Home Sale Tax Break: Get Moving

Q: My wife and I are building a new home that has taken longer than two years to complete. We sold our home in August, 1992, for $305,000 after expenses, and as of the end of August, 1994, we had spent about $201,000 on the new home. Our cost basis in the old home was $225,000. I am getting differing opinions from my attorney and accountant about my tax liability. One says I must have moved into the replacement home with 24 months of the sale of the original home; the other says the replacement home must have cost at least as much as the original. I am confused. -- D.L .

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A: Both your accountant and your attorney are correct. To defer your entire tax obligation on profits realized from the sale of your principal residence, your replacement residence must cost at least as much as the one you sold--and you must move into the replacement home within 24 months after the sale of the original home. (Taxpayers may still purchase a replacement house within 24 months prior to the sale of their home, but they must move into the replacement residence within two years after the sale to qualify for the tax deferral.)

So far, you have neither invested as much as you received from your home sale nor moved into your replacement house. In fact, because you did not even spend an amount equal to the tax basis in your original home--$225,000--within 24 months of its sale, you are liable for taxes on the full amount of your gain, some $80,000. (This is computed by deducting your $225,000 tax basis from the $305,000 sales price.)

If you had spent more than $225,000, but less than $305,000, you would have been liable for taxes on the difference between the sales price and what you had reinvested in the home under construction within the 24-month period.

401(k) Money: Touch It at Your Own Risk

Q: I recently left my job to start my own business. I received a check for $4,000 from my employer’s 401(k) account. I would like to use the money for personal uses. Are there any penalties or special tax repercussions if I do not roll it into an individual retirement account? I will wait for an answer before I cash the check. -- R.R .

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A: You bet there are repercussions--and penalties, too!

Taxpayers under age 59 1/2 who take disbursements from their 401(k) or IRA accounts face a 10% early withdrawal penalty on those funds. In addition, the money is subject to ordinary income taxes, just like your salary or other earnings. (Remember, 401(k) and IRA accounts were established to help you save for your retirement; hence the penalty for early withdrawal. And because most funds deposited into these accounts have not been taxed, any withdrawals of untaxed revenue are subject to ordinary income taxes.) The net effect is that you face losing $400 of your funds as a penalty and, depending on your tax bracket, at least another $700 to $1,400 in federal and state income taxes.

By the way, even if you decided not to spend any of your 401(k) money and intended to deposit it all into an IRA, you would still be subject to a 20% withholding tax on the $4,000. Why? Under rules that took effect in January, 1993, taxpayers cashing out of their employer’s 401(k) or other qualified pension plan are subject to a 20% withholding tax on the disbursement if they take possession of the money rather than rolling it directly into a qualified employer pension plan or individual retirement account. If you had wanted to roll your 401(k) account over into an IRA, you should have directed your employer to deposit the funds directly into that account. Never, never take possession of the money.

What can you do now? If you don’t mind the 10% penalty, go ahead and use the money as you wish. If you regret your decision, however, your choices are limited. Chances are your previous employer is powerless to cancel the check it has already issued and reissue a new one to an IRA account of your choice. According to employee benefits experts, 401(k) withdrawals are immediately reported to the IRS. It is highly unlikely that yours can be canceled. The best you can do is deposit the check in a rollover IRA and make up out of your own pocket any funds that were withheld as taxes on the disbursement. You can claim those taxes when you file your income tax next year.

Rules Are Rigid on the $125,000 Exclusion

Q: We are eligible to use the $125,000 profit exclusion when we sell our home. However, we have not lived in the house for the last five years. Is there any way we can possibly use the exclusion now? If not, can we transfer it to the new house that we will buy? -- R.S.B .

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A: To use the $125,000 profit exclusion on a home sale, you must be at least age 55. (If you are a married couple, at least one of you must be at least 55.) In addition, the home being sold must be your principal residence, and you must have lived in it for at least three of the five years immediately preceding the home’s sale. All three requirements must be met. No waivers.

So, despite what you think, you are not eligible to use the $125,000 exemption now because you clearly have not met the third requirement. And since you haven’t lived in the house for five years, one might even wonder if it can still be considered your principal residence. But, not to worry. There is nothing preventing you from using your exemption when you sell the home into which you are moving now. Of course, if your new home costs less than what you are selling your old house for, you will be liable for taxes that you will not be able to offset with the exclusion. You would be better off purchasing a replacement home now that costs at least as much as the home you are selling and saving the exclusion for the time when you are ready to sell the replacement home.