How to Avoid U.S. Taxes on Home Sale Profits

QUESTION: You often tell people they can defer their profit tax when they sell their principal residence and buy a replacement home of equal or greater cost within 24 months. However, I would like more details on how the deferral works. When is the profit tax due? Please clarify.

ANSWER: A simple example will show how this major tax break saves home sellers from paying thousands of dollars in taxes. Suppose you bought your home for $50,000, added $10,000 of capital improvements while you owned it, and sold the home for $100,000 net, after paying all selling expenses such as the realty agent’s sales commission and transfer costs.

Your profit is the difference between the $100,000 net or adjusted sales price and the “adjusted cost basis” of $60,000 ($50,000 plus $10,000). Tax on this $40,000 profit is deferred, using Internal Revenue Code 1034, if you buy a qualifying replacement home costing at least $100,000.

The tax deferral lasts as long as you own your replacement principal residence. If you should die while owning the replacement home, Uncle Sam forgives the tax that would have been due if you sold the home without buying another qualifying replacement principal residence.

This tax benefit can be used over and over without limit. You can start out with a small cottage, sell it at a profit, buy a qualifying replacement, and pyramid your way up to a mansion, all without paying profit tax. However, this tax break cannot be used more often than once every 24 months. Please consult your tax adviser for more details.

An Option to Purchase Locks in Price of Land

Q: I found a rural property, about 26 acres, which will be a perfect truck-stop site when the surrounding area is developed in a few years. It is at the intersection of two county roads that are due to be widened to four lanes in about five years.

My problem is I can’t find any financing for my purchase. My bank won’t touch it. The seller refuses to carry the mortgage because she had to foreclose on the previous owner. How can I borrow the money to buy this land?

A: As you have discovered, land speculators are not welcome borrowers at most banks. Mortgage lenders have learned that land can be very illiquid since it produces no income and can be difficult to sell. At best, you can borrow only about 50% of the land’s value from a hard money lender. For this reason, land sellers are the major source of financing for land sales.

Since the seller refuses to carry back a mortgage, why not buy a 10-year, renewable option to acquire the land? Such an option would give the seller monthly income just like a mortgage.

However, if you don’t make the option payments, monthly, quarterly, semiannually or annually, the option is canceled. The advantage to you is locking in the purchase price without having the big payments a mortgage would require. Options to buy property are far cheaper than mortgages.

It’s Better to Inherit Than Receive a Gift

Q: My father has terminal cancer. He is carefully planning to divide his assets fairly among his three children, including me. Since I am the only one with a family, he plans to give me and my husband his large house.

Since he is in a convalescent hospital and no longer needs the house, he has offered to give us the deed to the house now. However, a friend at work says she read in your column that it is better to inherit property than to receive it as a gift. Please explain.

A: Your friend is correct. If you inherit the house after your father dies, your basis will be the house’s fair market value on the day of his death. However, if your father gives you the house before he dies, then you take over his presumably much lower basis in the house.

To illustrate, suppose your father paid $25,000 for the house and it is worth $100,000 when he dies. If you receive a gift of the house now, your basis will be $25,000. When you eventually sell the house, you will owe tax on the difference between $25,000 and the net sales price.

However, if you inherit the house, your basis will be the $100,000 value on the date of death, so you will owe tax only on any net sale amount received over $100,000.

I realize that you plan to live in the house and don’t expect to sell it immediately, but you would be better off moving into the house now and inheriting it by your father’s will rather than receiving it as a gift. Ask your tax adviser to explain further.

No Matter Your Age, Buy Home, Don’t Rent

Q: My husband and I are retired, in our early 70s, and in excellent health. We recently sold our home and moved into our daughter’s house, while she and her husband are in Europe on a business assignment.

They will be returning in January, so we must decide by then whether we should rent an apartment or perhaps buy a modest house or condo. I am worried about inflation eating up our income and the profit from the sale of our home. What do you advise?

A: Years ago my parents went through the same dilemma you are encountering. For a few years, they tried renting a nice apartment. But the rent kept going up. Then their building “went condo.” They moved to another building which also “went condo.” I then advised them to buy their apartment.

To be more accurate, I twisted their arms and practically forced them to buy with a minimal 10% down payment, although they could have paid all cash, and a 90% mortgage. They thought the price and the 9% interest rate were outrageous. But that condo turned out to be their best investment, even better than the house where I grew up.

My point is, home ownership is better than renting. However, I urge you to take your time shopping for a house or condo. When you decide to buy, make the minimum down payment and obtain the maximum mortgage available. In today’s mortgage environment I urge you to take a fixed-rate mortgage so you know your mortgage payments won’t increase.

Two-Bedroom Condo Is Best Investment

Q: I am currently single, having recently divorced my husband. As the result of selling our home, I have a wealth of cash. There is a very luxurious new condominium building near where I work and I have decided to buy a unit there.

However, I can’t decide between a one- or two-bedroom condo. The extra cost is about $25,000 for the two bedrooms. My friends advise me to purchase the two bedrooms. But I think a one-bedroom unit is perfectly adequate. Or, I could buy a studio condo. What do you advise?

A: Listen to your smart friends. The resale demand for two-bedroom condos is much greater than for one-bedroom condos. Don’t even think of buying a studio condo because the resale potential is virtually nil.

You Can Get Tax Break on Home Outside U.S.

Q: My husband died recently and I plan to sell our home, which is far too large for me. I would like to return to my native Mexico where I can live very comfortably on my income, plus the proceeds from the sale of our home. However, I am not yet 55 so cannot claim the $125,000 home sale tax exemption. Is there any way I can avoid tax if I sell our house and buy one in Mexico?

A: Yes. Internal Revenue Code 1034, the “roll-over residence replacement rule,” does not limit the location of your replacement principal residence. It can be outside the United States. To qualify for tax deferral, its cost must equal or exceed the net (adjusted) sales price of your old home and you must buy and occupy it within 24 months before or after the sale. Please consult your tax adviser for full details.

Letters and comments to Robert J. Bruss, a San Francisco-area lawyer, author and real estate broker, may be sent to the Real Estate Section, Los Angeles Times, Times Mirror Square, Los Angeles 90053.