When ‘Rollover’ Date Has Passed, Be Creative

In my recent “Real Estate Tax Tips” series, I discussed the great importance to homeowners of an Internal Revenue Code provision called “the rollover,” which enables sellers to defer tax on capital gains on the sale of a principal residence.

To take advantage of the rollover, a homeowner must sell his principal residence and buy another principal residence at a price that is equal to or greater than the selling price within two years before or two years after the sale.

The article pointed out that the two-year deadline is absolute, and mentioned several ways to preserve the rollover when faced with the expiration of the two-year period.

Recently, a Los Angeles resident called me in a panic. She had read the article, was running out of time and wanted additional assistance on preserving the rollover.

She had bought her house many years ago, and two years ago bought a new house, intending to fix it up and then sell her old principle residence.

Unfortunately, because of market conditions, she was unable to sell her house--despite the fact that she had vigorously marketed it for some time--and was now concerned that she might have to pay upward of $150,000 in capital gains tax.

Hers is not an isolated problem. Many people now find themselves in a quandary, because, while the law does not care whether you buy first and then sell, or vice versa, to preserve the rollover, no more than two years can elapse between the two transactions.

There are some limited exceptions. If, for example, you were on active duty with the military, the two-year period can be extended up to eight years, depending on certain circumstances, including whether you were stationed in the United States or abroad.

But if you were not in the military, the two-year period is absolutely mandatory, as many court cases have made clear.

Thus, we have to find creative ways in which to avoid having to pay the capital gains tax on the profit on the sale of your old house. Keep in mind that currently the federal tax law caps the tax rate at 28% of the profit you have made. This does not, of course, include state taxes, which may also be owed.

An example:

Say you bought your house for $35,000 many years ago and sold it for $300,000. You have a gross profit of $265,000. Even if you take away such closing costs as real estate commissions, transfer taxes and other fees, it is still conceivable that you may have to pay as much as $60,000 to $70,000 tax to the IRS.

Here are some suggestions to defer the tax on the profit:

First, you can convert the house to a rental. If you believe the property has significant appreciation potential and is in a location where you can earn decent rental income, you may want to keep the house and rent it.

If you later decide to sell that rental property, you could take advantage of another provision of the Internal Revenue Code, namely the “like-kind” exchange, in which you “trade” your house for another income property.

This approach has similar qualities to the rollover, in that you can defer the profit if you obtain other investment property.

Some people also consider keeping the property for their lifetime, since, on their death, their heirs inherit the property at what is known as a “stepped-up basis.”

In other words, if your children inherit the property and it is worth $400,000, their tax basis is the value at the time of your death. Thus, all your appreciation would be non-taxable for your heirs.

Unfortunately, this approach means that you have to carry two houses--your new one and the old one. Many people are just unwilling or financially unable to do this.

Second, you could sell the property to a friend or relative. This is risky, since I do not know of any legal authority in which this approach has been approved and you assume the risk if the IRS audits your tax return.

If you do go this route, you must make sure that, to the best of your ability, you are treating your friend or relative on an arms-length basis. In other words, would you sell that same property to a stranger under the terms and conditions that you are selling the house to your friend or relative?

You should also make sure that your friend or relative understands the situation, and that when the property is ultimately sold, you are the beneficiary of the sales proceeds--and not your friend. The best way to handle this situation is for you to take back a promissory note and deed of trust (mortgage) securing your equity against the house.

You should discuss this situation with your current lender, since there is probably a “due on sale” clause in your current mortgage documents, and the sale of the property to your friend or relative may trigger that clause.

Under such circumstances, the lender would have the right to call the entire loan due, which obviously would be a problem for you. Ask your lender if it would be willing to cooperate if given advance notice of these facts.

A third procedure is for you to set up a Subchapter S corporation, which is totally controlled and owned by you. You then sell the property to the corporation,

An example:

Your current house is worth $300,000. Your existing mortgage is about $100,000. You sell the property to the Subchapter S corporation for $300,000. The Subchapter S assumes the obligation of your current mortgage and gives you a second mortgage of $200,000.

A promissory note is signed by the Subchapter S corporation, whereby the Subchapter S agrees to pay you interest on the note until the property is sold. I suggest that a safe interest rate would be at least 9%.

The mortgage payments do not have to be monthly, and they can be payable yearly, or even when the house is ultimately sold. Make sure that the Subchapter S has adequate homeowner’s insurance in the event of a fire or other casualty.

If the Subchapter S ultimately sells the house for $300,000, it has made no profit. If, on the other hand, the Subchapter S sells the house for $350,000, then it will pay the capital gains tax on the $50,000 profit--but clearly the profit for the Subchapter S is much less than the profit you have made.

By conveying your property to a Subchapter S corporation, within the two-year mandatory time limitation, you have complied with the rollover requirements of the Internal Revenue Code.

A Subchapter S corporation should be set up by a lawyer; it will cost between $300 and $400, and can be done in a few days, generally.

Several years ago, the Internal Revenue Service indicated in a private letter ruling (No. 8350084, Sept. 13, 1983) that this would be an acceptable way of meeting the two-year requirement. While a private letter ruling is not binding on the IRS, it indicates the agency’s thinking process.

No one can guarantee what the IRS will do if it audits your transaction. However, since the concept has merit, and since the alternative is that you will have to pay the capital gains tax, it is a method worth exploring if you are running up against the deadline.