transactions and be vigilant about changes in the tax laws affecting residences so that they can maximize the tax benefits of home ownership.


(1) Americans on the Move Are on the Rebound," Wall Street Journal, 27 January 1988.

(2) The moving expense rules under Code Sections 217(c)(1)and(2) require the distance between the taxpayer's new place of employment and old residence to be 35 miles or more greater than the distance between his old place of business and old residence. In addition, the taxpayer must work at the new place of employment for at least 39 of the 52 weeks following the move or 78 of 104 weeks in the case of self-employment.

(3) If an estate tax return is filed, Code Section 1014(a)(2) permits the executor of the estate to elect to use the fair market value on the alternative valuation date. The alternative valuation date is the earlier of six months after death or the date the property is distributed.
COPYRIGHT 1991 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Dykxhoorn, Hans J.; Sinning, Kathleen E.
Publication:The National Public Accountant
Date:Mar 1, 1991
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Next Article:The erosion of the privity doctrine.

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